Markets Now – Tuesday 5th May 2020

There’s an easy explanation for volatility: the range of possible outcomes needing priced into assets has widened so price discovery gets more messy. It follows, then, that falling volatility would indicate that the range of outcomes requiring priced into assets has narrowed. This is relevant to our current circumstances because the Vix has drifted back to around 35, which about matches its levels during the 2012 Eurozone crisis and the 2002’s difficult-to-summarise capitulation point:

But what if falling volatility doesn’t indicate a narrowing range of potential outcomes? What if it shows only that investors are growing accustomed to profound uncertainty? It’s generally agreed that after awhile a person can get used to anything (where “generally” is double-sourced on Maman in Albert Camus’s The Stranger and Bruce Springsteen in Straight Time). If that’s true then current valuations are no more likely to match up with future events as they were a month ago. The relative calm now compared with then owes everything to the psychological default states of adaptation and acceptance than to conventional EMH.

We raise the point because the FTSE 100’s up about 1 per cent at pixel (on oil, mostly) and there’s a clutch of strategy notes in circulation asking expansive questions about whether anything’s worth anything. Here’s one from Bernstein’s Inigo Fraser-Jenkins:

All investing comes down to the political backdrop in the end. Hence the enormous social changes that will likely be a lasting feature of the pandemic will probably change the outlook and even the goals for investing. For anyone who still believed that a “science of investing” is possible, while that belief was likely shaken by the GFC, we think the pandemic will be its death knell.

Fraser-Jenkins quotes Karl Marx, Daft Punk and a 2017 episode of Question Time as he kicks around the idea that a post-pandemic world might be one where there’s “a realisation of the importance of intimacy and introspection”, and where “reassessment of goals, including those of investing, seems plausible.” The depth of uncertainty requires an essay rather than a research note, he says, as “such notes have to be quantified, but our topic here cannot be quantified”:

The COVID-19 pandemic brings several huge changes with it. The direct social response to the virus is the lockdown which has temporarily all but forced an end to physical intimacy, it has also put the prevailing 24/7 culture on hold and thereby it has broken the social rhythm. Then there is the economic impact of the social and political change brought on by the virus. We think that the most profound of these changes could be a long-term impact on politics needed to respond to the social crisis. This may well involve a questioning and then a possible re-framing of some of the core tenets of neo-liberalism in the form of a shareholder-first corporate culture and technocratic stewardship of the economy via independent central banks with minimized government intervention. Methodologically, for finance this may lead to a realisation that there cannot be a Science of investing. Finance rests, ultimately, on political economy and the personal subjective sphere cannot always be ignored in economics, thereby highlighting the bounds of any model that assumes society is merely a sum of rational mean-variance optimising participants. The global financial crisis might have been the impetus to start that realisation, and the pandemic likely amplifies it.

It’s not all brown study. There’s some discussion of C19 accelerating the outperformance of megacap stocks, the rotation to passive management within equity portfolios and the expansion of duration (and hence interest rate risk) in fixed income portfolios. Pre-existing macro trends now unlikely to fade include the growth of government debt, the level of wealth inequality and the role of populist forces in the sphere of political economy. Nevertheless, the big questions keep coming:

This sets the stage for the huge investment question for the post pandemic age. How to save for retirement if inflation rises while returns from fixed income are lower, duration risk in multi asset portfolios is greater and equities and bonds no longer diversifed? What does the build-up of public sector debt mean for sovereign and currency risk and the fiscal space of future governments?

But it is in the interaction of the private sphere and the public sphere that the more profound questions possibly arise. If unemployment never again falls to the low levels of recent years and if inequality becomes a dominate social trend, what does this mean? This implies an ugly build-up of social pressures within the largest economies. Is some form of universal income needed to ameliorate these effects? The hiatus of rhythm and intimacy in lockdown could well change what is socially acceptable and politically possible and bring about changes in the goals of investing. What should governance structures look like in a world that desperately needs to extend the horizon of investment? Does an unravelling of some aspects of the neo-liberal age, along with a process of de-globalisation mean an end to and even a reversal of the long-term downward path of yields? Moreover, what is the status of theoretical statements about finance and investing and the attempt to frame investment as a scientific enterprise? The financial crisis of 10 years ago showed the fallacy of such a view, the pandemic may be its death knell

Following all that with a look at individual market movers feels a little like reaching to conclusion of Monty Python’s Galaxy Song. Nevertheless, the headline says Markets Now so markets are what we’ll now. Peel Hunt upgrades Hiscox, the reputationally damaged business interruption insurer, to “add” from “reduce” with a 725p target.

Hiscox has flagged that it is not ruling out an equity capital increase and we have taken the liberty to include a US$500m rights issue within our assumptions, alongside our central Covid-19 loss scenario (US$275m). The shares now trade below our pre-rights fair value (800p based on central Covid-19 loss) and our worst-case value (720p). At current multiples (1.2x TNAV) it may be worth taking any debate around capital off the table by raising equity pre-emptively.

We have assumed that HSX’s existing capital surplus (205% BMA solvency ratio at end-2019) can absorb even our worst-case Covid-19 scenario. Hence, any capital increase would serve to: 1) absorb losses after a very active hurricane season; and/or 2) retain capital to grow into a hardening property re-insurance market. We estimate that with US$500m of extra capital HSX would have the buffers to: 1) bring the solvency ratio back to 2019 levels (202%) post-Covid-19 and 2) allow for up to cUS$600m of incremental gross premium growth in property re-insurance lines, where rates should continue to harden.

Change in EPS – We have included a US$500m equity rights issue at a 30% discount in our estimates. Our 2020E adjusted EPS loss widens to -15.8c, and for 2021E/2022E we lower adjusted EPS by -14%/-8% respectively due to the dilutive economic impact of the capital increase.

Valuation – Whilst we appreciate that there will be noise around any possible capital increase, we believe the stock now seems attractively valued. It is trading below our post-rights target price of 725p (down from 800p pre-rights) and is now cheaper than its peers on pre- and post-rights bases (1.2x TNAV 2021). We upgrade our recommendation to Add from Reduce, supported by 6% upside to our target price pre-rights (+13% based on TERP).

Royal Mail goes up to “hold” from “sell” at Deutsche Bank in response to the recent stake building by Daniel Křetínský and Patrik Tkac. Deutsche has at much insight as the rest of us on whether the stake is financial or a bid platform but still raises its target 183p, up from 93p, which matches the multiple paid by Deutsche Post DHL for (the extremely different) peer UK Mail in 2016. Deutsche hasn’t sent the full note for some reason so here’s the line that was in the Breakfast Briefing:

Our fundamental view on Royal Mail is that it is overvalued on a stand alone basis and that the shares are fundamentally worth 93p, far below the current share price. However, last Friday, after market close it was disclosed that Vesa Equity Investment had upped its stake in RMG and crossed the 4 and 5% shareholder ownership limit to a 5.35% stake (RMG’s 4th largest shareholder).

Flutter gets a push from various places after completing its purchase of Canadian online poker shop The Stars Group. RBC’s keen:

Our view: The successful acquisition of The Stars Group positions Flutter as the most resilient of the gambling operators, with the most promising prospects for growth. We introduce our model for the combined group, raise the PT to £120 and remove the Spec Risk qualifier now the deal has closed. We reiterate Flutter as our top pick within the Leisure sector.

Key points: The Stars Group acquisition closes today creating a c£14.5bn global market leader in online gambling. The £140m of cost synergies results in a 70% enhancement to FY22e EPS on our numbers, with further revenue synergy potential from cross-selling.

An increasingly defensive business: The acquisition provides diversification that reduces the overall risk for the group. Firstly, exposure to the more mature markets falls (UK: 59% to 49% of revenue) with RoW rising from 9% to 31%. Flutter’s exposure to sportsbetting also falls from 78% to 45% – the importance of which is highlighted by the current COVID-19 crisis.

The US opportunity is vast: Flutter’s FanDuel has held pole position in key US States, commanding c51% share on average since January 2019. Stars’ FoxBet aims to reproduce the success seen by Sky Bet, which will be significantly helped by the backing of the US’s 2 nd -largest sports media group, Fox Sports. The combined dual-brand strategy offers a very powerful combination, in our view.

Lowest regulatory risk: Regulatory scrutiny & crackdowns are the key concern for investors in this industry. We have quantified the 3 key regulatory risks that could have a material financial impact on our groups (UK VIPs, UK online casino & Germany) and conclude that Flutter/Stars is significantly less exposed than peers GVC and William Hill.

Robust financials: Stars enjoyed £505m of FCF after capex in 2019 and Flutter £240m. We estimate the combined group will see £950m by FY22e post synergies and pre dividend. Impressively, Stars is so cash generative that the combined group remains cash generative even in a COVID- disrupted scenario. The new financing terms have set revised covenants of 5.1x. We estimate 3.7x ND/EBITDA in the COVID-disrupted year of FY20, falling to 2.1x next year.

£120 PT based on our sum-of-the-parts valuation using FY22e forecasts that incorporate the full £140m of synergies. We have taken a 14x EBITDA multiple for the online business (top end of the 8-15x range) and 7x for the more structurally challenged retail business. We value the US at £5bn in line with the Draft Kings market cap. The combined group trades on 16.5x FY21e PE falling to 14.4x in FY22e, which we believe is undemanding compared to the 14-21x trading range and considering the competitive market position of the combined group.

Liberum has a big (114 pages!) property note out that upgrades various things including Capital & Counties and Great Portland:

This crisis is different. It is primarily a crisis of income, not of values. Thankfully, REITs are in better financial health than they were pre-GFC. We think that almost everyone survives, but many will pick up bruises along the way. While we expect property values to keep falling under lockdown, we see share price value in those with the strongest balance sheets and best exposure to property mega-trends, which the COVID crisis will now likely accelerate. In that vein, we move GPOR and CAPC to our BUY list (from HOLD) alongside SGRO, WKP, CLS, NRR, SHB, TOWN, RLE, PHP, YEW, SMP, UAI and HWG. Given that we think there is a significant risk of a highly dilutive equity raise, we move HMSO to SELL (from HOLD) alongside INTU.

Canaccord goes up to “buy” on Stagecoach.

Long-term prospects for local bus services in the UK remain attractive, in our view, given environmental concerns, air quality, traffic congestion, etc. In the near term, however, the Covid-19 pandemic is having a major impact on UK regional bus given the nationwide lockdown. With social distancing rules likely to remain in place for some time, we expect the demand recovery to be gradual and over an extended period of time. Economic weakness and rising unemployment may further dampen the recovery. Despite these challenges, we believe that Stagecoach is attractively valued at current levels. …

The social distancing measures and lockdown introduced across the United Kingdom have had a profound impact on Stagecoach’s operations. According to its last trading update (3 April 2020), commercial sales at its regional bus companies were at c.15% of ‘normal’ levels. Vehicle mileage at those companies had broadly halved, with plans to reduce it further to 40%, and c.55% of the regional drivers and engineering staff had been furloughed.

In London, contracted revenue amounts should continue to be paid but any variable cost savings achieved as a result of reduced service levels must be returned to Transport for London (the contracting authority). Across England, Scotland and Wales, governments have committed to maintain the vast bulk of revenue associated with concessionary, tender and school bus services, while Bus Services Operators Grant payments will also continue. In addition, the government is providing a funding package for the bus industry for a period of 12 weeks (mid March-mid June 2020), which includes £167m of new funding to support critical bus services. This should allow Stagecoach, and other bus operators, to continue to provide bus services, albeit at significantly reduced levels, to support key workers and medical staff whilst breaking even financially.

For modelling purposes, we assume that regional bus operations break even until June 2020, after which we expect demand to gradually recover over the following 12 months or so. London operations should hold up considerably better than the regional business, given the agreement with TfL, although Quality Incentive Contract payments may be slightly reduced. Our new adjusted PBT forecasts for FY20E, FY21E and FY22E are £84.7m, £27.0m and £77.4m respectively.

The Group has over £500m of available liquidity, although this includes £94m of net rail liabilities, the majority of which is due to be settled within the next 12 months. Of the remaining £400m+ liquidity, debt facilities totalling £140m are due to expire in October 2021. Dividends, which are currently suspended, should resume in FY22E.

We have reduced our target price to 110p (from 150p) to reflect the significant near-term impact of Covid-19. This target is based on a prospective P/E of around 10x FY22E, which is in line with its historical pre-Covid-19 five-year average. This valuation is supported by a DCF-based SOTP. We upgrade our recommendation to BUY (from Hold).

And Davy has a note considering the pandemic’s effects on cardboard, which steps Mondi back to “neutral” from “outperform”.

The COVID-19 pandemic has long-term, fundamental implications for the European packaging sector. While the short-term impact on earnings continues to be negative, as detailed in this report, the importance of packaging in supply chains has been firmly established. Security of supply and changing consumer behaviours will favour larger players like Smurfit Kappa Group (SKG) and DS Smith. Further industry consolidation is likely to follow, which will ultimately drive a sector re-rating. Therein lies the opportunity.

We are reducing our full year forecasts for the European packaging sector on the expectation of a sharp fall in demand in 2020 with a gradual recovery in 2021. For SKG, we are reducing our 2020 and 2021 forecasts by 10% and 2% respectively. For Mondi, we are cutting our 2020 and 2021 forecasts by 10% and 6%. For DS Smith, we are reducing our FY 2021 and FY 2022 forecasts by 11% and 4%.

Despite the forecast revisions, all three companies remain solidly cash generative through the cycle. All three have substantial liquidity, while both Mondi and SKG remain within their stated leverage targets. Our discounted cash flow (DCF) analysis implies a value of 3300c per share for SKG, implying 15% upside, and it remains our top pick in the sector with an ‘Outperform’ rating. While our valuation analysis implies upside potential for both DS Smith (+7%) and Mondi (+11%), we are cutting Mondi to ‘Neutral’ given the near-term downside risk to earnings in its Uncoated Fine Paper and sack kraft businesses. We are maintaining our ‘Neutral’ rating on DS Smith.

We believe the current crisis will drive structural changes in the packaging sector. The importance of packaging suppliers in supply chains has been firmly established. Companies relying on packaging will increasingly favour larger, vertically integrated operators with more extensive networks that can guarantee supply. Consumers will demand safer (yet renewable) packaging that is increasingly delivered through more packaging-intensive online channels. We believe these trends will drive greater consolidation in what is still a relatively fragmented European industry. Over time, this should result in further structural improvement in margins and returns and ultimately a higher valuation rating for the sector.

• Updates to follow, which may or may not reflect any requests or complaints submitted via the comment box. There’s a Telegram Markets Live chat group for anyone who wants one of those.

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