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Investors’ Chronicle: Domino’s Pizza, Travis Perkins, Direct Line

BUY: Domino’s Pizza (DOM)

Higher wheat prices and driver shortages weigh on the pizza company, but its shareholder offering remains strong, writes Jennifer Johnston.

As the cost of living crisis intensifies, people are cutting back on takeaway meals — and this more conservative approach to spending is evident in the accounts of food delivery firms. Last month Deliveroo cut its UK sales forecast, while Domino’s Pizza has reported a fall in its pre-tax profits for the first half of the year.

With the prices of food and energy soaring, the pizza company said it will pass on cost increases to its franchisees “on a lagged basis”. It expects the full impact of these rises to be registered in the second half of the year. In a bid to retain customers, Domino’s also reported that it will increase its marketing spend significantly in the final six months of 2022.

Macro headwinds are blowing at something of an inopportune time for the company, which resolved a longstanding dispute with its franchisees last year. The company was able to close full-year 2021 with increases of more than 10 per cent in both pre-tax profits and revenues.

Though the current climate will no doubt prove challenging for the company, all has not been lost this year. Domino’s reported a year-on-year gain of 0.6 per cent in its share of the UK takeaway market and growth of 2.1 per cent in total orders in the first half.

Management is also keen to show shareholders that the business is resilient and, to this end, has increased the half-year dividend to 3.2p and launched a £20mn share buyback programme. Analysts at Peel Hunt estimate that some £500mn, or almost half of the market cap, could be returned to shareholders in the next three years.

With shares currently trading on 14.3 times forward earnings, Domino’s looks reasonably priced despite wider inflationary pressures.

SELL: Travis Perkins (TPK)

The double-digit growth in Travis Perkins’ top line doesn’t tell the full story of what was a tough six months for the company, writes Michael Fahy.

The increase is largely the result of higher selling prices, up 14.4 per cent. Volumes slipped by 4.1 per cent.

This is understandable, given industry forecasts suggesting a demand decline as the pandemic-fuelled home improvement boom unwound, with higher inflation and a more uncertain economic environment making the prospect of taking on projects less appealing.

Management put on a brave face, saying the flat adjusted earnings represented “a good performance” given the heightened levels of activity in the previous year, but some of its numbers made for uncomfortable reading.

Net debt increased by around 50 per cent to £902mn, with a cash outflow of £415mn during the period used to fund £172mn of share buybacks and the early repayment of a £120mn bond. Working capital also rose by £115mn as it had to pay more for stock.

One concern is the performance of its Toolstation business. Its like-for-like revenue declined by 10.6 per cent, triggering an adjusted operating loss of £8mn, compared with a £10mn profit last year. Travis Perkins attributed this to a “normalisation” of trading, with fewer DIY enthusiasts using its depots, which are once again mainly the preserve of trade customers.

Chief executive Nick Roberts said he was “as confident as ever in the long term growth potential” of Toolstation and would continue to invest in its UK operations. It has added a further 19 branches during the half year, bringing the total to 549.

It has also continued to pump money into Toolstation’s expansion into Europe, increasing branch numbers by 20 to 143. That business lost £15mn in the first half — a figure that is expected to rise to £30mn for the full year as it brings a distribution centre online in the Netherlands.

This is £10mn more than previously guided, UBS analysts said in a note. They expected “modest downgrades” to the company’s shares following these numbers. They weren’t wrong.

Travis Perkins’ shares fell by 8 per cent, bringing their year-to-date decline to 42 per cent. They now trade at just over eight times consensus forecast earnings of 114p a share, well below their five-year average of almost 13 times. Travis Perkins is a well-regarded operator, but elevated costs and weak demand make the home improvements space a tough place to be.

HOLD: Direct Line (DLG)

The car insurer looks set for an awkward second half as inflation beats at the door, writes Julian Hofmann.

Motor insurer Direct Line had the good sense to “kitchen sink” most of the bad news in its statement in an earlier trading update, which meant its inability to match premium price increases with inflation were priced into the shares before these results.

Nevertheless, with cost inflation running at 10 per cent in its insurance claims pipeline, the company will take a significant hit this year to the bottom line. Taken together, the company pitches its range for combined operating ratio to between 96 per cent and 98 per cent, with no sign that this will fall back to normal levels until after next year.

Car insurers, generally, have struggled to hold the line between increased price inflation, particularly for second-hand cars, and much higher claim levels as the damping effect of the pandemic wore off within the sector. This was obvious in the huge rise in loss ratios to 65 per cent, compared with last year, as more average car journeys per household translated into higher numbers of claims.

The company is currently transitioning to a different pricing model after the FCA’s ban on so-called “price walking” came into effect in the half. New business prices have increased by 15 per cent to get ahead of inflation, though it is estimated that the new business market is up to 20 per cent smaller because of more customers sticking with their existing insurer, rather than switching when teaser deals expire.

Shareholders will not be pleased that the second £50mn tranche of Direct Line’s share buyback is now cancelled, though the need to conserve capital to preserve its liquidity ratio is understandable. Consensus estimates currently put Direct Line on a forward price/earnings ratio of 8 for 2023. That looks about right.

Hermione Taylor: The problem with UK debt interest payments

The Conservative party leadership election has turned into a fiscal tug of war. On one side, Liz Truss has unveiled plans for an emergency tax-cutting budget. On the other, Rishi Sunak has refused to match proposed tax cuts and warned that reductions could fuel inflation. No surprise that interest in public sector finances feels heightened this month. And as it happens, those finances are proving particularly interesting.

According to the ONS’s June report, overall borrowing reached £22.9bn in June — £4.1bn higher than this time a year ago, and £600mn more than the OBR forecast. What’s more, government debt interest hit the highest level since monthly records began, reaching £19.4bn due to the impact of soaring inflation on index-linked gilts.

In theory, a high-inflation environment can be good for government finances. It reduces the real value of outstanding debt, and can even increase the tax take through “fiscal drag”. This is where taxpayers are pulled into higher bands as the tax code lags in adjusting to higher prices. But as June’s release shows, the reality is more complicated. This is partly down to the UK’s unusual penchant for inflation-indexed debt.

The UK was an early, enthusiastic adopter of inflation-indexed bonds and today, 25 per cent of UK debt is inflation linked. This is significantly above levels seen elsewhere in advanced economies. And as a relic of their 1980s origin, they are still tied to RPI inflation, which is running even hotter than CPI, at 11.1 per cent. This exerts huge pressure on the cost of debt: £16.7bn of June’s interest payable on central government debt reflects the impact of surging RPI.

Michal Stelmach, senior economist at KPMG UK, argues that “the accrued debt interest in June is sufficient to fully offset the £18bn expected yield from the income tax threshold freezes by 2025-26, which push people into higher tax brackets as their nominal incomes rise”. In short, these figures put paid to the idea that inflation could be an effective tool for reducing UK government debt.

As the OBR notes, another peculiarity of UK public finances is that the average maturity of UK government bonds is longer than that of most other advanced economies. This in theory offers some protection against rising rates: long-dated bonds (when not index linked) lock in the prevailing interest rate, which was at a low level for the past decade.

But the OBR also points out that quantitative easing (QE) makes the business of measuring maturity more difficult. In very simple terms, QE saw the Bank of England purchase UK long-term government bonds, financing them with newly created interest-paying reserves. While the gilts purchased had an average maturity of 13 years, the liabilities used to finance them carried an overnight rate of interest.

By the end of 2021-2022, 32 per cent of the public sector’s gross debt was forecast to be in the form of central bank reserves issued to finance gilt purchases. This dramatically increases the sensitivity of debt-interest spending to changes in short-term rates. So as the Bank of England continues its rate hiking cycle, will fiscal tightening inevitably beckon?

Not necessarily. Ruth Gregory, senior UK economist at Capital Economics, calculates that the government still has room to loosen fiscal policy by around 1 per cent of GDP. And she thinks that both candidates will be tempted to use it. Gregory expects a ‘looser fiscal/tighter monetary mix whoever wins, and for the two candidates to meet in the middle with a net fiscal loosening in the Autumn Budget. If she is right, today’s battle between restraint and largesse will be swiftly forgotten as the reality of the UK economic climate hits home.

Hermione Taylor is an economics writer for Investors’ Chronicle

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