With the outcome for 2023 very much dependent on high interest rates bringing inflation under control, our columnist compares two companies and their place in a long-term portfolio.
Finance and retail stocks fell on Monday, partly because a Bank of England representative cited “ongoing material inflation risks” and the next interest rate move being “more likely another hike”.
Furthermore, and before switching course, we’re told there needs to be “a significant and sustained deceleration in price increases...and underlying inflation... towards achieving the 2% target”.
It shows at least one element of the Bank’s monetary policy committee as hawkish, relative to its dovish governor who appears to believe interest rates higher than 4% would unacceptably compromise the housing market.
This topic is not just a crux for the economy and stocks most sensitive to it, but also ratings. Growth stocks are chiefly back in vogue because optimists reckon rates have peaked, and will fall again once the economy starts to hurt. “Growth” – typically higher price/earnings (PE) and lower yield, with a strong narrative – does best under lower interest rates.
Personally, I doubt we will see 2% inflation because pay awards are ingrained to a tight labour market. Central bankers will more likely compromise in mid-single digits, but every now and again, one of them puffs out their chest asserting the old 2% target and markets dive into fear.
Pets at Home vs Wickes: an interesting comparison
Retailer Pets at Home Group (LSE:PETS) used to enjoy a growth rating - a PE multiple that soared to near 24 times at its September 2021 high of over 500p. Pet ownership had boomed during lockdowns, feeding medium-term growth expectations, hence inflation and higher interest rates jolted the sense that people could afford animals. The stock had halved to 270p by the end of last year.
While some holders blamed the company overall, I suspect a double whammy – of higher interest rates knocking its growth rating, besides altered hopes for spending.
Higher costs are not helping. The first half-year to 13 October showed an 8.5% hike in selling, distribution and administrative costs, hence net profit down 22% to £43 million, which weighed on the stock towards the end of last year.
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Yet the share price has jumped 14% to 375p in response to Pets’ third quarter update (to 5 January) which asserted like-for-like retail revenue up 7.6%, with all categories in growth and achieving price competitiveness. Moreover, veterinary rose 18.0%.
Cynically, retail is static after inflation. Likewise, vet prices have hiked and as yet insurance policies have absorbed this, but will people be able to afford higher premiums in due course?
For now, at least, the original hunch for owning Pets' equity - Britain as a nation of animal lovers – remains. There has also been: “resilient gross margin performance...a strong grip on operating costs...good profit and cash conversion across the business...robust trading momentum continued...hence March 2023 financial year profit guided towards £136 million versus £131 million previously.”
It re-affirms a growth rating – by way of forward PE around 18 times and a modest 3.3% prospective yield, covered nearly 1.7 times by earnings, if expectations are fair.
Pets at Home Group - financial summary
Year-end 31 Mar
|Revenue (£ million)||729||793||834||899||961||1,059||1,143||1,318|
|Operating margin (%)||13.3||12.2||12||9.3||5.5||9.8||10.9||12.4|
|Operating profit (£m)||96.8||97.1||99.9||83.9||53.1||104||125||163|
|Net profit (£m)||72.2||72.8||75.4||62.8||30.5||67.4||90.4||125|
|Reported EPS (p)||14.4||14.5||15.0||12.5||6.0||13.2||17.7||24.5|
|Normalised EPS (p)||13.5||15.4||15.1||13.5||14.0||14.7||11.6||20.9|
|Operating cashflow/share (p)||18.3||22.1||22.0||21.4||21.4||42.2||38.1||48.9|
|Capital expenditure/share (p)||6.1||7.3||8.1||8.3||7.4||7.8||6.9||11.0|
|Free cashflow/share (p)||12.2||14.8||13.9||13.1||14.0||34.5||31.2||37.9|
|Earnings cover (x)||2.7||1.9||2.0||1.7||0.8||1.8||2.2||2.1|
|Return on capital (%)||9.4||8.9||8.8||7.3||7.0||8.8||11.2||9.9|
|Net debt (£m)||188||161||155||138||119||548||407||311|
|Net asset value (£m)||797||844||883||906||903||931||977||1,050|
|Net asset value/share (p)||159||169||177||181||181||186||195||210|
Source: historic company REFS and company accounts
Is this a justified premium, or is Wickes better value?
At 158p, home improvement retailer Wickes Group (LSE:WIX) trades on more like a classic “value” rating: a forward PE just over 9 times amid consensus for normalised earnings per share (EPS) to decline from 23.5p in its current financial year to March to below 17p.
Amid uncertainty for spending, the dividend is projected to fall from 10.7p to 8.3p, i.e. a near-7% yield easing to 5.3%, covered around twice by earnings.
If market pricing is fair, home improvement is thus a riskier prospect than pets, although forecasts are usefully cautious.
Wickes is intriguing on a contrarian view, as yet another over-priced flotation by private equity, albeit where disillusioned buyers selling out may have contributed to the stock potentially being over-sold:
Its April 2021 listing was well-timed for vendors, on the back of a DIY boom. But are prospects genuinely weak?
A 31 January update cites a like-for-like 11.0% fall in core retail sales in the 13 weeks to 2 April 2022, albeit a 5.2% rise in the 13 weeks to 31 December. An “improving trend since the summer” was cited and, although DIY sales remained below the final quarter of 2021, they stabilised amid demand for energy-saving products.
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The CEO said: “With the increased cost of living and colder winter months, we have seen more customers turning to Wickes to reduce their energy usage and bills...market-leading value on loft insulation to draught excluders...”
Wickes also has a Do It For Me – DIFM – side, effectively trade sales, which performed relatively more strongly such that group sales eased only 4% in the first quarter and soared 11.5% in the fourth.
Annual group sales growth of 3.5% is a fall, adjusting for inflation, and there is keen competition from Screwfix, Toolstation and B&Q. Should consumer spending be increasingly constrained, people may have leisure-based priorities come summer.
There is also a caution about cost headwinds such as energy up £10 million in 2023, and a staff pay rise. It’s unclear whether such costs were already reflected in consensus for EPS to fall 28% in the current financial year?
The EY Item Club chief economist said yesterday: “High inflation and falling household real incomes are likely to discourage spending on home improvements.”
An operating margin around 6% in 2021 does not leave much room for cost increases or revenue setbacks, although Wickes, like Pets, has a strong free cash flow profile:
Wickes Group - financial summary
Year end 1 Jan
|Turnover (£ million)||1,200||1,292||1,347||1,535|
|Operating margin (%)||4.7||4.4||4.5||6.3|
|Operating profit (£m)||56.6||56.2||61.0||96.7|
|Net profit (£m)||14.9||12.9||26.3||58.8|
|Reported EPS (p)||5.9||5.1||10.4||23.3|
|Normalised EPS (p)||11.0||14.1||17.8||34.6|
|Earnings per share growth (%)||28.5||26.1||94.8|
|Return on total capital (%)||5.2||5.3||7.2||11.8|
|Operating cashflow/share (p)||70.1||43.0||30.5||40.2|
|Free cashflow/share (p)||52.7||33.4||22.5||29.7|
|Net debt (£m)||879||830||784||619|
|Net assets (£m)||264||279||130||61.9|
Source: flotation prospectus and company accounts.
It is one similar to housebuilders, where I was cautious towards the end of last year – anticipating the narrative from such companies to get worse before it might improve – but the shift towards a generally more optimistic mood in January meant such stocks were bought anyway.
I suspect the story from Wickes will bump along, but if sufficient to sustain a 5% yield on currently modest forecasts, then its stock may have a better risk/reward profile than Pets, which is exposed to the slightest deterioration in narrative.
Overall, I would not disagree with anyone holding either stock in a long-term portfolio, hence “hold” ratings apply. Yet I remain wary on consumer discretionary spending, which explains why I currently shy off Wickes as a “buy” until there is more proof about how costs/revenues are evolving in the new climate.
You might still like to consider that a yield over 5% could be adequate compensation for possibly light risk of further downgrades.
Two generally astute hedge funds have shorted Pets shares
Holders of Wickes – indeed potential buyers – can perhaps take encouragement that its equity has no traders short of its equity, or at least over the 0.5% (of issued capital) disclosure threshold.
Last year, Marshall Wace reduced incrementally from 0.6% in August to 0.49% as of 16 December, so probably remains modestly short of the £400 million company.
Regarding £1.4 billion Pets however, this trader implicitly has more conviction as to downside. It used the strong latest update to raise its short position by 0.02% to 0.8% and, although seemingly tiny, depends on availability of stock lending.
Meanwhile, GLG Partners trimmed its short by 0.03% to 0.58% as of 26 January.
While both traders have sometimes been foiled on the short side, they are seasoned operators, which reinforces my sense that Pets’ valuation may be full.
Retail remains a challenging sector
“Growth” ratings are exposed after the new year rally if interest rates continue to rise and by more than optimists hope for. Meanwhile, “value” offers better risk/reward if material yields are secure. It all depends how the economy pans out.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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