13th October 2009
Why Ladbrokes could be a good bet
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Welcome back. This week I'll be taking another look at a company I've had on my watch list for some time, General Motors. I've also decided to close our options trade on Vodafone (LSE: VOD) you'll see why shortly.
But first, I've got a brand new tip for you. Here's why I think Ladbrokes (LSE: LAD) is worth a punt.
Ladbrokes a bizarre profit warning and rights issue
On 8th October, Ladbrokes stunned the market by announcing a surprise £275m capital raising, as it warned that third quarter profit had fallen 58% to just £22m from £52m the year before.
The company reassured investors that the underlying business was still solid. The reason for the rights issue is to bring debt under control, as in future, banks will be unlikely to support companies whose EBITDA (earnings before interest, tax, depreciation and amortisation) / Debt ratio exceeds 3.5.
The company is also cutting costs, cutting spending and scrapping its dividend (although this will be reinstated in 2010). Bear in mind that rival group William Hill raised £350m in new equity a few months ago.
The results
The fall in operating profit comes from a run of bad luck, which should be a one-off event. The company put this down to poor gross win margins (the amount of profit made on bets), which in the UK retail unit, fell to 14% from 17.5% last year.
Two specific events were blamed - a poor run in the summer horse racing season; and an unusual pattern in the results of the first 66 games of the Premiership. During this year's football season, only four out of 66 games ended in a draw (7%), whereas the average is 25% or 17 games. Because people tend to bet on one or other team winning, a draw is a bookmaker's favourite result, so a fall in the number of draws is bad for bookies. But clearly, this is a fluke event.
That's the good news. On the downside however, the fall in profits wasn't all down to bad luck. Turnover was down 15% at the UK retail unit. More worryingly, business fell by 13% at the e-gaming unit which supervises Ladbrokes' internet activities, showing that the core business has clearly been hurt by the recession.
The rights issue
300m new shares are being issued at 95p each on a ratio of 1 new share for every 2 existing ones. The stock went ex-rights last Friday. Parallel trading of the nil-paid shares has started and will continue until 16 October (I'll explain all this in a moment). As a result of this rights issue, net debt will be brought down from £995m at the end of September to around £680m, a sum which Ladbrokes reckons will be easy to refinance, even in our newly austere world.
What happens during rights issues
Because we have two classes of shares trading from now until 16 October, we have an arbitrage opportunity. In this case, the price of the fully-paid shares has to be equal to the price of the nil-paid ones plus 95p, otherwise you could make a profit by buying one and sell the other or vice versa.
However, in practice rights issues put pressure on the price of a stock for two reasons:
1. People who do not want to take part in the rights issue tend to sell the nil-paid shares because they are unwilling to invest the extra cash to convert them. This puts pressure on the value of the nil-paid shares which generally trade at a discount. The discount can also partly be explained by the fact that the nil-paid shares are also less liquid than the fully-paid, and so the price tends to swing more.
2. Because there is a discount between the two classes, institutional investors can sell the fully-paid shares and buy the nil-paid for a profit, putting further pressure on the price.
These factors tend to create a downward swing in the price, which is usually reversed once the rights issue is over.
The strategy
I reckon this is a good story for us to play. Ladbrokes is a market-leading, stable business, and the profits warning is down to one-off events, rather than structural problems. The share price is also close to the lows it touched back in March and October 2008 when the market was in meltdown as you can see from the graph below.
There's another good reason to bet on Ladbrokes. In summer next year, the football World Cup in South Africa should generate extra business and profits for the gambling industry. These extra revenues from occasional gamblers should be captured mainly by high street betting shops rather than their online rivals, as it's easier for to pop into the betting shop for one-off bets, rather than going to the effort of opening an internet account.
So with this medium-term benefit up ahead, and the price close to its lows, the company looks pretty interesting right now. Here's what to do it's quite simple.
Buy shares in Ladbrokes at 140p, and be ready to double up if the price falls to 120p while the rights issue is underway. You could use spread betting, but we might keep this position open until after Christmas, so please consider the financing issues it's probably easier to just buy the shares in the normal way through your broker.
The price target is 180p, which I'd expect to hit within two to six months, depending on market conditions
Risks
The main risk with this strategy is company-specific risk, or that once the rights issue is over Ladbrokes announces negative news or a further deterioration in its core business. But usually all the bad news is kitchen-sinked' (all thrown in at one go), so I don't think the company will come out with big negative surprises. In fact, it'll probably do everything it can to surprise investors on the upside.
The other risk is market risk. The market is now at its highs for the year, in expectation of the economic recovery. The rally has been quite prolonged and quite violent, and as you probably already know, I don't trust it. I believe the general economy will be weak for a while longer, especially after the government stimulus is withdrawn and taxes are raised to repay all the debt incurred.
There is also legislative risk, or the threat that a new government might announce an increase in taxes on gambling, which has always been a popular target. But unfortunately we can't really do much to guard against this possibility.
An update on General Motors
Since we last talked about the bankruptcy of GM, the company's bonds have rallied by around 30% and are now trading at 13% of face value, up from 10% which means an implied market cap of around $28bn for the new GM.
A few new developments are worth mentioning on this story. 30 November is the deadline for all creditors to submit their claims. After that, the courts will proceed with the restructuring plan and hopefully we will have more of an idea of what's going to happen.
According to a statement posted on the website which you can read here, the new GM is expected to file for an IPO in 2010. It may even do so in the first quarter of next year. The same document says that the date of distribution of the new GM equity to the bondholders will be decided by the courts, but that no date has yet been set.
Motors Liquidation company (as the old GM is now known) has begun liquidating itself, starting with real estate assets including a church and a golf course bundled with various industrial sites. Don't believe it? Check it out for yourself! You might find something interesting
All this means that it is highly likely that bondholders will receive their stake in the new GM before the IPO, so I expect that we should have major news before year end. The last news relates to September car sales figures, which were quite poor. That's because the federal cash for clunkers' programme has expired and will not be renewed. It's been a success, temporarily lifting the demand for cars. GM sold 156,600 vehicles in September, down 45% from last year and 36% from August. Now we will have to see how the real economy plays out, as car sales are highly sensitive to the overall economic environment.
Close the trade on Vodafone Puts
I have also decided to close the trade we have outstanding in Vodafone PUT November 09 strike 140. The reason for this is quite simple - the market corrected as predicted but rebounded rapidly. This means that the short term overbought issues have been corrected and the rally could continue.
Now don't get me wrong. I still think this rally has short legs and is based on false hopes of a fast recovery, but there's no way of telling when the trend will be inverted it could take days, weeks or even months.
So now that the stock has fallen to 134p and the options are trading at 10p, let's take our 67% gain off the table and regret we did not buy the October Puts which would have been even more profitable!
As usual you can contact me on my e-mail: eventstrader@f-s-p.co.uk. I will be happy to answer your questions.
Riccardo Marzi
Events Trader
Your capital is at risk when you invest in shares, never risk more than you can afford to lose. The share recommended is denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Spread betting is not suitable for everyone - ensure you fully understand the risks involved and never risk more than you can afford to lose. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. Please seek independent personal advice if necessary.
Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.
Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.
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