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Is Neil Woodford Right About BT Group plc, SSE PLC, Babcock International Group PLC & Game Digital PLC?

In February, Neil Woodford acquired more shares of SSE (LSE: SSE), Babcock (LSE: BAB) and Game Digital (LSE: GMB). Meanwhile, one of the fund’s core holdings, BT Group (LSE: BT-A), continued to “perform well on news it had successfully bid for the rights to continue to broadcast English Premier League football matches”. The obvious question, then, is whether the fund manager has actually added risk to his portfolio. 

Mr Market, SSE & BT

“The market’s valuation is nowhere near as stretched now” as it was at the height of the tech/media/telecoms bubble, but “it is elevated enough to warrant caution about the near-term outlook,” the fund said in its February update. “That said, it is worth remembering that even in an overvalued market, there are undervalued stocks,” it added. 

Rather than undervalued, SSE looks fully valued to me. Political risk is going to weigh on the utility sector for a couple of quarters at least, in a market where even a top performer such as National Grid is struggling to boost its equity valuation, while other players such as Centrica (in spite of a recent dividend cut) still have to sort out their finances. At Centrica, “a dividend cut was already largely reflected in the share price,” the fund said.

It doesn’t look like a dividend cut is reflected in the shares of SSE, which trade on a forward price-to-earnings ratio of 13x. At SSE, the outlook for profitability and net income remains highly uncertain, however, so a lower payout is a distinct possibility in 2016 or earlier. Dividend growth should move with RPI inflation, which does provide little reassurance in this environment. 

By contrast, the dividend looks safe at BT. The problem, however, is that BT has rallied a lot in recent weeks (+14.5% year to date) in the wake of its £12.5bn acquisition of mobile operator EE, as investors believe EE will help BT sort out all of its problems. Admittedly, this was a great deal strategically, although BT had to pay top dollar to secure the assets of EE. Yet in mergers and acquisition, integration and execution risks — how successfully the acquired assets will work as part of a larger conglomerate — pose a serious threat to value creation. BT’s pension deficit could pose problems, too. The stock last traded around this level in the summer of 2001, and at 17x forward earnings is not pricey, but upside could be limited. 

Babcock & Game Digital: How Safe Are They? 

Why the fund added shares of these two companies last month is very simple: it’s averaging down its investment, while betting on a bounce. By doing that, Mr Woodford is trying to minimise the risk associated to its existing Babcock and Game Digital investments — both shares were flat for the month — hoping that both will actually rise at some point, of course.

Well, neither stock is on my wish list. 

With regard to Babcock, a support services group, the fund pointed out that “outsourcing businesses typically win fewer than half the bids they participate in (Babcock’s win rate is c. 40%)”.

“Indeed, losing contracts in this industry can be indicative of pricing discipline, which we welcome,” it added. The stock is down 7.9% year to date, and 13% over the last three months. It may be perceived as an opportunistic buy, but its debt load and its forward valuation (17.5x forward p/e) signal that the company will need lots of growth to please investors. 

As far as the Game Digital is concerned, a high valuation and zero dividends place it in the “high risk/uncertain reward” territory, particularly since a profit warning in January rocked confidence: the stock of this £400m video games retailer is down about 20% this year, and I’d advise you to retain very little exposure if you really fancy the business, adding its shares only as part of a properly diversified portfolio. Then, you’d likely get a decent return only in the event that a steep growth rate for revenue and earnings materialise, but bear in mind that Game Digital has thin operating and net income margins. 

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has recommended shares in Centrica. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.