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Investors Chronicle: GSK, Sports Direct, Domino’s Pizza Hold: GlaxoSmithKline (GSK) Market conditions are difficult in consumer healthc...

Investors Chronicle: GSK, Sports Direct, Domino’s Pizza

Hold: GlaxoSmithKline (GSK)

Market conditions are difficult in consumer healthcare, but we like the way the company is refocusing, writes Megan Boxall.

Investors who condemned GlaxoSmithKline’s past strategy of bulking up its consumer health division will no doubt be relieved to hear that its “top priority is to improve in pharmaceuticals”.

Spending on related research and development rose 23 per cent at constant currencies to £1.6bn in the first half and the company announced £140m of investment in its medicine manufacturing sites. Meanwhile, revenue from new asthma drugs more than offset the decline in established respiratory products — the biggest single contributor to group revenue — meaning overall pharmaceutical sales ticked up 4 per cent at constant currencies.

But could this new strategy be too little, too late? GSK’s pipeline of new drugs still looks woefully empty, with just three projects currently in the final phase of clinical trials. The group is also still very reliant on asthma drug Advair, which contributed just under a fifth of pharmaceutical sales in these numbers.

The group’s new dividend policy also begs a question. Although GSK has confirmed its 80p dividend for 2018, it aims to build its free cash flow to 1.25-1.5 times the total payout. Free cash flow may have risen to £368m in these numbers thanks to a 4 per cent constant currency increase in adjusted operating profit, still well below the £1.9bn in dividends paid in respect of the period.

Broker Liberum, however, does not have any concerns about the sustainability of GSK’s dividend and has forecast adjusted earnings per share of 112p in the year to December 2017, from pre-tax profit of £7.9bn, compared with 101p last year.

Hold: Sports Direct (SPD)

Having battled through a year of currency concerns and reputational damage, Sports Direct seems to be back on the right track. But thanks to the renewed outlook optimism, shares now trade on 21 times forecast earnings — pricey, but the business has momentum.

Few companies could report a 59 per cent drop in underlying pre-tax profits and still enjoy an 11 per cent share price rise on the day. But Sports Direct has long been bucking trends. On paper, things don’t look good. Ineffective hedging on sterling weakness against the US dollar has ravaged gross margins, underlying free cash flow dropped 44 per cent and the continued costs associated with onerous lease provisions sent operating profits down 28 per cent to £160m.

There is a feeling that the worst is over. A new policy means that all forecast purchases for the 2018 financial year are hedged, so that margin effect should normalise. More importantly, Mike Ashley’s outlook statement is distinctly cheerier than this time last year.

The group’s 13 new-generation flagship stores, a big target for investment, are performing ahead of expectations and analysts at Peel Hunt expect pre-tax profits and earnings per share to tick up to £115m and 16.5p respectively in the year to April 2018 (full-year 2017: £113m and 11.2p). There also appears to be some hidden value in the group’s brands. In December last year, management sold Dunlop for $138m (equating to £110m at period-end) — 27 times its pre-tax profits.

Sell: Domino’s Pizza (DOM)

Consumer confidence is waning in the UK, and we’re concerned how long the company’s more mature sites will suffer at the hands of new ones, writes Harriet Russell.

Interim figures for Domino’s Pizza were accompanied by a warning of “reduced consumer confidence” at home thanks to nominal wage growth and a weaker exchange rate. Earnings downgrades from City analysts swiftly followed. Brokerage Peel Hunt shaved 4 per cent from its 2017 pre-tax profit forecast, and now expect pre-tax profits of £90m for the year ending December 2017, giving earnings per share of 15p, compared with £85.7m and 13.6p in 2016. That only bakes in a 1 per cent rise in like-for-like sales, despite easier comparative figures as the year progresses.

Elsewhere, Liberum analysts highlighted that like-for-like sales growth has fallen behind a rise in average order value, which suggests volumes are falling across the company’s more mature stores. When it comes to comparable sales, there appears to be a cannibalisation effect from “split” territories — effectively where an existing Domino’s store divides into two.

Of the 40 new stores opened during the period, 24 were territory splits. Including the drag from splits, UK like-for-like sales only grew by 0.1 per cent during the first half. It is these new openings which largely account for the 6.5 per cent improvement in systems sales, 3.5 per cent order growth and 2.9 per cent average ticket growth.

The international business is not expected to turn a profit until next year, and the company’s decision to concede on gross margins to support “great value national promotions” suggests competitive pressure.

Chris Dillow: When uncertainty doesn’t matter

In its latest economic forecast, the IMF says something odd. It’s this: “Rich market valuations and very low volatility in an environment of high policy uncertainty raise the likelihood of a market correction.”

There are several problems with this.

One is that high policy uncertainty should already be reflected in share prices. In fact, if policy uncertainty increases downside risk it should be a source of a risk premium in equities — something that generates high returns for the investor brave enough to take it on.

History shows that this is the case. We have an index of global economic policy uncertainty compiled by Stanford University’s Nick Bloom and colleagues. Since January 1997 (when their data begins) the correlation between this index and subsequent annual changes in the MSCI world index has been slightly positive, at 0.2. (That between policy uncertainty and subsequent changes in the All-Share index has also been slightly positive, at 0.17.) This means that above-average policy uncertainty has been associated with equities being slightly more likely than not to do better than average in the following 12 months. Which is consistent with uncertainty being priced into markets and generating a risk premium. For example, uncertainty peaked in January of this year and since then global equities have risen almost 7 per cent.

There’s another problem. Low volatility is not a sign that investors are complacent. It’s a sign that they disagree: share prices are stable and volatility is low when sellers can easily find buyers and vice versa. Disagreement, however, should have no predictive power in itself for share prices.

We can test this. If the IMF is right, we’d expect to see a significant positive correlation between volatility and subsequent changes in global equities — so that low volatility leads to poor returns.

But this isn’t the case. Since January 1997 the correlation between the CBOE’s Vix index and subsequent annual changes in MSCI’s world index has been just 0.04 — essentially zero. Volatility, then, tells us nothing about future returns. This is consistent with low volatility being a sign of disagreement rather than of complacency.

But what about the combination of low volatility, policy uncertainty and “rich valuations”?

One obvious sign of “rich valuations” is the cyclically-adjusted price/earnings ratio (or caper) on the S&P 500, complied by Yale University’s Robert Shiller. It is now just over 30, which is almost twice its average since 1871. This is “rich”.

So, how do this, the Vix and policy uncertainty taken altogether predict returns? We can answer this simply by a regression equation linking annual changes in MSCI’s world index since 1997 to these three variables.

Such an equation tells us that the caper is indeed associated with lower subsequent returns. But policy uncertainty and the Vix have no statistically significant association with subsequent returns. Valuations tell us something, but volatility and policy uncertainty don’t.

This regression points to global equities rising slightly over the next 12 months, albeit with a significant chance of a fall — around a one-in-five chance of a drop of 10 per cent or more. Maybe this corroborates the IMF’s warning of a heightened chance of a correction. But if it does, all the work is being done by valuations: policy uncertainty and volatility are irrelevant.

Does this mean the IMF is wrong to warn of the risk of a correction?

Not at all. There is such a chance simply because there always is.

I suspect that what the IMF is doing here is trying to find a rational basis for what is in fact a hunch or gut feeling. Frankly, I share that hunch: in fact, I reduced my equity exposure in May. But it’s hard to fully justify such a hunch. And it might even be impossible: if there were obvious warnings of market falls, investors would sell as these warnings became clear and so there wouldn’t be a subsequent fall at all.

Not all hunches, however, reasonable, can be wholly rationalised. Not all useful economic statements are entirely scientific.

Chris Dillow is an economics commentator for Investors Chronicle

The Financial Times and its journalism, including Investors Chronicle content, are subject to a self-regulation regime under the FT Editorial Code of Practice: FT.com/editorialcode

Sports Direct’s Ashley Wins Court Battle Over Drunk Bonus Deal

Mike Ashley, the billionaire owner of Sports Direct, won a court ruling denying a former employee’s claim that the retail tycoon made a legally binding 15 million-pound ($19.5 million) bonus deal in a London pub.

Photographer: Simon Dawson/Bloomberg

Jeffrey Blue, an ex-Merrill Lynch investment banker who worked for Ashley, alleged in a London lawsuit that his boss reneged on a pledge made in a bar in early 2013 that he would get the payment if he doubled the retailer’s share price to 8 pounds.

"No reasonable person present would have thought that the offer to pay Mr. Blue was serious,” Judge George Leggatt said in a ruling Wednesday. The case "shows only that the human capacity for wishful thinking knows few bounds."

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The court case, littered with references to heavy drinking, has been an unwelcome distraction for Ashley, who built Sports Direct from one shop into the U.K.’s biggest sportswear retailer. He’s trying to resurrect growth at the company after a dismal 18 months. Since a December 2015 undercover newspaper investigation exposed management issues at its warehouse, Sports Direct’s shares have lost more than half their value.

Mike Ashley School of Management: Drink, Gamble, Under-Table Nap

Ashley reacted to the verdict by calling the investment banker a “Blue-faced liar.”

“The only reason the Sports Direct share price exceeded 8 pounds and will hopefully do so again, is because of the sterling efforts of all the people who work at Sports Direct,” Ashley said in an emailed statement.

Sports Direct shares rose 1.4 pence, or 0.4 percent, to 361.90p at 12:20 p.m. in London.

The company has had a difficult 18 months. Since a December 2015 undercover newspaper investigation exposed management issues at its warehouse, the shares have lost about half their value.

A lawyer for Blue didn’t immediately return a call seeking comment.

Blue told the court that Ashley had made the pledge over drinks at the Horse and Groom pub in London in January 2013. As Ashley is the majority shareholder of Sports Direct, the shares’ rise personally increased his wealth by 1.6 billion pounds.

Fun Night

During the trial, Ashley claimed that he couldn’t “remember the details of the conversations” in the pub as he had consumed “four or five drinks in the first hour” and that any discussion over a bonus was merely “banter” on a “drink-fueled, fun night.” He also claimed that increasing the share price made “no commercial sense” since he wasn’t going to sell any shares.

The pub meeting was set up to discuss the role of corporate broker with Banco Espirito Santo SA, which was represented by three executives. Ashley, who also owns Newcastle United soccer team, joined the meeting alongside Blue.

Peter Tracey, who attended the meeting in his role as head of corporate broking at Espirito Santo, said that “at no point” did the deal seem serious and that it was “no more than banter over drinks in a pub.”

In his ruling, Judge Leggatt, who ordered Blue to pay 600,000 pounds of Ashley’s 1.5 million pounds in legal fees, agreed.

"Everyone was laughing throughout," he said. "It is unrealistic to suppose that anyone with business experience -- let alone someone with the business acumen of Mr. Ashley -- would seriously entertain" such a deal.

The trial exposed allegations of Ashley’s informal business techniques such as drinking competitions in the midst of management sessions and napping during client meetings.

Sports Direct increases French Connection stake to 27%

French Connection was founded by its current CEO Stephen Marks in 1972. Photograph: Martin Godwin for the Guardian

Mike Ashley’s Sports Direct has increased its stake in French Connection to 27%, taking it close to a level at which it must launch a takeover bid.

Sports Direct has bought out activist investors, including Gatemore Capital Management – a London-based hedge fund that had an 8% stake – and OTK, an investment firm that owned about 7%, to add to an existing 11% stake.

Under takeover rules, a shareholder owning shares worth 30% or more of a company’s stock must launch a formal takeover bid.

Ashley has a long history of building strategic stakes in rival retailers, including Debenhams, online specialist Findel and, most recently, Game Digital. It is not clear what his plans are for French Connection.

It is understood he has met with the fashion chain’s boss and 42% shareholder Stephen Marks in recent months, but not laid out any clear demands.

French Connection said: “Sports Direct is recognising the value that is in French Connection shares. We cannot comment on what their plans are.”

Marks, who founded French Connection in 1972, will be key to deciding the future of the business.

The sale of Gatemore and OTK’s stakes brings to an end a power struggle in which the two investors put Marks under pressure to relinquish his hold on the business he founded.

Liad Meidar, managing partner at Gatemore, has previously called on Marks to run an “open and transparent process to sell the company”.

On Thursday, Meidar said he was pleased with Gatemore’s 44% gain on its investment over the past two years. But he added: “French Connection remains a glaring example of the shortcomings of the UK corporate governance code; namely, that companies can get away with such violations with zero repercussions to the people at the top.”

At this year’s annual shareholder meeting, about 53% of independent shareholders who voted via proxy were against the reappointment of both Marks and the non-executive director Dean Murray. A higher proportion, nearly 56%, voted against the company’s remuneration policy after shareholder groups expressed concern about unclear targets.

Investors aimed to bring about change after five years of losses, which have led to a 52% slump in the value of the FTSE-listed fashion chain since 2014. On Thursday shares closed down 1% at 43p.