Investment Column: Buyers must avoid Drax's 'perfect storm'

Mears Group; Brown (N)
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Our view: Avoid

Share price: 505.5p (-20.5p)

Intuition should perhaps tell investors that a company caught in what its finance chief calls a "perfect storm" of suppressed global gas prices might not be the best of investment propositions, regardless of how much better things are likely to get when the tempest passes.

Drax, the coal-fired power station operator, said in yesterday's interim trading statement that full-year earnings are likely to fall by 34 per cent on last year, as margins come under pressure from lower gas prices, which drive overall power prices.

The group says the resulting low share price is nothing to worry about. The stock tracks the dark green spread – the difference between the wholesale price achieved for power and the coal and carbon dioxide costs faced in generating it – Drax says, and as the price of gas rises again next year, so the share price will improve. The group's renewable projects will also give shareholders a fillip in the medium to long term, says the finance director, Tony Quinlan.

While we accept that things beyond Drax's control have dampened the stock, investors should not yet feel the need to support the shares.

Analysts at Evolution also argue that clients should reduce their exposure to Drax. "We base our valuation of Drax on correlation with the dark green spread. The spread for winter 2009/2010 and summer 2010 currently averages £14.5/MWh, implying a target price of 490p, making the stock 8 per cent expensive," Evolution says.

Mr Quinlan, on the other hand, rightly points out that other industry experts argue the shares are cheap, using different methodologies.

We agree with the company when it says it will be around in years to come, and that there might be upside in the stock next year. We do not agree, however, that now is the time to buy, and would avoid Drax at least until we see some evidence that the all-important gas prices are on the up again. Avoid.

Mears Group

Our view: Buy

Share price: 239.5p (+9.75p)

"The market does not know how to value quality businesses," says Bob Holt, the chief executive of the social housing and domiciliary care maintenance group Mears.

Given the underlying safety of Mears' business model, and the tepid performance of the group's shares over the past year, we can only agree and would urge investors to fill their boots.

Mr Holt admits that there were few fireworks in yesterday's trading update, but argues that, despite the recession, it is very much business as usual.

We would say that social housing maintenance must be one of the most defensive sectors you can put your money in, even allowing for an expected cut to public spending budgets in the next few years, regardless of the shade of government. Punters will not get a super growth stock with Mears, but they will get stability and decent returns over the longer term.

That is not to say the shares have no room for growth. The experts at Investec were heartened by the update. "We maintain our view that the defensive nature of the majority of Mears' markets coupled with the outsourcing opportunities provides significant share price potential," they say.

Applying a price-earnings ratio, the watchers say, will see the stock reaching 332p in the next year, an upside of 46 per cent on Monday's closing price.

Mears said yesterday all divisions were trading well and that the order book is marginally ahead of where it was this time last year. We would not advise that buyers take the stock if they are looking for super returns, but nor do we think they will easily find them elsewhere. Mears is a safe, solid stock, and investors should buy at this depressed level. Buy.

Brown (N)

Our view: Buy

Share price: 217.5p (-20p)

Bigger bad debts, unemployment and higher input costs caused by the fall of sterling – these are all factors that the mail order shopping group N Brown says it faces in the coming year.

To make things worse, the stock tanked 8.4 per cent yesterday as the group increased its bad-debt provision and maintained the dividend level, despite the hike in profits.

But it is certainly not all bad news for investors. Not only are the shares cheap, but the company also announced record full-year profits yesterday, proving there is resilience in the business model.

We think the market overreacted a little and would be inclined to agree with watchers at Investec, who urge clients to buy on the weakness of the stock. "The current calendar 2009 price-earnings discount of 35 per cent to the sector is overdone relative to the strength of underlying earnings in our view," Investec notes.

The softening yesterday represents an opportune moment to buy. Buy.