Markets Now – Friday 29th May 2020

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Markets Now and (Markets Live, its more technologically advanced predecessor) apply a longstanding policy to censor all of Donald Trump’s tweets because they’re rubbish. It’s therefore encouraging to see some newer social media platforms moving towards similar quality control policies using whatever justifications they have available.

Over in markets, everything’s gone risk off. Narratives available include a deterioration in Sino-US relations, a deterioration in US-US relations, a running out of fuel for a rebound that was mostly short covering in cyclicals rather than actual open-the-economy optimism, or plain old end-of-month position squaring. Whatever the excuse it all boils down to this:

Rolls-Royce has finally been junked. S&P goes down two notches, to BB from BBB- previously. We’ve spent years talking about the loss of investment-grade status as an unacceptable outcome for Rolls as its forward financing business needs credibility with counterparties. No one wants to buy a jet engine from a company that might not be around to fix the blades in ten years time. Covid-19 is a pretty big mitigating factor though so the idea here is that customers won’t panic as much as they would in normal times, back when Rolls’ dropthrough cash generation was woeful solely for endogenous rather than exogenous reasons. Here’s Morgan Stanley:

We do not think the news should come as a major surprise to investors. The prior rating was only one notch above investment-grade, and prospects in the broader industry have clearly changed materially as a result of Covid-19. Rolls-Royce has also discussed the prospect in group events with investors over the last several months, stating that such a potential move would not significantly affect the business. Investors may question whether a sub-investment grade credit rating could affect customers’ preparedness to sign up to long-term service agreements, which are typically structured with monthly or quarterly prepayments from airlines to the engine manufacturer. However, the downgrade does not affect Rolls-Royce’s sole source position on two of its three major engine programmes, and broader conditions in the industry suggest that major new sales may be more limited over the next couple of years in any event.

And Citigroup:

Rolls-Royce has previously said (pre-COVID) that it aspired to regaining single A and this is clearly a step in the wrong direction. Rather than being a nice thing to have, we believe the key question for Rolls-Royce is “Is the business model viable without an investment grade rating?” We believe that it is. We see 3 company-specific reasons to want to have a good rating. However we do not see it as mandatory:

Long term service agreements – airlines pay Rolls-Royce ahead of the engine overhauls and want to be assured that the company will be still around to perform the overhauls when required. While it may make new LTSAs a bit harder to land, 1) there are no rating triggers with any of their airline customers; 2) the airlines have already paid some of the LTSA – to remain in the contract, they have to pay as they use the engines; 3) many airlines have little choice as they have outsourced the maintenance, they no longer have the capability to bring it back; 4) LTSAs are attractive to airlines – that is why they sign up for them..

Counter-party risk – FX hedging may become more expensive –however, we note that Rolls-Royce has $37bn of outstanding hedges and, we believe, may have been overly conservative by stretching out its hedge book (we also note that counter-party banks buy credit default swaps when hedges go against the company, widening spreads, even though a stronger dollar is good for Rolls-Royce’s underlying economics).

Vendor financing – with engines representing about 20% of the value of a plane, Airbus or Boeing may look to Rolls-Royce to take on its share of vendor financing. Putting together that financing package will likely be more expensive with a lower group rating

However, while we can see that all of the above are “nice to have”, we don’t see them has a must have and continue to believe that Rolls-Royce will manage through the crisis and move back to increasing levels of cash generation, albeit less and later than we expected pre-COVID-19.

JP Morgan Cazenove disagrees, quite strongly:

Downgrade to non-IG really matters: (1) RR is heavily reliant on customer advances (CA) from airlines and lessors, with c£7.5bn of these sitting on its balance at end 2020E. AIR’s CFO has publicly said AIR needs to maintain a single A rating given the large amount of CAs on its own balance sheet. S&P now rates RR seven notches below AIR and we believe Moody’s and Fitch are now likely to cut their ratings on RR. Will RR customers really be willing to leave £7.5bn on deposit with it when its S&P credit rating is BB/negative outlook? (2) RR is the only supplier of engines on AIR’s wide body aircraft (WBs). When the worst of COVID-19 passes, AIR will go into airline / lessor boardrooms to try and sell WBs. We believe such campaigns will be hampered by RR’s non-IG credit rating and so AIR itself may put pressure on RR to reinforce its balance sheet. (3) According to the FT (May 28th) “many large investors will have to sell their holdings [in RR]….as they are restricted to investing in investment-grade stocks.”

JP Morgan has been, we should note, a very aggressive bear on Rolls for quite some time. That call doesn’t change ahead of the half-year trading update on July 1. Also unchanged is a target of 125p, about 60 per cent downside from current levels:

We believe that RR will guide to EBITA and FCF materially below BBG consensus. Notably, BBG consensus for 2020E FCF is £-756m, whereas JPM estimates FCF will be £-2.5bn prerestructuring / £-3bn post-restructuring. (2) On August 31st RR will report its H1 results, which it has delayed by one month. We believe the delay reflects that RR will need to “clean up” its accounts and take major write-downs / impairments. We expect a statutory net loss of at least £3bn due to FX M2M charges, restructuring costs, impairments on long-term contracts, and possible impairments on intangible assets. We believe this will take RR’s shareholder funds to at least £-6bn. (3) After the H1 20 results we believe RR will need to reinforce its balance sheet significantly, something we argued was necessary before COVID-19. We expect a combination of material disposals and an equity raise. In previous notes we have argued that RR needs to issue £6bn of new equity and that this might not be possible from institutional investors; as such, we think there is a high chance of government intervention.

Flutter Entertainment is down a bit after doing a 5.5 per cent share capital placing with a second-quarter trading update. The bookmaker raises £813m at a 4.7 per cent discount to Thursday’s close.

The cash isn’t solely to pay down debt, though it is definitely for that: the leverage ratio will fall by 0.9 to 2.8 times ebitda or thereabouts. There’s also some talk of accelerating the US strategy, improving competitive positioning in international markets and, more prosaically, reducing interest costs. Fox, JV partner on US turf accountant Foxbet, is a backer. With Flutter trading at 27 times earnings, having nearly doubled since March, it all feels very opportunistic, but that’s hardly a surprise from a bookie. Here’s Peel Hunt with an analogy:

The US online betting and gaming market is set to grow faster than pre-Covid-19. In which case, Flutter having a few more bananas on its bunch will certainly not hurt. The valuation still seems high, but we are less sceptical …

Flutter has a leading market share in the US. Post Covid-19, we expect the US market for online betting and gaming to grow faster, and to a larger size, than we forecast previously. The placing will give Flutter resources to defend its existing US market share against any irrational exuberance when major sport returns and to invest in expansion in multiple states thereafter.

Covid-19 has driven a channel shift to online in gambling, possibly to the long-term detriment of offline. As a result there may be more opportunities to invest in Stars, particularly in the International division, which has seen a recent revenue spike. If poker fatigue develops, Flutter will be able to invest in retaining new players though cross-sell. …

Regulatory risks have not gone away. The US Department of Justice challenge to online gaming based on the Wire Act could disrupt the US market. In the UK, the House of Lords Select Committee has been delayed by Covid-19, but is being lobbied to recommend a £1 maximum stake for online casino. Measures introduced in several countries with the intention of protecting consumers during lockdown (advertising and incentive limits) may become permanent.

Yesterday’s placing reduces the risk to Flutter from excessive debt and opens more strategic options. We recognise the US growth opportunity, but we are cautious that there are several well-financed, and not necessarily rational, competitors for market share. We believe the share price is up with events. We change our recommendation to Hold (from Reduce) and our target price to 10,600p (from 8,040p) based on an FY21E P/E of 22x.

Elsewhere in sellside, doorstep lender Provident Financial gets an upgrade from Jefferies:

Balance sheet strength will help PFG to weather the recession, and it will emerge into a larger non-prime lending market with fewer competitors and with funding flexibility to take market share. Although we forecast an adj. PBT loss of £55m this year we expect CET1 to remain over 30% and for profitability to return in 2021 as the economy recovers. Our reduced PT of 250p is equivalent to c. 1x TNAV and we upgrade to Buy from Hold. ….

Broadly speaking, PFG’s customers come from the lowest 20% of earners, a target market of around 10.7m people, who have disposable incomes below about £20,000. Incomes are very likely to fall, and the experience of the last several recessions has been that those immediately above the bottom 20% see the biggest impact (and saw a reduction in disposable income in 2018/19 – source, ONS). While the effect is hard to quantify, it seems probable that PFG’s target market will grow.

Competition in difficulties: The biggest payday lenders have left the market (Wonga, QuickQuid), the biggest rent-to-own company (BrightHouse) folded in March and the biggest guarantor lender Amigo is under pressure too. PFG has been in boot camp since 2017, operationally and with the regulator, and therefore financially too.

Balance sheet strength: CET1 headroom of £190m excludes the £50m capital conservation buffer, and total surplus cash and liquidity stood at £1.2bn at the start of the week. Home credit collections have only fallen 20%, moving entirely online during lockdown, and the reductions in new lending are functions of the lockdown rather than problems with the business. PFG should therefore be well-placed when the recovery starts, glimmers of which are reported to have been seen in May.

Valuation: With a loss expected this year, we do not expect PFG to pay a dividend until 2021, and then not reaching 2019 levels until after our forecast period. Our dividend discount model valuation comes down from 470p to 343p, including using a higher discount rate of 12%, (formerly 11%) to account for economic uncertainty, in line with other lenders we cover. The shares trade at a premium to a Gordon Growth Model using valuation using our 2022 est. With growth likely to come, but a return to 2019 dividend levels three years away, we use an average of the two and derive a PT of 250p and Buy rating.

“Take the money and run,” Investec says of Barclays.

Fickle markets. We do not deny that Barclays shares had become absurdly “oversold” but, after a 53% 8-week rally, we now suggest that the easy pickings have gone. We continue to see LOKIN-20 as a material and enduring threat to the UK economy. Barclays was our preferred large-cap UK bank but, with the shares on 0.44x 2020e tNAV, we downgrade to Hold (from Buy). We now prefer Lloyds (Buy).

And SocGen’s turns negative on BP among others as part of a sector thing predicting a lot of divi cuts.

We adopt a new macro scenario for the European Oil Gas sector, with materially lower oil and gas prices We downgrade significantly EPS and cash/free cash flow estimates, some dividends, and all target prices Lower target prices in turn drive us to downgrade ratings on half of our stocks from Buy to Hold ( Eni, Equinor and least preferred Galp) We retain Buy on Total (most preferred), Shell, OMV and Repsol

New macro scenario: Enhanced visibility on oil supply reductions, has contained the initial brutal twin oil demand/supply shock and enables us to introduce a new macro scenario 35 bbl Brent in 2020 (from 60 bbl before), 40 bbl in 2021 (from 62/50 bbl then 55/60 bbl in 2022 23 We cut our NBP gas price forecasts by 39% in 2020 and 45 in 2021

EPS downgrades We significantly lower our sector earnings forecasts, by 85% on average for 2020 e and a further 74% for 2021 The biggest cuts to this year’s EPS are for Eni, BP and Equinor the more upstream geared and the smallest for OMV, Shell and Total

Free cash flow disappearing dividends used as a lever this time Our 2020 aggregate sector free cash flow estimate at the new 35 bbl is slightly positive but only covers c 33 of 2019 dividends The unprecedented nature and uncertainty of the present situation compared with the typical historical oil supply side price wars drove Shell and Equinor to deploy dividend cuts, alongside opex /capex reductions, as the levers of controlling balance sheet debt We would be surprised if they are the last ones and believe that both BP and Eni more upstream leveraged than others could use this crisis as an opportunity to reset dividends lower to protect financial resilience in a world where visibility on post COVID 19 oil demand and the oil price recovery path is lacking

The reduction in SGe sector cash/free cash flow and dividend forecasts leads to an average 33.7% reduction in TP across our coverage. The biggest TP reductions are for Eni (c 44 Shell and Galp, whilst the smallest is Repsol’s As a result of reduced 12 m TSRs (from the lowered TP and dividends), we downgrade half our coverage from Buy to Hold namely BP, Eni, Equinor and least preferred Galp But we retain Buy on Total (most preferred), Shell, Repsol and OMV.

• Updates may follow, which’ll be guided by requests and complaints in the comment box. A Telegram Markets Live chat group is also available.


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