Interactive Investor

Stockwatch: this share will be worth buying again

9th September 2022 11:13

Edmond Jackson from interactive investor

Pressure on revenues and margins could trigger a wave of profit warnings in the months ahead, but analyst Edmond Jackson thinks this mid-cap is worth monitoring.

Retailer and car service centre Halfords Group (LSE:HFD) is a particularly good example of the macro dilemma affecting UK domestic equities.  

After a torrid 2022 and an especially weak August, hard-hit stocks are re-bounding where trading updates are resilient. Alert traders may be able to exact a quick profit of 10% or more, but should long-term investors act, given we may only be the early stage of recession?  

Halfords exemplifies this, where price/earnings (PE) multiples dipped below 5x versus a yield of over 5%, apparently well-covered by earnings. But that assumes forecasts made before the cost-of-living issues have intensified. 

Affirming full-year guidance, at least for now 

In a 20-week update, Halfords has affirmed its full-year guidance for between £65 million and £75 million underlying pre-tax profit for its current year to April 2023.  

This comes with a pretty big caveat, assuming “no material changes in the macroeconomic environment or consumer spending patterns in the remainder of full-year 2023”.

It helps that Halfords is re-balancing towards car service work, reinforcing the image of an “essential” retailer. Service-related sales have more than doubled to 42% of group revenue, and 70% of group business is now motoring-related. Product sales, including cycling, remain the majority at 58% of revenue.  

This is relevant because people are keeping cars for longer while we await better battery longevity and charging facilities for electric vehicles. More used cars have also been bought due to chip shortages disrupting supply of new.  

Group revenues are a moving feast, however, up 9% with the help of acquisitions, while the like-for-like figure was 2% easier given a tough comparative period of emerging from the final Covid lockdown. 

Yet analyst consensus eases in response to update 

While investors responded eagerly, the stock closing up 15% at 154p after Wednesday’s update, at least one forecaster has trimmed numbers. Possibly, Halfords being in the news prompted caution due to macro concerns. 

Earnings per share (EPS) numbers have been cut by around 10% (weighted to 2024), now targeting 23.5p in respect of the April 2023 year and 24.8p in 2024. The consensus has reduced twice in the last day or so. With the stock easing to 150p, this implies a forward PE of 6.4x easing to 6.0x – which ought to price in significantly weak performance for a retailer of strong brand and national network. 

Consensus for dividend per share has also been shaved more like 7% to 8.4p in respect of April 2023 and 9.0p for 2024, implying a yield up to 6%. 

Energy price controls will mitigate sting of higher inflation  

Wednesday’s early news - how Liz Truss has pivoted towards classic socialist economics, of price controls – helped various UK consumer stocks, initially. At least if expectations for 20% inflation by early 2023 can be reined in, other utilities will benchmark against a lower figure for their billing.  

Yet despite the energy price cap being frozen at £2,500, it is estimated the average UK household will pay 64% more than last winter. 

Anyway, it was enough “change” to attract buying of hard-hit UK consumer stocks, where Halfords had fallen from 360p last January to 125p a fortnight or so ago. 

The long-term chart is illustrative of how Halfords is indeed low in its range, although the stock remains broadly “cyclical” in a sideways’ range. The fundamentals since 2015 show only modest progression and near 8% in 2022 the operation margin does not have much leeway should costs rise. 

Halfords - financial summary
Year-end 1 Apr

 20152016201720182019202020212022
Turnover (£ million)1,0251,0221,0951,1351,1391,1551,2921,370
Net profit (£ million)65.863.556.454.741.917.553.277.7
Operating margin (%)8.58.16.76.24.82.96.27.9
Reported earnings/share (p)33.332.328.627.521.08.726.336.4
Normalised earnings/share (p)32.732.929.332.426.433.955.133.4
Return on total capital (%)13.714.613.912.910.53.711.112.3
Operational cashflow/share (p)60.942.736.639.836.390.013556.4
Capital expenditure/share (p)20.119.617.518.614.816.813.622.1
Free cashflow/share (p)40.823.119.121.221.673.212134.3
Dividend per share (p)16.517.017.518.018.66.20.08.0
Covered by earnings (x)2.01.91.61.51.11.40.04.5
Cash (£m)22.411.916.527.09.811667.246.3
Net debt (£m)61.847.985.987.881.8480277345
Net assets (£m)368405408410409366418551
Net assets per share (p)185204205206206184210252

Source: historic company REFS and company accounts.

At least one institutional shareholder is bullish 

An institutional shareholder reportedly says a yield over 5% (based on current price, not what you may have bought at) is adequate compensation while waiting for things to improve. Halfords was oversold, the current recovery is only partial, and the stock needs to double to reach where it started 2022.  

By contrast, I say Halfords’ de-rating reflects how the stock market works: as a discounting mechanism. It has correctly anticipated tougher times. This and many other UK consumer-facing equities hinge on whether warnings continue.  

He continues: “By December, one should expect the bulk of rate tightening to be done. This should then act as a trigger for the next phase of the economic cycle, which may well see some form of meaningful economic stimulus.” 

I think this reflects how fund manager views have been conditioned by years of central banks rescuing markets with stimulus. No way is there scope to repeat such in the medium term. Central banks will be lucky to get inflation below 4% let alone their 2% mandate, given supply factors are dictating current inflation.    

Despite it often being futile to try and time markets, I incline to hold off buying until company updates get grimmer. Pressure both on revenues and margins seems liable to mean a wave of profit warnings in months ahead. 

Ideally, you will have accumulated cyclical-type equity before the economy reaches a lower turning point, as the stock market will try to anticipate recovery before any evidence manifests itself. 

Possible takeover bid emerging at earnings trough  

A potential flaw in my argument is US dollar strength versus weaker sterling, empowering US private equity buyers. 

The dollar continues to strengthen because the US is seen having relative independence in energy supply, versus continental Europe which became over-dependent on Russia. The UK’s limited storage means we are in a ridiculous situation, having exported gas to the Continent and now have to buy it back at much higher prices.  

Sterling is also under pressure due to a big increase in public borrowing to finance the energy price cap just announced, and soaring interest payments. One hedge fund manager has, however, gone long of sterling – reckoning US interest rates cannot rise much more without causing recession. 

I would still bear in mind that US takeovers of UK industry is a long-established trend – witness Morrisons, a year ago.  

Halfords’ 1 April balance sheet is quite a deterrent, mind. Against £551 million net assets, there was no debt, albeit £391 million lease liabilities and £300 million trade payables. The ratio of current assets to current liabilities was 0.9 and intangibles constituted 80% of net assets. 

It is not an overtly strained balance sheet, but I question the extent of dividend pay-out as prudent, and also the scope for a hard-nosed private equity buyer to inject debt.  

Halfords’ free cash flow profile (see table above) is good but not great, to pay down debt.  

Story has changed radically from a play on Covid

I last commented on Halfords two years ago, in terms of it being a play on more cycling and less public transport use – possibly also benefiting motoring. I applied a “hold” stance at 234p which was justified by the subsequent rally to 435p by July 2021, but events have changed hugely since. 

Unlike last Friday’s “sell” stances on two small caps, I think Halfords’ rating does significantly price in recession. It will be worth buying again, however, the UK consumer environment looks likely to deteriorate – despite the energy price cap. With fresh money, I would therefore wait, but a “sell” stance would currently be harsh. Hold.  

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

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