A differentiator in a competitive, crowded marketplace

Thursday, 22nd October 2015 10:38 - by David Harbage

All company stocks carry inherent risks, of various kinds, with some being more obvious than others. These range from straightforward, highly visible balance sheet health (beware intangible assets and expensive uncapped debt) to the prospect of unpredictable external shocks...

...(from political interference to threats of disruption from terrorism or war) or 'black swans' (an event that has yet to happen, and therefore unanticipated by those measuring risk). When assessing the business model of a company, one area (amongst a dozen others) meriting keen focus is competitiveness and the threat of losing market share - and, with it, pricing power and the ability to maintain profit margins.

Today investors studied trading updates from the media business Sky and Home Retail Group, the owner of Argos and Homebase. Both operate in highly competitive markets, but announced very different trading results by reference to turnover or revenue achieved; duly followed by reactions in the share prices, which say something about the City's immediate expectations for these numbers - as well as the longer term prospects.

In the three months to 30 September 2015, Sky (previously known as British Sky Broadcasting), reported a 10% jump in operating profit to £375 million, on a 6% increase in revenue to £2.8 billion, fuelled by 134,000 new customers and 937,000 new paid-for subscription products. Beating analysts forecasts, the shares rose 3% to £11 - just 40 pence short of the all-time high reached this summer - evidencing the same sort of momentum as has applied to their business of signing up clients to their telephone, broadband and TV services. Not without risks, as both Sky (and its prime telecom and broadcasting competitor, BT) are paying very big sums for the rights to domestic Premier League football matches. High levels of 'churn' as customers migrate from one to another provider is set to continue in the foreseeable future and cap profit growth. On a price earnings ratio of 17 times anticipated earnings for the year to 30 June 2016, Sky share price anticipates further growth than the 12% implied in this consensus of 23 broker forecasts. Or, more probably, a pace of growth in excess of the UK equity market's average for longer (at least into 2017 and 2018). The investment community remain, on balance, comfortable with the upside potential - with 9 analytical firms deeming Sky to be a Buy, 10 say Hold and 4 with a Sell recommendation - and take comfort in a growing belief that the telecom/media package is viewed as an essential, rather than a luxury, purchase.

If the competing HD television platforms and broadband offerings are somewhat limited for Sky, this is not true for the Home Retail group. The high overhead cost of displaying goods has seen the owner of Argos, with its very broad product range, try to reinvent itself - on more than one occasion, over the past decade. Most recently, the closure of shops and transformation into 'fast track' internet ordering, home delivery or store collection has endeavoured to lower its costs towards those of web-based competitors like Amazon. Today's results for the half year to 29 August 2015 fell short of the market's expectations with total group sales down 2% and, although profits were apparently 10% higher at £34.1 million, Argos costs rose by £14 million and resulted in profits from that part of the business falling by £5.6 million. By contrast, the DIY division Homebase performed reasonably well in response to 25 stores being closed. Investors were also spooked by CEO John Walden's comments about the unpredictability of the important forthcoming Christmas season, and the likelihood that full year profits would be below the bottom end of analysts' forecasts.

Home Retail is a business that has to 'run very hard to stand still' by reference to its cost base, with the introduction of the so-called 'living wage' in April set to adversely impact the wage bill. As with many other traditional 'bricks & mortar' businesses, across a range of industries, the incumbents are struggling to keep pace with the newer digital-only competitors. Home Retail shares fell 16% to 126 pence today and, in the absence of takeover, appear set to remain under pressure based on an unappealing (on fundamental trading) PE multiple of 12. A 10% plus fall in earnings is anticipated for the full year ending 29 February with little, if any, progress in either the bottom or top line likely before 2018. Both Argos and Homebase appear to have little to commend them over their peers, and the inexorable growth in online retailing - from bigger domestic and non-UK based businesses - suggests an ongoing struggle for this familiar firm.

By contrast with domestic retail, the competitive threat to Sky's business appears much easier to identify, is more obvious and limited; operating in an industry with underlying growth, there currently appears sufficient scope for both Sky and BT to create value for their shareholders.

Share price and information on Sky

More on Home Retail Group

Written by David Harbage for lse.co.uk on the 21st October 2015

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.