Stockwatch: This mid-cap has hit a sweet spot

An attractive blend of quality earnings and strong cashflow profile keep this successful tip active.

When brokers change stance to affirm a share's trend – finally, after a long run – is that a contrarian signal? A highly experienced, octogenarian investor I know in the North East is thoroughly dismissive of analysts: he only pays them attention in order to trade the opposite way.

Over decades it appears he got cynical of advice to buy at the top and capitulate when there's value. Contributing ideas to a brokerage, maybe I need to have a quiet word with him, for interactive investor encourages independent views. 

There's also an adage to cut your losses and let winners run, and the legendary American investor Jesse Livermore reckoned a share was never too high to consider buying. But I think my friend's point is valid, about how brokers can be relatively more attuned to trends, and the market has a tendency to exacerbate them, so take care.

Liberum goes out on a limb

A current example is this broker turning positive on mid-cap retail chain Pets at Home (LSE:PETS) for the first time in three years. The shares are 208p currently, and Liberum is targeting about 15% upside to 240p.

The context is, having floated at 245p in March 2014, the stock fell from 230p in November 2016 to 111p by November 2017. I've been positive on Pets in the past, drawing attention as a 'buy' at 125p in August 2018, when insiders were piling in and it was London's third most-shorted stock. It was also one of my "5 stocks for a durable ISA portfolio in the Brexit years" at 155p.

The price had tested 240p by last September then fell below 200p until Liberum's note pushed it up 6p to 208p.  

Source: TradingView Past performance is not a guide to future performance

Bullishness isn't exactly manifested by insiders, although Pets is in a closed period before interims on 26 November. The only fairly recent dealings have seen the CEO (since April 2018) and a senior manager exercise options and sell stock, then get bigger grants of options. It is not untypical, but option schemes enable bosses to book gains then get risk-free exposure to any further upside.

For what it's worth, two hedge funds increased their short exposure significantly at the end of October, and just over 7% of issued equity is out on loan. Five such funds, short of between 0.55% to 3.13% strike a contrasting view.

Mixed numbers yet current marketing success

The six-year table shows mixed trends, and consensus is for net profit to more than double in Pets' current year to March 2020, recovering to near the £70 million threshold it enjoyed in its 2015 to 2017 years.

If forecasts are fair, then Pets' forward price/earnings (PE) ratio is in the mid-teens and the stock yields 3.7%. However, a remarkable £1 billion of intangible assets on last March's balance sheet means negative net tangible assets per share of 20p. I also continue to note a large disparity of £185.8 million trade payables (19.3% of turnover) versus £68.9 million trade receivables.

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End-March net debt was about £120 million, and the net interest charge covered 26x by operating profit; at least debt should remain on a reducing trend given strong net operating cashflow, which last year was £107.9 million.

Pets' raw financials are good in parts however, yet don't lend much support if the trading narrative was to worsen. Presumably that is how hedgies develop a bear case. It's a near-term snapshot view but the price/earnings-to-growth or 'PEG' ratio is a whopping 6x (generally over 2x is deemed expensive) given earnings growth is expected once again to consolidate.

In fairness, the new CEO appears shrewd at marketing and is sorting out/integrating the vets services side with retail. The last financial year showed the dominant retail side (89% of group revenue) showing like-for-like growth of 5%, albeit on a 51% gross margin slightly lower, with vets' margin edging up to 48%.

Last August's trading update saw retail's like-for-like performance up 8.2% from April to July, with vets up 6.2%. Profit for the current 2020 year was guided slightly higher. On a company operations' view, I agree with Liberum about how the underlying trend looks good, as new CEO's initiatives bear fruit.

This very morning a retail analyst has been on the news saying UK retailers are "braced for a downturn" and Pets' last update concluded on a note of "cautious optimism" about the sector.  But, while I can see a downturn would affect acquiring new household pets, those already homed – with cats and dogs typically living a decade – require continued feeding and vets treatment. So, Pet's formula is about as spot-on as it's possible to be, for sticky earnings.

Three key drivers, out a 2020 earnings trough

This is Liberum's pitch and they argue in favour of buying Pets' stock ahead of interims which should affirm underlying momentum. They say: "The shares have run strongly overall this year, but we see upside as the market gains more confidence that earnings and free cash flow will positively inflect." Jargon-free, they mean the business is at a tipping point upwards, which consensus forecasts mask.  

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First, Pets is now highly competitive in food e.g. its own-brands are up to 20% cheaper than rivals, compared with 2017 when Pets was up to 25% dearer. Customer posts I've read online appear to confirm this, with Pets nowadays best-value for food.

A concern would be that this sacrifices margin and Liberum cites "price investment" lately trimming retail gross margin. Maybe you recall Morrison (LSE:MRW) reporting such "investment" to compete with Aldi/Lidl, and the question being how sustainable it proves. For now, Pets appears to have hit a sweet spot.

Second, the aspect of subscriptions. Some 765,000 group customers are on a subscription of one kind of another, having grown rapidly from scratch, although the number is still only equal to 17% of VIP loyalty members. This demonstrates there is clear headroom to grow the subscriber base.

Puppy Club is a prime opportunity where existing members offer around £130 million revenue or 13% of estimated sales in the current financial year, and flea/worm medication could offer a £70 million a year opportunity alongside vet healthcare plans. "These are driving more recurring, higher margin revenue streams and better visibility," we're told.

Third, restructuring the vets side is said to mean a possible £27 million cash outflow this year, but which then helps push free cashflow (i.e. after capital expenditure) over £70 million from the 2021 year.

So, Pets offers an attractive blend of quality earnings with a strong cashflow profile, able to further improve the balance sheet and enhance payouts, which isn't apparent from consensus forecasts. While conceding their target is still short of Pets' 245p flotation price in 2014, Liberum considers the business "better positioned now."

Another chance at medium-term 'buy'

Recalling my own stances, I think the balance of factors affirms this stock as worth retaining, despite all the political uncertainties. The current chief executive looks to be honing the group well and spending on pets is net-defensive.  

Trickier is whether to buy the shares afresh or add, given that this stock has to contend a headwind of wariness towards retailers generally – it's why they fell about 17% from September and remained volatile.  

Yet, the UK political parties seem to have converged on higher government spending as a means to economic stimulus (now the scope for interest rate cuts is diminished), they just disagree on specifics.  

So, despite potential for economic damage from Brexit there should be aggregate UK demand and consumers might not capitulate as feared. I wouldn't buy Pets as a short-term play on the interim results, but I disagree with those hedge funds perceiving risk over reward. A conservative investor would sit pat, but with fresh money there is scope to consider further investment: Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.