Broker tips: Water utilities, Tesco, Henderson

Severn Trent and United Utilities were under the cosh on Wednesday after RBC Capital Markets downgraded both stocks as it took a look at the UK water sector.

The bank cut Severn Trent to ‘underperform’ from ‘sector perform’ on valuation grounds but lifted the price target to 2,300p from 2,200p. RBC said it has updated its return on regulated equity calculation and valuation approaches such that the target price rises, but with -5% implied total return, it downgraded the rating.

“We believe SVT will continue to be one of the better-held UK water stocks by investors. Its management presents SVT’s investment case strongly and largely receives a positive feedback from those who have met them.”

RBC downgraded United Utilities to ‘underperform’ from ‘sector perform’, also on valuation, noting 4% implied total return, but lifted the price target to 1,000 from 975p.

The Canadian bank said its ratings on both stocks reflect its view that their current trading valuation implies a total return that compares unfavourably to the rest of the European utilities sector.

RBC highlighted a preference for outperform-ratedPennon, which it said offers a “one-stop shop for investors seeking exposure to various long-term themes, including water/waste, safety amidst Brexit, macro recovery (relative to SVT/UU), income-play, earnings growth and UK Water M&A.”

RBC lifted its price target for Pennon to 950p from 925p.

Shore Capital reiterated a ‘hold’ rating and target price of 189p on Tesco on Wednesday after the supermarket reported its first half results.

The company reported group sales grew 3.3% to £24.4bn and UK like-for-like sales improved to a 0.6% increase from the 0.3% rise the same period a year earlier. However, its pension deficit soared to a whopping £5.9bn from £3.2bn, reflecting lower bond yields.

Chief executive Dave Lewis also laid out his ambitious plans for growing profit margins. Lewis aims to lift group operating margin from its current 2.2% to 3.5-4.0% by the 2019/20 financial year, helped by cost cutting and a solid level of capital expenditure.

“The results themselves represent demonstrable operational improvement from the business with cash sales and not just volumes now positive in the UK in particular alongside much needed margin accretion. We welcome this progress,” said ShoreCap.

“However, the operations in isolation do not characterise the Tesco investment thesis. The burden of broad level indebtedness and the corresponding high solvency ratios, continue to prevent us from taking a more positive view on the group's shares.”

Shorecap said it may upgrade its current pre-tax profit forecast for fiscal year 2017 of £682m. Further out, the broker predicts an earnings before interest and tax margin of 3.7% in 2020.

“Indeed, whilst there may be some understandable excitement today on Tesco’s new margin ambitions and the greater confidence of management, it is important to point out the back-end weighted nature of the plan, wholly consistent with our understanding of the business and investment thesis on the stock.”

Barclays reiterated an ‘equal weight’ rating on Henderson Group but raised its target price to 270p from 215p on Wednesday after the investment firm agreed to buy US rival Janus Capital.

The merger will create a combined portfolio of assets under management worth £320bn and the two firms will be renamed Janus Henderson Global Investments. The companies hope to cut costs of $110m per year within three years of closing from areas including IT and office space.

“We believe investors were particularly excited about management’s projection of double-digit accretion as well as the possible future benefits from lower group tax and incremental flows,” Barclays said.

“However, we believe the $110m cost synergies (16% of EBITDA or 7% of costs) are likely to come under more scrutiny given the complementary geography and products of the group.”

Barclays said it believes management need to provide more detail around the $110m of cost savings to convince the market since much emphasis was placed on complementary investment capabilities and distribution strength.

“This is particularly true given that management specified the majority of the benefit would be realised inside 12 months but did not make it so obvious where back office or investment teams are to be rationalised.”

Barclays has raised its earnings per share forecast on Henderson for fiscal years 2016 and 2017 by 4% to 15.2p and 7% to 16.7p respectively.