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IC — Drax, Stobart Group, Dignity

Buy: Drax (DRX)

Completion of a deal with Scottish Power will mark a broadening of Drax’s generation sources, ultimately de-risking the group more widely, writes Tom Dines.

Drax has amended the terms of its impending acquisition of Scottish Power’s pumped storage, hydro and gas-fired generation to mitigate risks in the UK’s capacity market.

The group announced the deal in October, and still plans to pay £702m for the portfolio, but has now agreed on a risk-sharing mechanism worth £36m with Spanish energy group Iberdrola, covering the period from January 1 2019 to September 30 2019.

The capacity market is a UK government scheme that uses payments to incentivise investment in low-carbon electricity capacity, but the European Commission is investigating the UK government’s scheme establishing the market. While the investigation is ongoing, it has suspended payments. A significant portion of the earnings in the Scottish Power portfolio come from capacity market payment, so much so that if the contracted payments payable in 2019 are not received, it reduces the expected cash profit range to £43m-£63m from £90m-£110m.

Under the risk-sharing arrangement, Iberdrola will make a payment to Drax if the 2019 gross profit is below £155m, equal to 72 per cent of any shortfall. If the profit is more than £165m, Drax will pay Iberdola 72 per cent of any outperformance. Both payments are capped at £26m.

Hold: Stobart Group (STOB)

Based on analysts’ 2020 forecasts, the shares offer a potential dividend yield of around 3.4 per cent, down from upwards of 8 per cent, writes Julia Faurschou.

At the first-half results on October, Stobart Group announced that it would undertake a “capital review” in the second half to determine the optimal way to generate shareholder returns. While the ultimate conclusion is not due to be released until March 2019, the board has given a teaser of what is to come — the fourth-quarter dividend has been slashed to 1.5p, compared with payments of 4.5p during the first three quarters.

Since March 2017, dividend payments have been funded primarily through non-core asset disposals, prompting analysts at Stifel to view the move to cut the dividend as unsurprising.

Stifel analysts have forecast a 6p total dividend a year for full-year 2020 and full-year 2021. Stobart said the remaining dividend payments would be funded by “existing cash and other resources”, although the cash outflow from operating activities more than doubled to £18.1m at the half year.

During the first half, passenger numbers at Stobart’s London Southend airport were up 37 per cent to 838,742. Stobart is aiming to have 5m passengers per year through the Essex airport by 2022, estimating that £10 of cash profits could be generated per passenger. However, Stobart still has to improve the infrastructure at Southend so that it has the capacity to sustain that many travellers, such as extending runways and expanding terminal areas. Ryanair and easyJet both have commercial deals to have planes based at Southend.

Stobart also has ambitions to extend the services it can offer in its energy business and supply 3m tonnes of biomass per year by 2022. Stobart supplied 657,950 tonnes during the first half — a 72 per cent increase on the previous year, but it is looking at how it could increase its scale in energy, including building, owning and operating renewable energy plants.

Sell: Dignity (DTY)

If the Competition and Markets Authority decides “greater remedies” on funeral pricing are required, a potential price cap isn’t out of the question, writes Harriet Russell.

The decision by the CMA to escalate its market study of funeral sector pricing to a full investigation sent shares in funeral provider Dignity falling again. Dignity has had a difficult year to say the least, starting with a profit warning in January, lacklustre results in March and news of the regulatory review over the summer.

So far, management has responded positively to news of the investigation, arguing that tighter regulation would be beneficial for all operators in the sector. But the market is clearly wary about what a tighter regulatory environment could mean for groups such as Dignity. Brokerage Peel Hunt warned the language used by the CMA was “significantly more strident than expected”, and that “the spotlight is firmly on Dignity and the Co-op”, seeing as the focus is sharply on larger chains and recent price cuts.

Several years of above-inflation price hikes have caught the regulators’ attention, despite the fact the funeral market has been flooded with low-cost providers of late, intent on selling the most competitive funeral package possible. It was this race to the bottom that prompted Dignity’s profit warning at the start of the year, which said it would cut prices for simple funeral plans by roughly 25 per cent to maintain market share. It also said it would freeze prices for traditional funerals in most locations.

But this was not enough for the CMA. It still believes organising funerals costs “those on the lowest incomes nearly 40 per cent of their annual outgoings”, while evidence indicates “most people who organise a funeral remain extremely vulnerable to exploitation and future rises in charges”. The regulator also estimates funeral director prices have increased by more than 68 per cent over the past 10 years and crematoria by 84 per cent.

Chris Dillow: The tyranny of numbers

The Bank of England warned last week that a disorderly no-deal Brexit would cut GDP by between 4.75 and 7.75 per cent by 2023, and raise unemployment to between 5.7 and 7.5 per cent. These scenarios — the Bank denies they are forecasts — have been widely criticised even by sympathisers with the Bank. Andrew Sentence, a former monetary policy committee member and Remain supporter, called them “bogus”.

I agree. To see why, recall what happened to some US inner cities in the 1960s. They experienced “white flight”. At first, a few white people moved out but many then followed, with the result that cities became racially segregated, with inner-cities being almost all black and suburbs almost all white.

This didn’t happen solely because whites were racist and didn’t want to live among black folk. As the economist Thomas Schelling showed, it could have happened even if whites were happy with moderately mixed neighbourhoods. But, he warned, if such white people feared the mix would fall below a certain point, they would move out leaving the neighbourhood all black. And, he stressed, what matters isn’t just reality but expectations. “People do not wait until the alien colony exceeds their toleration before departing,” he wrote in his classic book Micromotives and Macrobehaviour, “as long as they can foresee the numbers increasing with any confidence”.

In this sense, the economic effects of a no-deal Brexit depend upon self-fulfilling prophecies. If companies believe it will be disastrous, they’ll leave in anticipation of others leaving and so it will indeed be disastrous. But if they think it’ll be tolerable, they’ll stay and so the effects will be moderate.

Another analogy here is with runs on banks. If depositors believe a bank will become insolvent, they’ll rush to withdraw their money and so the bank will collapse. Even if the bank is otherwise sound, the belief can therefore be self-fulfilling.

And here’s the thing. We cannot predict these processes in advance, because we cannot know what companies’ thresholds for relocating are. Some might accept the loss of a few neighbouring companies but others might be more resilient. Or less so. And everybody’s expectation will depend upon others’ expectations. As Christopher Carroll at Johns Hopkins University has shown, forecasts can spread across populations in the same way as diseases do. And some diseases can ravage a population while others don’t.

This means that precise forecasts of the impact of a no-deal Brexit are silly. They are a pretence to knowledge which we cannot in fact possess. We cannot quantify everything. We can identify relevant mechanisms but we cannot say in advance to what extent these will operate.

Investors should not, however, be too harsh upon the Bank. They too sometimes overweight numerical information such as earnings and cash flow and underestimate “softer” information which might be more relevant to future returns such as corporate culture or investor sentiment. Like the Bank, they forget the words of Jerry Muller in The Tyranny of Metrics: “measurement may provide us with distorted knowledge — knowledge that seems solid but is actually deceptive”.

Chris Dillow is an economics commentator for Investors Chronicle

The Financial Times and its journalism, including Investors Chronicle content, are subject to a self-regulation regime under the FT Editorial Code of Practice:


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