Investors’ Chronicle: Tesco, Microlise, Asos

BUY: Tesco (TSCO)

It’s all about price points at the UK’s largest grocer as inflation reduces real household budgets, writes Mark Robinson.

The market gave the thumbs down to Tesco’s full-year figures. The initial markdown of the shares seems curious given a 35.8 per cent increase in adjusted operating profit for its core retail segment, alongside a 69.9 per cent increase in related cashflow. Investors are probably giving more weight to the outlook for the net margin over the near- to medium-term. Management is guiding for annual operating profits of £2.4bn-£2.6bn, a potential shortfall of up to £400mn from this time around, with a wider spread than usual down to uncertainties over the severity and duration of the inflationary spell.

It’s too early to assess the impact that inflation (at a multi-decade high) will have on consumer behaviour, though it’s not difficult to make an educated guess. We have already seen upmarket rival Marks and Spencer cut prices on a range of household staples, a clear sign that the supermarket price war is in the offing. The German discounters would seem to be handily placed as the cost-of-living crisis unfolds, but the UK’s largest grocer is already extending price-saving initiatives such as Aldi Price Match, and is looking to drive cost savings over the next three years to bolster margins against an inflationary backdrop.

Tesco’s service offering is certainly a plus point, a potential differentiator between it and its price-point conscious rivals. The group confirmed that online sales remain well ahead of pre-pandemic levels, with its share of the UK market up 142-basis points to 34.8 per cent. It has also continued to roll out its click-and-collect and superfast delivery services. Anecdotal evidence suggests that online grocery shopping is gaining custom partly because it allows shoppers to take advantage of discount codes and comparison websites.

Tesco’s overall UK market share increased 30 basis points to 27.7 per cent, the highest jump since 2007, but it is still well adrift of the rate a decade ago. It would be loath to lose any more ground to the discounters, hence the intensified focus on price. Strengthening cashflows enabled the group to reduce net debt by £1.4bn, leaving the debt/cash profit multiple at 2.5. Management assumes that the group will “incur a significantly lower level of Covid-19 costs as colleague absence rates return to pre-pandemic levels”. It has also committed to buying back a total of £750mn worth of shares over the next 12 months. The net margin will undoubtedly come under pressure, but we think the stock will still find support at 12 times consensus forecasts, particularly given a forward yield of 4.3 per cent.

HOLD: Microlise (SAAS)

The revenue performance was robust in the company’s maiden post-IPO results, although the shares are still below the listing price, writes Christopher Akers.

Microlise announced solid growth across its revenue streams in its first full-year results as a listed company. But the business, which floated on Aim in July 2021 and provides transport management software to fleet operators, is feeling the impact of the microchip shortages that are causing havoc for the logistics sector, and consequently recorded a loss as exceptional costs took a chunk out of the income statement.

Recurring revenue was up by 9 per cent to £37mn, aided by the renewal of major partnerships — its biggest customer JCB gave the green light to a new five-year contract — and fresh contract wins. The most significant contracts have inflation clauses, providing some crucial relief in the current outlook.

The company’s non-recurring revenue was up by almost a third, to £24mn, as hardware was installed both for new customers and for those who had shuttered their factory doors in the comparative period due to the pandemic.

Without exceptional costs in the year — £3.4mn of charges relating to the IPO — these revenue spikes would have helped the company into the black. The float raised £17.6mn of net proceeds — management’s hope is that the company can now push for greater growth and prove that listing was the right move. While these results pushed the shares up by over 12 per cent, they are still below their listing price.

Post-period trading for the 2022 financial year is thus far in line with expectations. And a robust order book and strong pipeline visibility are reasons to cheer.

Saying that, there is no escaping from the headwinds around issues such as chip shortages, driver shortages, and soaring fuel costs. Management is confident that the outlook will improve as this year progresses, at least on the chip side of things.

Nadeem Raza, chief executive, said: “While we have been dealing with chip shortages for the past 18 months, the industry opinion is that from the third quarter of 2022, the situation will improve and return to pre-pandemic levels.”

Analysts from house broker Singer Capital Markets said that “investment into the mid market, where Microlise’s market share leaves opportunity for growth” is being boosted. Singer has the shares trading on 32 times forward earnings for the 2023 financial year and forecasts that revenue will continue to climb steadily over the next few years. With solid free cash flow generation, of £6.4mn this time around, the company is certainly one to watch.

HOLD: Asos (ASC)

Suspending sales in Russia is forecast to knock £14mn off the fashion retailer’s full-year profit, writes Madeleine Taylor.

Asos’s 15 minutes in the spotlight may be ticking down, after higher freight and warehouse labour costs sent the fast-fashion house crashing to a £16mn loss in the six months to the end of February. The online clothing brand said it expected a “greater risk than normal” to its profitability in the second half of 2022, which is under pressure from a double whammy of rising costs and weaker consumer spending that is “yet to be felt”. 

Meanwhile, Asos has suspended sales in Russia, a move that is expected to knock £14mn off adjusted profits for the year, and reduce expected sales growth by 2 per cent.

Billed as a pandemic winner after the closure of high street shops helped push sales up by a fifth, Asos has suffered a swift and severe market correction in 2022. The shares have fallen by more than two-thirds since June, with Asos catching the attention of short-sellers, along with other online retailers including Boohoo, N Brown, and AO World.

The online boom has certainly retreated. Data from the Office for National Statistics shows that digital sales currently account for a quarter of all clothing sales in the UK, which is a far cry from the online market share one year ago, representing 58 per cent of sales. At the same time, inflation in the prices of essential goods including food and fuel has squeezed consumers, and cut the amount they are able to spend on non-essentials such as fashion.

So far, Asos, which targets “fashion-loving 20-somethings”, has still managed to raise sales. Revenues were up by 8 per cent to £896mn in its largest market, the UK, and 11 per cent to £253mn in its strategically significant growth market, the US. Order frequency also went up, although was offset by a drop in the average basket size to £38.47.

Matthew Dunn, chief operating officer of Asos, said he expected sales growth to accelerate in the second half of 2022 due to “pent-up demand” for social occasions such as holidays and weddings. The retailer said profits should be supported by low to mid single-digit price hikes across its lines, which came in the last six months, and its efforts to fix costs and stock up ahead of the summer season.

This might be an example of the old adage “sales vanity, profit sanity”. Asos has not been able to feel the benefit of higher sales in the first half, since it was offset by steep increases in the cost of freight and staff wages, with operating costs swallowing up 43.3 per cent of these sales, up from 39.5 per cent a year earlier. Adjusted Ebit profit margins have fallen to just above break-even at 1.3 per cent, down from 5.9 per cent.

Although guidance has stayed the same, with pre-tax profits expected to come in between £96mn and 126mn, management’s commentary “effectively waves a red flag on full-year expectations”, said Hargreaves Lansdown’s equity analyst Matt Britzman.

Meanwhile, broker Berenberg slashed its target price to 4,100p from 5,500p, but kept Asos on a “buy” recommendation, saying the retailer is “relatively well positioned” to cope with a weaker retail backdrop thanks to its “lower-price own brands and younger customer base”.

Asos’s acquisition of collapsed retailer Topshop’s lines proved a shrewd move, sustaining triple-digit sales growth since the second half of 2021. Leaving aside Russia, it has also scaled up its international push effectively, opening pop-up stores with US retailer Nordstrom and partnering with well-known brands such as Adidas and Nike.

With the shares trading on an undemanding forward PE ratio of 16.1, Asos could re-rate on international progress or an improvement in retail conditions.

Chris Dillow: A tale of two curves

Investors are worrying about the fact that 10-year US Treasury yields have fallen relative to two-year ones — and, on a few days recently, have dropped below them. They are partly right to be concerned and partly not.

They are right because the yield curve predicts recessions; when longer-dated yields are below shorter-dated ones, a recession follows. Back in 2007, Glenn Rudebusch and John Williams (who now helps set interest rates as a member of the Federal Open Market Committee) showed that the curve was a much better predictor of recessions than professional forecasters. Subsequent events have vindicated them. A few months after they wrote the US fell into a deep recession which economists had mostly not expected even though the yield curve had been inverted months before. And in 2019 the yield curve inverted again — and recession ensued.

To see why the yield curve predicts recession, just ask why anyone would want to hold a 10-year bond when shorter-dated bonds yield more. It’s because they expect yields to fall so that when they reinvest the maturing bonds they will do so at a lower rate. Fearing this, they lock in returns by buying the longer-dated bond. But the circumstances in which yields fall are those in which the economy is doing badly. An inverted yield curve is a sign that investors expect bad times.

And they are often right.

The measure that matters here is not so much the precise shape of the yield curve but simply whether it is upward or downward sloping. The yield curve was more downward-sloping in 2000 than in 2007, for example, but the recession of 2008-09 was much worse than that of 2001.

The slope of the curve does indeed predict whether the economy will grow or not. Since 1977 US industrial production has grown by an average of 6.4 per cent in the three years after 10-year yields have been above two-year ones. But it has fallen by an average of 1.7 per cent in the three years after they have been below two-year ones.

Because share prices do better when the economy grows than when it doesn’t, this means that the yield curve also predicts equity returns. Since 1977 the S&P 500 has risen by an average of 36.7 per cent in the three years after 10-year yields have been above two-year ones, but by just 9.2 per cent after they have been below them.

Investors, then, are right to worry about the fact that 10-year yields are low compared with two-year ones.

Except for one thing. The two- to 10-year range is only one portion of the yield curve. Another portion of it is still upward-sloping. As I write, two-year yields are 2.3 percentage points above the fed funds rate. Which reflects the fact that investors expect the Fed to raise rates a lot in the next few months.

But, of course, the Fed will only do this if the economy is healthy enough to withstand higher borrowing costs. The bond market is therefore implicitly expecting economic growth — and economic growth means decent equity returns.

History tells us that these expectations have often been correct. Since 1977 industrial production has grown by an average of 6.5 per cent in the three years after two-year yields have been above the fed funds rate but by just 1.1 per cent in the three after they have been below it. And shares have done better in this time after this portion of the curve has been upward-sloping — rising by an average of 37.6 per cent compared with 16.5 per cent after downward-sloping curves.

Yes, the fact that 10-year yields are below two-year ones is troubling. But the fact that two-year yields are above the fed funds rate is comforting.

We can reconcile these two facts. The two slopes together can predict economic growth and equity returns. Since 1977 industrial production has fallen by an average of 2.5 per cent in the three years after both slopes have been downward; risen by an average of 0.2 per cent after the fed funds-two year slope has been upwards but the two-10-year slope have been downwards; and risen by 6.7 per cent after both curves have been upwards.

The S&P 500 has risen by 5.6 per cent on average in the three years after both slopes have been downward, meaning losses after inflation. They’ve risen by an average of 18.8 per cent after the fed funds-two year slope has been upward but the two-10- year slope downward, and by an average of 38.6 per cent after both have been upward.

The message, then, is plain. Even if 10-year yields do again dip below two-year ones it will predict slower growth and lower equity returns, but still respectable ones. No need to panic.

One caveat is that our current combination of an upward-sloping fed funds-two-year curve but downward-sloping two-10 curve is an unusual combination; it usually only happens when the market is moving to more fully upward or downward sloping curves. Any conclusions we draw from little data must therefore be tentative. Also, of course, I’ve written only about averages, and there is variation around these. The risk of a bear market would increase if 10-year yields fall below two-year ones again.

Nevertheless, insofar as we can draw inferences, the yield curve is telling us to still be cautiously optimistic about US equities. There might well be reasons to sell, but the yield curve is not (yet) one of them.

Chris Dillow is an economics commentator for Investors’ Chronicle