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Three stock market turkeys that might not be completely stuffed

Neil Wilson goes Christmas shopping for bombed-out shares that might be set to recover
Three stock market turkeys that might not be completely stuffed

The UK stock market saw its fair share of profit warnings in 2017. From the catastrophic operational overhaul at Provident Financial to Carillion’s calamitous contract write-downs, there have been plenty of times investors have been sent running for cover. There have also been more slow-motion crashes as investors gradually retreat from shares that have just become unloved.

UK-focused stocks seem to be the least attractive as investors, particularly international ones, shy away from being exposed to the triple threat of slower growth, Brexit uncertainty and domestic political and regulatory uncertainty.

Whenever stocks get hammered, bargain hunters start sniffing around to see if the market has overreacted and to test the efficient markets hypothesis again. Buying on averages usually attracts some funds to go long even when the market has decided to go short. Nevertheless, several of the FTSE’s best-known stocks have found it tough going even after suffering a big one-day fall.

So are there still bargains, or are these unloved stocks just plain turkeys?

Here we look at three UK-focused stocks that might be in for a happier New Year.

 

Dixons Carphone

Low bar for success?

Dixons Carphone (DC.) shares plunged by a fifth on 24 August after the company warned that profits would be materially lower than forecast in 2017. The shares have failed to recover from that shock, falling more than 50 per cent over the course of 2017. It must be noted the City has been turning its back on the retailer for a long time. The shares have slumped by around two-thirds after hitting 500p at the end of December 2015 amid strong macro headwinds.

In its latest update, Dixons guided headline profits before tax this year in the region of £360m-£440m. If we take the mid-point of £400m, it would represent a 20 per cent drop in profits from last year’s £501m, with only a very small portion of that down to the disposal of the Spanish business.

The biggest hit comes from EU roaming legislation, which will result in negative one-off adjustments relating to its mobile network debtor of around £10m-£40m, versus a positive contribution to profits of £71m last year, according to the update of 24 August.

In the core retail area, the UK mobile phone market is proving a tough nut in 2017. Consumers are holding onto phones for longer. Brexit matters here – the weak pound exchange rate has made devices more expensive and consumers are less willing to replace old handsets so quickly. But there's also a switch to lower-profit SIM-only deals that is hurting margins.

The lack of a significant upgrade cycle from Apple had played a part, and while the latest refresh has been well received, chief executive Seb James sounded cautious in August on the benefit for Dixons.

Meanwhile, TV sales are not doing so well versus 2016 as the comparable period featured a big football tournament.

However, there are reasons to be optimistic. Given strong forward sales of the iPhone X reported by Apple, mobile phone sales could bounce back and reverse the trend seen earlier in 2017. Softer mobile phone sales had already delivered a c£25m to profits in H2/2017, so some of this has already been absorbed and therefore makes for an easier year-on-year comparison in 2018. Looking further out, the World Cup in 2018 holds a strong potential for TV sales to pick up again.

All else being equal, the negative one-off adjustment from EU roaming charges is likely to roll off next year. If you strip out the effect of roaming charges, profits would be close to flat.

International exposure is strong, accounting for about 30 per cent of profits, alleviating margin and revenue pressure from a potentially softer UK retail market. And its dominant position in the UK gives it the scale to weather cyclical slowdowns in consumer spending and continue to compete gamely with Amazon (US:AMZN) and AO World (AO.).

Consumer spending in Britain has been squeezed but remains fairly robust. Inflation is set to be less of a burden with the current 3 per cent CPI run rate expected to ease back to 2 per cent in 2018. At the same time we note that the Bank of England expects wages to accelerate faster in 2018 as the labour market tightens, meaning real wages could climb.

The Connected World Services (CWS) business continues to grow very quickly, with revenues up 41 per cent and profits nearly doubling to £21m last year, helped along by contracts with EE and TalkTalk.

CWS also features Honeybee, the tablet sale software being rolled out across the Sprint store network in the US. The Honeybee pipeline is growing and Dixons has agreements with outsourcers in France and the UK that may deliver further customers. CWS is an area of growth potential that investors might be overlooking.

But it’s going to take time and August’s update makes that very clear. The big Sprint deal last year won’t be repeated and profits this year are expected to be limited. The hoped-for £20m in profits now seems unlikely. A move to the software-as-a-service model, away from upfront sales, is likely to result in a higher value, more sustainable business, but this cannot be achieved quickly and it will take time to be accretive to earnings.

Reeling off these positives makes it sound like a done deal, but there are considerable risks. First up, EU roaming charges are being guided to produce a maximum hit to profits of £40m – there is a chance this could be exceeded, albeit this seems small and may be easily overlooked.

The key dangers relate to the core UK retail market. The stock could have further to run lower if consumer spending weakens further than expected, if Black Friday sales proved slack or if the expected uplift from the iPhone X fails to match expectations. This could signal a soft Christmas trading period and therefore investors will want to see greater clarity from the half-year results on 13 December.

 

William Hill 

Chasing an American dream?

William Hill (WMH) has not suffered the same kind of share price drop in 2017 as others, but the market has been turning its back on the bookmaker for some time. For William Hill, the clearest advantage over other bookmakers is the US market and the chance to benefit from further consolidation.

In the trading statement covering the year to 24 October, there were some positive signals on trading:

Online continues to drive the growth, delivering the bulk of the +3 per cent rise in group revenues to date this year. In the 17 weeks to date in the second half, amounts wagered rose +13 per cent and revenues climbed 6 per cent, meaning growth accelerated from the first half. For a while, it must be said, William Hill was behind the curve in the online market but it seems to have made up ground with revenues +5 per cent year-to-date.

UK retail revenues rebounded in the June-October quarter as revenues from fixed-odds betting terminals continue to rise. Retail net revenue rose 3 per cent, with Sportsbook net revenue up 2 per cent and gaming net revenue up 4 per cent. Punters spent less, with Sportsbook amount wagered down 1 per cent, but this was down to the absence of any big sporting event over the summer and the rollover of Euro 2016 from the year-ago period. Gaming net revenues +4 per cent highlights persistent reliance on fixed-odds betting terminals.

The US business goes from strength to strength. Amounts wagered rose 33 per cent and net revenue was 28 per cent higher, although it must be noted that a lot of this was the one-off impact of the Mayweather-McGregor fight in Las Vegas in August.

And the outlook may be more promising than the various regulatory clouds would suggest.

In the UK, it is all about the government’s fixed-odds betting terminals triennial review. Merrill Lynch analysis (double upgrade to buy 7.11.17) highlights that even in the worst-case £2 stake limit, WMH offers an ‘attractive value opportunity’. In short, it seems like the market has priced in the worst-case scenario already and is not yet confident of something less onerous. However, consensus is for the government to set the cap at £20, which suggests the market is being too pessimistic.

If regulatory pressures may not be as bad as feared in the UK, the bookmaker could be set for a huge boost if the US liberalises its gaming laws. The US Supreme Court has already begun hearing New Jersey’s quest to legalise sports betting, with a ruling expected some time in 2018. It is anticipated that it will win and the prize is colossal – the entire US sportsbook market. The potential market size is vast – the 1999 final report of National Gambling Impact Study Commission suggested as much as $380bn was illegally wagered each year. William Hill’s market share in Nevada (one of just four states where sports betting is legal) is more than half. The potential from a big bang liberalisation of the US market is substantial and may not yet be reflected in William Hill's valuation.

Australia is tough and will get tougher, although as in the UK this ought to be well priced in by now. The credit betting ban has been passed (commences February 2018) and there is the potential for a so-called ‘Point of Consumption Tax’ to be adopted by individual states. The regulatory clampdown is all about managing the decline and this means cost control is paramount. A proposed merger with Australia’s CrownBet would help and is a sign that management appears open to deal-making.

And on that note, we must acknowledge that given the recent spate of mergers in the industry, William Hill remains a firm favourite to take part in further consolidation. Although previous merger/takeover bids have failed, an appropriate partner may yet be found for William Hill.

 

Merlin Entertainments

The building blocks of growth?

Tourists have been shunning Merlin Entertainments' (MERL) core, and these days rather tired, Midway attractions with visitation trends looking pressured. But after a sharp correction in the share price, these risks may already be reflected and investors might be underestimating the potential uplift from new developments, particularly the expansion of Legoland.

Aside from a tie-up with Entertainment One (ETO) to roll out Peppa Pig theme parks globally, the latest trading update was not the most upbeat.

Terror attacks have kept punters away from theme parks, resulting in like-for-like revenue growth at a meagre 0.3 per cent in the 40 weeks to the start of October. Profits for the year are expected to be flat on the previous year at £470m-£480m, below market expectations.

Nevertheless, total revenues rose 12.4 per cent after a string of new developments, including Legoland Japan and five new Midway attractions, boosted top-line growth. Foreign exchange moves flatter sales – 70 per cent of earnings come from overseas and at constant exchange rates the growth was 5.9 per cent. The core Midway division continues to show signs of stress, with revenues there 1 per cent lower on a like-for-like basis.

In the early part of the year Merlin benefited from the weaker pound driving more foreign tourism in the UK and boosting earnings repatriated from foreign operations, a trend seen throughout the latter half of 2016 that helped offset falling like-for-like revenues at Midway. However, Merlin warned in June that it is likely to see fewer foreign visitors this year as a result of terror attacks, and that it has already registered "further deterioration" in domestic demand.

Previous to this it warned in March that the threat of terror attacks had hit its UK business, citing events in Paris and Brussels as helping to keep punters away. This was before the Westminster attack on 22 March, meaning the impact on the UK business was likely to be significantly greater in 2017 than it was last year.

True to form Merlin reported "unprecedented levels of demand volatility" as tourists shunned busy London attractions. It has cited a material deterioration in international tourism over the peak trading period, but this does not tally with the figures showing record inbound tourism in the UK. All of which matters little for future valuations except that it may signal a problem with some of the older attractions it owns. Meanwhile, the outlook is a tad gloomy, with the company expecting depressed earnings from London sites to persist "for the foreseeable future". 

With this in mind, Merlin is turning its back on Midway and focusing its capital investment on hotels. Certainly investing in hotels makes sense. Enabling visitors to stay overnight at its attractions is a key part of the strategy as it boosts earnings potential, average spend, and stimulates additional demand. Merlin wants to add about 2,000 rooms by 2020. Some think this is too conservative and it could add even more rooms as it expands globally, with the resultant boost to earnings.

However, failure to invest in the existing estate could worsen the situation as it must keep investing in new rides, attractions and facilities to remain appealing to consumers.

Nevertheless, there are still important positives on the horizon that investors may be underestimating.

The deal with eOne to open Peppa Pig attractions globally could be significant for Merlin and will help offset declining like-for-like revenues at Midway.

And Merlin is barely a third of the way through a planned global expansion of Legoland. The Japan site opened in April and with plans for further expansion in Asia and the US (a site in South Korea is planned, while it is exploring options for sites in China and New York, too) there ought to be considerable new revenue streams coming in the longer term that investors who are worried about terror threats to the UK business in the near term may want to look more closely at.

Whilst Merlin is not a growth stock, it does look like the negative performance and cautious outlook is in the price.