Stockwatch: Bumper yield and re-rating potential

Has Telecom Plus fallen too far? The chart for the FTSE Mid 250 shares shows a bear phase from an all-time high of 1,903p in late 2013 to 785p just recently, with a bounce to 815p. The high represented a daft 49 times earnings (see table) in a context where many stocks became lathered up by loose monetary policy, then adjusted back. So there has likely been some macro influence with the five-year chart suggesting the stock has now returned to trend-line - if a rather simplistic, technical view.

Assuming earnings per share in a low to mid-50p area (implied by latest guidance) for the latest financial year, the price/earnings (P/E) has moderated to mid-teens with the stock supported by a circa 5.5% prospective yield. This makes Telecom Plus interesting and, moreover, five directors have just spent over £1.1 million buying stock at 800.75p.

The accounting reasons for downgraded profit expectations appear mainly short-term, while longer-term there are political/regulatory factors, and utility supply is becoming more competitive as price comparison websites encourage switching. Inevitably, Telecom Plus had to de-rate from a rich growth rating and it will take time for the market to determine a fair one in the light of change. On yield criteria, at least, it does currently look attractive.

Stock is prone to over-shoot, either way

It's a feature of stockmarkets how the trend in fundamentals can get stretched by sentiment, over-shooting fair values. This multi-utility offering telephony, broadband, gas and electricity has been a good example: I drew attention in May 2012 at 700p because customers were growing at 11% a year and half of new ones were taking at least four services; the prospective P/E was then about 20 times and the yield over 4%.

The re-rating was swift and a year later I argued it was fundamentally over-priced at 1,250p but the stock carried on rising - as if in a micro-mania. This extended to brokers' analysts recommending the stock and for illustration in the table I include their forecasts before a profit warning on 16 April downgraded profit expectations to £52-53 million after deducting a circa £6 million charge for higher than anticipated leakage and theft in the gas system. (This is management guidance, brokers have yet to publish.) It implies a £5-6 million shortfall in underlying profit - i.e. 8-9% - "due to the cumulative effect of retail energy price reductions during the fourth quarter and lower energy usage, mainly due to un-seasonally warm weather."

Currently the market is groping for an equilibrium price that balances these uncertainties; a chief risk being whether all this de-motivates the independent distributors on whom Telecom Plus depends as its sales-force. Many have built up shareholdings over the years, and the founder/chairman has attempted to boost their confidence with a letter saying the update reflects "incredibly good overall performance, and proves what a strong, financially stable business we are building together."

He says the shares have dropped again "because profits are expected to grow at a slightly lower rate than the market has previously hoped... I think this is a massive over-reaction." He's entitled to his opinion, although mine is that a de-rating was long overdue. It's been vital to arrest the fall, however, as negative sentiment can impact fundamentals if the distributors lose faith.

Directors plunge into the stock at just over 800p

Five directors have bought a total £1.1 million worth of shares as the price rose from about 780p, which looks quite a propping up exercise but also belief in value. The trading update was not altogether bad, and customer numbers for the year ahead are up nearly 11% to 587,223.

However, it is possible the industry ground is shifting and a higher dividend yield is necessary (by way of payout and stock pricing) to compensate for growing risks. "The outlook for the new financial year is subject to more uncertainty than usual, with the overlay of political and regulatory dimensions on top of any possible impact from movements in the wholesale energy markets or fluctuations in consumer demand caused by un-seasonally warm (or cold) weather."

Last November's interims were exemplary: adjusted pre-tax profit up 55% on revenue up 9%, with EPS up 41% and the dividend up 19%. But the shock revelation of a write-off for gas theft/bad debts and leakage over 7 years to 2014, quite begs the question whether new auditors appointed last February might challenge any other issues of aggressive accounting. While the write-off is an exceptional issue it reflects rather poorly and follows soon after a change of auditors.

It could therefore be argued, the 5.5% prospective yield - based on an indicated 14% dividend rise for the latest financial year and a 15% rise to 46p for the current year to end-March 2016 - is indeed required to help the stock establish a floor. Mind this extent of payout will likely reduce earnings cover to near 1.0 and the table shows a volatile cash flow profile, so for this dividend to be sustainable there cannot be any more setbacks. An £11 million write-down of balance sheet debtors will, however, not affect the cash position hence dividends.

"Averaging-in" would be the better policy

The dilemma is a penalty for hesitation; newsflow only needing to avoid any more bad news for the stock to edge higher as enough investors are tempted by the yield and directors’ buying.

Telecom Plus still has a good reputation among the likes of Which? and Moneywise; its distributors have grown by 6,000 in the last quarter, from just over 45,000; and the medium-term objective is to increase customers to one million. If such a target is at all realistic then useful earnings growth will resume and risk weighs to the upside. The logical approach, if you accept the risks, is a steady averaging-in.

Prelims are due 23 June, likely the next re-appraisal point.

For more information see utilitywarehouse.co.uk.