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Johnson Matthey's auto risks overplayed

Shares in Johnson Matthey have lagged the FTSE 100 over the past 12 months, but fears over changes in its key market have been overdone
August 31, 2017

Whatever the cause of climate change, what seems obvious is that it is the rate of change, rather than change per se, that represents the overriding risk. This also applies to technological change within industry. There are many examples of how the rapid introduction of technology has had a devastating effect on companies that failed to appreciate their impact – just think of Eastman Kodak and the arrival of digital photography.

IC TIP: Buy at 2779p
Tip style
Value
Risk rating
Medium
Timescale
Long Term
Bull points

Long established business credentials

Investment in new technologies

Limited competition in key market

Bear points

Exposure to automotive market trends 

UK commitment to electric motoring

Now, with the UK joining the likes of France and Norway in committing to phase-out the internal combustion engine, analysts have been focusing on valuations for companies whose business model is reliant on existing automotive technologies. Johnson Matthey (JMAT) is one company to come under scrutiny as it derives around three-fifths of its revenue from the sale of emissions control technology. Its share price has contracted by 13 per cent over the past 12 months, in contrast to an 8 per cent rise in the the FTSE 100 index. But we feel that the relative underperformance is unjustified given how events are unfolding.

The publication of full-year figures failed to galvanise the share price even though the return on invested capital increased by almost a percentage point; although operating profit was flat using constant-currency exchange rates. And although management guided for a 6 per cent increase in constant-currency sales in 2017-18, the shares now trade 7 per cent below their 300-day moving average. The upshot is that Johnson Matthey is rated significantly below its historic average across a range of measures. In particular, its enterprise value (equity plus net debt) is 8.6 times cash profit. That means Johnson Matthey is trading at a 7 per cent discount to peers on that measure, in contrast to a five-year historic premium of 12 per cent. A reversion to the historic average implies that the share price would rise by around a fifth.

On the face of it, analysts are right to question the long-term viability of the business model but, again, the rate of change is central to considerations. There’s no doubt that the FTSE 100 constituent looks vulnerable as it’s one of the world’s biggest producers of catalytic converters: an emissions control device that converts toxic exhaust gases to water. Fully electric vehicles don’t need catalytic converters and, if they took off rapidly, it would leave Johnson Matthey’s catalyst technology high and dry. But how likely are we to witness a rapid transition to electric motoring?

The public commitments by both French and UK poliiticians were suitably vague; a cynic might point to a degree of political opportunism – it’s easy for politicians to make commitments for which they’ll probably never be held accountable. The countries now have a decade or two to surmount the enormous technical and logistical challenges before widespread – perhaps ultimately universal – electric motoring becomes a reality. How many extra power stations the UK will need to power its 25.8m private vehicles is anyone’s guess.

Nevertheless, electric motoring is already a reality, even though its eventual share of the automotive market is difficult to predict. Yet Johnson Matthey is looking to profit from its expansion through its Battery Materials business, which hit break-even for the first time in 2015-16, and, besides, its activities have done plenty of evolving over the company's 200-year history. The group invested over £440m in capital expenditure and R&D combined in the year through to March 2017. It is already a major supplier of lithium iron phosphate cathode materials for light and heavy-duty vehicles.

Electric motoring aside, analysts have also been concerned about the knock-on effects of the Volkswagen diesel scandal on Johnson Matthey. After the news broke in September 2015 it wasn’t immediately obvious what the effects would be on auto-industry suppliers.  But a recent note from Bernstein Research said the risks surrounding a phase-out of diesel cars in Europe had been “blown out of proportion”. Public disquiet over the levels of nitrogen oxide emissions have given way to a tightening of regulatory measures across the automotive industry, while manufacturers, including Ford, Vauxall and BMW, have introduced new ‘scrappage schemes’, providing financial incentives for owners of older vehicles to trade up to newer cleaner vehicles.

JOHNSON MATTHEY (JMAT)  
ORD PRICE:2,779pMARKET VALUE:£5.38bn
TOUCH:2,777-2,779p12-MONTH HIGH:LOW: 2,702p
FORWARD DIVIDEND YIELD:3.1%FORWARD PE RATIO:13
NET ASSET VALUE:1,156p**NET DEBT:32%
     
     
Year toTurnoverPre-taxEarningsDividend
31 Mar(£bn)profit (£m)per share (p)per share (p)
201510.1049621168.0
201610.7138616671.5 †
201712.0346220175.0
2018*12.9341717980.0
2019*13.4851322085.0
% change+4+23+23+6
Normal market size:750   
Matched bargain trading    
Beta:1.34   
*JPMorgan Cazenove forecasts **Includes intangible assets of £895m, or 463p a share. †Excludes special dividend of 150p