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Markets Now – Wednesday 8th July 2020


With the Chancellor due up in about an hour, here’s how the afternoon is likely to pan out.

Rishi Sunak will attach big sounding numbers to some pleasant sounding concepts. Twelve milliradians for green initiatives, 14,000 bogomips towards each new work experience placement in the booster industries, that kind of thing. Then, immediately afterwards, people from consultancies will be invited onto television to say “the devil is in the detail” a lot. By about 1pm the serious men with bad hair will arrive to tell us that actually there’s no new money because, for example, the booster industry programme is a reallocation of funds from the industry booster programme and milliradians are units of angle not quantity. At approximately 3pm either Centrica or Drax will spike 10 per cent on a Gov.uk guidance footnote that some sales trader has misinterpreted, and by midday Thursday absolutely none of this will ever be mentioned again.

For more budget analysis let’s turn to the Institute for Fiscal Studies:

That pretty much covers it.

Boohoo’s now down 50 per cent in three days. That’s in spite of shareholders finally getting the independent review it should have announced on Monday (and in 2019, 2018, 2017, etc). Also, a whole £10m is going into the supply chain improvements, an ethical specialist consultant is being drafted in to do some Powerpoints about the internal audit structures and there’s a promise to appoint two more Noddies.

Why aren’t investors pacified? Is it because, while all these actions look to be travelling in the right direction, Boohoo’s entire business model was created to capitalise on exploitative rag-trade practices and if those are removed the company ceases to exist in its current form? Or is it all a media witch hunt? Let’s ask Stifel:

The Media has already found its scapegoat. At this point, it does not matter if boohoo is responsible or not, as the Media has conducted its ‘investigations’ and declared a ‘guilty verdict’.

Oh …. kay. Rather than pay attention to media ‘investigations’ let’s give some more airtime to Stifel’s ‘analysis’:

How can boohoo’s business model be so competitive compared to other retailers? Is this sustainable? These questions have been in investors’ minds for the last couple of days [ . . . ]. Below industry standard minimum order quantities and a supply chain close to home have allowed the company to minimise inventory risk and react fast to consumer behaviour, which reduces the need for markdown. Suppliers need to be very efficient when manufacturing low quantities, but boohoo has committed to suppliers’ growth and industry-leading payment standards that cannot be matched by competitors. The fact that boohoo is unwilling to fully disclose its supplier base, as deemed commercially sensitive, is understandable, but it is exposing the shares to a bearish angle. . . . 

Boohoo cannot be held responsible for industry-wide issues, namely illegal outsourcing and working conditions, in particular during extreme situations created by the COVID-19 outbreak, with major retailers pulling their orders and leaving suppliers with no revenue. It can, however, lead the way on the ESG agenda, as it has done on social media online engagement and an industry-leading supply chain. Today’s announcement is a first step in the right direction, but linking management remuneration to ESG targets would provide additional reassurance to investors looking to take advantage of this attractive entry point. . . . 

Our main concern remains consumers’ perception. We continue to monitor social media as we are now observing stronger mixed reactions; widespread media coverage has created awareness among consumers – who are leaving persistent messages on boohoo’s brand accounts – but equally, as core consumers are quite young, we see unawareness and ‘business as usual’ from the rest of the company’s customer base outside the UK. We remain supporters of the stock but we think the recent evolution (major brand aggregators dropping boohoo’s brands from their website) will likely amplify the message to consumers unaware of the financial headlines and we urge the company to proactively take a stand with its customers.

Well there we go. Peel Hunt (buy) is also cool with it all:

Boohoo is fully committed to its UK supply chain, with a concentration of c100 key suppliers that offer boohoo speed to market rather than a cost advantage. With air fr eight, boohoo successfully uses overseas suppliers for its test & repeat model too. There is no threat to margin, ultimately if production costs were higher, then clothing prices would be higher (we don’t see a volume impact from modest pricing increases), although boohoo makes the point that the larger factories have the proficiency to operate efficiently while complying with best practice. By committing an initial £10m investment into the process, boohoo will build on its compliance processes and offer training and support to its factory partners. There is even the suggestion that boohoo may set up its own factory as a model for best practice.

We’ve seen regular exposés into UK and overseas supply chain conditions, which rest on a high profile company such as boohoo or Primark. By accepting the need to rebuild Leicester’s reputation, boohoo is stepping up to the plate, rather than brushing this aside. Fundamentally, we see the share price fall as a buying opportunity, accepting that ESG remains a work in progress for boohoo, which the group and board remains committed to. Now trading on sub 25x PER.

While over at Shore Capital they’re a wee bit more worried that even young people can be activated enough to resist the pull of a £12 PVC handbag:

On current Bloomberg estimates [at the opening price] Boohoo trades on a forward one year (year to February 2021) PE multiple of 34x, EV/EBITDA multiple of 21x and EV/Sales of 2.0x, . In our view this is still a premium rating and implies no economic impact from the current supplier issues in Leicester.

We wonder what the negative impact will be from the supplier issues. We do not know the quantum but we do know that sales will be impacted by not being on the ASOS, Next and Zalando websites in the short term and we find it hard to believe that sales for the group’s brands won’t be impacted given the current media storm. We have noticed a surge in social media hashtags including ‘BoycottBoohoo’ and we highlight that millennial consumers are interested in both sustainability and business ethics.

We also question the impact on the cost base and question whether Boohoo has been experiencing input prices for goods that might be no longer sustainable. This may put pressure on gross margins and prices could rise, which would negatively impact their competitiveness. We also wonder what the new compliance measures that the company has announced this week will mean for the cost base. In our view, it will be potentially higher operating costs to demonstrate that the company has the appropriate processes in place for its supply base.

The company has to deliver the outcome of its own investigations and it faces the potential of external enquiries too, according to the media including a possible police investigation. Until the outcomes are better understood, the stock feels less than appetising for many investors and may be totally off limits for many ESG funds for now.

 This may in time prove to be a short-term blip and so no damage to brand equity, or it could be a Gerald Ratner moment. In our view, with a premium rating and major issues around brand equity, trading and financial fall-out, we think it wise to move to Sell (from Hold). We will re-visit when we feel the fall-out has settled and we have further clarity on the economic and reputation consequences. 

FirstGroup full-year earnings miss the consensus forecast and come with a slew of restatements, impairment charges, restructuring costs, insurance provisions and so on, which in combination make the report nearly incomprehensible. North America, which is still for sale, looks to be the main problem. There’s no outlook guidance and numerous warnings that the £850m of undrawn liquidity might not be enough. The shares are down 10 per cent at pixel, probably from fatigue rather than surprise. Jefferies offers a good and comprehensive summary:

Positive cash from operations before capex in 1Q21 is helpful. However, we think that higher exceptional items, including a larger Greyhound impairment (precursor to sale?) and North American self-insurance provision, will disappoint. The Board is committed to portfolio rationalisation through North America divestment, which FGP’s going concern scenarios suggest may be necessary to avoid alternative additional financing.

Headlines: For FY20 (March YE) Group revenue in constant currency +7.2%, or +2.6% ex the West Coast Partnership that started in December 2019, reported +8.8% to £7,754.6m. Adjusted operating profit was £256.8m, -18.4% YoY (JEFe £309.8m and -17% versus Factset Consensus of £311m), which includes the substantial reduction in volumes and revenue in March which is usually a significant month. Adjusted EPS was -48.9% to 6.8p (JEFe 12.6p) and Adjusted net debt ex restricted rail cash was £1,508m (JEFe £1,282). FirstGroup remains unable to give guidance, given recovery related uncertainties.

Material exceptional costs, including higher self-insurance provision: Exceptional costs for FY20E (JEFe £198m) included an increased Greyhound impairment charge of £186.9m (of which £124.4m was in 1H), North American self insurance provision of £141.3m, restructuring and reorganisation costs of £58.2m and COVID related charges of £21.5m. The North American self-insurance provision reflects the claims environment and a significant change in the market-based discount rate. This is an increase from 1H announced provision of £59m. We expressed our concerns surrounding social inflation in the US and the implications for FGP in Insurance Implications.

Balance sheet and liquidity update: Pre-IFRS16 adjusted net debt was £896m (JEFe £803m), with IRFS16 resulting in £2,382m of lease liabilities recognised. Net Debt:EBITDA on a frozen accounting standard basis relevant to covenants (of 3.75x) was 1.4x (2019:1.3x) and Adjusted Net Debt: EBITDA (excluding Rail ring-fenced cash and IRFRS16) was 2.4x. As at June 2020, FGP has c£850m of cash and committed undrawn facilities. FGP anticipates that this will decline with the normal seasonal decline in revenues in First Student when schools closed and then working capital requirements as it prepares for start-up in August.

Going concern base case and reasonable downside case scenarios: FGP states that positive liquidity headroom remains throughout the going concern period under both the Base Case and the reasonable downside scenario. For covenants, FGP’s base case indicates that banking covenants will be met throughout the period, with limited headroom at September 2020 and March 2021. Its downside scenario suggests there could be ‘marginal fails’ on all covenants at 31 March 2021 before any mitigating actions.

All Aboard: FirstGroup Reiterate Hold: We had cut FY20E/21E EBIT forecasts by 2% and 81%, respectively (noting April year-end). We continue to worry about FGP’s UK regional bus exposure, reliance on UK rail and US social inflation. We see risk/reward as fairly balanced given the current valuation. Valuation: FGP is trading on recovered FY22E 3.4x P/E and 3.0x EV/EBITDA.

What’s that about US social inflation? So, Firstgroup self-insures its North American liability risk, employing its own actuaries to avoid having to pay fees to insurers. This has in the past made the bus company a lead indicator for the insurance sector. For example, reserve strengthening by SwissRe, Axa and Allianz in February was preceded by FirstGroup acting in November. Back to Jefferies:

[I]f FirstGroup is once again highlighting the negative impact of a falling discount rate and deteriorating claims, then we believe insurance investors should take heed.

Social inflation is driving reserve strengthening. First Group’s commentary in their latest accounts is eerily reminiscent of the comments we’ve heard from insurers recently, with management reporting that they “..have continued to see a deteriorating claims environment with legal judgements increasingly in favour of plaintiffs and punitive in certain regions”. “In this hardening motor claims environment, we have seen further significant new adverse settlements and developments on a number of aged insurance claims”.

Prices to rise and insurers affected. In terms of the impact, we expect that this will continue to drive prices up for the near future, while the insurers most exposed are Swiss Re (via P&C Re and Corporate Solutions), Allianz (via AGCS), AXA (via AXA XL), Hiscox and Beazley.

Over in non-results sellside, HSBC gets a downgrade to “hold” from Ian Gordon at Investec.

One respected investor recently remarked that if a Buy rec on HSBC was the only positive rec we could manage for a large-cap UK bank then it must be time to look outside the sector. Who’s arguing? As it happens, YTD, HSBC has outperformed all within this peer group despite (according to Bloomberg) being the sellside’s “least preferred” stock, but we are now out of arguments to sustain an overweight stance; we cut to Hold (from Buy). We advise a switch into Lloyds (Buy); it screens cheaper and offers sustainably superior returns.

We make significant cuts to our EPS forecasts, down 27%/22%/9% for 2020/21/22e, primarily to adjust for what we see as a deteriorating outlook for revenues as well as recessionary credit costs. Our revised forecasts are 5%/14%/8% below Bloomberg consensus.

We forecast a 10% year-on-year decline in revenues in 2020e, (after a 7.5% YoY fall in Q1 2020), only partially offset by a 4% YoY reduction in underlying costs. We also model a 229% YoY increase in impairments to $9.1bn (after a 417% YoY increase in Q1 2020), resulting in a 50% decline in underlying profit before tax to $11.1bn. Such is the “rebasing” effect of increased revenue headwinds that, even after execution of HSBC’s planned restructuring programme, we do not expect underlying profit before tax to recover to the 2019 level ($22.2bn) before 2024e (at the earliest).

HSBC shares have outperformed all large-cap UK bank peers in 2020 year-to-date, reflecting their traditional “defensive” or low-beta credentials. However, given the scale of reliance on Hong Kong, which contributed 92% of underlying profit before tax in Q1 2020, it is increasingly difficult to validate HSBC’s “defensive” credentials (despite characteristic capital/liquidity strength).

The 21c 2019 final dividend was cancelled at the request of the UK regulator, with no further dividend due to be declared until February 2021. We forecast a 21c 2020e final dividend, but in the context of our expectation of subdued earnings, we forecast a rebased dividend of 30c/35c in 2021/22e vs 51c p.a. paid through 2015-2018. HSBC trades on a “premium” rating of 0.7x 2020e tNAV for ROTEs of 2.9%/4.1%/6.2% in the context of which we now see limited further upside. We cut our TP to 400p (from 520p) and downgrade our recommendation to Hold (from Buy). We now prefer Lloyds

Nokia gets a downgrade from JP Morgan Cazenove on Verizon exposure:

Our upgrade investment thesis was predicated on a margin recovery story as ASIC use improved as part of an overall turnaround story. However, recent supply chain datapoints are indicating that Nokia may lose share at Verizon which is likely to weigh on the shares. We believe Verizon is Nokia’s biggest customer. The potential long-term impact of market share loss will limit long-term turnaround. Hence, while we cannot be sure of Verizon’s intention, the datapoint is sufficient to make us turn cautious. We downgrade the stock to Neutral (from OW) and adjust our Dec-20 PT to €3.80 (from €5).

Supply chain datapoints indicate Verizon to use Samsung as major RAN supplier. While there is little visibility on timing, we believe that there is a real risk Verizon will depend less on Nokia as their primary RAN supplier going forward. Nokia’s ALU integration related problems coupled with its well-known delays in 5G has already impacted Nokia’s relations with Verizon (previously lost two markets in ’17 to Samsung). The volume of any transition to Samsung is unknown, i.e. if Nokia will keep some RAN markets at Verizon for example. However, it is clear that if Nokia were to lose RAN share at Verizon significantly, it would severely hamper the company’s network turnaround plan just as the product was improving.

It is a data-point but there is rarely smoke without any fire. We would note both Nokia & Verizon are saying the relationship is intact. There is precedent of a major telco negotiating price for equipment to their advantage via a public discussion. If this is “only” the case, then given Verizon is a strategic customer it still does not bode well. Given past share loss at Verizon we cannot ignore data-points ascribing them to potential price negotiation.

Verizon’s potential impact on profitability would be meaningful. From ’10-’15, Verizon contributed €1.58bn-€2.1bn of annual sales to Alcatel-Lucent. Meanwhile Nokia has lost some share at Verizon in ’17 since acquiring ALU. We estimate Verizon’s contribution could now be €1bn+ which would mean Verizon is still their largest customer or close. The loss of €500m in network revenue would mean that despite improving gross margin due to the use of ASICs, overall gross margin will not improve & absolute earnings will decline (Scenario A). In the ‘worse case’ where they lose sales of €1bn, gross margin & EBIT margin would decline (Scenario B). In both cases, EPS would be below ‘21/’22 consensus of €0.29/€0.33. At this point considering the less bearish scenario (Scenario A), we get EPS of €0.28 which when valued at 13.5x P/E (earnings risk discount), would value Nokia at €3.80. We set that as our Dec-20 target price & due to the uncertainty we downgrade the stock to Neutral.

Canaccord’s Charlie Sharp likes Cairn Energy as part of an E&P sector thing.

On its knees in the spring, the sector is now showing signs of recovery. Oil and gas may now be seen as a transition business to a greener future, but it is still a crucial part of the energy mix and will be for many years. Dismissing it risks missing some compelling value, strong management teams that can create organic worth, the continued gradual upward rerating as commodity prices edge higher and M&A potential. We raise our Brent oil price assumptions by $2.5/bbl to $45.5/bbl (2021) and $50/bbl (from 2022), in line with recent crude pricing increases, yet we are still some way below the much publicised oil price views of BP ($55/bbl) and Shell ($60/bbl). The uplift in oil price assumptions leads to widespread target price increases. There are two rating changes reflecting current share prices and target prices: [Africa Energy] (HOLD from Spec Buy) and CNE (SPEC BUY from Hold).

And Peel Hunt upgrades both Persimmon (hold to add) and Countryside (add to buy) in a housebuilder review:

CY20 reductions. We have cut our UK housebuilder revenue forecasts by around 30% to reflect the drop in volumes caused by the shut down of construction and sales activity for April and most of May. With operational gearing, that means our profit forecasts drop by c.40% from previous estimates.

CY21. We expect a bounce in volumes of c.15%, which is driven largely by the absence of a two-month lockdown. We see modest sales price deflation but the higher volumes, as well as some cost cutting and build cost deflation, will more than offset this impact leaving profits up 20% on 2020 levels.

Will CY22 get back to CY19 levels? Structurally, housing output needs to be higher than 2019 levels and we believe the government will continue to support the industry. The main variables are GDP/employment. Our revised 2022 volume forecasts assume they remain 5-10% shy of 2019 levels.

Balance sheets. The initial liquidity focus has passed, helped by dividend and land spend cuts, as well as furloughed staff, tax payment deferrals and reduced working capital investment. While we believe TW’s equity raise was early and aggressive, it highlights the medium-term opportunity for increased housing output for a number of companies in the sector once economic conditions have stabilised.

Near term. With the mini budget due on 8 July, currently there is plenty of speculation about Help to Buy extensions as well as stamp duty cuts. Both will be helpful for the housing sector, with the latter driving second-hand as well as newbuild activity. Rising unemployment remains the biggest risk over the next 6-12 months.

Valuations & recommendations. On our revised forecasts, the sector is now trading on a CY21 P/NAV of 1.21x vs the very long-run average of 1.26x. We retain our positive view on the sector and see the best short -term value in Redrow#, Vistry and Persimmon amongst the bigger names

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