Three shares to follow this month and beyond: Jet2, Restaurant Group and Redde

Well, February was another decent month for us, albeit not as stellar as January- see below for detail as we cannot lead with performance these days.

Beyond the veritable smorgasbord of day-to-day idea generation and stock picking for portfolios, one clear and distinct advantage of involvement in the Killik Special Situations service is the extent of deal flow access we potentially allow you, as a private client, to IPOs and secondary placings…it really is “institutional level” access. With regard to the three names highlighted last month we have had a lovely kicker to portfolio performance from the placings in Supreme, Actual Experience and Surface Transforms which are up 37%, 19% and 38% since their respective placings. Also, as previously expounded, we fully expect to see more M&A in our universe in 2021 and February also saw the bid approach for IDOX to follow on from January’s approach to AFH.

The last month has seen a pronounced move towards the embrace of “vaccine stocks” and we have been fortunate to hold a few of these in portfolios. We have decent holdings in the likes of Gym Group and Halfords (note today’s great update too), but in this article we wanted to focus on three others: Jet2 (where we have again supported its recent equity raise), Restaurant Group and Redde.

My outstanding wing man, Peter Bate, has summarised the investment rationale behind these names.

Please feel free to contact me via [email protected] if you would like to discuss the merits of the Killik Special Situations segregated discretionary service. 

Jet2.com…. reach for the sky

Jet2.com is a leisure travel company that has grown significantly over the last decade to become the second largest tour operator in the UK. We suspect that, in the wake of the pandemic, it will overtake TUI to become the UK’s largest operator. In common with the rest of its sector, and indeed any business related to the movement of people, the business has been in a state of hibernation for some months as a result of the wide-ranging travel bans imposed in the wake of the coronavirus outbreak.

Whilst the company has already raised equity once during the crisis (in a deal which we backed for clients at the time), the company has again come back to the market (12th February) to raise ￡422m at a price of 1180p. Whilst we believe it is possible that management could have continued without the equity raise, frustratingly, the company has fallen victim to confusing bureaucracy surrounding its c.￡300m COVID Corporate Financing Facility (CCFF). The CCFF was a funding scheme put in place by the UK Government for larger companies with a high credit quality back in March 2020. Jet2.com was confirmed as an eligible issuer back in May 2020 (less than a week before last year’s equity raise). Although the company has not drawn down any money under the facility, it was clearly planning to use the facility in the event that lockdowns continue through Spring 2021. The government has subsequently amended the eligibility criteria on the facility (we gather tightening up on what it deems acceptable leverage metrics), to reflect that fact that they deem market conditions to be improving. Clearly as a travel-related business, market conditions for Jet2 have not actually improved, exemplified by the same government announcing only days ago compulsory quarantine on return from certain countries, reminding the public that going on holiday is illegal and making threats of a decade of imprisonment for other travel-related infractions. Against this backdrop, we believe it is prudent for Jet2 to assume that they cannot rely on the availability of this facility.

In the near-term, we would expect that the share price will be driven by sentiment in the sector as plans for the eventual travel “unlock” arise (albeit late May is currently looking promising). Our investment case is however is not predicated on any great level of trading this summer, with trading next Summer (i.e. Summer 2022, which is Jet2’s FY23) our key focus. We are looking forward to more than “recovered” earnings and believe the excellent management team will be able to generate supernormal profits for a number of years as industry capacity is reduced (weaker players retrench from the market), significant pent-up consumer demand is released (driving pricing) and Jet2 drives its mix towards package holidays (driving margin higher too).

When considering what “recovered” earnings could be, if we use 2020 as a base, where the group generated ￡3.75bn in revenue and c.￡265m of PBT, it should be noted that this in itself did not include any benefit to the summer season from the collapse of Thomas Cook (which failed in September 2019). We would like to think that in a post-Covid world, the market structure now is even more supportive of a profit number materially higher than 2020.

We believe Jet2 will become the category killer in the UK package holiday industry – amid fragile competition whose customer service models (i.e. delaying/withholding refunds) and own funding models we suspect will remain under pressure, just at a time when customer demand in the sector begins to ramp aggressively.

Restaurant Group…..greed is good

Restaurant Group is a casual dining chain which has around 400 outlets in the UK. The main brands the group trades under are Wagamama (37% of the ongoing estate) and Frankie & Benny’s (c.26% of the ongoing estate). In addition, the company has an element of rural & suburban pubs (19% of such – most of which trade under the Brunning and Price brand) and a small Concessions operation (9%) with the balance made up with a handful of other brands, the most noteworthy being Chiquito (c.6%). Mindful that the estate has been closed (apart from take away service offerings ) now for the third time since March 2020, and with no concrete timetable for a reopening, we are assuming 2021 to be another write off in trading terms – not least because RTN needs around 65-70% occupancy to reach cashflow breakeven at its sites. In spite of this, we believe the company has more than sufficient liquidity to survive a protracted period of continued lockdown (with its monthly cash burn of c. ￡5.5m versus debt facility headroom of ￡125m). We believe this is the consensus view, and should there be a material rebound in trading in 2021 that represents upside to our expectations.

Our investment case in RTN has two broad elements. The first one is that in the wake of the pandemic, the company has accelerated the exit of a very large proportion of its loss-making Leisure sites (i.e. the combined Franky & Benny’s and Chiquito estate). Frankie & Benny’s and Chiquito had become the least well-liked part of the estate – with concepts that had not been well invested and profitability driven by continued price rises. The formats had begun to show weakness some time before the pandemic, with a long tail of outlets marginal or loss-making. Management had already outlined a 5 year plan to exit a large number of these sites organically (i.e. by not renewing leases as they expired).The shock from the pandemic however effectively forced the hand of the company (and its creditors) into a CVA process across 128 sites. The process has effectively extinguished any future lease liabilities from these premises, with the only commitment being for RTN to pay business rates on these sites until they are re-let (which may be up to ￡4.5m p.a). The net result is a reduction of around 60% of the prior Leisure estate and a c.30% reduction in overall group lease liabilities. This leaves a higher quality busines with more concentrated exposure to the differentiated, highly rated and fresh Wagamama brand (which was still growing very strongly as the pandemic hit) as well as rural and suburban pubs, which feel more structurally robust should patterns of working from home remain changed permanently.

The second strand of our investment case is that the pandemic will ultimately result in the removal of c.25 - 30% of supply in the casual dining sector. Whilst it is true that the barriers to entry in the industry are low, and over time we would expect new supply to come on stream, we expect there will be a period of several years where the number of casual dining outlets will be lower than it has for some time – and those operators that are able to trade during this period will benefit from this. This is against a backdrop of (we suspect) significant pent-up demand from consumers that have not been able to dine out for almost a year, and are supported by healthy levels of savings. In providing guidance to the market for the earnings potential of the ongoing estate (i.e. looking at those sites that where open in 2019 and will stay open in the future), the company has presented an illustrative EBITDA range of ￡110-125m. Most analysts in the market have taken this as the basis for their FY22 forecasts. We however believe that this number is too conservative, and given the reduced supply in the market, would not be surprised to see the group beat the implicit revenue assumptions in this profit range (we assume ￡800m) by at least 10%, which, as a result of operational gearing would result in a more significant beat to profit, and would not be surprised to see a profit outturn of more like ￡135m of EBITDA from the continuing estate. Whilst it may be premature to consider even more optimistic forecasts before lockdowns have been lifted, we also see scope for gross margin benefits to the group in a post pandemic world – as a result of menus that have been optimised during lean periods and lower numbers of staff as table ordering software enhances productivity. As an ￡800m revenue business, even small improvements to the gross margin line can be significant to profit.

The company has a complicated debt structure, which includes a ￡225m high yield bond, ￡195m of conventional bank debt (￡35m super senior facility and a ￡160m RCF) and ￡50m in CBILS loan. These facilities all mature in FY22, and as such, we would not be surprised to see the group refinance this debt at some point in the coming months. Whilst we believe the company is unlikely to be able to achieve the 4.25% interest rate it currently has on its Wagamama bond, we would not be surprised to see a more fundamental overhaul of the capital structure which could include a mix of sale and leaseback across its c.￡150m of leasehold property (mostly at the pubs business – i.e. replacing the rent exited by the CVA), a new bond (albeit maybe smaller) as well as fresh equity. Our view is the market would take a fresh equity injection as a positive (as has been seen at JD Wetherspoon), putting Restaurant Group in a position of strength – with a de-geared balance sheet and cash on hand to undertake acquisitions of distressed smaller and private operators without access to capital, or to fund a more aggressive roll-out of new Wagamama sites (to take advantage of the very attractive rental terms that are on offer at the moment).

The investment case is not simply one of a vaccine enabled rebound of the UK dining market – it is more of a busines that has undergone a fundamental restructuring that has left a high quality core (supporting a higher rating than the company has been awarded with for a while), combined with a significant removal of market capacity – which will help drive earnings ahead of expectations (we believe) as the unlocking process unfolds.

Redde….get strapped in

Redde Northgate is a “mobility services” business, created via the all share merger of Northgate (at the time c.60% of combined group EBIT) - a light commercial vehicle hire business – and Redde (at the time c.40% of combined group EBIT) – a credit hire and repair business. The rationale behind the merger was that there were two businesses, each with large vehicle fleets that have multiple touch points into the transportation industry. The combination could unlock better buying power with OEMs, greater fleet utilisation as well as significant operational synergies. The characteristics of the combined group are similar to Enterprise-Rent-A-Car; whilst best known for its light vehicle rental business, it is also a significant credit hire player, and is a major competitor on the Redde side of the business.

As in common with other companies exposed to transportation industries, Redde Northgate was impacted during the first lockdown period. As lockdown restrictions were eased however, trading at Northgate improved progressively, with this division (at the time of last reporting) trading ahead of pre-Covid levels in both the UK & Ireland and Spain – with no discernible impact seen in trading as lockdown 2.0 was imposed in the UK (we assume similar in lockdown 3.0). The division has been also a beneficiary of the strong residuals in the UK LCV market, which helped drive supernormal disposal returns (and cashflow).

The Redde Division however has been slower to recover. As the first UK lockdown was released, the division saw an improvement in trading to activity levels of around 20% below normal volumes in September. However, as local lockdowns increased into October, the division saw activity fall to 30% below normal October levels and activity subsequently weakened further into November as the second UK lockdown was imposed. In light of the reduced volumes at Redde, management has continued to review costs and still has a proportion of the workforce on the UK Government furlough scheme. We gather that Redde is currently in the process of participating in three live tenders with major insurers across both credit hire and repair services – and as such is keen not to cut the cost base too much more until the outcome of these tenders is known. Redde is a very profitable business (generating a run rate EBIT of ￡4m per month based upon pre-Covid levels of volume). Market expectations have been rebased to remove much of this contribution; we believe that a reversion to the mean in activity levels as the UK vaccine roll out progresses or large tender wins from the aforementioned major insurers (i.e. driving market share) could result in material upgrades to earnings expectations in FY22.

Whilst the significant synergies that have been realised as a result of the merger cannot be ignored, we believe that the market has not fully appreciated the wider benefits of the merger, which principally relate to the expanded service proposition the combined group can offer – indeed, we gather management has been able to pitch for and win large contracts either business would not have been able to win in isolation e.g. we think that they have won a large contract in the e-commerce space, which we suspect to be with Amazon. By offering larger contracts with a greater service component – i.e. offering true turnkey mobility solutions, we expect the quality of earnings and margins to increase over time, with a reducing capital intensity. At current levels the shares only trade on c.8x April 22E with a 6 % dividend yield and hence we continue to see significant value.

Killik Special Situations service background

Please see the link attached for our latest slide deck and full 10 year performance summary:

https://adobe.ly/2JPDXx5 

I am very pleased to be able to say that in 2020 the composite of all client portfolios in the Killik Special Situations service rose by 20.9% versus the All-Share TR (i.e. the UK market including dividends) being down 9.8%.

YTD in 2021 we are now +8.3% versus our nominated benchmark of the FTSE AllShare TR being up 1.2%

We now have c. ￡125m of AUM, around half of which is derived from City professionals such as yourself. So whilst in 2021 we start again, we are feeling very optimistic for the year ahead. We like portfolio holdings and the bigger unit holdings a lot, whilst we have the comfort of a very favourable (absolute and relative ) backdrop in terms of the UK market valuation and the extent of global FM underweights. Merryn Somerset Webb recently observed (the FT of the 19th December) that the UK is “…the only cheap market left”. Indeed the removal of the “no deal” Brexit overhang will give further tailwinds to the UK re-rating which can but support our names and as with any active manager we will always back ourselves to beat the wider market, though maybe not by 3,000+ bps of 2020.

As mentioned, we now have c.￡125m of AUM in the Killik Special Situations service. In managing this offering we operate a preferred list of around 65 companies at any one moment in time and the service typically builds for our clients an individual portfolio of 15-30 stocks, each sourced from our preferred list, and run on a segregated discretionary basis, and largely invested in UK small to mid-cap companies; our portfolios offer a relatively token yield, now c.1.0% (historic), but no longer a risible figure as one suspects that the days of chunky equity yields on the wider UK market have now gone, not just in the immediate wake of the pandemic, but maybe forever as company balance sheets are reset for greater durability against future "black swan” type eventualities. The segregated discretionary nature of this service does however means that individual client preferences can be catered for such that a bespoke portfolio can, for example, be tilted towards income if that is requested, or specific sectors excluded on ethical grounds (e.g. tobacco, munitions or gambling).

The minimum commitment to the service is ￡30,000 and there is no maximum (except what is a suitable level for each individual client).

In common with other smaller companies focused investment propositions, the exposure of the service to smaller companies means it must be considered high risk and therefore only contemplated by more adventurous investors that have the resources to do so.

The Special Situations service is high risk and you could get back less than you invest. Although the managers aim to mitigate stock specific risk through diversification, portfolios may be concentrated in a relatively small number of stocks (typically 15-30) and some may have large amounts invested in single sectors. This contributes further to the high-risk nature of the service. Past performance is not a guide to future performance.

We are very much bottom-up stock pickers and in our preferred universe of UK smaller cap, we are trawling a market of c.2,000+ companies with a multitude of different niche end markets and therefore earnings drivers, all at different stages of the maturity lifecycle. From an external perspective we may look like a small cap fund, given our number of holdings/unit size etc. but in reality we offer a bespoke segregated discretionary service to investors as every portfolio (of which we have c. 450) is run individually and literally none are identical. Any monies invested will normally be dripped in to the market on a stock by stock basis. This is one thing that our clients really seem to like about the modus operandi of the service, over that of rival unitised offerings, is our ability to precisely finesse individual portfolio construction for each client rather than invest 100pc in one fell swoop simultaneously across all of our names. This is not least because of course in the real world not all stocks in any portfolio manager’s locker are “screaming buys” all the time; they are in fact at least a “strong hold,” otherwise they would have been sold already, but we will have necessarily subjective judgements on the perceived correct valuation of all of our companies so, given share prices can move every second, we might end taking a month or three to totally invest new account monies as we precisely finesse entry and exit points. This is of course time consumptive but it has unquestionably contributed to the superior investment returns we have generated in our 10+years of running the service.

We would be most pleased to present the service to you face-to face (or for now, more likely via phone and email), as we pride ourselves on the personalised nature of running your money. For more performance stats and background on the Killik Special Situations team and the service, please don’t hesitate to get in touch.