Specialist distribution company Connect (CNCT) is trading on a forecast price to earnings ratio of just 6.5-times this year to 31 August 2017. The rating also implies a whopping 9.2% dividend yield, based on the current 107p share price. Is this too good to be true?
Not according to Martin Brown, analyst at broker Shore Capital, who upgrades the stock to ‘buy’.
Brown says that ‘the valuation has become disconnected from the current fundamentals’. In fact, he says that the company’s valuation has fallen to a ‘distressed level’. Why then would anyone want to buy a company with a distressed valuation?
STRUCTURAL CHALLENGES
Connect’s news and media division has been struggling. The analyst claims that the ‘decline in magazine volumes is currently running at around 8%.’ Brown believes that this is worse than the trend experienced over the last couple of years.
Even the parts of the business that are performing well, such as its Parcel delivery division Tuffnell, has issues. Brown is concerned by the level of capex needed. This could have stark repercussions on future free cash flow (FCF), and is already expected to roughly halve this year (to 31 August 2017) to £23.3m, from £45.1m in 2016.
UGLY SIDE OF UNIT SALE
More concerning is the recent disposal of Connect’s education and care division. Brown says this has reduced operating profit worth about 12% of this year's dividend payout, according to the analyst's calculations. Forecast dividend cash cover for 2017 is just 0.7-times, according to Brown, which means it will generate just 70% of free cash needed to pay the 9.8p per share payout.
The flip side to the division's £56.5m cash sale is that it will cut leverage and fund restructuring, says Sam England, analyst at the company's house broker Berenberg. That will bolster Connect's ability to pay this year's dividend.
WHAT FORECASTS MAY BE TELLING US
Looking ahead, consensus forecasts call for 16.8p of earnings per share in the year to 31 August 2018. They also anticipate a flat payout of 9.8p. On that basis the shares are trading on a forward price to earnings multiple of 6.4 and an income yield of 9.2%.
Those metrics tell us one of two things. Either the stock is trading at a ridiculously cheap valuation, one that implies the share price could easily double or more. Or the alternative, that the market simply believes current expectations have no credibility, either on the earnings or dividend lines.
If the latter proves correct, investors can probably expect much lower earnings in future than analyst currently predict, perhaps as little as 10p per share next year. And if so, that would almost certainly mean a big cut to the payout is lurking down the line.
Such deep cuts to forecasts would inevitably spark another big share price fall. Connect’s shares have tumbled by about 20% since April's interim results announcement, and have fallen by a third since 168p highs in September 2016.
Which makes it fairly clear which outcome most investors are betting on.
