I have little reason to change my investment strategy either as I still feel the UK bull market has some way to run. However, as I pointed out in my 2014 market preview last month (‘A year to remember’, 20 December 2013), the best of the gains this year are likely to be made by stock pickers rather than those trying to ride off the general market. It’s a challenge I am relishing already in order to create the 'alpha' my investment strategies have regularly produced over the years. In particular, I will focus on companies that are priced well below their sector average earnings multiples and offer potential to outperform their respective benchmark indices. The combination of earnings upgrades and sector specific reratings will be the key drivers.
It's a stock screening technique I will also try to encompass into my 2014 Bargain Shares portfolio which will be published both online and in the magazine on Friday, 7 February. For now though, some of my small-cap recommendations need updating on the back of a number of positive trading updates.
Expecting further seismic gainsOne of the reasons I target companies in the early stages of earnings upgrade cycles is to exploit a virtually guaranteed stream of positive newsflow to drive a rerating. This mitigates investment risk as long as the entry price is attractive enough in the first place, and I am able to accurately ascertain the probability of further upgrades in the future and their impact on earnings.
A classic example of this is Aim-traded Thalassa (THAL: 302p). To recap, the company provides marine seismic equipment and, in particular, a technology called Portable Modular Source System (PMSS™). This equipment is installed on vessels to provide a seismic source to enable oil and gas exploration and production companies to perform life of field seismic studies or permanent reservoir monitoring. It’s a technology that is attracting a great amount of interest across the industry, and not just from Statoil ASA (NO: STL), the Norwegian energy giant, which signed a bumper $85m (£51.93m) nine-year contract with Thalassa to provide long-term seismic acquisition services for permanent reservoir monitoring of the Snorre and Grane oil fields in the Norwegian sector of the North Sea. Other contract wins include one with SMG Ecuador, the Ecuador business of State Sevmorgeo Company, the Russian geological sea survey company.
It’s a line of business that's also proving very profitable too. In fact, the company has just announced that its 2013 earnings will exceed market expectations by more than 20 per cent and that follows on from a 30 per cent earnings upgrade last September.
To illustrate the strength of the upgrade cycle, analyst John Cummins at brokerage WH Ireland expects Thalassa’s turnover to have more than doubled from $14m to $30.6m (£18.6m) in the financial year just ended. In addition, he expects gross margins to rise from 23 per cent to 27.3 per cent, around 130 basis points more than forecast only four months ago. On this basis, pre-tax profits are expected to rise more than 250 per cent from $1.2m to $4.3m in 2013. After factoring in the extra shares in issue following a placing of 4.5m shares at 120p in April, and a subsequent institutional placing of 7.24m shares at 250p in October to strengthen the company's balance sheet at a time when order enquiries are running at record levels, expect EPS to surge from 10¢ in 2012 to 22.4¢ in 2013.
In the circumstances it’s hardly surprising that Thalassa’s share price has risen 120 per cent since I initiated coverage at 138p in March (‘Potential for seismic gains’, 19 March 2013). But even now the shares are hardly overpriced given the conservative forecast assumptions used by WH Ireland in its 2014 estimates.
Expect further earnings upgradesAssuming that only a quarter of the tender pipeline will be converted into firm contracts this year and next, Mr Cummins expects 2014 revenues to rise to $36.5m and deliver pre-tax profits of $5m and EPS of 17.7¢. The respective forecasts for 2015 are turnover of $41.6m, pre-tax profits of $6.1m and EPS of 21.7¢. Please note that the EPS figures have been adjusted to reflect the greater number of shares in issue post the placings.
However, that's taking a conservative assumption on the pipeline and I anticipate WH Ireland will be forced to upgrade its numbers as potential contracts in the pipeline are closed. Furthermore, even though Thalassa shares have done well since I initiated coverage in March, the valuation is still attractive.
Factoring in a low-yielding cash pile of $16.8m (£10.6m) at the end of June, and the proceeds from October’s placing, and then deducting capital expenditure of around $10m planned for this year, the pro-forma cash pile should be around $28.5m, or 70p a share at the end of 2014. This means that if you strip out net funds from Thalassa's market value of £76m, then a business that is conservatively forecast to report pre-tax profits of $5m this year is being rated on a prospective multiple of 21 times 2014 forecasts. That rating may seem full but the risk to estimates is firmly skewed to the upside as the company is now reaping the benefits of its early recognition of a previously untapped growth area in the marine geophysical market. It’s also one that industry experts estimate has potential to grow to $20bn over the next 30 years. I would agree and am not alone as Mr Cummins at WH Ireland raised his target price from 310p to 400p last month.
True, that is well above my own raised target price of 350p which I upgraded at the time of my last update (‘Cashed up for earnings upgrades’, 4 November 2014), but fair value nearer to 400p doesn't look too unrealistic using WH Ireland’s base case scenario.
How conversion of pipeline impacts earningsThe broker’s base case is "predicated on $45m in contract wins coming through for completion in 2015 (against current forecasts of $30m) following the use of $12m of the £18m monies raised in October’s placing". Assuming a gross margin of 28 per cent can be achieved this would imply 2015 EPS of 34¢. That’s the equivalent of 21p a share, or more than 50 per cent above WH Ireland's current earnings forecast and highlights the potential upside for upgrades as contracts are converted. On this basis, Thalassa shares are trading on a modest cash adjusted earnings multiple of 11 times for 2015, or half the current multiple for 2014.
Moreover, in WH Ireland's bull case scenario around 50 per cent of the $120m tender pipeline is converted for next year and two further PMSS™ units are built and are in operation. Given the operational gearing inherent within the business model, this would imply EPS of 67¢, or 41p, assuming gross margins rise to 35 per cent. Strip out net cash on the balance sheet and in this bull case scenario the cash adjusted earnings multiple falls to a miserly 5.5 times in 2015. Clearly there are execution risks to factor in, but even so this would be a bargain basement valuation.
So with Thalassa benefiting from a strong operational performance, the company riding an earnings upgrade cycle underpinned by a $120m bid pipeline, and the historic contract conversion rate significantly higher than those embedded in analysts estimates, then the risk to earnings is firmly to the upside.
In the circumstances, I have no hesitation reiterating my previous buy recommendation with the shares trading on a bid-offer spread of 300p to 302p. I am also maintaining what could be a conservative price target of 350p.
Please note that the sale last week of 1m shares by chairman Duncan Soukup to the employee discretionary trust, equating to 4 per cent of the share capital, is a very positive move as it will enable the company to incentivise employees through this high growth period. Mr Soukup has stated that he will not sell any other shares for the next 12 months at least. The company is due to release its full-year results in the week commencing 17 March.
Riding the earnings upgrade cycleThalassa is not the only company that is in a strong earnings cycle. As regular readers will know I have been a fan of Netcall (NET: 54p), a small-cap business offering software to make telephone call-handling more efficient, for the past three years.
I first advised buying at 13p ('Queuebusters', 17 Jan 2011) and have remained positive ever since. My last update was at the end of November (‘Dial into cloud based profits’, 28 November 2013) when the price was 45p. At the time I upgraded my target price from 48p to 55p and noted that if this was achieved the company would be valued on 12 times cash profit estimates net of a burgeoning cash pile, or 16 times earnings estimates, neither of which is excessive. In the event, Netcall’s share price rallied to a 13-year high of 61p just before Christmas.
In the circumstances, it was hardly surprising that some investors banked a bumper 33 per cent return made in less than four weeks. However, following a bout of profit taking the shares have retraced half of the gains and are now trading at around 54p. Interestingly, the 14-day relative-strength index (RSI) is becoming oversold (around 45) and is approaching the level from which the late November rally started from.
Moreover, there could shortly be a catalyst in place to spark a rally back to those highs and beyond. That's because later this month Netcall is due to release a pre-close trading update for the half-year to end December. It should make pleasant reading because the company continues to experience strong demand across its whole product portfolio, driven principally by the private sector and orders for business process management and software-as-a-service (SaaS) solutions. The client base of over 700 organisations includes two thirds of the NHS Acute Health Trusts.
Importantly, business remains robust for Netcall as its clients face the balancing act of having to improve the quality of their customer engagement while at the same time making operational efficiencies and reducing costs. Furthermore, businesses have to deal with customers across a growing number of channels including the internet, mobile networks, social media, web-chat, telephone and text messages. Therefore, to cater for its clients growing needs, Netcall has just made a joint investment in Farnborough-based Sentiment, a cloud-based platform that monitors global social media. This looks a sound move as it will enable Netcall’s own customers to analyse social media information across multiple social networks and engage through a single integrated application. Sentiment will also be integrated into Netcall’s own Liberty platform to exploit the business opportunity further.
Attractive valuationAhead of the trading statement, analyst Andrew Darley at broking house finnCap predicts Netcall's cash profits will rise from £4.2m to £4.5m on revenues of £17.1m in the current financial year to end June 2014, to generate free cash flow of £3.1m. That will not only underpin another hike in the dividend - finnCap is pencilling in a raised pay-out of 0.8p a share - but it is expected to swell the cash pile even further to £11.4m by June. That’s the equivalent of 9.5p a share.
Strip out the burgeoning cash pile from Netcall's market value of £63m, and the company is in effect being valued on a modest 11.5 times cash profit forecasts for the year to June 2014. For a business producing double-digit earnings growth, and one that is conservatively expected to grow EPS by 10 per cent to 2.8p in the current financial year, that is hardly an exacting valuation. So ahead of the trading update I continue to rate the shares a buy on a modest 14 times June 2014 earnings estimates net of cash. My new target price is 60p.
Please note that I have published another article today: 'A chic performance', 14 December 2014.
■ My new book, Stock Picking for Profit, has now been reprinted and can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213. The book is only being sold through YPDBooks and no other source. It is priced at £14.99, plus £2.75 postage and packaging. Full details of the content of the book is available online at www.ypdbooks.com. I have also published an article outlining the content of the book: 'Secrets to successful stock picking'
