Interactive Investor

Stockwatch: why I’m downgrading this FTSE 100 share

With global events casting a cloud over financial markets, analyst Edmond Jackson reviews his stance on this blue-chip company. He also explains why he won’t be upgrading these three stocks just yet.

19th April 2024 12:42

by Edmond Jackson from interactive investor

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Is the Middle East situation making equities especially high risk, or can you reasonably ride out volatility?

It is now fast-moving. I began this piece earlier today, noting how an Iranian Revolutionary Guards commander declared that if Israel attacks its nuclear centres, “we will surely reciprocate with advanced missiles against their own nuclear sites”. I then had to update amid news of Israeli airstrikes on Iran’s nuclear facilities area.

Markets are so far resilient to what is a serious escalation – to one major Middle East state striking another, after years of proxy battles. The FTSE 100 is down just 0.5% and oil and gold have eased from initial spikes. We await the next move from Iran.

easyJet (LSE:EZJ) exemplifies how an otherwise sound investment case faces disruption. When I rated the FTSE 100-listed airline and holidays group a “buy” last December at 475p, I cautioned that the rating assumed the Arab/Israeli conflict was confined to Gaza and did not spread in the region. Not that easyJet has any material exposure in its flights, but airline stocks were liable to succumb to jitters.

Otherwise, easyJet’s strong results for the September 2024 year and consensus outlook implied a forward price/earnings (PE) multiple of just 7.3 times, with its growing holidays side on course to generate around a quarter of group revenue.

At 516p this morning, its shares are down 10% from 580p a week ago, before Iran’s strike. The PE-to-growth ratio, or PEG (the PE multiple divided by the earnings per share growth rate on a 12-month rolling forward basis) is a very attractive 0.5. Ideally with growth-type shares you are looking for a PEG below 1.0 (a perfect correlation of growth and price), but if the company is impressive, then be flexible to below 1.5x as it will grow into the rating. That plenty of US technology shares are on PEGs anything like 5 times is partly why I am cautious of them.

Such a low rating is, I believe, because travel periodically faces a major disruption such as war or disease. As yet, the Middle East seems unlikely to disrupt most holiday plans; the war is “somewhere else. An uncertainty for Europe, however, and affecting shares far more generally, is if the West’s new fixation with Israel/Iran emboldens President Putin to aggressively finish this summer what he set out to do in Ukraine two years ago. War then comes closer to home.

It is a bit like banks, at least those lowly rated lenders in the UK. Since 2008, investors have yet to shrug off the sense that a major crisis could hit at some point. Market pricing thus exacts relatively high yields as well as on other London-listed financial shares.

Summer bookings building well

Easter was “particularly strong” and “bookings for summer 2024 continue to build well, according to this week’s strong half-year update, with an increase in volume and pricing compared to the same period last year”. The shares rose around 3% in response but have lost that, back to around 520p.

As ever, a first-half seasonal pre-tax loss is expected, this time guided at £340 million to £360 million, which would be over £50 million down on the previous winter’s losses. Capacity growth has been targeted where demand is strongest, alongside productivity and utilisation benefits.

Flying into Israel has been suspended for the summer but anyway represented just 0.3% of planned summer flying. This modest capacity is being redeployed to serve, for example, 42% year-on-year customer growth at easyJet holidays.

So it is a robust performance in the face of potential adversity, where a forward PE multiple possibly below eight times in theory accommodates much risk.

Mind, a near 3% yield is no real prop for the shares. Before Covid, earnings cover for the dividend was 1.5x to 2.0x, then last year it was 9.5x as payouts were cautiously resumed. Consensus anticipates around 5x cover in the September 2024 and 2025 years, but that assumes over 40% earnings growth this financial year easing to 8% in 2025.

easyJet - financial summary
Year end 30 Sep

Turnover (£ million)5,0475,8986,3853,0091,4585,7698,171
Operating margin (%)
Operating profit (£m)404460466-899-910-27.0453
Net profit (£m)305358349-1,079-858-169324
EPS - reported (p)64.775.974.0-223-159-22.442.7
EPS - normalised (p)65.411073.4-148-174-13.446.7
Return on total capital (%)
Operating cashflow/share (p)141204161-158-192103205
Capital expenditure/share (p)13421520914427.670.499.5
Free cashflow/share (p)7.0-11.0-48.0-302-22032.7105
Dividend/share (p)34.449.337.
Covered by earnings x2.
Cash (£m)1,3281,3731,5762,3163,5363,6402,925
Net debt (£m)-357-3963261,125910670-41.0
Net assets (£m)2,8023,2332,9851,8992,6392,5332,787
Net assets per share (p)594685633350348334368

Source: historic company REFS and company accounts.

While the targeted dividend payments look pretty secure, earnings could vary – another reason for their modest rating. In its favour, easyJet has a strong position and its keen ticket pricing should help recent revenue momentum as people feel liberated to travel post-Covid. Consensus anticipates over £10 billion of revenue in the September 2025 financial year.

Mind, operating margins are mid single-digit per cent at best and, if the Middle East is entering greater turbulence, then fuel costs are liable to rise.

Remaining low in chart context

easyJet shares and most equities have rallied from late October, but the airline remains well down on levels between 1,300p and 1,500p from 2014 to 2018. I disliked its growth PE at around 20 times back then, but part of my bull case last December was scope for mean-reversion – say to a benchmark PE at more like 10-12x.

From 12 to 16 April, Bank of America reduced its easyJet exposure from 4.0 to 3.3%, although it had anyway increased from 3.3% only a few days earlier. This holder appears to be a nominee for various investors, so I would not be concerned given scope for different views.

As with shares generally, the near-term crux is whether Israel and Iran are on an ascending trend of blows, diplomacy that the United Nations cannot halt. And over the medium term, whether Russia exploits the West losing interest in Ukraine. It’s also unclear if China senses it is opportune, then, to try to re-take Taiwan, disrupting Western semiconductor supply.

Events can therefore get nastier yet, which could be of benefit to investors with cash to take advantage. By this weekend it should be clear if Iran is going to stick to its threats or Israel’s action today has deterrence value. As yet, markets favour the latter and, despite easyJet seemingly exposed as an airline share, I downgrade only modestly to Hold.

Deferring thoughts of smaller asset managers as a fresh buy

Recent updates from Liontrust Asset Management (LSE:LIO), Jupiter Fund Management (LSE:JUP) and Premier Miton Group (LSE:PMI) have shown resilience relative to their shares, which are typically on low single-figure PE’s and yields towards 10%. This I find interesting given the market in financial shares is likely to try and price in an element of recovery before it materialises.

Given these shares represent a geared play on markets, however, if the Middle East runs out of control, then not even apparently cheap ratings are a prop. After their updates pushed them up my watch list, the macro-political context stalls me. Hopefully for holders, my caution is misplaced.

While I do not think it wise to be ditching equities in response to Israel/Iran aggression, investors need to follow developments carefully. Problem is if the Strait of Hormuz – where Iran controls the northern shore – gets compromised, given it’s where a third of the world’s liquefied natural gas and 25% of oil consumption passes. Holding oil & gas shares therefore constitute a portfolio hedge, in the sense that prices would jump if Iran intervenes. Higher fuel prices might thus delay further central banks cutting interest rates and a “stagflation” scenario ensue.

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

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