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Investors’ Chronicle: Vodafone, Burberry, Imperial Brands


BUY: Vodafone (VOD)

Inflation pressures will cause medium-term pressures but these results don’t change the long-term investment case, writes Arthur Sants.

Vodafone is always looked at in comparison to BT. The challenges facing management are the same. Rising inflation, increasing interest rates and the cost of living crisis. These factors make investment and financing more expensive whilst also making it trickier to raise prices in what is already a very competitive market.

The main difference between the two is which regions they operate in. BT has a global business which makes up 16 per cent of its revenue but the rest of its sales comes from the UK. BT’s fate is tied to that of the UK economy. Vodafone is much more international, just 15 per cent of its revenue is derived from the UK while the rest is generated in continental Europe and Africa.

This is why Vodafone is more valuable that BT. Vodafone currently trades on a forward price/earnings ratio of 11.4 while BT’s is just 8.7, though both multiples point to market uncertainties. The UK is Vodafone’s lowest margin market with an adjusted cash profit margin of just 21.2 per cent. In Germany, which makes up 30 per cent of Vodafone’s revenue, the margin is 43.2 per cent.

The other market that helps Vodafone stand apart from BT is Africa. In the past year, African mobile customers increased from 178mn to 184.5mn. For comparison, there were only 66.4mn European mobile contract customers.

To further monetise the growing African customer base Vodafone has been selling its M-Pesa mobile money platform. M-Pesa allows users to manage business transactions and to pay salaries, pensions, agricultural subsidies and government grants. Last year, there were 52.4mn M-Pesa users in Africa, up from 48.3mn. The goal to get 50mn M-Pesa customers has been exceeded three years before its original target date.

The high-growth market of Africa and the high-margin market of Germany sets Vodafone apart from BT but the fact remains the same: neither are moving anywhere quickly. This year, group revenue at Vodafone rose just 4 per cent, while adjusted cash profit was up 5 per cent and free cash flow rose 6.4 per cent. These aren’t bad numbers, they are just indicative of how slow moving the telecoms market is.

To justify the price rises needed to increase sales, a huge amount needs to be spent on improving the infrastructure and acquiring 5G spectrum. Last year, capital additions totalled €8.31bn (£7.04bn) and spend on spectrum was €896mn. Capital additions were up 5.9 per cent from last year and as raw materials and wages continue additional spending will only become more expensive.

However, investors will be pleased to see pre-tax ROCE rise 1.7 percentage points to 7.2 per cent. This shows that Vodafone is managing to increase returns on its significant investment. The progress is slow but if the figure keeps moving in the right direction then investors may eventually be rewarded.

This is presumably the hope of Emirates Technology Group, a UAE telecoms company that has just purchased 9.8 per cent of Vodafone’s shares. The group cited Vodafone’s “geographically diversified business” and “attractive valuation” as reason for the purchase. It also confirmed it doesn’t want a board seat and has no current interest of making a takeover bid.

Emirates Technology Group could be happy to take a back seat on the operational side because Scandinavian activist investor Cevian is reportedly already pressuring the Vodafone board to dispose of its slow growth assets. It hasn’t publicly stated its intentions for Vodafone — but there have been reports in the Financial Times that Cevian is pushing the board to speed up the corporate restructuring processes. This would likely include the sale of the Italian and Spanish businesses which have seen revenue growth flatten the last few years. Vodafone has already rejected an €11bn bid for its Italian business in the last year.

The FT has also reported that Vodafone UK and Three UK have opened talks about a merger. This would bring together the third and fourth largest mobile operators in the UK and give it the market scale to push through price rises more effectively in one of its lowest-margin markets.

In the long term, there is value in Vodafone if it can consolidate its most profitable European markets and then expand its fin tech and mobile business in the African market. However, in the short-term inflation is going to cause some pain as pushed up costs and limits customers spending power. Adjusted free cash flow was €5.4bn, which was €100mn below guidance, and next year management expects it to fall another €100mn to €5.3bn.

FactSet consensus is for free cash flow to rise again in 2024 which gives a healthy 2024 free cash flow yield of 13.2 per cent. This is well ahead of BT’s 2024 free cash flow yield of 6.9 per cent — although brokers expect BT’s to continue to rise in 2025 and 2026 as spend on Openreach eases back. Of the two, Vodafone is the better option but for investors the story is the same. It’s a long-term investment — sit back and enjoy the dividend.

HOLD: Burberry (BRBY)

Lockdowns in China continue to weigh on sales of luxury trenchcoats, writes Madeleine Taylor.

Burberry’s move upmarket is progressing faster than expected with profits ahead of expectations, despite Chinese sales slipping from fresh lockdowns. The trenchcoat maker’s adjusted operating profits grew by 38 per cent to £523mn at constant exchange rates in the year to April 2, with margins also jumping by 210 basis points to 18.5 per cent.

Burberry is reaping the rewards of the business revamp it began two years ago, cutting costs through staff lay-offs, store closures, and slashing the levels of price markdowns and outlet sales. Since then, full-price sales have risen by 30 per cent, but growth had slowed to only 7 per cent in the three months to April.

The leather goods label said it expected margins to keep going up alongside high single-digit sales growth in the medium term, but this outlook is “dependent on the impact of Covid-19 and rate of recovery in consumer spending in mainland China”. 

Asia-Pacific is Burberry’s largest market, accounting for £1.3bn or almost half of total revenues, but lockdowns in Shanghai and Beijing contributed to a 7 per cent drop in regional sales in the three months to April. How much longer Burberry will be able to offset this with growth in the Americas, where sales rose by 47 per cent to £696mn over the past year, remains to be seen — especially since more than half of its stores, including 39 new openings, are in Asia-Pacific.

Jefferies remains “more cautious” on full-year 2023, and forecast a 50 basis point contraction in the trading margin to 18.1 per cent. We agree, and view that Burberry’s dependence on China might cancel out some of the traditional shielding luxury brand enjoy against weaker consumer trends.

SELL: Imperial Brands (IMB)

Progress is being made through a five-year growth strategy, but proposals from the Food and Drug Administration highlight the difficulties for the tobacco sector, writes Christopher Akers.

Imperial Brands, along with its peers, is facing difficult societal and regulatory challenges as traditional tobacco products continue to lose their appeal and governments get tougher on the health risks from smoking. But a five-year growth strategy, robust cash generation, and the continuing deleveraging of the balance sheet is delivering progress.

The company is 18 months into its transformation strategy, and is now in the “strengthening phase”. A key part of this is a focus on the five priority markets (the US, UK, Australia, Spain, and Germany), which deliver around 70 per cent of operating profits, and the rollout of a next generation products (NGP) strategy.

Imperial increased its aggregate market share by 25 basis points across its key markets, which represents good progress after an unimpressive period of market share performance. Gains in the US, UK, and Australia offset declines in Spain and Germany, with the UK enjoying a 105 basis point uplift.

But there was bad news from the US following the year end. In April, the US FDA announced proposals to ban menthol cigarettes and flavoured cigars. This could stymie growth opportunities in a significant market. The company are currently appealing FDA marketing denial orders for some of its vaping products.

In terms of growth, NGP outperformed traditional tobacco in these results. NGP net revenue was up 8.7 per cent to £101mn, though this still equates to just 3 per cent of tobacco revenues. Heated tobacco products will now be rolled out across additional European markets, taking the NGP offering forwards. On the other hand, tobacco net revenue grew by just 0.1 per cent and volumes fell by 0.7 per cent. Prices were raised by 1.2 per cent in the period, with increases in the second quarter of 3.8 per cent.

When it comes to the balance sheet, Imperial has as big debt pile. The good news is that management is keenly aware of the need to reduce it, and is aiming for the lower end of a 2-2.5 times net debt to Ebitda target. Net debt fell by £1.2bn to £9.8bn in the half, driven by free cash flow.

Citi analysts said that “with the shares having lagged British American Tobacco significantly year-to-date, the risk/reward is skewing to the upside”. The bank thinks that the chances of a share buyback later this year have increased on the back of these results. That may be so, and strategic progress and debt reduction is encouraging, but we are not yet convinced of the merits of an upgrade.

Chris Dillow: Sell in May dilemmas

Should we sell in May? The question is not just about market timing. It also raises two issues which investors encounter in other contexts.

Issue one is that the theories behind investment ideas are often general, while the implementation of them must be more specific.

The theory behind “sell in May” is that investors’ appetite for risk is seasonal. As the nights get lighter and the weather improves in the spring we become more optimistic and hopeful, and so shares rise.

April has for years been the best month for equities, with the All-Share index posting a total return in the month of 2.9 per cent on average since 1966. Such optimism, however, pushes prices too high with the result that returns are lacklustre in the following months. And then, as the nights draw in, we get anxious and nervous. This causes shares to do badly, often falling to levels from which subsequent returns are good. Since 1966 the All-Share index has on average lost money in September but done well in the winter months.

Implementing or testing this general theory, however, requires us to buy and sell on particular days. An obvious way to do so is to sell on May Day and buy on Halloween. This isn’t just because these are salient dates. It’s because we’ve good historic evidence that this works. Since 1966, the All-Share index has given an average total return of 8 per cent from Halloween to May Day, but an average loss of 0.6 per cent from May Day to Halloween. This pattern is not confined to the UK, nor to recent years.

Last summer, though, this strategy was less successful: the index posted a total return of 5.4 per cent before inflation between May Day and Halloween. Much of this, however, was due to the market doing well in early May and in October. Shares fell between June and September. That’s consistent with the general theory that appetite for equities is seasonal, even though it is inconsistent with one specific implementation of the theory. By contrast, “sell on May Day” has worked well so far this year: the All-Share index is down 2 per cent since then. But this tells us little about whether the general theory is still correct.

This is an example of a common issue in the natural and social sciences (investing is applied social science). It’s the Duhem-Quine problem. This says hypotheses can never be tested in isolation but only jointly with other hypotheses. In our case the general theory (“appetite for risk is seasonal”) is tested alongside a specific one (“buy on May Day: sell on Halloween”).

This problem afflicts all investors. The idea that value stocks — or defensives or momentum or growth or whatever — will outperform is a general theory. Which shares you actually buy is a specific implementation of it. Sometimes the general theory will work and the specific implementation of it will fail, or vice versa. When Russia invaded Ukraine, for example, many low-beta stocks (such as Polymetal) slumped, suggesting a big failure of defensive investing. But more intuitive implementations of defensive investing — such as holding big oil or big pharma stocks — succeeded, suggesting a success.

Our second issue is distinguishing between noise and signal. Between Halloween 2021 and May Day 2022 the index gave a total return of just 3.1 per cent, implying a loss after inflation. This means there has been only one Halloween-May Day period in the past seven years when returns exceeded their 8 per cent average, and that was the Covid-19 bounce of 2020-21.

How should we interpret this fact?

One possibility is that investors have wised up to the mistakes that caused them to under price equities in the autumn and over price them in the spring and so have eliminated the mispricing.

In the 1980s, for example, economists discovered that smaller stocks had for decades outperformed larger ones. Investors piled into them, with the result that since 1989 small-caps have actually slightly underperformed. Maybe seasonal investing is going (or has gone) the same way as small-cap investing.

But there’s another possible reading. All investment strategies do badly sometimes. Even Warren Buffett struggled during the tech boom of the late 1990s; momentum investing did badly in 2009-10 and 2014-15 before roaring back; and so too did defensive investing in 2017-19. Maybe seasonal investing, similarly, has just had a shortlived bad time.

This throws us back on to theory. Do we have strong theoretical reasons to expect the seasonal pattern of share prices to persist?

For this year, the answer is: no. There is always statistical noise around even robust patterns.

On average over the longer run, however, I suspect so. Seasonal changes in our moods are thousands of years old, as we see in the contrast between traditional May Days (when we celebrate hope and fertility) and Halloween or Samhain which is a time of fear, anxiety and preparation for hard times. It’s not obvious to me that investors are so rational and disciplined that they can be relied upon to override such atavistic instincts.

Chris Dillow is an economics commentator for Investors’ Chronicle



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