Markets Now - Monday 13th July 2020

G4S has a whole “controversies surrounding . . .” Wikipedia page. Weighing in at ~7,000 words and with 84 references, G4S’s Wiki “controversies surrounding . . .” rap sheet is longer than the ones for the Legion of Christ and Grand Theft Auto V, though not quite as long as Silvio Berlusconi’s.

But, Mr Berlusconi having recently been decommissioned, G4S can still catch up. At the time of writing for instance, its Wiki entry on tag fraud was last updated in 2014 so will need some attention, because:

G4S has agreed to pay a £44m fine over its contract for electronic tagging of prisoners as the UK’s Serious Fraud Office said the outsourcer had “repeatedly lied” to the Ministry of Justice.

The SFO on Friday said G4S Care and Justice — a wholly owned subsidiary of G4S that has accepted responsibility for three cases of fraud — had misled the government about the true extent of profits earned between 2011 and 2013 for the prisoner tagging contract. 

The deal draws to a close the bulk of the SFO’s seven-year investigation into G4S and Serco over tagging contracts after Serco agreed to pay a £19.2m fine last year to settle three offences of fraud and two for false accounting between 2010 and 2013. 

Shareholders always like the idea of things drawing to a close, so G4S is up 10 per cent or thereabouts. It helps also that according to the BBC, G4S is preferred bidder on Wellinborough “mega prison” -- worth about £300m over 10 years -- which suggests the government’s approach to contract tendering remains Homeric. A third positive comes via a short, unscheduled trading update in which G4S says it “has continued to deliver a resilient trading performance during June” so expects first-half results to be “significantly above market consensus”. Here’s Bank of America:

We had modelled £40m in our estimates and our sense is investors were factoring in £40-50m. The fine is as expected, however we believe this removes a long-standing overhang for the business.

... [W]e think that the news . . . is a step towards abating concern around: 1) Cash generation: we expect this to improve in coming years "one-off" cash items (eg. SFO fine) reduce; and 2) Negative earnings surprises: We believe that the refined and simplified portfolio will now yield lower earnings volatility and perhaps higher visibility.

And Panmure:

we think that security should prove more defensive than other industries, as it has done in previous recessions, especially on the Secure Solutions (93/89% of revenue/EBITA in FY20E) side. Security has been deemed by most governments to be a key role and therefore activity is likely to have continued. We think Cash Solutions (7/11% of revenue/EBITA in FY20E) will have been more impacted during the pandemic as it will have been affected by the closure of the retail and hospitality sectors in many countries. For Cash Solutions, longer-term we think the pandemic could create structural headwinds by both accelerating the shift from physical to on-line shopping, which does not need cash, and from shoppers and consumer outlets being reluctant to use cash, as we see from the rise in outlets only accepting card payments. At least post the sale of much of the cash division to Brinks earlier this year the proportion of G4S’s results from this division has reduced considerably, from the previous 14% revenues and 24% profit.

And RBC:

G4S has a strong market position in an industry with some structural drivers and enjoys a competitive advantage from its ability to integrate services and from its technology capabilities. We continue to believe the group needs to be more operationally focused and to get overall gearing levels down over time. However, there are some good businesses within the group and medium-term growth prospects look robust, whilst we expect COVID 19 to have less of an impact than for many. We believe the stock remains too cheap on SOP and cashflow based valuations.

Valuation – 21E PE 8x, FCF Yield 7%, Div Yield 4.9%

What else? Causeway Capital Management LLC, the LA hedge fund, has declared 4.88 per cent of Micro Focus. Causeway’s a global value hunter rather than an activist, having big positions in the likes of BASF, Takeda and Volkswagen, so the disclosure probably says very little about whether Micro Focus will be able to sell itself either piecemeal or as a whole.

Ubisoft’s in a bad place. Libération published a detailed story on Friday all about “moral and sexual harassment allegedly committed at the highest level of the company”, which developed on reports along a similar theme from the start of the month.

On Saturday Ubisoft said its (right-hand man to the CEO) Chief Creative Officer and the Managing Director of its Canadian studios were out, effective immediately, and the search was on for a new Global Head of HR. CEO Yves Guillemot has taken over as CCO and will “personally oversee a complete overhaul of the way in which the creative teams collaborate”. The company has also reiterated that it’ll bring in “a top international management consulting firm to audit and reshape its HR procedures and policies”. The creative director of its Splinter Cell and Far Cry franchises resigned earlier in the month and the VP Editorial and Creative Services was placed on disciplinary leave.

A sidebar to all this is the “Ubisoft Forward” presentation over the weekend, which was meant to compensate for the lack of the E3 trade show this year. There was no real news though (apart from a reveal of Far Cry 6 that had already been leaked to the trade press) so there’s not much in the way of distraction from the sex story. Here’s Morgan Stanley:

The details of the allegations are worrying and appear to reflect poorly on the culture at the company, its internal processes and its lack of senior diversity. The action taken by the company over the last two weeks has been swift. It remains to be seen how quickly they can change the culture, particularly in the studios in Canada.

We do not believe the departures will have an impact on the performance of the company this fiscal year – in particular on 5 games scheduled for release, given how close they are to launch and the deep bench of creative talent at the company.The key question at this stage is whether we have heard the full extent of the issues at Ubisoft’s Canadian studios, or elsewhere at the company. Any company with nearly 16,000 employees should be able to withstand the departure of two senior executives, but, although unlikely, there is a risk that management focus on the issues raised in the past two weeks could have some impact on the development process for Ubisoft’s pipeline for fiscal 2022. The initial market reaction, which has reduced the market capitalization of the company by ~€800m this morning, seems disproportionate to the likely commercial impact, in our view.

Meanwhile, SocGen goes from “buy” to “hold” on Ubisoft on valuation grounds without really saying much:

With less than 10% upside potential, we cut our rating to Hold. Our EPS estimates remain unchanged, however, there may be new challenges from the recent personnel changes (especially in the key role of Chief Creative Officer)

Over in sellside, Jefferies has a big E&P review out. Enquest and Aker BP go onto the “buy” list “as the levered cashflow winners”. There’s a rejig of forecasts on a Norway tax break and a bit of fantasy M&A, which seems to be obligatory in E&P notes at the moment. Lundin and Serica Energy are also upgraded with Tullow and Cairn remaining on “underperform” and most other things are “buy”.

The charts are good:

Norway’s amended tax terms materially increase AKERBP & LUNE cash netbacks to the point that free cash flow in the next few years will now be higher than pre-COVID levels, even at oil prices almost $20/b lower. Norwegian government support for the oil industry is nothing new, but the materiality impresses even us and once again underlines the low-risk element of Norway E&P investments (if they have quality assets). It also increases the optionality to grow dividend returns and/or pursue inorganic M&A growth opportunities. Upgrade LUNE & AKERBP to Buy using 4.5x 2021/22 EV/ EBITDA alongside Total NAV.

UK North Sea - Shut it in, high-grade the portfolio. EnQuest’s cash netback lead among UK E&P’s has improved further as yet more legacy high-cost fields are shut-in permanently. This high-grading of portfolios is the long-overdue positive side-effect of the 2020 oil price downturn, with ENQ the main beneficiary. For the first time ever, we upgrade ENQ to Buy, expecting interim results to confirm more stable Kraken field performance and with our net debt forecast sitting 12% below consensus. Our upgrade uses 3.5x EV/EBITDA & Total NAV.

Tullow Oil - We came, we looked, we agreed. At the opposite end of the spectrum, we examined our Tullow Oil cost assumptions in some detail with the company but ultimately make no changes, keeping our view of negative cash margin next year. Retain Underperform using 4.0x EV/EBITDA & Total NAV. . . . .

Precedent M&A suggests assigning EV/EBITDA multiples in a range of 2.0-4.0x but with a premium for companies in a high-capex cycle of development growth (CNE, LUNE pre-Sverdrup first oil) or with sustainable asset quality of IOC-like quality (LUNE, AKERBP). There appears to be a floor to valuations in the 2.0-3.0 range as even growth-challenged companies can receive an offer (OPHR), but North Sea assets, outside of obvious standouts like Johan Sverdrup, appear to struggle to reach a 4.0x level. However, solid operational delivery and growth expectations appear to be worth that in West Africa (SEPLAT deal for ELA at 4.1x). Using this framework we apply our highest EV/EBITDA valuation multiple of 5x to Cairn Energy, CNE LN to allow for the company being in a development cycle of high capex/negative free cashflow for the West African, offshore Senegal, Sangomar development.

Barclays starts coverage of Fevertree with “overweight” and a £25 target. Except it doesn’t. The note refers to Fever-Tree at least 366 times. That’s the name of the product, not the PLC. The company’s actual name, Fevertree no hyphen, only turns up half a dozen times, mostly in charts, suggesting either that Barclays thinks £25 is a fair price for tonic water or it should hire a research editor. Whichever, here’s the upshot:

We see long-term best-in-class growth driving strong double-digit earnings growth that warrants Fever-Tree’s large premium to EU Staples and supports our OW rating.

Long-term growth: We forecast Fever-Tree to grow over 15% per year on average over the next five years, driven by the US and RoW divisions. We forecast the US and RoW to make up 57% of the group’s sales by FY25. Recent US price repositioning and expected SKU expansion give us confidence in strong double-digit sales growth over the coming years. Whilst the RoW division is small currently, we forecast it will provide strong longterm growth through premium spirit and mixer expansion in Australia, Canada and beyond. Growth has been driven by the UK and Europe over the last five years and has averaged c.50%; we forecast these divisions to grow LSD & MSD, respectively, as the markets mature. The outsourced production model gives considerable ‘plug and play’ potential and limits fixed-cost downside leverage.

Versus consensus: Fever-Tree reports H1 results on July 23, and we are in line with BBG consensus EBIT through our modelling of closures by category and country, incorporating Nielsen data. We model the on-trade at zero for six weeks (less in Australia due to a less severe outbreak) and incorporate the positive off-trade data. For FY20E, we are 3% ahead of consensus sales. We model GM compression of -130bps due to a further impact from rising glass costs. Maintaining opex at similar levels to last year, in line with guidance, results in a FY20E EBIT margin of 24.3% (-340bps YoY) and puts us at the top of the FY20E consensus range.

Valuation and scenarios: We use a DCF model with an 8.6% WACC and 4% terminal growth to derive our 2500p price target. We model an upside scenario of premium mixer take-off in the US, plus RoW uplift from increased premium spirit consumption, driving accelerated growth into the medium term. In our downside scenario, we reverse this, with limited share gains / category growth in the US, Australia and Canada.

Bank of America upgrades Legal & General to “buy”, mostly on valuation:

We upgrade Legal & General to Buy from Neutral as the stock has fallen 16% from its peak on 9th June (at which point we took a more cautious stance on the sector). Further, it has underperformed the sector by around 10% over this period. We now see 33% total return potential despite trimming our sum-of-the-parts based price objective to 265p from 270p to reflect recent debt issuance.

Legal & General offers an 8.6% 2020E dividend yield. We think this is a particularly appealing proposition in a market starved of yield. Further, we think that the regulatory risk to the dividend is low. L&G and its UK life peers were broadly allowed to pay dividends at FY19. Further, the UK regulator’s recent stress tests commentary suggest limited risk for life companies.

L&G's business is broadly resilient to COVID-19 shocks, in our view. The credit portfolio remains strong (with limited downgrades and defaults so far). Further, its annuity portfolio could (morbidly) benefit from higher mortality at higher ages and its protection portfolio is likely to see only limited impact (largely working age population).

Credit uncertainty remains the greatest risk for UK life insurers, including L&G, with COVID and Brexit both likely to exacerbate credit concerns. However, we believe this is reflected in our forecasts, which include £1.2bn of credit default losses over 2020/21E. And at our price objective the stock would trade on just 7.2x 2022E earnings, with a 6.9% 2020E dividend yield; these remain historically attractive levels.

JP Morgan -- Jupiter’s corporate broker and joint advisor on its not very popular recent deal to buy Merian -- says to buy Jupiter. “Overweight”, December 2021 target of 300p.

Jupiter’s share price declined by 40% YTD underperforming the European listed AM by 29%. We estimate Merian AUM at end June 20 of £16.8bn (vs. £15.7bn, Mar 20 and £22bn, Dec 19), and we estimate FY21 EPS estimate of 23.3p which incorporates 15% EPS accretion from the Merian deal. Jupiter shares are trading on FY21 PE multiple of c10.5x, a c25% discount to the sector which we believe is not warranted as this implies excessive further net outflows and considering historically Jupiter has traded in-line with the sector. The shares offer an attractive dividend yield of c7% vs. sector average of 4-5%.

 Jupiter Q220 net flows turn positive after 9 quarters of outflows. Following 9 quarters of consecutive net outflows we estimate Q220 mutual fund net inflows of +£0.4bn, with a recovery seen in funds such as Dynamic Bond fund. Whilst maybe too early to call a trend the inflexion is encouraging, in our view.

 Merian net outflows persist but are concentrated. Based on Morningstar data, we estimate Merian funds have seen H120 net outflow of c£4bn of which £1.7bn we estimate was from the GEAR strategy. The GEAR strategy had net outflows of £6.2bn in 2019, however the future drag should be limited as remaining GEAR AUM is c£1bn. Morningstar rankings indicate that Merian’s fund performance has improved recently, which combined with a reduction in uncertainty may help reduce net outflows.

 FY21 EPS deal accretion of 15%. We estimate FY21 EPS of 23.3p incorporating c15% accretion from the Merian deal. We estimate Merian AUM of c£16.8bn, June 20 (vs. £15.7bn Mar 20) and assume Merian achieves a c45% operating margin in FY21. We estimate a 5% increase in operating margin adds c4% to FY21 EPS.

 Sensitivity to further net outflows. Our estimates assume Jupiter sees further net outflows in H220 of -£1bn and flat flows in FY21. As a sensitivity every additional £5bn of net outflows in 2021 reduces our FY21 EPS by c9%. For Jupiter to trade in-line with the sector average, would need c£15bn of additional net outflows.

 Valuation. Jupiter is trading on FY21 PE of c10.5x, a c25% discount to the European asset management sector, whilst Jupiter over the past 5 years has traded in-line with sector. Our Dec-21 TP of 300p is based on applying a 10% discount to the sector multiple.

JPMorgan’s also pushing Ryanair. They reckon investors should be fine looking to post-Covid Y+3 by which point Ryanair, being Ryanair, will have exploited the circumstances ruthlessly:

With COVID-19 infection rates falling in the major European countries and airlines returning capacity to service, airline stocks have meaningfully bounced from their April lows. However, significant risks remain: a potential return of COVID-19 across Europe, with unpredictable government responses; the likelihood of large losses in the winter season; and a weakened European economy. Against this backdrop, we see RYA and Wizz as the most attractive European airlines. Both have strong balance sheets, can grow through expansion and market share gains, and will use the current crisis to cut costs. We upgrade RYA to OW and we reiterate Wizz as OW.

 Ryanair - Upgrade to OW (Dec-20 PT of €15.3): RYA is clearly a longterm winner in European aviation with its fortress balance sheet and ultralow costs in our view. We believe it will use the current crisis to negotiate better terms from airports and, potentially, to place a major new order with Boeing at a very attractive price. Using the current forward fuel price in our model we forecast a YE Mar 23E EBIT margin of c20%, similar to the margins RYA achieved from YE Mar 15 to Mar 18.

 Wizz Air - Reiterate as OW (Dec-20 PT of €41.5): We continue to see Wizz as a core holding for European airline investors. Despite the huge disruption caused by COVID-19, Wizz’s long-term structural growth story is unchanged; by YE Mar 23 we expect Wizz will carry 18% more passengers than in YE Mar 19A. With its ultra-low costs and the benefit of lower fuel prices, we expect Wizz to return to robust double-digit margins in the next financial year.

 easyJet - Neutral (Dec-20 PT of 760p): EZJ entered the COVID-19 crisis with weaker liquidity and lower margins than RYA and Wizz. Management has taken important actions since March: deferring £1bn of capex due in the next three years; raising c£2bn of debt financing and £419m in an equity issuance; and launching a major cost-savings plan which includes a 30% headcount reduction and plans to shrink/close underperforming bases. If EZJ can succeed in meaningfully reducing its costs this should lay the foundation for better future profits. However, the mid-point of EZJ’s new fleet plan suggests that in YE Sep 23 it will have 9% fewer planes than in YE Sep 19A; we believe this lack of medium-term growth makes the equity story less attractive than that of RYA and Wizz.

 EPS housekeeping: With this report we make significant EPS revisions (Table 2), but as this is our first COVID-19 update on European Airlines we are mostly catching up to market conditions. We believe investors will largely look through FY1 and FY2 earnings due to COVID-19, focusing on the “normalised” earnings of FY3. Per Table 3 we believe that in YE Mar 23E RYA and Wizz can beat consensus earnings and achieve PTP margins above the margins they achieved in YE Mar 20A.

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