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Investors’ Chronicle: Jadestone Energy, Keywords, Kingfisher

BUY: Jadestone Energy (JSE)

Suspended Montara production knocks out half of Jadestone Energy’s output and $45mn of 2022 free cash flow, writes Alex Hamer.

Even at a time of sky-high energy prices, you still need to be producing well to reap the benefits. Jadestone has certainly seen a positive uptick in earnings in the first half of this year, but operational problems at its offshore Australia Montara asset in June have hit production guidance for the year, while its non-operated new Malaysian holdings had a run of issues that will probably mean zero production from those two licence areas.

An oil leak at the floating production, storage and offloading (FPSO) ship at Montara in the Timor Sea in June was fixed, but another issue with the ship was identified in August and Jadestone shut down production.

Chief executive Paul Blakeley called the Montara issues disappointing, but the company was looking hard at how to prevent them from popping up again. A review of the whole inspection process has started. “While we understand that the lack of a firm restart date is frustrating for many of our stakeholders, our focus is on the remediation plan and its successful execution which, in turn, will restore confidence in the significant remaining value we see at Montara,” he said. Stopping further leaks is particularly crucial at the site, given the previous owners oversaw a massive spill in 2009. Broker Peel Hunt says this will knock $45mn (£39mn) from 2022 free cash flow, to $27mn. 

Oil and gas prices meant the first half was still profitable, and Jadestone increased its half-year dividend by 10 per cent. It is also in the middle of a $25mn buyback programme, which began in August, while the cash balance remains healthy and the company is debt-free.

Jadestone has been a weak performer compared to others in the space — its share price is down 10 per cent year to date, compared with the FTSE All-Share oil and gas constituents climbing a quarter. Assuming Montara gets back to production in November, the dividend and buyback plans are enough to keep us on board.

BUY: Keywords (KWS)

The gaming outsourcer has maintained organic growth but warns that worsening macroeconomics could make games releases more volatile, writes Arthur Sants.

Keywords Studios is a gaming outsourcer. It helps developers with everything including designing, testing and marketing games. The benefit of this model is it gets access to the fast-growing gaming market without the risk of games flopping. In the first six months of the year, it has worked nicely.

Organic revenue growth was 21.7 per cent while the adjusted cash profit (Ebitda) margin rose 60 basis points to 21.8 per cent. The margin growth was driven by faster growth in the higher-margin Create and Globalize businesses. More revenue at a better margin meant cash profits rose 49.5 per cent to €61mn (£53.5mn).

Despite the increase in profits, operating cash dropped from €34.4mn to €31.3mn. The dramatic-looking fall in the cash conversion rate from 94.9 per cent to 57.9 per cent was because of a €21mn increase in working capital. The company says this is exceptional and should normalise at about 80 per cent for the full year — but it is worth keeping an eye on.

The growth argument is that Keywords only makes up 5 per cent of the outsource market and it is not just limited to traditional games. Media companies are diversifying their offerings as shown by Netflix’s foray into gaming and they will need partners to help with development and marketing. Keywords has just acquired Canadian mobile game developer Smoking Gun, which works for both Netflix and Microsoft.

The flipside is that media companies have been throwing money at new content to attract subscribers, but now they are more concerned with cash flow. In the coming years they could be more circumspect about the money they spend.

Broker consensus is for Keywords’ earnings per share to rise to 119p in 2024, giving a 2024 PE of 22. That’s not terrifying given the long-term potential of its market — even if there are some short-term bumps in the road.

HOLD: Kingfisher (KGF)

The heavily-shorted company looks exposed to the changing dynamics of the sector, writes Christopher Akers.

Kingfisher faces the same headwinds as its peers in the home improvement and DIY space. Demand is threatened by high inflation, weak consumer confidence and the tightening of belts after the sector boomed during the pandemic.

And the potential normalisation of a volatile housing market, which is susceptible to expected further interest rate increases, could also damp enthusiasm. But the owner of B&Q and Screwfix also faces particular challenges that make it look vulnerable when set against competitors, as it revealed a downturn in sales and profits. This is demonstrated by the circling of the short sellers — the company sits near the top of the list of the most shorted shares in London which is hardly an encouraging sign.

While like-for-like sales rose by 17 per cent on a three-year basis, they were down by 4 per cent against last year. Of the company’s three regional income segments, growth was only posted by the smallest revenue contributor. Other international sales, dominated by Poland, were up by 15 per cent to £1.3bn. It was bad news, however, for the key UK and Ireland and France markets, where revenue fell by 10 per cent to £3.2bn and by 5 per cent to £2.3bn respectively.

And gross margin fell by 130 basis points to 36.7 per cent. Management said that this, and the fall in pre-tax profits by a third, was due to strong comparatives. But this doesn’t inspire confidence as the sector outlook becomes more uncertain.

We recently maintained our buy recommendation on peer Wickes, which we think is more resilient in this market with its trade exposure and growth model. Kingfisher’s market reach looks more saturated, and its high and increased level of inventories — free cash flow fell by 86 per cent as result of an inventory rebuild programme — complicates the picture. And Wickes trades at a more attractive forward rating of six times consensus forward earnings, against Kingfisher’s nine times, according to FactSet.

Panmure Gordon analysts said after Kingfisher’s capital markets day in July that “investors need to see the business shape once trade patterns have normalised post-Covid” and that profit forecasts “look exposed”. We think this is a wise position to take, especially after the business flagged in these results that adjusted pre-tax profits for the full year could come in within a range of £730mn to £770mn after it guided towards the latter figure at the start of this year.

Hermione Taylor: Core inflation spooks markets

US inflation figures were met with consternation last week. After September’s release, the S&P 500 fell by 4 per cent, and former secretary of the treasury Larry Summers said it was confirmation that “the US has a serious inflation problem”. Yet inflation is hardly spiralling out of control — overall (headline) CPI has increased just 0.1 percentage points on last month’s figures. What is all the fuss about?

Concern is mounting about US “core inflation”. Core figures strip out the effect of energy and food prices — which can move wildly when affected by adverse weather and geopolitical events. Though energy and food prices can have a substantial impact on overall inflation figures, there is little that monetary policy can do to address them. By stripping them out, core inflation leaves us with a measure of the “segment” of inflation that central banks can hope to influence. This month, the core inflation rate increased from 5.9 per cent to 6.3 per cent — the highest in a generation. It looks like the Fed has its work cut out.

Unsurprisingly, interest rate expectations rose on the inflation release: the terminal Fed policy rate (the point at which no further hikes are made) was repriced from 4 to 4.3 per cent. Markets were caught off guard too, with the dip in the S&P 500 accompanied by a 5.3 per cent drop in the Nasdaq. High interest rates can be bad news for companies at the best of times, dragging on earnings and discounting future valuations. But persistent inflation also increases the probability that the Fed will increase rates above their “neutral” level — causing significant collateral damage. ING economists raised the prospect of the Fed hiking rates even into a recession, arguing that “in the US, the spectre of Volcker looms large”. Economists at Pantheon Macroeconomics agree that the Fed won’t take any chances with inflation — even if it increases the risk of “over-tightening”. 

Yet there are signs that the US inflation picture is improving. Paul Ashworth, Capital Economics’ chief North America economist, argues that the increase in core inflation is “somewhat hard to square with all the other evidence pointing to signs of price pressures easing”. He adds that he can “see disinflation everywhere except in the official CPI statistics”. He may be right — the US Producer Price Index (PPI) statistics released just days later saw PPI cool by 1.1 percentage points — a sign that inflation is decelerating in some parts of the economy.

UK commentary has, so far, placed less emphasis on core inflation figures. With energy prices representing the biggest driver of UK inflation, our focus has been on headline figures — which take these into account. But the government’s new energy price scheme means that the inflation outlook has materially improved. Forecasts from earlier this month suggested CPI could rise to more than 20 per cent in the absence of policy intervention or a significant drop in energy prices. CPI is now expected to peak at a lower rate (11 per cent) — and far sooner — than these pessimistic estimates suggested.

With external pressures cooling, attention may soon turn to core inflation in the UK, too. UK CPI is at 9.9 per cent, down from 10.1 per cent last month. But core inflation has crept from 6.2 per cent to 6.3 per cent — the same figure that spooked US markets.

Growing domestic inflationary pressures cannot be ignored. The Bank of England has been concerned about the UK’s extremely tight labour market for months, and September’s low unemployment figures will do little to reassure them. The new energy price package could also stoke household consumption, increasing core inflation over the longer term.

The UK economy is expected to reach peak inflation over the next few months, before returning to target in 2024. We are not out of the woods yet: we may find that soaring headline figures are replaced by stubbornly high core inflation rates.

Hermione Taylor is an economics writer for Investors’ Chronicle

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