MmO2 worth holding for mobile revival

Lloyds TSB; Somerfield

After one of the most closely-monitored gestations in corporate history, British Telecom yesterday gave birth to mmO2. And the new baby has a silver spoon in its mouth.

Most mobile phone businesses across Europe and the rest of the world are burdened by vast debts, racked up after the splurge on third generation mobile phone licences. Not so, mmO2. BT Group, a kindly parent, has absorbed most of those costs, and the demerged mobile business has debt of just £500m. Unfortunately, that privilege only partially compensates for the other challenges facing mmO2's new management team.

There is trouble abroad. Viag Interkom, the mmO2 business in Germany, and Telfort, its Dutch operations, are set to be a drain on the group's cash for the foreseeable future. Both are loss-making and neither has critical mass in their market. An expensive rebranding exercise, converting the local names to the new mmO2 brand, is not the answer either. Cost cutting at Cellnet and at Digifone in Ireland is central to short-term earnings growth, but it is pretty thin gruel as a reason for following mmO2 for the long haul.

Cellnet, while generating cash at last, has lower margins and is losing market share at home to Vodafone and Orange. Revenue growth is slowing across the group, and the speedy adoption of 3G data services is more important to mmO2 than its rivals.

Many City investors are talking up the prospect that mmO2 will fall quickly to a takeover. Perhaps, but bidders may prefer to wait to let the current management do the hard work of squeezing out costs and improving business performance. Until that has been done, the stock is not likely to outperform. BT Group shareholders should hang on to their new mmO2 shares, which closed at 84p yesterday, in the expectation of a better performance by mobile stocks next year, but new investors may want to take a look at Orange or Vodafone first.

Lloyds TSB

The stock market is treating banks as if they are incubating a particularly nasty disease: recessionitis, possibly. But having slashed the banking sector's price-earnings ratio to 60 per cent of the market average, yesterday investors breathed a huge sigh of relief at what was only a so-so trading statement from Lloyds TSB.

It is frightening to think what bank watchers might have been expecting when the best that Peter Ellwood, Lloyds' chief executive, could come up with was that "many of the positive trends seen in our first-half performance have continued into the third quarter". Total revenue in the first half rose 12 per cent, and earnings per share on a business-as-usual basis went up by 9 per cent.

Investors were comforted by his assertion that asset quality remains good and he expects "a further satisfactory performance for the year, in line with market expectations".

Those expectations are for operating profits 10 per cent higher at £4.4bn, securing the current 4.7 per cent yield.

That confirms Lloyds shares as a firm hold, but the outlook for 2002 is distinctly cloudy. As Lloyds is already the most efficient bank in the country, its scope for further efficiency gains must be becoming more problematical, and like its rivals it will have to confront the prospect of bad debts – corporate and personal – as the economy tries to fight off recession.

Meanwhile, interest rates look set to continue at 30 to 40-year lows, cutting the banks' income from cash deposited with them in current accounts. Margins on mortgages and credit cards are under constant attack from consumer lobbies.

Mr Ellwood's declared way out of jail is a deal. The Government stopped him taking over Abbey National this year, so he has been clocking up the air miles looking for a foreign partner – the shopping list of names in Europe, America and Asia is already lengthy, with Standard Chartered rumoured to be one of the latest additions.

The omens are not looking good. In the current uncertain climate, potential sellers think they might be getting out at an artificially low price, while in better times Lloyds' bargaining position will suffer because it is so widely known to be keen to do a deal.

The risk of a value-damaging takeover, and the possibility of a major corporate casualty among its customers, makes Lloyds a buy only for the brave.

Somerfield

Somerfield's recovery looks to have stalled at the first hurdle. Sales figures at the supermarket group, which includes the Kwik Save chain, showed like-for-like growth of just 0.6 per cent. With consumer spending still buoyant and an uneasy truce in the supermarket price wars, there is no excuse for negative growth.

Somerfield says it scared customers away with an end to the special offers that had driven growth in the first quarter. It is still groping for "a better balance between sales and gross margins".

The shares fell 5.5p to 86.5p, and have lost more than a third of their value since this column advised selling in July. The programme of store refits at Kwik Save has sparked some impressive sales recoveries, but the easy turnarounds have been achieved. The next wave of refits will be costlier, while the economic climate is looking less benign, and retail stocks are losing favour.

Somerfield shares are on 10 times forecasts of 2003 earnings. That is a big discount to its rivals, but rightly so, given a portfolio of old-fashioned stores away from prime locations. Avoid.