THE MARKET ENVIRONMENT
Major global markets generally finished the second quarter higher, continuing the relief for the year-to-date period following a challenging 2022. In the U.S., the Russell 1000 Growth Index gained 12.81% versus the Russell 1000 Value Index, which gained 4.07% as technology and AI-related companies led the advances. While the U.S. and Europe equity markets showed strength on the back of better than expected economic data, Asian markets were mixed with China equities finishing lower and Japanese equities reaching 30-year highs.
Central banks continued to focus on reining in inflation, which remains elevated across most regions. The U.S. Federal Reserve increased its benchmark interest rate by 25 basis points in May before pausing at its June meeting. Comments from members of the Federal Open Market Committee pointed to further hikes in the future and interest rates remaining elevated for some time. The European Central Bank and Bank of England both increased their respective interest rates in May and June, reaching 4.00% and 5.00%, respectively, while Japan and China opted for more accommodative monetary policies. In the face of tightening financial conditions, inflation fell from prior year levels during the quarter throughout most of the world.
Regardless of the economic backdrop and central bank activity, our disciplined investment process continues to revolve around bottom-up, fundamental research. As long-term investors, we value our companies through the economic cycle and focus portfolio construction on optimizing what we believe are our best investment opportunities. We attempt to identify growing businesses that are managed to benefit their shareholders and invest in those businesses only when priced substantially below our estimate of intrinsic value, then patiently wait for the gap between share price and our estimate of intrinsic value to converge. We believe this approach best serves our goal of growing our clients’ capital over the long term.
BMW released a strong set of fiscal first-quarter results, in our view, demonstrating continued positive momentum in price/mix that reflects improved product mix, disciplined pricing, and BMW’s premium positioning. BMW is also showing excellent progress in its electrification strategy. Its battery-electric vehicles have increased by 112% year-over-year to 11% of volumes. Management reiterated its targets of 15% of volumes by 2023 as well as long-term guidance of over 50% by 2030. Although overall volumes declined slightly in the first quarter, this was largely due to a 6.6% decline in China. Management expressed significant confidence that volume performance will improve as the market cycles Covid-19 effects as well as in the company’s long-term premium position for both battery-electric and internal combustion vehicles. BMW delivered a 12.1% EBIT margin in the automotive segment. While already robust, this understates the underlying performance because of the accounting related to the company’s purchase of an additional stake in its Chinese joint venture last year. We continue to appreciate BMW’s forward-thinking management team, strong balance sheet, focus on technology and flexible approach, allowing it to be one of the best-positioned original equipment manufacturers to meet the challenges facing the automotive industry.
First-quarter results from BNP Paribas were mixed with headline revenue growth up only 1.4%. After adjusting for the partial consolidation of Bank of the West, we find revenue grew about 5.3% year-over-year, mainly driven by strong performance in commercial and personal banking and corporate and institutional banking, which grew 5.9% and 4.0% year-over-year, respectively. The company reported a common equity tier 1 ratio of 13.6%, which grew 130 basis points year-to-date. Notably, BNP generated positive jaws of 30 basis points across its three operating segments as gross income growth exceeded expense growth. Management confirmed its 2022-2025 targets, noting that it was ahead of schedule to reach its net income and earnings per share compound annual growth rates of 9% and 12%, respectively. BNP initiated EUR 2.5 billion in stock buybacks in early March and expects to begin the remaining EUR 2.5 billion of its authorization in September. The company’s EUR 5 billion in buybacks and its dividend of EUR 3.90 per share will result in a total capital return yield of 14.1% in 2023, while remaining significantly overcapitalized. Beyond 2023, we appreciate that management plans to return 60% of earnings to shareholders with strong net income growth.
Mercedes-Benz Group’s first-quarter revenue outpaced our expectations, with unit sales up 3.4% with a 12.4% margin in the cars segment. Car margins benefited from product mix and strong net pricing that more than offset cost inflation and the vans segment reported solid margins behind a strong mix and pricing benefit, with units up 11.7% and revenue up 25% year-over-year. Overall, sales across all regions grew, with Europe the strongest at 8.3%. The company’s top end vehicles and entry segments rose by 17.5% and 26.8%, respectively. Industrial free cash flow was strong at EUR 3.3 billion, despite including around EUR 900 million of working capital outflows, driven by new vehicle stock and the transition to the new direct sales model in the U.K. Guidance was largely unchanged, and the company sees demand in the U.S. as healthy, recovering in China, and Europe weakening but being supported by order book. Management expects net pricing to more than offset inflation for the full year and guided for continuous price increases going forward. Even with higher research and development costs and capital expenditures, management expects free cash flow to be in line with the previous year, which we found to be impressive.
Sentiment in Chinese equities has degraded after the initial excitement from China’s reopening earlier in the year. Incremental macroeconomic data coming out of China indicates that the Covid-19 re-opening bounce is fading, and the economy is struggling to sustain healthy growth. As the largest e-commerce platform in China, Alibaba’s share price has been caught up in this storm. The company has also continued to face intense competition from the likes of short video players and traditional e-commerce companies. Despite these negative factors, Alibaba remains an extremely important platform in China and continues to generate significant free cash flow. In the most recent completed fiscal year, the company generated $25 billion of free cash flow, which is 12% of the current market capitalization. Its core commerce business trades at approximately 5x adjusted earnings, a valuation we deem much too cheap, even with the headwinds noted above. Alibaba’s management team has been aggressive with share repurchases and recently formed a capital management committee. In addition, the company recently announced a major restructuring that will effectively break up the company and separately list various businesses within Alibaba. Today, the market is assigning little to no value to these businesses and having a market quote may force investors to give Alibaba value for these assets. Irrespective of whether the restructuring works or not, we appreciate management’s efforts to help unlock value in what, we see, is clearly an undervalued stock.
Worldline reported first-quarter results largely in line with prior guidance. Organic growth was up 9.2% with merchant services continuing to drive growth, up 12.6%, due to continued strong transaction volume growth in store (11%) and online (19%). Going forward we expect merchant growth to benefit from the lapping of the 2% Russia-exit headwind and pricing initiatives. In addition, a rebound of Chinese travel to Europe should prove beneficial as Worldline is Europe’s top partner for UnionPay, Alipay, and WeChat Pay. Financial services grew 2.3%, in line with management’s expectations; and full-year guidance reiterated 8-10% organic revenue growth, a 100-basis point margin improvement, and 46-48% free cash flow conversion. Management noted that Worldline’s new partnership with Credit Agricole (CA) will allow the company to enter the French merchant acquiring market, which we view as an attractive opportunity. France is a EUR 700 billion payment volume market that has been closed to non-bank merchant acquiring, and CA holds around 25% market share within France. We recently met with Worldline’s CEO and CFO, Giles Grapinet and Gregory Lambert, who remain optimistic on the company’s ability to reach its organic growth target for 2023 despite the potential macro headwinds. Management plans to focus on improving margins and utilizing a more structured capital allocation framework which should shift growth to be primarily organic. Further, the reduction of costs from merger and acquisition integration and platform consolidation should result in an acceleration in margin improvement. As the company finishes its asset integration in 2024, management noted the duplicative costs of the business should come down, and its efforts to move workloads to the cloud will lead to additional cash cost reductions.
Kering reported first-quarter results with revenue growth of 1% year-over-year in constant currency, against a 21% increase for the same period the year prior. The business improved sequentially throughout the quarter with March retail sales up 12%. Total growth was weighed down by an accelerated pullback from the wholesale channel at Yves Saint Laurent (YSL) and Bottega Veneta and a 32% drop at the other houses segment. Balenciaga grew in the first quarter, despite the brand still recovering from its controversial campaign last November, driven by double-digit growth in Asia. Management expects mid-single-digit growth this year for Gucci after its 1% growth during the first quarter and is pleased with the progress in elevating the brand. Management reiterated that for the full year, growth in Gucci will be flat to slightly up, YSL is expected to expand, and other houses may be driven down by wholesale rationalization.
During the quarter, we initiated positions in Bank Mandiri and Recruit Holdings. There were no final sales during the period.
Past performance is no guarantee of future results.
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