European equity markets fell in September as mixed economic data, fresh spikes in Covid-19 cases and the reintroduction of new restrictive measures tested market sentiment. 

The Fund underperformed, mainly due to a 20% decline in United Internet’s share price as the company unexpectedly cut its annual run-rate earnings guidance by some 13% to reflect higher wholesale costs for its mobile virtual network operator (MVNO) activities. Whilst management disputes the legal validity of these extra costs charged by network operator Telefonica Deutschland, until a legal settlement is reached these extra costs (even if reversed at a later a stage) needed to be reflected in their guidance. The positive investment case for a 5G network buildout is reinforced by higher wholesale costs, but a prolonged period of legal uncertainty regarding mobile wholesale pricing obscures the mid-tem cash flow picture. We therefore reduced our exposure and invested in two new positions: Swiss-listed SIG Combibloc and Italian utility Enel.
 
Packaging solutions supplier SIG Combibloc (€5.1bn market cap) re-listed two years ago after the company was taken over by a private equity company in 2008. SIG Combibloc is the global number two aseptic carton solutions supplier (21% global market share) with €1.8bn of sales. Aseptic carton packaging is a niche market for sterile food packaging applications (mainly liquid dairy, non-carbonated soft drinks and liquid food). Global usage is steadily growing because of food safety priorities, green credentials and under-penetration in emerging markets. SIG’s business model combines the engineering and selling of complex filling systems with the sale of proprietary packaging consumables (i.e. the sleeves or predesigned packaging boxes) under (typically) 7-year lease agreements whereby consumable prices are reset annually as a function of anticipated volumes and raw material costs. SIG has an installed base of over 1,200 filler machines whose economic life exceeds 20 years, as customers’ reluctance to change is reinforced by their own food safety reputation. These dynamics create high barriers to entry, reinforce capacity to innovate and explain why SIG and industry leader Tetra Pack (privately-owned) have a combined market share of 87%. SIG’s revenue and cash flow is very steady and predictable (like the razor/razorblade business model). Moreover, as customers on average pay some 30% of the initial filling machine investment upfront, SIG’s payback on an installed filler system is less than three years and net tangible returns exceed 25%. On short-term earnings multiples, the value opportunity in SIG does not appear that obvious, but objective financial characteristics and consistent valuation assumptions imply an intrinsic value of €7bn, CHF24 per share, which implies some +35% upside.
 
On 15x expected earnings (€5.1bn) and 16.4x free cash flow (€4.7bn), Enel’s valuation (€77bn market cap) might not stand out. Utilities are typically slow growing and their cost of capital economics are unfavourable. While this hasn’t changed, Enel has (and continues to do so). It has stepped up its growth investments in the last five years, especially into green power (and smart grid/meters, electric vehicle charging networks, power storage and fibre) where investment returns, whilst not great, exceeded regulated asset returns and even our conservative cost of capital assumptions (by a modest 3-4% margin). Enel invests each year some €6bn in discretionary ‘growth’ investments which depress reported free cash flow. A third of these growth investments go into regulated power distribution activities to which we ascribe no positive net present value effect (no value creation). But the remaining €4bn of growth investments is largely going into green power projects where returns are good considering the low beta and cheap funding costs of these projects. With some 30% of Enel’s EBITA already coming from green power generation, and growth investments in green power exceeding EBITA, further earnings and value growth can be expected. Excluding growth investments, Enel trades on an equity free cash flow multiple of just 10x (or a free cash flow yield of 10%): even if all growth investments would happen at the cost of capital, we believe the shares to be undervalued by just over 40%.  The Fund is typically very underweight utilities because of their cost of capital economics, but Enel’s transition from traditional utility to a more vertically integrated green energy provider, opens a rare value opportunity.

Apart from reducing our United Internet position, we sold out of Reckitt Benckiser (after excellent performance the price reached our fair value) and JC Decaux (the 25 stock limit of the Fund forces us to trim names, hence we took our loss but maintain travel normalisation exposure through other existing positions with more upside by our calculations). In addition, as Siemens spun-off the Siemens Energy subsidiary to shareholders, we sold our Siemens Energy allocation as the majority of the Siemens Energy valuation is driven by its listed and overvalued wind turbine subsidiary SiemensGamesa.  

Data shown net of fees, net income reinvested. Please note that all fund performance is shown against the MSCI Europe NR 12pm adjusted. Performance of other share classes may vary and is available on request. Where shown, monthly returns table shows compounded discrete monthly performance.

Past performance is no guarantee of future performance. The value of an investment and the income from it can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested.