Croda: Cheapest Since 2020 as Sales Hit Post-COVID Cyclical Lows

Re-initation of Coverage (CRDA LN) (Buy)

Highlights

• Shares are 47% down from peak after a profit warning last week

• Weak 2023 due to post-COVID factors like customer destocking

• P/E is at 28x on trough EPS that assumes little growth from 2020

• Future growth is to be driven by new businesses

• At 5,526p, we see 47% upside (16.7% p.a.) by end of 2025. Buy

Introduction

We reinitiate our coverage of Croda, a U.K. mid-cap specialty chemicals company, after shares hit a multi-year low following a profit warning last Friday (June 9). Shares fell 12.5% that day but have rebounded 4.3% since.

Croda shares are attractive because both earnings and valuation multiples are cyclically low. The share price is at its lowest since July 2020. 2023 sales are expected to be hit by post-COVID customer de-stocking and a further decline in vaccine-related sales. The P/E is less than 28x on trough 2023 earnings, and the low end of the outlook implies only a slight growth from pro forma 2020. Management targets imply mid-to-high-single-digits EPS growth over time, and the P/E multiple peaked at around 42x in December 2021.

We believe targets are likely achievable, though this is based on subjective views of Croda’s strengths instead of an objective track record. Most of the expected growth is to come from newer businesses, and its older businesses had low growth in the years just before COVID. Cash conversion and ROIC have been poor recently, because of acquisitions, planned investments and working capital. Our forecasts see Net Income reach its 2021 peak again in 2025 and a 32x P/E. With shares at 5,526p, these mean a total return of 47% (16.7% annualized). Buy.

Croda Company Overview

Croda is a U.K. mid-cap specialty chemicals company that sells high-performance ingredients. Its two main segments are Consumer Care (40% of 2022 Adjusted EBIT) and Life Sciences (45%):

Croda Revenue & & EBIT by Segment (2022)

Source: Croda annual report (2022).

Each of the two main segments further consists of a number of businesses with distinct products and characteristics. Consumer Care consists of Beauty Care (~55% of segment sales as of 2022), Beauty Actives (~15%), Fragrances & Flavours (“F&F”) (~25%) and Home Care (~5%), while Life Sciences consists of Pharma (~60% of segment sales), Crop Protection (~30%) and Seed Enhancement (~10%).

Sales are global, with EMEA being the biggest region with 42% of 2022 revenues, followed by North America (25%) and Asia (23%); LATAM contributed 10%, though F&F revenues are around 80% from Emerging Markets.

The focus on high-performance ingredients means Croda tends to sell chemicals that are in relatively small quantities but can alter the performance characteristics of an overall customer product materially. (This makes Croda very different from the likes of IFF, Givaudan or Symrise; it has some similarities with Ashland). The company has been at the forefront of innovation, notably supplying lipids to the Pfizer-BioNTech COVID-19 vaccine since 2020.

Croda is highly diversified, with 17,000+ customers and 6,000+ of products. Its customers tend to include the largest players in each sector, but its sales are weighted towards mid-sized and regional companies and independents.

The company is highly active in M&A, making small bolt-on acquisitions regularly and large platform acquisitions occasionally. The largest deals in recent years are Solus Biotech (in Beauty Actives, for £232m, in 2023), Iberchem (in F&F, for €820m, in 2020) and Avanti (in Pharma, for $185m initially and up to $75m in earn-outs, in 2020). It also divested most of its Performance Technologies and Industrial Chemicals (“PTIC”) for €775m in June 2022.

Our Croda Rating History

We have been tracking Croda for more than 5 years, first publishing our research online with a Neutral rating in July 2019 (when the share price was 4,674p). We let our coverage lapse after July 2020 because we viewed the stock as still too expensive (at 5,850p), only to see it close to double thereafter (to 10,505p) by December 2021.

More recently, with the significant correction in Croda’s share price since 2022 and the further decline last week, we bought a small position during the morning of the profit warning, pending further research.

Croda Shares at Multi-Year Low

Following the profit warning last Friday (June 9), the share price closed at 5,526p on Wednesday (June 14), its lowest since July 2020 (when it troughed at 5,196p) and 47% below the peak in December 2021:

Croda Share Price (Last 5 Years)

Source: Google Finance (15-Jun-23).

We believe Croda shares are at a multi-year low because its earnings are at a cyclical low, making them attractive for long-term investors.

2023 as Post-COVID Trough

With the profit warning last Friday, Croda now expects Profit Before Tax (“PBT”) to be £370-400m in 2023, down from £496m in 2022 (on an adjusted basis, excluding exceptionals but including £39m from the now-divested PTIC assets):

Croda Adjusted EBIT & PBT (2013-23E)

Source: Croda company filings.

The 2023 P&L is expected to be impacted by the following:

• Customer destocking in Consumer Care, following the strong post-COVID rebound in 2022

• Customer destocking in Crop Protection in Life Sciences, similarly following a strong 2022

• Continuing decline in sales related to the Pfizer-BioNtech COVID vaccine, with volume paused until H2 2023

All of these can be attributed to COVID-related factors and partly expected, with Consumer customer de-stocking already having begun in H2 2022 (but previously expected to be completed in H1 2023) and Crop Protection de-stocking previously expected in H2 instead of H1. (Expectations on sales related to COVID vaccines are unchanged. Vaccine-related lipid sales to Pfizer/BioNTech were ~$190m in 2021, ~$100m in 2022 and expected to be $40-50m in 2023.)

The low end of the £370-400m PBT outlook assumes no sequential improvement in H2 (i.e. annualizing year-to-date performance and adding H2 Pfizer-BioNtech sales) and “sensible self-help” on costs, while the high end assumes revenue growth in Consumer improves by 10-20% between H1 and H2.

Management also disclosed the following figures for January-May of 2023:

• In Consumer Care, volumes “remain down double-digit” year-on-year while revenues were “broadly flat”

• Consumer Care EBIT margin was “at a similar level” to H2 2022 (18.9%, compared to 26.6% in H1)

• Life Sciences EBIT margin is likely to be at mid-25% in H1 (compared to a 30%+ long-term guide)

• Group PBT was £143m (compared to £250m for January-June of 2022, excluding divested PTIC assets)

The main reason behind weak margins in January-May was negative operational leverage, as there were less revenues than expected to absorb the same overheads. Negative mix shift was also a factor, as the businesses with lower revenue growth (Beauty Actives and Pharma) had higher margins than their respective segments.

Because the factors involved were one-off by nature, the weak P&L expected for 2023 should be temporary. Management has already observed “early signs of improvement” in the order book for Consumer Care, and the non-COVID part of the Pharma pipeline continues to be strong. The 2023 outlook should represent a cyclical trough.

P/E Below 28x on Trough 2023 Earnings

With shares at 5,526p, Croda’s P/E is less than 28x at the low end of the new 2023 outlook, which represents cyclically depressed earnings, and is 25.8x at the high end:

Croda Net Profit & P/E (2023)

Source: Croda company filings, Librarian Capital estimates.

At its peak in December 2021 (10,505p), Croda’s P/E multiple peaked at around 42x with respect to what actual 2021 Adjusted EPS turned out to be (249.5p).

The dividend was 108p in 2022, implying a Dividend Yield of 2.0%.

Net Debt / EBITDA was 0.5x at 2022 year-end (vs. 1-2x targeted), and the defined benefit pension scheme is in surplus.

New 2023 Outlook Not Much Larger Than 2020

The low end of the new 2023 outlook implies little growth from pro forma 2020.

Consumer Care and Life Sciences together had £271m of EBIT in 2020 (on the current reporting structure), acquisitions have added another £58.5m, and the PTIC disposal meant Industrial Specialities was left with £40m of EBIT in 2022:

Croda Pro Forma Adjusted EBIT (2020)

Source: Croda company filings.

These give a pro forma 2020 group Adjusted EBIT of £370m. 2023 net finance costs are expected to be “minimal” (they were only £19.1m in 2022, and Croda cut its debt from £823m to £295m during 2022), and the GBP/USD rate remains weaker than the 2020 average (1.285), so 2020 pro forma results likely imply a PBT close to £370m once adjusted for current finance costs and currency rates.

Mid-to-High Single-Digits EPS Growth Expected

Croda has the following targets for its two main segments:

• Consumer Care: >5% sales growth + synergies, >25% EBIT Margin (2022: 22.8%)

• Life Sciences: High-single-digit sales growth, >30% EBIT Margin (2022: 33.6%)

These imply a mid-to-high single-digits EPS growth over time, mainly driven by sales growth.

We believe these targets are achievable, based on our subjective views on the structural growth in many of Croda’s underlying markets, its record of innovation, strong existing intellectual property, deep relationships with customers, etc.

Growth Driven By New Businesses

Croda has a strong record over the long term, but its performance in the past decade does not on its own support our belief in management’s ability to deliver the targeted growth.

Most of the expected growth is to come from newer businesses. For example, in Consumer Care, about half of the expected 2021-25 revenue growth is expected to come from F&F, a new business created with the acquisition of Iberchem in 2020 (though Iberchem on its own had a sales CAGR of 15% and an EBITDA CAGR of 20% in 2010-20):

Croda Consumer Care Expected Sales Growth (2021-25)

Source: Croda Consumer Care investor seminar (Mar-22).

Outside F&F, 2021-25 growth rates expected for other Consumer Care businesses are much higher than what they achieved in 2011-21 (low-to-mid--single-digits vs. 2.4% for Beauty Care, and double-digits vs. 3.5% for Home Care), or slightly higher (mid-to-high-single-digits vs. 6.7% for Beauty Actives).

Similarly, In Life Sciences, the Pharma business (~80% of segment sales) include relatively recent acquisitions such as Avanti (acquired 2020) and Solus Biotech (2023) that lack a track record as part of Croda in normal market conditions.

Relatively Weak 2015-19 Track Record

Before the new acquisitions, Croda’s older businesses had low growth in the years just before COVID.

Consumer Care’s underlying revenue growth averaged just 2.0% in 2015-19, and Adjusted EBIT margin was flattish (margin fell in 2020 partly due to the Iberchem acquisition, and also due to mix shift and a new biosurfactant plant), leading to an average underlying Adjusted EBIT growth of just 3.9% in 2015-19:

Croda Consumer Sales & EBIT Growth and EBIT Margin (2015-22)

Source: Croda company filings.

Life Sciences did better in 2015-19, with an average underlying revenue growth of 4.0%, despite the decline in an Active Pharmaceutical Ingredient (“API”) contract in North America from 2016 and its subsequent exit in 2017. Underlying Adjusted EBIT growth averaged 10.0% in 2015-19, helped by a strong 2015 (when it grew 17.9% underlying):

Croda Life Sciences & EBIT Growth and EBIT Margin (2015-22)

NB. 2018 Life Sciences underlying revenue growth was 6.7% excluding API exit.

Source: Croda company filings.

Because Croda’s customer proposition is innovation-based, it has had to periodically repositioned its business towards new categories or technologies. We believe the stronger performance of the Life Sciences segment in 2015-19 is more indicative of what it can achieve as a group in the medium term, but this is a necessarily subjective view.

Relatively Weak Cash Conversion and ROIC

Croda also has had relatively weak cash conversion and Return on Invested Capital (“ROIC”), though this is due to acquisitions, planned investments and working capital that can be attributed to its recent repositioning to new growth businesses and COVID-specific one-offs, and may be temporary in nature.

Cash conversion, as measured in Free Cash Flow (“FCF”) / Adjusted Net Income, has fallen to just over 40% since 2021, due to large working capital outflows (partly due to inflation on receivables and inventory) and large CapEx:

Croda Net Income & Cashflows (2018-22)

Source: Croda company filings.

CapEx on PP&E was £141m in 2022, equivalent to 6.8% of revenues, compared to a base CapEx of around 6%. This would have made a difference of £16m, or around 4 ppt in cash conversion. Management is in the process of spending £175m in a 2021-24 program to broaden Croda’s Pharma footprint, with £90m spent so far as of 2022 year-end (with another £50m to be spent in 2023 and another £35m in 2024).

Working capital outflows exceeded £100m in both 2021 and 2022, though it “has started to reduce” after commodity prices peaked in Q3 2022 and is expected to show a “positive unwind” in 2023.

Croda’s ROIC has fallen from 19% in 2018 to 14% in 2022:

Croda Return on Invested Capital (2018-22)

Source: Croda annual report (2022).

Croda is a unique asset but ultimately still a specialty chemicals company. Relatively large CapEx and working capital requirements are likely to be inevitable.

Croda Return Forecasts

We assume Croda’s Net Income will be at the low end of new outlook in 2023, rebound by 15% in 2024 and grow by a further 8% in 2025. We also assume a 32x P/E, a flat share count and a 50% Dividend Payout Ratio (except 2023, when the dividend will be flat).

Our forecasts imply an overall Net Income CAGR of 6.1% across 2019-25 (not adjusted for M&A). Our 2025 EPS forecast is 245.6p, sightly lower than the 2021 EPS of 249.5p:

Illustrative Croda Return Forecasts

Source: Librarian Capital estimates.

With shares at 5,526p, our forecasts show a total return of 47% (16.7% annualized) by 2025 year-end. Buy

We reinstate our coverage of Croda with a Buy rating.

Ends

Stocks mentioned: IFF 0.00%↑, $GIVN, $SY1, ASH 0.00%↑ CRDA LN. We are long.

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.