Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and here with me today is Alan Porter, Manager of the Securities Trust of Scotland (STS).
Hello, Alan.
Alan Porter: Hello.
Wall: So what's the first stock for us today?
Porter: Well, I was going to talk about UPS, United Parcel Service (UPS).
Wall: And that's in the U.S., isn't it? Why do you find that stock compelling?
Porter: Well there's three things we look for when we're looking at stocks; one is an attractive income margin of safety. So this stock yields over 3% and its free cash flow covers its dividend very healthily, so we expect to run about 8% dividend per share growth each year for the next few years. We also look for valuation margin of safety, so from a discounted cash flow point of view, cash flow is very important for us because after all, it's the cash flow that pays a dividend.
It looks very attractive from that point of view. Also in the traditional multiple basis, so your P/E ratio or your EV/EBITDA ratios, it's kind of trading close to or slightly lower than historical averages.
But the most important thing is you know what sort of insight do we have; what is it specifically about any stock that makes us think that the market is going to view more positively. And for UPS, there's really several things. One is an improvement in its domestic pricing. So it's really enjoying, the benefits that we're seeing in growth in B2C, business to consumer.
So if you think about online shopping effectively, so the online retail in the U.S. is probably growing four times faster than GDP is in the U.S. at the moment. So that's a pretty punchy growth rate and its UPS that is providing the infrastructure to allow those packages basically to get delivered. And what it's doing is its saying to retailers, come on we put this investment into the infrastructure, you need to pay us for it. So they're being much cleverer on pricing.
Wall: We've seen a number of delivery services in the U.K. go under recently. Presumably UPS is global enough to not be hit by the things that have affected the U.K. ones?
Porter: Well, it is truly global, but I think the ones that you probably found that struggled a bit, are the smaller ones that just don't have the infrastructure where basically they're getting competed out of the market. The beauty of UPS is quite frankly that it's the biggest. So if you're a very large retailer, you want to be able to get your packages delivered everywhere by a one-stop shop and that's the beauty of the UPS model. I mean, it's predominantly U.S., but it's global as well.
Wall: And what's the second stock today?
Porter: Well, the second stock, I thought I'd talk about is a U.K. stock; Kingfisher (KGF) more of a turnaround story. So again, we do see a decent dividend margin of safety. Again it's yielding more than 3% at the moment, but we expect quite strong growth in that, probably high single-digit growth in the dividend over the next few years. And it's attractively valued, which is important, but really our insight there is a new Chief Executive has just started at the company.
And when I talk about turnaround, it's very interesting. She came out with, at the end of March, her sort of first review of the business, and two things really struck us and we bought this just before her review.
On the one hand, it's the very positive structural trends that home improvement is seeing around Europe, because don't forget a lot of people know Kingfisher just for B&Q, but actually it's got just as many sales outside of the U.K. in different formats. What she was really saying is home improvement is a top spend for European households, number one.
And number two, there are some big trends out there, which are positive for them, such as urbanization even in the developed markets, more people living in smaller homes, the rise of home technology, all of which means you are doing home improvements continually to accommodate all those things. But it's not just the structural growth; it's also the turnaround situation.
She made one really good point, I thought, which was, an Kingfisher Group has something like 393,000 products, but of those only something like 7,000 are sold in more than one of their operating companies and they have five main operating companies, that's absolutely crazy. So she is coming with this whole concept of bringing in a sort of a One Kingfisher and they've just started rolling this out, so think the prospect is going forward.
Wall: Our equity analysts actually rated it very highly and they did say the other week that the fact that Labour hasn't come in [to Government] and introduced the Mansion Tax, is obviously a positive for Kingfisher as well.
Porter: Yes, that's absolutely right.
Wall: And what's the third stock today?
Porter: So the third stock, completely different, a stock – our most recent purchase is Intesa Sanpaolo (ISP), which is an Italian bank and that may surprise some people, I often get an interesting look when I mention that one.
But for us, it's keeping it back to basics again. When we talk about the dividend margin of safety, so we are talking about a bank here, so it's all about how much does its net profit coverage its dividend? It's an annual dividend payer, it's just paid an annual dividend, which is equivalent to about 2.2% yield and it's forecasted double that next May, so 100% growth in dividends, which I think you'll agree as very healthy, meaning it's on a 4.4% prospective yield and the reason it can do that.
It's a very strong bank. It is a plain-vanilla bank with a strong asset management business. What they are seeing is a lot of fee growth, partly because a lot of the assets they have under administration are going into their assets under management pile if you like, so the fee is improving and that's very important, they've got a great cost control programme out there, where they are keeping headcount very stable for the next few years.
And most importantly, the Italian economy is recovering, so provisions are falling, provisions set aside for non-performing loans are coming down rapidly, all that is meaning the bank is generating a lot of net profit. It's got a solid capital base already, so it means that we are seeing excess capital generation and they've basically said a large amount of that will come back to shareholders in the form of dividend.
Wall: Alan, thank you very much.
Porter: You are welcome.
Wall: This is Emma Wall for Morningstar, thank you for watching.
