Is the airline industry heading into a downturn? That’s certainly how the market is pricing British Airways owner International Consolidated Airlines Group (LSE: IAG).FTSE 100-listed IAG trades on a 2016 forecast P/E ratio of 5.9, falling to 5.4 for 2017.
You wouldn’t normally expect to see a big company trading this cheaply unless it was in financial distress or was about to head into a major cyclical downturn. So was IAG’s recent decision to “moderate its short-term capacity growth plans” an early sign that the airline sector’s strong run of growth is coming to an end?
I think it could be. But I’m not sure whether we should expect earnings to collapse, or simply flatten out. After all, IAG now owns Iberia and Aer Lingus, so the firm’s growth isn’t just the result of expansion against the competition. IAG now owns two of its former competitors.
I’m not sure how to call this one. IAG’s 4.2% forecast yield is attractive, but if earnings do weaken this could be at risk. There are probably safer buys elsewhere.
Should you catch this falling knife?
Shares in support services and construction group Interserve (LSE: IRV) fell by as much as 27% this morning before recovering to trade at about 310p, around 20% below last night’s closing price.
The cause of the sudden drop was the news that Interserve will take a £70m cash impairment charge on an energy-from-waste project it’s running in Glasgow. This is expected to increase net debt by £35m in 2016.
Interserve’s operating margin is only about 3%. This means that despite generating revenues of £3.2bn last year, net profit was just £68.9m. Today’s impairment would have cancelled out the group’s entire profit last year.
Interserve’s share price has now fallen by 40% in 2016, leaving the shares on a 2016 forecast P/E of just 4.8. A dividend of 25.3p per share was forecast for this year, giving a potential yield of 8.1%.
I suspect that this valuation will prove to be too good to be true. Interserve didn’t reduce its profit guidance in today’s announcement, but I expect earnings forecasts to be downgraded at some point this year. Given the sharp rise in debt, a dividend cut also seems possible.
Better alternatives elsewhere
Housebuilder Redrow (LSE: RDW) is among the cheapest stocks in the FTSE 350 on a forecast P/E basis, but it may not be a bargain.
Cyclical stocks like this often look cheap at the top of the cycle, when the market is pricing in the risk that earnings could drop. Redrow is now one of the cheapest of the housebuilders, on a forecast P/E of just 7.4.
However, while I still believe that some housebuilding stocks may be worth buying, Redrow isn’t one of them. The main reason for this is that Redrow hasn’t been generating surplus cash like some of its peers and still has net debt of £183m — around one year’s profits.
As a result, Redrow’s forecast dividend yield for 2016 is quite low, at just 2.6%. Given the 5%-plus yields on offer from several other debt-free housebuilders, this doesn’t seem attractive to me. I believe there’s better value elsewhere in the housing market, and won’t be investing.
