FTSE Friday: Doom and gloom from telecoms to tax

Markets seemed unfazed by Chancellor Jeremy Hunt’s Autumn Statement (a budget in all but name). Creditors were also placated, which was a relief considering what happened the last time a new British chancellor took to the dispatch box to lay out Britain’s spending plans. And voters can take comfort in the fact that Hunt managed to keep his policies within the Tory manifesto, by scheduling tax hikes and public spending squeezes for after the next general election in 2024.

This interesting chart from Bloomberg shows where the tax hikes and spending cuts will provide money:

But let’s not kid ourselves that this was a positive statement. In the coming years, Brits are going to see their tax bills scream skywards via a series of stealth tax hikes:

• Dividend and capital gains threshold has been slashed (remember to use your ISA allowance)
• The threshold for the additional rate of income tax has been lowered to £125,140 (the pension salary sacrifice can help you manage your tax bill)
• The freeze on the inheritance tax threshold has been extended along with almost all other personal tax allowances (investments in many AIM companies are exempt from IHT)

So while there are a few mitigations which can help you handle the pain of the tax rising tax bill, this update on top of the squeeze in living standards caused by rising mortgage and interest rates means it’s bleak out there. Unfortunately the financial results that we’ll be running through this week don’t provide much cheer either:

• Vodafone’s cash concerns could put pressure on the dividend
• SSE has a tricky task ahead to please all stakeholders
• Are sin stocks the way to invest as 2022 comes to a close?

Next week I will make an effort to search for cheerier topics!

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Vodafone: Cash flow concerns

Many investors don’t like the EBITDA figure because it hides what is actually going on at a company. Vodafone (LON: VOD) uses ‘adjusted EDITDAal’ as its headline metric - a figure which includes depreciation on leased assets, but excludes that on owned assets and joint ventures. It is very hard to unpick. But no amount of accounting wizardry can hide the problems at Vodafone. The business is haemorrhaging cash, leaving the dividend (currently yielding just over 8%) on shaky ground.

In the six months to September, Vodafone spent €2.2bn on mobile network licenses leading to a free cash outflow of €3.2bn. True, big mobile spectrum auctions don’t happen every quarter, but to compete Vodafone is having to cough up cash it doesn’t have. Operating cash inflows were €6.3bn in the period, a 2.7% decline on the previous year owing to an unexpected increase in receivables. Being a big beast doesn’t protect Vodafone from the symptoms of recession - customers are taking longer to pay their bills, making it harder for the company to manage its working capital.

With €7bn of cash and €75bn of debt, Vodafone’s net gearing has now exceeded 100% - the figure most analysts deem a cause for concern. Net borrowing is now 4.5x the company’s forecast forecast for ‘EBITDAal’ in FY2023 (or 12x actual operating profits reported last year). And that borrowing doesn’t come cheap. Finance costs were €1.4bn in the period and management expects this to rise as interest payments on its borrowings increase.

Meanwhile, new legislation in Germany (Vodafone’s biggest market by revenue and profits) has made it easier for customers to switch, leading to a net loss of 83,000 customers. It’s the same problem which has pervaded the UK business for years - higher rates of switching undercut margins massively, leading to lower profits.

But chief executive Nick Read isn’t sitting on his hands and waiting for the damage to be done. He has plans to shake up the business, starting with the sale of its stake in the mobile towers business, Vantage, worth €14.8bn. That sale will free up some capital for the company to pursue acquisitions, giving it a stronger foothold in the European mobile networks business. It’s a good plan, but an expensive one and right now, Vodafone just doesn’t look like it has the cash.

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Sin Stocks: Poor behaviour, high performance

There are some stocks which investors who seek only companies which do good for the world as well as their wallets wouldn’t touch. Tobacco company Imperial Brands (LON: IMB) and defence giant BAE Systems (LON: BAE) are two of these. They are also among the five top performing shares in the FTSE 100 this year.

Numbers from both companies this week offer some explanation for their outperformance.

BAE: Strong dollar and defence spending

Sales at BAE are due a boost from the strength of the US dollar. About 40% of the company’s sales come from the US market and almost all of the major contracts won this year are with the US army. In this week’s third quarter trading statement, management at the defence giant revised their forecasts for sales, profit and EPS growth to an upper limit of 9%, 12% and 13% respectively (from 4%, 6% and 6% when the pound was worth $1.38).

Management also said that most of the governments in which the company operates had announced an increase in defence expenditure within the last year. Fiscal pressures may be hurting government spending plans, but at a time when war is raging in Eastern Europe, no one is going to expect defence cuts. BAE secured orders worth £18bn in the first half of 2022 and a further £10bn since then.

Imperial Brands: Turnaround creaks into gear

For the first time in more than five years, Imperial managed to report a net gain in market share. Not a big one, but a gain nonetheless. Next generation products (which centre around the company’s Blu Vape brand) rose 11% to £208m (still a tiny proportion of overall revenue), while rising tobacco prices helped the company offset the ongoing fall in demand.

There is also evidence that Imperial is becoming a leaner operation. Net debt fell from £9.4bn in FY2021 to £8.5bn in FY2022 and operating cash conversion rose to 102%. Thus, the company’s leverage is now in lime with its long term target of 2 times adjusted operating profits. In the coming year, management has plans to strip out another £150m of costs.

The fact that investors reacted well to a final results statement (which revealed a 0.7% decline in reported revenues and a 15% fall in operating profits) shows just how poorly the company has performed in recent years. But the absence of a profit warning is a welcome improvement. The turnaround plan has finally creaked into gear.

Financials alone don’t tell the full story behind the strong share price performance for BAE and Imperial in the last year. Both companies are also benefiting from three shifts in market sentiment:

1. The wind has come out of the ESG sails
   When liquidity-boosted markets were making investing seem easy, investors could afford to include ethical metrics in their investing criteria. The easy money is gone and with it the appetite for ESG stocks. What’s more, events in Ukraine have highlighted the difficultly in assigning an ESG ‘score’ to companies. This time last year defence stocks like BAE were being hounded for providing arms to Saudi Arabia. Now they’re being heralded for their role in protecting democracy.
   
2. High yield income stocks are back in vogue
   Both BAE and Imperial have a long track record of healthy dividends and share buybacks (BAE announced a £500m extension to its buyback programme this week). Value investing was an unpopular style during the growth-fuelled bull run, but this year we have seen a change in sentiment and value investing (including the hunt for high yield) is the style-du-jour.
   
3. Recession proofing is beneficial
   Economic frailty doesn’t stop smokers from buying cigarettes or governments from buying weapons. Both Imperial and BAE are there relatively resistant to the broader economic outlook, which is very welcome as the western world teeters on the brink of a deep recession.

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SSE: An unenviable task

Energy giant SSE (LON: SSE) has a tough list of responsibilities:

• Help British residents cope with a cost of living crisis caused by rising energy prices
• Plug the hole in the British government’s finances by paying extra taxes on the excess profits made as a result of said energy crisis
• Invest in the infrastructure which will help bring down the cost of energy in the future
• And make sure that energy isn’t causing further damage to the environment
• (A dividend for shareholders would be nice too)

The challenges of working through that list are reflected in interim earnings released this week. Adjusted earnings per share for the period were more than four times higher as the company’s gas storage and thermal power divisions reaped the benefits of higher energy prices (on a reported basis, profits were hit badly by an unfavourable revaluation of commodities in the energy management business).

Management goes to great lengths to explain that the distribution and transmission divisions (money made by providing energy to people’s homes) are regulated and therefore not linked to the underlying price of power, but that hasn’t stopped headlines like “SSE profits soar on back of rising energy prices” - big bad businesses are worthy scapegoats for the problems facing British heating this winter.

It’s true that SSE, its investors and its peers including Centrica and National Grid (which both announced numbers last week) are benefiting from higher energy prices, but - just as is the case in the oil and gas market - bringing those prices down requires investment. SSE’s boss Alistair Phillips-Davies claims that “if the investment required to meet 2030 targets had been delivered by 2022, about £30bn would have been saved in GB expenditure on gas this year.”

Stabilising the future of energy provision means investment is also needed in gas infrastructure, however unpopular that might sound to climate activists. SSE’s results show clear evidence of that: in the six months to September, renewable energy transmission was restricted by unfavourable weather conditions.

Last week, Centrica (owner of British Gas) chose to buy back shares with its excess profits - a decision which didn’t much endear it to the public. By contrast, SSE has said it will rebase its dividend to 60p next year and invest £12.5bn in projects to reduce the UK’s exposure to international gas prices. A worthy gesture, but a big hit to the shareholders who own SSE for its dividend and will receive 93p per share this year.

Striking the right balance between satisfying the customers, the government, the climate activists and the shareholders is going to be tough. But getting it right could put SSE at the centre of an exciting revolution in Britain’s energy provision.