Stockwatch: A 'tantalising' share

Is a near "double-bottom" in £430 million discount retailer Poundland worth backing? Being an actively traded FTSE SmallCap may contribute to volatility, but the chart since flotation in March 2014 shows a semblance of having formed one.

After plunging briefly below 140p in response to quite disappointing news on 14 April, the stock rallied firmly to about 175p, a level that could be seen as short-term resistance. Chart-focused traders will be interested to watch if another move up affirms a double-bottom, but meanwhile - what of the fundamentals?

Another sour lesson in private equity flotations

The stock's debacle from a 300p flotation price in March 2014 and a 420p peak a year ago affirms scepticism of "revolving door capitalists". Poundland started in 1990, its founder selling his stake for some £50 million and US financier Warburg Pincus buying the business for £200 million in 2010, then raising £142 million by selling half its stake to 16.4% in early 2015 when Poundland acquired 99p Stores. As with Debenhams, the cynical view is that this reflected quite a culture of wheeler-dealing to enhance progress and exact gains, leaving long-term shareholders with the risks.

The financial summary table shows good revenue growth and, broadly, an expansion of profits, but such a general high street retailer has become challenged to sustain the kind of growth expected by the stockmarket. Online sales were only introduced last autumn with delivery costing £4 unless you spend over £50 on £1 items - not exactly a compelling retail formula.

The February 2015 acquisition of 99p Stores Ltd for £55 million is now characterised as "mainly a property deal" to grow the Poundland estate. After the trading losses from 99p Stores proved worse than expected, management has had to achieve a 15-months' refurbishment in four months.

The latest update comes across well, excepting "a tough quarter for the core business" and like-for-like sales down 4.9% over six months to end-March. Analysts downgraded in response and there is also concern (e.g. from HSBC) over how the actions and investment needed to stabilise 99p Stores have compromised cash flow - such that the group now has net debt.

Aspects of this should improve with changes in working capital, but it poses questions for the extent of prudent dividend growth in the short term, up from 1.5p per share, on which a prospective yield of 3% is based.

The table shows very strong cash flow (from which dividends are paid), albeit historic figures. The 2017 price/earnings (PE) multiple may only be about 12 times, but that assumes record profitability; for the financial year just passed, the PE could be over 20 times. Without any margin of safety in key valuation metrics, the stock is, therefore, sensitive to news flow.

New CEO adds £574,782 worth of stock

Amid a steady trend of director/senior manager buying, the trade that stands out is the chief executive designate adding 321,107 shares at 179p in March, to own 340,000 overall. Kevin O'Byrne ought to have decent judgment of retail businesses, having been a director both of Dixons Retail and Kingfisher - latterly as CEO of B&Q.

Mind how cash purchases by CEOs may later appear to involve "cost-averaging" when a board makes sizeable share option grants, but it underlines his belief in Poundland's potential - and, by implication, the medium-term synergy benefits of the 99p Stores' integration, as implied by brokers' forecasts for the 2017 year.

Weighed against this are general uncertainties for high street retail when Poundland has plenty of further challenges, e.g. a rollout of stores in Spain (under the Dealz brand) and a new multi-price approach. Also, the group is quite operationally geared, meaning variations in sales have a greater effect on profits.

It all makes for a wide range of analyst targets, from Haitong Securities, which lately cut from 140p to 130p per share, to others over 200p and Peel Hunt (which is not the company's broker) looking for 300p (albeit downgraded from 400p).

The defining issue being: when can a turnaround show better traction? And is the 99p Stores' acquisition genuinely transformational for the group's reach, or adding to challenges in a tough retail environment? The verdict won't be apparent for a while, the next update being mid-June prelims, so the stock is presently fluctuating on hopes.

EU Referendum and dividend decision will be influential

More positively, if the new boss can demonstrate in June that he is getting to grips and this coincides with a "Remain" vote in the EU Referendum (to my mind the likely scenario, which would benefit UK retailers as importers, on the basis sterling rises), then the stock could get chased up like it has been from about 140p.

Prelims will need to affirm dividend expectations, otherwise a circa 3% yield looks modest compensation for the marketing risks, should Poundland remain squeezed by supermarkets' efforts to discount items e.g. in "value/essentials" ranges.

The cash flow statement at interims cited an improvement in net cash from operations to £17.5 million, albeit after significant changes in stock and trade payables, while pre-tax profit fell 43.5% to £5.3 million. The end-September balance sheet had £72.1 million cash versus only £6.0 million debt, implying the position has changed radically, if HSBC is correct to assert the heavy investment required to deal with 99 Stores implies net debt.

Poundland, therefore, remains a risky turnaround which will evolve according to the CEO's actions and wider context. Meanwhile, its chart tantalises with a bullish double-bottom from about 175p.

So 'buy' if you trust chart indicators and see the price building on 175p, or - if you are cautious - then await more evidence of fundamentals in June. It will be an interesting test as to which approach holds sway in the current market.

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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.