Why Tate & Lyle PLC isn’t on my buy list

Tate & Lyle PLC no longer runs the branded sugar or syrup businesses it’s famous for, but the company is still an interesting and relatively defensive option for many investors.

With its shares trading at 675p Tate & Lyle’s dividend yield is 4.2%, which is slightly above the FTSE 100’s yield of 3.8% (with the index at 6,900).

That high yield is attractive, especially for investors who are fond of dividends, as I am. Another positive is that the company paid a dividend in every one of the last ten years, and also increased that dividend almost every year.

However, despite its attractive dividend yield and dividend history, I won’t be buying any Tate & Lyle shares at their current price. Here’s why.

Growth has been slow despite a move towards more profitable products

Tate & Lyle operates in the defensive Food Producer sector and is one of the world’s largest food ingredients companies. It has two main businesses:

Bulk Ingredients – Supplies commodity food products such as high-fructose corn syrup. This is a high volume, low margin and low return on capital business, operating in a market-driven primarily by price.

Speciality Ingredients – Develops innovative, technical and sometimes patentable ingredient products and solutions. This is a lower volume, higher margin and higher return on capital business, which seeks to build defendable competitive advantages. A good example is Splenda, Tate & Lyle’s zero-calorie sweetener.

Over the last few years, the company has made a concerted effort to divert cash from the low-return bulk ingredients business into the higher-return speciality ingredients business.

Has this strategy been working? Have a look at the chart below:

Adjusted operating profits from the bulk ingredients business have clearly been declining over the last few years, but that decline has not been seriously offset by growth from the speciality ingredients business.

Of course, things might improve in the future, but for now, I’d say there’s little evidence that the speciality ingredients business has any significant ability to grow.

This mix of slow growth in one business and negative growth in the other is reflected in the company’s overall results:

It’s clear from the chart that Tate & Lyle is not a growth company.

Since the financial crisis in 2008, dividends have grown by around 3.4% each year, which is not too bad. However, profits have grown by an average of just 2.2% per year and revenues have actually fallen by an average of 3% per year.

The company’s overall growth rate was less than 1% per year, which is less than the rate of inflation.

That’s too bad because I have a rule of thumb which says:

• Only invest in a company if its 10-yr growth rate is more than 2% (i.e. the expected rate of inflation)

So Tate & Lyle’s growth rate of just 1% per year is kind of a deal breaker.

However, I’m a flexible chap and if the price was extremely low then I might be inclined to ignore that rule, at least to some extent.

Something that might keep me interested in this slow-growth company would be a track record of consistently high profitability, i.e. high returns on capital employed (ROCE).

There are two main reasons why I like to see a high ROCE:

1. Consistently high ROCE means any earnings retailed by the company are likely to generate decent returns
2. Consistently high ROCE could be a sign that the company has a strong competitive position, which in turn can make a company more robust in the face of adversity

So let’s take a look at Tate & Lyle’s profitability.

Profitability has improved but from a very low base

The chart below shows how total capital employed and returns on that capital have changed in recent years:

Over the years, capital employed has declined slightly while returns on that capital as a percentage have increased (at least if we assume the poor returns of 2016 are a temporary blip).

This seems to bear out the underlying story of the company’s move from lower-return bulk to higher-return speciality ingredients.

Improving profitability is good, because at the start of the period, ROCE was barely above 7%, and that would have made Tate & Lyle very unattractive according to another of my rules of thumb:

• Only invest in a company if its profitability (ten-year average ROCE) is above 7%

The company’s profitability is now above 10%, which is average rather than exception, but is still a lot better than 7%.

Something else I like to look at, and which relates to profitability, is how much money a company has been investing into its capital assets. This is the buildings, machinery and other long-life assets which are essential to almost all businesses.

The next chart compares the company’s expenditure on capital assets (capex) to the depreciation of those assets and the company’s post-tax profits:

The financial crisis was clearly a trigger for massive cuts in capex, which is quite understandable. During the crisis, cash earmarked for capital investment was quite sensibly put to work to reduce debt and strengthen the balance sheet (which I’ll get to in a moment).

After the crisis capex recovered, but not to anything like its pre-crisis levels. I haven’t looked at it in detail, but I assume this is at least partly down to the company’s decision to invest in the less capital-intensive speciality ingredients business rather than the more capital-intensive bulk ingredients business.

Generally, I like to see capex being higher than depreciation and lower than profits, although I don’t have a specific rule of thumb about this.

• If capex is typically higher than depreciation: Over time this should result in an expansion of the company’s capital assets, which should increase the company’s productive capacity
• If capex is typically lower than profits: The company probably only needs a relatively small capital asset base in order to function, which can leave more cash available for growth investment or to return to shareholders

In Tate & Lyle’s case, both of these conditions have been met on average over the past decade, with 10-yr capex coming in at 140% of depreciation and 70% of profits.

The picture so far then is one of a high-yield, slow-growth defensive sector company, which is generating average returns on capital from average levels of capital investment.

Next up I want to look at debt and pension liabilities because both of those can cause serious problems for otherwise healthy companies.

Overall debt and pension liabilities are on the high side

The chart below shows debts (borrowings) and profits on two axes, with the ratio between the values on those axes set to five (i.e. when the borrowings and profit lines cross, the pound value of debts are five times greater than profits).

I set the ratio between the two axes to five because I have a rule of thumb about debts and profits:

• Only invest in a defensive sector company if the ratio between its debts and 5-yr average profits is less than five

As the chart shows, before the crisis the debt line was far above the profit line, indicating that debts were far higher than five-times profits (the chart shows annual profits rather than 5-yr average profits, but the outcome is much the same).

When the financial crisis struck, Tate & Lyle cut capex (as well as many other things) and paid down its debts, which is sensible. Even after the crisis, the company has continued to reduce its debts, which is good.

Currently, Tate & Lyle’s debt ratio is, well below my limit of five.

That debt ratio is fine in isolation, but there are other financial liabilities to worry about, and for me, the most important one is the company’s defined benefit pension liabilities.

The chart below shows how Tate & Lyle’s pension liabilities have changed over time, compared to the company’s profits.

As with the debt chart, this chart also shows profits and (pension) liabilities on two separate axes. However, this time the two axes have a ratio of ten to one between their values, and this relates to another rule of thumb:

• Only invest in a company if the ratio between its pension liabilities and its 5-yr average profits is less than ten
  

The good news is that the pension liabilities have consistently been below the profit line in the chart, which indicates that they have been consistently less than ten-times profits.

Tate & Lyle’s current pension ratio is 6.8, which is of course less than my upper limit of ten.

One downside to the pension is that it has a deficit of around £200m, which is only slightly less than the company’s average profits of £240m. That isn’t the end of the world, but it isn’t exactly good news either.

With a debt ratio of 3.1 and a pension ratio of 6.8, both of which are within my preferred limits, there doesn’t seem to be a problem. But as I mentioned before, liabilities do not exist in isolation.

Instead, they add up, and a company with substantial borrowings and substantial pension liabilities is much riskier than a company with just one or the other.

As you may have guessed, I have a rule of thumb to cover this:

• Only invest in a company if the sum of its debt and pension ratios is less than ten

For Tate & Lyle, the sum of its debt and pension ratios is 3.1 = 6.8 = 9.9.

That means it’s right on the brink of having liabilities which are outside my comfort zone.

Personally, I’d like to see the company grow its profits while continuing to pay down those debts, and perhaps do some sort of deal with an insurance company to cover its pension risks.

So at this stage, I would say that Tate & Lyle is probably not a company I would invest in, thanks to its low growth and large financial liabilities.

However, both of those negatives are borderline and the company is not an obvious basket case. So if I was in a good mood then perhaps there is some chance that I would invest, but only at a very attractive price.

I would only buy Tate & Lyle if the share price was below 300p

To value a stock I compare its 10-yr growth rate, 10-yr growth quality (consistency), 10-yr profitability, 10-yr PE ratio and 10-yr PD ratio (price to dividend) with every other eligible stock in the FTSE All-Share.

It works somewhat like Professor Greenblatt’s Magic Formula, with each stock being assigned a rank according to the relative attractiveness of those five factors.

In general, I’ll only look seriously at stocks that are in the top 50, and with a share price of 675p Tate & Lyle has a rank of 127.

To get into the top 50 stocks on my stock screen, Tate & Lyle’s share price would have to drop below 300p.

That would give it a dividend yield of over 9%, which would nicely offset the company’s almost non-existent growth rate.

However, a 9% dividend yield is unlikely to occur unless the company is facing a serious crisis and if the dividend was at serious risk of being cut or suspended. So if it ever did reach 300p I’d have to re-evaluate the risks to see if the investment case still stacked up.

I don’t expect the company’s share price to fall to 300p, but such a fall is far from impossible.

You only have to look at a few FTSE 100 companies to see that share price declines of more than 50% are not that uncommon.

So despite the outrageously low target price, I might still end up buying Tate & Lyle at some point in the next couple of years. But first, I would like to see it reduce those liabilities and get growing again.