IC — On the Beach, Vodafone, Sophos

Buy: On the Beach (OTB)

Targeted capital allocation has enabled On The Beach to expand its market share, despite the general cooling, writes Tom Dines.

Difficult markets threaten to undermine the genuine progress made by On The Beach to diversify and invest in its business. Adjusted pre-tax profits were up 14 per cent in the six months to March, on revenue growth of 41 per cent, but management warned that the “ongoing uncertainty” arising from Brexit meant trading in the background market was 10 per cent weaker in 2019.

Management said it would be cautious of the consumer environment until Brexit is resolved, but has been maintaining its strategy of investing. The group opened its new digital headquarters in Manchester in the period, aimed at helping it attract new talent, and expanded its operational headquarters in Cheadle.

It also launched Classic Package Holidays, an online booking portal for travel agents to complement its growing business-to-business offering, which kicked off with the acquisition of Classic Collection Holidays last August.

The collapse of Danish airline Primera Air in October last year affected revenues in the international division, but the group said it offset this with a
75 per cent reduction in marketing spend in the business.

The decrease was more muted in the broader group, falling from 48 per cent of revenues to 43 per cent, but management reported record levels of brand awareness and branded traffic.

House broker Peel Hunt expects adjusted earnings per share to rise to 23.3p for the September 2019 year-end, from 21.2p in full-year 2018.

Hold: Vodafone (VOD)

Vodafone 5G is due to launch in the UK this July. However, we prefer — on balance — to watch the next stage from the sidelines. advisers

Vodafone has slashed its dividend in a move that will disappoint — but not necessarily surprise — income-seeking investors. Going into its latest full-year results, a depressed share price — and correspondingly high yield — had indicated that many were anticipating a cut.

It does, perhaps, come as a relief that Vodafone intends to pursue a progressive dividend policy from its rebased position — although some may remain sceptical. As recently as last November, the group had planned to maintain the previous year’s payout.

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Chief executive Nick Read explains that increased competition in Spain and Italy, headwinds in South Africa and high spectrum auction costs have reduced “financial headroom”. Lower dividend payments should help to reduce debt and “delever to the low end of our target range” (2.5 to 3 times cash profits) “in the next few years”.

A dip in sales reflected currency movements, new accounting rules and the Vodafone Qatar disposal. Meanwhile, a decline into the red came after impairments and a loss on the disposal of Vodafone India.

For full-year 2020, Vodafone expects adjusted cash profits of €13.8bn-€14.2bn, with pre-spectrum free cash flow of at least €5.4bn. Such goals are, ostensibly, underpinned by its portfolio optimisation plans — including the €2.1bn sale (announced just before these results) of its New Zealand business, and its €18.4bn acquisition of assets from Liberty Global — which, all being well, should complete in July.

JPMorgan forecasts adjusted pre-tax profits of €3.06bn and earnings per share of 7 cents for full-year 2020, against €2.54bn and 5 cents in full-year 2019.

Sell: Sophos (SOPH)

Shares in cyber security group Sophos were up 14 per cent on release of a better-than-expected set of full-year numbers, writes Harriet Clarfelt.

Revenues beat consensus estimates (per Bloomberg) of $696m, underpinned by a double-digit rise in subscription sales. Billings were flat at constant currencies —
hardly inspiring, but still representing an improvement on the “modest decline” anticipated within January’s third-quarter update.

A year ago, Sophos enjoyed a step up in demand in the wake of the “WannaCry” ransomware attack and the launch of its “Intercept X” product. But it has since seen “a return to more traditional levels of cross-sell activity”, leading to a net renewal rate of 124 per cent – down from 140 per cent. It has also undergone a “mix shift” in billings, with growth in smaller customers buoyed by managed service provider monthly billings, and fewer big transactions.

Such momentum among MSPs has contributed to Sophos’s new approach to guidance – now focusing on revenues and adjusted operating profit, while billings are “becoming less indicative of the medium-term growth in our business”.

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Consensus forecasts are for adjusted earnings per share of 15 for the September 2020 year-end, against 13.9 in full-year 2019. The cyber security market looks attractive, with its worth estimated at around $46bn. But — as (albeit bullish) broker Stifel notes — the “shares will be in purgatory until it proves that it is not ex-growth”.

Chris Dillow: Small-cap warning

Many of us hold small-cap stocks and funds, which poses the question: can we predict when these will do well or badly? The answer is yes, up to a point, and lead indicators are warning us to be cautious of them now.

I say this because simple statistics tell us that a few things have in the past predicted annual changes in the FTSE SmallCap index relative to the All-Share index. Three types of indicator matter.

The first are dividend yields. This isn’t surprising. What might be surprising, though, is that when we control for other things it is not small-cap yields themselves that have the best predictive power. What matters instead is the yield on the FTSE 100. When this is high — other things being equal — small-caps subsequently underperform. This is simply because big stocks recover after they have been unusually cheap, which means that small-caps underperform.

A second set of predictors are interest rates. Small-caps do well after 10-year yields have been low relative to shorter-term rates. You might find this surprising: inverted yield curves predict recessions, which are bad for smaller stocks. Once we control for other things such as dividend yields, however, it seems that small-caps swiftly discount the bad news of an inverted yield curve, which means their prices tend to rise.

A third pair of predictors are the oil price and shipping costs, as measured by the Baltic Dry index. Small-caps do well after these have been low, controlling for other things.

These predictors now point to small-caps underperforming the All-Share index in the next 12 months. This is largely because the yield on the FTSE 100 index is well above its post-1990 average, while yields on the FTSE 250 and Low Yield index are around their average. This implies that bigger stocks are relatively cheap, which points to them outperforming smaller stocks.

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But how reliable is this signal? Collectively, these lead indicators have explained almost three-fifths of the subsequent annual changes in small-caps relative to the All-Share index since 1991. Notably, they successfully predicted both the best and worst performance of small-caps, during the financial crisis and subsequent recovery.

We can look at this another way, though, by considering how these lead indicators performed in each calendar year. In the past 28 years they have gone seriously awry five times, in the sense of small-caps outperforming or underperforming by 10 percentage points or more when our lead indicators predicted a move in the opposite direction. On four of these five occasions, small-caps outperformed when our lead indicators predicted underperformance: this happened in2012, 2013 and 2015.

This warns us that small-caps can sometimes enjoy reratings — doing better than they should, given valuations and cyclical conditions. Which poses the question: how likely is a repeat of this?

One hope would be that Brexit uncertainty recedes. Insofar as this would increase appetite for risk, it should benefit smaller stocks more — their valuations have been more sensitive to policy uncertainty than those of the All-Share index. Another hope would be that the world economy regains its vigour, which should also help raise appetite for risk and hence smaller stocks — the recent recoveries in narrow money growth in the eurozone and China support this possibility, although the possibility of an intensification of the trade war speaks against it.

There are, therefore, hopes for small-caps despite the fact that valuations are slightly against them. Perhaps, then, they should be part of a balanced portfolio, but not — for now at any rate — a very large part.

Chris Dillow is an economics commentator for Investors Chronicle

The Financial Times and its journalism, including Investors Chronicle content, are subject to a self-regulation regime under the FT Editorial Code of Practice: FT.com/editorialcode



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