There are certainly positives here, and our companies analyst has successfully backed this business in the past, but a few issues are now making him think twice.
A warning by mid-cap retailer Pets at Home (LSE:PETS) within its annual results statement, reminds us of how the sector outlook remains impaired during the pandemic.
However, the stock’s initial 10% fall below 200p for the first time since March, triggered buying yesterday.
The share price ticked higher when, at 3.48pm, it was revealed that chief executive Peter Pritchard had added a total 121,632 shares at prices around 204p.
In chart context, this meant Pets at Home had retraced to its March low, then enough investors decided to look through a challenging financial year to March 2021, and give the business some benefit of the doubt.
And this morning, we hear that Ian Burke celebrated starting his new role as chairman with the acquisition of £100,000 of stock at 208.7p each.
Continues to affirm a broadly resilient business
Demand for pet food is inelastic – “they all have to eat” – and while grooming is currently deferred, veterinary services remain essential, and social distancing may possibly prompt more ownership of dogs especially, for company.
UK pet care is a £6.5 billion market where Pets at Home has a strongly competitive position, combining physical stores, online, and vets.
I have drawn attention to the shares, which had been a short-sellers’ favourite, at various times, especially when a new CEO took the reins.
I rated them a ‘buy’ at 125p in August 2018 when insiders were piling in, and I have also cited Pets at 155p - among five stocks for a “durable ISA portfolio for the Brexit years”. So, is it time to follow the CEO, or turn more cautious?
Source: TradingView. Past performance is not a guide to future performance.
In a context where UK pet care is growing by around 4% annually, profit on Pets’ retail side is up 4% and veterinary by 5% - so, 'in line' with the market if hardly substance that stock market investors look for.
Underlying earnings per share (EPS) has managed 5.6% to 14.7p hence a price/earnings (PE) multiple near 15x with the stock currently around 215p, and, if the 7.5p annual dividend since 2016 can be sustained, then the yield is 3.5%.
Pre-virus, that would not qualify as a prop, however, fewer companies will pay out in the medium term, and less if they do.
Pets’ strength is affirmed by its “essential retailer” status during any extent of lockdown, albeit vets are on reduced hours, and not needing to resort to furloughing workers on government support.
Business rates relief this year could however mean its cash flow benefits to the tune of £33 million and (just) tip the financial side of Pets’ cash flow statement to maintaining the dividend, although the directors omit to give payout policy guidance in an otherwise detailed statement on operations.
Uncertain behavioural factors affecting demand
Exceptional demand for pet-food in mid-late March unwound as anticipated, but, as a result of imposing social distancing and restrictions on sale of pet products and health care services deemed non-essential, this has “temporarily” depressed turnover.
Personally, I find it tricky to assess to what extent people will remain less willing to shop regarding pet food. If you can get it during a supermarket outing, then why go through another chore of queuing with masks at another store?
The crux going forward is summed up by “online sales remaining at materially elevated levels,” supported by improved capacity and good product availability. However, these are “unable to mitigate the reduced level of in-store sales”.
While it is still early days for emerging from lockdown, such an update affirms a cautious view of retailing: sales may find equilibrium materially lower than pre-virus, but exactly how much lower is impossible to say.
Much, of course, will depend on whether the virus slowly ebbs or returns in a second wave – which even professors of epidemiology hotly dispute.
The medium-term upshot for UK employment also remains unclear. People may prioritise existing pets, but unemployment would affect buying new ones.
So, macro/medical factors remain unpredictable but, if you take the “Oxford” rather than “Imperial” view (by university professors), then the virus will peter out and now is a good time to accumulate stock in well-placed retailers and other businesses affected by Covid-19.
|Pets at Home Group - financial summary|
|year end 31 Mar||2015||2016||2017||2018||2019||2020|
|Revenue (£ million)||729||793||834||899||961||1,059|
|Operating margin (%)||13.3||12.2||12||9.3||5.5||9.8|
|Operating profit (£m)||96.8||97.1||99.9||83.9||53.1||104|
|Net profit (£m)||72.2||72.8||75.4||62.8||30.5||67.4|
|Reported EPS (p)||14.4||14.5||15.0||12.5||6.0||13.2|
|Normalised EPS (p)||13.5||15.4||15.1||13.5||14.0||16.0|
|Operating cashflow/share (p)||18.3||22.1||22.0||21.4||21.4||43.0|
|Capital expenditure/share (p)||6.1||7.3||8.1||8.3||7.4||9.4|
|Free cashflow/share (p)||12.2||14.8||13.9||13.1||14.0||33.6|
|Earnings cover (x)||2.7||1.9||2.0||1.7||0.8||1.8|
|Return on equity (%)||9.4||8.9||8.7||7.0||3.4||7.2|
|Net debt (£m)||188||161||155||138||119||85.9|
|Net asset value (£m)||797||844||883||906||903||931|
|Net asset value/share (p)||159||169||177||181||181||187|
|Source: historic Company REFS and company accounts|
New accounting method is a revelation as to lease liabilities
Short-selling data shows total stock out on loan (to short sellers), down to 4.8% versus 14.3% in October 2018, and 3.1% of the latest numbers is attributed to one hedge fund's position nearly a year ago. Another one – Bonitas – has just appeared (though not disclosed over 0.5%) with a report claiming circa £34 million of undisclosed trading loans hidden from Pets’ balance sheet, in support of circular payments from the vets’ side’ joint venture operation – which are used to boost overall profits.
Bonitas claims to have studied Companies House filings by 432 such joint ventures. I must say, my past sense of Pets’ vigorous expansion into the vets was wariness, if based more on whether vets' outlook is compatible with a Plc profits’ culture.
The claims are the sort likely to be rubbished my management if it came to a public dispute. There have been various such Punch & Judy shows in the last year or so - Babcock (LSE:BAB) fended off "Boatman", while Burford Capital (LSE:BUR) became entangled by Muddy Waters.
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What rather perturbs me, though, is the extent of lease liabilities that have now appeared on the balance sheet, and their cost, which bumps up a sense for financial gearing to 60%, even netting off cash.
Yes, IFRS 16, a new standard on lease accounting, has come along, but the leases quite connect dots in a sense of “can the balance sheet be trusted?” A total of £463.9 million of short and long-term leases have appeared on the end-March 2020 group balance sheet – explained in note 12 – which generated a £14 million interest expense additional to £4.4 million for bank debt.
This meant that the net annual finance charge took 16% of £111.3 million underlying operating profit, compared with 3.8% of £93.2 million profit in 2018/19. And it is why underlying pre-tax profit edged up only 4.2% at £93.5 million. A slightly lower tax charge then helped underlying net profit up 6.4% to £74.9 million.
This is significant for dividend payout policy going forward. Net cash flow from operations has doubled to £215.2 million versus investment needs up only 7% to £50.3 million, and the 7.5p dividend (being maintained) costing £37.1 million.
However, the financing side of the cash flow statement included a £77 million repayment of borrowings, £67 million capital lease payments and £14 million interest on leases, additional to £3.7 million interest on debt. It both compromises headroom for the dividend and adds to a generally complex set of accounts that short sellers are prone to exploit.
So, I flag this as a concern, although management says it has “significant headroom on banking covenants and liquidity including cash of around £162 million”.
Additional costs related to social distancing
Some £5 million of exceptional costs were incurred for Pets’ initial response to Covid-19, although management cites additional and un-quantified costs going forward which will contribute to profits in the current financial year being “materially” lower.
Management avoids guidance while it remains “difficult to make a clear assessment of how consumers will react as we emerge from lockdown”.
Looking at cost dynamics within the income statement: selling & distribution costs as a percentage of turnover is down from 32.7% to 29.6%, although the ratio for administrative expenses has edged up from 8.2% to 8.8%.
Overall, the normalised operating profit margin has improved from 9.7% to 10.7%. The question will be whether additional costs get treated as “exceptional” as virus-related, so as to present a more meaningful comparison.
So, it is a mixed conclusion on Pets: its marketing capabilities under a new CEO are affirmed, and it is encouraging how he sees long-term value, albeit in a more uncertain and costly retail environment, and with short-sellers popping up occasionally. I would like to see more evidence about how 2020 evolves, so temper my stance from ‘buy’ to ‘hold’.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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