Markets Now - Wednesday 12th August 2020

Day 224 of plague times and we wait for the storms to come. Word lately arrived from Muscovy of a cure (or a nostrum more likely, the learned ones say). Our guides have concerned themselves with trinkets and chimera while the natives are being driven to distraction by stories of invaders on boats. Two-thousand-score on this island alone are dead -- perhaps fewer, probably more -- and still the prices rise interminably. Here’s the mid-session scoreboard:

Where to begin? There’s UK GDP, which lazy commentators would call a curate’s egg. The good bit’s an 8.7 per cent month-on-month rise in June, which beats the 8.0 per cent consensus. The bad bit’s the confirmation that the UK’s in its biggest recession since the Great Depression. Nevertheless, a record breaking 20.4 per cent drop for the second quarter as a whole was also slightly better than the 20.7 per cent consensus and sterling’s up a wee bit in response so . . . mostly good? Here’s Goldman:

Cumulatively through the first two quarters of 2020, GDP fell by 22%. Given the scale of that shock, the level of GDP at the end of Q2 was broadly in line with the level of quarterly GDP in mid-2003. Today’s expenditure breakdown reflects the relatively large share of UK aggregate demand that is reliant on face-to-face interaction: household consumption collapsed by 23.1% qoq non-annl. in Q2, accounting for more than 70% of the quarterly contraction in overall GDP.

And Cazenove:

A couple of months ago we developed a high frequency activity tracker based on monthly and weekly alternative data from internet searches, mobility, travel and booking data . . . .

The chart shows that the activity tracker has lined up with reported monthly GDP fairly well so far. Based on its relationship with the official data so far this implies GDP took another large step up in July worth 6-7%. The data for the week leading up to the 7th August show activity running around 24% below its pre-lockdown levels. While there is a lot of room for error, this early indication suggests activity may be falling a little short of our August forecast. We will review this again when more data become available for later in the month.

Returning to the details of the GDP report, construction leapt 23.5%m/m after its slump in April while industrial production and services showed gains of 9.3%m/m and 7.7% respectively. The higher level sector details show retail making a swift recovery helped by online spending. Other consumer facing sectors involving greater social interaction are languishing behind in June, with levels of output in accommodation and food services still down 83% compared to February levels and entertainment and recreation down 40%. Given the reopening of many of these services over the Jul/Aug period a strong bounce is likely, but key will be where the new normal lies.

On the demand side consumption was confirmed down 23%q/q with business investment down 31%. The decline in consumption is a reminder that the retail sales data (which were down 10%q/q in 2Q) should not be used as a proxy for overall consumption or GDP at the moment due to significant compositional shifts in spending patterns and the possibility for goods spending to show temporary overshooting.

In corporate, the forced separation of online shoppers from office postrooms has had a positive effect on Asos. Full-year guidance gets a bump higher in tandem with landfill projections.

Is it a good or a bad trend at the very start of a recession that people are buying stuff they won’t wear and can’t work out how to return? Will that act as a disincentive on future purchases? The analysts mostly talk about moderating benefit as trends normalise; none seems to consider an accelerating detriment as trends reverse. Here’s UBS:

Q: How did the results compare vs expectations?

A: This morning ASOS announced FY20 sales and profit will be ahead of current market expectations. FY20 sales are expected to be +17% to +19% (UBSe +17%) and PBT £130m-£150m (UBSe £70m).

Q: What were the most noteworthy areas in the results?

A: The upgrade reflects: 1) stronger underlying demand (although we estimate this is a smaller proportion of the upgrade) and 2) the positive impact from lower return rates yoy on product mix and consumer behaviour (purchasing more deliberately). Other apparel retailers like Next have made similar comments regarding returns rates.

Q: Has the company's outlook/guidance changed?

A: Yes. FY20 sales +17% to +19% and PBT £130-150m (was ~£70m)

Q: How would we expect investors to react?

A: The profit upgrade is likely to be taken positively today, but we note return rates are likely to normalise next year, making the upgrade more of a one off item to be removed in the PBT bridge for FY21, all else equal.

And Barclays:

No question the ASOS update this morning is encouraging. But most of the upgrade is due to lower returns, with better underlying gross demand trends only a small part of the uplift. No question returns are a real cost for fashion e-commerce businesses and there is a structural tailwind from Covid-19 on this factor. But there remains a question as to how long this returns tailwind will be sustained; it is quite possible that much of this is one-off in nature. The stock is now trading at 1.2x EV/Sales in cal ‘21E. That is not cheap, in our view; definitely factoring in a name that can sustainably grow high teens or better and show a path to mid-digit margins in the medium term. ASOS has always been about the medium term – so we would look past the current returns tailwind. The company has definitely shown good progress on cost momentum but we believe executional risk hasn’t fully gone away and the top line isn’t yet firing on all cylinders. Our inclination is to think quite a bit is priced in at this stage. We are Equal Weight.

...  Key thing to point out is this is largely due to returns: we estimate returns rates are high single digit % lower from the normal c40% base. Lots of retailers have seen this dynamic with a shift to lower returns categories like active wear and beauty (vs dresses) as well as some change in consumer behavior in lockdown. ASOS had expected returns rate to normalize post lockdown – that hasn’t happened. They account for returns via a provision in revenues – the majority of this guidance upgrade is a reversal of the provision, which drops through with also few costs to process returns.

A much small portion of the uplift genuinely better gross demand trends.

At some point it seems likely that returns trends normalize so remains to be seen how much of this carries over to FY21. Potentially some but this stock has never traded on next year’s numbers – it is all about perception of where numbers might go in the medium term. And at this point we wouldn’t want to assume this is a tailwind forever.

To be clear there has been some acceleration in u/l demand, we’d assume also including the UK as pubs and restaurants have re-opened. It is hard to decipher exactly what the underlying gross demand trends are but we would assume closer to high teens – still a decent number but not blowing the lights out in the way that some of the other fashion ecommerce names are (albeit everyone is seeing a boost from lower returns).

ASOS still doesn’t look crazy vs history here but e-commerce names don’t command now what they did back in 2018. ASOS is starting to get back to the territory it commanded before the end ’18 profit warning. Execution is much improved from then, but it hasn’t been categorically shown that this is a sustainable 20%+ rev growth business on 4%+ EBIT margins, which is how the market felt in 2018. On cal ‘21E EV/Sales of 1.2x, the stock is on 24x a steady state EBIT if we believe there is a 5% steady state margin. We don’t think it is particularly cheap. Zalando is on 1.5x EV/GMV but we have much more confidence in the LT trajectory of margin at Zalando so prefer that name.

Avast, the FTSE 100-listed vendor of freemium virus checkers and occasionally Chinese malware, is down quite heavily on in-line results. Buyside expectations had run ahead of themselves on the idea that work-from-home would encourage more people to sign up for premium, which did happen but seems to have moderated of late, though billings still look healthy enough and most brokers were calling the stock higher pre open. Also worth noting is the wind down of Jumpshot, Avast’s data harvesting business, which is continuing on schedule. Here’s Morgan Stanley:

1H20 results demonstrate resilience of Avast's free-user model, FY20 guidance tweaked higher, billings accelerate: Avast reported a strong set of 1H numbers, with organic adj. revenue growth of 6.6% in the first half, broadly in-line with MSe and street. More importantly, billings, the leading indicator for revenues, were up 9.2% organic for 1H, suggesting an acceleration from 1Q to double digit growth (we estimate +7-8% organic in 1Q), as Avast benefitted from WFH trends. The strong billings growth has led management to tweak FY20 guidance higher, with revenue growth now expected to be at the top end of the previous "mid-single digit" range (MSe 7.7% organic FY20). Below the line, 1H adj. EBITDA came in c. 2% ahead of street, although a touch below MSe. On cash, uFCF came in c. 8% ahead of street expectations, or 19% ahead excluded $23m cash donation to COVID-19 causes. Avast currently trades at 21x FY21e P/E or c. 5.5% FCFF yield, a level we continue to view as attractive vs. the wider software sector, especially given WFH benefit as well as optionality around M&A/buybacks as Avast de-levers (1.7x at 1H20 vs. 1.5x floor).

And Peel Hunt:

The company kept its original guidance of mid-single- digit organic growth, but expect to be at the upper end. Given the stock’s strong rally recently, investors may have expected larger upgrades. This would also explain today’s weakness. However, there was a hint of management being slightly conservative with guidance, given macro uncertainty. We too are slightly above guidance at 8.1% organic revenue growth for FY20E, which we leave unchanged for now.

Valuation: We keep our TP at 355p, which takes into account longer-term threats. We use a weighted-average DCF to arrive at our TP – a base case of 407p (40%), bear case of 127p (35%), and bull case of 592p (25%).

Capital & Counties, the owner of two plots in the capital and none whatsoever in the counties, is down a bit on a gloomy outlook. The Covent Garden landlord had a trading update in late July so there are few surprises in the figures.

Shareholders representing 28 per cent didn’t approve Capco’s purchase of another stake in Shaftesbury, which helps diversify Capco’s portfolio to the other side of Charing Cross Road, yet that trade continues: Capco will hold 26.3 per cent of Shaftesbury by Thursday morning. “This puts Capco in the driving seat with regards to consolidation in our view, although there are no guarantees a quick move will be made given raising debt or equity at this point comes with its own challenges,” says Kempen (“neutral”), which summarises the headlines like this:

Key Points:

Value decline driving NAV falls: The -16.3% l-f-l portfolio value decline to £2.3bn (with Covent Garden down -17% l-f-l) drove EPRA NTA down -18% to 241p, which is already ahead of our 12/20E of 252p. This aggressive mark down came in the form of ERVs -12% l-f-l and yields expanding +17bps. Having said this we are less concerned about this relative to other predominantly retail names given the resulting LTV is 32%.

ERV retreating heavily: the £125m ERV target by 12/20E could not look further from reality now with the ERV now back at £95.5m, as the business focuses on maintaining as much of the estate as possible. Although 22 leases were signed in the first half with a rental value of £2.7m, the underlying l-f-l net rental income was down -22%, and along with adjustments for bad debts etc. this resulted in EPRA EPS was -1.2p vs 0.3p last year.

66 units handed over at Lillie Square phase two: although Lillie Square values were down -5% l-f-l to £138m, completion of phase two continues with 66 units handed over representing £81m (£40m Capco share) of proceeds.

Rent collection ticking up: Following the July 21st update where 20Q2 and Q3 rent collection was 44% and 27%, meaning 71% of 20H1 rents had been collected overall, this became 44% and 30% respectively. Capco has made a £5.8m bad debt expense accordingly, which has contributed to the £12.8m reduction in net rental income. . . . 

Valuation: Capco trades at an -42% discount to spot NAV, which compares to the wider retail sector of c.-57%. Although this may screen expensive, given the quality of the portfolio, the stronger balance sheet, and the lower structural headwinds (once social distancing is relaxed), we believe this is fair.

Sunrise Communications is leading the Stoxx Europe 600 after Liberty Global has a second shot at buying the Swiss network operator. Liberty offers SFr110 per share, or a 28 per cent premium to Tuesday’s closing price. The Sunrise board unanimously recommends shareholders accept the offer and Freenet, its 24 per cent shareholder, has agreed to tender. Kepler with the maths:

Total synergies of CHF3.1bn on a net present value basis after integration costs, with the annual run rate synergies estimated at CHF275m, of which the vast majority of the benefits (approximately CHF2.6bn) relate to lower opex and capex.

The transaction values the company at 7.5x adj. EBITDA and 10.3x adj. OpFCF (post-synergies) or 10.0x adjusted EBITDA and 17.6x adjusted OpFCF before synergies.

And Goldman with the readthrough:

Liberty Global (Neutral, $24 target price) - The transaction value is underpinned from a Liberty Global perspective given the NPV of synergies guided is c.45% of the overall Sunrise deal valuation. Given weak operating trends in Switzerland, we believe consolidation of the market and scale cross-selling of fixed-mobile products can act as a meaningful tailwind to operating trends over and above the immediate cost and capex synergies.

Sunrise (Buy-rated, CHF111 target price) - We value Sunrise at 111CHF/share (GS target price), which is consistent with the announced transaction value (110 CHF/share). As per the company, the transaction value represents an 10.0x adjusted 2020 EBITDA and 17.6x adjusted OpFCF before synergies and 7.5x/10.3x after reflecting guided synergies (net of upgrade costs).

Freenet (Sell-rated, 14 EUR target price) - We view this as a positive de-leveraging event for Freenet given the announced valuation means their stake could be sold at a 32% premium to the 60-day average and there are no synergies from ownership in our view. Proforma leverage adjusting for this transaction would be meaningfully lower at c.2x 2020E (vs our current 4.5x estimate) and the cash-in represents c.60% of Freenet’s equity value. We would note that given Freenet has a long-term leverage target of c.3.5x Net debt/EBITDA, the transaction as currently proposed could support upside to shareholder returns.

Swisscom (Sell-rated, 428 CHF target price) - . . . A Sunrise-UPC Switzerland combination could be a potential negative for Swisscom. The company could lose wholesale broadband revenues, as Sunrise could shift traffic to UPC’s cable infrastructure, and MVNO revenues may also be lost if UPC shifts mobile traffic to Sunrise’s network. Combined, we estimate that this represents SFr107m of annual wholesale revenues, of which SFr 33m is revenues from Sunrise’s broadband wholesale (SFr 100 over 3 years). This creates a 1% headwind to group revenue growth. Given the high-margin nature of these wholesale revenues (we estimate 80%-90%), this could ultimately represent a 2% headwind to EBITDA growth.

And back to Kepler for more readthrough:

This transaction is a negative read-through for Swisscom as through this transaction UPC will reinforce its position as the second largest market player in mobile, TV, broadband and fixed-line telephony after Swisscom and as the incumbent telco’s leading converged challenger. By owning a mobile network, UPC could benefit from ownership economics but also from synergies by complementing fixed-line products with mobile offerings, suggesting strong cross- and upselling potential. Through convergence, UPC has significant potential to accelerate growth in Switzerland, and this should make UPC a stronger player in both the consumer and business segments. Moreover, the combination of the dense urban infrastructure of UPC and the fibre core network owned and operated by Sunrise would form a strong backbone for high speed mobile broadband access and for a next-generation 5G network.

What the impact will be for Sunrise and Salt recently announced plans to enter a strategic partnership to create a fibre-to-the-home (FTTH) platform for broadband services on an open access basis across Switzerland is still unclear.

British Airways-owning IAG goes down to “neutral” at Davy Stockbrokers in a sector thing.

The pertinent question for the network airlines, which transfer passengers through large hubs connecting long-haul destinations, is whether they can recover and, if so, how long will this take. Inter-continental and corporate travel look certain to recover later than continental/leisure travel. We have revised our estimates for the three main European network airlines. All are restructuring (plan to be 33% to 20% smaller in 2021) and will have a future focus on deleveraging and repairing balance sheets. We don’t know yet whether their restructurings will enhance or weaken competitive positioning when we see other global airlines restructuring. We maintain our ‘Underperform’ rating on both Air France KLM and Lufthansa but downgrade IAG to ‘Neutral’ with its highly dilutive rights issue to come in September.

IAG – painful rights issue

Details of the rights issue will be announced post-AGM approval on September 8th, but we assume it will be at least 50% dilutive as management looks to raise €2.75bn. The base case plan is to be 24% smaller in 2021, with IAG not expecting passenger demand to recover to 2019 levels until at least 2023. The rights issue assumes a downside case of a slower recovery versus the current capacity planning scenario (-35% versus 2019) and further downside to RASK in 2020-21 versus 2019. We have assumed the base case with operating losses of €2.9bn in 2020 before a pick-up through 2021 (€620m), 2022 (€2.0bn) and 2023 (€2.7bn). The price target is £2.0 assuming 3x P/E (half our normal valuation pending dilution), 4x EV/EBITDA.

Lufthansa – needs to deleverage but has some time

Government funding meant that the group had a total of €11.8bn in liquidity available as of June 30th. It currently expects demand for air travel to return to pre-crisis levels in 2024 at the earliest (for 2021 capacity, currently planning for capacity at two-thirds of 2019). The group has therefore decided on a comprehensive restructuring programme (‘ReNew’), with the aim to maintain the global competitiveness and future viability of the Lufthansa Group. The financial planning of Lufthansa Group stipulates that positive cash flows will be generated again in the course of 2021. On last week’s analyst call, management commented that the liquidity buffer means it doesn’t need to do an equity raise when the share price is this low; on asset sales, it implied that it would not be forced into fire sales, but a solution for Technik may be minority investor, partial IPO, etc. We have assumed operating losses of €4.9bn in 2020 before a pick-up through 2021 (€130m) and 2022 (€1.4bn). Price target is €6.7.

Air France KLM – business objectives pushed to 2025

Post the government financial packages, Air France KLM now has €14.2bn in liquidity to weather the crisis; however, it will be a long road ahead to deleverage and restructure, with equity and quasi-equity planned by May 2021. The transformation plan targets have been pushed one year to 2025 (7-8% operating margin) and positive operating free cash flow to 2023. It expects to operate a capacity of ASKs for 2021 at a minimum of -20% compared to 2019 and anticipates that a recovery to the pre-crisis capacity level will be reached by 2024. The group intends to keep the schedule of committed fleet deliveries as much as possible intact between 2021 and 2025, for which it is carefully considering financing options. The group sees September/October as important months to garner the level of corporate demand. The strategy to increase the share in point-to-point demand out of Paris remains. We have assumed operating losses of €4.1bn in 2020 and €590m in 2021 before a pickup through 2022 (€880m), 2023 (€1.1bn) and 2023 (€1.7bn). Our revised price target is €3.5.

And Barclays is keen on Dunelm in new coverage:

Resilient, cash generative, strong balance sheet, and growth opportunities online: OW: There may be risk to the homewares/furniture markets in a recession, but Barclays UK Spend Trends 2.0 indicates industry growth rates are currently strong (next catalyst, FY results on 10th Sept). Combined with market share gains for Dunelm, we believe the company will be resilient and deliver attractive growth (14% PBT growth in FY22). The recent trading statement revealed 30% of sales were derived from online since stores re-opened, and 12% of sales derived from click & collect. We see clear potential for combined digital channels to be >50% of revenue, which could drive earnings upside and valuation support. Dunelm may lack capabilities of best in class online players in terms of delivery speed, and despite many areas for improvement, recent online sales growth was >100%. Ongoing improvements to online, combined with strong product (often non-branded) from a committed group of suppliers, 50% gross margins, and a low cost store estate in c170 locations (click & collect, potential to deliver from store), mean the company has sources of competitive advantage. The opportunities for growth are clear, and whilst execution is critical, our discussions with management indicate a company with the capabilities and desire to evolve and succeed. With the Adderley family's 50.4% shareholding (source: Bloomberg), management has support to make the right LT decisions. We initiate with an OW rating, 1425p PT.

Valuation – focus on FCF, yield of 4% at PT: Dunelm is trading on a premium PE, and we base our rating on confidence in growth, rather than re-rating. That said, there are factors that inflate the PE: lockdown in FY20, up to £8m annualised costs in FY21 from distancing measures, £8m of technology investment in FY21 expensed not capitalized, and net cash. We focus on FCF, and use a 4% yield in FY22 to drive our PT. Our upside case (1800p) assumes store growth remains, but online growth rises >50% vs base case to c£600m of revenue (40% online), with FCF c30% above base case. Our downside case (845p) assumes a weak macro backdrop offsets category and market share growth, online cannibalizes store revenue and EPS is c20% below our base case.

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