Ansell discounted on insufficient earnings visibility

Knowing full well that the market doesn't like negative surprises, CEO Magnus Nicolin of rubber glove and condom maker, Ansell (ASX: ANN) forewarned the market, only days before announcing its interim result, that the first six months' numbers were going to seriously disappoint.

The company warned its first half profit would be 10% lower than it forecast at its annual general meeting last November, due to underlying weakness in the industrial and medical parts of its business, and the challenges this presents to forecasting visibility.

While laying some of the blame at his own feet, Nicolin attributed much of the reported 21.6% dive in first-half net profit to $US69.6 million ($98.4 million) – with revenue falling 7.4% to $US784.8 million in the six months ended December 31 – to some of the most volatile trading conditions in his 25 years of management experience.

With emerging markets like Russia and Brazil representing around a quarter of their sales, an entrenched global down-trend only places greater emphasis on a sustained recovery in the US, and how successful Ansell is with price increases.

Ansell's cyclically exposed customers – including the oil and gas, mining, chemical, and automotive sectors – account for around 42% of Ansell's revenue. While sectors less exposed to the business cycle, such as medical, sexual wellness (condoms), life science and food processing, contribute the remaining 58% of sales.

Nicolin's missive to investors last week was simple: nervous customers are buying less, with typical three month inventories from some of his largest distributors globally being cut back to as little as six weeks.

But volatile markets aside, Nicolin also conceded that some mismanagement over Ansell's Melaka plant – which produces about half of Ansell's surgical gloves and currently undergoing consolidation – contributed to weak operating performance at the site.

However, despite efforts by Nicolin to soften the blow, the downgrade still spooked investors, who collectively wiped $600 million off the stock's value in one day, with shares shedding a little under a third (29%) since trading at $21.42 late December.

But despite migration issues in Europe, the possibility of Britain exiting the European Union, and the US presidential election causing uncertainty, Nicolin remains optimistic that second-half earnings will be stronger than in the first six months.

What will help to boost growth will be the exclusive distributor relationship recently signed with US giant Grainger, plus new products, a continuing strong performance from the sexual wellness business, price increases in Europe, and the low cost of raw materials.

During the second half, Ansell also expects to benefit from stronger distribution of its products in North America, better-than-expected performances from acquired businesses, and growth in emerging markets like China and Mexico.

Ansell also expects to have its Melaka plant running more efficiently, after making changes to the management line-up.

Ansell maintains its revised earnings per share (EPS) guidance for the full year of 95 US cents to $US1.10, down from its previous forecast of $US1.05-$US1.20, and plans to return excess cash to shareholders through dividends and the current share buyback.

Based on the current AUDUSD exchange rate, consensus estimates are expecting Ansell to report at the low end of this guidance. But given that between 51% and 52% of sales are usually recorded in the second half, EBIT margins are also expected to improve.

The difficulty that Nicolin and his management have in providing meaningful outlook statements, within a highly volatile market, is concerning for investors looking for an attractive entry point.

With a relatively strong balance sheet, Ansell is well positioned to continue to pursue acquisitions, and assuming they can generate a payback on investment within two and a half years and beat the cost of capital at 8.5%, it plans to focus on acquiring assets from within non-cyclical sectors.

Ansell does have a long term funding gap of $471 million, but its long term cash flow relative to reported profits is strong.

While earnings per share (EPS) growth has been excellent over the last five years, weaker EPS growth is now forecast; with EPS of $1.58 in 2015 jumping to $1.66 by 2018. 

Similarly, while ROE has averaged 17.34% since 2006, it is forecast to drop to 14% by 2018.

The share price is trading at a 25% discount to its intrinsic value, and a 45% discount to its 2015 high of $29.37.

While the stock does look cheap at current levels, the market appears reluctant to afford greater value to it until there's greater earnings certainty and less volatility.

But what should also help Ansell withstand further the economic turbulence is the diverse nature of its portfolio of products.

For those who like the long-term outlook for Ansell, the current share price does look reasonably compelling; however, it wouldn't hurt to await an uptrend and some more stable earnings before entering into this one – wait until the negative surprises disappear.