Cube Midcap Report (28 Feb 2020) – Airlines face bumpy landing #IAG #EZJ #RMV #PLUS #JUP

Cube Midcap Report (28 Feb 2020) – Airlines face bumpy landing #IAG #EZJ #RMV #PLUS #JUP

Good morning! It’s Roland here with today’s Midcap report.

It’s been an eventful week on the stock market. There have been a deluge of FTSE 350 results. And of course the FTSE 100 has fallen by around 800 points, resulting in a 10% correction. Does the index now offer real value? On balance I think it probably does, barring the risk that the coronavirus outbreak leads to a wider economic downturn.

I certainly remain a buyer of equities. As a long-term investor with a focus on income, my approach this month has been to sell nothing and buy more when I have cash available. Although there’s no way to know how much further the market will fall, my feeling is that there are some attractive valuations out there at the moment. But it’s certainly an unsettling time, given the continued spread of the coronavirus.


There’s an unusually high level of newsflow today for a Friday. I’ll do my best to cover some of the more interesting stories, but won’t be able to cover everything. As always, any requests are welcome to help shape our coverage here at Cube.

Let’s see how we get on. I’m going to start with the following stocks:

  • International Consolidated Airlines Group (IAG) – final results and coronavirus warning
  • easyJet (EZJ) – coronavirus update
  • Rightmove (RMV) – final results
  • Plus500 (PLUS) – trading update

I also hope to take a look at some of the following stocks – feel free to let me know if there are any you’d like prioritised:

  • Jupiter Fund Management (JUP) – FY results
  • Man Group (EMG) – FY results
  • Rolls-Royce Holding (RR) – FY results
  • London Stock Exchange Group (LSE) – FY results
  • IMI (IMI) – FY results
  • ConvaTec (CTEC) – FY results

I’ll be here until noon.


International Consolidated Airlines Group (IAG)

  • Share price: 473p (-8%)
  • Market cap: £9.4bn

Full-year results

Coronavirus update: British Airways owner IAG is down sharply today on a predictable warning that the coronavirus is hitting demand, resulting in a weaker earnings outlook:

We are currently experiencing demand weakness on Asian and European routes and a weakening of business travel across our network resulting from the cancellation of industry events and corporate travel restrictions.

A slowdown in corporate travel is bad news for IAG, which relies on premium class long-haul ticket sales for a sizeable chunk of its profits. The airline says that its cutting long-haul flights to affected areas and redeploying this capacity elsewhere, when possible.

However, shorthaul capacity is not being redeployed at this stage — the airline has cut flights to Italy and expects to make further reductions.

In total, IAG expects these changes to reduce available seat kilometres (ASK) — an industry metric — by 1%-2% this year.

The group says it has a strong balance sheet and enough cash liquidity to withstand the current weakness. I wouldn’t disagree with this at this time, but I would note that the group’s net debt rose by €1.1bn last year, resulting in an increase in leverage. If the current slump becomes a longer downturn, this could become more of a concern:

IAG FY19 results - leverage

Net debt rose by €1.1bn last year as the group invested in new aircraft. Note that the increase in interest-bearing borrowings reflects the adoption of IFRS 16 (+€5.2bn) and €1.2bn of new leases.

FY19 results: Even before the coronavirus outbreak, I felt unsure how to value airlines after such a long run of growth. The question for me was how much of the demand growth seen in recent years was truly structural, rather than cyclical.

I’m not sure we have the answer to this yet, but IAG’s 2019 results do highlight some of the reasons why I’d be wary about investing in airlines at the moment.

Although revenue rose by 5.1% to €25.5bn last year, operating profit before exceptional items fell by 5.7% to €3,285m.

This implies a reduction in the group’s underlying operating margin from 14.4% to 12.9%. IAG’s adjusted return on invested capital fell from 16.9% to 14.7%.

These are still attractive figures, in my view, but the falling trend could become a concern. It’s worth noting that last year’s revenue increase came from capacity growth, not from improved pricing power or lower costs:

IAG FY19 ASK metrics

Note the 2018 figures are pro forma, to reflect the adoption of IFRS 16.

Pricing power seems likely to weaken, at least while the impact of the coronavirus outbreak persists. I suspect we’ll see a big reduction in in profitability this year.

2020 outlook: Given the uncertainty surrounding the impact of the coronavirus outbreak, IAG understandably says that it’s unable to provide financial guidance for 2020 at this time. I’d expect existing broker forecasts for the year to be cut after today. In any case, I’m not sure they’re of much use at this time.

My view

I think there’s little doubt that airline profits will be hit hard this year. What’s less clear to me at the moment is how quickly they might recover.

The picture is also made more complicated (for me, at least) by the long period of expansionary growth enjoyed by IAG and other winning airlines in recent years. Although some of this has come at the cost of rivals’ bankruptcies, there has been a substantial net increase in capacity.

IAG shares always tend to look cheap. Recent falls have exaggerated this effect — as I write, IAG stock is trading on 4.6 times 2019 earnings, with a dividend yield of 5.9%.

However, I think it pays to remember that throughout airline history, the high fixed costs of these businesses have always made them prone to cyclical swings. I don’t feel competent to judge whether IAG shares are truly cheap at the moment, so I’ll be staying on the sidelines for now.


easyJet (EZJ)

  • Share price: 1,060p (-4.5%)
  • Market cap: £4.2bn

COVID-19 update

easyJet has been one of the biggest fallers in the FTSE 100 over the last week. The shares are down by almost a third from the 1,500p level seen on 21 February. As a result, today’s fall is fairly modest — a lot of bad news has already been priced into the shares.

The company has issued an update on the impact of coronavirus. It says that there has been a significant softening of demand and load factors for flights to and from Northern Italy. There’s also evidence of slower demand across other European markets.

Like IAG, easyJet plans to cancel some flights on the worst-affected routes.

Various measures are being taken to cut costs. These include freezes on recruitment, promotion and pay. Capex is being postponed, discretionary spending is being cut and staff are being offered unpaid leave. Aircraft are being reallocated for the summer season to “maximise revenue opportunities on market recovery”.

The firm says it’s too early to determine the impact of the virus on the outlook for the full year, but management appear to be planning for the worst. I think this is a prudent and responsible choice.

My view: I’ve always seen easyJet as a focused and well-run business. I’m tempted to say that at c.1,000p, the shares could offer long-term value. However, the caveats I mentioned in relation to IAG probably apply here, too. On balance, my stance is neutral.


Rightmove (RMV)

  • Share price: 607p (-4.4%)
  • Market cap: £5.3bn

Full-year results

We’ve grown used to strong results from the UK’s dominant property website, and today is no exception.

RMV FY19 results

My sums show that Rightmove’s operating margin remained unchanged at about 74% last year. According to Stockopedia data, 2019 was the sixth consecutive year that the firm has generated an operating margin of more than 70%.

The group’s return on capital employed was 384%, a mind-boggling figure. On this measure, Rightmove is the most profitable listed business in the FTSE All-Share index. I should point out this result is actually a reduction from last year, when ROCE was 799%! But the main reason for this appears to be that Rightmove’s cash balance doubled to £32m last year. This resulted in an apparent increase in capital employed. I wouldn’t be too concerned by this.

Management’s continued focus on share buybacks saw the share count fall from 892,871,026 to 878,055,698 last year, a reduction of 1.7%. This boosted earnings per share growth to 10%, ahead of the 8% that would have been implied by an unchanged share count.

Rightmove’s focus on buybacks rather than more generous dividends won’t suit everyone. But it’s been a highly effective way of enhancing earnings growth over the years — the number of shares in circulation has fallen by nearly 15% since 2013.

Revenue up in a difficult market

A key performance metric for this business is average revenue per advertiser (ARPA). In this context, an advertiser is an individual estate agency branch or new home seller.

ARPA rose by £83 to £1,088 per month in 2019, but the number of advertisers fell by 3% to 19,809. What seems to be happening is that agencies with low stock levels are leaving Rightmove as the costs are too high. However, the firm also says that many of these branches are closing altogether — according to today’s results, the number of agency branches fell by 6% last year.

This shortfall is currently being offset by a growing business listing new homes for sale. I’ve certainly noticed this when browsing through local Rightmove results for the area where I live.

Rightmove is keen to highlight its ability to grow related businesses out of its core operations:

In 2019 the Commercial Property, Data Services and Overseas Property businesses grew by 19% to contribute £24.5m (2018: £20.6m) revenue.

To put this in context, group revenue was £289m last year.

The company says that website traffic rose by 2% to 135m visitors per month in 2019, driven by a 14% increase in mobile traffic. Average time on site was down slightly — as you’d expect from mobile visitors — but is still over 1bn minutes per month.

Although market confidence is said to have improved since December’s election, management expect smaller estate agents to continue struggling. A further decline in agency branch numbers is expected, but this should be offset by growth elsewhere.

My view

Rightmove is an incredible business that dominates the UK property listings market. It’s also showing an impressive ability to expand into areas such as residential lettings.

In a housing market downturn, I guess Rightmove’s growth could slow or even reverse for a while. But I don’t believe a market slump would present any structural risk to the business.

The other risk that’s often flagged up is that agents will rebel against Rightmove’s ever-increasing prices. The problem with this is that the exposure provided by Rightmove is hard to replace. Second-tier sites Zoopla and OnTheMarket just don’t have the same traffic.

On balance, my view is that unless Rightmove’s management are stupid or greedy, this business should continue to perform well. At a last-seen price of 600p, the shares are trading on about 28 times 2020 forecast earnings. That doesn’t seem outrageous to me.


Plus500 (PLUS)

  • Share price: 939p (+7.6%)
  • Market cap: £1.0bn

Trading update

No surprise here. CFD and spread betting firm Plus500 has issued a statement today flagging up a significant increase in levels of customer trading activityas a result of recent market volatility.

Q1 trading to date is significantly ahead of the same period in Q4 2019.

The company warns that it’s too soon to say whether this trend will persist. It also reminds us of incoming regulatory changes in Australia that could affect activity.

I’d expect a similar increase in YTD performance at peers CMC Markets and IG Group Holdings (disclosure – I hold IG Group).

My view: To some, Plus500’s increased profits may appear to be coming at the expense of human tragedy. But periodic market volatility is a fact of life and can have many different causes.

One of the reasons I like holding IG Group is because I see it as a counter-cyclical play on the markets. When everything else is doing badly, we can be fairly sure that firms such as IG are doing better. The way I see this, it provides an element of hedging for my portfolio, while providing an attractive income.

As I’ve commented before, I’m not a massive fan of Plus500, as my perception is that it’s more opportunistic than its peers and has a lower quality client base. But there’s no doubt that the business has survived several challenges and appears to be maturing well.


Jupiter Fund Management (JUP)

  • Share price: 304p (-7%)
  • Market cap: £1.4bn

2019 results

Shares in this FTSE 250 fund manager are down by nearly 7% today, perhaps because the company has decided not to pay a special dividend this year. This will see the total dividend per share fall from 28.5p in 2018 to 17.1p in 2019 — a reduction of 40%.

Based on consensus forecasts I can see for a total dividend of 23p per share, analysts appear to have been expecting a reduced special dividend, not a cessation of this payout.

Chief executive Andrew Formica says the decision not to make a special payout has been made to preserve funds for the acquisition of Merian Global investors. This seems reasonable enough to me. It can be a mistake to rely too heavily on special payouts, as by definition they aren’t intended to be regular or progressive.

AUM flat despite outflows

The existential question surrounding generalist active fund managers is whether they can deliver sufficiently good performances to justify charging higher fees than rival passive funds. There are also risks associated with star fund managers, who may start to misfire or choose to leave.

Today’s figures from Jupiter highlight some of these issues.

  • Assets under management (AUM): £42.8bn (2018: £42.7bn)
  • Gross inflows: £11.4bn
  • Net outflows: £4.5bn

This is an example of star fund manager syndrome. Alexander Darwall, the highly-regarded manager of some of the group’s European funds, left last year to start his own firm. According to today’s results, this resulted in outflows of £4.3bn from the group’s European growth strategies. In other words, Mr Darwall’s departure accounted for almost all of Jupiter’s net outflows last year.

Leaving this aside, the group’s funds appear to have performed fairly well. 72% of mutual fund AUM are said to be above median over three years. Fee margins remained stable last year, at 0.84%.

However, Merian Global investors will add “lower margin business” to the mix. This is expected to result in a “significantly lower” fee margin for 2020, albeit on much higher AUM.

Profits down

Jupiter’s financial performance as a group declined last year. A reduction in average AUM meant lower management fees and a fall in profits.

Jupiter FY19 summary

However, the group’s profitability remains attractive, with an operating margin of 43% (2018: 44%). This group has consistently generated returns on equity of around 22% in recent years, supporting generous dividends.

My view

I don’t have the time or means to analyse how this business might look after it’s been combined with Merian Global Investors.

My concern is that ultimately, fund managers will need a specialisation, not just scale, to protect themselves against relentless pressure on fee margins.

However, I do think consolidation makes sense in this sector. On balance, I continue to view Jupiter favourably after today’s results.


That’s all I’ve got time for today. Thanks for your company and your thumbs up (or down). All feedback is really valuable to us.

I hope you all have a good weekend. Let’s hope next week is a slightly calmer one.

Cheers,

Roland

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    I would vote for LSE and/or JUP.

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    JUP was probably my top pick too, although I’m tempted by RR as today’s only FTSE 100 gainer!

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