5 Undervalued UK Stock Picks

Morningstar equity analysts have revealed the best value stocks across the world - and five UK-listed companies make the cut

Alex Morozov, CFA 13 November, 2018 | 8:29AM
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British Telecom BT telco communication stocks telephone tech

BT Group (BT.A)

While narrow-moat BT Group has had some issues in the past two years that caused its stock to decline, we believe the sell-off is overdone. BT is the incumbent telecom operator in the United Kingdom. In 2016, it acquired EE, the largest wireless telecom operator in the country. The company now has the largest fixed-line telephone, broadband, and wireless telephone subscriber bases in the country. Additionally, it is the only operator in the U.K. that owns both a retail fixed-line and wireless network. We believe this provides BT with an advantage in selling a converged package of these services plus pay TV.

The company has been slow to market its converged services, but we believe now that it has reached an agreement with telecom regulator Ofcom regarding Openreach, its U.K. business that owns its fixed-line network and wholesales access to it to other operators, we expect a more aggressive marketing push into converged services during calendar 2018. BT has been hurt by the widening underfunding of its pension plan as interest rates have declined in the U.K. We think interest rates have bottomed and are more likely to increase from here.

We believe the benefit on the pension will be greater than the hit on higher interest on its bonds, the reverse of what happened as interest rates declined. We also think the company has dealt with its problems in Italy and will be able to improve its revenue in its global services division.

The market appears to believe that BT's problems will continue, and possibly worsen, whereas we believe business can improve over the next few years. In the meantime, the stock yields 6.3% and the company has increased its dividend for each of the past seven years. Additionally, because it is a U.K.-domiciled company, there is no foreign tax withholding on the dividend.

G4S (GFS)

Global security leader G4S has fallen more than 25% from its 2017 peak on the back of concerns about its India and Middle East business and resultant cuts to full-year revenue growth guidance. However, this division generates just 11% of group revenue and 15% of EBITA – earnings before tax, and we believe many of the issues highlighted by investors in this business are short term in nature and do not pose a significant structural risk.

Longer term, we believe the ongoing restructuring program can further simplify the business and remove costs, and structural improvements as the largest players in the industry shift toward higher-value activities should go some way to improving revenue growth and operating margins for G4S. We see material upside to our fair value estimate.

Imperial Brands (IMB)

Imperial is the unloved stock in a sector that is very much in favour. The market is valuing tobacco stocks based on their exposure to heated tobacco, the emerging category that is achieving impressive growth in Japan and select markets around the world. We are bullish on heated tobacco, and we think a valuation premium for those leading and developing the category is appropriate.

However, we think the market is overestimating the value of the first-mover advantage, and if heated tobacco gains traction in other markets, particularly the U.S. and Europe, we expect Imperial to leverage its wide moat and follow Philip Morris, British American, and Japan Tobacco into the space with its own technology. Imperial's current multiple discount of 9 times P/E is much larger than the historical discount, and we think this is unjustified.

Royal Dutch Shell (RDSB)

Shares of Best Idea Shell have performed well, as uncertainty around the safety of the dividend, integration of BG Group, and ability to achieve its 2020 free cash flow and return targets have faded. While the last few quarters have disappointed on cash flow, we do not see them as indicative of its long-term potential and think Shell is well on its way to achieving 2020 targets.

Meanwhile, there remains further room for cost-cutting, upstream margin improvement, and reduced capital intensity that should ultimately improve free cash flow generation and drive the shares higher from here.

Vodafone (VOD)

Vodafone is one of the largest wireless carriers in the world, with 275 million fully-controlled wireless subscribers and 530 million including joint ventures. While Vodafone has had issues in some countries, such as India and Italy, it is growing revenue in local-currency terms in most markets. Its reported revenue has been hurt by currency moves as the euro has strengthened against most of the currencies where it has operations.

We think the stock has significantly oversold relative to the issues it has faced. In the meantime, the stock yields 7.9% while shareholders wait for a turnaround, and we believe the dividend is safe. The firm has been focused on moving from a wireless-only provider to a provider of converged services. Within Europe, fixed-line telecom services now accounts for about 30% of revenue.

We expect fixed-line service revenue to continue to grow faster than wireless services, so this percentage should continue to increase. Fixed-line revenue also tends to be more stable. On the wireless side, Vodafone continues to transition customers to smartphones and 4G technology, both of which generally lead to higher data usage and higher revenue. We believe this trend will continue.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
BT Group PLC191.74 GBX1.58Rating
Imperial Brands PLC1,736.00 GBX0.29Rating
Royal Dutch Shell PLC B1,748.60 GBX-3.31Rating
Vodafone Group PLC122.62 GBX4.32Rating

About Author

Alex Morozov, CFA  Alex Morozov is the director of the health-care team at Morningstar.