HL Select UK Income Shares: Summer Results

Steve Clayton - Fund Manager

31 July 2017

In a week full of company results, there were more of our holdings reporting than we have space to cover here in detail. Suffice it to say that for Reckitt Benckiser (RB), British American Tobacco (BAT) and Relx, all looked in order. Each reported solid underlying growth, with no real shifts in their strategic directions. Both RB and BAT have recently completed large acquisitions and in both cases, the early indications from the acquired businesses look to be broadly as expected.

Results in detail

Britvic made steady progress in its third quarter, with growth supported by favourable weather and market share gains by Pepsi at home and a strong performance in France.

Lloyds Banking Group reported decent enough interims, but was hit by another big charge for PPI mis-selling, bringing the total to £18bn. With the FCA (Financial Conduct Authority) having set a time limit for these claims, the end is in sight, but they have continued to run at a higher than expected level for longer than ever seemed likely. That did not stop the interim dividend from being raised by 18% and the group expects a strong underlying performance for the year.

Primary Health Properties reported an increase of 6% in the portfolio’s value and the acquisition of some additional UK healthcare premises, along with a further quarterly dividend, to be paid in August.

Please remember that past performance is not a guide to the future. The value of investments will fall as well as rise, so investors could get back less than they invest. Where quoted yields are variable and not a reliable indicator of future income.

AstraZeneca overshadowed by MYSTIC

AstraZeneca's interim results were totally overshadowed by news that an important drug trial had failed to deliver the hoped-for results. Imfinzi is a breakthrough treatment for a broad range of cancers and had scored some successes. But the MYSTIC trial was looking at its effectiveness in lung cancer, far and away the most lucrative market opportunity for the drug. A failure to prove any benefit in stopping the cancer spreading, compared to existing treatments has drastically reduced the drug’s overall commercial potential.

We had reduced our holding in AstraZeneca by almost a third in the run up to this news, because the stock had been strong and trial results can go either way. The stock is now at risk of takeover, having attracted interest from Pfizer a few years ago. If that happened, it would clearly be a positive result for investors, but in the meantime, the lower future earnings potential of the group places a question mark over its dividend prospects.

The group currently has a progressive dividend policy, which in this instance has led it to maintain the dividend in the face of bad news from MYSTIC. We will review our ongoing investment in AstraZeneca; the current yield of almost 5% is attractive, but only if the company can continue to afford the dividend.

Ascential impressive

Ascential shares rallied following impressive first half results. Operating profits from continuing operations grew by 28% (helped in no small part by sterling weakness) and free cash flow rose by 27%, underpinning a 20% increase in the dividend.

The majority of Ascential’s brands are truly unique. Cannes Lions has such a rich heritage and is so deeply entrenched in the creative industries it serves, that it would be virtually impossible to replicate. WGSN is so deeply embedded into the workflow of fashion companies that, without it, their ability to predict trends, and to stock their stores and websites accordingly, would be seriously compromised. The size of Ascential’s ‘moat’ or competitive advantage - judged purely on the value its brands create for its customers – is simply enormous.

We met with Ascential’s CEO, Duncan Painter, and FD, Mandy Gradden, following these first half results which reinforced our positive view of the management team. Since 2011, Ascential have steadily focused their portfolio onto their strongest brands, disposing of many smaller, weaker properties, whilst acquiring fast growing assets like Medialink and One Click Retail. These actions have transformed the overall quality and growth potential of the portfolio and Ascential remains a core holding.

Provident Financial stumbles

Provident Financial’s recent announcement of problems with their move to a new lending and collections model in their Consumer Credit Division meant that the market had a pretty clear view of what the interims would look like. Sure enough, the losses incurred were substantial and the business has lost momentum in new lending which it needs to rebuild ahead of the Christmas peak.

But the largest division, Vanquis bank is still growing well, as is the Moneybarn online car loans division. Looking forward, there could be some impacts on results from new accounting rules relating to lending businesses, but these will not affect the profits of individual loans, just the timing at which they are recognised. We are sticking with our position, because this is a business that has traded successfully through an extraordinary range of challenges over many decades and which generated a return on equity of over 30% even in the depths of the financial crisis.

Cheers to Diageo

Diageo grabbed the limelight with their full year results (they have a June financial year end) which saw the group come in a little ahead of expectations, accompanied by a raising of their margin targets and a massive £1.5bn share buy-back announcement. The stock rose to an all-time high on the news. Brokers hailed the results as the best from the group for several years, with positive organic growth in all the group’s key territories.

Diageo has a long history of growing the dividend and announced a further 5% hike in the 2017 payout. Organic operating profit growth of 5.6% was boosted by currency moves, while returns on capital improved to 13.8%, and look set to improve further if Diageo succeeds in raising margins as planned. With the business performing strongly we remain very confident in Diageo’s fundamental strengths, but note that the valuation is currently at a historically challenging level.

Domino's delivers mixed results

Domino’s Pizza served up a 9.9% increase in underlying earnings per share, and increased its interim dividend by 7.1%, while raising its full-year store opening target. However, the shares fell by 5% as investors focused on slowing UK like-for-like (LFL) sales growth and the group’s plan to invest an extra £4m to "improve value for customers and strengthen national promotions".

We think the slowdown in growth is probably due to a combination of UK consumers tightening their belts and intensifying competition in the online food delivery market from the likes of Just Eat and Deliveroo. However, even though Domino’s growth slowed in the first half of 2017, its share of the UK delivered pizza market still grew. One thing’s for sure, if Domino’s is feeling the squeeze, competitors will be in agony.

In our view Domino’s benefits from multiple competitive advantages, including a superior brand, greater scale, more consistent service, and a better quality product. This means Domino’s franchisees are highly profitable, and clearly still feeling confident, for the group announced a step-up in franchisee store openings, in spite of the more difficult environment.

The shares have fallen by over a quarter in the space of a few months, but we think a lot of bad news is priced in at these levels and are maintaining our position. Domino’s is hugely cash generative, because it is the franchisees, not Domino’s itself who own the stores. This cash generation, combined with a very solid balance sheet, gives the group plenty of scope to return cash to shareholders in the years ahead in our view.

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