Edmond Jackson's Stockwatch: Buy if you reject deflation scare

This autumn has meant tricky news for weighing up stocks. In early October, weak macro-economic signals upset markets that are broadly exposed after a five-year boost from quantitative easing (QE). Then US companies declared robust profit and revenue growth for the third quarter of 2014, re-kindling excitement: Wall Street is re-testing highs. Another wave of quantitative easing in Japan has also kept the party alive and there is talk of a "Santa rally". Yet the essence of equity values derives from companies reporting, which is why it is useful to keep tabs on cyclicals as canaries in the coalmine. 

Market is pricing shares for increased risks

Premier Farnell, a distributor of small electronics and electronic parts, is a good example: the five-year chart for its Mid 250 shares is volatile-sideways, chronically disappointing in the wake of the 2008 financial crisis. A compensating feature is the market pricing Premier shares to exact a generous yield for their risks, about 6.5% prospectively.

This has risen from 5.7% after the shares dropped from 180p near to160p after a third quarter 2014 update gave a mild warning on the operating margin and cited "softer market conditions in Asia and Europe." Understandably, investors read a profit warning between the lines. You can see from the table how analysts have been more optimistic than the market, with expectations for a flat financial year to 3 February 2015 then a double-digit annual advance in earnings per share. The market is clearly more pessimistic, as if 2015/16 downgrades will follow. 

Cash flow has a robust profile

Notice how the record of cash flow per share - which pays the dividends -has been robust relative to earnings (except for 2013/14) and capital expenditure. Also, in Premier's first-half 2014/15 year, net cash generated from operations jumped from £12.2 million to £21.2 million, like-for-like.  Forecasts in the table have yet to be amended, where earnings cover was projected at 1.4 to 1.5 times; so unless the board has a fixed objective with this ratio the dividend should not be at high risk of a significant cut. 

The tactical game with cyclicals is guessing when the market is pricing these shares over-cautiously for future risks, so not only do you lock in an attractive yield, you also benefit from capital appreciation when the stock re-rates to price the yield more appropriately. In part, this involves evaluating a company's longer-term dividend and cash flow record, i.e. the downside risk to Premier's dividend looks limited unless there is a serious recession. 

Two years ago, lots of quality cyclicals were priced low as markets feared chaos in the eurozone and a double-dip recession, yet 2012 company reporting proved these worries excessive.  The worst-case scenario is Asian/European deflation gripping more severely, and is why Premier's warning is significant for investors generally.  Yet fear is also helpful to equity buyers, so best keep objective. The shares' being down at 162p implies European and Asian macro indicators worsening, but if QE follows to stave off serious deflation then Premier's pricing is already a medium-term low.

Asia-Pacific is biggest risk

Management explains its shortfall as due to geographical factors and the product mix: slower growth in high-margin Asia-Pacific and acceleration in low-margin North America.  In the last financial year, 47% of revenue was derived from the Americas, 24% United Kingdom, and 29% rest of Europe and Asia Pacific.

While the US economy is a relative success story, if deflation continues to spread in East Asia then it will compound debt problems there - excluding Japan, Asian debt is estimated to have risen from 147% to 207% of GDP over six years. China is the chief risk with total debt now reckoned around 250% of GDP, and falling prices there are increasing the risk of debt defaults. If China cuts interest rates to cope, it could tempt beggar-thy-neighbour currency devaluations i.e. potentially a repeat of the 1997 Asian financial crisis that raised fears of contagion and recession. Quite what could be the impact in Europe as it struggles on under the single currency; whether China will assume a hegemonic role like the US did in 1998, or simply pursue its own interests.  Be aware, Premier’s is no small irrelevant warning! 

Electrocomponents has also cautioned about deflation

On the day previous to Premier reporting, peer Electrocomponents said with its interim results that its gross margin was down 0.7% - likewise as a result of its product mix, also increased discounting in the UK and Asia Pacific. Electrocomponents has quite a similar product profile and five-year share price chart as Premier, although forecast earnings cover for the dividend is slightly keener at 1.2 to 1.3 times. If forecasts can avoid a serious downgrade then its stock is also in a buying range; but if deflationary indicators worsen then the market will continue to exact a high yield (about 5.75% with this stock at 205p).

Premier is the more geared company, with financial gearing near 200% versus about 40% for Electrocomponents.  Premier's interim results showed net finance costs of £6.7 million versus £43.1 million total operating profit - so it should withstand a downturn, but its circa £280 million debt further explains market caution. The balance sheet also has very little by way of net tangible assets.

Currently a risky "buy", but eventually Premier shares will improve

Hopefully you appreciate from this piece, why the market is treating Premier quite severely. Yet it remains a well-established company with a good overall financial record i.e. the kind of share to buy when sentiment is against. If you believe the deflation story is scaremongering quite like "24 hours to save the euro" nearly two years ago, then start to average in, otherwise keep Premier on your watch list.  Its higher gearing relative to Electrocomponents, further guarantees a bounce from a medium-term low.

For more information see: premierfarnell.com.