Concluding our review of sectors Consumer Services

Tuesday, 21st August 2012 08:21 - by David Harbage

The conclusion of the Olympic Games, which produced a superb ‘feel good’ to the nation and London in particular, may mark a turning point in investor sentiment.

The Merrill Lynch Bank of America survey of UK fund managers, published this week, indicated a more optimistic perspective on the global macro-economic and market outlook, a significant pickup in appetite for risk assets and consequent increase in equity weighting in asset allocation.

A 10% rise in the FTSE100 index over the past 10 weeks

Buoyed by the European Central Bank’s promise to ‘take whatever action might be necessary’ to stabilise the region’s financial structure (public and banking industry), maintain economic health and defend the Euro currency, aided by evidence of action by the Chinese authorities to counter an apparent slowdown in that country, the overall view of domestic fund managers has warmed. Seemingly, consensus opinion anticipates a ‘muddle through’ scenario – rather than a global economic recession. Rather like good weather for the Olympics, something which markets had not been ‘pricing in’ at the beginning of June. 

A return to reality, or at least uncertainty, beckons

In responding to the survey, managers of domestic equities may have their focus on the ‘bottom-up’, and their assessment will have been influenced by their portfolio’s constituents – which have typically delivered respectable earnings and dividends over the past month. Even the less encouraging guidance, on company management’s outlook for the next twelve months, has not suggested a return to negative growth. Cynics might proffer “they would say that”, but nowadays company management are careful to understate rather than disappoint. Economists and market commentators are currently wrestling with statistics that seemingly contradict each other; in particular a rise in UK employment (to 29.5 million, according to the Office for National Statistics) and a fall in unemployment (jobless down from 8.2% to 8.0% in June), which contrasts with a 0.7% fall in total output in the three months to end of June. The latter, as measured by gross domestic product, compared unfavourably with much of the well-publicised beleaguered European continent. The oft-quoted descriptor of numbers as being ‘lies, damned lies and statistics’ comes to mind, along with a hope - if not strong conviction - that longer term data provides a more reliable assessment of trends. 

Moving away from Olympic euphoria to look at the UK consumer

Having reviewed most of the major industry sectors represented on the UK equity market over the past couple of months, and looked at the first of two ‘broad brush’ segments – in the form of industrials - last week, we turn our attention to the final ‘catch all’ business activity of consumer services. This is not the first commentary proffered on the consumer, as the writer has previously pronounced on food and general retailers plus also house builders, but does take a closer a look at a few interesting consumer-focused businesses within what is currently an especially difficult trading environment. As intimated in earlier blogs, geography or location may be critical to success; something borne out by a statement on Wednesday from Westfield, the Australian developer/owner of the Stratford retail centre adjoining the Olympic Park. Investors have to look hard to find successful domestic consumer businesses, with such a search helped by a logical assessment of demographic trends, likely changes in consumer behaviour and lifestyle choices.

Change provides opportunity

Making an assessment of precisely who the corporate beneficiaries, on either a short or longer term basis, of the current tough economic conditions might be is not easy. One could merely make a judgement that all consumer-facing businesses will struggle or fail (to match previous expectations, if not disappear altogether), but undoubtedly some will thrive. Developed economies, such as the US or the UK, will have a major dependence on the consumer – and his/her appetite to spend. When most personal incomes are squeezed (as is currently the case), by lower wage rises and higher prices of products/services/taxes, consumers will inevitable select cheaper essential goods (such as food) and curtail discretionary expenditure. In the absence of top-line growth, companies have also sought to reduce costs and spend more carefully wherever possible. The following examples provide instances of corporate success, if only relative to other businesses.

The cost of rail travel is rising

This week’s inflation data, showing an unexpected pickup in both CPI and RPI, prompted media attention on likely rail fare increases in 2013 – an item of expenditure which many commuters cannot escape, but something which travellers for leisure purposes may choose to avoid. Publicity surrounding Britain’s railways was reinforced by the news that Virgin Trains had lost their 15 year franchise over the prestige West Coast mainline service to an existing operator FirstGroup. The FTSE250 constituent has a mixed track record (please excuse the pun) in the bus/train industry which, post privatisation, has seen predatory pricing (as a means of gaining market share in a crowded fragmented market) and poor levels of service.  This latest award, at a cost of £5.5 billion, for the right to run the line from December 2012 until 2026 (which compared with Virgin Train’s £4.8 billion bid) represents a bold move on the part of its management and will be the prime determinant of the travel company’s future success. Beyond the much higher offer, which equates to paying annual premiums of £390 million, FirstGroup offered £265 million in guarantees - including a £190 million penalty if the company decides to walk away from its contract.

EasyJet continues to pleasantly surprise

Budget air travel has undoubtedly transformed leisure opportunities for the consumer, especially in Britain and Ireland where easyJet and Ryanair dominate, and compete against the major high cost airlines that have a natural bias to long haul flights. Eighteen months before Mr Richard Branson put his Virgin brand on the railways, easyJet took to the European skies and, notwithstanding a little turbulence along the way, the company has made good progress. The operational and business models have proven to be robust, overcoming considerable headwinds such as high or volatile oil prices, essentially by ensuring that pricing remains flexible (average fare £58) and cabins full (currently 89% occupancy). easyJet’s fleet of 200 Airbus 319/320 planes (which operate 600 routes in 30 countries, with destinations pushing out to the Middle East and North Africa), represents a high overhead cost. The board’s natural ambition to expand – which would incur higher debt, as more planes are ordered - has been criticised by the company’s founder (and near 38% stakeholder) Mr Stelios Haji-Ioannou , who would prefer to see the company being run for more immediate cash returns.

‘You pay your money and take your choice’....Train or Fly

Notwithstanding an appealing dividend, currently worth 9.2% based on an equity worth of 245 pence, FirstGroup shares have been a disappointing investment over the past five years. Although the prospect of winning the West Coast line sparked life into the stock, via a near 30% rise over the past month, a longer term recovery will depend on investors’ belief in the management’s ability to deliver on this key contract. FirstGroup equity appears unloved: based on underwhelming broker opinion (of 17 recommendations, 2 are Buys, 13 are Holds and 3 are Sells) and, against predicted profits in the current year to 31 March 2013 and the following period, the stock is priced on 8.1 times and 7.0 times respectively.

easyJet shares have rallied strongly over the past year (rising from 320 pence to 550 pence), in part reflecting lower fuel costs as well as their lower cost proposition, and may be ‘up with events’. The stock is currently valued on a price/earnings ratio of 10.2 times forecast profits for the year to 30 September 2012, and 9 times expected earnings for the following year. As might intuitively be expected for this growth, cum higher risk-reward, business, the company currently only distributes circa 20% of its earnings - resulting in a dividend yield of just 2.0%. Broker opinion is positive, of 24 analysts covering easyJet, 15 say Buy, 6 are neutral and 3 post a Sell recommendation.

Not all consumer stocks are the same

We said the same of industrials last week – highlighting the fundamental and valuation differences between aerospace and technology businesses – and the same clearly applies to consumer companies. The FTSE100 constituent Whitbread is a prime example of a leisure business, which ten years ago actively repositioned itself away from its brewing and pub heritage, meeting today’s specific UK consumer needs. Describing itself as a hospitality company, by becoming Britain’s biggest owner of hotels (Premier Inn) and restaurants (notably Beefeater, Brewers Fayre), as well as benefiting from the inexorable rise on the high street of coffee shops (via Costa). Both the personal consumer and, perhaps most crucially, an increasingly cost-conscious corporate sector has driven demand for the budget priced Premier Inn. The group is focused on growth, planning to add 4,200 more rooms this year (currently 49,800), 350 Costa shops (from 2,270 of which 840 are overseas) and 8 restaurants. The prospect of adding value to shareholders, by hiving off Costa as a separate entity, has been debated but current management have no immediate plans in this regard. Whitbread’s latest trading results, for the 13 weeks to 31 May, witnessed strong like for like (excludes new openings in the period) sales growth in each proposition: hotels 4.3%, restaurants 2.1%, Costa 8.4%, overall 4.5%.

But rare, and relative, success comes at a price

Based on the consensus of analysts’ forecasts for the current year, to 28 February 2013, Whitbread shares are valued on a price to earnings ratio of 14.7, which falls to 13.4 times in the following year. This is a heady rating, by contrast with its peers and the wider UK equity market, after the stock price has tripled from its nadir some three and a half years ago. This leaves little scope for disappointment, and prudent investors should never be shy to take a profit – on shares, very close to their five year high – with current opinions of the 22 analysts reflecting 10 Buys, 9 Holds and just 3 Sellers. While the Jubilee and Olympics should act as a catalyst to overseas tourists, the drivers of domestic demand remain in place and Costa’s expansion into new territories appears impressive, maintaining the pace of historic growth will be challenging. A dividend yield of 2.6%, which is 2.7 times covered by earnings, offers some support.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.