Markets Now - Thursday 11th June 2020

Should we start at the top? It’s the obvious place to start.

Market reports are in their usual push-me-pull-you act of citing stimulus for up moves and blaming down moves on the reasons why the stimulus is needed. Down means things today are “dour”, “bleak”, “gloomy” and suffering “a reality check”. Sure, why not.

In truth neither the FOMC statement nor the presser revealed any new negative and Wall Street had drifted to a nothing sort of close after Jay Powell had finished speaking. The only real tension in the room came via a question (from Michael McKee of Bloomberg Television and Radio) about whether three more years of guaranteed zirp was inflating an asset bubble. (Jay’s reply -- to paraphrase: sunk costs have kept markets functional and if they stay functional the man dgaf about asset prices because the market isn’t the economy -- was exactly what you’d expect him to say.)

Nevertheless, there were enough basic materials provided by the Fed to piece together a reasonable case for top slicing. Here’s an unusually good bit of post-facto commentary from Damien Boey at Credit Suisse:

In response to the Fed announcement, volatility in equities (VIX) and bonds (MOVE) have fallen slightly, while bonds and commodities have rallied and equities have faded. Importantly, passive and risk parity portfolios have fared reasonably well, because weighted strength in bonds and commodities has overshadowed weakness in equities. Short term, these developments have made sense, because Powell has explicitly linked the size of the Fed’s balance sheet to market volatility. By expanding QE, the Fed has tried to limit the contagion of wide tracking error on the Fed funds rate (relative to traditional policy rules) to priced interest rate volatility and term risk premia. And given that equities have become extremely expensive relative to bonds, to the point of negative risk premia on long-term horizons, the capping of bond yields and bond volatility has been designed to take away a potential catalyst for a sell off. But clearly, equity market investors have shown a willingness to look through the Fed’s engineering ... in part because the VIX has already come back a long way from its highs. Indeed, the VIX futures curve has become upward sloping at the short end, coinciding with US election uncertainty and consistent with doubts about the near-term credibility of the Fed put. Also, we note that the real yield curve has remained quite inverted, signalling tight financial conditions and foreshadowing heightened correlation risk in passive and risk parity portfolios. . . . .

How many moves until checkmate? In the past, greenshoots of recovery and central banks erring on the side of easing would have been a powerful risk on signal. But no longer apparently. The Fed has telegraphed its concerns about longer-term growth risks and asset price bubbles bursting. It has stopped short of explicit yield curve control, presumably because of concerns about how this might weigh on bank profit margins, and what it might signal for the broader economy. But effectively, by expanding QE, the Fed has achieved almost the same thing as yield curve control. Had it not chosen to expand or innovate on its balance sheet, the risk would have been that long-term bond yields would have increased, ultimately weighing on equity market valuations and passive or risk parity investors. Indeed, markets have moved so much in a short space of time, that for all of our concerns about inflation, negative term risk premia and the expensiveness of bonds, the reality is that equity risk premia have become even more negative than bond risk premia. Equities have become even more vulnerable than bonds to inflation risks and shifts in policy settings. Major asset classes have become vulnerable to a sell-off together. Therefore, either way the Fed chose to go, there were always going to be downside risks for officials to contend with, with the only upside scenarios being from a strong domestic growth recovery to temporarily distract equity market investors from extreme valuations, or reflation in emerging markets. Looking forward, we take a view consistent with the upward-sloping short-end of the VIX futures curve - that the Fed is juggling too many balls in the air. From a factor perspective, we are leaning more towards quality and away from value. We are also becoming less negative on defensive momentum and therefore less concerned about crowding, especially given that momentum factors have badly underperformed in early June. From sector and asset allocation perspectives, we are happy with gold and larger cap resources stocks that rank well on quality because of strong balance sheets.

Onto movers then, and Ocado’s still doing what it knows best: raising and burning money. Another 33.2m shares have been printed and sold at £19.60, a 5.7 per cent discount to Wednesday’s close. There’s also £350m in convertible debt, taking total raised to more than £1bn (or 1000 KLFs). That’s in addition to the £600m convertible Ocado sold just six months ago.

Ocado says it needs moar to accelerate growth with current partners, find some new ones and invest into innovation. A reminder that paying for innovation has kept Ocado lossmaking in all but two of the 20 years since its foundation and has so far managed to innovate (even with a pandemic providing a presumably unanticipated tailwind for grocery delivery adoption) a 1.6 per cent UK market share.

Okay, but why does Ocado need more money?

It’s because the Microsoft of Retail loads a bunch of very un-software-ish costs at the front of deals. The shares having almost doubled year to date, expansion is needed to justify a silly valuation (~8 times trailing sales! EV of ~157x trailing ebitda!). Expansion means building its customers’ warehouses for them, which is quite expensive because they have to be made of bricks, robots etc.

And when’s the payback? Or breakeven, even? Middle of the century maybe? Later? Earlier? Ocado avoids getting bogged down in specifics about profit and whatnot, which is sensible given its guidance has been worse than useless over the previous two decades. All that’s important is the general concept that Ocado will make more money by burning more money. Investors should be honoured that they’re getting yet another opportunity inhale deep on the fumes. Here’s HSBC:

Ocado’s biggest problem was its ability to respond quickly to any increase in interest in its platform. Simplistically, Ocado’s model relies on it effectively designing and then buying automation equipment that is then leased out to customers. Bottlenecks in its business exist in platforming customers and in getting the equipment built. The raise could help with some of these issues but we wonder whether Ocado’s supply chain will be able to respond in order to supply it with equipment faster. Effectively, to address the potential opportunity, Ocado needs to release capacity quickly. New customers are unlikely to sign up for its service while it cannot deliver its service for almost 5 years. If online penetration is sustainably higher, potential customers will need a solution soon otherwise they will lose ground to competitors.

The raise does not solve the problem with Ocado’s centralised model which is very difficult to optimise and has structural higher delivery costs. Delivery economics are roughly twice as important as picking economics in online grocery and Ocado’s model optimises picking costs at the cost of sacrificing delivery economics. When stem drives are longer, it is very difficult to convert more drops into efficiency. The CFC-based model has also proven inflexible in the current environment. Ocado Retail sales might be +40%, but all its competitors have at least doubled; Tesco has almost tripled with a store pick model.

Reduce rating, 1,000p TP. If Ocado can release capacity, there is a chance it could attract further customers but to justify the current share price it needs to triple its business. We do not believe that is realistic.

And here’s Jefferies:

‘... in order to ‘capitalise on opportunities arising from the significant acceleration on online adoption and grow faster over the medium term’. We note comments from the CFO at finals in Feb that £110m of cash fees and £515m capex (net of Andover insurance proceeds) would take the co ‘back to £400m cash outflows for Solutions’ in 19/20. With the £1.4bn gross cash position post-December convertible implying c.3 years of funding headroom. Indeed, Mr. Tatton-Brown at the time argued ‘in two years, we’ll think about how you might fund the business’. Today’s announcement represents a clear acceleration of that timetable. In the meantime, the size of the contracted development pipeline has remained unchanged at the equivalent of 54 Andover-like sites (the three new Kroger CFCs detailed last week, taking the total identified US sites to 9, were within the context of a total KR commitment of 20). The first two are currently in their very early ramp up phase in Paris and Toronto. The third one will not come on-stream until 2021.

OCDO will host its interims on 14 July. At that juncture we will be in a better position to judge the exact rate of cash burn in the Solutions division. This latest funding round suggests that the shape of our DCF-driven 700p fair value is clearly mistaken, with self-funding status pushed back by a considerable extent. More visibility on the exact drivers behind this development is needed to review longer-term estimates, something that we are unable to do today, given the absence of any new details.

A thing we like to do sometimes, just for the lols, is to go back to the initiation of coverage from Ocado’s in-house broker Goldman Sachs. In the year of its flotation, 2010, Goldman had the company turning profitable in 2011 with an EPS of +3.3p, rising in a straight line to +14.8p by 2014.

Here’s Goldman’s working back then, and here’s what its forecasts looked like this morning.

2:00pm BST - Domiciles are fascinating, aren’t they? No. No they’re not. They weren’t in 2018 when Unilever asked to scrap its dual listing and shift its parent company domicile to the Netherlands. They’re still not fascinating in 2020, when Unilever asked to scrap its dual listing and shift its parent company domicile to the UK.

A few active investors get exercised about changes of domicile meaning a loss of indexing and enforced sales, but those kind of complaints are giveaways that they’re just rentier index huggers who should be defunded. Other complaints -- protection of corporate heritage, nationalist interest, blah blah -- are all sort of sketchy. Is it really a blot on the national psyche that GVC, Glencore and Carnival have domiciles of convenience in the Isle of Man, Jersey and Panama respectively?

Anyway, Unilever has a plan B to unify its legal structure. The Dutch side’s getting folded into the UK side rather than vice versa. The reverse means Unilever can remain listed in both the FTSE index and Dutch AEX index. Vote needs >50 per cent of the NV shareholders, who are mostly big institutions, which is in contrast to the >75 per cent required from PLC shareholders in 2018. It all looks much less worrisome. Why they didn’t do it this way round in the first place is anyone’s guess.

On timing, it’s probably Brexit rather than any preparation for a large bid (though if you were really wanting to reheat the old Colgate theory, this provides a convenient platform). Here’s Credit Suisse:

The rationale for the unification is to increase strategic flexibility for portfolio evolution (including through equity-based acquisitions or demergers) and to remove complexity by creating one class of shares. It would for example be easier to demerge Unilever’s tea business that is currently the subject of a strategic review by management.

We understand the timetable is for the respective shareholders to vote on these proposals early in Q4 and (assuming affirmative votes) for the unification to complete before year-end. The proposals require a 50% majority of the votes cast by NV shareholders.

This unification is not expected to prevent Unilever’s shares continuing to be listed in NL nor change Unilever’s inclusion in the FTSE UK and AEX indices. Financial results for the group will continue to be presented in euros and for the dividend to be declared in euros.

We do not believe this a precursor to a demerger of Unilever’s food business from its HPC business (nor a precursor for a large equity-funded acquisition). However, we note that Unilever has today made a commitment to list its food business in the NL should it ever choose to demerge which we suspect will fuel speculation that this strategic option (which may be seen as a way of unlocking value for shareholders) is now ‘on the table’.

2:30pm BST - Requests below the line for Luxembourg-domiciled B&M European Value Retail, whose full-year results are in line at the headline and mixed bag below. Margins are a bit weak, expansion is a bit slow and guidance is a bit non-existent. JP Morgan Cazenove can explain:

Group sales were up 5% yoy in 2H (LFLs reported 2W ago), boosted by a strong March (due to stockpiling, adjusted LFL closer to flat in 4Q versus headline 6.6%). This was partly offset by less openings (36 net B&M UK stores vs. 41 expected, and only 30 planned for FY21) and the deconsolidation of Germany. Group EBITDA came in broadly in line in 2H, on stable margins. B&M UK margins were down c70bp yoy in 2H, mainly as a result of the mix (solid lower margin grocery and FMCG sales and the increase in the wholesale revenues), mostly compensated by a solid Heron and the deconsolidation of Germany (c€10m losses LY). Babou stores were closed for 2W in March due to COVID-19, hence the more marked losses. PBT stood at £252.0m, up 3% yoy. Cash generated from operations stood at £532.6m (2019: £423.0m), with net debt of £347.5m before the payment of the £150m special dividend in April 2020 following the sale and leaseback of the Bedford DC. Final dividend to be proposed at 5.4p p/s (FY19: 4.9p) to be paid on 28 Sep, bringing FY to 8.4p (+6.6% yoy). No guidance was provided, in line with previous years.

In quotes:

o “All our stores are currently trading and we do not have any employees on furlough under the Government’s scheme, other than colleagues in receipt of the “shielding letter” for those extremely vulnerable to the virus. We have not taken any loans under the UK Government’s lending schemes, nor are we currently paying VAT or any other taxes on a delayed basis. However, the pandemic has brought significant increases in cost of working both at a store level and in distribution. Due to the general uncertainty over future consumer behaviour and the duration of restrictions, it is currently particularly difficult to predict what the remainder of the year may be like.”

o “We have seen very strong early LFL sales in the UK businesses since the year-end of 22.7% to 23 May 2020. Excluding Gardening and DIY categories, the LFL sales performance for that period was 10.3%. We have also incurred increased costs of trading (excluding the benefit of the business rates holiday) from the social distancing measures implemented in our stores and warehouses since the onset of the Covid-19 crisis. Together with closure period losses in Babou, these costs partially offset the additional revenue from the recent surge in Gardening and DIY sales.”

o “Our strong trading performance in the B&M UK stores in the initial 8 weeks of the new financial year was boosted in particular by our Gardening and DIY categories as announced on 29 May. Much of that outperformance is likely to have been a pull-forward of sales which would ordinarily be achieved later in the first half of the financial year. LFL customer count was -28.9% whilst LFL Average Transaction Value was +72.5% over the initial 8 weeks. Whilst trading has continued to be strong in more recent weeks, the growth rate is unlikely to be sustained as Gardening ranges have sold through and stock in some other categories is now lower than normal for this time of year.”

And Barclays off the conference call:

[T]he theme was perhaps “the pandemic has been relatively kind to B&M so far, but it is very hard to know how it will be impacted for the remainder of the year”. The CEO went out of his way to stress that there are many areas of uncertainty, particularly around the effect of social distancing as the year goes on. Customers have been prepared to queue outside B&M stores in the pleasant April/May weather, but they may be much less stoical in the colder weather ahead of the crucial Christmas trading period. Equally, restrictions may be loosened by then and the issue may be less important. While the company simply does not know the extent of this problem, the CEO also highlighted some almost inevitable headwinds (upward wage pressure, limited stock availability in some categories, reversal of the strong working capital inflow from 19/20).

The FY19/20 adjusted EBITDA was a shade below our forecast and the CEO’s cautious tone was clear – so it does not seem unreasonable that the shares are weak today, especially after a strong rebound. However, we still think the medium-term picture is that B&M has a sizeable opportunity to increase its store estate and to improve its quality – and that its concept is only likely to become more attractive to consumers if the economic outlook weakens.

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