Interactive Investor

Stockwatch: Should you follow stake-building intrigue?

13th July 2018 09:47

Edmond Jackson from interactive investor

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These shares have started rising again after a long decline and results have scope to surprise on the upside, suggests Edmond Jackson who also examines takeover potential.

Following my recent piece on BT Group, it's useful to compare its much smaller mid-cap rival TalkTalk Telecom whose stock has similarly been out of favour, albeit now rising. Might it reflect a general shift in sentiment towards telecoms, or is it chiefly a coincidence according to company specifics? 

I continue to favour BT for demonstrable value, although stake-building by Toscafund – a proactive investor with over 16% of TalkTalk's equity – will certainly result in dialogue with the board, and Tosca is likely to have identified what actions management should take in order for the stock to converge on its own sense of value. 

A special situations fund like this might be unlikely to sway BT, some 16 times bigger than TalkTalk, though clearly it sees scope here.

Another blend of speculative/investment credentials

With BT, strong cash flow supports a circa 7% yield, with the stock on a sub-9 price/earnings (PE) multiple and, after multiple setbacks took the shares down to around 200p, the group has appeared to pass "peak restructuring" –  the prospect of a fresh CEO adding "something new" to the narrative.  This flags scope for BT equity to rise as the market de-risks the dividend yield.  Speculation is still involved as to whether the non-consumer businesses can sustainably improve.

TalkTalk's stock has likewise started rising after a long decline – from over 400p three years ago to 95p just recently and 115p currently.  There's a restructuring parallel here in the sense that a 2015 hacking scandal brought issues to a head, prompting a change in chief executive (albeit a long-term insider promotion than a fresh pair of hands). 

Source: interactive investor      Past performance is not a guide to future performance

TalkTalk's recent claim is being one year into a "reset" to simplify the group and enhance its value offering for "core connectivity".  But despite the de-rating the stock still anticipates recovery given a prospective PE multiple testing 20 times and yield of 2.7%. Like BT, its dividend is covered about twice, albeit with the expectation of rapidly recovering profits/earnings (which being a relatively smaller group helps).

Balance sheet risk factors also compare less favourably for TalkTalk, which is around 350% geared versus 130% for BT.  Both companies have persistently negative net tangible assets, the trend at TalkTalk "worsening" slightly (see table). 

None of this is much of a problem barring a stagflation scenario, though in principle it argues BT should be the better-rated stock given TalkTalk's financial structure is riskier.  The group had anyway made a £200 million equity raising at 107p last February and de-rated its dividend (see table again), although the planned sale of a direct business-to-business operation has been scrapped.

Mixed broker views as to share price targets

Earlier this week the stock was upgraded by Cazenove to a 'neutral' stance on the basis the company has reached the end of its downgrades cycle.  Thus, there’s a parallel with BT where I suggested its stock can rise due to being past "peak restructuring", a welter of bad news items already reflected in its stock which enjoys a near 7% yield. 

Stocks like these can rise simply because investors intent on selling are out, and negative barbs are reducing.  That doesn't amount to an investment rationale but can help tip sentiment positively.  These analysts reckon TalkTalk's operations' narrative is now mostly encouraging with scope to surprise on the upside; although I see quite some hope already in current forecasts (see table) versus last year's outcome. 

In the opposite corner, Credit Suisse has just reaffirmed its 'underperform' rating and cut its price target to 90p from 140p, which attunes to my sense of intrinsic value, although I suggest the stock could still advance according to newsflow.

Five consecutive quarters of net customer growth

This is a bull point management proclaims – especially now TalkTalk is in partnership with Infracapital for fibre broadband, rolling out a network to over 3 million homes and businesses as "Britain’s leading value provider of fixed connectivity". 

The 2017/18 year saw customer growth of 192k versus a 49k decline in 2016/17, with Q4 showing net adds of 109k up from 22k, "our highest ever number, exceeding guidance, due to particularly strong performance in wholesale" (where TalkTalk has taken share from BT).  Fibre-to-the-premises plans are "progressing well" and the business-side Ethernet customer base rose 8% to 8.3k. 

I may be over-cautious, but think it's vital such a telecoms group shows net-positive customer growth, lest price competition or technology advances pressure revenues.  It needs a margin of safety by way of growth, just to stand still. 

For example mobile packages – including home broadband as 4G and 5G extend – could eat into those fixed-line, although the rise in monthly broadband fees from £15-20 in past years nearer £50 with superfast nowadays, offers scope for the keener pricing TalkTalk is known for, so long as this achieves worthwhile margin.

In headline terms the group was loss-making in 2017/18, reflecting £119 million one-off re-organisation costs.  Operating profit fell from £95 million to an £18 million loss on revenue down 4% to £1.7 billion. 

Mind that TalkTalk has yet to establish a mid-teens percentage operating margin like BT's, although management says the benefits of a bigger base, regulatory tailwinds and ongoing cost reduction are expected to boost operating profit by 15% this financial year.  Capital expenditure appears to be easing, to £128 million from £133 million in the 2016/17 year, although an IT transformation programme continues to 2021 underpinning the wider group strategy.

TalkTalk Telecom Group - financial summary           Consensus estimates
year ended 31 Mar 2014 2015 2016 2017 2018 2019 2020
               
Turnover (£ million) 1,722 1,795 1,835 1,783 1,708    
IFRS3 pre-tax profit (£m) 31.0 32.0 14.0 70.0 -73.0    
Normalised pre-tax profit (£m) 51.0 81.0 14.0 181 38.0 91.1 115
Operating margin (%) 4.3 5.9 2.3 12.3 6.1    
IFRS3 earnings/share (p) 3.0 7.7 0.2 6.0 6.0    
Normalised earnings/share (p) 6.3 12.8 0.8 18.3 -0.6 5.8 7.3
Price/earnings multiple (x)         -192 19.8 15.8
Historic annual average P/E (x) 44.7 31.7 205 57.2 7.1    
Cash flow/share (p) 15.9 18.7 17.1 20.8 12.0    
Capex/share (p) 11.9 12.1 17.7 14.0 11.1    
Dividend per share (p) 11.0 12.6 14.5 15.9 2.5 2.7 4.3
Dividend yield (%)         2.2 2.3 3.7
Covered by earnings (x) 0.6 1.0 0.1 1.2   2.2 1.7
Net tangible assets per share (p) -28.6 38.8 -51.4 -62.6 -97.5    
Source: Company REFS              

Speculation as to buyout potential

Triggers emerged last week when an RNS announcement cited Toscafund raising its stake, through 16% from 11% at the start of June.  Traders linked Tosca's history of supporting buyouts with Charles Dunstone, TalkTalk's chairman, simultaneously raising his stake to over 30% which, together with another "onside" investor, appeared to show a party with a controlling interest over 50%.  

In principle, TalkTalk is indeed at a timely stage for a buyout following its "reset", quite like I’ve indicated the off-chance of an industry bid for BT, although in practice debt is already high - so quite what the buyout vehicle for a £1.3 billion group would be structured.  Moreover, if Dunstone was considering such a move then he would not be able to buy stock beforehand, or at the very least time would have to pass.

Stay the course if you're already in

So, with fresh money I'd favour BT’s demonstrable value credentials and strong market positioning, yet TalkTalk does have scope to assert its own competitive position.  I'd ignore speculation as to Toscafund's motives.  Existing shareholders ought to remain patient for the benefits of the new management/strategy.  Hold.

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

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company’s or index name highlighted in the article.

Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

Details of all recommendations issued by ii during the previous 12-month period can be found here.

ii adheres to a strict code of conduct.  Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.

In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

Details of all recommendations issued by ii during the previous 12-month period can be found here.

ii adheres to a strict code of conduct.  Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.

In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.

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