Broker tips: Electrocomponents, Tesco, Serco

Electrocomponents rallied as Numis upgraded its price target to 295p from 275p and reiterated its ‘buy’ rating on Monday following a trading update.

The company said it expected full year profits to hit the top end of market expectations after a solid fourth quarter in which the UK recovery gained pace.

Encouragingly, third-quarter declines in North America eased off and continental Europe remained on the charge to counterbalance Asian declines and enable 2% growth in group fourth quarter sales and 3% for the full year.

The FTSE 250 company said the final quarter had seen further stabilisation in the gross margin, with the year-on-year decline reducing to 0.4% points, having been down 1.7% points in the first half of the year. This means, management said, that full-year gross margin should be down around one percentage point on the previous year.

“Management's pre-close trading update indicates that the full year 2016 pre-tax profit out-turn will be around the top of the consensus range, which we attribute to a combination of a strong fourth quarter sales per day (SPD) performance, currency, and having delivered ‘at least’ £6m of cost savings in the year to March 2016.

“We have upgraded our 2016-18 forecasts by around 2-3%, and our price target to 295p (previously 275p).”

However, given the macro-economic uncertainty, Numis left its SPD growth assumptions broadly unchanged.

Tesco was under pressure on Tuesday after Deutsche Bank downgraded its stance on the stock to ‘hold’ from ‘buy’ with an unchanged price target of 210p.

The bank noted Tesco is due to report full year results on 13 April and said that after joining in September 2014, this represents chief executive Dave Lewis' first full year.

“It’s been volatile from a share price perspective, as enthusiasm for the new management and the potential deleveraging impact from asset sales collided with the reality of earnings downgrades, an aborted sale process for Dunnhumby and earnings and cash flow dilution from the South Korea disposal,” DB said.

It continues to expect the best relative EBIT margin development at Tesco versus its UK peers, mostly on the back of commercial gross margin gains and cost cutting.

However, the bank pointed out the shares are up 35% in the past three months.

Deutsche said the new management team has made some real progress, but pressures remain.

It argued that the pension deficit funding agreement and the disposal of South Korea has alleviated concerns on Tesco’s balance sheet.

“While leverage remains high, liquidity is strong and the debate about a potential rights issue has largely disappeared,” DB said.

In addition, the closure of 43 unprofitable stores, and of Cheshunt headquarters and relocation to Welwyn Garden City is one of a number of ways management is creating a ‘new’ Tesco and driving around £400m of cost savings.

Serco was still facing a difficult outlook so it was too soon to get back into the shares, Nomura said.

The company's management believed it would be able to lower the company's net debt to about twice earnings before interest, taxes, depreciation and amortisation by year-end.

That was about right, but analyst Andrew Chu cautioned that net debt would only peak at approximately 2.8 times operating profits at the end of 2018.

Furthermore, Chu estimated the company would not generate any positive free cash flow over the next three years.

Onerous contract provisions would weigh on the Hampshire-based firm’s cash flow to the tune of £90m in 2016 and by a further £60m in 2016 and 2018 each.

Compounding matters, there was a lack of clarity around its growth prospects over that same time horizon.

On a multiple of 13.2 times enterprise value to EBITDA that yielded a target price of 96.0p, Chu said in a research note sent to clients.

He reiterated his ‘neutral’ recommendation on the shares.