Interactive Investor

Stockwatch: An early-stage 'buy for income'

21st February 2017 09:27

Edmond Jackson from interactive investor

Is it time to buy plunging mid-cap retailer Pets at Home, the biggest UK supplier of pet products and services?

It floated two years ago at 245p and had fallen to 167p by autumn 2014, then rallied to 311p by summer 2015 only to start a major bear leg down to about 185p currently.

US hedge funds are short selling which has risen to 4.4% of the issued share capital since a 19 January trading statement cited flat like-for-like revenue, with the merchandise aspect - pet food and accessories - static at £177.4 million despite new openings. Revenue from services - vet practice and recently acquired referral centres - jumped 47.8% to £26.3 million.

This third-quarter period (October to December) followed an interim report citing like-for-like growth up from 1.8% to 2.5%, albeit softer in Q2.

Beware flotations after US private equity involvement

Hopefully, you would have been sceptical and avoided this stock to date - Pets at Home has had two US private equity owners and characteristically became debt-laden albeit on a reducing trend from £413.9 million as of March 2013.

A Cayman Islands company owned by Kohlberg Kravis Roberts still owns nearly 20% of Pets, so they partly still eating their own cooking. Debenhams (DEB) was one of the worst examples of US private equity barons exiting a business set-up it still struggles to recover from.

The question here is whether private equity has set Pets on an ambitious roll-out leading to over-capacity. Consumer confidence faces the test of incipient inflation just as management says it is on course to open 15-20 superstores, 45-55 vet practices and 50-60 grooming salons, in its current year to end-March.

Short sellers are gathering

Another type of buccaneering American trader – hedge fund short-sellers – is currently positioning in Pets, with four disclosed positions over 0.5% all having increased since the Q3 update, representing 4.4% of the equity.

We saw with Home Retail Group, short sellers don't necessarily get their trade right, although I drew that to attention after it had become one of the most shorted stocks with some 20% out on loan. Carillion (CLLN) presently has 23.5% on loan, which is so far proving astute for borrowers who have sold.

You have to be sure of judging a business better than shorters in the hope a crowded trade will enhance any rebound as they buy back – a short squeeze. That could be some way off, though, and hedge funds continuing to gather around a new target can exacerbate technical weakness as they borrow stock and sell.

Falling between two stools of growth and income

The essential dilemma is Pets at Home being perceived as going ex-growth, but yet to offer sufficient yield to tempt income investors; hence its stock de-rating to exact a higher yield as the constituency of shareholders changes.

Also, high street retail is under pressure from online growth, higher business rates and the minimum wage. The table shows estimates as of 20 December 2016 by Numis Securities, company broker, for effectively flat earnings (considering inflation) and a potential dividend yield of about 4%. That's twice covered by earnings, albeit with a strong track record of cash flow with seemingly less by way of capital spending needs.

So, in principle, Pets has good potential as an income share. Household pets are immensely popular in Britain and the group also provides veterinary services bolstered by widespread insurance schemes.

The dilemma is a management/board with expansionist mentality whereas a shareholder perspective might be to temper this – especially if consumer spending softens – and raise distributions. Earnings growth of 3% achieved with acquisitions (possibly the best-case scenario) won't attract growth investors; Pets at Home must re-orientate for income.

On that basis, if a 5% yield is deemed more appropriate then the stock is heading nearer 150p. I suspect this is part of the short sellers' rationale, how they are reading market change.

Balance sheet appears less than supportive

When a share de-rates its balance sheet also comes under closer scrutiny as investors look for props. The table shows negative net tangible assets per share, if down from -44.9p to -26.0p, the last interim accounts citing £857.5 million net assets of which £988.6 million constituted goodwill.

Note 8 asserted: "the goodwill is considered to have an indefinite useful economic life...its total amount recoverable for the group's cash generating units...is greater than the carrying amount and therefore no impairment charge has been booked in each period."

If you want to trust this, the net asset value works out at 171.5p per share, but many portfolio investors will be concerned at the extent of goodwill – its only proof being what a trade buyer may offer.

There's £212.2 million longer-term debt, part of a £260 million revolving facility, although a £2.7 million interim net interest charge was covered 18.3 times by operating profit. I'd point out a 13% rise in trade payables to £175.3 million, not as much as a 16.3% jump in trade receivables to £63.5 million, but the imbalance comes across as if Pets is enjoying credit off others.

Moreover, it tilts the current ratio slightly negative at 0.97, which may not be such a worry with cash up from £28.4 million to £42.2 million, but, again, it's not what investors want to see.

So where's the anchor for value?

My sense for interest in Pets at Home is it being a worthwhile retail business with a strong cash profile for dividend growth. Interim net cash from operations rose 24.3% to £60.5 million even if enhanced by the increase in trade payables.

The next trading update won't be until later in April, then prelims late May. The finance director was awarded nearly 200,000 options at 212.8p last November, although such grants are inherent to remuneration packages so I wouldn't read any value assumption into this.

On 10 February a non-executive director added 5,673 shares at 188.6p to own 30,000 in total, which represents belief in value, although he could also be averaging down.

Overall, Pets at Home is an early-stage "buy for income" because the market will await more evidence on like-for-like revenues, which may weaken. Beforehand, if the stock continues to fall nearer 150p against reasonably firm UK consumer spending, it's potentially worth starting to accumulate.

This stock is moving towards a useful inflection point and income; the challenge is timing.

Pets at Home Group - financial summary     Broker forecasts
year ended 31 Mar2012201320142015201620172018
        
Turnover (£ million)544598665729793
IFRS3 pre-tax profit (£m)25.626.522.587.092.1
Normalised pre-tax profit (£m)25.832.733.287.093.096.297.9
Operating margin (%)12.19.99.512.211.1
IFRS3 earnings/share (p)4.5-20.0-13.814.414.5
Normalised earnings/share (p)4.5-15.3-7.714.414.615.115.6
Earnings per share growth (%)48.5   1.53.43.3
Price/earnings multiple (x)    12.712.311.9
Price/earnings-to-growth (x)    8.73.73.6
Annual average historic P/E (x)   19.217.114.7
Cash flow/share (p)12.863.753.016.621.1
Capex/share (p)  15.05.96.7
Dividends per share (p)   1.85.67.67.8
Yield (%)    3.04.14.2
Covered by earnings (x)   8.12.62.02.0
Net tangible assets per share (p)  -44.9-31.7-26.0  
        
Source: Company REFS       

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