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March 29, 2018

Report: One Year Till Brexit

by Tajinder Dhillon.

As the UK plans on exiting the European Union on March 29, 2019 (at 11pm GMT for those interested), a lot has changed since the initial Brexit vote. We looked at how the markets reacted immediately after Brexit and decided to check in again one year before the inevitable deadline. This report gives a picture as to how industry analysts view UK equities and which industries are seeing the most positive and negative sentiment. Equity valuation levels are also analyzed on an aggregate basis to see how undervalued or overvalued the UK market is relative to its peers.

Where’s the “smart money?”

It’s informative to look at the changes in analyst sentiment at the industry aggregate level.  For this study, we’re looking at analyst revisions for all UK companies at the Business Classification (TRBC) Industry Group level.

Change in analyst sentiment are represented by the StarMine Analyst Revisions Model (ARM). ARM is a percentile (1-100) ranking of stocks based on changes in analysts’ estimates (typically EPS, EBITDA and revenue) and changes in recommendations for the current period, full year and next year. It also incorporates the Predicted Surprise, the percentage difference between the StarMine SmartEstimate® and the consensus estimate for each estimate measure and fiscal period combination. The key when looking at Exhibit 1 below is that the lowest numbers are most bearish and the highest ones are most bullish.

How have analyst and consumer sentiment changed?

Immediately after the Brexit vote in June 2016, we saw analysts downgrade regional airlines, home builders and banks, fearing a decline in property values and threats to London as a global financial hub. At the same time, analysts upgraded industries that would benefit from a cheaper pound sterling — multinationals (strong foreign revenue exposure) and oil & gas firms (oil traded in US dollars could buy more pounds).

When looking at the data in March 2018, we still see currency playing a big role in analyst sentiment. In Exhibit 1 we show the 16 industry groups with the most positive changes in analyst sentiment, in descending order — these include commodities, airlines, grocers, hotels and entertainment. It certainly appears that the Brexit worries immediately after the vote have dissipated as consumers are still looking to spend disposable income on holidays and entertainment.

Exhibit 1: United Kingdom – Bullish StarMine Analyst Revision scores

Source: Eikon/StarMine

Spotlight on commodities

If we take a closer look at the companies driving positive analyst revisions in the UK, we can see that the large cap diversified mining companies are benefiting from positive macro conditions. Exhibit 2 below highlights synchronized global GDP growth, rising inflation, strong PMI momentum and a weak US dollar, which led to a 17.5% increase in the S&P GSCI Commodity Total Return index over the last year.

In particular, a surge in global inflation will boost demand for inflation protection assets such as commodities, which provide a natural hedge. The companies about which analysts are most bullish include Rio Tinto (RIO.L), Anglo American (AAL.L), BP (BP.L), and BHP Billiton (BLT.L).  The industry is also benefiting from supply/demand improvements in the oil market, as OPEC has taken a stance to re-balance the market and hopes to extend current supply cuts into 2019. Finally, with the evolution of electric vehicles taking center stage, cobalt, which is the key input to producing batteries, has surged almost 300% since 2015.  This will certainly bode well for the largest global producer of cobalt – Glencore (GLEN.L), which currently has an Analyst Revision Score of 98.

Exhibit 2: Global Economic Indicators

Spotlight on airlines

Airlines are a cylical sector, tied to the macro environment which as seen in Exhibit 2 has been fairly positive. The industry is complex, facing variable demand, high fixed costs, volatile commoditiy prices, labor union issues, on top of weather and technology distruptions.   Since our last Brexit post, we have seen a remarkable turnaround in analyst sentiment concerning the major UK airlines. Exhibit 3 shows Analyst Revision sentiment from July 2016 (left side) vs. today (right side).  International Consolidated Airlines Group (ICAG.L) and easyJet now have Analyst Revision scores of 91 and 88 respectively, compared to a score of 1 and 1 in mid-2016.

Since then, we have seen a number of European airline-related bankruptices, including Monarch Airlines, Air Berlin, and Alitalia.  This has provided an opportunity for ICAG and easyJet, which have gobbled up vacant slots at European airports and provide more comprehensive flight offering in both short-haul and long-haul categories.

Exhibit 3: StarMine Analyst Revision scores for UK Airlines – July 2016 vs. March 2018

Source: Eikon/StarMine

Low-cost airline flying high

Newly appointed easyJet CEO Johan Lundgren, recently said in the latest earnings release, “we’re looking at the forward bookings. Customer demand is strong with encouraging levels of forward booking … which reflects building earlier loads than last year … we’re going to move from 80 million to 90 million passengers this year.”

EasyJet’s former CEO Carolyn McCall mentioned that they are looking to expand UK capacity by 5% in 2018.  She also mentioned that passenger load (which looks at flight capacity utilization) increased 1% in 2017 to an impressive 92.6%.  All indicators look to healthy customer demand for low-cost airlines with seats being filled and easyJet investing in more flight routes.

International Consolidated Airlines Group (ICAG.L), the parent company of British Airways, has also invested in expanding their flight offering by purchasing 20 take-off and landing slots at Gatwick Airport after the bankruptcy of Monarch Airlines.  One risk factor to consider for UK airlines will be the potential consequences of Brexit on the EU-US Open Skies agreement.  Those airlines will have to sort out an agreement with the US to continue flying transatlantic routes with ease.

Where are analysts turning bearish?

Let’s take a look: Exhibit 4 lists the 16 industry groups that have the lowest StarMine Analyst Revision score, in ascending order.

Exhibit 4: United Kingdom – Bearish StarMine Analyst Revision scores

Source: Eikon/StarMine

Spotlight on UK retailers

When looking at the full picture, it appears that UK consumers are shifting their capital expenditures into holidays and entertainment experiences as noted above, and out of items such as clothing and jewelry.  Retailers failed once again to escape from the bottom half of downward revisions when compared to July 2016, as the effects of Brexit have continued to cause secular declines in consumer spending, especially in brick-and-mortar.

The effect Brexit had on sterling has been well-documented, causing import prices to soar in a sector that is heavily exposed to foreign products. Combined with weak wage growth (which has been rising recently), consumers are being squeezed and are more cautious with their hard earned disposable income, as seen in Exhibit 5.

Exhibit 5: UK retailers battling rising inflation

Shopping for profits

Retailers who also face the brunt of higher production costs must decide whether to pass on costs to consumers or consume them and hurt their profits. There have been differences in strategies, as Tesco (TSCO.L) decided against passing on higher food costs to consumers in 2017, which resulted in record sales during the holiday trading period. CEO David Lewis said, “in either the Christmas week itself or if you take the full seven trading days before Christmas, we sold more than ever before in our food offer, as we made our offer the most competitive it’s been for many, many years.”

However, Next PLC (NXT.L), was not able to pursue the same strategy – “we had to increase selling prices to maintain margins,” and noted consumer patterns shifted outside of retail and into entertainment experiences. Some of the retailers that are on the wrong end of analyst sentiment include Burberry (BRBY.L), Kingfisher (KGF.L), and Marks & Spencer (MKS.L) with ARM scores of 29, 26, and 37 respectively.

Retailers will hope that the 13% rise in sterling over the last year will improve trading conditions and improve purchasing power, while consumers will find it less expensive to buy imported goods. They will also need to improve the customer experience by making it easier for consumers to purchase items (i.e. digital, mobile) and provide flexible means to receive the goods (i.e. home deliver, click-and-collect) if they plan on competing with Amazon.

Valuation – UK looks “cheap”

To wrap up our analysis, let’s look at how undervalued UK equities are on aggregate vs. the rest of the world on a 12-month forward P/E basis.  In exhibit 6, we can see that the UK is trading at a 16% discount to global equities and a 23% discount vs. US equities. To put this in perspective, the last time we saw these discounts was more than five years ago when comparing to global equities and since the financial crisis when comparing to US equities.

Exhibit 6: 12-month Forward P/E Ratio

Attractive yield

A cheap valuation combined with an attractive dividend yield could see further rotations into the UK market by institutional investors, as the UK offers an aggregate 4.0% yield vs. a 2.5% yield globally and 2.0% yield in the US when looking at Datastream global indices.

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