Interactive Investor

Stockwatch: I like this share despite the valuation

30th June 2023 11:03

by Edmond Jackson from interactive investor

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They’re trading within throwing distance of a one-year high, but analyst Edmond Jackson questions this mid-cap’s share buyback strategy and implications for its growth rating.

Liking a share 600

Share buybacks get mixed reviews. If management is generating great investment projects – organically or by acquisition – then spare capital should be directed at such to derive a high rate of return. This is why true growth stocks rarely pay dividends. 

Obviously, not every business is a wonder growth play. Most retain some capital for investment but also pay out, to give shareholders a return and as proof of operational cash flow. 

The concept of a return has become extended – some might say twisted - however to include share buybacks, such that daily company news is dominated by them.  

Indeed, Warren Buffett says this is logical where a company’s overall return on equity is better than what new investment projects offer. Buybacks are thus value-accretive to earnings per share when such equity is then cancelled. To me, it at least underlines why such equity (no longer) deserves a growth rating. 

There is also a potential conflict of interest where executive director remuneration awards are linked to earnings per share (EPS) targets, these made easier to achieve when buybacks reduce the number of shares issued. Non-executive directors are meant to overcome this “agency” dilemma where control is separated from owner-shareholders and managers, such as ensuring a balance between dividends and buybacks. But all too often, I feel, their mindset as to what is appropriate reflects the managerial class. A cynic would say that directors sit on each other's boards and are “in it together”.     

A case exists why this is appropriate for Pets at Home 

A typical example of all this is mid-cap Pets at Home Group (LSE:PETS) which has just declared another £50 million buyback programme – in context of a £1.8 billion market value with the stock currently at 375p. 

I am broadly a fan not critic, having drawn attention to the shares as a “buy” at 125p in August 2018, when insiders had piled in after short-sellers impacted the price. A new CEO had also taken the reins.

At 155p in March 2019, I included it among five stocks to hold for a reliable ISA portfolio over the Brexit years. Britain is a nation of animal lovers where Pets has a leading 24% share in a market that has since grown from around £5 billion over £7 billion. Pets require constant expenditure on food and healthcare, which owners are unlikely to defer.   

Return on equity is around 10% - so yes, if management does not consider expansion is appropriate as consumer belts tighten, there is logic to buying back shares for cancellation.  

Some investors might argue, however, that given a very strong free cash flow profile (ahead of earnings) then why not genuinely return more to shareholders? This would raise the yield from a modest 3.5% and prop the stock just as well as buybacks while also delivering real returns. 

Pets at Home Group - financial summary
Year-end 31 Mar

Revenue (£ million)7297938348999611,0591,1431,3181,404
Operating margin (%)13.312.2129.35.59.810.912.49.7
Operating profit (£m)96.897.199.983.953.1104125163137
Net profit (£m)72.272.875.462.830.567.490.4125101
Reported EPS (p)14.414.515.
Normalised EPS (p)13.515.415.113.514.014.711.620.922.8
Operating cashflow/share (p)18.322.122.021.421.442.238.148.950.4
Capital expenditure/share (p)
Free cashflow/share (p)12.214.813.913.114.034.531.237.934.8
Dividend/share (p)
Earnings cover (x)
Return on capital (%)
Cash (£m)13340.056.359.860.579.1101169180
Net debt (£m)188161155138119548407311362
Net asset value (£m)7978448839069039319771,0501,025
Net asset value/share (p)159169177181181186195210212

Source: historic company REFS and company accounts.

Slip in operating margin is one justification 

Pets’ rationale as declared in its 25 May annual results (to 30 March) was having net cash near £55 million (before lease liabilities of £421 million). Its declared capital allocation policy prioritises organic investment, a progressive dividend policy and value-accretive acquisitions, but “we will return” to shareholders any surplus free cash flow. 

I am inclined to think that EPS needs a bit of a prop while inflation is compromising margins. Pets’ operating margin slipped in the last financial year, from a recent years’ strong context of 12.4% to 9.7%, hence return on total capital eased from 11.2% to 9.2%.  

Return on equity similarly eased from 12.3% to 9.7%. While operating cash flow rose to over 50p per share, greater capital expenditure near 17p per share trimmed free cash flow to below 35p per share. Yet this was still comfortably ahead of normalised EPS of 23p. 

The trading outlook was said to be one of sustaining financial year-end performance “with strong consumer loyalty supporting continued volume growth alongside continued consumer acquisition”. 

I suspect the effects of mortgage/interest rate rises on consumer spending are yet to fully manifest. So, while most pet owners will continue to spend, an element of people will be less inclined to take on the commitment of a new pet – especially a dog or cat, whose costs are higher than small animals for children. 

According to how resilient UK consumers prove, I therefore see some risk to Pets’ revenue on a two-year view. If that expectation is taken up more widely, it could temper demand for the stock which already is in a consolidation phase. 

In fairness, consolidation is happening anyway – as part of the business re-adjusting after exceptional demand for pet products during Covid lockdowns.  

From March 2020 to September 2021, the stock more than doubled from 215p to an all-time high over 500p, on a forward price/earnings (PE) ratio of around 23 times. It has now mean-reverted to around 18 times consensus earnings for the current year to end-March 2024, which may not price in some revenue risk if my concern is justified. 

This may also be the crux for sentiment, lest consensus for 13% growth in net profit to £116 million in March 2025 need altering. On this basis, the forward PE is just below 16 times and the yield 3.7%. 

Perhaps Pets’ board is thus justified in reducing shares issued, to mitigate any impact on EPS. 

Strategic ambition to build world’s best pet care platform 

The chief executive talks of being “incredibly excited about this opportunity ahead,” although cynical me regards it as a necessary “jam tomorrow” tease to keep shareholders engaged.  

There will be a unified pet care app, from booking surgical appointments, ordering repeat prescription deliveries, to managing food subscriptions and buying a special birthday treat. Yet most businesses nowadays offer such a dedicated app. 

The retail side of the group currently dominates at 91% of revenue, although various costs involved whittle down a 47% gross margin to below 8% at the pre-tax level. As yet, the veterinary side constitutes less than 9% of revenue but enjoys a 42% pre-tax margin. 

While pets’ need for food and veterinary care implies relatively good quality earnings in the retail sector, my concern about new cat/dog ownership in tough times would affect both sides of the group. 

Short-sellers look to have thrown in the towel 

In October 2018, Pets was one of London’s most-shorted stocks with over 14% of its issued share capital out on loan. My recollection was, maybe just one bearish stockbroker had managed to persuade several hedge funds that the company’s reported numbers were not altogether true. 

The March 2019 year did see a drop in profitability, although the financial downside (and in following years) was nowhere near as bad as warned. 

Short-sold disclosures over 0.5% of Pets’ issued share capital then were eliminated by March 2021. A 2% overall short position existed last May but, ahead of the latest annual results, experienced hedge funds such as GLG and Marshall Wace reduced short positions, leaving only BlackRock Investment Management short just below 0.7%.   

For the avoidance of doubt, I would retain Pets in a long-term equity portfolio. It retains secure qualities relative to other retail stocks especially. Just be aware how resorting again to buybacks, in a context where revenue growth may get harder, shows a quasi “growth” rating may be a tad rich. Hold.   

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

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