Why Pearson was an obvious value trap, and is Jackpotjoy worth a closer look?

Hello and welcome to my latest blog. I’m a UK-focussed fund manager with a focus on small and mid-cap equities, and this is where I share my weekly thoughts on whatever I find interesting in the world of investing.

It’s a bit too big for my universe, but this week I want to make a few points about Pearson and how it perfectly illustrates value traps. There has been much talk that Pearson was a well-established dividend stock. And yet it takes five mins to look into its financials and see this most definitely should not have been in people’s portfolios as an income investment.

On a different subject, there has been talk over the last week in some quarters of the press about the poor performance of the FTSE 100 once the sterling deterioration is stripped out. I’m not a BRemainer or BRexiteer but I do feel the need to point out the facts, at least to put some balanced perspective out there.

Finally, I put down some thoughts on Jackpotjoy/Intertain, a company that is shortly joining the UK markets. Full disclosure, I do hold an investment in it, but I think it’s an interesting company.

Pearson warning signs there for all to see

The article I wrote last week went into some detail about the important factors to consider when investing in a “yieldy” stock. So the highly disappointing announcement from Pearson a couple of days later announcing a rebased dividend, and wiping £1.8bn off its value, demonstrates my points perfectly. The red flags were clear as day.

The above graph plots the dividend yield and the share price progression over the last seven years (using year-end prices). In isolation, the yield indeed started to look attractive in 2015 and still in 2016 offering a 6-7% annual return. However, the reason for this jump is easy to see as share prices fell significantly in that period.

Did this attractive dividend look sustainable?

Three metrics I mentioned in my last post to analyse the robustness of a dividend were:

• Dividend coverage (i.e. DPS/EPS) to show how much safety margin there is in downturns,
• Return on Equity to assess the quality of the earnings that fund the dividends, and
• Dividend growth track record, to get a feel for how strong the track record is.

So let's take a quick look at these for Pearson.

Dividend coverage was a very healthy 2.6x back in 2011, meaning earnings were 260% greater than dividends that year. Since that time, dividend coverage has been low and getting worse. Earnings have not covered the dividend for the last four years and were negative in 2015. That’s a warning sign.

Next, let’s look at Return-on-Equity and Pearson’s dividend growth track record together.

Pearson’s dividend growth has steadily declined over the last five years, from a 9% increase in 2011 down to just a 2% increase in 2015. That’s another warning sign.

Finally, Return-on-Equity fell from a pretty healthy 15% in 2011 down to low single digits and then negative in 2015 as Pearson reported a loss. Another clear warning sign that dividends were not sustainable at current levels.

The picture here gets slightly messy as you could look at ROE using earnings just from continuing operations or also include earnings from discontinued operations, and 2015 saw a significant change in the business with the sale of the FT and Economist, as well as a £850m goodwill and intangibles impairment. I focussed on continuing operations.

Overall, Pearson is a company in flux as it restructures in the face of serious disruption to its business model from online/digital competitors and big headwinds. It's not in my universe so I won't comment on its outlook, but this has not been an income stock for a long time and as the above shows, there were enough warning signs for it not to be in investors portfolios for its yield.

FTSE 100 - Setting the record straight

There’s been a lot of noise for months now that the FTSE is in rude health which looks undeniable when you see the price action. There has also been some commentators over the last week or so implying the opposite, namely that the FTSE performance is bad once you strip out the Sterling weakness.

The below chart shows that as usual, neither extreme is correct and the reality is far more reassuring. Since the Brexit vote the FTSE, in dollar terms, has been nice and flat thank you very much, so please ignore the doom-mongers and the blindly optimistic. UK plc is just quietly getting on with business.

Jackpotjoy listing in the UK this week

Below are my thoughts on what I think is an interesting company joining the UK market this week. As I said above, full disclosure I do hold an interest in the shares.

On Wednesday, January 25th shares of Jackpotjoy should start trading in London as they look to transfer their primary listing from Canada but unlike most listings, they are not raising any money. Perhaps for that reason alone, this is unlikely to cause much fanfare, probably barely a ripple, but it could represent an interesting company for investors.

Jackpotjoy is currently listed as Intertain on the Toronto exchange, Canada, but the UK ought to be its natural home as it’s the leading UK online Bingo site owner with 27% UK market share (across a multibrand portfolio but with Jackpotjoy by far the largest). The UK makes up over 70% of the business EBITDA with the rest coming mainly from Scandinavia and Spain.

Jackpotjoy started life as a highly rated roll up strategy rapidly buying several online bingo assets in a series of complex deals. However, Canadian investors rapidly fell out of love with the business for a myriad of reasons too long to cover here but widely available on the internet. Step forward new management in mid-2016 and a strategy change built around a new UK listing, running the assets for cash and reducing debt to more moderate levels.

The consensus price-earnings stands at a lowly 5.5 times 2016, which on its own ought to make some investors take a look. It’s rare for what will be £450m market cap company to have such a low rating.

Online Bingo a growing niche market

Online Bingo is an attractive, growing (8-10%), and niche market. Unlike most gambling markets it has a predominately female demographic and usually has highly loyal customers who often prefer the social chat functions than the bingo playing itself.

Perhaps the most eye-catching stat is that “in 2015 89% of Jackpotjoy revenues came from players that joined in 2014 or earlier” meaning that Jackpotjoy spends a lot less on marketing costs, allowing industry-leading EBITDA margins of well over 40%.

The other key attraction is the growth of mobile (now over 50% of the business in most brands) where typically a multichannel player spends 2.5x higher than a single channel (desktop or mobile only) player meaning mobile is expanding the overall size of the market.

High debt gives it an LBO impression

Jackpotjoy does have a lot of debt, on Edison’s expectations net debt including expected earn-outs for year-end 2016 should be around £385m or about 3.9 x EBITDA, and this goes a long way to explaining the low PE rating.

It also pays some hefty interest rates. Most of the debt pays LIBOR plus 6.5% with 90m at LIBOR plus 9%, meaning total interest charges in 2017 are estimated at £33m, compared to forecast EBITDA of £105m. This makes owning the shares more of a Leveraged Buy-Out or Private Equity type of investment over the next two years, something that’s somewhat rare in current equity markets. Cash generation and bringing down debt ought to be Management’s number one priority.

According to the prospectus the Group has $366m of borrowing and around the same again in contingent consideration relating to earn-outs for the previous Jackpotjoy acquisition. Looking at the last reported full year (2015), it generates c$100m in operating cash flow. Using that to pay down debt, it should be able to reduce interest costs that appear to be c.$33m pa, by $8-9m pa on an (assumed) EBIT base of $100m. Hence debt repayment would offer a further 8-9% EPS growth for the next few years.

The prospectus was published on Friday and can be found here (prospectus link).

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To read a brief outline of how I think about stocks, and what I aim to achieve in this blog, please check out my first blog where I set out my stall.

Recent blogs:

• 16 Jan 17 - How sustainable are current dividends
• 8 Jan 17 - Implications of Trumponomics for equities
• 18 Dec 16 - Millennials - Becoming the most important demographic
• 12 Dec 16 - CFDs - Tough week but worth a closer look
• 5 Dec 16 - Pension deficit dogs starting to look interesting
• 28 Nov 16 - Setting out my stall...plus my thoughts on bond proxies 

Please Note: To be clear, I do not and will not ever give any advice. I will rarely mention individual stocks but when I do these will not be recommendations, instead just my thoughts at that point in time.