- Nervousness is rising about the outlook for the UK's post-lockdown recovery
- That could provide a buying opportunity in domestically focused companies
- 6 Best of British shares
It’s that time of year when the stock screen column indulges in a bit of home bias. My Best of British screen looks for shares in quality companies that generate three-quarters of their revenues from these fair shores and have been displaying good, recent share price momentum.
I first ran my Best of British screen in reaction to a bout of pessimism about the UK’s economic prospects as the country struggled back from the great financial crisis. Once again, the country is struggling back from a major economic shock: lockdown.
While the nation’s vaccine roll-out has bolstered optimism about the economic recovery over the past year, angst is now once again on the rise due to a litany of supply-chain-related issues ranging from empty petrol pumps, to chef-less kitchens, to bare supermarket shelves. There’s a tendency for alarmism at such times and, given this screen was designed to climb walls of worry, the increased fretfulness about the country’s prospects arguably makes it a good time to be hunting for Best of British stocks.
Given the strong rally the UK market experienced from November last year when vaccine breakthroughs were announced, the performance of the screen’s picks from 12 months ago is a bit disappointing (see table). However, the biggest stock market winners from the rally were shares in lower-quality companies. These were the companies that had the most to gain from an improved economic backdrop. They also are not the type of situation this screen looks for. In that context, the screen’s underperformance of the FTSE 350 index looks forgivable, although the performance of the top five picks was particularly underwhelming.
|Name||TIDM||Total return (13 Oct 2020 to 29 Sep 2021)|
|Auto Trader||AUTO||3.0%||Top 5|
|Best of British||-||23%||-|
|Best of British Top 5||-||13%||-|
|Source: Thomson Datastream|
The long-term performance of the screen continues to look good, though. The screen has now clocked up a 10-year track record. The cumulative total return over that decade for the version of the screen focused on the top five picks stands at 340 per cent while the total return from all the screen’s picks stands at 278 per cent. That compares with 104 per cent from the FTSE 350 over the decade.
The screen is meant as a source of ideas for further research rather than an off-the-shelf portfolio. But if I factor in a 1.5 per cent annual charge to represent notional dealing costs the total return from the top five drops to 235 per cent and 188 per cent for the larger version of the screen.
The screen’s full criteria are:
■ At least three-quarters of revenue from the UK.
■ Three-month share price momentum better than the FTSE 350.
■ Return on equity of more than 10 per cent.
■ One-year beta of less than one.
■ Forecast EPS growth in this and the next financial year.
■ Better than average five-year compound annual growth rate (shorter periods used when a full five-year record is unavailable).
■ Net debt of less than 2.5 times cash profit.
This year, only one stock passed all of the screen’s tests. I’ve taken a closer look at this one below. The other stocks included in the results have passed the Britishness and momentum tests but fail on one of the other criteria. Meanwhile, the top five picks are made up of the single fully-qualifying stock along with four partially-qualifying picks showing the strongest three-month share price momentum. Put another way, all the share picks except Gamesys (GYS).
Details of the picks, along with fundamental data can be found in the table at the end of this article. A downloadable excel version of the table is also available, which contains loads of extra data.
This is the last stock screen for four weeks as I am off on a month’s sabbatical during which I hope to finish writing a book. It’s on stock screening, of course.
Pets at home
|Pets At Home Group Plc||PETS||Specialty Stores||498p|
|Size/Debt||Mkt Cap||Net Cash / Debt(-)||Net Debt / Ebitda||Op Cash/ Ebitda|
|Valuation||Fwd PE (+12mths)||Fwd DY (+12mths)||FCF yld (+12mths)||EV/ EBITDA|
|Quality/ Growth||EBIT Margin||ROCE||5yr Sales CAGR||5yr EPS CAGR|
|Forecasts/ Momentum||Fwd EPS grth NTM||Fwd EPS grth STM||3-mth Mom||3-mth Fwd EPS change%|
|Year End 31 Mar||Sales||Pre-tax profit||EPS||DPS|
|source: FactSet, adjusted PTP and EPS figures|
|NTM = Next Twelve Months|
|STM = Second Twelve Months (i.e. one year from now)|
Not only does Pets at Home (PETS) generate all its sales from the UK, it does so by catering to a national obsession: pets.
Prior to lockdown pet ownership was pretty steady in the UK. Nevertheless, the humanisation of animals supported growth in the £6.2bn pet-care market of about 3.5 per cent a year as Brits paid up for everything from better pet food to more elaborate veterinary procedures.
Lockdown caused a surge in pet ownership. Pets at Home estimates there was a massive 8 per cent jump in a year. This, the company believes, has added a whole percentage point to the long-term annual growth rate, taking it to 4.5 per cent. Happy days for a business that has a 23 per cent share of the UK’s pet-care market.
Pets at Home clearly seems to be doing something right, too. Its market share rose a full 3 percentage points in the 12 months to the end of March 2021. Meanwhile, a first-quarter update in September brought news that it already expected pre-tax profit for its current financial year to be at the very top of the range of analyst expectations of £123m to £130m. Broker Berenberg, while holding back on its official forecast, suggested pre-tax profit could come in as high as £160m given the first-quarter trading momentum.
Nice earnings surprises are becoming familiar events for Pets at Home shareholders. A wave of broker forecast upgrades have been carrying the shares higher ever since the first lockdown eased in the second quarter of 2020.
The company operates a retail business and a network of vet practices, chiefly under the Vets4Pets brand. The retail business is the larger of the two operations, accounting for just over £1bn of sales and £79.5m of underlying operating profit (69 per cent of the total). Pet food is the largest source of revenue for the division at 55 per cent of the total. Accessories account for a further 40 per cent and services such as grooming and commission on pet insurance sales make up the rest.
The company is trying to drive growth in retail through deeper customer engagement. This is a key area of investment. Almost half the £70m of planned capital expenditure in the current year is earmarked for a project to create a seamless digital pet-care experience for customers.
There is also a strong focus on using data gathered through the company’s VIP loyalty scheme, as well as its kitten and puppy club, to try to boost sales by better catering for customers through its 452 stores and website. Meanwhile, it locates its vets and grooming rooms in or alongside stores to make them more of a destination for pet lovers.
The company has also been trying to boost sales of higher-margin private-label products to 50 per cent of retail revenue, although the proportion of private-label sales actually slipped from 40 per cent to 39 per cent last year. It is also keen to grow its reliable subscription revenue. This stood at £90m last year and represents repeat orders of things such as flea treatment and food.
The first-quarter update showed strong ongoing progress on most of its key retail objectives.
While the growth is very impressive, one less positive aspect of the retail business is the continued decline of the retail gross margin. This has gradually fallen from 52.2 per cent in 2018 to 49.2 per cent last year.
There has been a change in the reporting of gross margin, which makes it harder to assess the trend in years prior to 2018. Before this, the company used to break out the 'merchandise' gross margin rather than 'retail' gross margin, which includes some lower-margin services. However, for several years investors lived with fears about the impact online competition was having on the profitability. But the company’s growing market share suggests winning customers’ hearts and minds is compensating for more competitive pricing. The share price recovery from the late 2018 lows of around 110p certainly seems to suggest investors are now relaxed.
The division that has supported the group-wide underlying gross margin is the vet business. Its gross margin rose from 42.7 per cent to 46.0 per cent last year. Meanwhile, the underlying operating profit was up from £30.6m to £36m.
Even with no further growth in vet practice numbers, this business should see free cash flow rise considerably as existing centres mature. Pets at Home estimates that practices are mature after about a decade. Currently only 32 per cent of its 441 centres have been operating for 10 years or more. Half have been around for between five and ten years and the rest for less time. The group projects that free cash flow from the existing estate should be £60m a year when all existing practices have had their 10th birthday, compared with £38m last year.
The problem for investors trying to understand the vet business is that 395 of the centres have been set up through a joint venture (JV) model. This model involves Pets at Home backing an entrepreneurial vet to set up in business with an interest-free loan of about £30,000 then facilitating a bank loan of about £450,000. Pets at Home then provides support and services to hopefully take the practice to profitability. A fee is paid by the vet partner based on a percentage of sales. Last year, Pets at Home booked £57m of fees plus £8.2m rent on gross vet sales of £418m.
The trouble is JV practices often fail, which leaves Pets at Home to pick up the pieces. The company has reported tens-of-millions in write-offs over the years and has significant provisions in place for bad debt. In fact, the write-offs only represent those associated with Pets’ operating loans to vets rather than the full buyout costs of JVs gone bad. The buyout costs associated with dealing with troubled JVs are treated as exceptional items even though they seem to occur regularly.
The good news is that a big clear-out of troubled vet practices in 2019, the disposal of a specialist vets business last year and the strong trading caused by the rise in pet ownership, all helped make 2021 a pretty clean year for “non-underlying” items related to the vet business.
Still, this feels quite an opaque part of the group’s operations. The complexity around the accounting for JVs is illustrated by the fact that two of the three issues singled out by the group’s audit committee last year for closer scrutiny related to these operations. Indeed, it was worries about the mounting bad debt provisions as well as concerns about online competition that were central reasons for Pets becoming the most shorted stock on the London market a few years ago. Short interest fell to zero this February.
The vet business has recently been strengthened by the £15m purchase of Vet Connection, an animal telemedicine business.
The digital push makes sense for shareholders given the valuation of web-based pet businesses. Online pet-care retailer zooplus has recently been the subject of a bidding war. It currently looks like the winning bid will represent a takeout multiple of 39 times cash profits. That compares with Pets at Home’s enterprise value (EV) to forecast cash profits of about 11.
But while the take-out price may suggest Pets at Home’s shares could represent good value, the fact the leading private equity bidder for zooplus also owns Europe’s largest vet business may suggest a competitive threat to its digital goals.
Pets at Home has been doing really well from changing habits during lockdown. However, the ongoing decline in retail gross margins is a niggle and the JV structure makes the seemingly-promising vet business more complicated to understand. But it’s the surging growth that investors will probably stay focused on as long as upgrades keep coming through. And it looks odds-on that they will keep coming.
|6 Best of British shares|
|TEST FAILED||Name||TIDM||Mkt Cap||Net Cash / Debt(-)*||Price||Fwd PE (+12mths)||Fwd DY (+12mths)||FCF yld (+12mths)||PEG||Net Debt / Ebitda||Op Cash/ Ebitda||EBIT Margin||ROCE||5yr Sales CAGR||5yr EPS CAGR||Fwd EPS grth NTM||Fwd EPS grth STM||3-mth Mom||3-mth Fwd EPS change%|
|None||Pets At Home||PETS||£2,490m||-£407m||498p||23||2.1%||3.9%||0.8||1.9 x||67%||9.4%||7.0%||7.6%||6.5%||27%||9%||7.1%||6.1%|
|RoE||Liontrust Asset Mgmt||LIO||£1,292m||£69m||2,110p||18||3.2%||3.5%||1.4||-||92%||-||33%||31%||23%||25%||14%||21%||8.0%|
|LT EPS grth||Howden Joinery||HWDN||£5,337m||-£104m||901p||21||1.7%||3.9%||0.6||0.5 x||101%||16%||18%||4.9%||-1.8%||13%||4%||9.0%||16%|
|LT EPS grth||Rightmove||RMV||£5,801m||£56m||679p||29||1.2%||2.7%||0.9||-||86%||72%||143%||1.4%||2.0%||20%||6%||2.1%||12%|
|LT EPS grth||Gamesys||GYS||£2,027m||-£235m||1,847p||11||2.4%||-||-||1.4 x||96%||15%||10%||-||-||10%||9%||0.3%||1.6%|