Phil Oakley s Weekly Roundup

Transcription

1 Phil Oakley s Weekly Roundup Exclusively for SharePad and ShareScope users 28 June 2018 Market Overview Top FTSE All-Share risers Top FTSE All-Share fallers 1

2 Some thoughts on the current state of the stock market I haven't commented on the state of the markets for a while. So, for what it's worth, I thought I'd share my current views with you. It's been hard to make good money from shares in general in 2018 as the markets come up against a number of challenges. We have had a nine-year bull market in stocks which has seen the valuations of many high-quality companies become very stretched. Generally speaking, I take the view that outstanding businesses are scarce and that the stock market tends to undervalue them. This is a different view from saying that quality companies are a buy at almost any price which is what I feel many leading professional quality investors are coming perilously close to endorsing today. Let me use the example of Diageo (LSE:DGE) - which I think is an outstanding business that has few genuine competitors - to illustrate this. Forecasts for revenue growth for the next three years are in the 3-4% range with EPS expected to grow by around 8% per year. That's OK but nothing stellar however the shares are valued at a rolling forecast PE of 21.6 times. Bulls will argue that the bond-like predictability of Diageo's cash flows warrant a high valuation and there are strong grounds for saying this. The trouble for investors is how are they going to make money buying at the current valuation? Do they really expect Diageo's PE to go higher? It might do, but its share price has gone nowhere in The risk of owning highly-valued shares is that the market will severely punish any profit disappointments. Many highly- valued shares justify some of their price tags by having been very dependable businesses in the past. The question is, how long can their profits hold up? Donald Trump playing around with tariffs, the possibility of rising interest rates and high levels of household debts all provide a challenge to companies trying to keep on growing their profits. I'm not going to call a recession but what I will say is that the combination of high valuations and many years of growing profits behind companies does not feel like a happy hunting ground for equity investors right now. Momentum investing seems to remain very much in vogue and is used to justify sky high valuations of some shares. As I've written previously, momentum strategies work well until they don't. Not everyone can get out at the top. One thing that I have become increasingly nervous about is the state of the UK economy. Recent announcements from housebuilders and estate agents are saying that the housing market is slowing quite rapidly. Housing equity underpins a lot of consumer spending, especially from downsizers and people paying for extensions on their properties. Retail businesses also continue to struggle. I therefore think that staying away from companies with heavy exposure to consumer spending might be a good idea. It is possible to make money from shares in all kinds of markets. Avoiding losing money is even more important which is why good analysis of companies and their finances should focus on risks as much as rewards. 2

3 Whitbread (LSE:WTB) The case for investing in Whitbread is that it has two very strong consumer brands in the form of Premier Inn Hotels and Costa Coffee. What tends to make investors a little nervous of the company is that it is essentially a play on the fragile UK consumer despite attempts to expand both its businesses overseas. Trading in the first quarter of the 2018/19 financial year doesn't look great, despite the company saying that it is on target to meet current analysts' profit forecasts. For me, Premier Inn is the main attraction of Whitbread. It offers great value accommodation across the UK and still has scope to grow further. That said, growth in the first quarter has been held back by a very weak London market where Whitbread is investing heavily by adding new hotel rooms. This has dragged down the occupancy rate of the hotels to 77.2%. With average room rates increasing by 0.7%, revenue per available room (REVPAR) fell by 1.9% which is disappointing. A closer look at the London market gives some cause for concern in my opinion. Premier Inn has increased its capacity in this market by 13.8% but its REVPAR has declined by 6.6%. Certainly, the new hotels will take a little time to get up to speed but with overall occupancy levels falling in London because of strong growth last year according to Whitbread and competition remaining fierce, it does raise questions as to whether Whitbread should continue to keep investing heavily in this area. 3

4 Outside of London, things seem to be a little better but REVPAR still fell by 1.2% in the first quarter. Total sales growth of 3.8% came from a 5.1% increase in capacity which is helping Premier Inn take market share. Whitbread wants to create a big Premier Inn business in Germany where the hotel market is very fragmented. Up until now it hasn't given much information about how its small number of existing hotels has been performing. The fact that the Premier Inn hotel in Frankfurt has been open for nearly two years and is only achieving occupancy levels of 64% (something nearer 80% would be good) is not very encouraging and could see investors revise down their expectations of how much additional value Whitbread can create in the German market. The chief concern with Costa Coffee is that there are too many coffee shops in the UK and that Costa is opening too many new ones which may take sales from its existing shops. Throw in a weak high street trading environment and you have a few things to worry about. Whitbread is opening new stores in areas of higher footfall than the high street but like-for-like sales in its UK-owned stores fell by 2.9% during the first quarter. Total sales increased due to Costa having more stores than a year ago. The saving grace for Costa is its Express coffee machines. These are extremely profitable and earn very high returns on capital. They are also a lot easier and faster to roll out and grow the business than opening new coffee shops. 1% UK LFL sales growth is not too bad but is a sign that there is little underlying growth. Growth is coming from adding new machines which contributed to a 9.5% growth in total sales in the quarter. With 1300 machines to be installed in the UK and abroad this year, there should be some decent sales and profitability from Express coffee machines. 4

5 However, with such a poor performance in the UK coffee shops the profitability of the estate which did not grow last year could fall unless cost savings are found to plug the gap. My concern with cost cutting is the levels of customer service could fall. If my local Costa shop is anything to go by then this is already happening as it appears to be short staffed and it takes ages to buy anything. My other concern is that Costa's coffee and food offer is too expensive and lacks range such as healthy options and this could see it lose customers to cheaper and better competitors. For a long time, it has been argued that Whitbread shares look cheap on a break up basis. I accept this if you put Costa profits on a similar multiple to Starbucks and compare Premier Inn's with a hotel operator such as Accor but I think this argument is weakening. Both businesses have weak underlying growth in the UK and have yet to demonstrate that they can be successful overseas. Costa is going to be demerged sometime over the next couple of years but it may be losing value in the meantime. I can see Whitbread shares continuing to trade at a discount to break up values of per share unless someone comes along and bids for one or both of its businesses. 5

6 Northgate (LSE:NTG) Northgate is the UK market leader in the provision of rented vans (referred to as light commercial vehicles or LCVs). It also has a large rental business in Spain. Its customer proposition is to offer more flexibility and less risk through renting than owning a van outright. Like most rental companies its profitability is determined by a few key factors: The size of its fleet. How many of them are on hire throughout the year their utilisation. The daily hire rate. The profit or losses made when selling vehicles. Northgate has a chequered history. It grew rapidly in the early to mid 2000s in both the UK and Spain and took on lots of debt. At the same time, it had significant exposure to the construction industries in both its markets. When the financial crisis and subsequent recession hit, demand for rented vans collapsed and the company was put into serious financial difficulties that required fresh money from shareholders. Since then it has taken a cautious approach to both businesses and has shrunk them in size before starting to grow them again. It has also looked to move into the contract hire market where customers rent vehicles for an agreed period of time (3-4 years is quite common) to give its business more secure and predictable cash flows. The business is very sensitive to changes in the economy which means that profits have the tendency to move up and down a lot. At the moment profits are falling. The key performance metrics for the UK business are shown below. 6

7 Average vehicles on hire have continued to fall and the utilisation also fell slightly. Rental profits fell significantly as did disposal profits. Total operating profits for the UK business fell to 30.6m which represents a near halving of profits from just a couple of years ago. Margins have taken a big hit due to Northgate not passing on higher vehicle costs to customers in order to stay competitive, as well as the growth in the contract hire fleet (11% of total fleet) which has lower rental margins. Prices were raised in May and, so far, there has been no significant loss of customers. The good news for Northgate is that the number of vehicles on hire started growing again in the fourth quarter and this has continued into the new financial year. This needs to happen because at the moment the UK business is earning a very poor return on capital employed of just 6.4%. The company expects this to improve going forward as it ages its fleet by keeping vehicles for longer which will reduce the capital intensity of the business. The Spanish business is doing well with good growth in vehicles on hire and rental profits. Total operating profits fell due to lower disposal profits caused by a change in depreciation policy (this means that the balance sheet values are higher than previously and this makes the profits on disposals smaller) 7

8 As with the UK business, trading momentum got stronger throughout the year due to a very healthy Spanish economy and a continued shift to renting rather than owning vans. The stability of cash flows of this business has also improved with 23% of the fleet now on long-term hire. ROCE here has taken a big hit due to the growth and changes in mix of the fleet but is just about respectable at 10%. The company's finances are in reasonable shape despite heavy investment in new vehicles particularly in Spain - that resulted in significantly negative free cash flow and a hefty increase in net debt. 8

9 Underlying free cash flow also fell slightly due to lower profits but was still sufficient to cover the cash cost of dividend payments. Net debt to EBITDA increased from 1.3 times to 1.8 times but interest cover still remains pretty comfortable at 6.2 times. Northgate shares do not look particularly expensive. At 397p, they trade on a one year forecast rolling PE of 10.7 times and offer a prospective dividend yield of 4.4% with some expectation of dividend growthalbeit small. The share price is also below the net tangible asset value per share of 399p. As both the UK and Spanish businesses continue to make profits on the disposal of vehicles investors can have a reasonable degree of confidence that the company's balance sheet value is not overstated. Despite this, I find it difficult to see the shares as attractive despite the profit momentum from the end of last year continuing into the current year. ROCE from this business is just not good enough for me which means that the company has to spend huge amounts of money to give itself a chance of growing its profits. I also don't like the cyclicality of profits despite the increase in contract hire revenues. That said, I think the share price is not baking in high expectations of lofty profits growth. Despite my preference for higher quality businesses, it is quite possible that the shares could do reasonably well if the current momentum continues. 9

10 Carpetright (LSE:CPR) Occasionally, buying shares in a distressed business can pay off handsomely, providing the business concerned can recover. Carpetright certainly fits the description of a distressed business and has done for some time. I'm sure that many deep value investors have had their fingers burned by this share over the last few years as the share price has continued to plunge. So will Carpetright survive and recover or is it going to join the growing scrapheap of failed retailers? The company's problem is typical of many struggling retailers. It operates in fiercely competitive markets and has too many stores and too many costs rents being the biggest problem. It has also significantly underinvested in its stores which has put off potential customers. A series of profit warnings due to declining sales has pushed the company to the edge of bankruptcy. This can be seen clearly from its cash flow statement where nervous suppliers had cut their payment terms to the business which meant that Carpetright operated at a significant trading cash flow loss of 21.5m last year. 10

11 Things have become so bad that it has entered into a Company Voluntary Arrangement (CVA) with its landlords with the aim of cutting its rent bill and exiting unprofitable stores. Its UK store base has been split into the following categories: 176 stores making reasonable profits with a rent to sales of 15.4% and an average 22,500 in weekly sales. 82 stores with 13,200 in weekly sales and a rent to sales of 18.8% - not making sufficient profit to cover overheads. 30% rent reduction for 3 years under CVA. 31 stores with average weekly sales of 12,200 and rent to sales of 20.7%. Marginally profitable with 50% rent reduction under CVA for three years 81 stores - 11,500 average sales per week and rent to sales of 28.9%. Making no profit, 50% rent reduction with option to exit after 23 September 2018 Based on my calculations the CVA will lead to a maximum reduction in rents of 12.2m per year. However, with 81 of the worst performing stores with the highest rent to sales ratio to close, the impact on profitability will be significant as these heavily loss-making stores will disappear. The company then has three years to turn the other 113 stores around. It has also raised 60m of fresh equity that gets rid of all its net debt. The hope is that store refurbishments and a focus on fast growing product categories such as hard flooring can restore the company back to health. But can it do it? The store refurbishment programme has produced some reasonable uplifts in like-for-like sales and this is where bulls of the shares will be pinning their hopes of a recovery. My concern is that Carpetright will need a favourable trading environment to get itself out of trouble. The UK housing market is showing signs of slowing down, particularly in the south east and this may not be a favourable environment for selling more flooring and carpets. I honestly have no idea if Carpetright can trade itself out of trouble. All I know is that it has bought itself some time to try and do so. 11

12 So far, the market seems to have given a very lukewarm response as the share price has continued to go lower. At 28p, the company has a market capitalisation of 85m. Assuming zero net debt to keep things simple, my rough and ready reckoning is that Carpetright needs to be making sustainable operating profits of around 10m to justify the current market capitalisation. This compares with an underlying operating loss of 5.9m last year. Taking into account the savings in rents from the CVA and the reduction in losses from the closure of stores a big improvement in profits is a possibility. The key is whether any improvement is sustainable given that the rent reductions will be reviewed in 2021 and the current weakening of the UK housing market. Help us win the Investors Chronicle Award If you haven t done so already, we d be delighted to receive your vote in this year s Investors Chronicle Investment Awards. In recent years, these votes have been very tight so we need your help to win! To vote for ShareScope/SharePad, please click on the link below and go to the Investor software & data tools category. Thank you! Disclaimer: This newsletter is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice. 12