Interactive Investor

Stockwatch: is this 8% yield too good to be true?

30th September 2022 10:55

by Edmond Jackson from interactive investor

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Analyst Edmond Jackson has watched this business through previous cycles and is moved to re-examine prospects following recent events.

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This £700 million commercial vehicle hirer and servicer Redde Northgate (LSE:REDD) has seen its stock fall by over a third since March, so that a current price of around 285p offers a 7.8% yield covered over twice by projectedearnings. There’s also a decent record of free cash flow generation. 

It is of wider relevance to ask: does such a valuation now constitute attractive risk/reward? Or, for a cyclical industry, does a forward price/earnings (PE) ratio of 6x - below the dividend pay-out - represent an “inversion” similar to that on short/long-dated bonds, when the yield curve signals recession? 

The investment case moves on from Covid 

I drew attention to Redde Northgate in January 2021 when it was citing resilient performance despite Covid lockdown. The stock was 258p versus a 130p low in March 2020 when Covid first struck markets, having soared from 180p the previous November when credible vaccines appeared. 

This stock has offered attractive yields before if one’s investment timing is fair. In early 2021, it was around 5%, rising to near 7% based on expectations for a 13.7p dividend. The table below shows strong growth to 15.4p in respect of the April 2021 year and 21.9p for 2022.  

So, if you had bought at 258p, that would have locked in an 8.5% yield or, at the 130p low, a mouth-watering 17%, at least while the UK economy held up.  

It probably helped a rally to 430p by mid-2021 after which the stock bumped along sideways to March 2022, since when it has de-rated. 

I concluded with a “hold” stance due to the possibility of lockdowns persisting. There were also concerns about whether the end-2019 merger of Northgate vehicle hire group with the Redde accident management specialist, might prove a stretch. Both companies had been struggling; Northgate with reduced UK demand and competitive pressure in Spain, and Redde with working capital issues and higher debt, plus a large insurer not renewing a hire-and-repair contract. 

I therefore put down a marker on Redde Northgate being potentially well-suited for the post-pandemic era “offering a superior and dependable yield”. 

This is why I return to the stock now that UK cyclicals are being smashed. As yet, last Tuesday’s AGM cited “an encouraging start” to the current financial year. 

A resilient outlook for trading  

As the new UK government digs in behind its tax-cutting agenda, markets are pricing for a long deep recession and, sooner or later, a Labour government. 

If that is a realistic scenario, you can brush aside recent forecasts; better to wait for trading updates and revised guidance. Narratives and numbers will worsen. 

This group did however make nearly a third of its operating profit in Spain during the last financial year. Northgate Spain contributed operating profit around £44 million on circa £260 million revenue. It was in context of £145 million group profit on £1,244 million revenue. 

Management cites long-term contracts for vehicle hire, although I have had a few hard lessons trusting situations that proclaim “a high level of recurring revenues”. More positively, it does appear that service work should benefit from more used vehicles on roads after the supply of new vans and other vehicles was disrupted by microchip shortages. 

The update has said the supply of new vans remains tight, and cars are showing early signs of improvement. 

In Spain, supply of new vans is better than expected and fuelling growth. 

Also, the Redde accident hire cars side has seen a strong rebound, post-Covid, with little impact on traffic activity so far – from higher fuel costs or recessionary fears. 

Profit margins “remain strong” where the table shows growth near 12%, and they say inflationary pressures are being actively managed. 

Redde Northgate - financial summary
Y
ear end 30 Apr

20152016201720182019202020212022
Turnover (£ million)6146186677027457791,1091,244
Operating margin (%)15.614.612.39.110.13.67.211.7
Operating profit (£m)95.890.681.864.175.528.479.4145
Net profit (£m)66.861.560.943.251.47.765.6102
EPS - reported (p)49.245.545.132.037.84.926.240.4
EPS - normalised (p)49.246.345.833.438.035.228.439.8
Price/earnings ratio (x)7.4
Return on equity (%)13.712.38.29.31.17.410.9
Operating cashflow/share (p)6.354.535.4-60.528.421.755.150.8
Capital expenditure/share (p)4.84.64.59.911.87.63.721.4
Free cashflow/share (p)1.549.930.970.416.514.151.429.4
Cash (£m)9.755.241.221.435.767.811.224.6
Net debt (£m)338310310439437576530583
Net assets (£m)426471517539564872908947
Net assets per share (p)320354388405423354369385

Source: historic company REFS and company accounts

But compare what happened in 2008-09 

According to Northgate’s 2009 annual report, underlying profit and earnings per share (EPS) plunged nearly 70%, despite a 5% rise in revenue. 

Here’s an extract from the chairman’s statement at the time: “Following nine years of consecutive growth in sales and earnings, the second half of 2008 saw the group’s markets start to deteriorate rapidly...the speed and severity of the current economic downturn resulted in a sudden and prolonged period of reduced vehicle utilisation and a significant decline in residual value of used vehicles, necessitating an impairment of assets.” 

Total write-downs reached £146 million putting Northgate at risk of breaching its bank covenants. 

This time around, management re-financed its debt a year ago, with maturities extending up to 10 years, but the rapidity of downturn for hiring vehicles when a tough recession strikes remains relevant.  

Do net tangible assets of 289p a share constitute a prop? 

Last April’s balance sheet had £947 million of net assets, equivalent to 402p a share, or 289p on a net tangible basis. Some £1,162 million of property is involved. 

But that is strictly relevant only in a break-up scenario, whereas if trading continues then the assets are worth what they earn. This kind of business does require an extensive network. 

On the liabilities’ side, there was £443 million debt, chiefly long-term; also £165 million lease liabilities versus £25 million cash. This generated an £18 million net interest charge that took 12% off operating profit.  

It is a sound balance sheet, if arguable that instead of ramping up a share buyback programme from £30 million to £60 million, cash might instead be augmented – given a recession may offer scope for acquisitions at keen prices, or used to reduce debt. 

Buying back shares can be seen as lacking growth opportunities and an artificial way to enhance EPS (to which directors’ bonuses are often linked). The programme is two-thirds completed, with just over 11 million shares re-purchased during this time, relative to 246 million issued at the start, hence a near 4.5% reduction. 

Personally, I find this value-destructive, at the back end of UK recovery from Covid, although many listed companies are doing the same. 

Risks with consensus forecasts  

EPS is projected to rise 25% to 49.6p this financial year, based on £122 million net profit, then ease 45.3p in the April 2023 year.  

I find this hopeful now that the Truss government has created huge economic uncertainty – liable to more than offset any benefit from tax cuts. 

The Bank of England cannot flip-flop between monetary tightening and easing like it has done in the last week - giving intimations of higher interest rates then engaging quantitative easing, or QE, to support the debt market. 

Fear surrounding UK domestic equities and sterling is likely only to abate once fiscal and monetary policy is seen no longer in conflict. Yet the prime minister and chancellor remain on their high horse. 

The longer this continues, the more likely UK company profit forecasts need downgrading – especially for consumer discretionary and industrial cyclical stocks. 

Dividend growth of 4% to 21.9p is targeted in respect of the April 2023 year, then 22.1p – implicitly covered over twice by earnings. 

Stock prices may be nearer reality than at any time this year  

A key risk with my cautious stance is UK equities now behold to every twist in macro events and sentiment. 

Redde Northgate and many others have sold off amid political/economic chaos, but if the shock factor eases then stocks will bounce in the near term.  

As a mainly companies' analyst, however, I think the trough on consensus earnings lies ahead. Cyclicals especially, face downgrades.  

Redde Northgate merits being on a prospective “buy” list, but for now: Hold. 

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

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