Monitoring our 'Winners' Performance in July 2016

Monday, 1st August 2016 14:01 - by David Harbage

What a difference a month can make: after a wet June, much of Britain experienced a brighter July. Stormy conditions also gave way to a more stable showing in the UK equity market. The FTSE100 index, which had slipped below the 6,000 level in the last week of June, managed to shrug off an eventful political month at home and terrorist acts abroad to remain above 6,450 throughout July and progress to 6,750.

The appointment of a new prime minister and cabinet has brought some semblance of stability and a raft of trading updates, cum outlook statements, from leading companies has soothed some of the post-referendum hysteria and reassured markets. In the United States, economic activity has been sufficiently robust (notably as measured by output and employment) as to indicate that another interest rate hike is possible by the year-end.   

As with the leading indices, individual performances within our list of company shares were unremarkable for the most part:    

Turning to company developments, easyJet provided an update of its trading in the three months to 30 June – a period which featured 1,221 flight cancellations, as air traffic control strikes, runway closures at Gatwick and specific tragic events (Brussels, Egypt, Nice, Turkey) adversely impacted. This is an industry in which operational skill is required to quickly adapt to changing circumstances or opportunity, but exceptional events can represent major unforeseen and uncontrollable risk. Headline numbers showed 5.5% growth in capacity to 21.9m aircraft seats, a 5.8% increase to 20.2m passengers (equating to a load factor of 92%); although total revenue fell 2.6%, costs (driven by a lower fuel price) were 3.8% lower and the balance sheet remains strong via £368m of net cash. Although Brexit and the prospect of increasing terrorist activity could restrain consumer confidence in the short term, longer term demand for budget short haul flights should ensure that this well-managed business can continue to thrive. easyJet shares, which have encountered considerable turbulence since the 23 June referendum, appear oversold at their current (near £10 level) based on a consensus of 25 broking analysts’ forecasts of 113.7p earnings per share (EPS) in the year to 30 September 2016. With a likely 56p dividend pay-out, this would mean the stock offers an income yield of 5.4%. A recovery in profits to 121.2p is predicted for next year – putting the shares on one of the lowest earnings multiple for a FTSE100 index constituent, of 8.4x – along with a 60p dividend.           

Ahead of its interim results on 3 August, HSBC shares have enjoyed a rally - but is this just a case of “it’s better to travel than arrive”? The stock touched a multi-year low point of 416p on 7 April 2016, but in the past six weeks has recovered to almost touch £5. This comes despite moves to lower interest rates in many countries in which HSBC operates (which typically squeezes banks’ profitability), concerns about investment banking in London post ‘Brexit’ and forex traders behaviour in the US. Trading in the first half of 2016 is unlikely to ‘shoot the lights out’ or announce any new strategic path for this banking giant. However, the absence of further bad news could prompt a further bounce in confidence as investors acknowledge that the equity of this major US dollar earner is undervalued. There is scope for sentiment and research output from the Sell side community to turn more positive: of 22 brokers, currently 10 publish a neutral view and 5 are sellers. Their collective wisdom points to 43.5p of EPS in the current calendar year and a 5% improvement in 2017 to 45.6p; but the 7.3% income (appealing to institutions and retail clients alike) probably represents its prime attraction. The strength of the US dollar means that the dividend (upon translation, and expressed in sterling terms) is much bigger, as well as more secure, than some had thought. Maintaining respectable, rather than sensational, trading results should be sufficient to persuade investors of its position as a proxy for global GDP performance: diversified, steady if unexciting. Meantime, investors can expect further action to tidy its portfolio of assets as well as simplify its balance sheet.    

Unlike the operating model of a mature bank (which seeks to attract depositors’’ monies at a certain rate and lend that money on at higher rates), the business of Sky is considerably more complex – especially as the market seeks to value the worth of its technology-facilitated future. On Thursday the broadcaster announced its trading results for the year to 30 June 2016, which pleased City analysts whose enthusiasm for the company had been waning over the past year. This company has an impressive track record of delivering growth and is both clever, and rapid, in its reporting of a swathe of key performance indicators (KPI). Sky’s headline numbers featured a 12% increase in operating profit on a 7% hike in turnover, EPS 13% higher but a stingy 2% uplift in dividend. Much of the company’s growth focus is now overseas and Germany in particular – where securing rights to Bundesliga football (out to 2021) follows the successful pattern used to grow in the UK. Prompted by competition from BT, the cost of broadcasting rights to the English Premier League has risen dramatically and clearly is a high upfront cost – especially in the first year. Sky paid £4.1bn for 126 live matches per season, which runs for 3 years from 2016, which is 83% more than it paid (for 116 games) in the last round in 2012. Incidentally, BT paid £960m for the remaining rights to 42 matches, 18% more than in 2012 when it showed 38 matches.

At home, Sky will be focusing on maintaining and upselling to its customer base in TV, broadband and telephony and, secondly, adding new revenue streams from the likes of mobile telephony, advertising and new apps. As intimated above, sentiment towards the shares had been waning – from 1140p last August to touch 797p in the last week of June. Brokers had expressed reservations about the group having become mature or ex-growth, but evidence of greater cost control and pleasing top-line growth (aided by 4-5%, inflation beating, TV subscription hikes) in these latest results (EPS expectation was 61.65p but the company delivered 63.1p) could prompt upgrades for the current year. The stock is higher risk-reward by reference to its nature (has to ‘run hard to stand still’ or make progress given the pace of change in technology), a geared balance sheet (net debt increased from £5.1bn to £6.2bn as at 30 June 2016, but net debt to EBITDA ratio reduced from 2.6x to 2.4 times) and the shares’ relatively high rating. While offering a dividend yield of 3.9% (although limited growth in pay-out is in prospect), the PE ratio or price to earnings multiple is a little higher than the wider UK equity market on (ahead of anticipated broker upgrades), at 15.7 times. While the UK consumer is proving to be considerably more promiscuous in switching from one TV or broadband provider to another, until there is evidence that a less affluent consumer switches off such services altogether, investors are likely to retain confidence and an interest in the likes of BT and Sky, who dominate the domestic landscape.      

The final company within our list meriting comment this month is another consumer stock, Whitbread, best known as the owner of Premier Inn and Costa coffee. Its proposition is well suited to current corporate and secular demographics – offering lower priced hotels, for business customers as well as consumers, and meeting a coffee shop culture which extends to other outlets beyond the High Street or retail mall. Fund managers have expressed concern about a slowdown in growth in the UK hotel market (especially in London, and softer rate cards), notably as measured by revenue per room, and the diminishing returns offered on new coffee outlets. However, most concern had surrounded the overall pace of expansion, especially overseas where the brand name may have less appeal, against the backdrop of greater indebtedness (net debt rose from £583m to £909m in the year to the 3 March 2016). On 13 July, new CEO Alison Brittain announced a new strategy insofar as the company’s international growth is concerned: concentrating on a smaller number of specific markets to enhance the prospect of procuring benefits of scale. As a consequence, in its overseas hotel business, Whitbread will withdraw from India and South East Asia to concentrate on Germany (“a structurally attractive market”) and the Middle East.

Rather like Sky, the shares of Whitbread have also borne a neglected look over the past year – falling from £52 to a low point of £34 at the end of June. The more focused expansion of Premier Inn (essentially one can expect the hurdle rate applied to the viability of new projects to have been increased, in addition to the choice of location change) represents a positive, and could see a more generous pay-out ratio if future capital expenditure is restrained. Currently Whitbread stock is set to yield 2.6%, based on a dividend of 96p, but forecast EPS of 243p next year suggests there is scope for the dividend cover to be reduced from 2.5 to 2 times. Interestingly, the stock market values these two companies very similarly based on earnings (a PE ratio of 15.7 also applies to forecast earnings for the year to 28 February 2017), with broker opinion being similarly mixed: Sky (11 Buy recommendations, 6 Holds, 7 Sells) and Whitbread (9 Buys, 12 Holds, 3 Sells).              

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.