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Short Screen: June 2021 Update

Refreshing Our Stock MOT

Summary

  • We update our ‘stock MOT’ tool with fresh data to identify the highest scorers per our 34 screening criteria.
  • We review the European universe of non-financials with >€1bn market cap for potential red flags clustered around: 1. balance sheet, 2. business model, and 3. governance.
  • Our criteria try to spot situations where there is an increasing gap between market expectations and underlying economics.
  • We look into incentives that could push management to front-load earnings, using techniques like accelerated revenue recognition. We try to spot how this can be manifested in the financial statements (e.g. bloated working capital, expense capitalisation, slower cash conversion).
  • A good short usually combines: 1. a challenged business model in a sector that faces softer margins, 2. problematic corporate governance, and 3. a debt-laden balance sheet which is difficult to service. 
 

 

Following another quarter of results and new screening criteria, we update our Short Screen. This screen scores stocks based on how many red flags they hit in our categories of balance sheet, business model, and corporate governance. 

 

This note highlights potentially interesting short ideas by showing:

  • Our top 30 scorers which hit the highest number of our screening criteria out of the European non-financials universe, with market caps over €1bn and liquidity greater than $5m/day;
  • Companies with relatively high retail trading volumes per Tradegate Exchange;
  • Recent issuers on the Schuldschein market, a red flag highlighted in previous notes;
  • Companies audited by higher risk audit partners, and;
  • The most crowded and growing commercial shorts in Europe.

 

Please note we have no current recommendation on the stocks covered in this note, unless specifically mentioned. 

 

The Top 30 Scorers

Exhibit 1 summarises the 30 companies that hit the most red flags on our updated screen, representing the highest scoring ~5% of non-financial companies in Europe with >$5m/day liquidity and >€1bn in market cap. 

Exhibit 1: Top 30 Scorers

Source: The Analyst, Bloomberg

 

Webuild 

Having rebranded from Salini Impregilo in May 2020, this €1.9bn Italian construction group resurfaces on our top 30 list as:

Business model and balance sheet: Lumpy earnings are dependent on contract accounting, and revenue has been declining since FY’16. 15% of total revenue in FY’20 derived from gains on bargain purchases and other income which may contribute to the €52m in ‘other non-monetary’ items that boosted the P&L in FY’20. Arguably, the acquisition and recent ramp up in ownership of Astaldi—which has its own difficult past having filed for bankruptcy protection in 2018—reduces comparability of the financial statements and brings with it a sizeable €832m in contract assets. We believe this is an elevated risk for a company that has been cumulatively FCF negative since FY’15. 

Corporate governance/other: Given a development strategy that ‘aims to increase employment and work in Italy and other countries where [they] work’ we question whether interests are fully aligned with shareholders. Alongside mostly local brokers currently covering the name, this may be an interesting time to investigate the name further.

 

Swatch Group

This CHF17bn watch manufacturer hits our top 30 as:

Balance sheet: while the company enjoys a net cash position, FY’19’s inventory balance of CHF 6.9bn represented >80% of revenue, and this balance remains high at CHF6.3bn at 2020 with CHF3.3bn of this relating to finished goods. 

Business model: lacklustre top line performance of -0.6% CAGR between 2015-19,  with arguably high operational gearing that has contributed to operating margins falling ~5% to 12% in the same period. With structural mid-priced watches arguably going nowhere, the pressure on top line may persist longer term, and margins could face pressure from accelerated investment in digital watches. Combined with an equity story highly dependent on success in China, we believe the 19x FY’23e P/E multiple may be demanding.

Corporate governance/other: with the CEO  and CFO holding their positions for over a decade, there is evidence of entrenched management who may be reluctant to address the structural pressures. Alongside the shares recovering since an initial COVID-19 decline, this could be an opportune moment to dig deeper. 

 

Sacyr 

This €1.4bn Spanish company has broad revenue streams across over 20 countries—from construction services and facilities management to concession operations. The latter is the largest segment, accounting for ~50% group EBITDA. It hits our top 30 as:

Balance sheet: a €5.6bn in net debt balance places the business on >7.5x EBITDA. While >80% of this relates to project financing, the business is reliant upon contract accounting for revenue recognition from construction projects largely in the higher-risk markets of southern Europe and LatAm. We also note €506m of the €2.1bn gross trade and other receivables balance, relates to ‘other receivables’, which has increased 26% on FY’19.  This is alongside impairment on receivables overall, rising sharply by 78% in FY’20 to €198m, as well as a sizeable €410m provision balance. 

Business model: Sacyr has been cumulatively FCF negative for the last three years and has struggled to exceed a 1.5% return on assets. We also note other operating income accounts for ~7% of revenue and non-controlling interests accounted for >65% of total consolidated net income in FY’20. 

Governance/other: Manuel Cecilia is the CEO and chairman and is a founding member of the business, providing evidence of management entrenchment. Sacyr is also one of the sell side’s most loved stocks in Europe, with >90% of analysts holding a buy recommendation. 

 

Veolia

This French €15bn liquid water, waste, and energy conglomerate reaches our screen as:

Business model: the low growth business that has struggled to deliver >1.5% return on assets over the last four years, operating in a fragmented market that dilutes pricing power and results in low operating margins of ~5%. Managing a business with >170,000 employees alone is an arduous task and there is sizeable integration risk ahead following a complex deal with Suez. We also note the company’s headline free cash flow excludes the ~€150m paid to minorities.  

Balance sheet: net debt of €13.5bn represents an > 3x leverage ratio and FY’20 saw €687m in receivables derecognised as part of Veolia’s factoring programmes. This is alongside a sizeable €2.4bn total provision balance. 

Corporate governance/other: with the current CEO in the position for over a decade there is evidence of management entrenchment. Combined with arguably high expectations on the Suez acquisition and associated synergies, this could be an interesting time to investigate, as the focus shifts to delivering on these acquisition promises.  

 

Retail Trading: Tradegate Exchange

This quarter we also looked at the most traded names on the Tradegate Exchange. This is a securities exchange specialised for private investors, primarily in Germany and Austria. We ranked names >€1bn in market cap by taking the average trading volume as a share of market cap on three sampled days between 19 May and 16 June 2021. Exhibit 2 shows the top 10 names that also ranked in the top third of our screen and may highlight noteworthy names where there is elevated retail investor interest.  

Exhibit 2: Recent Relative Retail Volumes Per Tradegate Exchange

Source: Tradegate Exchange, Accessed May and June 2021; The Analyst

 
There is an unsurprising home bias towards German companies in the top 10, though we note ITM Power is the exception. Alongside existing short recommendations of TUI and TeamViewer which feature here, we also highlight:
 
Jenoptik: This €1.4bn German optical electronics provider has averaged mid-single digit revenue growth over the last decade, arguably lacklustre for an equity story centred on growth. Contract accounting is also becoming a larger part of the business following the acquisition of Interob, with contract assets rising by 36% on FY’19 to 9.7% of revenue. Alongside a factoring programme initiated in 2019 and a punchy 80 year maximum useful economic life for buildings depreciation, this may be an interesting name to explore further.  
 

Schuldschein Market Issuers

Our detailed note on the Schuldschein (SSD) market highlighted why we believe it is a red flag for shorts, namely due to lax documentation requirements, no external credit rating required, and flexible loan structures. With Asian investors buying more than half of the international issuance in 2019, this may lead to a geographic mismatch between issuers and buyers, where issuers are keen to avoid better-informed local investors. Moody’s recently flagged that auto-suppliers—which have relied on SSDs and raised an estimated €12.8bn of SSD debt in the last five years—have seen a deterioration in credit quality, and even before the pandemic many suppliers would fail to meet investment-grade criteria.  
 
Exhibit 3 highlights new issuers since our last note by non-German or non-Austrian listed entities.

Exhibit 3: Recent Non-German, Non-Austrian Listed Issuers on SSD

Source: Bloomberg, GlobalCapital.com, Accessed June 2021; Elisa Q1 Update

 
Jumbo: the €2.1bn Greek retail operator caught our attention in the past, with 27% EBIT margins appearing high for a retailer, a slow inventory turn of 1.3, low trade payables of ~5% of sales, and cash conversion of ~53% of net income since 2005. However, following store visits in Athens and Romania, our previous note highlighted that Jumbo operates a popular retail format with strong Chinese sourcing operations, an integrated supply chain, and limited competition.  
 
Elisa: This €8.6bn telco’s prize for operating in the relatively favourable Finnish market structure is an underwhelming ~1% revenue growth rate and a 20% operating margin that has arguably been propped up by cost cutting. €1bn in goodwill represents ~40% of total assets and is subject to annual impairment testing. Additionally, with the credit rating just above investment grade, negative performance could prove costly to earnings. The CEO and CFO have both held their position for over a decade, suggesting entrenched management.
 

Auditor Watch List Update

Following our previous notes, we continue to monitor audit partners that have been sanctioned by the UK’s Financial Reporting Council, or those that have overseen accounts of companies which experienced material shareholder value destruction. Exhibit 4 details this full watch list and illustrates which companies these auditors have also worked on. The green highlights draw attention to this quarter’s new additions, following additional FRC sanctions. While an oversight on one engagement may not necessarily mean an oversight on another, we believe it raises the risk profile of related accounts. 

Exhibit 4: Our Auditor Watch List

Source UK FRC, Sentieo, Bloomberg, Accessed June 2021

 

Most Popular and Growing Shorts

Exhibit 5 summarises the stocks in Europe with the highest short interest, drawing attention to popular current short ideas. We spotlight the high days to cover on some of these names, suggesting a poor margin of safety and supportive technical factors for a contrarian long position. 
 
Exhibit 6 indicates the fastest growing shorts positions, between 2 June 2021 and 15 June 2021, that enjoy low days to cover. This identifies potentially interesting names that are growing in popularity and which remain commercially viable.

Exhibit 5: Most Popular Shorts in Europe

Source: S3 Partners

 

Exhibit 6: Fastest Growing Shorts Since May 27 2021 with Low Days to Cover

Source: S3 Partners

 

Conclusion

We have identified several companies that raise potential red flags over 1. governance, 2. business model, and 3. balance sheet. When accounting assumptions meet business reality, a reset in market expectations can trigger a good short opportunity. We also highlighted companies which:
 
1.  Have high relative trading volume on Tradegate exchange, indicating high retail interest;
 
2.  Have recently issued debt on the SSD market and have had higher risk individuals involved in their audits; and
 
3.  Are the most popular shorts in Europe and ones with the fastest growing short interest. 
 
We will continue to run this screen quarterly, and would invite any clients with interest in these names to get in touch. 
 
Please keep in mind we do not have any current recommendations on the names flagged by the short screen unless specifically stated.
 
 
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