Global Equity: The Case for Quality Continued

Last week, we updated you on the current earnings season with our note entitled “The case for Quality” providing you with company results recently released for the stocks held by the EPIC Global Equity Fund.

Whilst the reporting season is not yet over, the overwhelming majority have reported solid results with rising revenues, margin expansion and free cash flow growth. Whilst Paypal and Meta Platforms (aka Facebook) have disappointed, overall, we think that the market has over-reacted.   

At times like these it is important to remember that companies generate shareholder value when they are able to generate returns above their cost of capital over the market cycle. In the long term, it’s all about substance i.e., the underlying business’ performance and not speculators’ fickle opinions.

Here are some more recent earnings updates:

Idexx Laboratories 

Idexx reported a robust 11% fourth quarter revenue growth which was driven by the 13% companion animal group diagnostics recurring revenue growth. The strong growth was supported by the record number of instrument placements which further grew Idexx’s global premium instrument installed base by 14%. 

For the full year, the firm enjoyed 220 bps of comparable margin expansion which led operating profit margins to reach 29% of revenue. Due to the strong operating leverage, EPS grew 29% on a comparable basis year-on-year whilst free cash flow grew 17.5%. The firm is projecting to have another strong year of double-digit top line growth and a further 50 - 100 basis points of comparable operating margin improvement.

Reassuringly, concerns that the unusually high number of pets adopted during the pandemic would be returned to shelters once the work from home impact subsides so far appear to be unfounded. Pet shelter data suggest that pet intake over the past few months remains lower than pre pandemic levels. This bodes well for Idexx.

Amazon 

Amazon posted fourth quarter results which showed a 10% constant currency top line growth. Spectacularly, growth at AWS continued to accelerate as the cloud services division turned in its strongest growth rate since its 2006 launch. At an annualised revenue run rate which has now reached $71 billion, up from $64.4 billion, in the previous quarter, AWS grew a staggering 40% year-on-year. Advertising continues to grow at scale and grew 32% year-on-year. 

The pandemic-induced boom continued to subside, against strong comparatives; online stores slowed to a 1% decline, whilst third party seller services grew at a relatively pedestrian (compared to recent growth rates) 11% year-on-year. The return to normality benefited physical stores, which grew 17%.

Operating profit at $3.5billion was higher than guidance of $0 to $3 billion despite the well-documented higher wages, employee incentives and shipping costs.

Amazon’s pricing power was evident as the firm announced that it plans to raise prices in the U.S on Prime to $139 from $119.

Despite the rally in share price, we think the shares remain materially undervalued.

Roper Technologies

Roper closed 2021 on a strong note. For the full year, the firm achieved top line growth of 19% to $5.7 Billion; organic growth contributed meaningfully with a 9% growth rate. The firm’s free cash flow grew a further 19% to $1.8 billion to reach 31% of revenue. Due to the high cash generation, the firm exceeded its deleveraging plan, reducing net debt by $1.7 billion.

Encouragingly, management reported that they have a large pipeline of high-quality acquisition candidates and that the strong 2021 software recurring revenue growth provides significant momentum. The company also reported a record backlog and broad-based demand strength.

Roper is enviably positioned to keep on compounding cash as it has been doing for the best part of these last three decades for the following reasons:

• Roper is introducing new products increasing recurring revenue with further exposure towards the cloud;
• It continues to focus on acquiring asset light business at a valuation where its cash return on investment is attractive;
• It has negative 13% working capital as a percentage of sales; and
• Its free cash flow conversion tends to consistently hover above 120%.
• We think that the shares are currently trading at a discount to fair value of approximately 10%.

Diageo

Diageo made a strong start to fiscal 2022 with revenue growth of 20%, ahead of expectations. Trading was particularly strong in the European region which showed a 23% organic volume growth.

Contributing to the strong top line growth was the company’s favourable price mix, particularly in the United States where volumes increased by just 1% yet pricing contributed 11% to organic growth.

The strong pricing led gross margins to expand by 147 basis points to 62.9% whilst operating margins expanded by 131 basis points despite higher marketing costs. 

Alphabet

Alphabet reported fourth quarter results which crushed market expectations both on the top and bottom line. Top line grew 31%, propelled forward by a 31% increase in Google services and a 45% increase in Google cloud revenue.

Search revenue was up 36% whilst total advertising revenue grew 33% year on year. We highlight that Google’s cloud backlog grew 70% to $51 Billion far outpacing Google Cloud’s 45% year on year revenue growth.

Due to operating leverage, the strong top line growth led to operating margins expanding 150 basis points to 29%.

We think that the shares are currently trading at a discount to fair value of approximately 20%.

Malcolm Schembri
Fund Manager, EPIC Global Equity Fund