Interactive Investor

One in, one out at the FTSE 100 reshuffle?

28th August 2020 15:25

Edmond Jackson from interactive investor

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B&M likely to join from the FTSE 250 index, while ITV is likely to leave, but what does this mean for investors?

There could be a ‘one in, one out’ flavour to the FTSE 100 reshuffle next week, according to the FTSE Russell index provider, as B&M European Value Retail (LSE:BME) is likely to join and ITV to drop out.

Superficially this would appear a classic case of indices affirming stocks’ momentum rather than a verdict on their underlying risk/reward profiles.  

On fundamentals, B&M is broadly up with events as a food and merchandise retailer: around 482p, on a forward price-to-earnings (PE) ratio of near 17x and dividend yield over 2%.

At around 62p, ITV trades on a derisory PE of 6.5x. It yields 6.7% if the brokers’ consensus is right to expect a dividend slashed to 1.25p this year, then recovering to 5.7p in respect of 2021. 

Both stocks present dilemmas: B&M being possibly fully valued, while ITV has good reason to look cheap.

In key respects we are looking at a beneficiary and loser from Covid-19: value retailers doing very well as more households are forced to spend less on shopping.

Growth at peer companies Aldi and Lidl shows this too.

Meanwhile advertising has taken a hit while firms cut budgets, hence a dent in ITV (LSE:ITV) revenues. However, we learned yesterday from WPP (LSE:WPP) it reckons the second quarter of 2020 marks a trough. 

In that case, potentially ITV is over the worst and being dumped from the index is akin to backward-looking credit rating agencies downgrading just when a business might be on the turn.  

Consequently with both stocks there is an aspect of judging the virus’s longevity, or at least its disruptive effect. 

With respect to B&M this means likely overall levels of employment, namely if there will be much greater redundancies from the autumn as the government’s furlough scheme unwinds.

More unemployed people would then switch to cheaper food retailers especially. Heightened uncertainty, say if Covid-19 infections accelerate once people spend more time indoors, could again give advertisers reason to pause.

But let us examine these companies more closely to see if a ‘momentum’ case for or against, is justified.

B&M European Value Retail 

This FTSE 250 stock has likely enhanced its shareholder support since the outbreak of Covid-19, by increasing the frequency of its trading updates to about monthly – and with ongoing good news. 

Initially in April it temporarily closed just 7.5% of its (smaller) UK B&M stores, although all Heron Foods remained open, and updates have since been plenty strong. 

For example, market consensus for £208 million adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) for the six months to 26 September, was at end July guided upwards to a £250 million to £270 million range. Benchmarking against the median, that is a rare 25% beat. 

While the update cautioned it was hard to predict trading for the second half year (to March 2021), you sense this is prudently cautious PR. Yet the group is actually well-placed to prosper – also developing its concept in France and having acquired in Germany back in 2014. 

Best not get carried away, mind. The last financial year’s results showed like-for-like revenue growth only of 3.3% overall for the UK stores, within group revenue up 16.5%. Group pre-tax profit rose just 3.2% and the full-year dividend by 6.6%.

It would appear July’s beat means B&M is enjoying a boost from operational gearing as recently higher sales convert quickly to profit. The EBITDA leap may therefore be exceptional but again, much depends whether unemployment soars or not – to which you might also add the risks of a hard Brexit if EU negotiations end in acrimony. 

I therefore regard B&M’s rating as fair if not full, on current knowledge. My limitation for judging the business is not having B&M or Heron stores in my vicinity in Southern England, though I have called in after visiting relatives in Lincolnshire and again in the North, needing to boost carbohydrate supplies on one of my fell running trips. 

The shops seem like bazaars versus the typical supermarket experience, and I was able to buy e.g. basmati rice and Lucozade at the keenest prices. Marketing-wise B&M is very well positioned for these times hence should continue to do well, thus an FTSE 100 promotion suggests a ‘hold’ stance as currently fair.  

More aggressively: if you take a negative view of the UK economy, especially employment, B&M is a ‘buy’ for the short to medium term, able soon to benefit also from index fund buying. Personally, I find this is more speculatively than my taste however alert traders may find reason to back B&M afresh - according to how its chart unfolds, and the national news. 

ITV 

The FTSE 100-listed broadcaster had a difficult first half of 2020, both for production and advertising.

However, when reporting interim results on 6 August management cited “an upwards trajectory with productions re-starting and advertisers returning”.

There was good progress with a digital transformation: online viewing was up 13%, or 15% by monthly active users, in the first half. Around £51 million of £60 million overhead costs planned for 2020 were achieved in the first half, with a further £25 million to £30 million targeted by 2022.  

Yet with revenue down 17.5% to £1.2 million and £1.1 million operating costs leaving just £33 million operating profit, this extent of cost cutting seems the barest minimum. It appears management is quite hoping revenues can recover to tilt profits favourably again.  

While £1.1 billion debt is virtually all long-term, its £25 million interim service cost then took net profit down to just £15 million.  

The cash flow profile offers respite. Adding back exceptional costs plus depreciation/amortisation, and respecting working capital movements, net cash from operations was able to rise from £171 million to £248 million. 

This implies the business can weather a way through the Covid-19 crisis, despite an income statement weighed down by costs. It is also burdened by the balance sheet groaning from £1.6 billion of intangibles – as if there is no real asset base or income to justify shareholder value. 

Mind how 3.5% of ITV’s share capital is out on loan, i.e. sold short in anticipation of further price decline. 

Hedge funds can make mistakes like anyone. However, I would note that Paloma partners lifted their short 0.11% to 0.62% on 10 August and Millennium Management 0.15% to 2.09% on 26 August. 

Yes, Adelphi Capital cut its short 0.08% to 0.79% on 30 June but the balance of conviction is for further downside – and I doubt hedge funds base their judgment chiefly on FTSE 100 demotion potential. 

Bulls of ITV are encouraged by good growth for its BritBox UK service, which has seen good growth in subscriptions and free trials taken up – benefiting from lockdown. The service is available on some 20 million devices and to 60% of streaming households.

I tend to see this as more strength of story than financial substance, though bear in mind my idea of watching TV shows – especially anything historic, beyond the obligatory Dads Army episodes at Christmas – is a form of torture. ITV’s touting the return of Spitting Image seems passé.  

Quite recently I looked at ITV as a potential Stockwatch piece but concluded insufficient grounds to dispute the market’s wary view. Yet neither its cash flow strengths nor the current better outlook for advertising, imply a ‘sell’ stance. If a shareholder I would hang on and not assume any ejection from the FTSE 100 is much verdict on the business. ‘Hold’.    

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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