With stock markets at short-term highs, I’ve cut back on my buying activities. At the moment, the only stocks I want to add to my portfolio are companies I believe are significantly undervalued on a long-term view.
Today I’m looking at two companies that could fit this description.
New strategy is delivering results
EI Group (LSE: EIG) was formerly known as Enterprise Inns. It’s a mix of pub chain and commercial property company. The EI share price is up 4% at 131p at the time of writing, after the company issued a solid set of half-year results.
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The group has three divisions — leased and tenanted pubs, managed pubs, and commercial property. Each delivered a positive performance during the first half.
The benefits of its shift from tenanted pubs towards managed ones were highlighted by decent sales figures. Whereas like-for-like (LFL) sales only rose by 0.6% at tenanted locations, managed pubs saw a 6.6% increase in LFL sales over the same period. The number of managed sites has doubled to 276 over the last year.
These shares could double
The group’s underlying pre-tax profit was unchanged at £57m during the first half, but net asset value rose from 313p to 326p per share, thanks to a reduction in net debt. This means that at a price of 130p, the shares trade at a discount of 60% to their net asset value.
For a profitable business this seems too low to me. The problem is that EI isn’t really generating much in the way of growth. There’s no dividend at the moment and shareholders face a real risk that the company will remain a slave to its net debt of £2.09bn.
Personally, I’m becoming more optimistic about pub stocks. Trading in 6.3 times forward earnings and at a 60% discount to book value, I think EI could double in value over the next five years or so.
A safer alternative?
EI’s high debt load and lack of growth means that it’s not without risk. My next company also operates in the hospitality sector, but has very little debt and a strong record of profit growth.
FTSE 100 firm Whitbread (LSE: WTB) owns the Premier Inn and Costa Coffee chains. The group’s sales have risen by an average of 10% per year since 2013, while operating profit has increased by an average of 8.4% per year over the same period.
This firm’s profitability is also much stronger. Whitbread’s return on capital employed (ROCE) was 14.5% last year, compared to just 6.1% at EI Group. ROCE is a useful measure of profitability as it compares operating profit with the money invested in a business.
Companies with a high ROCE are generally able to fund expansion without too much debt. They also tend to generate a reliable supply of free cash flow for shareholder dividends.
Still good value?
Whitbread’s share price jumped higher recently after the group announced plans to spin out the Costa Coffee business into a separate concern. It’s expected to attract a higher valuation alone than as part of a group.
However at £42, the share price is broadly unchanged from one year ago, despite continued growth. Trading on 15.8 times forecast earnings, I think there’s room for further gains.
I believe Whitbread shares should hit £50 at some point, giving potential upside of about 20%. I’d be happy to buy at current levels.
