Commentary
Ryanair (European airline) reported strong full-year results during the quarter with passenger numbers, revenue and profit all rising significantly. However, CEO Michael O’Leary said that while demand for the summer season remained positive, recent pricing was ‘softer’ and that ticket prices for its peak season may be flat to modestly ahead of the previous summer. This, combined with additional delivery delays for new aircraft from Boeing, came as a near-term disappointment. We believe the longer-term investment thesis remains fully intact: Ryanair is a low-cost airline that will increase passengers flown as a result of expanding its fleet and by taking market share, leading to growing profit and strong free cash flow generation (despite the on-going investment). The company has a very strong balance sheet (net cash position), recently announced a €700m share buyback (c. 3.5% of market cap) and has started paying a dividend (2.9% yield). The shares trade on a forward price-to-earnings multiple of 8x vs. their historical average of 13x.
Portfolio Activity
During the quarter we initiated positions in Winpak and Whitbread. We reduced the holdings in Fairfax, JD Wetherspoon and Lloyds Banking Group to fund these purchases.
Winpak is a Canadian packaging company that was founded in 1978. Winpak operates twelve manufacturing facilities across North America, producing flexible packaging, rigid packaging and packaging machinery. More than 90% of revenues are to food & beverage end-markets (mostly perishable foods). 80% of revenues are from specialised products where they are the #1 or #2 player.
Customers choose Winpak because of product quality, reliability and service. Their relatively small size positions the company to focus on more specialised and low-volume products, respond more quickly to opportunities and offer more bespoke service than its larger competitors. The customer base is well diversified with the largest customer being less than 10% of revenues and the second largest less than 5%. Customer relationships are generally very sticky due to high switching costs.
Winpak’s packaging verticals have historically been very predictable and non-cyclical. Since 1998, the biggest revenue decline was 2% in 2020 and 1% in 2009. Over the last 20 years, they have grown volumes ~4% p.a. In the future, management are targeting volume growth of 3-6% p.a. and earnings growth to exceed revenue growth. Return on operating capital employed averaged an attractive 19% over the last 10 years.
Winpak has no debt and US$550m in cash, which is nearly 30% of its market capitalisation. The company has historically returned cash to shareholders through special dividends. In addition, Winpak announced a buyback in February, the first time in its 46-year history.
There has been much debate about the role of plastic as society moves to more sustainable packaging. Currently plastics play an important role in preserving the freshness of food and beverages hence reducing waste, and Winpak’s 13-layer film technology is at the leading edge of this innovation. By 2025, Winpak is focused on offering a recycle-ready solution for all products and longer-term, is exploring renewable materials made of natural fibres or organic by-products.
The valuation has derated from 12-14x EV/EBIT historically to 8x currently. We believe this is too cheap for a simple, non-cyclical business with a strong track record, high returns on capital, excellent balance sheet and significant insider shareholders. We see annualised returns in the teens based on conservative assumptions.
Whitbread operates budget hotels under the Premier Inn brand across the UK and Germany. It also operates a number of restaurant chains, many of which are located next to their hotel sites.
The UK is the company’s most important market, accounting for 86% of rooms. Whitbread entered the UK hotel market in 1987 and today they are the largest player with a market share of 12%. The UK is an attractive market with many weak competitors and difficulty to add supply given limited availability of land and restrictive planning processes. The pandemic, interest rates and cost inflation hit the competition hard, with supply now 5% below pre-COVID levels. Supply is set to remain below 2019 levels until at least 2028.
Within the UK market, Premier Inn has some additional competitive advantages. Firstly, it operates a non-franchised business, allowing it to have a simple operating model and consistency across sites. Secondly, it has scale over independents which create benefits on purchasing and distribution. Thirdly, and most importantly, 97% of bookings come directly from its website, saving fees to third-party distributors like Booking.com. It is easy to see why Premier Inn wins when most competitors pay 10-20% of a room’s nightly rate to third-party distributors and perhaps another 5% in franchise fees. The company’s most serious low-cost competitor is Travelodge which enjoys many of the same benefits as Premier Inn. However, another key difference is that Premier Inn owns the real estate at half of their hotels while Travelodge leases all of theirs and have substantial financial leverage over and above the leases.
Premier Inn’s attractive market position is reflected in pre-tax return on capital which has averaged 13% over the last decade, excluding the COVID years. The main challenge for the UK business is finding new opportunities to deploy capital, but the company believes that there is still space to expand the number of rooms by over 45% in the medium-term.
The German business is smaller but an important source of growth. Premier Inn have deployed c.£500m into the market and expect to increase this to £1.1bn in the next few years. The business is expected to reach run-rate break-even this year. The opportunity in Germany is vast, with the market 40% bigger than the UK, but having no clear market leader, with the largest
Commentary
Quarterly Portfolio Performance
The fund fell 1.0% in the second quarter of 2024 while the MSCI EAFE Index fell 0.4%. The largest contributors to the fund return in the quarter are shown in the table below.
Commentary
Allison Kirkby, the new CEO of BT Group (UK telecoms), suggested that normalised free cash flow in 2030 would be double the current level. This significant increase is primarily driven by falling capital expenditure. The adjusted free cash flow forecast of £3 billion in 2030 compared with a market capitalisation prior to the announcement of just £10bn, highlighting the significant value in the shares. We see fair value at over 200p, providing potential upside of over 40%. In addition, the shares are offering a dividend yield of over 5%, based on a dividend that has now returned to growth. Others also clearly recognise the value of BT with three industry operators (Deutsche Telekom, Altice and Carlos Slim) now holding sizeable investments in BT.
The largest detractors to the fund return in the quarter are shown in the table below.
Commentary
Ryanair (European airline) reported strong full-year results during the quarter with passenger numbers, revenue and profit all rising significantly. However, CEO Michael O’Leary said that while demand for the summer season remained positive, recent pricing was ‘softer’ and that ticket prices for its peak season may be flat to modestly ahead of the previous summer. This, combined with additional delivery delays for new aircraft from Boeing, came as a near-term disappointment. We believe the longer-term investment thesis remains fully intact: Ryanair is a low-cost airline that will increase passengers flown as a result of expanding its fleet and by taking market share, leading to growing profit and strong free cash flow generation (despite the on-going investment). The company has a very strong balance sheet (net cash position), recently announced a €700m share buyback (c. 3.5% of market cap) and has started paying a dividend (2.9% yield). The shares trade on a forward price-to-earnings multiple of 8x vs. their historical average of 13x.
Portfolio Activity
During the quarter we initiated positions in Winpak and Whitbread. We reduced the holdings in Fairfax, JD Wetherspoon and Lloyds Banking Group to fund these purchases.
Winpak is a Canadian packaging company that was founded in 1978. Winpak operates twelve manufacturing facilities across North America, producing flexible packaging, rigid packaging and packaging machinery. More than 90% of revenues are to food & beverage end-markets (mostly perishable foods). 80% of revenues are from specialised products where they are the #1 or #2 player.
Customers choose Winpak because of product quality, reliability and service. Their relatively small size positions the company to focus on more specialised and low-volume products, respond more quickly to opportunities and offer more bespoke service than its larger competitors. The customer base is well diversified with the largest customer being less than 10% of revenues and the second largest less than 5%. Customer relationships are generally very sticky due to high switching costs.
Winpak’s packaging verticals have historically been very predictable and non-cyclical. Since 1998, the biggest revenue decline was 2% in 2020 and 1% in 2009. Over the last 20 years, they have grown volumes ~4% p.a. In the future, management are targeting volume growth of 3-6% p.a. and earnings growth to exceed revenue growth. Return on operating capital employed averaged an attractive 19% over the last 10 years.
Winpak has no debt and US$550m in cash, which is nearly 30% of its market capitalisation. The company has historically returned cash to shareholders through special dividends. In addition, Winpak announced a buyback in February, the first time in its 46-year history.
There has been much debate about the role of plastic as society moves to more sustainable packaging. Currently plastics play an important role in preserving the freshness of food and beverages hence reducing waste, and Winpak’s 13-layer film technology is at the leading edge of this innovation. By 2025, Winpak is focused on offering a recycle-ready solution for all products and longer-term, is exploring renewable materials made of natural fibres or organic by-products.
The valuation has derated from 12-14x EV/EBIT historically to 8x currently. We believe this is too cheap for a simple, non-cyclical business with a strong track record, high returns on capital, excellent balance sheet and significant insider shareholders. We see annualised returns in the teens based on conservative assumptions.
Whitbread operates budget hotels under the Premier Inn brand across the UK and Germany. It also operates a number of restaurant chains, many of which are located next to their hotel sites.
The UK is the company’s most important market, accounting for 86% of rooms. Whitbread entered the UK hotel market in 1987 and today they are the largest player with a market share of 12%. The UK is an attractive market with many weak competitors and difficulty to add supply given limited availability of land and restrictive planning processes. The pandemic, interest rates and cost inflation hit the competition hard, with supply now 5% below pre-COVID levels. Supply is set to remain below 2019 levels until at least 2028.
Within the UK market, Premier Inn has some additional competitive advantages. Firstly, it operates a non-franchised business, allowing it to have a simple operating model and consistency across sites. Secondly, it has scale over independents which create benefits on purchasing and distribution. Thirdly, and most importantly, 97% of bookings come directly from its website, saving fees to third-party distributors like Booking.com. It is easy to see why Premier Inn wins when most competitors pay 10-20% of a room’s nightly rate to third-party distributors and perhaps another 5% in franchise fees. The company’s most serious low-cost competitor is Travelodge which enjoys many of the same benefits as Premier Inn. However, another key difference is that Premier Inn owns the real estate at half of their hotels while Travelodge leases all of theirs and have substantial financial leverage over and above the leases.
Premier Inn’s attractive market position is reflected in pre-tax return on capital which has averaged 13% over the last decade, excluding the COVID years. The main challenge for the UK business is finding new opportunities to deploy capital, but the company believes that there is still space to expand the number of rooms by over 45% in the medium-term.
The German business is smaller but an important source of growth. Premier Inn have deployed c.£500m into the market and expect to increase this to £1.1bn in the next few years. The business is expected to reach run-rate break-even this year. The opportunity in Germany is vast, with the market 40% bigger than the UK, but having no clear market leader, with the largest
Commentary
player having just 2% market share. Premier Inn target pre-tax returns on capital of 10% to 14% in Germany. We do not think the possibility of success is factored into the current valuation.
The shares trade on a price-to-earnings multiple of 14x compared with an average over the last decade of closer to 20x. Alternatively, the market capitalisation is at just over £5bn, around the same valuation as the property assets, implying no value for the operating company. Travelodge, which owns no property and is a smaller and inferior business was rumoured to being sold for £1.2bn last year.
Outlook
Warren Buffett’s advice for investors is to be fearful when others are greedy and greedy when others are fearful. Greed is often associated with markets that are trading at all-time highs but today we believe it is fear, the fear of missing out, that is driving markets to all-time highs. The posterchild of this fear is Nvidia, a company that has risen over 30x in the last 5 years to briefly become the world’s largest company, as measured by market capitalisation (but little else).
Nvidia is valued at 40x trailing sales and 70x trailing earnings. People will point to the growth and suggest the 45x forward earnings is more acceptable. This is based on a 54% net profit margin, which is unlikely to be sustainable. Microsoft is valued at 13x forward sales and 38x earnings with a near record 35% net margin. Apple is valued at 8x forward sales and 32x earnings also on a record 26% net margin. The operational performance of these companies is obviously exceptional, however, their beatification perhaps premature.
The Halo Effect, a book written by Phil Rosenzweig, perfectly highlights this risk. The star of that book was Cisco whose story looks remarkably like Nvidia’s. A leading fabless semiconductor company that was going to play a dominant role in the prevalent technology of the next decade or two. In 1999 Cisco had a net margin of 16%, a net cash balance sheet and had doubled revenues over the previous two years. Over the next 25 years revenue rose 5x and earnings 7x. Today the share price is still nearly 40% below the March 2000 high. One could argue that all the magnificent seven suffer from the Halo Effect fallacy. Valuation always matters.
We are also starting to see some signs of excess outside the US, with over 18% of MSCI EAFE constituents by weight now trading at over 30x forward earnings. This is up from 9% five years ago. The most striking examples are the two largest constituents of the index: Novo Nordisk and ASML. The pair trade on 41x and 51x forward earnings, respectively, with margins at or near record levels. While we admire both companies, we struggle to see scenarios where investors generate reasonable returns from current valuation levels. That said, over 40% of EAFE constituents trade on valuations of below 15x earnings and we continue to find many value opportunities.
Moreover, we believe the outlook for the portfolio remains bright with the forward valuation of just 9x earnings and the underlying holdings generating low teens return on equity. The weighted average upside is at 50%.
Commentary
Commentary