Stockwatch: A winning bet against the hedge funds

This one proves why you shouldn't always fear stocks on the list of short-sellers' favourites. 

How resilient will spending on pets be as the prospect of a hard Brexit weighs on consumer behaviour?  Probably it will hold up in the short to medium term because cats and dogs are a commitment for a good few years. However, if household budgets contract, then demand for new or replacement pets may fall.

Shares in Pets at Home (LSE:PETS), the retailer of pet supplies, veterinary and grooming services, is enjoying a rebound this year, up from 115p to about 185p currently, with strong sentiment shown by it promptly regaining a 12-month high after going ex-dividend on 13 June.  

The medium-term historic context has been a de-rating from 311p in 2015 to as low as 110p in the late 2018 market sell-off.  Short-sellers targeted the stock, pointing to debt and an inability to compete with Amazon.com (NASDAQ:AMZN) and the supermarkets, although financial results quash these claims.  

Rude health defies a 14% equity short position last year

Pets' progress may also reflect benefits of a new chief executive, in place for 14 months, starting to flow.  Last May's prelims to end-March showed underlying pre-tax profit up 6.1% to £89.7 million on like-for-like revenue up 5.7% (6.9% overall) to £961 million.  "We are confident about the year ahead, entering the 2020 financial year with good momentum and on a higher revenue and profit base than previously anticipated," he said.

This would appear to affirm my citing Pets' as one of "5 stocks for a durable ISA portfolio in the Brexit years" at 155p last March, having drawn attention as a 'buy' last August at 125p when insiders were piling in and Pets' was the third most-shorted stock on the London market.  

• Is this shorted retailer now oversold?
• Stocks for a durable ISA portfolio in the Brexit years

I suggested upside potential on this technical position alone, given the extent of stock needing buying back once Pets' results proved its calibre.  Yes, historic private equity owners had floated Pets' in 2014 with some £450 million debt, but that was down to £195.5 million at end-March 2018 - and structured long-term – hence the situation was manageable with £58.8 million cash and debt cost covered 18 times by operating profit.  The situation shows that you should not necessarily flinch at a big short position; indeed, it can enhance your returns as a contrarian buyer.  

Care is still required: shorting has reduced from a 14.3% peak last October to 6.4% currently: Immersion Capital LLP raised its short by 0.11% to 3.13% on 18 June.  Also, a Canadian pension fund sold its entire 10.8% stake at 148p last April having bought in during 2016 well above 200p.  This may have been a case of managers buying prematurely then preferring to rid a "mistake" than regularly have to justify it to trustees; although both these institutions' actions justify re-examining Pets'.

Meanwhile, Norway's sovereign wealth fund – the world's largest - has accumulated a 4.5% stake, some of which could have resulted from April's placing. Last February Norges Bank said it would be investing irrespective of near-term negatives of Brexit: "We foresee that over time our investments in the UK will increase."  

Source: TradingView Past performance is not a guide to future performance

Slight margin dip

Pets' last declared on trading at prelims on 22 May, and the AGM is due 11 July. However, last year there was no update until a 3 August statement in respect of the first quarter of the financial year. 

Certainly, UK pet care is a valuable market and Pets' is the only means of focused investment exposure: 2018 revenue is estimated at £6.3 billion, up 3% in retail and 5% in veterinary.  Management says it grew market share by 0.9% in food, 1.1% in accessories and 1.2% in veterinary, if more interesting to learn exactly what these shares are.  

Customer reviews online (Trustpilot) suggest they appreciate highly competitive pricing, and May's results statement cited prices "within 5% of our most competitive online peers... with scope for our most loyal customers to opt into cheaper Easy Repeat delivery..." which appears to pre-empt Amazon.  

There are signs of mild margin pressure: Pets' underlying operating margin on retail eased from 8.1% to 7.9%, for underlying profit of £67.2 million, in part-due to "price investment plans," but also growth in food sales versus higher-margin accessories.  The veterinary side saw slightly greater margin loss from 31.4% to 30.1% - albeit still very good! – for profit of £32.1 million, relating to overhead costs in practices bought out and also increased costs of specialist referral centres.  Central costs also edged up 3.4%.  

Altogether, it doesn't look a worry and Pet's operating margin remains around the double-digit mark versus a couple percentage points at best for food retailers. It's also 1-2% ahead of the respected Dunelm (LSE:DNLM)home accessories group.    

A strategic aim is for pet care revenues to rise from 34% of group total in the last financial year to 50%, with store staff incentivised to introduce customers to pet care plans.  Implicitly, last year's easing in Pets' underlying group operating margin from 9.9% to 9.7% would reverse or better.  The CEO is certainly ambitious, aiming to become "the leading global pets group" versus sales 100% UK-derived.  

In terms of potential Brexit effects, supply chain disruption could require greater inventory, but product is unlikely to spoil and there's no risk of material tariffs because the majority of products are imported from outside the EU.  Risk is probably greater and intangible on the vets' side, given the extent of non-UK EU nationals working here as vets, where changes in immigration policy may prevent or discourage them.

While I continue to see margin trend at Pets reflecting a calibre business, management should really have substantiated better and more clearly, why they are guiding the current financial year for a "slight decline" in underlying pre-tax profit, also a "decline" in underlying free cash flow, despite total revenue growth "ahead of market".  

A basic interpretation is that margins will fall at a business bolstered with acquisitions.  The 7.5p dividend is set to be held, although, at 185p, a 4% yield doesn't exactly prop the stock versus any sense of "ex-growth" creeping in.  
Investor psychology is pretty firm, about how a "growth company" means no interruptions, although on an historic price/earnings (PE) of 13, the multiple could rise to the mid-teens, which is still considered fair enough if management resumes bottom-line growth in the year to March 2021. 

Trade payables still due better explanation

My chief concern both times I've enthused for this stock has been trade payables approaching three times trade receivables, tipping the balance of current assets to current liabilities slightly negative – a ratio of 0.91.  

That's no huge worry as cash has remained fairly constant at around £60 million, though it does invite a sense that £185.8 million trade payables involves delaying on suppliers to an extent it massages reported profit.  At least the new CEO appears to have instilled an improving trend - trade payables as percentage of turnover, reduced from 19.3% to13.3%.  However, the financial review continues to avoid any mention of the matter.

Another balance sheet aspect to mind is £1 billion intangible assets versus £124 million property/plant/equipment and £68 million inventory, within the £903 million net assets' mix. It means negative net tangible assets per share of near 20p.  Debt reduced 8% in the last year to £178.8 million, generating £3.5 million net income expense – covered nearly 27x by underlying profit, however.

Conclusion

So, a short case appears to rest on a more savage UK consumer downturn combined with some aggressive accounting for profit, neither of which I would presently accept.  

Given recent guidance for slightly lower profit this year, I wouldn't be surprised if the stock consolidates this year.  So, buyers who got in below 113p might consider locking in some gains, perhaps depending on July's first-quarter update.  Longer term, the fuller benefits of a new CEO combined with attractive markets in pet care should flow, thus,overall I rate Pets at Home shares: Hold. 

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