Interactive Investor

Stockwatch: will shift in rate expectations boost these two shares?

Both companies have had a tough time, but predictions that borrowing costs will begin to fall in 2024 are encouraging investors to look again. Analyst Edmond Jackson explains what he’d do with them now.

1st December 2023 12:38

by Edmond Jackson from interactive investor

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Thinking about trust discounts 600

November has proved rip-roaring, the S&P 500 index up over 10% with a follow-through into UK stocks as confidence builds that interest rates are heading down. The Vix index, which reflects expectations of market volatility – hence it being referred to as the “fear index” – plunged from around 20 to 13. But is this radical change in sentiment supported by fundamentals? 

Despite both UK and US central bank governors re-asserting that markets have got ahead of themselves on this matter, US stocks continued to soar this week after Federal Reserve Governor Christopher Waller said on Tuesday that he is “increasingly confident” the current benchmark interest rate will get inflation down to the Fed’s 2% target – nodding to rate cuts in months ahead if inflation continues to fall. 

Yesterday, a key measure of US inflation eased for October to the lowest level since April 2021, as consumer spending slowed, affirming the effect of higher rates. The “core” US personal consumption expenditure index fell to a 3.5% annualised for October, down from 3.7% in September. Lower energy prices helped the headline number lower too. US Treasury bonds sold off – hence their yields rose. 

Macro enthusiasm confuses interpretation of individual stocks 

Bulls take heart from apparent “bowl” chart patterns, indicative of a major rally ahead, although with closer examination I find enough charts are more like “V-shaped valleys” which do, admittedly, appear to break downtrends. 

Yet it is easy to assume that company specifics justify this change in stock behaviour, when in reality the macro tide has swept plenty along. 

One example is mid-cap Direct Line Insurance Group (LSE:DLG), up 22% to 192p (currently 189p) after a 7 November update cited its key Motor division writing policies profitably again, having been a drag amid high claims and stiff competition on price. Total policies for the group’s ongoing operations rose nearly 5% and overall gross written premium by nearly 20%. 

The stock’s rise makes it easy it infer that this underlines a turnaround, and also that “market efficiency” means we can better trust consensus for a 9.5p a share dividend in respect of 2023, rising to 14.3p in 2024. That implies a 5% yield with potential to lock in 7.5% at the current price of 189p, which should rise further given the yield looks generous if Direct Line has better prospects under a new CEO. 

But resuming dividends, having omitted the final payout for 2022 and interim 2023, rests – in the short to medium term – on completing the sale of commercial insurance broker NIG to Royal Sun Alliance for an initial £520 million plus earn-out. This is targeted to complete in the second quarter of 2024, hence providing vital cash flow. Otherwise, a 9.5p final dividend would not quite be covered by expected earnings and, while Direct Line has a respectable long-term record on free cash flow, it has lagged earnings. 

It is possible that the stock’s rise reflects growing confidence the disposal will happen, although its last three-month chart is quite the same “V-shaped valley” shown by the FTSE 250 index that was forged by macro influence. More significant on a technical view, I would note, are 2023 lows at 135p end-March and end-June, as constituting “a double bottom” reversal pattern.  

A Deutsche Bank analyst has upgraded from “hold” to “buy” targeting 250p, which looks fair assuming fundamentals improve. My sense is “hold” being more appropriate given how competitive the insurance industry is, although I concede that waiting for proof that Motor especially is sustaining a turnaround could mean the stock rises further.  

Direct Line Insurance Group - financial summary
Year end 31 Dec

201420152016201720182019202020212022
Turnover (£ million)3,3493,2533,3213,4963,4273,2843,2023,2303,168
Operating margin (%)13.615.410.415.216.815.414.013.6-1.4
Operating profit (£m)457500345531577506447441-45.1
Net profit (£m)373580279434472420367344-39.5
Reported EPS (p)26.027.620.231.532.929.225.524.1-4.3
Normalised EPS (p)26.726.524.133.633.029.928.230.0-4.3
Earnings per share growth (%)1.8-0.8-8.939.4-1.7-9.4-5.76.4-115
Operating cashflow/share (p)51.437.662.439.635.633.442.532.461.6
Capex/share (p)13.99.99.56.911.313.611.710.29.2
Free cashflow/share (p)37.527.753.032.724.319.930.822.252.4
Ordinary dividend per share (p)12.613.814.620.421.021.622.122.77.6
Covered by earnings (x)1.82.01.41.51.61.41.21.1-0.6
Special dividend per share (p)14.027.510.015.08.30.014.40.00.0
Cash (£m)8809641,1661,3591,1549491,2209561,004
Net debt (£m)-284-381-571-523-319-126-153-897-939
Net assets/share (p)205191185198187193200194176

Source: historic company REFS and company accounts.

THG Group soars 30% despite only marginal improvements 

I make a radical comparison for THG Ordinary Share (LSE:THG) with Direct Line’s advance given this e-commerce group is a different beast yet has seen a similar rise – up from 62p at end-October to 80p a few days ago (currently 76p).  

They have similarity in the sense of currently being turnarounds, although THG has not issued an update since 17 October.  

It floated at 500p in September 2020, raising £1.9 billion on the back of home-shopping during Covid lockdowns, and achieving a market value near £10 billion a few months later when its price tested 800p. 

Euphoria dissipated, hence a plunge to 170p where I examined it in November 2021, concluding with a “sell” stance given a worsening macro context into which THG was vigorously expanding. Beauty and nutrition products are the group’s mainstay, albeit competitive areas exposed to change in consumer discretionary spending. 

But with expectations suddenly shifting from interest rates “higher for longer” to cuts in 2024, such a stock would indeed try to price that in. Despite THG having fallen from fanciful values, a re-rate from 62p initially seems in order. 

Quite whether THG is growing at all, or steadily wilting as an over-hyped retail concept, is unclear. In 2022, revenue ground 2.7% higher to £2,239 million in 2022, although consensus expects £2,106 million this year and £2,223 million in 2024 – hence a medium-term decline in inflation-adjusted terms.  

THG - financial summary
Year end 31 Dec

20152016201720182019202020212022
Turnover (£ million)3345017369161,1401,6142,1802,239
Operating margin (%)5.33.3-0.51.8-1.7-30.0-6.3-22.1
Operating profit (£m)17.816.6-4.016.6-19.7-482-137-496
Net profit (£m)13.510.8-10.10.8-44.2-533-138-540
Reported EPS (p)1.21.0-0.90.1-4.1-66.2-12.6-49.1
Normalised EPS (p)1.21.0-0.90.1-1.2-42.4-1.9-18.7
Return on capital (%)7.43.7-0.61.8-1.8-25.6-5.2-21.2
Operating cashflow/share (p)3.86.91.54.25.09.42.13.4
Capex/share (p)3.413.96.67.316.629.817.216.1
Free cashflow/share (p)0.4-7.0-5.1-3.2-11.6-20.4-15.1-12.6
Cash (£m)142174187235312774537474
Net debt (£m)40.7134220294476-11.2302540
Net assets (£m)63.31443193854681,1451,7561,302
Net assets/share (p)5.813.229.435.543.191.912892.0

Source: historic company REFS and company accounts

Consensus is for THG’s net loss to reduce from £540 million to £148 million, and further to £104 million in 2024. It’s an encouraging trend albeit value-destructive still. Yet the table shows material profitability back in 2015, 2016 and 2018 – arguably affirming THG’s business model. 

Last September’s interim results focused on “continuing operations’ adjusted EBITDA” up 23%, near peak-guidance, with such margin at 5.3%. Loss-making businesses had been exited albeit at a £26 million cost, hence a near £100 million reported operating loss. Finance costs of £39 million saw the interim net loss edge over £133 million versus £106 million like-for-like. 

After these numbers, the stock fell from around 90p and bumped along in a 60p range until end-October. It did not respond to a 17 October third-quarter update, citing overall like-for-like revenue down 4.4% albeit September sporting a 3.2% return to growth at constant currency, despite a 0.3% slip in reported terms. Performance was cited as “improving” each month, but this depends on your perspective. 

Beauty products are leading the way says the company: “The impact of global de-stocking on our beauty manufacturing business has eased, supporting its return to growth in September – up 1.7% or by 5.1% at constant currency. A focus on higher-margin sales helped.” 

Nutrition benefited from a re-branding, hence “record third-quarter adjusted EBITDA” and the Ingenuity e-commerce software side saw an improvement of sorts – like-for-like revenue down 2.3% in September after the first-half-year fell 14.9%. 

But with consensus expecting a circa £150 million net loss in 2023, easing to £100 million in 2024, I find THG’s re-rating essentially sympathetic to the sentiment-change on interest rates, hence potentially consumer behaviour. It is also helped percentage-wise by a relatively low arithmetic base.  

The CEO wants us to focus on “each division delivering improved performances... the momentum with which we exited the third quarter was especially pleasing, with a return to constant currency revenue growth of 3.2%...we remain focused on restoring margins to pre-inflation levels... positive free cash flow of £5 million despite £140 million capital expenditure.” 

This latter point is indeed a break-through – if sustained – versus the table above showing firmly negative free cash flow.    

So reasons do exist for THG holders to take heart, and a better 2024 generally could enable a turnaround to gain traction. A “hold” stance is fair but in terms of other choices out there, I would sooner buy Direct Line, for example.

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

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