Investment update - What are our companies up to?
It is earnings season, and with over 75% of the portfolio having reported we thought we’d share some common themes that have bubbled to the surface.
Is it the end of globalisation as we know it?
One very common theme when we were entering lockdown was to be wary of companies that had vast, sprawling supply chains that would be vulnerable to disruption, resulting in a constrained supply and ‘lost’ sales – especially those that leaned heavily on China and South East Asia. Whilst this may have been true to begin with, given the virus emanated from China, what we have subsequently learnt from a number of companies is that they were able to leverage off their global network to ‘outrun’ the spread of the virus.
For example, toothpaste giant Colgate was able to shift production from lockdown-impacted factories to facilities elsewhere within its manufacturing portfolio by upping production in those unaffected sites. This has enabled the company to fulfil demand – even in the most heavily disrupted countries - as panicked consumers stockpiled supplies.
Industrial conglomerate 3M mentioned that despite social distancing measures and safety protocols, it was still able to operate 75%1 of its manufacturing sites. The company is aiming to ramp up the production of N95 respirator masks in order to meet demand which continues to outstrip supply by doubling the current one billion a year capacity.
It would seem the greatest threat to globalisation as we know it continues to be political rather than viral. Even then, we doubt it will impact many of our global businesses as many already manufacture within a region for that region and as COVID-19 has highlighted, each relatively unaffected area has acted as an alternative production site and capacity buffer for those that are not able to operate either at full capacity (or at all).
Despite the bad news companies are still investing
Q1 earnings have been, so far, not great for a number of our companies and the overriding message is that it will most likely get worse in the second quarter.
For example, The Walt Disney Company saw earnings fall over 90% 2. Park and resort closures have cost the company billions in lost revenue whilst fixed costs eat into past years' profits. Even the one bright spot is not helping; Disney’s streaming service Disney+ has accumulated a stunning 55m3+ subscribers worldwide (it had originally predicted 60m within five years of launch), boosted no doubt by the lockdown, yet the business unit finished some $800m2 in the red as the company continues to invest into the technology and content that supports the service.
Waters Corporation saw sales in China halve4 over the quarter and it expects the situation to deteriorate across the rest of its global client base through Q2. The company, however, continues to focus on its priorities which, amongst a host of cost cuts, was a commitment to retaining its competitive position by continuing to invest in R&D and its new product cycle that is being phased into the market throughout this year.
Death by a thousand cuts?
Management is obliged to tell investors the truth, yet how the truth is communicated will largely come down to how transparent they wish to be. Anyone with a problem may look to play for time by not alluding to the full extent of the issue(s) at hand in one go. This is often the case under normal circumstances. Whether it’s overconfidence in their ability to address the problem, or their inability to face reality, the result to investors is often the same – a slow and tortuous collapse in stock value.
There has been none of that as far as we can make out. The magnitude of the issue at hand and the fact that peers are very much in the same boat has given management teams the confidence to say it how they see it – no bluff or sugar needed. The Q1 playbook for most businesses has followed a similar pattern. An upbeat start to the year for most western economies offsetting the impact of shutdowns across much of Asia. However, management were keen to highlight the impact containment measures had on earnings during the last few weeks of the quarter and much of April as the virus went global.
Thankfully, the market has been consuming this bad news in its stride. It knew it would be bad, and expects it to get worse. So why the strength of the market rally to date? It’s clear investors are betting on a sharp recovery when economies re-open with a return to growth in 2021, especially given the stimulus injected by central banks. However, could this be a bit premature?
This bullishness jars somewhat with management, who in most cases are saying that due to such uncertainty they are withdrawing guidance for the rest of the year. If the guys at the coal face don’t know how their situation is going to pan out, the call to equity must be being made by those with a view from 30,000ft. There is an argument to have some equity exposure in case markets have got it right, but these are not slam dunk prices and we very much run the risk of a death by a thousand cuts ourselves as the unknown slowly reveals itself over the months and quarters ahead. We continue to operate with a conservative mind set and have largely sat on our hands through most of this rally as a result.
E-commerce
A definite saviour for those businesses that have the capability has been e-commerce or direct to consumer services “DTC”. Sports apparel company Nike has been investing heavily in its DTC strategy since announcing its Consumer Direct Offense in June 2017. This seems to have paid off handsomely in the current environment, with digital sales in China up 30%5 in the three months to the end of February helping to offset a significant decline in retail sales (as stores closed). Overall, Chinese sales ended the quarter down 4%5 compared to the same period in 2019. Likewise, cosmetics giant L’Oréal saw its e-commerce sales in China soar 67%6 compared to the prior year and, for the first time, ecommerce sales represented over 50%6 of L’Oréal’s overall sales in the region. Whilst initially fuelled by a desire to remain safe, the benefits provided by the convenience of shopping online are expected to resonate with consumers long after the threat from the virus subsides. Businesses that have been on the front foot when it comes to rolling out their e-commerce strategies are likely to be well positioned to emerge from this crisis stronger.
Our companies are doing the right thing
Our companies have been keen to impress upon us that the welfare of staff and customers is coming first although some have acknowledged that furloughs and possible redundancies will be inevitable should matters deteriorate further. Where they can, companies are redeploying staff from areas that are under utilised to areas that are at full capacity. Costs are being cut aggressively, the biggest victims being deferrable capex, advertising budgets and to some degree salaries, particularly that of C-suite management. A handful have tapped the corporate bond market in pre-emptive moves to bolster cash, either to help weather a prolonged period of unrest or help play offense should the opportunity arise – "flexibility" was a commonly used word for many during the calls.
On top of this, many of our companies have been actively involved in the collective fight against COVID-19 as we looked at in this update last month. From the likes of Apple, who have designed face shields and are distributing millions each week, and LVMH, who have retooled their production lines to produce hand sanitizer for hospitals, through to companies like Johnson & Johnson and Sanofi who are actively working on identifying a vaccine.
Overall, we’re pleased with the way our companies are handling themselves so far. This quarter and next won’t be about the financials but how companies are dealing with the crisis. When all is said and done, will the management teams we invest into be able to look at themselves in the mirror and say “we did the right thing”? We would expect nothing less. Our preference is for companies that adopt a broader stakeholder mind-set which extends past shareholder objectives as highlighted in this update a fortnight ago. Companies can’t exist in their own bubble - they rely heavily on employees, customers, suppliers, the communities and environment they impact as well as shareholders. The success of this ecosystem relies on the strength of these relationships. Whilst such bonds are hard to value they are vital for sustained success – how a company handles itself with its stakeholders during this crisis will determine its longer-term fate.
Sources:
- 3M 2020 Q1 Earnings Call Transcript https://s24.q4cdn.com/834031268/files/doc_financials/2020/q1/Q1-2020-Transcript.pdf
- Walt Disney 2020 Q2 Earnings Press Release https://thewaltdisneycompany.com/app/uploads/2020/05/q2-fy20-earnings.pdf
- Walt Disney 2020 Q2 Earnings Call Transcript https://thewaltdisneycompany.com/app/uploads/2020/04/q2-fy20-earnings-transcript.pdf
- Waters 2020 Q1 Earnings Press Release https://www.waters.com/waters/en_GB/News-Releases/nav.htm?cid=134627991&locale=en_GB
- Nike 2020 Q3 Earnings Press Release https://news.nike.com/news/nike-inc-reports-fiscal-2020-third-quarter-results
- L’Oreal 2020 Q1 Earnings Press Release and Call Transcript https://www.loreal-finance.com/eng/news-release/first-quarter-2020-sales