Kingspan Recommendation | SRTC Members Area!

Kingspan Group plc

Share price: €63.00

P/E: 32 (trailing 12 months)

Dividend yield: Cancelled due to uncertainty caused by Covid 19

Kingspan is fortunate to be in the right type of business at the right time, and management is absolutely making the most of it.

It has five segments to its construction business:- Insulated Panels, Insulation Boards, Light & Air, Water & Energy and Data & Flooring and the recent earnings per share growth has been very impressive. Fully diluted earnings per share (eps) for the year ended 31st December 2019 was up 11.5% at €2.03 compared to €1.82 for 2018. The 2018 eps was up 15.9% on 2017's figure of €1.57, which in turn was 10.5% higher than 2016's figure of €1.42.

Earnings per share growth of more than 10% per annum for the past few years, and sometimes far in excess of that, would seem to justify the high price to earnings ratio of 32 times. How is Kingspan managing to achieve such rapid earnings growth? A trawl through the annual report for 2019 indicates that this is mostly achieved by acquisitions.

Organic growth is much more preferable to growth by acquisition, but the former is quite rare in practice compared to the latter. Kingspan is borrowing money from investors by issuing loan notes, at very low rates of around 2% per annum. It does not have to make much in the way of a return from investing these funds in buying other companies, to generate growth. Providing of course, that interest rates remain very low, and that investors are prepared to back it.

It is likely that interest rates will remain at these extraordinarily low levels for another 5 to 10 years, in my opinion. Governments need very low interest rates to inflate their way out of the huge debt levels that arose from the financial crisis of 2008, on rescuing the banks. And just when they were making some progress in doing that, along comes another crisis, the Covid 19 crisis of 2020, and more borrowing is required, this time to counterbalance the economic damage done by the lockdown measures taken. So the low interest rate era looks like continuing for some time yet. The danger period will come when government debt falls to an acceptable percentage of gross domestic product (not by debt falling, but by debt staying at around the current level and gross domestic product increasing due to the various stimulus measures). This will at first seem like good news - a fall in national debt is surely good news? Not for the stockmarket! Why? Because the era of extraordinarily low interest rates will finally have come to an end.

Do not invest in Kingspan shares, unless you share my view that the era of very low interest rates has some way yet to run. That is why Kingspan, in my opinion, is the ultimate bull market stock. There will be little in the way of a safety net - for a company so heavily dependent on acquisitions to generate growth- when the bear market finally comes. Last time around, in 2008/2009, Kingspan shares nose-dived by 90%. We are probably looking at the same again, when the next bear market comes.

The other risk factor for Kingspan's growth by acquisition strategy, is that investors lose confidence in its ability to repay the debt level clocked up by issuing all of these bonds.

That is why the shares took a nasty knock back in March - April when the Covid crisis blew up. All of these bonds have redemption dates, and will investors happily roll-over in to more of the same for a paltry 2% pa, when construction is badly disrupted and cash flow dries up? No, is surely the answer to that. But luckily for Kingspan, the lockdown measures were gradually eased, and the crisis now looks to have abated.

Therefore, you should not invest in Kingspan shares if you believe that there will be a second wave of Covid 19 in late 2020/early 2021. My guess is that these fears are overplayed, and even if proven to be correct, the shock effect will be lesser this time around and we will to a large extent, learn to live with it, by wearing masks and social distancing etc. Furthermore, it is probably only a matter of time before an effective vaccine is developed.

Nothing too controversial to see, when one goes through the 2019 annual report, having first ploughed your way through all of the guff about "sustainability", protecting the planet, supporting local communities, employee welfare et al - this being a feature of many annual reports, not just Kingspan, in 2020. A few years back, it was all about "corporate social responsibility" or CSR for short.

All a load of meaningless bilge. Just for the laugh, I had a look at the 2016 annual report of Wirecard plc, the German company that has recently gone wallop, and was producing fraudulent accounts for the past few years. Yep, there it is...on page 29 (I didn't have to go too far!) a note on corporate social responsibility. In fact, these German boys were actually ahead of the game, because the next note is headed "sustainability strategy and management". Oh yes, they were terribly concerned about the environment... But they even go further, the next note is headed "responsibility for fundamental social rights and principles".... I kid you not! It is still up on-line, if you don't believe me, just search for Wirecard plc 2016 Annual Report..

This brings me to the newly created 'Sexton's Law':- 'The durability of a company is in inverse proportion to the amount of waffle in its latest annual report about sustainability'.

We'll move on. Nothing too controversial in Kingspan's annual report. The stock turnover is down slightly at 6.1 times for 2019, compared to 6.5 for 2018 and 6.44 for 2017, indicating that stock is taking a little longer to sell - but not so poor compared to prior years that it is an issue. You calculate this ratio by taking the cost of goods sold figure from the profit & loss account, and divide it by the average stock figure (stock per 31 Dec 2019 balance sheet + stock per 31 Dec 2018 balance sheet, divided by 2).

The net profit margin looks satisfactory at 8% of turnover. Looking at the segment reporting notes, it is still mostly all about those insulated panels for Kingspan. The insulated panels sales at €3 billion, represent 65% of total turnover of €4.6 billion. The operating profit margin on these is 10%, so the 'light & air' and 'data & flooring' business units with margins of 6.8% and 6.4% are dragging down the overall margin to 8%.

The segment reporting notes further breaks down the turnover between geographical areas. The Republic of Ireland is now only responsible for a paltry 3.77% of turnover. The UK represents 19% of turnover and the "Americas" 21%. That leaves a rather large 49% coming from "Rest of Europe" and 6.7% from other areas.

The segment reporting notes do not, however, show how much profit is generated in each of the above geographical areas. I wonder why? Could it be that one area which represents only a small percentage of turnover, is responsible for a disproportionally large percentage of profit? Therefore, this would be an embarrassing revelation as it would lead to media headlines about customers being "ripped off" in that geographical area.

I wonder which geographical area that is? All I will say is that competition law effectively started in the UK in earnest in 1948, with the introduction of the Monopolies Act. It took rather longer for this issue to be addressed here in Ireland, and a Competition Act was finally introduced in 1991 (with considerable opposition from the eminent Corkonian, Deputy Peter 'Tea Bags' Barry, according to an interesting Oireachtas report at the time, but I digress...).

This absence of a geographical breakdown of the profits earned, has rankled with some commentators in the past, who have voiced their objections. This has perhaps irked members of the board, as the relevant section in the annual report contains the rather pained statement that "no further disclosures are required with respect to disaggregation of revenue other than what is presented in this note".

Total long term debt as a percentage of equity looks reasonable at 41% as at 31 Dec 2019 (down from 55% in 2018).

There is of course, a whopping figure of €1.5 billion for goodwill on acquisitions in the assets per the balance sheet as at 31 Dec 2019. This is due to Kingspan's huge acquisition activity. It is an accounting figure representing the difference between the amount that Kingspan paid for the acquisitions, and the resulting net assets acquired.

There was a time when companies had to write off this goodwill on acquisitions figure over a period of 40 years, until the accounting standard was changed around 2004. It is rather sobering to consider that Kingspan would probably be reporting little or no growth in earnings, if this accounting standard were still in place, as it would be taking an extra yearly hit to its profits as a result of these write downs.

The accounting standard in place since 2004, allows companies to avoid writing down any of this goodwill on acquisitions figure, providing an 'impairment' test is satisfied. This means that the company estimates the annual cash flow that will be generated by its new acquisition in the coming years, and discounts this back to get a net present value. That net present value is the theoretical value of the new business it has acquired, so deduct the net assets acquired from that, and hope the resulting figure is higher than the goodwill figure on the balance sheet. Otherwise, a write down of goodwill is required.

If you didn't understand all of that, don't worry. I will summarise it for you. The 'impairment' test contains so many assumptions by management about future cash flows that it is almost meaningless. And by the time the management has decided it is time to make a huge write down of the goodwill figure, because many of the acquisitions are not performing as well as expected, it will then be far to late to sell the shares as they will have tanked.

I will say in Kingspan's defence however, that the 'impairment' test they have done on the goodwill figure seems more conservative than CRH's - Kingspan has applied a discount rate of 8.2% to the estimated future cash flows expected from its largest cash generating unit. This gives a lower net present value figure than CRH's discount rates of 6.6% to 8.7%. Also, there is more detail in Kingspan's annual report on this key item than in CRH's.

There was a bit of a bust up about director's remuneration (particularly pension contributions) at the 2019 annual general meeting. 23% of shareholders were opposed to the remuneration policy according to the annual report. There is a new chairperson of the remuneration committee, probably as a result of this kerfuffle. Discontent about excessive director's remuneration is not an issue confined to Kingspan - it is widespread in the market. At last, many billions of euro later, some of the large institutional shareholders are begginning to do something about this issue. Giving them some free tickets, and plying them with bolly at the rugby or the golf doesn't seem to work that well any more....

So Kingspan shares are likely to trade like a highly leveraged call warrant on the bull market, outperforming on the way up - but no hiding place when the roof caves in. There is a place for it in the high growth/high risk part of your portfolio, but some top-slicing in the event of outperformance would be prudent.