Over the past four months, shares in Reckitt Benckiser (LSE: RB) have declined by 14% as the market relfects concern over the group’s growth potential. I believe that these concerns are mostly overblown.
Even though sales growth might slow a few percentage points, Reckitt still owns a portfolio of highly defensive brands, and over time, this portfolio will continue to yield results.
However, even though I believe the future is bright for Reckitt, I’m not buying the company after recent declines. Instead, I’ve decided to take a position in Entertainment One (LSE: ETO).
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Enormous potential
The reason why I’ve chosen Entertainment One over Reckitt comes down to valuation.
Reckitt is one of the highest quality stocks in the FTSE 100. Over the past six years, the firm’s operating margin has remained stable at around 25% and return on capital employed – a measure of how much the company makes for every pound invested – has fallen from around 28% in 2011 to 19% for 2016… disappointing, but 19% is still an attractive number. These high returns mean that management has plenty of cash to reinvest in the business and return to investors. Shareholder equity has expanded at a compound annual rate of 8% per annum for the last six years while the dividend has grown at 4% per annum.
Reckitt should be able to continue to produce these returns for many years to come, thanks to its portfolio of household brands. Assuming book value continues to expand at 8% per annum, within two decades it will have grown from £8.4bn to £39.2bn.
Right now the shares are trading at 5.7x book value. This valuation imposed on a prospective book value of £39.2bn gives a share price of £312, up from today’s £6.78. This is just a rough calculation, but I believe it shows Reckitt’s potential.
The one downside is at nearly 19 times forward earnings, Reckitt’s shares are relatively expensive.
Undervalued growth
Compared to Reckitt, Entertainment One looks cheap. Shares in the company are trading at a forward P/E of 11.2 and EV to EBITDA ratio of 3.1, compared to the market median of 11.4. In a trading update issued today, the creator of the Pepper Pig franchise announced that it is on track to meet City forecasts for the full year.
Analysts have pencilled in earnings per share growth of 5% for the fiscal year ending 31 March 2018, followed by growth of 14% for the following fiscal year.
As well as Entertainment One’s low earnings valuation, I also believe that there’s hidden value in the group’s content portfolio. According to today’s trading update, an independent assessment of the company’s content library has valued this unique asset at $1.7bn, up from the last valuation of $1.5bn. At the time of writing, the group’s market value is only $1.5bn.
Entertainment One has long been touted as a takeover candidate, and if a buyer does swoop, it’s likely they’ll have to offer at least the value of the content portfolio to get management interested. On this basis, the shares should be worth at least 293p.
