Kerry Group plc
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5th August 2020
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Share price: €106.70
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P/E: 35 (trailing 12 months)
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The typical rule of thumb on the market is that for a company to qualify as being a 'growth stock', and therefore be deserving of a high price to earnings ratio, it needs to generate earnings per share (eps) growth of a minimum of 10% per annum. Kerry reports its full year results in February each year, and usually reports in or around 8% eps growth every time. This is a little short of what is required to be a growth stock per the above definition, but it is fairly close, and probably good enough in this era of extraordinarily low interest rates. I have often noticed that the shares drop back a bit in the few days after the results are announced, and just when I am saying to myself that the pull back in the shares looks justified because the earnings growth falls a little short of that required to justify such a high rating - they then go on a serious run upwards! Perhaps they have some key supporters in the Irish market, whose well timed purchases put a more positive complexion on the results...
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Or maybe, Kerry is just very good at presenting its investment case. The annual report certainly passes 'Sexton's Law' with flying colours. Sexton's Law says that the durability of a company is in inverse proportion to the amount of guff in the annual report about sustainability. But Kerry's note on sustainability is reasonably concise, and some concrete examples are given as evidence of same. So nothing contrived or duplicitous is evident there.
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The interim results for the 6 months ended 30th June 2020, were announced last Friday. Trading was affected by Covid 19 and revenues were down 4.3% and the adjusted earnings per share was down 19.8%. However, a significant improvement was noted in the second quarter, so providing there is no second wave of the virus, then this may only be a bump on the road to continued growth.
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Free cash flow did take a major hit, down a whopping 45%, from €195 million for the first half of 2019 to €107 million in the first half of 2020. Kerry explains this away as being working capital demands due to "supporting" customers during the covid crisis. In other words, their customers are a lot more sluggish in paying their bills this year. Again, probably a temporary setback and will be resolved when the world goes back to normal later this year (we hope). But it does show that Kerry Group is not a Covid 19 resistant stock.
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The Covid 19 crisis gives CEOs a free pass this year - poor results can be explained away by the crisis. Why not throw in a few extra provisions to more than cover any potential problems that might emerge in the coming years, and blame it all on Covid 19? You can then show some apparent growth in 2021 & 2022 by releasing some of these over-provisions... But in fairness to new CEO, Edmund Scanlon, he does not appear to have gone down that road. He does however see no need this year to classify some expenses as "non-trading" items, like he did last year, and thereby exclude these in calculating adjusting earnings per share. Why? Maybe because there was no pressure this time around to show earnings growth due to Covid 19.
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I am always somewhat suspicious of companies that announce "adjusted" earnings per share growth, and highlight this prominently in the results - while the basic earnings per share (which is calculated in accordance with the accounting standard) is hidden away in the small print. A handy accounting manoeuvre, if your shares are highly rated and you are struggling to show the required 10% eps growth, is to classify some of current year expenses as "restructuring" expenses and exclude these in calculating the "adjusted" earnings per share.
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Is that what Kerry was playing at last year? It is difficult to say for sure. Firstly, Kerry excludes the expense associated with the yearly write down of the brands on its balance sheet. OK, I can accept that as it is a non-cash item. What about all of the other expenses that Kerry included in "non-trading items" for 2019? These amounted to 51.9 cent per share, and are described as "integration costs of recent acquisitions" (in other words, restructuring expenses) and something called the "consumer foods re-alignment programme".
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So, in 2019, Kerry reported an increase of only 4.7% in the basic earnings per share, while the adjusted earnings per share (which excludes the above expenses) was up a much more respectable 8.3%. What effect does this have on the P/E?.....The basic earnings per shares for 2019 was €3.204, so on a share price of €109, this gives a P/E ratio of 34 times. Contrast that to the "adjusted" earnings per share for 2019 of €3.937, and this brings the P/E down to 27.7 times. A handy reduction, making the shares look less expensive. However, I have seen much worse than that, in terms of "aggressive" accounting, so not quite enough to wave a red flag.
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I had a look back at the 2018, 2017 & 2016 annual reports to check out the stricter basic earnings per share compared to its more flaky cousin, "adjusted" earnings per share (eps). In 2018, basic eps was up 8.3% compared to adjusted eps up 8.6%. Not much difference there, so nothing to warrant further investigation. In 2017, something rather peculiar happened - basic eps was up 10.1% whereas adjusted eps was up a lesser 9.4%, due to a rather esoteric accounting entry (the release of a deferred tax provision due to US tax changes). In 2016, basic eps was up a paltry 1.4% whereas the more optimistic adjusted and "constant currency" eps was up an impressive 12.3%. OK, in 2016 sterling 'fell out of bed' due to Brexit, so I suppose some allowance for that distortion is acceptable for that year.
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Perhaps there is a pattern here - that when basic earnings per share growth is up 8% or more (thereby just about fulfilling "growth" stock criteria), then there is no need to fool around with the adjusted earnings per share figure. But when the basic earnings per share growth is less than the above, then some expenditure is conveniently classified as "non-trading" and excluded from the more optimistic adjusted eps figure. Maybe - but in Kerry's defence, pretty much every growth company does likewise. Except for Big Tech - Big Tech does not need to do this because the growth is mostly organic, and not driven by acquisitions. In fact, Big Tech is trying to conceal its rapid earnings growth and lessen the political pressure for breakups due to market dominance.
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So does Kerry Group justify its high P/E ratio of around 35 times earnings? Just about, in my opinion. Kerry has two divisions, taste & nutrition (formerly called "ingredients") and consumer foods. The smaller consumer foods division has lower margins of around 7% compared to the higher margins of around 15% for taste & nutrition. The overall margin works out at around 12%, and this could be improved by selling the consumer foods division.
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Kerry depends on acquisitions for growth, and these are financed by debt. The net debt was €2 billion as at 31 December 2019, which was two times earnings before interest tax depreciation and amortisations (ebitda). That looks fairly reasonable. Servicing debt has got much cheaper in the past few years. In 2016, Kerry paid €70.4 million in interest costs on €1.323 billion of debt, which was a cost of around 5.3%. By 2019, the interest cost was down to €37.3 million on €2 billion of debt, being a much lower cost of 1.865%.
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This massive reduction in interest costs makes life much easier for a company like Kerry that depends on acquisitions for growth. Loan notes can be issued at lower and lower interest rates to investors desperate for yield. Kerry's return on capital employed is around 10% per the 2019 annual report. Raise funds by issuing loan notes yielding less than 2% and invest this in acquiring new businesses that will return close to 10% per annum, and the Kerry growth model will continue to thrive. The track record of making good acquisitions does provide comfort, but of course, like everything else, is not infallible. It is also in a business where there is a very high barrier to entry. High capital investment, specialist expertise and key relationships are all required for the worldwide supply of food ingredients, so it looks very unlikely that a new entrant will disrupt the incumbents.
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Kerry Group had a near miss in losing out to International Flavours & Fragrances (IFF) of New York, in buying the nutrition and biosciences business of Du Pont, at the end of last year. However, this does signify intent on the part of Scanlon, and the probability of making a large and successful acquisition in 2021 is greatly enhanced with the negligible funding costs available in this low interest rate era. Furthermore, when such an acquisition does happen, and this looks like only a matter of time, then tracker funds will have to scramble for more shares in this tightly held stock (12% held by Kerry Co-op plus 30% held by small private shareholders) as it will then form a much larger percentage of the ISEQ.
Finally, is this company good at what it does? Will it be wrong footed by changes in consumer taste, or structural changes in the industry? The 2019 annual report does highlight the changes that are occurring in the marketplace, indicating an urgency to stay one step ahead of the trend.
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Not cheap, but the current low interest rate environment is very favourable for acquisitive companies like Kerry, and shareholders are likely to benefit from an earnings enhancing major acquisition in the short term.