Five Contrarian Value Plays

While there is plenty to muse about regarding the underperformance of value, the fact is that over the seven years I’ve run my Ken-Fisher-inspired contrarian value screen it has actually done very well despite being ensnared by its share of value traps along the way. Indeed, last year was only the second out of the seven years I’ve run the screen that the top five shares failed to outperform the FTSE All-Share (see table below). A screen of this nature should certainly not be expected to outperform consistently given the risks it takes on.

2017 performance

Source: Thomson Datastream

Over the seven years since inception, the cumulative total return from the screen’s top five shares stands at 200 per cent ignoring notional dealing costs. After taking the important step of factoring in an annual charge of 1 per cent, that total return drops to 179 per cent (the assumption of this column is that the screens are most useful for readers as a source of ideas for further research rather than off-the-shelf portfolios). This compares with 78 per cent from the FTSE All-Share, which is the index shares are selected from.

The larger version of this screen boasts a cumulative total return of 100 per cent, or 87 per cent after costs. While I continue to run the larger screen, as I’ve pointed out for a number of years many of the shares highlighted actually do not look all that cheap based on the key valuation measure: enterprise value/sales (EV/S). My view is that the longer the current bull market has run, the more questionable the value of this larger screen has become given that value lies at the heart of the strategy.

The reason the screen looks at EV/S is based on the idea that the best contrarian situations often exist when companies have seen their profits temporarily decimated. In such situations, the last place one would want to look for value is an earnings-based metric because low or even negative profits will make earnings-based valuations look incredibly high just at the point the most recovery potential is on offer. By contrast, if sales remain robust and have historically been a source of profits, the possibility exists that the return on sales (margins) will bounce back, prompting a substantial re-rating. By contrast, when earnings-based valuations look extremely attractive, it can often prove an indication that earnings are set to decline precipitously.

Given how deceptive earnings-based valuations can be when assessing contrarian situations, I’ve taken a look at the share with the least attractive valuation based on forward price/earnings (fwd NTM PE) from the top five stocks highlighted by the screen, alongside the share with the most attractive fwd NTM PE valuation. The table below provides details of the top five shares along with the other 15 shares that make up the larger (and not necessarily all-that cheap) screen ordered from lowest to highest EV/S. The screening criteria are:

■ Enterprise value of £25m or more.

■ Five-year compound average annual sales growth rate of 7 per cent or more (5 per cent or more above the 2 per cent target rate of inflation).

■ Forecast sales growth in each of the next two financial years.

■ An average operating profit margin of at least 10 per cent over the past five years.

■ Positive free cash flow.

■ Gearing of less than 50 per cent, or net debt of less than two times cash profit.

■ The cheapest five stocks are chosen based on EV/S and the next cheapest 15 are then added to create a larger portfolio. The most expensive of the stocks in the larger portfolio at an EV/S rating of 2.2 actually looks relatively pricey on a simple rule-of-thumb (valuations-of-one-or-less-look-cheap) basis.

Source: S&P CapitalIQ

Drax – high Fwd NTM PE

Over the past five years the valuation of Drax’s (DRX) shares has sunk as the company and the market have tried to understand what a low-carbon future will mean for a business that has historically generated power by burning coal; an extremely high-carbon way to generate energy that the UK wants to phase out by 2025. A recent re-rating of the shares (see chart below) suggests the strategy set out by Drax to reinvent the business may finally be finding resonance with investors.

The shares could do well if the company comes good with its plan to potentially become a negative carbon business and its target to raise cash profits (also known as earnings before interest, tax, depreciation and amortisation, or Ebitda) from £229m in 2017 to over £425m by 2025. Broker JPMorgan forecasts that the next few years will see declines in the £180m charge for depreciation and amortisation (the 'DA' in Ebitda) and the £40m interest bill (the I in Ebitda) at the same time as Ebitda rises. Indeed, predictions that depreciation, amortisation and interest costs will drop by a combined £20m over two years, coupled with the prospect that Ebitda will reach £295m come 2019, underpins the broker's expectations that adjusted profits after tax will rocket from just £3m last year to £75m by 2019; with a fair wind, financial and operating gearing can be wonderful things. This would take EPS from a paltry 0.7p in 2017 to 18.3p by 2019 (giving a 2019 price/earnings ratio of 19), with plenty more EPS upside to come if the company can stay on course for its 2025 Ebitda objective.

Drax’s history as an operator of coal-fired power stations means the move to lower-carbon sources of energy has presented major challenges for its business. Since 2012, the proportion of the UK’s energy supply coming from coal has plummeted from 43 per cent of the total to just 7 per cent. In order to adapt, Drax has invested heavily in converting coal-fired power stations to use biomass (wood pellet) fuel. Biomass accounted for 65 per cent of the energy the company produced during 2017.

The company remains in a state of change. Drax’s profit targets are tied to plans to grow as a low-carbon business -– potentially negative carbon if it can harness carbon-capture technology. There are three strands to its plans. First, on the power generation side the company has completed the conversion of three of six generation units to biomass to date. While government vacillation on its financial support has thrown the company curve balls in the past, recent agreements have been encouraging and the company is looking into the development of a fourth biomass unit and applications to convert two units to gas are being reviewed. 

As well as trying to boost power generation profit by investing in its power plants, the group is investing in production of wood pellet production. This should boost supply-chain efficiency and reduce Drax’s need to compete in the open market for fuel for its biomass plants. To this end, it acquired wood pellet business LaSalle Bioenergy last year, which is its third wood pellet production facility.

The third part of Drax’s strategy focuses on growing its operation that supplies energy to businesses. This division was boosted substantially by the acquisition of Opus Energy from Telecom Plus in February 2017. 

Trading in the 2017 financial year was encouraging and the recent share price momentum suggests investors are starting to believe Drax’s goals are achievable. Drax re-set the dividend last year to a level from which it felt it could grow the payout. This followed a refinancing to lower the cost of debt in May and was also accompanied by a promise that shareholders would get further capital returns when possible. And Drax announced a £50m share buyback when it reported full-year results (the same amount being paid out as dividends for 2017). Meanwhile, year-end net debt was well below the forecast level and Drax’s target of two times cash profit. Given the relatively low rating Drax trades at compared with forecast Ebitda (6.4 times based on Bloomberg consensus data), and the prospects of an EPS surge, buybacks could provide a very useful boost to shareholder returns.

Drax can still be regarded as a contrarian situation and a range of external factors from government policy to commodity price movements means there could always be “bumps in the road”. Indeed, first-half performance was hit by a generation outage caused by a fire, although full-year results are still expected to be in line with expectations. However, the market seems to have warmed to the potential for a recovery, which makes the shares an interesting proposition.   

Pets at Home – low Fwd NTM PE

There’s clear reason to be cautious about the seemingly low rating commanded by pet product retailer and veterinary practice group Pets at Home (PETS) based on it being London’s most shorted stock – according to Castellain Capital’s short tracker, short interest currently stands at 13.4 per cent. The end markets Pets serves are not an issue, with the company putting market-wide growth for pet products at about 2 per cent a year and for veterinary services at 5 per cent. However, as with many other retailers, online competition is a major issue.

Pet products represent the kind of retail niche, offering long-term growth and repeat orders, that makes e-commerce types salivate. The market’s niche characteristics means bricks-and-mortar incumbents have historically been able to generate high margins because they stock goods that are hard to get elsewhere. This means it is easy for online-only retailers to compete on price, especially as they don’t have the high overheads associated with physical retail estate to contend with. Meanwhile, for many pet owners it is simply a chore to buy items such as hamster bedding or dog food, so the convenience of shopping online is a bonus.

Arguably, it’s therefore unsurprising that faced with thriving, well-financed competitors such as zooplus and Amazon, Pets at Home has seen profitability decline sharply (see chat below). The short-sellers would seem to think there’s more to come.

For contrarians, the big question is whether Pets at Home can revive its fortunes by making its stores places that people really want to visit. Recent trading has held some cause for encouragement, with the group managing to produce progressively improving like-for-like sales growth in each quarter of the 2018 financial year (see chart below). While the company has focused on a range of initiatives, from product innovation to subscription services, a key reason for the sales improvement has been substantial price cuts. This has significantly contributed to the margin attrition in the above chart. And while 'omni-channel' (online etc) revenue rose 75 per cent, these sales still only represent 7 per cent of merchandise sales. So in all, despite an 8 per cent rise in revenues in 2018, underlying pre-tax profit was down 12 per cent and free cash flow dropped 14 per cent.

However, there are hopes that the price-cutting to date may have already made Pets competitive on the pricing front. Meanwhile, the company has been looking to support growth by opening joint-venture veterinary practices and groom rooms, many of which are located at its stores to help drive footfall. Indeed, according to broker Shore Capital, cash profit per square foot is 24 per cent higher at the 58 per cent of shops that have a groom room and vet practice located within them.

What’s more, the vet practices could prove an important source of profit growth as they mature. More than four-fifths of the 461 practices are less than 10 years old, which suggests there could be locked-in potential because profitability builds slowly. Pets takes 17 to 18 per cent of practice revenue in exchange for back-office support and help with financing the initial set-up through a corporate loan combined with lending from an external bank. Broker Berenberg forecasts that the vet business, which accounted for 31 per cent of last year’s operating profit, will see revenue rise from £94m last year to £126m by 2021, while margins are predicted to increase from 31.5 per cent to 35.1 per cent.

However, there has recently been reason to worry about the veterinary venture. Low numbers of newly qualified vets mean the company has reduced its targets for new openings from 40-50 a year to 20-25. The lack of labour is also contributing to higher costs. Practices are costing more to set up and taking longer to become profitable. This was reflected in an increase in the level of external financing taken on by new practices, as well as an increase in the provisions made by Pets for bad corporate loans. Given the relatively young nature of this venture and the operational distance created by the joint-venture structure, the setback is worrying.

If Pets can stabilise its business quickly, then the shares certainly represent a bargain. However, the risk is that the decline will continue and there is not yet that much evidence to suggest the negative trend has really started to abate.