Interactive Investor

Stockwatch: what to make of two big warnings on economic outlook?

Unless you’ve been heavily invested in US tech stocks, the start of 2024 has been challenging. Now, analyst Edmond Jackson reviews a couple of pertinent warnings for investors, both domestic and international.

23rd January 2024 10:55

Edmond Jackson from interactive investor

News from insolvency practitioner Begbies Traynor Group (LSE:BEG) and fasteners company Trifast (LSE:TRI) – a classic industrial cyclical stock – merit consideration as to whether a mild recession (or worse) is likely. 

A latest quarterly “red flag alert report” from Begbies cites UK corporate financial distress up nearly 26% in the final quarter of 2023, “the second consecutive period where critical financial distress has grown by around a quarter”.  

But I think this may sound worse than the actual substance involved, aspects of which are ironically welcome. 

In annual terms it is a modest 6% rise on the fourth quarter of 2022, to 539,900 UK businesses said to be in significant financial distress. I see this as inevitable given ultra-low interest rates persisted unduly beyond the 2008 crisis, and monetary stimulus ramped up again during Covid lockdowns. The effects were to prop up weak businesses – so-called zombies generating no real return beyond paying debt interest – that should have failed in a healthy market economy. 

Such an overhang of weak businesses was always likely to trigger bad headlines once interest rates rose to tackle inflation. It is unclear quite whether the fallout will weigh on the UK economy overall – certainly there could be job losses – but we should welcome resources deployed elsewhere. 

Care is needed because zombies may not be the whole story. Begbies cites health & education – seemingly defensive – incurring a 41% jump in critical financial distress, cyclical construction up 33%, property (services) up 25% and support services up 24%. Construction and property have most likely been affected by interest rate rises, and support services may be relatively easy to cut back on when companies are tackling costs. 

Begbies’ revelations tally with the EY Item Club saying the UK probably slipped into recession in the final quarter of 2023 after a 0.1% slip in GDP over July-September. 

Yet without a sudden jump in unemployment, it is hard to see UK economic demand being materially hurt. Labour shortages mean a strong element of the population is enjoying wage growth, and the “triple lock” means pensions are likely to rise by 8% or so given this was September’s average wages’ increase. Yes, aspects of discretionary spending are down, but food retailers’ revenues have at least pegged inflation. See today’s strong update from Premier Foods (LSE:PFD) citing double-digit sales growth. 

EY still expects UK growth this year albeit down from the 0.6% targeted to 0.3%, and is optimistic longer-term – anticipating lower inflation and interest rates. 

Begbies shares are a conundrum despite distress being supportive 

In principle, Begbies shares should be an ideal investment for a UK slowdown. In December 2020, and given the fall-out from Covid, I rated Begbies “buy” at 87p, moderated to “hold” at 140p in May 2021, re-iterating “buy” at 137p that October – on a rationale of “one to own if you are losing confidence in Boris Johnson’s promises.” 

The stock bumped along sustaining a 140p range until a year ago, then fell back to early 2021 levels around 112p currently. A significant aspect during 2023, however, was selling of UK small caps generally. 

I think investors may also be wary about how Begbies’ acquisitive record has meant a big differential between reported and normalised earnings – for example with acquisition transaction costs besides amortisation of intangibles, being kept out of the latter.  

Respecting such costs would indeed blur the performance comparison of the businesses being integrated, but they are still group-level costs and regular ones where a Plc is a serial acquirer. It can vex, how companies include adviser fees even share bonuses as “exceptional”. They all weigh on value. 

Begbies Traynor Group - financial summary
Year ended 30 Apr

 201520162017201820192020202120222023
Turnover (£ million)45.450.149.752.460.170.583.8110122
Operating margin (%)0.73.72.95.37.35.53.34.45.9
Operating profit (£m)0.31.91.42.84.43.92.84.97.2
Net profit (£m)-1.60.5-0.31.42.30.90.2-0.52.9
EPS - reported (p)-0.60.40.21.31.90.70.1-0.31.8
EPS - normalised (p)1.40.91.32.02.92.43.53.14.3
Return on equity (%)-1.00.70.42.53.91.50.2-0.63.5
Operating cashflow/share (p)3.96.25.26.64.91.39.56.44.2
Capital expenditure/share (p)1.30.50.30.40.90.60.90.70.6
Free cashflow/share (p)2.65.84.96.24.00.78.65.73.6
Dividends per share (p)2.22.22.22.42.62.83.03.53.8
Covered by earnings (x)-0.30.20.10.50.70.30.04-0.10.5
Cash (£m)9.27.66.73.54.07.38.09.78.0
Net debt (£m)12.810.410.315.714.611.15.81.75.2
Net assets (£m)61.060.258.156.258.165.686.384.584.3
Net assets per share (p)55.754.354.451.150.851.357.255.154.6

Source: historic company REFS and company accounts

Furthermore, and within the interim results to 31 October 2021, there was a £4.5 million “acquisition consideration deemed remuneration in accordance with IFRS 3” seemingly requiring an article in itself to explain. When investors can’t reasonably understand what is presented, the easier, if not logical, action is to look elsewhere.  

Begbies trades on around 10x projected normalised earnings, albeit over 60x reported earnings per share (EPS) of 1.8p in the April 2023 financial year. The financial summary table also shows no real growth in reported EPS since 2015. Yet such a period could reflect monetary stimulus propping weak firms, and Begbies is now set to truly benefit.   

The interim results did show organic revenue growth was 8% within 13% overall. I therefore retain: Buy.      

Trifast suggests economic risks are spread far and wide 

It is pertinent how this small-cap fastenings manufacturer and distributor cites a “disappointing” December, with “significantly lower than forecasted volumes in both our Asia operations and global distribution sales channel”. 

This counters management previously expecting both areas to recover after a subdued March to September, but “demand conditions and excess customer inventory levels have pushed this recovery further into 2024 and we now expect these challenging conditions to persist through to the end of the (31 March) financial year.”  

It is unclear quite whether we should accept such reassurance after recent guidance was wrong. 

Annual results to 31 March will be “significantly below previous expectations,” we’re told, with revenue around £230 million and an adjusted EBIT margin around 5%. Mind how net profit will be compromised by finance charges: relative to £4.7 million interim operating profit there were £2.8 million net financing costs despite near £60 million debt all longer-term and £32 million cash. 

It is a second key warning from Trifast in nearly a year. Last February the stock plunged over 30% to a low 60p area when pre-tax profit guidance was cut from £14 million to £9 million, although a history of single-figure operating margins on circa £200 million annual revenue means profit does easily vary. 

Trifast - financial summary
Year end 31 Mar

 2017201820192020202120222023
Turnover (£ million)187.0198209200188219244
Operating margin (%)9.69.68.22.04.75.30.0
Operating profit (£m)17.919.017.14.18.811.60.0
Net profit (£m)12.715.112.2-0.25.89.0-2.9
EPS - reported (p)10.412.29.9-0.24.36.6-2.1
EPS - normalised (p)10.311.99.93.94.76.92.0
Operating cashflow/share (p)14.58.28.012.717.4-13.12.2
Capital expenditure/share (p)2.42.93.43.82.33.80.0
Free cashflow/share (p)12.15.34.68.915.1-16.92.2
Dividend/share (p)3.53.94.31.21.62.12.3
Covered by earnings (x)3.03.22.3-0.22.73.1-0.9
Return on total capital (%)14.615.012.92.35.45.70.0
Cash (£m)24.626.225.228.730.326.731.8
Net debt (£m)6.57.414.230.3-0.537.553.8
Net assets (£m)102110121116132139136
Net assets per share (p)84.590.999.394.996.910299.8

Source: historic company REFS and company accounts.

Inventory issues were similarly blamed – specifically de-stocking by an Asian customer – but they essentially reflect softening demand. Annual cost savings of £5 million were exacted but the setback was serious enough for Trifast’s long-time CEO to step down.  

Now, due to “a more testing environment,” a 10% cut in non-operational staff globally is to happen, saving £3 million annually. 

The stock is down around 25% at 71p versus a 66p low early last November before the “everything rally” on hopes for interest rate cuts.  

Even at this level, Trifast’s near-term forward price/earnings (PE) looks at least 20x, with one broker downgrading March 2024 EPS to 3.5p and the next financial year looking highly speculative. 

The chair of the board has still decided to add nearly £25,000 worth of equity at around 73p to her holding. 

As for cyclical stocks generally, the medium-term outlook seems to hinge on whether interest rate cuts materialise and start to reverse economic slowing. 

It bothers me that Trifast may now be one of those companies forever restructuring to cope with shifting markets. “Sell” is possibly harsh, yet despite the director purchase, “buy” feels premature. “Hold” is an awkward compromise given further downside risk if economies slow – especially as the Middle East conflict spreads. 

Last time, “hold” was the best I could muster on Trifast after its profit warning and CEO departure. It was when long-term debt was introduced in support of inventory management.   

Net tangible assets were £93 million, or 68p a share, last September, yet £83 million of inventories could need some provisioning despite a fall from £103 million in September 2022. 

Dramatic mean-reversion means this stock is back to levels a decade ago after hitting 265p in 2018. This makes it interesting to follow, and also for takeover potential. Just mind how, if international slowdown is materialising, “value” cyclicals easily get cheaper. 

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

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