Interactive Investor

Stockwatch: Is this shorted retailer now oversold?

7th August 2018 09:41

Edmond Jackson from interactive investor


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London's third most shorted stock combines a 6% dividend yield with a price/earnings multiple in the single digits, prompting companies analyst Edmond Jackson to ask if this retailer is oversold.

At about 125p, the price of FTSE 250-listed retailer Pets at Home Group has turned up from a 113p low after a trading update delivered four consecutive quarters of group revenue growth over 5%. It’s interesting to consider whether this might be an inflection point, especially with 12.8% of issued share capital sold short.

Upside potential on market technicals alone

Stock on loan soared in 2017 and 2018 making Pets currently the third most shorted stock on the London market, a trend which broadly correlates with the stock halving from 242p. That’s some crowded trade, so either sellers will be proven correct about financial risk (Carillion remains number one) or deteriorating profit/revenue (Debenhams, the fourth most-shorted).

But it only really needs Pets to stand its retailing ground for its stock to rise, once some of these hedge funds decide not to push their luck and buy back. While I wouldn’t base an investment case on a stock’s technical position, this one is worth noting because if Pets’ fundamentals are overall sound then it adds upside potential.

Timing challenge, to spot an inflection point

I originally drew attention at 185p in February 2017 as an early-stage one to watch, and while cautioning it could drop to about 150p I was surprised recently to see Pets' fall to 113p. 

Though I cautioned about ex-private equity owned firms with high debts, since Pets floated in 2014 its debt halved to £212.2 million and it's all long-term. This has levelled off somewhat at £195.5 million as of end-March 2018, although there was also £58.8 million cash, and last year’s interest charge was covered 18 times by operating profit.

So Pets' debt should not present a financial risk issue, say if consumer demand gets pressured and interest rates jack up (Mark Carney's Brexit warning, if credible).

I pointed out the stock was falling between two stools of growth and income appeal, amid end-2016 estimates for flat earnings and a 4% dividend yield twice covered; 18 months later the market has seen fit to exact a 6% yield by way of lower pricing; although the board has broadly maintained the payout around 7.5p per share.

"This stock is moving towards a useful inflection point and yield, the challenge is timing." 

I'll concede it's taken much longer than I expected and the hedge funds reckon there's no turn due yet. But they don't always get such trades right.

Year two of a three-year strategy to recover growth

Management says it is repositioning retail at better price and product innovation, with a bigger focus on digital sales, to combat online competition from warehouse-focused rivals. It also believes vets' services are "a very attractive space in which we can grow" despite skills' shortages limiting expansion.

Thus in the last financial year, merchandise (pet products) generated 85.1% of group revenue and within this “omnichannel” (including online) grew at 75% to represent 6.7% of total merchandising revenue.

So Pets is catching up, though online remains relatively small and the group has a way to go to arrest/improve its fall in operating margin – the tables shows it peaked in 2015 at 12.2%, consolidated around 11% then fell to 8.6%.

Vague read-across to Morrisons' turnaround

Management speaks of "price investment" in merchandise - £13 million during the last financial year - just like Morrison (Wm) Supermarkets did a year or so ago, albeit not productive investment in plant/people/product, instead price cuts so the business can stand its ground. 

The latest update asserts the overall price gap versus online retailers has halved in the last 18 months - without specifying what it is - which leaves a risk of further margin erosion if Pets wants to get broadly equal. Yet management also claims its merchandising is now "ahead of the online pet market and key competitors" after various improvements.  
A new CEO at Morrisons appears to have arrested its losing share to Aldi/Lidl, keeping prices down, and its stock (MRW) has risen nearly 30% from its low. Thus a positive case for Pets’ equity can exist simply if the underlying profit trend stabilises versus the current extent of shorters betting it will get worse; and I don't recall anything like 12.8% of Morrison’s stock being out on loan. 

Vet practices and grooming salons

Similarly the vets’ practices are said to be "growing ahead of the market" with a 24% cash return on invested capital despite some 84% of the practices being relatively young.

The CEO proclaims:

"We know one of the biggest opportunities is to accelerate the maturity and returns of our vet practices."

In the last financial year, "services" improved its growth from 7.9% to 8.5% inclusive of grooming, which not surprisingly has seen slower growth in the challenged consumer climate. 

While spending on vets' services ought to be relatively sticky, grooming is easily given up if cash gets tighter. Its relative contribution to "services" isn't disclosed but it seems fair to assume vets’ revenues are much the higher element i.e. “services” should be able to ride out further consumer downturn.  

Pets at Home Group - financial summary              
year ended 31 Mar 2014 2015 2016 2017 2018 2019 2020
Turnover (£ million) 665 729 793 834 899    
IFRS3 pre-tax profit (£m) 22.5 87.0 92.1 95.4 79.6    
Normalised pre-tax profit (£m) 33.2 87.0 93.0 96.2 80.4 85.2 85.2
Operating margin (%) 9.5 12.2 11.6 11.2 8.6    
IFRS3 earnings/share (p) -13.8 14.4 14.5 15.0 15.0    
Normalised earnings/share (p) -7.7 14.4 14.7 15.2 6.0 13.6 14.6
Earnings per share growth (%)     1.9 3.3 -60.4 127 7.4
Price/earnings multiple (x)         20.8 9.2 8.6
Annual average historic P/E (x)   19.2 17.0 12.5 19.4    
Cash flow/share (p) 53.0 16.6 21.1 21.0 21.4    
Capex/share (p) 15.0 5.9 6.7 7.8 8.0    
Dividends per share (p)   1.8 5.6 8.0 7.5 7.5 8.0
Yield (%)         6.0 6.0 6.4
Covered by earnings (x)   8.1 2.6 1.9 1.7 1.8 1.8
Net tangible assets per share (p) -44.9 -31.7 -26.0 -21.5 -17.3    

Source: Company REFS           Past performance is not a guide to future performance

Looking as if earnings have bottomed out

Pets' latest update for April to July did not make an issue of four consecutive quarters of like-for-like sales growth over 5%, but some observers have latched onto this - e.g. Liberum Capital upgrading to "Hold" in reaction, despite Pets keeping its full-year forecasts unchanged.

The analysts are wary about ongoing margin risks amid competitive pricing and they also see a tougher outlook for vets describing the vets' business model as "cash exhaustive" while new practices are funded with internal loans. Even so, at current share prices "we feel the risk/reward profile may have shifted."
From the update, Pets has abandoned two new store openings where leases had been committed, at a cost of £1.6 million, as if the industry economics are mercurial. With due credit however, this will be treated as an underlying cost rather than exceptional item.   

It's still hard for the market to ignore latest like-for-like group growth of 5.5% (or 7.8% total) with merchandise recovering from 0.8% to 5.0% growth and services up from 7.9% to 8.5%. Demand for items to keep pets cool has reportedly helped.

Two quasi insiders buy a total £595,945 of shares

These purchases were around current prices before the down-dip to 113p. On 11 June a person connected to a director or senior manager bought 265,208 shares at 131.31p equivalent to £348,245; then on 17 July the chairman's wife bought 200,000 shares at 123.35p, an initial holding worth £246,700.

This affirms a conservative sense, you can find flaws in Pets' narrative and financials, but all-considered its equity is priced cheaply – on a forward P/E around 9 times and 6% yield covered nearly twice by earnings. 

Net cash flow from operations only fell 2.9% last year to £107.7 million; investment (mainly property, plant etc) took £43.1 million and dividends £37.3 million, enabling £15 million to be spent cutting debt in context of £4.6 million interest paid on it. 

The 6% yield therefore looks well-supported, and the sky will need to fall in on consumer spending for circa 125p to represent fair price for this stock. Buy.

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

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