Interactive Investor

Stockwatch: this share’s not just about the 7% dividend yield

Amid concerns about recession in the UK, analyst Edmond Jackson revisits a company most of us will have visited at some point. And it’s one he’s still backing for the long term.

30th January 2024 10:57

Edmond Jackson from interactive investor

An interesting revelation this week is data from EY-Parthenon, showing over 18% of publicly listed companies issued profit warnings in 2023 – even higher than the peak of the financial crisis in 2008.

Yet 294 warnings was actually down on the 305 issued in 2022, and despite many equities suffering between spring and autumn last year, prices are rebounding – justifying a “hold” stance through the volatility.

A UK soft landing is way off confirmation

Within last year’s warnings, 26% related to contract delays, 19% to higher costs and another 19% higher interest rates. The analysts note “an ongoing reluctance to commit to discretionary spending” and “many moving parts need to slot into place before we can be sure of an economic soft landing.”

Of stock-picking relevance, EY-Parthenon says “we expect to see increasing disparity between businesses positioned to capitalise on still limited growth and those hampered by earnings pressures or cost of capital”.

In principle, this is supportive for Wickes Group (LSE:WIX), the near-£400 million small-cap home improvement retailer whose pre-close update shows it managing the situation well. Despite a 0.3% slip in annual group sales, profit is indicated at the upper end of forecasts.

Wickes Group - financial summary
Years to 1 Jan then 31 Dec

 20192020202120222022
Turnover (£ million)1,2001,2921,3471,5351,559
Operating margin (%)4.74.44.56.34.3
Operating profit (£m)56.656.261.096.767.1
Net profit (£m)14.912.926.358.831.9
Reported EPS (p)5.95.110.423.312.6
Normalised EPS (p)11.014.117.834.623.7
Earnings per share growth (%) 28.526.194.8-31.5
Return on total capital (%)5.25.37.211.83.7
Operating cashflow/share (p)70.143.030.540.248.4
Capex/share (p)17.49.68.010.514.7
Free cashflow/share (p)52.733.422.529.733.7
Cash (£m)16.225.46.512399.5
Net debt (£m)879830784619592
Net assets (£m)264279130161164

Source: flotation prospectus and company accounts.

I rather like Wickes in the sense of a value retailer for home maintenance items, albeit there is some overlap with Screwfix, which is owned by Kingfisher (LSE:KGF) and Toolstation, owned by Travis Perkins (LSE:TPK). These latter stocks remain in the doldrums, perhaps due to their wider retail and building materials interests, respectively, and a sense that this is a competitive area. Yet Wickes shares have jumped around 10% in response to their pre-close update, at 157p re-gaining a level last seen a year ago.

I drew attention to Wickes as a “buy” at 135p last March, potentially to average in, although it was down to 120p come June – partly amid an exodus from UK small-caps. The price then rallied to trade sideways in a 125-145p range before this latest profits surprise.

The longer-term context is a slide from 275p mid-2021 after Wickes was spun out of Travis Perkins; another example of how flotations can be over-hyped. But with a strong cash flow profile aiding buybacks, shares issued continue to reduce since flotation. If the business model is apposite for challenged times in retail, it is reasonable to expect the latest mean-reversion steadily to continue.

Latest guidance implies £36 million net profit for 2023, or earnings per share (EPS) of 14.4p, hence a price/earnings (PE) multiple near 11x versus 9x for Kingfisher. Wickes has the more attractive yield close to 7% versus 5.3% for Kingfisher.

Such a comparison implies Wickes will need to leverage better profits to rally above 200p, a level that currently implies a PE over 14x. 

While projected earnings cover for the dividend is quite tight at 1.3x – implying a dividend cut, should we get a recession – free cash flow cover has been around 3x versus 2x for Kingfisher.

So despite the stock settling back from an initial jump to 160p, its yield should be supportive.

A 4% operating margin means little headroom for recession

For retailers, it all depends on how the “moving parts” fall into place, as EY-Parthenon says.

Wickes’ revenues split between just over 75% “core” retail and near 25% “DIFM” (do-it-for-me) projects led by design consultants. I suspect this distinction is made given DIFM is liable to be lumpier, with greater sensitivity to the consumer economy. In the first quarter of 2023, it saw 6.2% growth easing to 5.3% in the second; then a downturn accelerated to a 5.5% fall in the third quarter and 13.7% down in the fourth.

Given this also happened in an inflationary environment, a 1.7% annual fall for DFIM could be nearer 10% taking an “underlying” view of 2023. Companies like to adjust figures for exceptional costs, so why not bear inflation in mind?

“Core” retail slipped 4.4% in the first quarter, then edged up 2.3% in the second, settling at just over 1% in the third and fourth - hence a negligible 0.1% ahead for the year, which could be viewed as at least a 5% slip.

I make an issue of this because if group revenues do remain challenged, value-accretion will depend on exacting more efficiencies; but has management already taken out what costs are reasonably possible?

Balance sheet geared via lease liabilities

Based on last June’s interim numbers, a strong profile of cash generation meant no financial debt, although – hardly unexpected of a retailer – there were £671 million lease liabilities, chiefly long term.

They compared with £164 million net assets despite only £23 million of which involve goodwill/intangibles. Yet after adjusting items on the interim income statement, £13.5 million net finance costs took 39% of £34.6 million operating profit.

This is likely to keep the stock volatile according to the economic outlook, and unlike paying down bank debt, I wonder how swiftly lease contracts could be cut, even if cash flow facilitates doing so.

Another aspect I note from the interim balance sheet is minor reductions in inventories and trade receivables, versus trade payables up 2.2%. While such changes are slight, they can still be material for profit. Is it being squeezed higher with the help of a few overdue payments?

A good example how yield should not be chief consideration

I risk quibbling when fundamentally Wickes offers good-value products to address challenges of upgrading UK housing – fundamentally the oldest in Europe, with an average age of 65 years and a third built before 1945. Around half require upgrading for energy efficiency to meet an EPC rating of C or better, where current proposals are for all homes to achieve this by 2030 and rental properties by 2025.

The medium-term crux could still be said to be “kitchens and bathrooms” sentiment: how many people might be turned off such upgrades if discretionary spend gets tighter? It hardly surprises me that the DIFM side has “fewer new leads in the market” and the first quarter is targeted lower year-on-year. Otherwise, “core” is flat.

After some past rationalisation of stores, three new ones opened in the second half of last year, which again implies the “underlying” revenue trend is soft. “A good pipeline” of refit and store openings is promised for 2024.

I am therefore quite wary that this latest profit improvement could be a one-off, and the market may continue to exact a 5%+ yield as compensation for risks. I retain a “buy” stance cautiously, with a horizon of between two and three years rather than months.

Mind how a mid-single-digit yield is not exactly a “return”, it currently compensates you for inflation if the stock remains somewhat rangebound. It’s why we need to keep capital growth (or loss) prospects in mind, rather than be specially enticed by attractive yield.

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

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