My view is that if I can maintain an 80 per cent strike rate of winners in my investment calls, then anyone following my recommendations will be well compensated over the long run. It’s also fair to say that if you monitor the companies I have been focusing on then there have been repeat buy opportunities to avail yourself of, especially in last month’s market shake-out. With this subject in mind, a company I have followed closely over the past 18 months has just issued a trading update and one that requires updating.
Massive contract win for Communisis
Shares in marketing services provider Communisis (CMS: 61.5p) rocketed over 11 per cent today on news that the company has been awarded a ten year contract with Lloyds Banking to become the group’s outsource partner for the production of all transactional customer communications in the UK.
Although details of the size of the contract are confidential and commercially sensitive, so have not been disclosed to the market, I understand that this is by far the largest available contract of its kind in the UK. Under the arrangements, Communisis will assume responsibility for Lloyd’s current manufacturing sites in Copley and Crawley and means that the company's annual production volumes for these services will double on an annualised basis, confirming Communisis as the UK market-leader in the outsourced production of transactional communications. Substantial revenues will be generated over the ten year term of the contract which will start in October.
To put this into some perspective, prior to the Lloyds contract win analyst Johnathan Barrett at brokerage N+1 Singer had expected Communisis to grow revenues by around £7m to £237m this year, rising to £245m in 2014. On this basis, pre-tax profits rise from £10.3m in 2012 to £12.2m in 2013. And as legacy contracts are replaced with much more profitable new business wins, revenues of £245m in 2014 were expected to generate profits of £13.9m. Moreover, if margins hit 9.5 per cent in 2015, and Communisis meets N+1 Singer's revenue target of £256m, expect pre-tax profits to rise even further to £16.1m. On that basis, the EPS figures for the three financial years are 5p, 5.5p and 6.3p.
But you can now tear up those earnings forecasts. Analysts at Cenkos Securities believe that “the contract indicates a potential increase of 10 per cent to annualised revenues for 2014”. The investment required by Communisis in additional high quality colour digital capacity has yet to be clarified, so the brokerage is holding fire on upgrading earnings estimates until the company’s interim results on 1 August. Broking house N+1 Singer is taking the same stance. That said, I have a pretty good idea of what we can expect.
Expect significant earnings upgrades
That’s because when the board appraises new contracts they have to be consistent with an internal objective of delivering double-digit operating margins on sales, generating an internal rate of return of 20 per cent on capital employed and have a maximum payback period of three years. In other words, the rates of return on the new contracts are well in excess of both the cost of equity and the blended cost of the company's capital.
Therefore, I would not be surprised at all to see EPS upgrades in the order of 15 per cent on both the 2014 and 2105 estimates, and possibly even more on the basis that the Lloyds contract is worth around £24m a year in revenues and the operating margin will be in double digits. In other words, there could be at least £2.4m of operating profit to add to those profit estimates for 2014 and 2015, which equates to 15 per cent of the 2015 forecast.
The forthcoming earnings upgrade could arguably be even greater since Communisis is now reaping the benefits of a restructuring programme to reduce exposure to the more commoditised parts of the print market. The plan is to focus on higher-margin specialist production, improve margins by reducing costs and improve capacity utilisation.
Restructuring gains to come
As part of the restructuring, Communisis is ceasing cheque production at the Trafford Wharf site in Manchester and moving production to a site in Leeds. A significant amount of the remaining, more commoditised direct-mail print will be outsourced, while the more specialist, higher-margin direct mail production remains in Leeds. These changes are expected to generate annual cost savings of £4m in 2014. True, the reorganisation will cost £3.5m to implement, of which £2.8m of the cash cost will be incurred in the second half of 2013 and the balance of £700,000 in the first half of 2014.
Importantly, the restructuring is "consistent with the company's objective of delivering a double-digit margin on sales over the next three years". It is also positive in terms of profits and we should have a clearer indication of what proportion of the £4m of savings will not be reinvested when Communisis reports half-year results in a few weeks time. It can only be positive news which is another reason why the shares have risen strongly today.
Buy ahead of earnings upgrades
Clearly, the triple whammy of higher margin contract wins, cost savings from restructuring and bolt-on acquisitions is an attractive mix. It is also yet to be fully priced into Communisis’ share price which is still priced 20 per cent below pro-forma book value of 76p, rated on 11 times earnings estimates (pre-upgrades) for 2014, falling to less than 10 times 2015 pre-upgraded forecasts. Realistically, those forward earnings multiples could drop to 10 and 8, respectively, for 2014 and 2015. Moreover, the shares offer a 3 per cent prospective yield based on a 1.8p a share dividend in 2013, rising to a yield of 3.3 per cent based on a 2p a share pay-out in 2014 according to N+1 Singer.
In the circumstances, I am very comfortable with my 70p a share target price, having upgraded my fair value estimate a couple of months ago ('Buy the triple top break-out', 7 May 2013). In fact, it could prove conservative if I am proved right in my assumptions on the scale of likely earnings upgrades.
And as I pointed out at the start of this article we have been well rewarded over the past 18 months after I initiated coverage when the price was 28.5p last year ('Small-cap trading buy', 13 Feb 2012). I subsequently reiterated that advice when the price was 40p ('Communisis shares to fly', 19 Oct 2012) and at 36p just before Christmas ('Happy Capital returns', 17 Dec 2012). In fact, I was so convinced that full-year results would not disappoint in March that I advised buying again twice in January ('Jumping the gun', 14 Jan 2013 and 'Bumper trading gains', 23 Jan 2013). And when Communisis raised £20m through a placing and open offer the following month ('A fundraising well worth backing', 18 Feb 2013), I had no hesitation telling readers to take up their allocations of new shares at 40p. The share price at the time was around 45p, so you will have made a 50 per cent return on the open offer shares alone in little over four months. Needless to say, we should all be heavily in profit. And there should be more upside to come.
It goes without saying that offering a further 15 per cent upside to my conservative target price, Communisis shares continue to rate a value buy on a bid-offer spread of 61p to 61.25p. I will update the holding again at the time of the interim results in early August.
