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What’s the most profitable trade in the FTSE 100? Long HSBC, short Barclays? Long ABF’s Primark, short Marks and Spencer? No. It’s long paper in the UK, short containerboard in continental Europe. Or, rather: DS Smith.
It’s also something of a trick question, of course. That last “trade” is more a description of DS Smith’s advantageous trading position: producing lots of profitable high-price paper in the UK, while ensuring it has no more than it needs for cardboard packaging in Europe. But this has helped to sustain a tenfold rise in its shares since 2009 — which has now propelled it into the blue-chip index.
For investors, then, the question is whether DS Smith has wrapped a Christmas gift that can keep on giving.
On Thursday, its shares gave investors another 4 per cent gain, before profit-taking, after news of an 11 per cent rise in half-year operating profit to £251m — some 3 per cent better than JPMorgan Cazenove’s estimate. And, as befits a group committed to sustainable fibre-based boxes, DS Smith’s growth has been largely organic. Of the £450m in extra revenues reported, only £110m was from an acquisition: two months’ worth of contributions from its $920m deal for US packager Interstate.
Overall, organic volume growth in the period reached 5.2 per cent — faster than the last full year’s 3.2 per cent, and the wider trend in European corrugated sales. These figures do not include the effect of Santa’s little helpers, either. With ecommerce proving one of the main drivers of demand, the Christmas period is likely to boost this further, given almost everything for home delivery comes in a box, and ecommerce uses six times more packaging than bricks and mortar stores.
But bricks and mortar shopping trends are playing into DS Smith’s box-wielding hands, too: more convenience food shopping, and different store formats, mean more packs in different sizes.
Better still for DS Smith — if not consumers for whom Yuletide is a rising tide of cardboard — its recycling capabilities can take a box from your bin and have it back at your front door in 14 days.
However, recent growth is not just from volume. DS Smith’s prices have also been rising, because they have had to — which represents a risk. Higher paper prices have led to “substantial input cost pressures” and, although DS Smith has been recovering these costs from customers, higher prices to achieve the same profit dilutes margin. In the half-year, the operating margin fell 60 basis points to 9 per cent.
JPMorgan Cazenove also highlights currency risk: a €0.01 adverse move in the sterling/euro exchange rate rips up £2.1m of operating profit.
Still, with strong cash flows enabling acquisition debts to be paid down quickly — keeping leverage below two times earnings — DS Smith should continue to look like a householder on Boxing Day: seeing cardboard everywhere and the virtue of recycling.
General knowledge test
A colleague has suggested that a well-known UK company may be becoming an unsung hero. This led Lombard to wonder how easy it might be to guess. So, as practice for the tedious parlour games you will endure over Christmas, why not play along with this corporate version of 20 Questions?
1. Are you on target for record annual earnings and profit? Yes.
2. Has growth strengthened further in recent weeks? Yes, particularly.
3. Are all your core businesses performing well? Yes, they are now.
4. Have you just disposed of an old ex-growth business for a well-received price? Yes, just the other day.
5. Have you managed to sell more of something that people don’t even need to buy? Yes, even after the government said people didn’t have to.
6. Are people handing over more of their money? Yes, they’ve asked us to look after another £38bn this year.
7. Are some of them Americans? Yep.
8. Are you hoping more of them might be Europeans, in future? Yes, we do.
9. Are you also investing in long-term UK assets? Yes.
10. Are you selling more products direct? Yes, via new distribution deals.
11. Have you reversed past losses? Yes.
12. Do regulators think you have enough capital? Yes, a surplus.
13. Are you still paying dividends? Yes.
14. Is the forecast 2017 yield more than 5 per cent? Yes, for some reason.
15. Are you trading on less than 12 times 2018 earnings? Yes, it seems so.
16. Have your shares risen less than 4 per cent this year? Er, yes.
17. Are you more than 150 years old? Yes.
18. Do you feel the market doesn’t give you enough credit? Yes.
19. Are you Legal & General? Yes!
How many did it take you? Just for reporting a 93 per cent increase in individual annuity premiums, after the government said they weren’t needed, the company deserves recognition.
But with at least one analyst still citing “balance sheet risks”, “macro vulnerability” and “increasing UK uncertainties” — even after Thursday’s update on questions 1-13 — it looks like a case of “maybe next year”.