Stockwatch: A 4% yield and upside potential

Is a 4% yield enough to tip the risk/reward profile on FTSE 250 (MCX) retailer Pets at Home (PETS) positively?

At about 190p currently, and according to 25 May projections by company broker Numis Securities, its stock trades on a forward price/earnings (PE) of about 13 times, yielding just over 4% covered 1.8 times by earnings.

The chart shows a prolonged fall from 311p in mid-2015 to 155p last June and July, when it appeared to consolidate. There was then a bounce to 195p, albeit promptly back down to 175p, then another rebound to test 190-195p.

Such action implies the 4% yield is becoming seen as a prop, while also considering wider risks for the business.

Most likely, it’s being exacted through market pricing to compensate for an overall flat earnings profile from 2015 to 2019. A 10% earnings drop in the current year to March 2018 was affirmed by an 8 August trading statement that focused on revenue progress, while adding merely that, with operational cost savings going to plan, the outlook for financial year 2018 was “in line with expectations”.

Pets at Home is, therefore, in that category of stock whose growth hopes are somewhat dashed and short sellers have helped bring down the annual average historic PE from the high teens. A chunky 8.8% of the issued capital is out on loan, with all six disclosed traders raising their short exposure between last May and August.

In principle I wouldn’t flinch: herd behaviour on the short side can depress a stock excessively and it often pays to buy before they start closing out. In practice, critical judgment is required as to the business dynamics and industry context to determine if the stock really is at an inflection point.

Traditional retailer pressures have prevailed

Clearly, something has gone wrong as the stock trades at a 20% discount to its 2014 flotation price of 245p, which valued it at £1.2 billion. With hindsight, it was one of a string of retailer IPOs at the time hoping to capitalise on an improving UK economy, albeit which also involved private equity looking to cash in.

Pets at Home had been geared up by US private equity group KKR, thus an objective to part-reduce debt by raising some £275 million at flotation. Founded in 1991, the group has clear leadership in UK pet care, with some 447 stores, 440 vet practices and 296 grooming salons; and a mission to be the best pet shop in the world.

Among these flotations, however, traditional high-street operations began to encounter higher costs and struggled, such as Poundland, which was taken over, while those adept online such as (BOO) have prospered hugely.

The short-selling rationale may essentially have been to exploit a contrast between high hopes back in 2014 that extended to mid-2015, and a shift in terrain for traditional retailers – e.g. a rise in the UK minimum wage and business rates – that further empowered online specialists.

Pets at Home’s last annual results portrayed growth in veterinary services and accessories. There was no specific online element to the narrative save: “The transition to online has been consistent with our expectations, accelerating slightly compared with historical rates, reaching 11% of the pet market in 2016.”

Total share of the pet product market has risen from 19% to 20.1% and of the veterinary market from 9% to 12%, the overall UK pet market growing at a 4.5% annual compound rate and worth £6.8 billion in 2016.

That’s hardly a corporate/industry context for short selling, unless the stock is stupidly overvalued; but its PE and yield imply fair to modest valuation.

Chart-wise, having twice recently bounced off 160p and 175p, there’s a “reverse head & shoulders” pattern that could be interpreted bullishly. With scope to attract institutional interest for the yield, the stock ought to be around an inflection point after a two-year downtrend.

Veterinary increases its contribution

The 8 August update cited revenue growth of 5% to £256.5 million for the end-March to 20 July period (2.7% like-for-like), with merchandising predominant up 2.8% to £216.4 million (1.5% like-for-like) and services up 18.8% to £40.1 million (10.5% like-for-like), including joint venture veterinary income up 19.7% to £16.2 million.

If this side can sustain double-digit growth – recently helped by TV campaigns and specialist referral centres – it ought to mitigate the risk of regular pet product revenue flattening as disposable income gets pressured by inflation.

“We are confident the investments we are making to grow our veterinary business and to reposition our pricing and deliver everyday value for our customers are creating a strong platform for sustainable future growth.”

Modest balance sheet issues

Short interest may also be motivated by intangibles representing 112.2% of net assets, which appear acquisitions-related but deserve better clarification.

The debt profile is not risky, however: at end-March there was no short-term debt beyond £209.3 million longer-term debt, which resulted in an annual net finance expense of £4.5 million, down from £4.8 million after £325 million debt was repaid in 2016.

The ratio of current assets to current liabilities is a sound 1 times, though you might quibble at trade payables being 2.4 times trade receivables, as if profit may benefit from not paying in a most timely fashion.

Yet, with end-March cash up 40.9% to £56.4 million amid £110.9 million stable net cash flow from operations, it’s hardly a balance sheet exposed to the risks of UK consumer downturn.

Management retains strong equity holdings

The chief executive retains 4.2 million shares worth just over £8 million and the chairman 3.3 million shares for £6.3 million exposure.

Admittedly, the finance director is more in line with hired management, owning 46,000 shares; the non-executive directors’ holdings are similarly modest. Yet outside shareholders’ interests are well-aligned with two of the most crucial directors.

Upcoming events are an investor/analyst day on 21 September, which potentially could lead to more brokers taking up coverage – Berenberg (not in the REFS’ consensus) upgraded its share price target from 180p to 230p in response to the August update.

What doesn’t altogether tally is the company broker having guided profitability and 2019 earnings per share (EPS) down to 2015 levels in a context where 2017 prelims asserted “a resilient market, independently forecast to grow at about 4.5% over the next 5 years”.

That statement did prominently display “FY18 guidance” involving margin pressure according to “price investment” (i.e. price cutting) and foreign exchange cost (i.e. importing with devalued sterling), also capital investment of £40-42 million.

Yet the cash flow statement shows £40-55 million investment anyway in each of the last two financial years.

Medium to long-term odds favour upside

Barring a consumer slump and the improbable scenario of Brits letting their pets go hungry and sick, this is a robust business – not a shorting candidate.

The more likely scenario is yield support with short closing in due course also helping, then over the next two years the benefits of investment in a growth market should manifest.

I drew attention at 185p last February, suggesting it was an early-stage “buy for income”, with a non-executive director adding 5,673 shares at 188.6p to own 30,000 in total.

I suggested that if the stock continued to fall nearer 150p then it was time to start accumulating as it would generate an inflection point; the challenge being timing.

That has so far proven correct and a higher short element bakes in upside potential.

Pets at Home Group – financial summary Broker forecasts year ended 31 Mar 2013 2014 2015 2016 2017 2018 2019 Turnover (£ million) 598 665 729 793 834 IFRS3 pre-tax profit (£m) 26.5 22.5 87.0 92.1 95.4 Normalised pre-tax profit (£m) 32.7 33.2 87.0 93.0 96.2 85.2 97.9 Operating margin (%) 9.9 9.5 12.2 11.6 11.2 IFRS3 earnings/share (p) -20.0 -13.8 14.4 14.5 15.0 Normalised earnings/share (p) -15.3 -7.7 14.4 14.7 15.2 13.6 15.6 Earnings per share growth (%)       1.9 3.3 -10.3 3.3 Price/earnings multiple (x)           12.3 11.9 Annual average historic P/E (x)     19.2 17.1 12.5 Cash flow/share (p) 63.7 53.0 16.6 21.1 21.0 Capex/share (p)   15.0 5.9 6.7 7.8 Dividends per share (p)     1.8 5.6 8.0 7.5 7.8 Yield (%)         4.2 4.0 4.2 Covered by earnings (x)     8.1 2.6 1.9 1.8 2.0 Net tangible assets per share (p)   -44.9 -31.7 -26.0 -21.5 Source: Company REFS

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.