Over the past few weeks, questions have been raised about how the fall of Bear Stearns might affect the UK’s banks and economy. The Federal Reserve rate cut has temporarily buoyed markets, but the core issue remains the flagging confidence of consumers, investors, central banks and the wider banking sector.
The bottom line is that the UK consumer will find life much tougher in the short term as banks rein in lending, house prices flatten, and higher food and energy prices squeeze incomes. We expect the next few months to be characterised by liquidity issues and mis-trust.
As the cost of debt rises, raising cash from shareholders is stigmatised and earnings become increasingly hard to predict, we’ve focused on firms with resilient balance sheets, high levels of free cash flow, conservative funding structures, and strong underlying stories.
Aggreko (AGK), which provides temporary power units to developing countries, is one such firm. It performed well in 2007, securing deals for the 2008 Olympic Games and from the Uganda Electricity Transmission Company. Full-year figures met the top end of City hopes. Capital expenditure of £1bn over the next five years shows confidence in the growth of the business. While the US outlook is clouded, Europe remains strong, and the international business is firing on all cylinders. We expect upgrades and remain buyers on weakness.
Strong 2007 figures were also posted by power-generators group International Power (IPR), which continues to churn out an impressive amount of cash (+43%), with financing in place for further growth. It has forward-contracted over 70% of its US generation in 2008. But we expect the majority of growth to come from the Middle East, where 50,000 megawatts of electricity will be generated by 2015, and the company is winning one in every three contracts.
Recently, the share price has weakened on concerns about a rise in its net debt position. However, despite a small hit to margins, its borrowing is asset-backed and the company is able to pass on input prices. After meeting management, we remain buyers.
Shares in Tesco (TSCO) have been hit due to worries about its Fresh & Easy stores in America. Analysts reckon the US operation is running 70% below budget and believe poor footfall will remain an issue. However, Tesco is taking steps to rectify the situation, with senior management working on a recovery strategy. The impact on sentiment is hard to ascertain, but Tesco has a reputation for speedily disposing of failing units.
We believe the US is a risk worth taking; spending there has been financed by the cash-generative South Korean business. If it succeeds, Tesco could achieve a 20% return on capital. The UK business remains defensive and diversified, with any impact from the weaker pound offset by globalised earnings elsewhere. The stock trades on a discount to other global food retail brands, and we will add on weakness.
Mobile telecoms remains a defensive area, but the markets have reacted badly to recent news flow. Vodafone (VOD) is cheap. It offers a well-covered, reasonable yield of 4.6%. Growth is being driven by emerging markets and higher data usage in developed countries.
The stocks Julian Chillingworth likes
Stock, 12mth high, 12mth low, Now
Aggreko, 658p, 421.5p, 634p
International Power, 489p, 359.75p, 402.75p
Tesco, 494.25p, 364.25p, 397.25p
Vodafone, 197.5p, 133.7p, 153.4p