This proved the right call with the shares finally bottoming out at 50p in December. Since then they have rallied strongly and are now above where I advised taking money off the table. What has changed though is the valuation on offer. That's because Communisis has been winning a number of contracts, the largest of which, a new 10-year outsourcing arrangement with Lloyds Banking Group (LLOY), was announced last week. The contract involves Communisis handling all the in-bound imaging and mail processing services for the bank and will see the company take on 14 existing Lloyds sites in the UK and handle more than 30m incoming documents each year from the bank's customers. These documents will be scanned into a digital format, indexed and distributed to the relevant bank department for processing.
Interestingly, this latest contract win follows on from a 10-year agreement announced last summer for all the outsourcing of Lloyds transactional communications. As a result, Communisis is in effect dealing with all the inbound and outbound communications for Lloyds. It’s quite a coup and one that means the company is ideally placed to take on similar such arrangements with other large multi-nationals looking to outsource in this area. Given quality and reliability is of the upmost importance in servicing such contracts, it’s only reasonable to assume that potential customers looking to initiate similar such arrangements for their own communications, will now consider Communisis as one of the few operators in this area capable of supporting such large contracts. That can only be positive for new business.
Contract wins drive earnings
To put the size of these new contracts into some perspective, prior to the first Lloyds contract win last summer, analyst Johnathan Barrett at brokerage N+1 Singer forecast that Communisis would grow revenues by around 3 per cent to £237m in 2013r, rising to £245m in 2014. However, the broking house now predicts revenues of £251m last year and expects them to increase to £269m in 2014. On this basis, adjusted pre-tax profits rise from £9.3m in 2012 to £11.4m in 2013, before soaring to £15m this year as margins on legacy contracts are replaced with much more profitable new business wins and the benefits of restructuring come through. In turn, this is expected to drive EPS up by a third to 5.9p in 2014. The EPS figure for 2013 will be down slightly from 4.9p in 2012 to 4.5p when Communisis releases its 2013 results in March due to the dilutive effect of an equity fundraising last year to provide the working capital to fund the raft of new contract wins.
But with margins on new business driving profits up sharply, the equity raise was well worth doing and means that the company is well financed for the years ahead. In fact, net debt at the end of 2013 was slightly better than expected at £25m, or the equivalent of 18 per cent of shareholders funds of £142m. It also means that Communisis is trading comfortably within its £55m revolving credit facility which runs until March 2018. The company also has a £5m overdraft renewable annually. Moreover, with profits rising, expect dividends to get a significant lift too. N+1 Singer are pencilling in a 1.8p a share dividend for last year, including a final of 1.2p a share to be declared in March, rising to 2p a share this year and 2.2p a share in 2015. The prospective yields are 2.9 per cent and 3.2 per cent, respectively, for this year and next.
Risk to earnings on upside
It's also fair to say that the risk to both earnings and dividends is on the upside as a result of the stringent criteria Communisis management team now apply to new contracts being tendered for. Namely, 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. This also means that with the shares trading on only 11 times earnings estimates any new contract wins will enhance earnings per share.
Therefore, I would not be surprised at all to see EPS upgrades in coming year as the pipeline of potential new work converts into firm contracts. But even without upgrades, N+1 Singer predicts revenues will rise to £285m in 2015 which would lift profits by a fifth to £18.3m. On this basis, EPS jump again to 7.1p and the forward PE ratio drops sharply to 10. These earnings estimates are also underpinned by a restructuring programme that has reduced the company’s exposure to the more commoditised parts of the print market.
Favourable technical set up for medium-term gains
The chart set up also suggests that Communisis shares should break through the 70p barrier and beyond towards my new target price of 85p. The 14-day RSI has a reading around 65, so is not yet over bought and offers scope for the price to run up higher. For good measure, the price printed at 66p last week, so giving a triple top buy out on the point & figure chart (one point per box). It's one I believe is well worth following and trading on a bid offer spread of 68.5p to 69p, I rate Communisis shares a buy on a six month basis. My new target price is 85p, equivalent to 12 times 2015 prospective earnings.
Please note that my 2014 Bargain share portfolio will be published online and in the magazine on Friday 7 February prior to the market opening. I will also be updating my views on all the 10 shares in my 2013 Bargain share portfolio at the same time. Now my research is complete, I will update a number of the shares on my watchlist that have reported trading updates in the past few weeks.
