Markets Now - Monday 10th August 2020

Hot, isn’t it? Today we present exclusive analysis suggesting it’ll get even hotter. Based on the year-to-date trend, London’s peak daily temperature is projected to reach 68 degrees centigrade by next February:

Elsewhere in numbers that can be relied upon to rise into perpetuity, the halftime scoreboards look like this:

Cineworld’s rising after a US federal judge said the Justice Department can terminate the Paramount Decrees, a package of 1940s antitrust rules that restricted movie studios’ control over the exhibition process. Lifting the decree means big studios can buy cinema chains, if they like. The context here comes with reports in May and June that Amazon or maybe Netflix might buy a knackered cinema operator such as AMC — though they’re not classed as big studios so were never covered by the Paramount Decrees anyway. Remember also that AMC signed a deal in July with Universal Pictures to encourage people not to go to the cinema.

Here’s Morgan Stanley to say that none of it looks all that positive for Cineworld:

1/ We think the case for studios buying exhibitors has been weakened by the development of Premium Video on Demand. We think Covid has accelerated the maturation of the cinema industry, and with increased focus on direct-to-consumer streaming by the likes of Universal (new deal with AMC that reduced window to 17 days) and Disney (releasing Mulan on Disney+), we think the appeal for studios to vertical integration has reduced, not increased. 2/ Netflix, Amazon and Disney were not covered by the decrees, so this makes no difference here, with other (smaller) studios as the theoretical incremental buyers. 3/ Other consequence of decree - which allows “block booking” from two years’ time - is a negative for exhibitors. This will allow studios to sell their films in a package (i.e. only sell a blockbuster if exhibitors also take other (weaker) films as well). We think this further erodes the negotiating leverage of exhibitors, and while larger sites may be able to weather this better, we still see this as a negative development overall.

View: we rate Cineworld shares Underweight with a 60p price target, and a 20p bear case, which assumes a muted recovery and a derating to the low end of recent history. We think Covid has diminished the company’s capex-driven bull case and accelerated structural risks from streaming and PVOD through which studios generate superior economics.

AA’s up about 13 per cent after Sky News said Apollo Global Management was “weighing a £3bn takeover bid”. The report doesn’t specify whether £3bn is enterprise value or market cap though the latter would suggest a more than 1,200 per cent bid premium so it’s probably the former.

AA said last week that it had talked to three potential bidders -- a Centerbridge Partners/Towerbrook Capital Partners consortium, plus Platinum Equity, plus Warburg Pincus -- and Apollo’s interest “is said to be less advanced in its work than the other private equity funds.” The Times followed this morning with a report that indicative proposals were pitched at between 40p and 50p a share (or a 6 per cent premium at the bottom end on current pricing), while the Sunday Telegraph had some flagrant book-talking by Drew Dickson of Albert Bridge Capital, AA’s biggest shareholder.

“The five-paragraph soliloquy about their purportedly dire ­circumstances risked jeopardising their negotiating leverage with potential buyers. I did wonder if it was intended to compel existing shareholders to acquiesce. But we believe the AA is under no duress, is cash flow positive, and is wholly capable of refinancing its debt right now.”

Hm. This is certainly true if you ignore the nearly £1bn of debt AA has expiring in January and July 2022 (whose yield to maturity’s close to double digits with more than £80m of make-whole payments attached) which compares with AA’s free cashflow to equity of just £55m in its pre-Covid fiscal year ending January 2020. Maybe that’s why AA is also nearly definitely working on some kind of debt-for-equity swap, having said last week that any bid proposals on the table would be for the “entire issued and to be issued share capital”. Perhaps shareholders can force a bid premium from PE while speaking for ~5 per cent of the enterprise in current form, or maybe they’ll be cannon fodder. Good luck to all holders!

Capita’s up on news that it’s won an extended contract from TFL to run the London Congestion Charge, along with the Low Emission Zone and Ultra Low Emission Zone, because during a pandemic renew is easier than rebid.

The new deals run for five years from October 2021 to October 2026. Capita’s had the Congestion Charge deal since 2014, having won it in 2003 then lost it in 2009 to IBM. An extended scope -- the ultra-low emissions zone growing to cover everywhere between the North and South Circulars from October 2021, HGV safety monitoring, etc -- means Capita will hire 900 extra employees. Here’s Panmure Gordon:

The contracts are worth £355m between 2021 and 2026, which equates to around 2.0% of FY21E revenue pa. The previous five year contract had revenues of £150m, so more than doubling the size of the contract. We will review our estimates when Capita reports H120 results. We note that this continues a trend by the UK public sector to extend contracts, we think as public sector bodies focus on dealing with COVID-19.

We have a Sell recommendation. The shares are not expensive on a 2021 PER of 4.2x and we think management are pursuing a sensible turnaround strategy of investing in the better businesses and trying to sell the weaker ones. However, we think it will be difficult to improve a diverse collection of businesses, many of which face structural headwinds especially in terms of competition and market position, and that selling the non-core businesses in the Specialist Services division, which are particularly challenged, will be tough.

Ocado, the 20 year old groceries startup, is a sell at Barclays:

One of the most obvious effects of the COVID-19 pandemic on the grocery sector has been the dramatic step-up in demand for online groceries. This should be good news for Ocado, both as an online grocery retailer and as a provider of online grocery solutions to other grocers. What is more difficult to determine is whether the surge in the share price fairly reflects growth in the market opportunity. Our analysis – although we concede that it is hard to be scientific at this still-early stage of Ocado’s development – suggests that a market cap of £16bn is excessively generous, and we cut our stock rating to Underweight with a price target of 1,600p (albeit raised from 1,200p) – implying c30% downside potential.

When will Ocado’s valuation look reasonable? We have no issue with the fact that Ocado’s near-term valuation looks very high on ‘conventional’ measures (e.g. EV/EBITDA of 270x FY21 BBG consensus); after all, IFRS 15 means that the new Solutions contracts are only reflected in the P&L with a lag. However, we, and likely the market, will start to care about conventional valuation measures at some point. Our analysis suggests that it might take five to ten years for Ocado’s valuation to look ‘reasonable’ versus relevant peers (and longer if we look at P/E rather than EV/EBITDA). That might be fine if Ocado enjoyed a monopoly with respect to online grocery solutions, but there are numerous competitors that want a slice of the same pie and it is not certain Ocado’s solution will prove the most widely adopted.

Ocado’s capital intensity differentiates it from the most highly rated ‘comps’. The ‘Software as a Service’ (SaaS) names tend to enjoy the highest multiples of Ocado’s potential comps. Ocado’s business model has similarities, but the crucial difference is Ocado’s much greater capital intensity; ultimately Ocado builds things as much as it writes code. We think this will limit its ability to claim a SaaS-style rating.

Risks – in both directions: The upside risk is less that Ocado might sign more Customer Fulfilment Centre (CFC) deals in obvious markets (Korea, Germany) – in our view, this is already assumed in the share price – but more that it might enter somewhere surprising (e.g. China), find a non-supermarket customer or tweak the model (e.g. setting up multi-user CFCs). The downside risk is less that earnings will suddenly disappoint and more that competing models become more visible (as might the lengthy timescale to reasonable valuation).

Gear4Music’s upgraded at Peel Hunt. “You don’t have to feed a violin,” they observe:

It’s not a great look to be turning buyer of a stock at 500p having been a holder all the way up, but it’s time to stop being an anchor and move positive. Current trading is obviously stellar (at unsustainable levels), but our renewed faith goes beyond the short term. G4M has comprehensively shown that its new, gross profit first strategy is the right one and with the competition’s demise accelerated by C19, the future is rosy. The valuation is not dramatic for such a strong player in a steadily growing market. We switch from Hold to Buy with a new 600p TP.

Taking full advantage of structural advantage – With music shops not being classed as essential, online retailers clearly had the field to themselves through lockdown. Hard data on the overall number of instruments sold is hard to come by, but anecdotally we expect that the industry is in strong growth. It is not, however, in 50%+ growth, but that is the level of sales increase we have seen from G4M, both at home (+80% April-Ju ne) and overseas (+55%). This hasn’t been achieved with a big marketing camp aign, nor has management’s change of strategy to concentrate on profitable sales been reversed. So, the strong sales growth is profoundly lucrative.

A changing sector – Sales growth won’t continue at these levels now that bricks and mortar stores are re-opening, but the long-term trend towards online in this industry has clearly accelerated. It’s hard to make big claims about store closures without walking every High Street in the UK, as the industry is extremely fragmented, but many music retailers are small independents and the pain caused by C19 will have been fatal in lots of cases. The same trend is true in Europe as well. Of course, others who are multi- channel will have benefitted from the stronger demand through lockdown, but few will have made hay like G4M.

A short-term spike, but long-term positives are manifold – This isn’t like, say, the pets industry where someone buying a dog for the first time becomes a brand new, hopefully loyal customer for 12 years. You don’t have to feed a violin, and whilst some who have bought at the value end to test their renewed interest in participation will trade up, repeat purchases are not at the heart of the G4M business model. The bumper sales growth now is great whilst it lasts, but investors wondering about the long-term picture should be reassured by the effectiveness of the strategic rethink. G4M would probably admit to getting a little too obsessed with the top line and sought sales growth even if the achieved margin was very low. The vanity/sanity parameters have been reset, and whilst that will have a long-term impact on sales growth, it means that the achieved turnover increases will be much higher quality. We are changing our forecasts today (our old ones were incredibly stale so the % increases are not of relevance), and are just about top of the range. G4M could feasibly join the dividend list too.

Buy from Hold – The shares are still on a teens multiple and that to us feels cheap for the quality of G4M’s position and its potential for continued forecast momentum. There is more to go for here.

And Citi has a big note on “bond proxy play” Nordic insurers that turns buyer of Sampo:

The Nordics have often been seen as a relative safe haven, given their stable dividends backed by highly defensible P&C business models in mature markets. Against a backdrop of declining interest rates, they have appealed to yield seekers as bond proxies, and valuations have soared as a result. In this note, we highlight the operational resilience through this crisis, and continue to expect high dividend dependability despite the high pay-outs. We acknowledge the premium valuation of pure Nordic P&C plays (Gjensidige, Tryg, Top) but see cheaper ways to play this theme through Sampo (upgrade to Buy) and RSA (Top 3 pick).

Strong operating trends through 2Q

The ability to manage underwriting margins against a depressed investment return outlook is key. Heading into this crisis, pricing momentum has picked up particular in large commercial segments while certain names have also been successful in repricing selected retail segments. Through the 2Q reporting season so far, these trends showed no signs of slowing partly owing to the lighter lockdown approaches in the region. There is no overhang of unknown exposures such as business interruption compared to other regions. Retention rates and overall commentary paints a generally positive outlook. This puts the Nordics in a much better position compared to the global financial crisis where competition was fierce and pricing lagged claims inflation.

Better dividend dependability at Sampo

The shares have underperformed peers by c20% YTD, and its sum-of-the-parts discount has widened to c30%. This has primarily been due to the dividend drag from Nordea, but the outlook is better now (recently upgraded to Buy by our Banks team) which lowers downside risks. Nordics P&C exposure through If P&C and Topdanmark supports around 60% of Sampo’s dividend, where this is expected to remain stable. As such we see the current valuation disconnect to be an attractive opportunity. Sampo offers a c7% yield in 2021e on a c12x multiple compared to pure P&C peers offering a 4% yield at c20x. While the upside from Hastings remains to be seen, inclusion of a well-run retail P&C player improves the group’s dividend stability. We see further strategic decisions to be unlikely in the near term, but think the current opportunity offers a free optionality around a divestment in Nordea which would unlock further value.

The semi-Nordic in RSA

The Nordics operations make up half of group earnings, and the shares offer a c7% yield in 2021e on a c9x multiple. This makes RSA the cheapest way to play this theme, albeit with a relatively lower safe haven appeal. Despite what appears to be good underlying business performance as reaffirmed at 1H, potential UK Business Interruption (BI) losses continue to weigh on the shares. It has underperformed UK non-life peers by c30% YTD, with its current sum-of-the-parts discount of c50% at all-time highs. Unlike the Nordics, it has more headroom for dividend growth through operational improvements at certain segments (e.g. Denmark) and its pay-out ratio (currently 60%).

• Updates follow, influenced or otherwise by requests and complaints in the comment box. A number of AV Telegram group chats are also available.