Knowing when to sell is one of the toughest problems in investing. For example, shares of consumer goods group Reckitt Benckiser Group (LSE: RB) have doubled over the last five years but sales and profit growth haven’t kept up with Reckitt’s share price. The stock now trades on a P/E of 24, compared to a P/E of about 14 in 2012.
Is Reckitt now overvalued, or do its high profit margins and strong cash flow mean that it deserves a premium valuation?
$17.9bn deal could change the picture
One of Friday’s big corporate stories was confirmation of Reckitt’s acquisition of US formula milk company Mead Johnson for a total of $17.9bn. That’s a fairly full valuation of 17.4 times earnings before interest, tax, depreciation and amortisation (EBTIDA).
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Reckitt will take on a total of $20bn of new debt to fund the deal. This will transform the group from a low-debt business to one with a high level of gearing. To help speed up repayment rates, there will be no more share buybacks until “the debt level is materially lower”.
Reckitt has repurchased nearly 5% of its own shares since 2011, providing a helpful tailwind for earnings per share. Management expects the contribution from Mead Johnson to make up for this shortfall. The acquisition is expected to make a double-digit percentage addition to earnings per share by the third year of ownership.
Reckitt has managed major acquisitions successfully in the past. I suspect Mead Johnson will prove a decent buy. But it might take a few years for the benefits to reach shareholders.
Cautiously optimistic
The group’s 2016 results were also published on Friday. These were broadly as expected. Like-for-like sales growth was just 3%, but adjusted net income rose by 15% to £2,157m, thanks to favourable exchange rate movements. The total dividend rose by 10% to 153p, giving a 2.1% yield.
In my view Reckitt Benckiser remains a reasonable bet for long-term income growth. But the stock’s forecast P/E of 22 and below-average dividend yield mean that it’s not cheap. I believe the shares could underperform in the short term.
Should you follow the founder and leave?
Motor insurance firm Admiral Group (LSE: ADM) has been a cracking investment over the last five years.
The share price has risen by 95% and shareholders have received dividends totalling 439.4p per share. For anyone who invested in February 2012, that equates to a 45% cash yield to date.
The problem is that growth is slowing. The UK market is competitive and overseas ventures are struggling to turn a profit. Consensus forecasts suggest that Admiral’s earnings per share rose by 3% in 2016 and will rise by just 1.5% in 2017. This could leave the shares looking a little pricey, on a forecast P/E of 17.
A second concern is that Admiral’s solvency ratio, a measure of surplus cash above regulatory requirements, fell sharply during the first half of last year. Dividend growth could come under pressure.
A final concern is that the group’s well-respected founder, Henry Engelhardt, stood down last year.
I don’t see Admiral as a compelling buy at current levels. I’d probably continue to hold for income, but investors looking for capital gains might want to consider taking some profits.
