Investment Column: Yield is what makes listless Drax a buy

Home Retail Group; Telford Homes
Click to follow

Our view: Buy

Share price: 465.8p (+9.6p)

The problem with the power station operator Drax is that there seems to be little on the horizon that is likely to give the stubbornly undervalued shares any oomph.

Tony Quinlan, the finance director, concedes that Drax is a complicated share for what he terms "unsophisticated investors," saying that two types of punter are drawn to the stock: the majority that believe the group is a "buy and hold" for the long term, and those that see the group as a proxy for the volatile world of commodity prices.

Sophisticated or not, all investors will be well aware that as the equity markets have recovered over the last six months, Drax has been something of a laggard and has failed to spark, falling by nearly 15 per cent during the period when most have soared.

Operationally Drax is rather impressive: the group had the foresight to book 80 per cent of its 2010 contracts long ago, and has cleverly secured better prices than the average 2009 contract prices. It has also successfully refinanced its debt and extended the maturity out to December 2010.

The problem is that we are not at all bowled over by Drax's shares – with the contracts already in place and the debt issue resolved for now, we fail to see what will send the shares northwards in the next 12 months. Ordinarily therefore, we would not recommend the stock to investors, regardless of how sophisticated they are.

But that is before you consider the all-singing, all-dancing 7 per cent yield. The fact that the shares are pretty cheap too, trading on a 2010 price earnings ratio of 6.2 times, is rather compelling.

The company's trading update yesterday conceded that trading conditions remain tough. Indeed, we would be nervous about the performance of the stock in the next 12 months, but investors cannot ignore such a juicy yield. Buy.

Home Retail Group

Our view: Hold

Share price: 308.1p (+0.1p)

Home Retail Group, the owner of Argos and Homebase, has defied market expectations this year. The company appears to be benefiting from tight cost control and a sharp rebound in the fortunes of its DIY retail chain. Yesterday, the general merchandise group delivered a 1 per cent uplift in pre-tax profits, before exceptionals, to £123m for the half-year to 29 August, which was ahead of City expectations. Over the period, Homebase posted a 66 per cent uplift in operating profit to £48.9m, but profit growth and underlying sales fell at Argos.

The DIY retailer benefited from a "double digit" sales uplift in kitchens, helped by the demise of rival MFI last year, and an improved performance on furniture and bathrooms. Homebase also made hay on its seasonal products, such as garden tables, during the favourable spring and summer weather. But there are reasons for investors to be cautious about snapping up Home Retail's shares like one of Argos's Go Go Pet Hamster toys ahead of Christmas.

Argos suffered a 7 per cent fall in operating profit to £79.7m and a 2.1 per cent drop in underlying sales over the half, despite strong sales of TVs and toys. Home Retail's chief executive, Terry Duddy, also warned of a "more significant impact from adverse currency movements" over the second half related to the weak pound. Furthermore, its shares are not cheap, trading on a 2010 price-to-earnings ratio of about 16. But Home Retail – which has £352m of net cash on the balance sheet – is well placed to benefit from a sustained upturn in consumer spending. When this comes, it represents a safe pair of retail hands in the long-term. The valuation remains a concern, but given that Mervyn King, Governor of the Bank of England, is beginning to see signs of recovery, we'll hold, at least for the moment.

Telford Homes

Our view: Buy

Share price: 96.35p (-4.65p)

Telford Homes does lots of social housing around the East End of London, a place where it's desperately needed. With the possibility of spending cuts to come and maybe a Conservative government with an inclination to land the cuts on poor people who don't vote for them, it's a sell. Right? Well, maybe. Those with a social conscience who live around the area will note that recently its developments have been rather good. That's not a reason to invest, to be sure, but the funding it has for projects until 2011 is. And then there is the issue of the discount. Based on its portfolio the company trades on about 130 per cent of net asset value per share. Telford is refreshingly open about it does too, something others could learn from. All that being the case, we think this could be a diamond for investors among the rough of the East End. The operation is also not just a one-trick pony, either – it doesn't just handle social housing.

The business does have headwinds in the face of spending cuts. But with demographics in its favour and a proven record, it's a long-term buy.