Croda International (CRDA) has proven to be a very dependable share over the past decade and has handsomely rewarded its investors. Its business model ticks a lot of boxes in terms of what it does and the high returns it generates. This has led its shares to become highly valued by the stock market. That it is a good business is not in question, but unless its profits can keep on growing the high valuation attached to its shares looks unwarranted. Recent results suggest that the company has some work to do to keep shareholders happy.
A very good business
Croda is a speciality chemicals business. Its aim is to create products and ingredients that improve the quality and performance of its customers products. For example, an ingredient that creates a high-performance skin cream, better sun protection, or something that allows a farmer to get more crops from a field or a drug or vaccine to work better.
It is these products that make Croda an essential part of its customers’ business. By offering them something that allows them to differentiate their products from their competitors’ products, Croda can create value for them and get paid handsomely for it. Croda acts as both a problem solver and a product enhancer and is therefore the kind of business that can do things that others find hard to copy – the kind of business that often makes a very good investment.
Croda is also a little bit different from other speciality chemicals business in that it is not overly dependent on crude oil to make its products. A large proportion of its raw materials come from natural and renewable resources. This not only fits the growing trend for more environmentally friendly sourced products but also means the company is not under lots of pressure to change its selling prices when the oil price changes.
The company’s business model has many similarities with the one used by Spirax-Sarco (LSE:SPX) with excellent returns. Croda has a direct selling model – it does not use middlemen – and places a lot of emphasis on integrating itself with its customers’ business and building long-term relationships with them. It supports them with sales and technical support as well as warehousing close to their businesses. The company has many customer innovation centres across the world to develop new products that help both parties to keep on growing.
Croda operates a value over volume business model. It will not chase market share at the expense of financial returns. In some ways this is encouraging but you can’t help wondering if it is an approach that leaves some parts of its business vulnerable to competition with its prices being undercut by rivals.
In recent years, Croda has spent a lot of time increasing the proportion of its sales that come from new and patent protected (NPP) products which account for just over 28 per cent of total sales and allow it to earn higher profit margins.
Most of the company’s sales are made outside of the UK which means that it has been a big beneficiary from the weaker pound in recent years.
Croda’s business is split into three core areas:
- Personal care
- Life sciences
- Performance technologies
Personal care
This division is Croda’s biggest source of profits and where it earns its biggest profit margins. Its customers include some of the biggest health and beauty companies in the world. Croda supplies them with ingredients from natural plant sources that go into premium skin care and sun protection products and colour cosmetics.
The business has been doing well as it is tapped into the growing trends of premiumisation and more ethically and sustainably sourced products. Over 40 per cent of its products are in the NPP category.
Personal Care (£m) | 2014 | 2015 | 2016 | 2017 | 2018 | TTM |
Sales | 369.1 | 377.3 | 420.6 | 466.6 | 487.8 | 486.9 |
Op Profit | 117.3 | 124.5 | 143.1 | 155.5 | 160.3 | 158 |
Op margin | 31.8% | 33.0% | 34.0% | 33.3% | 32.9% | 32.5% |
Source: Annual report
Profits have stagnated somewhat during the first half of 2019 despite the skin care business doing well. Customers have cut their stocks due to the uncertainty of tariffs from the ongoing trade dispute between the US and China.
Croda will be hoping that this effect is short-lived and that stocks will have to be rebuilt in the second half of 2019.
Life sciences
This business makes products that are used in healthcare and agriculture markets. In healthcare, Croda makes products that allow better delivery of drugs and vaccines to patients to improve their efficiency.
It has a sizeable agricultural business specialising in crop protection that keeps crops free from weeds, pests and fungi. Its seed enhancement business is all about boosting the yields that farmers get from their crops - a business that looks to be well supported by the need to feed a growing population from smaller bits of agricultural land. That said, the business has historically been volatile, depending on trends in agricultural demand and supply.
Life Sciences (£m) | 2014 | 2015 | 2016 | 2017 | 2018 | TTM |
Sales | 204.5 | 231.3 | 292.2 | 322.6 | 324.5 | 350.2 |
Op Profit | 64.7 | 76.2 | 82 | 97 | 95.8 | 104.8 |
Op margin | 31.6% | 32.9% | 28.1% | 30.1% | 29.5% | 29.9% |
Source: Annual reports
This business is performing very well at the moment and saw strong growth in profits during the first half of 2019. As you can see, it is also a business that has consistently earned very high profit margins.
Performance technologies
This is the most economically cyclical part of Croda’s business. It focuses on energy technologies such as additives for lubricants that go into engine oils to improve engine efficiencies and reduce emissions. It also produces special waxes that help oil flow more easily through pipelines.
Croda also makes smart materials such as fibre protection for clothes and special chemicals that go into industrial and home cleaning products.
Performance Technologies (£m) | 2014 | 2015 | 2016 | 2017 | 2018 | TTM |
Sales | 355.2 | 354.8 | 405.6 | 456.9 | 456.4 | 447.3 |
Operating profit | 63.8 | 56.8 | 66.6 | 75.4 | 85.2 | 80.4 |
Operating margin | 18.0% | 16.0% | 16.4% | 16.5% | 18.7% | 18.0% |
Source: Annual reports
Soft demand in the automotive sector has seen profits go backwards in this business during the first half of 2019.
Consistently high margins and returns on capital but patchy free cash flow performance
Croda has proven to be a very resilient and, up until recently, growing business. Its profits held up very well during the last recession, which is a good indicator as to how it might weather a future downturn. It is not totally recession proof given its exposure to automotive markets. Its sales to high value consumer beauty products could leave it vulnerable to trading down in a recession.
Croda historical performance
Year (£m) | Sales | Operating profit | Capital employed | Free-cash-flow | Operating cash flow | Profit after tax |
TTM | 1,398.8 | 343.4 | 1,708.6 | 185.8 | 359.5 | 246.6 |
H119 | 714.7 | 179.4 | 1,708.6 | 94.2 | 181.8 | 128.3 |
2018 | 1,386.9 | 342.5 | 1,670.4 | 159.5 | 331.7 | 249.9 |
H2 18 | 684.1 | 164 | 1,670.4 | 91.6 | 177.7 | 118.3 |
H1 18 | 702.8 | 178.5 | 1,517.4 | 67.9 | 154 | 131.6 |
2017 | 1,373.1 | 332.2 | 1,414 | 103.8 | 359.3 | 234.4 |
2016 | 1,243.6 | 298.2 | 1,258.5 | 158.4 | 345.1 | 207.6 |
2015 | 1,081.7 | 264.2 | 1,070 | 114.8 | 282.1 | 183.5 |
2014 | 1,046.6 | 248.4 | 899 | 110.6 | 233.3 | 169.6 |
2013 | 1,077.0 | 264.6 | 851.8 | 146.4 | 251.1 | 178.8 |
2012 | 1,051.9 | 255.4 | 834.8 | 87.1 | 207.3 | 161.9 |
2011 | 1,028 | 237.7 | 805.4 | 106.6 | 232.7 | 167.5 |
2010 | 1,001.9 | 198.6 | 768.1 | 91.3 | 188.4 | 128.9 |
2009 | 827.5 | 121.5 | 758.8 | 115.7 | 196.9 | 68.1 |
2008 | 956.4 | 114.7 | 892 | 6.6 | 120.8 | 69.8 |
2007 | 804.8 | 83 | 790.5 | -91.2 | -15.2 | 50.1 |
The reason why investors have come to see Croda as such as high quality and dependable business has been the consistently high profit margins and ROCE the business has produced in recent years.
Croda financial returns
Croda | Operating margin | cash conversion | Free-cash-flow conversion | ||
TTM | 24.5% | 20.1% | 13.3% | 105% | 75% |
2018 | 24.7% | 20.5% | 11.5% | 97% | 64% |
2017 | 24.2% | 23.5% | 7.6% | 108% | 44% |
2016 | 24.0% | 23.7% | 12.7% | 116% | 76% |
2015 | 24.4% | 24.7% | 10.6% | 107% | 63% |
2014 | 23.7% | 27.6% | 10.6% | 94% | 65% |
2013 | 24.6% | 31.1% | 13.6% | 95% | 82% |
2012 | 24.3% | 30.6% | 8.3% | 81% | 54% |
2011 | 23.1% | 29.5% | 10.4% | 98% | 64% |
2010 | 19.8% | 25.9% | 9.1% | 95% | 71% |
2009 | 14.7% | 16.0% | 14.0% | 162% | 170% |
2008 | 12.0% | 12.9% | 0.7% | 105% | 9% |
2007 | 10.3% | 10.5% | -11.3% | -18% | -182% |
Source: Annual reports
Its profit margins have been transformed over the last decade and have been remarkably consistent at a very high level. These high margins and ROCE of over 20 per cent are the hallmarks of a very high quality business. The free cash flow performance as evidenced by the free cash flow margin has been a bit patch as the company has invested in the business.
ROCE has come down in recent years as the company has been a buyer of businesses. The capital invested in the business has almost doubled since 2014 and whilst the extra profits and free cash flow generated since then has been good, the ROCE has been more modest.
Post-2014 returns
£m | Sales | Operating profit | Capital employed | Free-cash-flow | Operating margin | Return on capital employed | Free-cash-flow margin |
Additional Since 2014 | 352.2 | 95 | 809.6 | 75.2 | 27.0% | 11.7% | 21.4% |
Source: Annual reports/Investors Chronicle
The company’s financial position is very strong, with debt levels at a very comfortable level even after special dividends have been paid in recent years.
Where’s the growth going to come from?
I like a lot of what I see with Croda, its products and the way it does business. The one thing that worries me is its ability to keep on growing its profits. 2018 saw a slowdown in profits growth while the first half of 2019 saw no profits growth at all. The second half is expected to see a slight pick-up, but I can’t help questioning whether analysts’ forecasts for operating profits (EBIT) in 2020 and 2021 are too high given the somewhat muted outlook statement in the company’s recent half-year results.
Croda forecasts
Year (£m) | 2019 | 2020 | 2021 |
Turnover | 1,414.40 | 1,469.70 | 1,528.30 |
EBITDA | 410.6 | 438.9 | 463.3 |
EBIT | 349.7 | 375.4 | 398.2 |
Pre-tax profit | 333.9 | 357.8 | 381.3 |
Post-tax profit | 251 | 269.8 | 287 |
EPS (p) | 190.6 | 204.8 | 218.6 |
Dividend (p) | 89.6 | 112.8 | 130.7 |
CAPEX | 80.7 | 81 | 82.7 |
Free cash flow | 227.1 | 245.6 | 264 |
Net borrowing | 506 | 420.2 | 343.7 |
Source: SharePad
When it comes to making money from shares growth matters. Without meaningful profit growth, it is usually difficult to make money unless the company gets taken over.
This issue becomes even more important when a company’s shares are highly valued as Croda’s are. At a share price of 4614p, they trade on a one year forecast rolling PE of 23.2 times. My view is that you need to be growing profits by high single digit percentages for a good few years to warrant a valuation like this. I’m not sure that Croda is capable of doing so.
For me, Croda may have become what I have recently termed a “quality trap”. The flocking of investors to shares of businesses that are earning high profit margins and ROCE backed by reasonable free cash flow generation has pushed up their valuations - perhaps by too much. Quality is all well and good and provides a degree of security but without growth it is almost irrelevant if you want to make money. Without growth, you are arguably left owning a slice of an overvalued business which makes you very vulnerable to losses if trading deteriorates.
So how is Croda going to start growing again?
It looks as if doing so is going to be quite tough, at least in the short run.
Its US and Asian Personal Care businesses are expected to keep on going through a bit of a soft patch, as is the Performance Technologies business. The good news is that the health and crop business is expected to keep on growing but that overall growth for Croda is uncertain.
The company is putting its faith in new products and technologies that exploit current megatrends. It has new capacity coming on stream in the US to replace petrochemicals with biosurfactants and new marine and plant raw materials to go into its personal care products which should increase the attractiveness of its products. It also has new lubricant technologies that can extend the lifespan of wind turbines.
These developments mean that it has a good pipeline of new valued added and high margin products, but when these actually turn into sales and profits is uncertain. That is not what Croda’s share price and high valuation needs right now. I find it hard to envisage the shares going up much in the short term and see quite a bit of downside risk.
