Stockwatch: A high-profile speculative buy

Developments around Home Retail Group, the FTSE 250-listed owner of Argos and Homebase, shows just how tricky stock-picking has become as deflation spreads. It can be seen on stockmarkets as investors turn risk-averse and companies warn of falling revenue amid weaker prices and demand.

Royal Bank of Scotland has joined renowned bearish Société Générale strategist Albert Edwards in warning that a recession is inevitable, so "dump stocks now".

Indeed, Home Retail's latest trading update reflects a challenging picture, with like-for-like sales at Argos (83% of group operating profit in the year to end-Feb 2015) slipping 2.2% over 18 weeks from 30 August to 2 January. Within this, performance contrasts markedly; for example, store sales fell 13% in December while digital sales rose 10%. Homebase enjoyed 5% revenue growth thanks to kitchen and bathroom products, but altogether full-year profits are indicated to be at the bottom end of a £92 million to £118 million range.

Such a "below expectations" outcome explains why I have been quite cautious on Home Retail lately, despite respecting the strengths that powered it from 70p to over 200p in 2012/2013. Yet management proclaims "meaningful progress reinventing Argos as a digital retail leader" - hence the takeover interest from Sainsbury's.

Odds on a higher bid

It's in just such glum times that industry can seize low stockmarket values, but at least one institutional shareholder has warned that Sainsbury's will need to significantly increase its takeover offer "to reflect all the hard work and investment that has been made in the transformation programme".

While Sainsbury's contends a clear rationale for integrating Argos, a chief risk has been the uncertainty of divesting Homebase (affecting both the price and structure of any offer). This is now removed after Home Retail affirmed media speculation that it's in advanced discussions to sell Homebase to Australia's Wesfarmers for £340 million.

Remarkably, a firm offer was made for Homebase in November, shortly after Sainsbury's approach for the group, but the board hadn't seen fit to disclose all this until now: in both cases, responding to a soaring share price and media reports.

Anyway, the future is all that counts and Home Retail is being de-risked, enabling management to better focus on the Argos turnaround - also for Sainsbury's to more easily revise its offer. Making presentation rounds in the City of London, the supermarket's management appear in favour of making a higher offer unless enough institutional shareholders insist against it.

Special dividend

Relative to a current share price of around 150p, the last interim results showed net assets constituting £2.7 billion, or 328p per share; and goodwill/intangibles of £873 million, or 107p per share. Analysts at Cantor Fitzgerald just recently contended a break-up value of over 260p a share, in part due to "one of the strongest balance sheets in the retail sector with cash forecast at £292 million this February, mail order debtors of £580 million and relatively high provisioning" - the cash balance plus debtors equating to 106p, they reckon. No value for Homebase is implied in such calculations, they say.

The 13 January news confirming interest from the Aussie owner of the Bunnings DIY chain indicated the proforma cash and loan book at about £904 million, slightly better than this forecast, although the forward earnings picture is quite complicated e.g. by exiting Argos concessions currently in Homebase. It implies a range of forecasts, but investors will need to be patient in waiting for Sainsbury's to cut through this uncertainty with clear offer terms. They're speculative and depend on the supermarket's own projections, but the near-term prospect may be about 30p upside in the region of 180p, against a drop in the order of 20p if Sainsbury's backs off.

Downside risk will be limited if more focused action with Argos can bear fruit, also considering Home Retail's declared intention to return some £200 million to shareholders - i.e. near 25p per share, a 16% special dividend equivalent. This would be possible after spending £75 million on total costs for ceding Homebase and making a £50 million contribution to the pension scheme (which last August was in £100.5 million deficit), retaining £15 million.

Existing shareholders should therefore sit tight, as the payout prospect ought to mitigate near-term downside risk of Sainsbury's walking. The chief risk of Home Retail staying independent is whether Argos can genuinely be turned around or shareholders will be left in uncertainty amid a deteriorating UK consumer environment. If worse news emerges for UK retail and the wider economy in January, this could tip sentiment in favour of a renewed Sainsbury's offer.

All this makes Home Retail an interesting, speculative 'buy', even if the stock does drop with Sainsbury's in retreat. If speculative positions were to exit, value relative to net assets and a special dividend could emerge. Mind that this is no tuck-away stock, more one for alert long/short traders.

Ignore the noise

Words on Home Retail would not be complete without a mention how the reporting of hedge fund trading can contribute to market bias. For example, on 12 December reports highlighted that Crispin Odey was short Home Retail "because Argos is a working class brand". Well, Sainsbury's appears keen enough to want more "working class" shoppers. Similar pieces have appeared regarding Sports Direct: on 8 January it was reported that Crispin Odey had slashed his stake in Sports Direct... "I've seen the writing on the wall, I've lightened my load."

Then, on 13 January, The Telegraph led with: "Sports Direct investor Crispin Odey ups stake to 5% on back of share price fall."

Who benefits from this? Not smaller investors, if their sales enable bigger traders to buy back more profitably. The true message is very clear and will become vital, should profit warnings increase generally: don't be swayed by "noise trading/reporting", focus on the underlying risk/reward profile in stocks.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.