Croda: Back to May 2020 Levels on 24x Trough Earnings

Company Update (CRDA LN) (Buy)

Highlights

• Shares has limited downside but potentially dramatic upside

• Customer de-stocking is industry-wide and one-off in nature

• Shares are at 24x 2023 EPS even if H1 weakness continues

• At 4,712p, base case is 58% upside (15.6% p.a.) by end of 2026

• IRR can be much higher if sentiment improves or a buyer emerges

Introduction

We revisit Croda after shares have fallen a further 15% since our last update in June to their lowest since May 2020:

Croda Share Price (Last 5 Years)

Source: Google Finance (28-Sep-23).

We have tracked Croda intermittently for more than 5 years. Our most recent involvement began on June 9, when the company issued a profit warning and shares fell 12.5%, and we bought a small position at around ~£52. We published our research online with a Buy rating on June 15 (when the share price was ~£55), but exited our position on June 28 (also at ~£55) after a lack of momentum in the shares. We have reinitiated a small position in Croda at ~£48 this morning.

We believe Croda now has limited downside but a potentially dramatic upside. Shares have more than halved since their December 2021 peak, and are at 24x 2023 earnings. This year will be a cyclical low due to post-COVID customer de-stocking and the shrinkage of vaccine-related sales. Full H1 2023 results have provided some positive datapoints, and the recent weakening of the U.K. Pound is a tailwind. However, near-term sales are still highly uncertain, and two Croda executives have recently sold substantial amounts of stock. With shares at 4,712p, if we assume the low-end of the 2023 outlook, a 9% 2023-26 EPS CAGR and a 28x P/E, then we arrive at a total return of 58% (15.6% annualized). More speculatively, there can be an outsized upwards re-rating if investor sentiment return to a fraction of their former bullishness or a strategic acquirer emerges.

We discuss each of the above in more detail below.

Limited Downside on 24x Trough EPS

Since the June 9 profit warning, management has guided to a 2023 Profit Before Tax (“PBT”) of £370-400m, which with a 25% effective tax rate implies an Adjusted EPS of roughly 195-211p:

Croda Net Profit & P/E (2023)

NB. Tax rate assumption raised from 24% to 25%. Source: Librarian Capital estimates.

(Current sell-side estimates for 2023 Adjusted EPS has an average of 199p and a range of 179-210p.)

With shares at 4,712p, the low-end of our estimate (195p) implies a P/E of 24.2x, while the high end implies 22.3x. These are low by historic standards – at its December 2021 peak, the P/E was 42x (relative to what was ultimately its 2021 Adjusted EPS).

The low end of the 2023 outlook represents merely a continuation of the weak Consumer Care performance in H1 2023, but some recovery in Life Sciences, as CFO Louisa Burdett explained on the H1 2023 call:

“Our guidance remains unchanged for Adjusted Profit Before Tax, with a full year forecast in the range £370-400m. As a reminder, delivery at bottom end of the range assumes no change in the second half for Consumer Care versus the run-rate in the year to date, COVID-19 lipid sales in Q4, an uptick of Crop (Protection sales) in Q4.”

H1 2023 Adjusted PBT was £174m, and there were zero COVID-related lipid sales (compared to $62m in H1 2022), so the low end of the 2023 guidance implies a H2 Adjusted PBT of £196m with some COVID-related lipid sales.

The high end of the 2023 outlook represents further self-help cost actions and a 10-20% rebound in Consumer Care’s growth rate, as Burdette explained on the profit warning call in June:

“The move up to £400m … has a couple of layers in there. There's a layer that is within our control. What I would call implementing sensible self-help cost actions that we can choose to do not damage the business in the medium term whilst we wait for that destocking to come through either but keeping our focus on growth. And then at the higher end of that range of £400m, it's an assumption that the Consumer Care growth rate half on half increases between 10% and 20%.”

We believe there is now little downside, because the 24x P/E is historically low and 2023 earnings will be a cyclical low.

2023 Earnings as Cyclical Low

2023 earnings will be a cyclical low due to post-COVID customer de-stocking and the shrinkage of vaccine-related sales.

Post-COVID de-stocking has been an industry-wide phenomenon, as customers who built up stocks during 2021-22 to mitigate supply chain disruptions turn to reducing them in 2023, even as their owns sales continued to grow.

The impact of customer de-stocking was particularly severe in Consumer Care, as this chart from Croda’s H1 2023 results presentation shows, with volume seemingly down 20% or more in Beauty Actives, Beauty Care and Home Care, offset by growth in Fragrances & Flavours (“F&F”) (the chart has no scale, but we know the pink bar for F&F’s total sales growth represents 20%); overall Consumer Care volume decline was 14% year-on-year:

Croda Consumer Sales Growth Breakdown (H1 2023)

Source: Croda results presentation (H1 2023).

Similar dynamics were reported by U.S. specialty chemical company Ashland Inc. (arguably Croda’s closest listed comparable), which saw a double-digit volume decline in its Personal Care in FY23 Q1-3 (October 2022 to June 2023):

Ashland – Customer Growth vs. Own Growth (FY23 YTD)

Source: Ashland results presentation (Q3 FY23).

Ashland has reported declines of 8% in sales and 22% in EBITDA for its Personal Care business in Q1-3 FY23. Similarly, DSM-Firmenich, a European specialty chemical company, has reported declines of 5% in sales and 18% in Adjusted EBITDA for its Health, Nutrition & Care business in H1 2023.

The shrinkage of vaccine-related sales was long expected, and was the mirror image of Croda’s success in becoming a key lipid supplier to the Pfizer-BioNTech COVID-19 vaccine in late 2020:

Croda Lipid System Sales (2021-25E) (Pre Profit Warning)

Source: Croda results presentation (2022).

As shown above, Croda’s non-COVID lipid sales have been growing and will eventually more than offset the decline in COVID-related lipid sales. Overall lipid sales are expected to stabilize in 2024 and return to growth in 2025.

Recent Positive Datapoints

Croda’s full H1 2023 results, released on July 25, have provided some positive datapoints.

Consumer Care volumes have troughed at the start of 2023 and started to improve sequentially since:

Croda Consumer Care Volume (3-Month Average)

Source: Croda results presentation (H1 2023)

Management also described the current weakness in Consumer as 75% due to industry de-stocking and 25% due to Croda-specific issues, including production outages (after running at peak capacity for a prolonged period), and observed that salespeople have started to generate sales growth again. CEO Steve Foot said on the H1 2023 call:

“Our analytics would show 75% of this is destocking and demand, but predominately destocking … So 25% is more self-inflicted by Croda, which is around things like forced de-marketing because of supply issues and in particular we mentioned on the last call around the one-off outage we had in the U.S. …

There is a recovery under way to buy back into some of those businesses and some of those lost products and customer combinations, so we’re doing that …

One of the big things is in the sales environment in Croda is they haven’t had much to sell in three years. Our factories have been full, it’s been an oversold industry. So now is a great environment to go out there and develop business. We’ve got a lot of hungry salespeople around the world.”

However, he cautioned that Croda’s visibility on sales is only about two weeks and that “we don’t have the confidence in the datapoints, accurate datapoints to suggest that this is going to come back much stronger in the near term.”

The currency backdrop has also improved. Since H1 results, the U.K. Pound has fallen by 5.4% against the U.S. Dollar (to 1.22, lower than the 2022 average of 1.237). This represents a positive for Croda, which has most of its earnings from outside the U.K. Each $0.01 movement in the GBP/USD rate is estimated to translate into a £1m impact, and recent currency moves have turned currency from a small headwind to a slight tailwind.

Near-Term Uncertainty is High

Near-term sales are still highly uncertain, with Croda’s visibility of sales being only about two weeks.

Adding to this, two Croda executives have recently sold substantial amounts of stock:

• Chief Scientific Officer Nicholas Challoner and family selling £334k of stock at ~£49 on September 27

• General Counsel Thomas Brophy and family selling £272k of stock at ~£52 on September 11

Croda has also announced on September 22 that it has chosen Danuta Gray as the next chairperson, another negative in our view. While we understand there may be legitimate reasons for sticking with British candidates, Ms. Gray has no experience in the chemical industry (being a telecoms veteran). She has also been the chair at Direct Line since 2020 (and a non-executive director there since 2017), thus fully involved in that company’s recent accident-prone history, which included multiple profit warnings, several run-ins with the FCA and the share price almost halving since 2020.

Back at H1 results (on July 25), management has mentioned the possibility of breaking with tradition and releasing a Q3 trading update in October. This has not yet been scheduled, but can be the source of material news.

Long-Term Croda Bull Case

The long-term bull case for Croda is for its EPS to rebound in 2024 and resume a mid-to-high single-digits growth.

As a reminder, Croda has the following targets for its two main segments:

• Consumer Care: >5% sales growth + synergies, >25% EBIT Margin (H1 2023: 20.9%)

• Life Sciences: High-single-digit sales growth, >30% EBIT Margin (H1 2023: 23.8%)

Margins are currently much lower, largely because of negative operational leverage (as price/mix remains positive); they will return to more normalized levels when sales recover, driving an initial earnings rebound. Thereafter, EPS growth should be mid-to-high single-digits, mainly driven by sales growth.

We believe these targets are achievable, though this is a more subjective view than in our other investment cases, as Croda’s business model of providing differentiated, value-add chemicals to its customers also means that it has less “recurring” revenues and has to constantly innovate and invest, including through bolt-on acquisitions.

Croda’s track record partly supports our view. Across 2013-22, including acquisitions and the benefit of a much weaker U.K. Pound (GBP/USD’s decline was worth 2.3% annually), Croda has grown its Consumer EBIT at a CAGR of only 4.9%, but Life Sciences EBIT has grown at a CAGR of 16.4%, thanks partly to COVID-related lipid sales since 2021:

Croda Adjusted EBIT By Segment (2013-23E)

Source: Croda company filings.

(2013-22 Life Sciences EBIT CAGR would still be 10%+ if we were try to adjust out COVID-related lipid sales by assuming a 100% margin for the latter.)

Offsetting doubts about Croda’s long-term organic growth record, there is enough momentum from recent acquisitions to drive growth in the next few years. The €820m acquisition of Iberchem in 2020 is still generating strong growth (in the form of the Fragrances & Flavours unit growing sales by 20% in H1 2023), and the £232m acquisition of Solus Biotech was only completed in February.

Croda as Potential Acquisition Target

We believe there is a realistic chance for Croda to be acquired by a strategic buyer at a significant premium.

U.K. companies have been seen as easy targets seen Brexit, attracting interest from both strategic buyers and private equity. Recent mid-market transactions include Abcam (agreed to be by Danaher for $5.7bn in August) and Dechra Pharmaceuticals (acquired by EQT for £4.5bn in June).

Croda is a unique asset in specialty chemicals, thanks to manufacturing and R&D expertise, its portfolio of patented technologies and strong “consultative sales” relationships with 17,000+ customers. It has historically possessed much higher growth and margins than large chemical companies. Acquisitions represent a common tactic in the industry as players (including Croda itself) seek to position their platforms in the best markets. There may also be synergies in combining Croda’s ability to identify new, differentiated ingredients with a large chemical company’s ability to manufacture ingredients in bulk cheaply once they have become less differentiated.

Historically, a strategic acquisition of Croda was widely seen as unlikely because its standalone culture was regarded as a key to its success but incompatible with being part of a larger conglomerate. However, with shares now at a multi-year low, its Enterprise Value has fallen to a more digestible £6.6bn ($8.0bn) that may tempt some acquirers to try. Acquisitions of listed companies in public markets have typically involved premiums of 20%+.

Croda Valuation

At 4,712p, Croda shares have a P/E of 24.2x relative to the low end of management’s 2023 outlook.

The Dividend Yield is 2.4%, based on last-twelve-month dividends of 112.5p.

Net Debt / EBITDA was 0.7x at June 2023 and 1.1x after a payment for the Solus Biotech acquisition, thus at the low end of management’s targeted 1-2x range.

Croda Illustrative Return Forecasts

We cut our estimates again, reducing our 2023 Net Income (to reflect a higher tax rate), our post-2024 Net Income growth (to reflect lower growth) and our 2026 year-end P/E (also to reflect lower growth). We also extend our forecasts by a year to 2026.

Our assumptions are now:

• 2023 Net Income of $272.5m (was $276.2m)

• 2024 Net Income rebound of 15% (unchanged)

• Thereafter Net Income to grow at 6% annually (was 8%)

• Share count to be flat (unchanged)

• Dividend Payout Ratio of 50% (unchanged)

• P/E of 28.0x at 2026 year-end (was 32.0x)

Our assumption of a 28x P/E is based on our view of market sentiment. In absolute terms, Croda’s cash conversion (Free Cash Flow / Adjusted Net Income) averaged just 60% in 2018-22, as CapEx continued to significantly exceed depreciation (with frequent “one-off” projects like the £181m biosurfactant plant in 2016-19 and the ongoing £175m pharma capacity program for 2021-24). With a 50% Payout Ratio, a 28x P/E also implies a Dividend Yield of 1.9%.

Our forecasts imply an overall Net Income CAGR of 8.9% between 2023 and 2026. Our new 2025 EPS forecast is 3% lower than before (245.6p), and our 2026 EPS forecast matches 2021 but is 7% below the 2022 figure:

Illustrative Croda Return Forecasts

Source: Librarian Capital estimates.

With shares at 4,712p, our forecasts show a total return of 58% (15.6% annualized) by 2026 year-end.

These forecasts reflect the expected return in holding the stock for just over 3 years. More speculatively, investor sentiment can turn bullish, especially when Croda demonstrates a return to growth, and a strategic acquirer may emerge. In these scenarios, Croda’s P/E would re-rate upwards dramatically, there returns could be outsized on an annualized or even absolute basis.  While these scenarios are less likely, we feel the risk/reward is attractive because downsize risks are limited, given a valuation of 24x what we believe to be trough earnings.

We reiterate our Buy rating on Croda.

Stocks mentioned: CRDA LN ASH 0.00%↑ . We are long Croda.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.