I’m sure you’ve heard of Brexit. It’s been in the news regularly since the referendum in 2016. We have been frequently warned of the consequences of a “hard” Brexit – empty shelves, grounded flights shortage of medicine and basic supplies, closure of factories and generally an economic Armageddon. This narrative – not completely without merit, but largely exaggerated – has created rare investment opportunities on the London stock market, which investors with a medium-term investment horizon can exploit. I will discuss three British stocks I own, which are exposed to a potential hard Brexit, but are sound businesses at attractive valuations.
The Brexit Drama
By investing in domestic-oriented stocks in the UK, you automatically take on Brexit risk. There is no easy way to hedge it, as both the pound and equity prices would suffer in a hard Brexit scenario. I don’t know what path we will take from here and there can be no guarantee that a hard Brexit will be all together avoided. However there are a number of attenuating circumstances and the risks are surely as overblown as they are widely recognized, while asset prices have discounted Brexit to some extent.
Firstly, the risk of a hard Brexit was much higher in the months after the referendum and is significantly lower now. It is clear that apart from a Brexit fringe (~30 MPs) in the Torry party there is no support for a hard Brexit in the British parliament. No party wants to preside over Brexit-related chaos as it would most certainly lead to losing next elections. The parliament may be divided in what deal it wants with the EU, but it clearly opposes a hard version of the exit and the Tories would hate to hand over power to Corbyn-led Labour.
This mirrors the British public, where the median voter is now in the “Bremain” camp. Also keep in mind that the referendum was held during a refugee crises in the Mediterranean, when over a million refuges flooded Europe. This crisis and related media outcry are now under control (we are down to tens of thousands per year across the continent from >1 million), which helps public perceptions.
Theresa May has been working with Brussels on a compromise solution (ie a fudge, Brexit in name only or some form of soft Brexit), which so far remains elusive, but both sides are trying their best to reach a deal. The argument for holding a second referendum is compelling, as the full consequences of Brexit were not understood at the time of the first referendum.
Secondly, UK financial assets have de-rated as a consequence of Brexit fears and some selling in anticipation of the the UK leaving the EU. There is evidence of significant outflows from UK-oriented funds and considerable selling pressure in the market. Presumably certain funds who have a mandate to invest within the European Union, have been paring down UK positions in anticipation of Brexit. Others have simply been too afraid to take on the well-flagged risk. The relentless selling of British stocks has left the market quite cheap as can be seen on the Price-to-cashflow measure below (show relative to the rest of the world).
Pets at Home
Pets at Home (PETS) is a leading retailer of pet products and related services for pets. The company is exposed to positive trends in pet ownership and “humanization” of pets. Pet ownership is on the rise in the west – younger people choose to have pets before they have children (or even instead), while older people, whose offspring have left the household, fill the void with a beloved four-legged companion. Dogs are no longer there to guard the house, they are family members and get treated as such – treats, special care, medical chekups etc. This comes with more spending going towards pets – both merchandise (food and accessories) and services (grooming and vets). PETS is well positioned to address this demand dynamic. The company operates 448 stores, 461 vet practices and 309 grooming salons.
The share price has been under pressure over the last 3 years, and admittedly it was not purely due to Brexit fears. Although Services (vets and grooming) have been growing comfortably (up 13.7% in FY 2018, ending in March) and are delivering stable margins (34.1% in FY18), merchandise sales have come under pressure from internet competition. The internet does provide a quick and convenient comparison of prices and it is easy to order your cat food from another provider. PETS have made price adjustments over the past two years to reduce the gap on certain key products relative to internet players such as Zooplus, Amazon and Pet Supermarket. This largely explains the drop in group EBITDA margins from 16% in FY16 to 13.7% in FY18. I suspect this was largely a one-off and it also begs a greater question – can PETS not have higher prices than pure online competitors? Their data show that customers who come to use their services (Vet/Grooming) end up spending more on merchandise than customers who only come to shop. (NB grooming/vets are generally co-located at the store) Once you are in the physical store, it might not matter so much if Amazon is £1 cheaper on a bottle of dog shampoo, you will pick it up there and now. Customers who order merchandise online are more price-sensitive, but this is where selling to pets is different than selling books – the service offering brings people to the physical store. This is strengthened by loyalty cards and bundled healthcare packages and insurance.
Pets at Home trade in London under the ticker PETS, has a market value of £780m and a dividend yield of 4.8%.
For this one, it helps to be familiar with the British custom of sending cards to friends and family on anniversaries, weddings and the other special occasions. It’s deeply engrained in the culture and not being replaced by the internet. People don’t buy their anniversary cards on Amazon, because they usually need them immediately. In addition, Card Factory (CARD) is a value player in this space selling cards for around £1, while some of the more established competitors (ie Hallmark) sell theirs at 2-3 times more. Even Hallmark greeting cards sold via Amazon UK are priced around £2. CARD has a market share of 19.3% in cards and <10% in related accessories (gift wrapping, party products). In a flat market, CARD has continued to take market share from the higher-priced traditional players in 0.5% to 0.7% clips per year. They are the disruptor.
Revenue has grown at a CAGR of 5.4% in 2015-2019 (financial year end in January), however profitability has been hurt as underlying EBITDA margins fell from 25% in 2015 to 20.5% in 2019. Revenues have been driven by consistent growth in like-for-like sales as well as some new store openings. Profitability has been negatively impacted by an increase in the minimum wage in 2018 and (wages are ~20% of costs). The devaluation of the pound post the Brexit-referendum has also increased raw material costs, most of which are imported. The company trades at a ratio of enterprise value to EBTIDA of 9.2x, which is not outright cheap, but it’s down from around 14x in 2017, and largely justified given the strong growth prospects. Margins, in the opinion of this analyst, will not continue falling and the company is in the process of improving efficiencies and reducing costs to counter the negative impact of higher wages and raw material costs.
Card Factory trades in London under the ticker CARD, has a market value of £680 and a dividend yield of 4.7% and 7.3% if you include the special dividend that has been paid in 2018.
McColl’s (MCLS) is a convenience store chain in the UK. For a unexciting and stable business which is selling milk, donuts and tobacco, McColl’s share price has had a truly crazy ride in recent years. The share has trade around 150 pence for three years after listing in 2014 at 160 pence (with a dip below 130 post Brexit referendum). It rallied to 300 pence in the following year. The news that was particularly well-received by the market was the all-cash acquisition of 298 Co-Op convenience stores (adding to the then 650 or so stores around the country). Earlier this year the stock fell as low as 50 pence, before rebounding to the current 83p.
Given the relative stability of operational results, this must be a case of the market overreacting, with Brexit-fears not helping international managers allocate capital to British stocks. It is true that profit fell by around half in 2018 (on the back of a 1.4% like-for-like sales drop), however this was due to extraordinary circumstances, which will not be repeated. The wholesale supplier of MCLS, for which the operator relied upon to supply 700 of its stores, unexpectedly went into receivership. The collapse of Palmer & Harvey created massive disruption and at its peak even staff from the company’s head quarters was sent out to drive delivery trucks to stores around the country. This event is now dealt with as MCLS has transitioned all of its 1’253 stores to a new supply partner – Morrisons – a leading UK supermarket chain. Thus the drop in profits in 2018 should be seen in this context. The company took on debt during the Co-Op acquisition. As a result net debt jumped from 37m in 2016 to 142.2m in 2017. However in 2018 – as turbulent as the year was – the company brought net debt back down to 98.6m. This is proof of MCLS’s strong cashflow generation. Apart from selling groceries, MCLS is one of the UK’s largest post office operators, houses amazon lockers, and allows customers to make bill payments. It is not at risk from internet competition. The retailer is also testing rebranding some of its stores as Morrisons Daily.
Based on the depressed EBITDA generated in 2018, MCLS trades at a multiple of EV/EBITDA of 5.6x, while using 2017 EBITDA (probably a good estimate of the run-rate profit) the multiple is 4.4x. Barring another distributor bankruptcy, the underlying business of McColl’s should prove stable and resilient.
McColl’s trades in London under the ticker MCLS, has a market value of £97m and a dividend yield of 4.8%.