Portfolio update – Two new purchases: Avient & China Mobile
Much like buses, you wait ages for one and then two come along at the same time.
Avient is a chemical company that was formed when PolyOne purchased Clariant’s Masterbatches division in August 2000. We had looked at PolyOne in the past and were very interested in the business model. However, with a market cap below $4bn it was slightly too small for us. As the deal closed last year it gave us an opportunity to revisit.
Avient is a provider of specialised and sustainable materials which are used in a wide variety of applications, mostly in packaging (35% of sales), consumer goods (23% of sales) and industrials (17% of sales) but also in Healtcare, building & construction, transport and eletrical & electronics. The company partners with OEMs, processors and assemblers. Avient offers very specialised materials that vastly improve the quality of the end product but have a low impact on overall cost of the end product. In that respect the business model is similar to the one of Fuchs or Evonik, both of which we own in the fund, or even Food Ingredient companies.
It’s probably best to explain their input into end products with a few examples:
– Barrier technoloiges that preserve the shelf-life and quality of food, beverages, medicine and other perishable goods through high-performance materials that require less plastic.
– Leight-weighted solutions that replace heavier traditional materilas like metal, glass and wood which can improve fuel efficiency in all modes of transportation.
– Breakthrough technologies that minimise wastewater, improve the recyclability of materials and advance a circular economy.
The common theme across many of Avient’s products is the minimisation of use of materials and resources and increased recyclability of its products while operating in high growth areas. This is reflected in another revenue split the company offers:
– 15% of revenue is in sustainable solutions, which has a growth rate of 8-12%
– 15% of revenue is in healthcare, which has a growth rate of 8-10%
– 18% of revenue is in emerging regions, which has a growth rate of 5%
– 6% of revenue is in composite/5G products, which has a growth rate of 10%
– 47% of revenue is in segments that grow in line with GDP, i.e. 2-3%
The long term drivers across all businesses is the increased complexity of customers’ need in achieving their sustainability and environmental goals. Unfortunately, there is not enough recycled content for everyone to achieve their ambitions. The biggest tailwind for Avient is its capacity to use more recycled content than peers, which in turn gives its customers a higher recycled input for their products.
Avient spends 3% of sales on R&D. Through innovation and pricing Avient is anticipating a long term top line growth rate of 6.5% CAGR. Margins should also continue to expand as synergies from the merger are still to come through and due to the company’s strong pricing power: 35% of sales is generated from products that are introduced in the last 5 years and 25% of products renew once a year when pricing can be taken. This is achievable due to the imbalance between cost and quality to the end product as explained above.
The asset light business model gives Avient plenty of cash to invest in R&D and look out for other successful M&A targets which in turn will transition Avient into a higher margin and ROIC business.
We have met management multiple times and were very impressed by their drive and vision for the business. On our conservative assumptions of 6% sales growth and about 100bps margin improvement 2021-25 the shares were trading on 16.5x Y1 PE and 9.3x Y5 PE, not reflecting the structural growth opportunities over the next few years. The starting dividend yield was just below 2%. However, at around 30% payout ratio and a cash cover of 4x we believe there is amble room for a more attractive yield in the next couple of years. Net debt/EBITDA should come down to below 2x this year and the FCF yield on the shares is expected to grow to over 8% in the next couple of years. We initiated position in August at $49.78.
We have never really been enthusiastic about investing in utilities: the debt often made us uncomfortable, and regulation is frequently a tightening noose that reduces returns for investors.
Telecoms was once perceived as a high growth/tech area, but they too succumbed to never-decreasing levels of capex, which brought high levels of debt and competitive pressures that reduced returns.
Against this background, it was with some bias that we re-examined China Mobile. The company is a leading mobile telephone company in China. It is well invested and has been a leader in 5G role-out. The implementation of this technology and the geographic diversity of China suits mobile as a faster growth platform than fixed line. Capex is likely to remain high as 5G is rolled-out. Unlike many utilities, China Mobile has substantial net cash resources. While the majority of returns are likely to be from dividends, the shares look oversold and are attractive at these levels. US investors have been forced to sell the shares which has led to significant underperformance in the last year.
Despite capex to sales running above 23% since we started covering in 2007, the business has substantial levels of net cash. It appears to us that the long-term decline in operating margins has played out. Indeed, it has been remarkable, that despite the rapid increase in customers, 61% over the last 10 years, and 86% increase in revenue, that EPS is 11% lower! The operating margin was 34.6% in 2008 and 14.7% last year. The story used to be about voice, then SMS but with 4G and 5G it is all about data. There is still a transition to 4G and 5G that should prove beneficial both for revenues and operating margins over the forecast period.
Investing in China is not without risk. However, it is a domestic business, in a stable, competitive market and consequently many of the data security issues do not arise. For a business that is leading the roll-out of 5G, data will lead to a stabilisation and probable growth in ARPU (remember that!). With the PE multiple and yield both around 7%, we view the price set-back from the forced sale of US investors as an attractive entry point.
Graham Campbell (firstname.lastname@example.org)
Bettina Edmondston (email@example.com)
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