Broker tips: A.G. Barr, Drax, Tullow Oil

A.G. Barr shares fell on Friday as Berenberg downgraded its rating on the stock to ‘sell’ from ‘hold’ and cut its target price to 470p from 530p, citing a “weak” trading update by the soft drinks maker.

In a 2 August trading statement, the Irn Bru maker said it expected a 2.9% year-on-year drop in first half revenues to £125m due to challenging market conditions. A.G. Barr said it had faced continued deflation and volume declines. The market’s overall performance was also expected to be hurt by poor weather in June and early July.

The company said if market conditions improve, it expects to meet its full year profit forecasts.

“In our view, this will be very tough to achieve as it requires both a significant turn around in sales performance and margin expansion,” said Berenberg.

“In addition, we feel that over the coming years the company could struggle to deliver on its key growth strategies and is likely to see margins come under pressure.”

Berenberg reduced its earnings per share estimate (EPS) by 5% for fiscal year 2017. It also lowered its forecast for EPS in 2018 and 2019 by 7% and 6%, respectively.

A.G. Barr has responded to a planned new sugar tax in the UK by announcing a new Irn Bru zero sugar variant called Irn Bru Xtra. However, Berenberg said it believes it could prove difficult to convert existing customers quickly and was unsure its new releases will substantially broaden the customer base.

The broker also reckons despite strong performances in international and Funkin sales, the businesses remain too small to contribute significantly to group growth.

Due to a weaker pound, A.G. Barr is likely to see the cost of raw materials purchased in foreign currencies increase notably in fiscal year 2018, Berenberg added.

“We expect the company to tightly control operating costs in order to counteract the issue, but believe the earnings before interest and tax margin will fall to 15.9% next year.”

Drax got a boost on Friday as HSBC upgraded the stock to ‘hold’ from ‘reduce’ with an unchanged price target of 315p following weakness in the shares after the first-half results.

The bank pointed out that Drax has underperformed the market after its first-half results.

“The company mentioned that its FY 2016 EBITDA will come in at the bottom of the consensus range, which in our view has resulted in the share price weakness.”

HSBC noted the share price has fallen around 8% in absolute terms in the last month, whereas the sector index – MSCI Europe utilities – remained relatively flat over that period. As a result, the stock is now trading in line with its price target, which implies 1% upside.

HSBC highlighted the short-term opportunity from auxiliary services.

“The short-term strategy is for Drax to offer services to National Grid as it seeks to balance intermittent and distributed power availability. National Grid suggested that these services could amount to £2bn by 2020.”

The bank said there are a wide range of services such as balancing reserve, reactive power and black start capability, that Drax could offer.

“With 10.5GW (nearly 20% of UK-installed capacity) of solar on the system and 20% of power provided by renewables in 2015 in the UK, these services will be increasingly required.”

HSBC said this was a considerable opportunity for Drax, which has capacity to service around 7-8% of the UK’s power demand.

Bank of America Merrill Lynch upgraded Tullow Oil to ‘buy’ from ‘neutral’ and lifted the price target to 285p from 275p.

BofA noted the shares have materially underperformed the sector.

“Over the past 24 and 36 months, shares have returned -70% and -80% respectively, against the sector at - 60% in both time periods.

“Further, we believe when we overlay the operational progress with our commodity price view, Tullow Oil is one of the most compelling levered E&Ps to gain exposure to an upswing to a recovery in oil prices.”

Merrill pointed out that Tullow is on the cusp of a 30% increase in group production, while simultaneously lowering opex and capex 25% and 40%, respectively.

“With the TEN field start-up imminent (18 August), Tullow is in a position to generate 15%+ free cash flow yields as group production grows 30% year-on-year.”

In addition, BofA said that while Tullow’s net debt position has been a perennial overhang for the company, with an organic pay-down focus, it will now be in a much stronger position in negotiating its reserves-based loan facility at year-end 2016.

“Indeed, we think Tullow is about to enter the most rapid deleveraging of any company in our coverage, moving from YE16 net debt: EBITDA of 5.9x to 3.9 x by year-end 2017.”

Furthermore, it said that now that management has successfully raised $300m via a convertible issue in July, it is under significantly less pressure to sell upstream assets pro-cyclically, which is a positive step.