Bunzl’s inflation-proof credentials had been a big bull point for the distributor of everything. It was enough to convince investors to look past the fading Covid boom in sales of hygiene and personal protective equipment during the pandemic.
It can no longer rely on hoisting prices. Organic revenue declined 4.7 per cent during the third quarter, worse than the 0.4 per cent decline over the first half of the year and a miss against analyst forecasts. It means that achieving the 0.6 per cent growth forecast by analysts for the second half of this year will be a stretch. Revenue for the year is now expected to be “slightly lower” at constant exchange rates, rather than “slightly higher”. There are several impediments at play. One is the slow comedown in sales of cleaning and PPE products, which has weighed on annual growth since 2021.
Another is the fast fall in raw materials and freight cost inflation, which had proven a boon for Bunzl and its ability to pass on prices to customers. Analysts at Jefferies reckon inflation drifted down to 0 per cent in the third quarter. Then there are the challenges that come with a broader macro slowdown.
Disappointment is rare for Bunzl. The global distribution group has established a reputation as a steady cash compounder. But no company is immune to looming recession. The impact of the pandemic and price inflation on annual comparisons is expected to unwind at the end of this year. It should then become clearer how the underlying business fares in the downturn. Scepticism is high. The shares are priced at just 15 times forward earnings. Exclude the March 2020 pandemic crash and it leaves them valued at close to their decade low. Bunzl’s peak-to-trough decline in earnings during the 2008 financial crisis amounted to just 8 per cent. Apply a cut of that magnitude to next year’s earnings forecast and the shares would still trade at a forward multiple of just under 17, a discount to the long-running average. That leaves Bunzl a wide margin of error.
Scale is key: the idea is to be a one-stop shop supplying everything from first-aid kits to cleaning supplies and coffee cups. Customers pay Bunzl for the working capital benefit. There is an efficiency that comes with a supply agreement with a distributor, rather than holding the cost of products on their own books. It has big companies on its supply list, the largest being Walmart. But its customer base is highly granular.
Bunzl’s organic revenue growth has never been knockout. It broadly tracks GDP. The key ingredient is a bolt-on acquisition strategy, which has typically accounted for two thirds of revenue growth. Deals are small in size, filling in the gaps within its product ranges and geographical reach. It has a record of buying well. Over the past decade its return on invested capital has ranged between 14 and 18 per cent, easily outpacing a weighted average cost of capital of between 6 and 8 per cent.
The business model is not capital intensive, which makes it naturally cash generative. A further reduction in inventories over the first half of the year pushed free cashflow to £286 million. Weaker organic sales are a risk. But analysts estimate that free cashflow will average between £650 million and £750 million a year until at least 2027. Over the past five years that metric has ranged roughly from £400 million to £700 million.
The balance sheet is not overstretched either. At just over £1 billion, net debt stood at 1.1 times adjusted earnings before interest, taxes and other deductions, against a target ceiling of somewhere between 2 and 2.5. A focus on buying up higher-margin safety equipment suppliers means adjusted operating profits are still expected to be “moderately” up this year. In any case, Bunzl has a low bar to surpass.
ADVICE Buy
WHY The shares’ de-rating looks too severe given the long-term earnings potential
Softcat
Softcat is in a tight spot. Companies are becoming more cautious around their IT spend as the global downturn bites. The IT products and services seller has also just finished a year of heightened spending on hiring and overhauling its own data storage and analytics software. The question for investors is whether the FTSE 250 group can recoup its investment.
Growth in operating profit contracted to just under 4 per cent last year, compared with 14 per cent during the previous financial year. Headcount rose by just over 20 per cent, which together with investment in its own IT systems limited the gross profit that trickled down.
That was compounded by weaker hardware sales. Targeting devices such as laptops to companies ranging from SMEs to multinationals accounts for about a tenth of revenue. Customers are “sweating” that tech rather than upgrading, said Graham Charlton, the Softcat boss.
Investors have already positioned for lower growth. The shares trade at about twenty times forward earnings, less than half the 2021 peak and a discount to the ten-year average.
Easing cost growth should provide some relief. Headcount will rise by 10 per cent to 15 per cent, Charlton estimates. An IT systems upgrade is also complete. High levels of variable costs gives some protection against weaker sales. About 35 per cent of the costs that sit between gross and operating profits is staff bonuses.
Analysts expect operating profit to rise by about 10 per cent this year to £150 million. Gross profit, its preferred measure, is this year expected to be weighted more heavily towards the second half, purely the result of a stronger comparative in the first half of the year. Delayed progress naturally brings with it more risk around hitting the market’s expectations.
Softcat needs business to improve to make the outlay on expanding its workforce worthwhile. Analysts at Jefferies estimate that between 2020 and last year headcount has risen at a compound annual rate of about 13 per cent, versus a 3 per cent rise in gross profit per employee.
Until it can demonstrate better balance between sales and costs, Softcat may struggle to regain the confidence of investors.
ADVICE Hold
WHY Cheap valuation justified by weak near-term prospects
