New Holdings - Next and Paypoint

Charlie Huggins (CFA) - Fund Manager

12 June 2020

We’ve made some further changes to the portfolio since we last updated you on the first quarter (to the end of March). The sell-off created an opportunity to add two new stocks to the portfolio. We’ve also sold one of our long-standing holdings and significantly added to an existing holding which has been caught up in the cross-hairs of the virus.

Rightmove out

We told you in our last update that we’d significantly reduced our position in Rightmove and we have now fully exited the position. Rightmove had been held since launch.

While we still like the business, we believe its customers are likely to be significantly weakened by COVID-19. Estate agents were already struggling prior to the virus. We expect this crisis to lead to a number of these agents exiting the industry, while making it more difficult for Rightmove to raise prices. We are also worried that the current situation may exacerbate tensions between Rightmove and some of its customers.

Analysts’ forecasts for FY22 look far too optimistic to us and the current valuation doesn’t look to be discounting these risks. Once we gain more clarity on the impact of COVID-19 on Rightmove’s customer base we may well re-consider, but for now we will watch from the side-lines.

Paypoint and Next in

Paypoint is a business we’ve followed for many years and has been held in our Select UK Income Fund since launch.

Paypoint has an unrivalled installed base of terminals in convenience outlets, providing basic payments services like energy meter prepayments. While we expect some parts of the business to be impacted by COVID-19; we believe the business will remain profitable and cash-generative. The balance sheet is also very strong with just £13m of net debt as at 31 December 2019 so the group looks well-placed to weather any near-term impact on trading.

Longer-term we think some services that Paypoint provides, like ATM payments and cash top-ups could well see lower demand; but others, like parcels and card payments could benefit from accelerated digital trends. The business has become increasingly diversified in recent years which means the overall impact should be manageable; and arguably the importance of Paypoint’s core customer base (convenience stores) to the local community ought to have been cemented further during this period.

The shares have sold off aggressively during this crisis, more than halving from peak to trough. We managed to take advantage, buying 1 million shares between 30 March and 7 April at an average price of £5.31; the current weighting is c. 2.5%.

Next, the clothing-retailer, is another business that has been taken to the cleaners during this crisis, with the share price more than halving peak to trough. We established a c. 2.5% position between 24 April and 4 May, paying an average price of £46.30.

Its stores have been closed since 23 March and its UK warehouses and distribution networks were also closed temporarily as the group adapted its operations for working safely in a coronavirus world.

We are not expecting a fast recovery, even once lockdown measures are lifted. Indeed, Next itself has set out a series of downside scenarios in which sales decline by up to 40% this year. Even in this scenario, the group expects cash profit (EBITDA) for the year to be positive and year-end net debt to be lower, reflecting cost-cutting and cash conservation measures.

Importantly, we see Next as not only very well-placed to survive this pandemic, but to emerge stronger. As a high margin retailer with a very profitable online business, led by the highly impressive Lord Wolfson for the best part of two decades; we believe Next is in a far better position than most of the competition. We believe COVID-19 will accelerate the demise of Next’s competitors (indeed, this is already happening) enabling Next to gain market share. As surviving clothing retailers look to bulk up their online presence in a post-COVID-19 world, the appeal of Next’s online platform business, which offers a low cost route to market for partner brands, should also increase.

Compass share placing

Compass, the contract-caterer has seen perhaps the biggest impact of all our holdings from Coronavirus. With schools, universities and offices closed; and sports venues empty, it has seen revenues from a large part of its business evaporate and is now incurring losses.

On 19 May the company launched a 12% share placing to raise £2bn of cash. This strengthens the balance sheet further and should provide more than enough liquidity to allow the company to withstand a prolonged period of weaker trading. Importantly, it should also enable the company to get onto the front foot during the pandemic, ensuring they can maintain investment and capitalise on any opportunities, rather than spending years paying down debt.

We participated in this placing and added further shares in the open market after the placing to increase our position to around 3.8%.

With the balance sheet de-risked we’ve been thinking carefully about what the recovery might look like for the sector and Compass in particular. There are some undoubted headwinds. There will likely be more working from home for example, and both the sports and education sectors will likely to be slow to recover. There will also be additional costs in the recovery phase.

However, we also see clear positives for Compass. With competitors likely to retrench we expect Compass to gain share through this environment as we see it as the best placed in the sector to support its customers and exploit new business opportunities. The virus may also accelerate outsourcing trends as the costs and complexity makes many in-house offerings unviable.

We will always seek to maintain a long term view at HL Select. While we would expect the recovery over the next couple of years to be a bumpy one, the share price is materially lower than it was at the start of the year, and we think the long term risk-reward is favourable.

Please note the author and/or his connected parties own shares in Paypoint.