Ian Lance

Ian Lance

Portfolio manager

In for free

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Some of our most successful investments have been ones in which sentiment towards a company becomes so negative, that the valuation ends up making no sense versus the worth of its various parts. Sometimes this is so extreme that you can buy a business where one part of it is worth more than the valuation of the entire group and so in effect, you are getting the other parts ‘for free’.

In yet another example of how irrational the valuations of companies suffering temporary earnings declines have become, we believe the market today is offering a number of opportunities to buy companies where you are getting part of it for nothing.

Below are six examples:

Royal Mail

RMG owns a European parcels business, GLS, which makes a 6-7% margin in a normal market environment and which has grown at mid to high single digit (benefitting from structural growth of online retail). In 2019, GLS made an operating profit of £180m and is therefore worth c.£2b if we put it on a multiple of 11x. The current market cap of the entire group is £1.7b and therefore the UK business is not just in for free but actually valued at -£300m.

BT

BT’s Openreach division generates £2.6b of Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) which we have valued at £22b. This represents a multiple of just over 8x historic EBITDA which compares favourably with other utilities and therefore ought to be achievable. The enterprise value[1] of the entire group is currently £31b meaning that all the other businesses are being valued at £9b, which is only 3x their historic cash EBIT of £2.8b. Rumours surfaced in the last weekend’s Financial Times that BT might be about to monetise a stake in Openreach.

Marks and Spencer

Marks and Spencer have a food retail business which makes £237m of Earnings Before Interest and Tax. If we value this at 12x historical EBIT, add their £750m investment Ocado at cost (less the future performance payments), take away net debt and give no benefit for the company’s freehold property, the total is around £2.0b, which is in line with today’s market cap. The entire clothing and home business, which is still the largest clothes retailer in the UK and which last year made a profit of £224m, is therefore in for free.

ITV

ITV is, in effect two business; broadcasting which is very reliant on advertising revenue and content production. In 2019, the content production business made EBIT of £267m and we might value this at around £3.5b (13x EBIT). The enterprise value of the entire group is £3.8b meaning that the broadcast business which last year made c.£500m of EBIT is being valued at around £300m in the stock market. Another way to think about this is that companies like Netflix spend around $15b a year on content production; for a fraction of this, they could have ITV’s entire back catalogue and all future content.

Capita

Capita has a software business which made just over £100m of EBIT in 2019. As these businesses are high margin (28% in this case) they tend to be valued quite highly. Using a multiple of 15x(which would be the low end of their peers) would value this division at £1.5b which is not far short of the enterprise value of the entire group of less than £2b. The rest of the businesses, which in 2019 made around £200m are thus only being valued at around 2x EBIT.

Each of these companies has a strong franchise within them that is being undervalued by a market that is fixated on short-term earnings momentum and hence creating some genuine bargains in the market today.

[1] Enterprise Value is a measure of a company’s total value, often used as an alternative to equity market capitalization. Enterprise value includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company’s balance sheet. The formula for Enterprise Value is Market cap – cash and cash equivalent + short-term and long-term Debt.

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. This article does not constitute investment advice and the names shown above are for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. Forecasts and estimates are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. The forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment

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