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Bangers and batteries

Albert Gubay, the billionaire the popular press labelled “Britain’s richest navvy”, made his fortune bringing no-frills supermarkets to the UK. His Kwik Save operation was the prototype for today’s Lidl or Aldi. When a gaggle of City fund managers once toured Kwik Save’s operations in 1970s Liverpool, a pin-striped slicker asked in the best Bertie Wooster tones: “Mr Gubay, to what do you owe your firm’s success?” Gubay took his arm, pointed to the tower block of council flats opposite and said: “See that. You’ve got a lorra lorra people up there – and they’re all eating.”

Chances are, many were – and still are – eating sausages. That means a lorra lorra emulsified offal and an equal amount of collagen casing to squeeze the stuff into. If you don’t want to think too deeply about the filling that goes into your British banger, votre saucisse de Toulouse or deine wienerwurst, you’ll want to pay even less attention to what makes the casing.

But the point is, the world loves sausages and you can’t have your sausage without its casing, which is where Devro (DVO) comes in. The Glasgow-based group claims to be a world-leading maker of sausage skins, with sales in over 100 countries and six processing plants spread across four continents. It should be the recipe for an outstanding business that Devro is so embedded in a consumer market that shows resilience in the developed world and sizzling growth in developing economies. Yet the group’s trading record and its share price history is more mash than bangers.

Revenue for the year just ended is likely to top £250m, but that will be just 4 per cent higher than Devro generated in 2012. Operating profit for 2021 is likely to be much the same as the £41m the group made in 2012 and EPS, at about 17p, would be 10 per cent lower. The dividend, which has been stuck on 9p for the three years 2018-20, will nudge up to perhaps 9.5p. That would compare with 8.5p in 2012, but the mystery is why the payout has not been cut in the intervening years as Devro’s bosses consistently recommended dividends – and shareholders approved – much higher than cash-flow generation justified. In the 10 years 2011-20, the company distributed £138m in dividends but aggregate group free-cash flow was only £71m. Hardly surprisingly, its net debt, which had been as low as £10m in 2010, was still £103m at 2021’s halfway stage; at least that was a third lower than its £152m peak in 2016. By that stage Devro was generating just £1.47 of revenue from every £1 of debt it borrowed compared with almost £12 of revenue per £1 borrowed back in 2010.

As a result, holding its shares has been a great way to lose money. Since the share price peaked almost nine years ago, it has lost almost 50 per cent to stand at its current 203p.

Still, that was then, this is now and, compared with recent years, Devro will show decent figures in its 2021 results due in early March; this, despite sterling’s strength, which will take about £3m off operating profit (about 80 per cent of Devro’s £250m revenue is made overseas). Crucially – and unlike some recent years – there should be little in the way of one-off charges to disrupt pre-tax profit or EPS. So City analysts expect about £42m of operating profit feeding through to around 17p of EPS.

The question is, will 2021 be typical of a revitalised Devro or will the pattern of 2013-20 reappear? In that period, Devro generated £316m operating profit, producing an average profit margin of 16 per cent. That gives the appearance of a business with pricing power and the resilience to cope with tough trading. The problem is during that period one-off charges became so normal that Devro’s former bosses clocked up £138m of them, which left the pre-tax margin looking an ordinary 5.5 per cent.

With production plants in Scotland, the US and China rationalised, the hope is Devro can now turn rising demand for sausages in emerging markets into profits growth. Its bosses reckon that market volumes in emerging economies will grow by 6-10 per cent a year, while in mature economies growth will top out at 2 per cent a year. With group sales split roughly one-third emerging markets, two-thirds mature markets, that indicates Devro’s sales volumes could typically grow by about 3 per cent or so a year. In addition, Devro should gain from the trend that favours sausage skins from collagen casings rather than gut. Back in 2010 collagen casings, which are made from animal skin, accounted for 33 per cent of sausage casings but their share had risen to 46 per cent by 2020.

Put all of this together and what have we got? Interestingly, capitalising accounting profit or free cash flow tell very different stories. The accounting-profit narrative assumes that inconvenient one-off charges no longer get in the way and ends with Devro’s shares being worth about 240p each. The free-cash-flow narrative, which fully accounts for all cash costs, comes up with much less – about 160p per share. An intuitive, but unscientific, splitting of the difference gets us almost exactly to the current share price.

This might be just as well since Chart 1 does not show Devro’s shares as being obviously cheap. This chart – and Chart 2 for Johnson Matthey (JMAT) – compares the dividend yield with its average over the past 10 years and with the average plus and minus one standard deviation (a measure of dispersion around the average). The idea is that, as the yield rises, then, other things being equal, a company’s shares become more attractive. And they are in buy territory when the yield exceeds the average plus one standard deviation, a level which, if values are normally distributed around their average, will occur about one-sixth of the time.

Devro’s excess yield seems biased towards the high end. That may not matter much because the current yield is not in buy territory anyway. Meanwhile, the yield on Johnson Matthey shares is very much in buy territory. The shares, which have been highly rated over the years, have an average yield for 2012-22 of only 2.6 per cent with limited movement around that. So anything a bit above 3 per cent prompts a buy signal.

One snag is that with both Devro and Johnson Matthey the long-term trend in the yield is upwards. This suggests both groups are in slow decline – Matthey because the end has been signalled for its main cash generator, making catalytic converters for internal combustion engines; Devro because it can’t compete with bigger, better diversified rivals in the collagen market.

True, Johnson Matthey’s bosses protest that the internal combustion engine will be around for many years, especially to power trucks and buses where zero-emissions technologies still struggle. Even so, within the group there is something of a race against time for the cash generated from its Clean Air division – expected to be at least £4bn over the next 10 years – to fund enough successful research and development (R&D) that Johnson Matthey can continue to make a living from metals chemistry for decades to come. For a group whose capital spending is running at over £300m a year, with R&D absorbing another £150m annually, £4bn-plus will go a fair way. That said, the cost of finding new profit streams implies less cash going to shareholders and – other things being equal – that must make the company’s equity less valuable.

Besides, the scale of the task is formidable, as was made clear by the decision to abandon development of the high nickel cathodes operation, dubbed eLNO. The resources devoted to eLNO were considerable – as was management’s confidence in the project – so scrapping the plan to become a player in electric-vehicle batteries was a big blow.

The shares have paid the price. At 1,952p, they are almost 30 per cent lower than the price immediately before November’s decision and nearly 50 per cent below mid-2018’s all-time high. Simultaneously, City analysts have become unusually bearish. Out of 18 analysts known to have updated their recommendations since the announcement, just five rate the shares a buy. For scribblers whose jobs are shaped by keeping good relations with the companies they cover, that’s a really low ratio.

Paradoxically, it fosters the notion that there is now more upside than downside in the share price. It is not just that analysts are often much better at understanding the companies they cover than calling the share prices. It also implies that the bad news is baked into the share price while the good news isn’t in the mix.

Still, before I decide which new holdings will go into the Bearbull Income Fund, there are other candidates to consider; in particular, construction engineer Severfield (SFR) and retailers Topps Tiles (TPT) and Kingfisher (KGF). More on that, next week.