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Royal Mail woes hold back Temple Bar

Temple Bar has published results for the year ended 31 December 2022. Unfortunately, the trust underperformed the All-Share over the year, returning -2.0% in NAV terms versus +0.3% for the index. The share price did a bit better with a return of +3.6%, however, helped by a narrower discount. The chairman notes that, since Redwheel took over the trust’s management at the end of October 2020, the NAV total return has been 57.7% compared with 39.0% for the benchmark (to the end of 2022).

The dividend was increased from 7.9p to 9.35p (+18.4%) and this year (unlike last) the dividend was covered by earnings, leaving a small surplus to go towards rebuilding the revenue reserve.

Extracts from the managers’ report

Given its high exposure to the Energy and Materials sectors and an under-weighting towards high growth technology sectors, the UK market fared relatively well in 2022, delivering a small positive total return. The Company portfolio delivered a small negative return over the period, although this masks a large disparity in the performance of some of the individual names. The Company’s holdings in the Energy sector (BP, Shell and Total Energies), Pearson, Centrica and Standard Chartered all delivered strong returns, with each stock adding between 1.5% and 3.0% to the portfolio return. Conversely, the portfolio’s holdings in International Distribution Services (formally Royal Mail Group), Marks & Spencer and Currys all declined markedly as investors attempted to factor in the deteriorating economic outlook. Each stock detracted between 2% and 4% from portfolio return.

The share prices of the three energy companies performed well on the back of rising oil and gas prices caused by the effects of the war in Ukraine coupled with a muted supply response; itself caused by several years of under investment in bringing new resources to the market. We cannot predict the path of future oil and gas prices, but would make the observation that demand for fossil fuels is strong today and is likely to remain so for many years at a time when many companies in the sector have severely curtailed investment. This provides the set up for continued strength in energy prices at a time when the share prices to levels of all three companies continue to discount commodity prices that are much below where we are today. By way of illustration, according to their own sensitivity analysis, BP, Shell and Total Energies are valued on price to earnings ratios of around 10x assuming a $60 Brent oil price. Oil prices at the time of writing are around $80 per barrel, and we therefore take the view that there is a considerable margin of safety built into the share prices of the companies. Centrica likewise delivered strong returns in the year, benefitting from high gas and electricity prices and significant consolidation in energy supply markets following the demise of a number of its competitors.

Pearson has struggled for some time with the transition from physical print textbooks to a digital offering in its North American Higher Education business and although this journey has proven to be protracted and damaging to group profitability, we continue to believe that educational publishing is an attractive business offering the prospect of healthy returns. The company’s share price performed well in the year prompted by two separate bid approaches from the private equity firm, Apollo, and evidence that the company has again returned to revenue growth. Although both Apollo bids were rejected by the management team as undervaluing the company and therefore came to nothing, the approach highlighted the potential undervaluation in the company’s shares.

Standard Chartered has been a beneficiary of rising interest rates, which in turn should lead to higher income growth and thereby help the bank achieve its 2024 10% Return on Equity target. Although the large increase in interest rates that we have seen could lead to credit stresses and increased loan loss provisions, the bank has been significantly de-risked over the last few years and lending standards are now much improved. It is possible and maybe even likely therefore that credit provisions will not need to be increased significantly from current levels. If the company is successful in hitting its financial targets for 2024, its shares would be valued by the stock market at less than seven times its annual profits. In January 2023, it was announced that First Abu Dhabi Bank had evaluated the idea of making a bid for the company and whilst again it came to nothing, it serves to highlight the strategic value of the company’s geographic footprint and its attractive valuation.

At International Distribution Services, a normalisation of parcel volumes post COVID, coupled with an inability to make productivity improvements in the UK (as a result of poor labour relations) has meant that its UK business, Royal Mail, is expected to lose money in the current financial year. The company continues to negotiate with the unions but has made it clear that any agreed pay deal needs to be accompanied by an improvement to outdated working practices. It has also said that it will not allow its international business, GLS, to destroy shareholder value by continuing to fund the UK business, and, if necessary, will separate the two companies to prevent value leakage. GLS is a parcel only business (no letters), with a non-unionised work-force, whose standalone value is greater than the stock market valuation of the entire group. The stock market has therefore placed a substantial negative valuation on Royal Mail, even though it is the leader in the UK parcels market and has significant surplus property that can be sold off over time. Any formal separation should throw a spotlight onto the very significant under valuation of the group’s shares.

Marks & Spencer fell on investor fears that the cost-of-living crisis will result in falling consumer spending and lower profitability. The food retailers generally (Marks & Spencer derives two thirds of its revenues from food) are going through a difficult period, with likely worse to come as they struggle to recover all their input cost increases without damaging sales volumes. However, our view is that this has already been more than factored into the Marks & Spencer share price. The shares are valued on a historic price earnings ratio of 7x at a time when we believe that there are many positive changes happening at the company. The company sells almost 40% of its clothing online (where it is number 2 in the UK by market share) and store-based clothing sales now account for just 20% of the group total, whilst in food the company continues to take market share. The company management target a level of operating performance in line with peers in the sector, which if they were able to achieve would result in further significant growth in earnings and a price earnings ratio of less than 6x at today’s share price.

Currys, the electrical retailer, is struggling with a difficult economic backdrop and as a low margin, operationally geared business is sensitive to relatively small declines in sales volumes. Accordingly, profit expectations have been significantly downgraded since the Summer. Although electrical retailing is a competitive business, the company is well managed and occupies the number one or two position in the UK and the Nordics. Although there is further downside risk to short term profit forecasts, the company is valued at less than 8x 2022/23 earnings, with the potential for a significant profit recovery as and when trading conditions improve.

TMPL : Royal Mail woes hold back Temple Bar

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