Markets Now - Tuesday 1st September

It’s symptomatic of cultural vacuity within the investment industry that its biggest contribution to the artistic realm is the saying: “sell in May and go away, come back again on St Leger’s Day”. This single line of sub-Vogon poetry encapsulates how bankers can be relied upon to deliver shit advice in the most ugly way possible. St Ledger’s is still nine working days away, however, and today’s drift pulls the FTSE 100 into negative territory versus the May 1 open so perhaps 2020 will be one of the years the Vogons win. Here are the mid-session scoreboards:

BT’s soaring 2.3 per cent lower at pixel amid the continuing fantasy that it’s a takeover target. The FT reported late on Friday that KKR is “monitoring” BT but “has not drawn up any concrete plans or invested resources in detailed work on the company”. KKR’s homeopathic level of interest “comes as senior figures from several large rival private equity firms told the Financial Times they had decided not to consider a move for BT, one of the UK’s best-known companies, because of its large pension deficit and the potential size of a deal.”

The report suggests a consortium bid might be the only option given given BT has a £10.2bn market cap, £18.3bn of net debt and a gross actuarial deficit exceeding £10.1bn as of June 2020. It also makes passing reference to the fact that BT's pinned to the canvas by various branches of government, which want nationwide full fibre, a UK corporate tax rake and complete confidence that the only bugs in the system are their own. All this press talk of barbarians at the gate might be useful for BT’s negotiating position with its various stakeholders, at least in a “better the devil you know” sense, but the idea of a PE bid remains just as fantastical as when we talked it through this time last week.

Elsewhere in weekend press, AA’s down nearly 12 per cent after Sky’s Kleinman reported:

Two of the putative bidders for the AA are in talks about joining forces in a move that could undermine shareholders' hopes of a hotly contested bidding war for Britain's biggest breakdown recovery service.

Sky News has learnt that Warburg Pincus is holding preliminary discussions about partnering with a consortium comprising two other buyout firms - Centerbridge Partners and Towerbrook Capital Partners.

The talks have yet to result in a definitive agreement, but if the three firms do formally team up, it would leave Platinum Equity as the only publicly declared potential counterbidder to the consortium.

Apollo Global Management had been contemplating an offer, but is understood to have switched its interest to participating in a potential refinancing of the AA’s £2.65bn debt mountain.

Buying the equity ahead of a debt refinancing is really stupid thing to do and yet here we are, with AA still up more than 100 per cent from April lows on the belief that the PE firms positioned on both sides of the trade would somehow play themselves. “Long-suffering AA shareholders had their hopes raised of a full-blown auction of the debt-laden company this month when it said it was in parallel talks with a number of prospective bidders as well as examining a refinancing,” Sky continued; John Lydon put it more succinctly.

Saga, AA’s nearly-as-ugly sister by the same father, is up 30 per cent on news that shareholders are getting a chance to fund its former boss’s MBO. The mostly insurance company, whose move into cruise ships was perhaps the least opportune diversification in corporate history, it’s in advanced talks to raise £150m of equity capital (versus a £200m market cap) backed by former CEO/Chairman Roger de Haan. Sir Roger plans to kick in a minimum of £75m but might go to £100m alongside a £75m placing and open offer. The bailout refinancing comes after Saga received and rejected a “highly conditional” a share offer (which is presumably dead) from two US financial investors in recent weeks at 33p apiece, versus a live price of 17.5p.

Here’s Peel Hunt:

The total capital raise is higher than what we had considered (£100m) and allows for greater capital and cash flexibility to carry the Travel business through what is likely to be a longer-than-anticipated Covid-19 disruption. Saga will also outline a refreshed strategy at the interim results on 10 September, which will coincide with the placing and open offer. . . . 

The alternative [to the 33p per share bid] is a ‘restart’ under de Haan and the new CEO. De Haan will initially subscribe in a firm placing to 20% new ordinary Saga shares at 27p per share (£60.6m), followed by an additional firm placing of £14.9m at a maximum of 15p. De Haan will also backstop £24.5m of a £74.5m placing and open offer for shareholders up to 15p/sha re. The open offer is planned to be launched around the time of the interim results.

Additional cash liquidity and capital flexibility is necessary to lower the leverage ratios and allow Saga’s travel business to operate through a long(er) Covid-19 disruption. The cash burn rate of the Tour & Cruise businesses together is £6-8m/month. We believe Saga has greater certainty to maintain the business intact under its new leadership (a break-up is unlikely we believe), which will include de Haan as Non-executive Chairman. Saga’s current cost of debt today is c10% (vs 8% in March) and we believe that a successful £150m capital raise would put it on a firmer footing notwithstanding the dilution that shareholders will face. We await the equity raise and to see how a refreshed new strategy can crystallise long-term value whilst carrying the Tour& Cruise businesses through the Covid-19 pandemic.

Over in actual bids there was Veolia’s weekend bear hug on Suez, which moves the French utilities towards a combination that’s been in train since since at least 2012 (though because it’s France they were allowed to lie about it). Engie’s announcement last month that it was switching to an asset-light model was what seems to have bounced Veolia into making an offer for nearly all of Engie’s Suez stake as a platform to launch a bid. It also follows quite a lot of market speculation in recent weeks around whether Suez might sell its waste disposal bit, which appears either to be an intentional headfake or a defensively minded Plan B. We’ll probably never find out which it was, because France.

Engie’s been trying to play hard to get with regards Veolia’s €15.50 per share offer for Suez but it’s convincing no one. Here’s Kepler Cheuvreux:

We believe it is highly likely that Engie will accept the offer from Veolia. We expect some negotiations with the final end price to be agreed. Engie would certainly try to get the highest price possible but the opportunity to sell a big part of Engie’s block at once with a solid strategic industrial project does not happen every day. With no regulatory approvals needed for the 29.9% and Veolia already having the necessary funds to close the first part of the transaction, and the industrial project of holding both firms together makes sense in our view.

In terms of the support of the French state as an Engie shareholder, we believe that the project as proposed by Veolia to create a world champion around the environmental services provides, in our view, a comparative advantage against the possible proposal a private equity fund could provide. First, the government would appreciated to keep the knowhow within France, if compared to the second option of a private equity fund, which could provide further upside from the financial front but prove weaker on the industrial positioning of a company if a deal goes through.

We doubt there could be someone who could really counter Veolia from the industrial front of the proposal and the operational efficiencies possible from the merger of both Suez and Veolia activities. Besides Veolia, the possible candidates would most likely come from either infrastructure or private equity fund, but the fully integrated business with both and Waste and Water within the company rather than a full focused profile, makes it difficult to find another industrial candidate interested in the whole company.

Within this framework, a private equity firm could be interested to acquire some of Suez’s activities, or if they went for the whole entity, the would later split of the activities into more pure-play and regional parts that could unlock some hidden value creation within the fully consolidated entity on an integrated level.

But this would be a complex process and would be simultaneous to the company already making some disposals and an asset rotation programme. We believe that a counter proposal from a private equity investor would most likely provide a less interesting industrial approach to the deal and with it, it would have to obtain the support from the French government, which is a shareholder of Engie and in our view could support the creation of a French champion around the circular economy front.

We therefore expect a negotiation process within the parties, under which Engie would like to obtain the highest price paid, while not forcing Veolia to walk away from the discussions, while the French state, Engie’s primary shareholder (with a 24% stake) would look at the proposal that makes sense from an industrial point of view with the possible creation of a combined entity as a new positive champion in the sector.

And Bank of America with a handy overview:

Veolia's intention to acquire 100% of Suez for cash at an indicative price of €15.5/share has compelling strategic rationale that could release value for shareholders of both companies, in our view. A successful deal requires several independent pieces of the puzzle to fit together smoothly, but we think that stakeholders' interests are currently aligned in a new way that makes a combination scenario more likely than not. The resulting earnings c30% EPS accretion by FY23E and improved growth prospects would expose VIE as at least 25% cheap relative to peers on our initial numbers, so we raise our PO to €25/share (US$29.25/sh) from €19/share (US$22.23) to reflect the likelihood that a deal will happen and double upgrade to Buy from Underperform. Our new PO would imply an undemanding P/E of 15x in FY22 and only 11.5x in FY23 for double digit growth with increasing ESG momentum. We move Suez to No Rating given we believe the shares are no longer trading on fundamentals. Investors should no longer rely on our previous opinion or price objective on Suez. . . . 

... No agreement [between Veolia and Engie] is currently in place, although we think VIE's formal offer to Engie, which is valid until the end of September, will likely be attractive. The second stage would be preparation of antitrust remedies before extending the offer to all other Suez shareholders, probably within 12 months, and Veolia has already lined up French infrastructure investor Meridiam to buy Suez's domestic water business to alleviate any concerns about market dominance. This would also help to reduce the enlarged group's reliance on municipal contracts, consistent with Veolia's strategy. Our analysis supports multiple options for controlling leverage, and Veolia's €500m annual cost synergy estimate feels plausible in the context of significant operational overlap and each company's existing c€250m pa efficiency programme.

We think the opportunity to create a French national champion that can more effectively compete in fast growing green activities will have political appeal, particularly as there is a commitment to no redundancies in France. The state owns c24% of Engie

Given that Veolia is acting unilaterally, there can be no guarantee of agreement or that the necessary chain of events can be executed. Nevertheless, we would not see demands for a higher offer price as incompatible with a mutually beneficial outcome if supported by new evidence about improved prospects or profitability. The Suez board has given a cautious, yet constructive initial response to the offer.

To sellside.

JP Morgan Cazenove likes Campari based on, among other things, agave prices. Those are relevant to Campari because it bought Cabo Wabo tequila from Van Halen’s third-choice vocalist Sammy Hagar in 2007 for $80m. Cabo Wabo tequila takes its name from Mr Hagar’s nightclub near Tijuana, which was named in honour of a drunk man he once saw falling into some barbed wire. Here’s JP Morgan:

We are upgrading Campari (CPR) to Overweight with a Dec-21 price target of €10.00. As a COVID-19 (relative) winner (despite >40% on-trade exposure), we see continued top-line outperformance in H2 with a more balanced portfolio vs history (eg tequila). Recent benign commentary on agave prices (c115bp margin headwind 2018-20E) offers the prospect of cyclical margin momentum (agave c160bp tailwind 2021-23E) on top of accretive product mix (+50-60bp). In the MT we see scope for the 600-1,000bp margin gap vs peers to close driving DD organic EBIT growth and 14% EPS CAGR 21-24E. Robust balance sheet (1.8x 21E EBITDA) offers scope for DD EPS accretive M&A and a change in holding structure opens the door to potentially larger strategic M&A. Despite FX headwinds, we increase our 2020/21 EPS by 6-7% with DD increases from 2022. Reflecting the LT margin upside potential, we change our valuation methodology to a DCF using 6.8% WACC and 3.5% terminal growth rate. Our PT values CPR on 40x 2021 P/E (ex-further M&A) vs Spirits on 23x.

 ST momentum to hold. With depletions ahead of sell-in during H1 (and positive Nielsen market share momentum in core aperitif & tequila categories), H2 will still likely outperform peers (flat organic; H1: -11% vs average -15%) with higher EM and travel-retail exposure. For 2020, we expect CPR to deliver -5%/-16.4% organic sales/EBIT decline (H2: 0%/-5%), well ahead of the wider spirits sector on -13%/-28% organic sales/EBIT. We expect +12.6%/+30% organic sales/EBIT growth for 2021. From 2019-22E, we forecast CPR at 7% adj EPS CAGR (in the absence of further M&A) comfortably ahead of LSD-MSD elsewhere.

 LT margin potential: From 2021, we expect an inflection in EBIT margin delivery which underpins our DD organic EBIT growth forecasts as raw materials (especially agave) turn more favourable on top of the historical 50-60bp per annum expansion model. The tequila category (c115bp headwind to margin 2018-20E) should turn into a c160bp tailwind 2021-23E as agave prices soften. This should help to drive over 120bp per annum EBIT margin expansion 2022-24E closing the gap to international peers. We include a tequila category primer in this note.

 Toasting the future potential (organic & M&A): On top of our 14% organic EPS CAGR 2021-24E, M&A is likely to continue to be an important part of the CPR story (including closing the margin gap vs peers). By 2021, CPR could deploy up to €1bn for bolt-on deals which could be DD EPS accretive and still keep ND/EBITDA below 3x. More strategically, the new Dutch office and multiple-voting structure opens doors for larger deals and could see a share count increase by c90% (worth c€9bn) while still keeping control within the Garavoglia family.

Jefferies puts an “underperform” on AJ Bell, the fund supermarket with overripe adverts, in new coverage. It’s too expensive, they reckon. The broker also upgrades larger peer Hargreaves Lansdown to “hold” on valuation grounds. Here’s a chart, then the main thrust of the former, then a wee bit of the latter:

In the near term, we think consensus may be slightly too low but that the market is pricing in higher long-term growth than is likely to be achieved, or underestimates the competitive risks to the business. A 5bps reduction in D2C revenue margins would take 19% off our bottom line. We like the market opportunity, product pricing and business model, but we would not pay 50x FY20 earnings or 55x FY21.

There is a lot to like: AJB has a strong business model and excellent customer retention. Pricing of both its advisor and direct-to-consumer (D2C) platforms is competitive, so we expect it to win market share, and it faces less danger from price competition than more expensive players. The exposure to both markets is also attractive, because although the advisor market is currently more competitive and has lower pricing, it still represents a bigger total opportunity.

The business is scalable and should see some operational gearing benefits as it grows, although its lower headline rates mean that it will not reach the same PBT margin levels as HL/, its biggest D2C competitor, and costs will rise in line with user numbers beyond a certain point. The recent market volatility showed that it is susceptible to asset pricing and interest rates, but flows have been resilient and AJB has benefited from high transaction volumes.

So why the underperform rating? On our estimates, the current share price implies 15% annual profit growth from 2023 - 2028 and then 6% for ever. The medium term implied growth is higher than peers like Aegon (13.5%) or observers like Fundscape (9%) expect over the next five years. Given that the bottom line is highly sensistive to revenue margin compression, and that there are well-funded cheaper players in the market (Interactive Investor), as well as new entrants with competitive offers (FBK IM), this seems too high. We could eventually see a race to the bottom on price, as seen among the US discount brokers.

We have compared AJB to a variety of other platforms, marketplace businesses, exchanges and the US discount brokers. AJB has a higher P/E ratio than any of them except Rightmove (RMV LN), where the consensus estimate for earnings CAGR over the next three years is 25%, five times higher than AJB. To justify its rating, we would need to be confident of very high earnings growth resulting from a significant and sustainable competitive advantage. With price the main differentiator in the higher-growth D2C market, we do not have that confidence.

Catalysts: A failure to live up to growth expectations, a new entrant making a big impression or fee reductions could trigger a de-rating. Or it could be gradual.

Forecasts and valuation: We forecast close to 9% earnings CAGR from 2019 to 2022, but only 3.5% from 2020 to 2022, with a dip in 2021 due to lower average AUA, lower interest rates feeding through and the return to lower transaction volumes. Our EPS forecasts are 0.5p and 0.9p ahead of consensus in FY20 and FY21. To value AJB, we take our earnings forecasts to 2022, assume 15% annual growth for five years and terminal growth of 4%. Discounting back at 9% we reach a 280p price target.

Looking at a range of platform businesses and the relationship between consensus earnings growth over three years and P/E, HL now sits in the pack, having been an outlier in the past. In May 2019, EPS CAGR from FY19e to FY21e was 14%, the 2020e - 2022e figure is now 7%, and the 1-year P/E ratio has come down from 43x to 33x. This puts HL/ roughly in line with the average for our basket of investment platforms, exchanges and market place businesses (34.5x, or 30.4x excluding RMV LN and AJB).

Goldman doesn’t fancy Inditex, which owns Stradivarius the clothes shops not the violins.

Ahead of the Inditex 1H results on September 16, we have reviewed recent clothing market growth trends and discount activity on Zara websites. We note that across 2Q21, Spanish clothing sales growth remained weak (May/June/July -59%/-23%/-21% yoy). In addition, both the South and North American markets continued to lag Asia and Europe, with May-July Brazil clothing sales c.-52% and USA c.-35%. In this context, we have reduced our 2Q21E sales forecast -300bp to -31% yoy (cFX -28%, ccy -3%). Given the-51% cFX sales decline in May, this implies June/July cFX sales c.-16% yoy.

We also note that the weekly data sources for August have seen sales declines broadly in line with July (July/August German clothing sales -10%/-12%). Hence, the improving yoy growth trends from May to July appear to have stalled in August, albeit with online still outperforming offline. On this basis, we have also reduced our 3Q/4Q21E cFX sales growth to -6%/-2% (from -5%/+4%).

From a gross margin perspective, our recent web-scrape data suggests the Zara average price discount in Spain has increased c.260bp yoy in 2Q21E. In the context of the group’s €287mn inventory provision taken at the last full year, we retain a -50bp 2Q21E gross margin decline.

Implications: Taken together, the above updates drive a €150mn 2Q21E PBT (from €210mn), and reduce our FY21E/22E PBT -16%/-8% to €2,315mn/€4,340mn (EPS €0.56/€1.08).

Valuation: Our €26 12-month target price (from €29, given the above earnings reduction) is DCF-driven and equates to a 24x FY22E P/E. The +8% upside to this target price is in line with our general retail sector coverage average, and hence we reduce our rating to Neutral (from Buy).

Also, Zalando goes up to “buy” at Goldman. Plus there’s a “sell” on H&M:

Partner Programme sales growth has accelerated as brands view Zalando’s online reach as complimentary to their own online offering, especially in the current accelerated online channel shift environment. Between April and June 180 new brands joined the partner Programme, taking the total to 680, and driving Partner Programme GMV +120% yoy. In our view, rising Partner Programme and Zalando Marketing Services sales penetration should drive a meaningfully higher adj EBIT margin outlook, given the c.10% and 40% adj EBIT margins vs. Fashion Store c.3.5% (2019). We upgrade the stock to Buy from Neutral. . . . 

In reviewing clothing market revenue trends across H&M’s 3Q20, we note that German store-based clothing sales growth in August so far is c.-12% yoy, similar to the -10% yoy decline in July, and hence the improving yoy growth trends from May to June and into July appear to have stalled in August. This theme is repeated in the high frequency UK clothing market data. On this basis, we retain a -20% H&M 3Q20E sales decline. From a gross margin perspective, our recent web-scrape data suggests the H&M average price discount in Germany has increased c.600bp yoy. We derive a -400bp 3Q20E gross margin decline. We remain Sell rated.

Rolls-Royce is the FTSE 100’s biggest faller following a load of post-results commentary that says it really, really needs a proper rights issue yet is still guddling about with disposals and stuff. For a company whose accounting processes have often baffled (and whose finance director has just quit), it’s really not a good look. Jet engine makers should generally seek to avoid an impression that they’re stalling. Here’s Credit Suisse:

Rolls-Royce’s communication focus on its investments in zero-carbon power should not distract investors from 1/ the absence of appeal in its main business (widebody engines) and 2/ its strategically damaging absence from the most attractive aircraft engine segment (narrowbodies), with no material improvement in sight. . . . 

The group announced >GBP2bn of disposals, materially more than what the market had in mind (GBP1bn) and possibly implying a lower need for fresh equity to repair its balance sheet. This has raised questions on whether Rolls-Royce was waiting for things to improve before a rights issue or taking the risk of seeing things get worse (a feeling reinforced for some by the “severe but plausible” downside scenario, which would require the group to draw down its GBP1.9bn RCF). This downside scenario comes against a base case where capacity is back to 90% of 2019 levels by H2 2022, seen as potentially too optimistic. . . . 

We maintain our Underperform rating with a reduced target price of 200p (average of updated 2024e FCF yield and SOTP-based valuations). In our view, the lack of visibility on the balance sheet rebuild, the persistent volatility in forecasts and the unattractiveness of the underlying investment case mean the stock remain unappealing for many investors.

And IAG gets a downgrade from JPMorgan:

IAG has a strong airline portfolio and very well-respected management. However, given a challenging and uncertain outlook (both near- and medium-term) we move our rating to Neutral. Our new PT of €2.50 is derived by applying a target EV/EBITDA of 6.4x (IAG’s median since 2013) to our 2022 estimates. As we enter autumn we are tactically cautious on all airlines, as we expect fading leisure traffic and only anemic business traffic. On a relative basis, we prefer Wizz and RYA (both have strong liquidity and the chance to take market share / further lower their costs).

 IAG’s balance sheet will be strengthened by upcoming rights issue: Prior to COVID-19 we had expected IAG to generate >€1bn of FCF but we now expect its 2020E FCF to be c€-5.7bn (broadly in line with BBG consensus). IAG has been very proactive in dealing with this crisis. (1) It has reduced its 2020-22 capex plan from €14.4bn to c€6.9bn. (2) Per Table 2, it has secured new debt facilities, raised funds from sale and leaseback deals, and it recently secured c€830m from a deal with American Express (pre-selling Avios loyalty points, and a one-off exclusivity payment). (3) Around September 10th IAG plans a rights issue to raise c€2.75bn. IAG believes this large RI will allow it to withstand a long downturn and fund its revised capex programme. Per Table 2, we estimate that after the RI, IAG will have enough liquidity to survive c15 months of another total cessation of flying (something we do not expect). (4) In addition to the above actions we note that IAG is implementing radical restructuring measures, primarily at BA.

 Many uncertainties and challenges: Whilst the above steps solidify IAG’s financial position, its trading outlook remains uncertain. (1) In 2019 IAG flew 29% of its capacity to/from N. America and c18% to/from LatAm & the Caribbean, both currently COVID-19 hotspots. (Conversely, this also makes IAG’s shares highly levered to a successful vaccine.) (2) IAG does not disclose the % of its profit from long-haul premium/corporate travel but we suspect it is material (maybe 30-50%). We expect this segment to recover slowly and it may not return to its former size given the “Zoom revolution”. (3) On July 28th, the BBC reported that BA employees belonging to the Unite union could strike in response to the major redundancies BA is proposing.

 Updating our financial forecasts and PT: We make significant revisions to our PT, and EPS and cash flow estimates (Table 1), but as this is our first COVID-19 update on IAG we are mostly catching up to market conditions. Our estimates include a €2.75bn equity raise (we use the closing share price on Aug 31st as we don’t know the RI details). Our estimates do not include the proposed acquisition of Air Europa in Spain.

• Updates might follow, influenced or otherwise by requests and complaints in the comment box.