Stockwatch: Should you follow stake-building intrigue?

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.

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.