It's a business I have been following closely for the past couple of years, having initiated coverage when the price was 33.5p ('A valuable stock check', 18 Jul 2011). My 60p target price was duly achieved a few weeks ago when the company announced a very smart looking acquisition. It was also one that prompted me to upgrade my target on the shares from 60p to 70p.
There was further good news in a pre-close trading update ahead of final results on Tuesday, 26 November 2013. Not only is Sanderson attracting new business, but margins are on the rise, too; gross margins increased by over three percentage points to 87 per cent on revenues of £13.8m (from £13.4m in 2012) in the financial year to end September 2013, driven by higher-margin proprietary software. The value of contracts signed with new customers during the 12 month period rose by 10 per cent to £1.6m, or 12 per cent of the total, partly reflecting an increase in sales capacity, but also ongoing product development, especially in mobile, that extends the company's proprietary software to smart phones and tablets.
As a result broking houses are maintaining full-year pre-tax profit estimates of £2m for the year just ended, but with the benefits of recent acquisitions and the move to higher-margin sales, analysts at WH Ireland expect revenues in the current financial year to ramp ahead up to £16m to produce pre-tax profits of £2.7m and EPS of 4p. The earnings figure has been adjusted to take into consideration an institutional placing which raised £3.5m earlier this month following Sanderson’s acquisition of One iota, a provider of mobile applications for retailers including Thorntons, Littlewoods, Superdry, and Very.co.uk.
Importantly, the acquisition provides the company with a talented team of 14 developers, and should easily integrate into Sanderson's existing e-commerce operations. It will also help Sanderson expand further into mobile applications, win new customers, and provide the latest mobile technologies to its existing clients. The fundraising will fund the integration of One iota's MESH technology, a cloud-based technology that integrates existing back office systems to optimise a retailer’s applications, with existing Sanderson ecommerce solutions; accelerate the development of Sanderson mobile solutions business; and increase sales and marketing activities.
Strategically, it makes a lot of sense as Sanderson's ongoing investment in proprietary software for mobile devices has clearly been paying off; mCommerce now accounts for 10 per cent of the sales, having rocketed in the past 18 months.
Profit estimates well underpinned
In my opinion, WH Ireland's forecast of a £700,000 profit uplift this year doesn't look stretched at all once you factor in the contribution from One iota, a highly profitable and fast growing business that boosted revenues by 31 per cent to £665,000 and generated operating profit of £193,000 in the financial year to January 2013. For the seven months ended 31 August 2013, One iota reported turnover of £610,000 and profit before taxation of £210,000. It is only reasonable to expect this momentum to continue because, as part of a larger business, there is scope to grow sales and profits markedly by leveraging off Sanderson’s balance sheet strength and plc status. This should enable One iota to close new business deals that previously might not have been possible due to its smaller size, according to Mr McNally.
Interestingly, with greater financial resources behind it, Sanderson management team believe they can grow "One iota's revenue to £1.1m within the next year" with its backing. The £5.43m acquisition has been sensibly structured with only £750,000 of the initial consideration paid in Sanderson shares and £2.38m in cash, and a further £2m of the balance deferred and dependent on One Iota achieving performance targets over the next three financial years. On this basis, the acquisition is priced at less than 10 times operating profit on the initial consideration and 16 times including the deferred consideration. However, with only 55 per cent of the consideration payable upfront, Mr McNally at Charles Stanley estimates “that the deferred payments have been structured in such a way that effectively pays for roughly 75 per cent of that consideration itself."
Increasing exposure to e-commerce
It's worth pointing out that the One Iota acquisition is part of planned strategy to boost exposure to e-commerce in Sanderson's multi-channel retail division and follows hot on the heels of the acquisition of e-commerce solutions company Catalan in a £500,000 deal. It's a hot area to be operating in as, buoyed by projects for Aspinal of London, JoJo Maman Bébé and Axminster Tool Centre, operating profit from Sanderson's multi-channel retail division jumped a fifth in the first half of the last financial year. And there is little reason to expect the sales momentum to wane any time soon since Sanderson makes its money by offering software products and services that have the benefit of reducing costs or improving the efficiency of their business.
For example, Sanderson works in partnership with clients to deliver e-commerce software systems that underpin their online operations and enable them to cross and upsell products, offer a '3D' secure payment process and integrate online offerings with other parts of their business. It's a fast-growing segment of the retail sector, too; analysts at IMRG, the industry association for e-retail, and Capgemini, a leading consultancy, estimate that UK online sales will grow by around 12 per cent in 2013.
Anomalous valuation
Despite the fact that some of Sanderson's businesses are operating in clearly high-growth areas, the shares are not highly rated.
After factoring in acquisitions, I believe that the company's pro-forma cash is currently around £5m, or a little under 10p a share. Strip this out from the current share price of 64.5p, and the shares are rated on a prospective PE ratio of 13.7, a hefty discount to the software and computer services sector average of 19. There is a decent dividend too, as analysts at WH Ireland expect the full-year payout for the 12 months to end-September 2013 to be raised by a quarter to 1.5p a share. On this basis, the shares offer an attractive prospective yield of 2.4 per cent.
Interestingly, analysts at WH Ireland have just upgraded their target price from 57p to 72p. I have a feeling that could prove conservative. Realistically, a rally back to the eight-year old all-time high of 76p looks a realistic possibility and I am very comfortable maintaining my positive stance with Sanderson shares priced on a bid-offer spread of 62p to 64.5p.
■ Finally, as a pre-Christmas offer exclusive to Investors Chronicle readers, all telephone orders placed with YPDBooks for my new book Stock Picking for Profit will receive complimentary postage and packaging. This offer is strictly for a limited period, is subject to stock availability and applies to only telephone orders placed until Friday, 15 November 2013.
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