Markets Now - Thursday 4th June 2020

You know what we don’t talk about much around here? Cheese. It’s National Cheese Day and to mark this occasion there’s a press release through from Gousto, a company that sells recipe boxes presumably including cheese:

Revealed: The UK's Favourite Lockdown Cheese

It’s Red Leicester.

The press release also has an infographic:

Today is also National Hug Your Cat Day and National Moonshine Day but the flacks for moonshine and cat recipe boxes didn’t send infographics.

All of which begs the question: where are all the European listed cheesemakers? Dairy Crest was bought last year by Saputo and Arla Foods was taken private by its parent company way back in 2007. Danone pivoted in 2017 towards “dairy fermented products” rather than cheese, which is an interesting example of syllogistic logic. Glanbia has steadily deprioritised its cheese business over the past decade to concentrate on protein shakes named things like Isopure and ThinkThin. Parmalat finally shuffled off in shame a few years ago to become a subsidiary of Lactalis of France, which is privately owned. Unilever only does cheese sauce, having exited cheese cheese about 20 years ago. Why do investors hate cheese? What’s with the antipathy for a product that can literally be used as bank collateral? Answers in the comment box, ideally without any puns.

A person might think that we’re involving ourselves with cheese because the Great Flight To S***e Rally of 2020 has hit stall speed on very little news, and a person would be right. It’s dull out there. Here’s the mid-session scoreboard, after which we’ll plough into the day’s main sellside:

Asos goes up to “buy” at Investec.

ASOS’ recent trading performance is reminiscent of times past and the recovery appears sustainable, in our view. Customer profitability in H1 appears to have returned to FY18 levels and we see potential for further upside from warehouse and distribution efficiencies which should materialise after the impact of Covid-19 dissipates. We downgrade our earnings forecasts for this year (due to Covid), but upgrade FY22E PBT by c. 7% putting us comfortably ahead of consensus. We move our recommendation to Buy.

In H1, customer profitability returned to prior FY18 levels with larger basket sizes, increased customer purchase frequency and lower distribution costs improving basket economics. Importantly, declines in Average Selling Prices (ASPs) were finally lessening and cash costs had been controlled, due to marketing and warehouse efficiencies. In H2 we expect much of this improvement to reverse due to Covid-19 impacting trading. However, once this passes, we believe customer profitability will quickly return to prior levels.

Upside to customer profitability further out: Assuming the impact of Covid19 passes, we expect further warehouse efficiencies and lower US distribution costs to now contribute as much as £1.50 to £4.70 of extra profit per customer in the longer term, implying EBITDA (per customer) could reach as much as £12.30 to £15.40 in the outer years. Yet implied consensus assumes EBITDA per customer will be just £9.50 by FY22E. We therefore see as much as c.30% to 60% potential upside to outer year consensus estimates.  Changes to forecasts: We downgrade FY20E earnings below consensus levels and expect losses. Given elevated inventory levels at H1, we expect markdown levels to be high in P3 as excess stock is cleared in a highly promotional market. However, our outer year forecasts reflect EBITDA per customer improving as efficiencies materialise.

Valuation: Based on outer year forecasts, the FY22E PE is broadly in line with peers but when earnings growth is considered, its PEG ratio is very low, at 0.5x, on our estimates. Valuation based on customer lifetime value now implies that, at current levels, ASOS’ customer base is expected to regress, which we deem highly unlikely given current growth rates. To this extent, we believe there is long-term deep value at ASOS despite the recent share price rally. Our target price moves to 4820p (from 3582p). Upgrade to Buy.

Michelin goes up to “buy” at Citigroup:

Tire recovery is underway and Michelin will benefit the most, upgrade to Buy.

As a market leader with growing high rim tire exposure and a solid balance sheet that supports continued investment, Michelin could benefit disproportionately from the recovery in vehicle usage that mobility data suggests is underway. Michelin’s modest 20% capex reduction this year compared to peers (30-70% cuts) should sustain mid-term growth in high rim tires and enable market share gains. Assuming Michelin continues to increase exposure to 18” and replacement demand recovers to 2019 levels by 2021 we see scope for 10% consensus upgrades in pas-car (SR1) tires.

Market share data corroborates Michelin’s position as a price leader.

Industry oversupply remains a risk for pricing power but Michelin’s position as a market share leader facilitates strict pricing discipline that makes its earnings more resilient than peers. In FY19 Michelin’s price/mix improved by +20bps compared to peers, which saw 100-250bps declines. We expect 1.4% FY20 price/mix vs consensus +0.4% driven by Michelin’s strict pricing discipline and a mix tailwind from the rebound in higher margin replacement tires relative to OE tires where demand will lag.

Specialty tire (SR3) resilience underestimated by the market, Citi 20% ahead.

As noted in recent research from our Cap Goods team (see here and here) the COVID impact on mining (40% of SR3) has been limited and we see upside risk to consensus estimates, which have fallen 38% since February (vs 44% in pas-car tires). SR3 earnings have historically been more resilient to economic downturns (in the GFC SR3 EBIT -40% vs -55%-75% in SR1/SR2) and we see exposure to high margin Specialty tires as favourable, especially as mining demand today is more stable than during the GFC.

Raise target price to €111 (previously €96), open catalyst watch.

Michelin’s relative de-rating to auto suppliers provides a late-cycle mispricing opportunity in our view. The shares are trading at a 15% discount to Auto Suppliers having traded at between a 5% discount and 20% premium since Jan-18. We expect the gap to close and apply a 9.5x EV/EBIT multiple to FY21 EBIT to reach our target price. We open a positive catalyst watch into the forthcoming monthly tire volume data releases.

Smith & Nephew goes up to “overweight” at Morgan Stanley. A V-shaped recovery in kneecaps isn’t in the price, they say. Twelve times 2021 ev/ebitda looks cheap versus 13.5 times for Zimmer and Stryker, they say:

We are upgrading SN to Overweight as we believe the fundamentals of the business are less challenged compared to other sectors in our coverage,and we expect Orthopaedic/Sports Medicine will demonstrate one of the fastest recoveries towards pre COVID-19 volumes in the second half of 2020 and in 2021. SN has underperformed the EU MedTech sector by -5% since the COVID-19 outbreak (down -8% vs the sector of -3%), driven by significant declines since March in elective surgeries followinghospital actions to delay procedures to free up capacity for COVID-19 patients. With April likely the trough in revenues, the debate for the stock has now shifted to what the shape of its recovery could be and what are the mid-term implications. . . . 

1] Elective Procedures Returning- Normality Reached Sooner Than Expected: Based on channel checks with doctors, hospitals and manufacturers, elective Orthopaedic procedures are beginning to return across the globe following the April trough at ~20-30% of normal levels and improvement to 40%+ in May. . . . [W]e believe Orthopaedics/Sports Medicine will see a recovery in 1-2 quarters, based on the following key dynamics: 1] Procedures being delayed rather than cancelled, leading to a waiting list build up; 2] Patients’ desire to reduce pain and immobility and complete the procedures, resulting in pentup demand; 3] Financial incentives for providers and surgeons to resume activity and prioritize higher margin procedures; 4] Adequate supply,especially in the summer months, with surgeons willing to work overtime to recover delayed surgeries; and 5] Governments’ desire to clear the backlog and reduce waiting lists. As government policies and restrictions are lifted, we believe Orthopaedic surgeries will accelerate to 70% of normal levels in June and then deliver positive growth in the seasonally weak Q3 as surgeons work through the waiting lists and recoup some of the shortfall from Q2. We believe the recovery will continue into Q4 and end the year -14% down organically,although with an exit rate closer to flat. In our view,2021 will see a recovery in 1H before normalising in 2H and we expect 2021 to be approximately -4% below our pre COVID-19 estimate. ....

British Land goes down to “add” from “buy” at Peel Hunt:

The results from Landsec (12 May) and British Land (27 May) laid bare the differing fortunes of the London office markets and the wider UK retail real estate landscape. While broadly anticipated, the c26% decline in British Land’s retail portfolio epitomises the yield-driven re-pricing we have seen. We update our forecasts and conclude there is still value on offer in both stocks. Following recent share price strength, we downgrade BLND to Add (TP 500p), and LAND remains Add (TP 760p).

Three observations

1. BL’s retail parks now more fairly priced? Down nearly 40% over the past two years, and now yielding 7% equivalent, the valuation is now looking more realistic and the average ERV has fallen to £22.90.

2. Landsec to consider “long-term strategic direction”. Profound structural trends, the current crisis, and the arrival of Mark Allan provide this opportunity. We will hear about the outcomes in the autumn.

3. Doing the right thing. Sustainability, social obligations and customer relationships have all risen to the fore. Both REITs have shown themselves to be good corporate citizens with their commitments to be net zero carbon by 2030 and their immediate support to local communities.

... Largely, the [earnings forecast] changes in FY21 reflect the FY20 outturn, with British Land’s NAV miss reducing our future year forecasts and Landsec’s decision to make a £23m provision for FY21 rent effectively bringing forward c4.3p of lost earnings. For FY21, we have taken a more pragmatic view on like-for-like rents across both portfolios, resulting in reduced earnings forecasts.

We are still unsure about future dividend payments. Although both companies have signalled their desire to resume distributions as soon as possible, guidance is understandably limited beyond acknowledging REIT obligations. As such, we continue to assume that both restart payments in Q3, and at a level that in FY23 equates to a c80% pay-out on adjusted earnings.

Value still on offer despite the share price appreciation

We continue to believe that both shares offer good value for the patient investor. British Land has outperformed its larger peer over the past few months and there is once again little to choose between the two names with very similar valuations and capital structures. Both sit at a c35% discount to our trough NAV forecasts, yield 5.5%+ based on forecast annualised dividends, and have trough LTVs around 35%.

Following recent share price outperformance, British Land joins Landsec on Add. We increase out target prices to 500p and 760p, respectively.

RBC, the Canadian broker, takes profit on IWG, the Jersey/Swiss office landlord:

We continue to like the long-term potential and see IWG as becoming an even more dominant market leader. However, the shares have bounced strongly, the catalysts of further franchising deals are unlikely in the short-term and we see risk reward now more balanced with the valuation c20% above our mid-cycle valuation of the existing estate at maturity. We move to Sector Perform from Outperform, with a 325p target.

Expect minimal profits this year - Whilst the COVID-19 impact has been largely limited to date to the loss of high drop through ancillary revenue, we would expect lower sales activity to result in a weaker picture in Q2, whilst the pace of recovery in H2 remains uncertain. We expect IWG to focus on renegotiating leases where possible, but would expect a higher number of closures and network rationalisation costs to impact profitability through the year.

Forecasts reduced - We have reduced forecasts to reflect the higher rationalisation costs along with the dilution on the equity placing. We still expect the business to remain profitable in 2020 (£26m of EBITA vs £135m last year) and expect a recovery in 2021 which should benefit from less of a drag from fewer new openings, a full year of renegotiated lease costs, an improved market and less network rationalisation impact. Long-term growth potential - We continue to believe in the structural growth in the flexible office space market and would expect the current crisis to lead to a rethink of how large corporates use office space - we would have thought reducing fixed costs and using flexibility makes sense. IWG, as market leader is also very well positioned to take share given its scale and network advantages. The rationale for the placing was primarily to take advantage of market opportunities and we expect to see deals over the course of 2020 - we would note the recent deal (source FT) to take over a WeWork lease in Hong Kong as an example.

But franchising likely on hold for the time being - Given the uncertainty, we think further large master franchising deals are unlikely in the short- term and these ultimately are key to demonstrating value in the group, reducing capital employed and justifying a higher long-term multiple. As such, we see short term catalysts as somewhat lacking.

Risk reward more balanced - The stock is up 81% since our last note - Taking The Plunge, and has gone over our original 275p valuation based on a mid cycle valuation of the existing estate. With the placing since then taking that down to 250p, we set a new target of 325p attributing a 25% premium to our mid-cycle existing estate valuation for the growth and franchising potential.

L’Oreal’s been downgraded at Credit Suisse. Stock priced for a V-shaped recovery that’s looking increasingly unlikely, they say:

Downgrade to Underperform (from Neutral). We are lowering our FY21 EPS estimate by 8% and our (APV-derived) target price by 2% to €225. We now anticipate a 5.6% decline in L’Oréal’s LFL sales this year, followed by a 9.8% increase in FY21, a 2-year stacked growth rate of 4.2% versus 9.7% previously. We are now assuming a FY21 EBIT margin of 18.3% (previously 19.0%), 30bp lower than in FY19. In our view, the current valuation assumes L’Oréal’s top-line growth quickly resumes its pre-COVID-19 momentum which is too optimistic.

We now expect: (1) a protracted return to normality and, (2) a muted recovery in consumer spending, impacted by higher levels of unemployment. Unquestionably, China (14% of group sales in FY19) continues to be a stand-out success story for L’Oréal; we expect the beauty category in China to register HSD growth this year and for L’Oréal to outperform. However, in the rest of world, which is suffering longer lockdowns and deeper economic downturns, we expect the beauty category to decline by LSD this year and for L’Oréal to underperform due to its over-exposure to the hair salon and travel retail channels. We expect the category to rebound next year and for L’Oréal to outperform, although for that outperformance to be tempered by its over-exposure to the make-up and hair care categories. We also expect a step-up in marketing investment in the face of consumer down-trading (as we saw in 2009) and FY21 margin (CSe 18.3%) to be below FY19.

Valuation: We continue to advocate looking through the COVID-19 distortions and focus on FY21 earnings, in order to assess relative valuation within the sector. On our new estimates, L’Oréal trades on an FY21E P/E of 32.6x, the highest premium versus the consumer staples sector for over 10 years.

Lufthansa’s a “sell” at Berenberg as part of a sector note:

•  Easing lockdowns and a turn in booking patterns have returned some investor interest to European flag carriers: Regardless, we see clouds of financial repression gathering over the European flag carriers, driven by their choices on where to source much-needed liquidity over the past 80 days; with this note we incorporate state aid into our models. We expect investor focus to soon move on from liquidity and cash burn rates. Next up, FCF and balance-sheet repair will drive the stocks, in our view. We look to aggressive aircraft deferrals and sharply lower fixed costs to protect against a long period of demand uncertainty. We recalibrate our estimates, consistent with our industry demand assumptions, for industry revenue in 2021 c25% below that of 2019. With each carrier on a current 0.7x EV/IC, we take a more cautious view by downgrading Lufthansa to Sell and retaining our Buy rating on International Airlines Group (IAG) and Hold rating on Air France KLM (AF-KLM).

•  The current story - reduce cash burn and rebuild liquidity: We remain in this phase, in our view, where the industry has been since mid-March. The credit market offers improved if yet still uncertain debt market access (see "The big chill in airline credit markets"). Solvency assurances and multi-billion-EUR state aid packages, which we detail in this report, have buoyed Lufthansa shares in particular, which have outperformed those of IAG and AF-KLM by c15ppt. State aid packages, however, offer no equity value protection in the medium term.

•  The next chapter - limit balance sheet overhangs: We expect impaired balance sheets to drive the next chapter in stock performance. In this note, we illustrate how for AF-KLM and Lufthansa debt levels hold equity at risk much more substantially than for IAG. We estimate Lufthansa and AF-KLM will lose over EUR2bn in FCF through 2021, when leverage may still hover around 5x EBITDA for each. Capex deferrals would limit further balance-sheet erosion, in our view. Additional equity could help, particularly if IAG can differentiate its leverage and FCF potential. We would expect a positive response if IAG combines new equity (a cEUR2bn secondary offering could bring IAG's net debt below 2.5x normalised EBITDA) with other commercial liquidity that holds fewer conditions than those facing Lufthansa and AF-KLM.

•  For extra credit - positioning for margin recovery: Each flag or legacy carrier faces the need for bold downsizing. We expect each airline's ability to execute on this to emerge as a final step of recovery, but one that could gain attention quite soon. A return to discussions around margin potential can only occur, in our view, after airlines have re-profiled their delivery schedule, accelerated fleet retirements and planned their debt repayment commitments. Structurally lowering future costs, including cutting employment levels, falls under this step - one we fear that state aid commitments for Lufthansa and AF-KLM could forestall.

•  We downgrade Lufthansa to Sell: A robust and well-structured state aid package leaves the carrier in a comfortable solvency position. Its prospects in terms of balance-sheet overhangs, FCF generation and margin recovery, however, appear more challenging, in our view. We take the opportunity to move our recommendation to Sell; Lufthansa's de-rating from 1 January has significant scope to disappoint further.

HSBC’s gone off Wizz Air:

Downgrade to Hold but lift target to GBP35 from GBP33: We see the business outlook as impressive, but we think it is fairly priced in by the market. The stock has risen 70.7% from its recent trough of GBP20.06 on 19 March. We do see the business as being well placed to expand as peers retrench, and its customer demographic is optimal to benefit from an early recovery. Relative to other European airlines, we see fewer opportunities to rebase its cost base – in costs, Wizz may see less inflation but probably not a step change down. Its substantially opportunistic network development lacks a clear strategic narrative: earlier this year, it was inflecting to the east away from Western Europe and now it is back heading into Western Europe. But opportunism can work: the company has a record of being quick to grab opportunities and, importantly, to cull those that do not perform.

UBS upgrades South32, the miner that no one mentions much. It’s worth noting that South32 is valued at £5.4bn and would if permitted be comfortably FTSE 100. Bigger by market cap than IAG, Pennon, Barratt, Whitbread, ITV and Pearson. Still too cheap, UBS reckons:

We upgrade S32 to Buy (from Neutral) as we believe the risk/reward is attractive with the share price down ~20% YTD, underperforming BHP/RIO by ~20%. We see S32’s commodity risk as attractive, forecasting upside to spot alumina, aluminium and met-coal prices medium term (as they are below the marginal cost), part offset by manganese ore which has surprised positively in 2020 (note). S32 has a strong balance sheet (Mar-20 PF net cash ~$50m post-1H dividend) and is reshaping/upgrading its portfolio with the Hermosa project, Ambler & Eagle Downs options, and by the exit of SA Energy Coal and Mn alloy smelters (expected 2H CY20). S32’s FCF is ~5% at spot, rising to ~9% with prices of its key commodities at the marginal cost; it is trading at ~0.8x P/NPV vs a long-term average of 0.9x

Catalysts: Buy-back, SA coal sale, Hermosa PFS, Aluminium power contract(1) We expect S32 to restart its buy-back with FY20 results on 20 August given its balance sheet strength/cash flow generation and as the S32 share price is depressed and China demand recovery robust; the program was suspended in Mar-20 due to COVID-19 with US$121m remaining. (2) S32 expects to exit SA Energy Coal by Dec-20; we see this as a value- and ESG-accretive transaction, removing an $824m closure provision; there is some risk to terms given weak coal price/supply contract. (3)S32 will release the PFS for Hermosa in Sept-Q; this should help the market value the project with capex, volume and timing details. (4) S32 has agreed in principle a new power contract for Hillside which is still to be approved by NERSA; this should extend the life of smelter. (5) We see potential for S32 to exit orphan (e.g. nickel) or downstream (e.g. smelters) assets medium term; it recently placed the Metalloys Mn alloy smelter on care & maintenance.

And JPMorgan’s gone off Electrocomponents:

We have downgraded Electrocomponents to Neutral, following a strong recent share price performance. Since mid-Jan the stock has been flat vs FTSE 250 down 18%. FY20 results were solid, with an encouraging start to FY21e. However, at c.18x recovered earnings, we’d prefer to look elsewhere or wait for a cheaper entry point. We now forecast FY21e PBT of £162m, with an 8.4% organic revenue decline, and have reduced our FY21e forecasts by c.30%.

• Updates may follow, which’ll be guided by requests and complaints in the comment box. A Telegram Markets Live chat group is also available.