Is Genuine Value in genuine trouble?

Over the past 12 months the screen produced a negative total return of 13.7 per cent compared with a positive 8.7 per cent from the FTSE All-Share (the index the shares are selected from). The incredibly poor run leaves the screen’s cumulative total return since I started monitoring it in 2013 at 56.0 per cent, compared with 46.7 per cent from the index. If I take the important step of adding in a notional annual dealing charge of 1.25 per cent (the screens run in this column are regarded as primarily a source of ideas for further research rather than off-the-shelf portfolios) the total return over six years drops to 44.7 per cent, which is just below that of the index.

Genuine Value over the past 12 months

Source: Thomson Datastream

The ratio this screen focuses on takes enterprise value (EV) as its starting point. EV subtracts cash from market capitalisation and adds debt. The idea behind doing this is to take into account all key sources of financing (equity and debt) in order to give a whole-company take on valuation. Debt-like pension deficits and lease obligations can also be factored in, although this screen does not do this.

A ratio of EV to operating profit (Ebit) is then created as a measure of value. This is compared with the expected return for shareholders based on forecast earnings growth (Fwd EPS grth) plus dividend yield (DY). That means the Genuine Value (GV) ratio is:

GV = (EV / Ebit) / (Fwd EPS grth + DY)

Essentially, what the ratio hopes to unearth are companies that have a valuation that looks attractive compared with their growth and dividend-paying potential. The lower the GV ratio, the more 'value' potentially exists. The screen’s full criteria are:

■ A GV ratio among the lowest quarter of stocks screened.

■ Three-month share price momentum among the top third of all stocks screened.

■ Above-average forecast EPS growth in each of the next two financial years. The average forecast growth rate must be less than 50 per cent – anything above this level is considered to be very likely to be highly unsustainable.

A criterion I experimented with last year to require stocks to have not experienced forecast downgrades did little to improve performance. While I am not separating out companies passing this test from those that do not as I did last year, I am including details of three-month forecast changes in the table below.

This year the screen highlighted 22 stocks, which can be found in the table below. I’ve taken a closer look at one of them, On The Beach (OTB), which helps highlight some of the limitations of the screen’s approach to valuation.

Source: S&P CapitalIQ. *All foreign FX converted to sterling.

On The Beach

Valuation measures that fail to consider how indebted or cash-rich companies are ignore what should be a major consideration. However, valuations that use enterprise value to get around this problem can also give a lopsided view of certain businesses. Online short-haul package holiday company On The Beach (OTB) is a case in point.

OTB’s enterprise value is based on its hearty year-end net cash position. Of this £86m cash, £38m was restricted, only to be made available after customers had travelled. But perhaps more significantly, the high year-end cash levels are not representative of trading throughout the year, because of the seasonality of the business and the large size of working capital items.

Indeed, in 2018 OTB’s debt peaked at £29.5m. Given the company’s debt facilities currently only stretch to £28.5m following a small reduction last year, the year-end net cash looks necessary to support trading as opposed to representing capital available to shareholders. Indeed, the difference between trade creditors (amounts owed by the group) and trade debtors (amounts owing to the group) of £55m was significantly more than the £47m year-end, not-restricted cash.

So arguably, high year-end cash levels actually reflect the need to manage a key risk for investors, which is OTB’s substantial working capital items – year-end creditors represented 121 per cent of sales and trade debtors represented 68 per cent. True, revenue looks so dwarfed compared with working capital because OTB’s sales mainly represent commission (Classic Collection sales being an exception) rather than the gross value of holidays sold. This is because the responsibility and risks associated with holidays sold are judged to chiefly lie with a third-party supplier.

Still, given the package holiday industry is beset by unpredictable events – weather, terrorist atrocities, airline failures (Monarch’s collapse cost OTB £2m net of insurance reimbursements), for example – risks associated with sizeable working capital items cannot be ignored. This seems especially salient following the implementation last year of the EU’s Package Travel Directive (PTD) that seeks to push responsibility for holiday failures onto agents. Other risks associated with such large working capital items include the fact the company has to estimate amounts expected from hitting 'override' volume targets and the potential cost of cancellations.

This aside, OTB has reported strong growth since listing in 2015 and the shares are highly rated compared with traditional tour operators. Indeed, there are some good reasons to think the business model sets it some way apart from traditional tour operators, such as Thomas Cook and Tui. That said, the downward revisions to earnings forecasts over the past two years are testament to the fact that the advantages of the business model only go so far. Brexit uncertainties, for example, are likely to be a shared industry headache.

From its beginnings as a teletext travel agent in 2004, On The Beach has become a noteworthy presence in the UK online short-haul package holiday market with a share of over a fifth. It made good use of its 'disruptive' technology and has also stayed ahead of the game in the 'dynamic package holiday' market by using its increasing scale to create direct relationships with suppliers, which has boosted margins. Importantly, the company does not own any physical assets itself, which makes its business more flexible and asset-light than traditional tour operators. In theory, this should also make it less sensitive to declining demand.  

A key cost for On The Beach is marketing, which accounted for 37 per cent of 2018 sales, down from 41 per cent in the prior year. While it has had success in its efforts to reduce spending as a proportion of sales, marketing is still very important in driving site traffic.

The company is seeking to take advantage of a new growth opportunity caused by the increased regulatory burden on small high-street travel agents caused by the new European PTD rules. This makes agents liable to carry the can if the holidays they’ve organised fall through. Last year, OTB bought Classic Collection, which sells holidays to this shrinking but still significant part of the market. OTB plans to use the business to launch an online portal for high-street agents that will provide them with both product and compliance with the new regulation. This looks like a good opportunity, but OTB is up against some much larger established players. It will need to demonstrate a convincing technological edge to meet its ambitious targets to win market share.

The company is also attempting to grow by moving into long-haul holidays and Scandinavian markets. While this could potentially be lucrative, revenue from these areas is currently minimal. The group is at a relatively early stage in forging the partnerships that would allow it to dependably offer good value long-haul packages.

While OTB has found a way to grow fast and mitigate some of the big capital risks associated with traditional tour operators, it remains exposed to competition and the unpredictable nature of the market. Its technology may provide some advantage as it moves to sell holidays to high-street agents. That said, the attractive GV ratio needs to be seen in light of the large seasonal swings in working capital. So while it is a business with an interesting growth story, the high forecast price/earnings ratio looks as though it reflects this.