“In 1686, esteemed scientist Sir Isaac Newton unveiled his ground-breaking laws of motion. In it he proved that the force on an object was equal to the rate of change of momentum. This formula has not only been hugely influential in the field of mathematics, but also successfully adopted by the fund management industry. That’s because by identifying businesses that possess strong underlying momentum, astute investors can be richly rewarded.”
And the company the analysts had in mind to show case this important point is Aim-traded Tristel (TSTL: 77p), a maker of infection prevention, contamination control and hygiene products. It’s a company I know quite well, having belatedly cottoned onto the investment case after Tristel announced its third profit upgrade in as many months ('Clean up on superbugs', 6 May 2014). The price then was 60p, the price now is 25 per cent higher, and climbing again. It’s a company well worth following too as this upwards earnings momentum shows no sign of abating. In fact, less than a month after publishing that article, Tristel announced its fourth upgrade in as many months (‘Bug busting upgrades’ 10 June 2014), and the fifth in a year! That created the momentum for the shares to hit my upgraded 90p target price three weeks later.
These earnings upgrades highlight the operational gearing effect of the business, whereby a higher proportion of increasing revenues fall straight down to the bottom line. That's because Tristel's fixed-cost base is already covered, which means the profits earned from incremental sales are much greater. As a result, analysts expect the company to report a 275 per cent surge in pre-tax profits to £1.8m in the financial year to end June 2014, driven by a 27 per cent rise in revenues to £13.5m and a fair bit of margin improvement too.
Interestingly, a segmental break down shows that the momentum in the business is gathering pace. Second half revenues of £7m, and pre-tax profits of £1.08m, compare favourably with those reported in the first half of £6.44m and £720,000, respectively. It’s hardly a wonder that both Mr Hill and Ms Crowe "believe our fiscal 2015 estimates of turnover (£15m), pre-tax profits (£2.3m) and EPS (4.4p) are conservatively biased, and we hope to upgrade again as the new year unfolds." I certainly wouldn’t bet against that possibility either. That’s because extrapolating the second-half performance and at the current run rate Tristel is already generating annualised revenues of £14.1m and pre-tax profits of £2.16m.
The headline grabbing sales and profit numbers aside, this is also a business generating huge amounts of cash. In fact, the company generated net cash in excess of £1m in the past six months to leave the balance sheet ungeared with net funds of £2.6m, or the equivalent of 6.5p a share. That’s a tidy sum for a company with a market value of £31m. A year ago the cash pile was only £500,000.
It’s also apparent that with cash generation robust, and earnings growing at a lick, then shareholders can expect some bumper cash returns. In fact, analyst Keith Redpath at broking house finnCap predicts the payout will be quadrupled to 1.6p a share when Tristel announces its full-year results on 13 October. For the current fiscal year to end June 2015, Mr Redpath is pencilling in a payout of 2p a share. So with Tristel’s shares being offered in the market at around 77p, the prospective yields are 2 per cent and 2.6 per cent, respectively. That’s not only attractive, but those payouts are covered more than twice over by post-tax earnings estimates, so dividend cover is comfortable too. There is even scope for these forecasts to be surpassed because Equity Development expects the cash pile to swoon by almost half again to £3.9m by June 2015, or the equivalent of 10p a share.
Bug busting technology
It’s not just Tristel’s share price that has been hot. Fighting superbug and contamination is a hot area to be operating in too.
The key to the company’s growing success lies in its chlorine dioxide technology that differentiates the company from rivals. Over 1.7m decontamination procedures were carried out globally last year in 27 countries using the Tristel Wipes System on the small flexible endoscopes and ultrasound probes that are used in a range of hospital departments, including gynaecology, urology, ear, nose & throat, cardiology and IVF.
It's a fast-growing market as last year’s bumper sales growth highlights. Moreover, as demand has grown, Tristel's patented chlorine dioxide chemistry has become the 'gold standard' in the UK for sterilising small medical instruments. In fact, so effective is Tristel's technology that the NHS recommends using chlorine dioxide-based disinfectants for the dual function of cleaning and disinfecting. The company is trying to replicate this success internationally by targeting China, Germany and Australia as key markets.
Another key attraction of Tristel's business model is that almost three quarters of revenues are derived from products with intellectual property (IP) protection and so create a high barrier to entry. Indeed, the company's main commercially important patents are effective for another 14 years or so. This means that not only does Tristel have operational leverage in its business, but it has products under patent protection that are proving increasingly popular. In the circumstances, it’s hardly surprising that the shares have taken off, almost trebling in the past year.
Fair value targets
To arrive at a fair value estimate for Tristel’s equity it’s best to strip out that burgeoning cash pile from the share price. On this basis, the shares are currently being priced on 20 times cash adjusted earnings for the fiscal year to June 2014. Assuming the share price doesn’t move at all in the coming year, hardly a realistic possibility, but one worth considering in order to highlight the undervaluation, then cash adjusted PE ratio drops sharply to only 15. This reflects both the anticipated earnings growth, growing cash pile and of course it assumes Tristel delivers on what are looking very conservative analysts’ earnings estimates for fiscal 2015.
In my opinion, that’s a modest rating for a business that looks nailed on to grow EPS by over a quarter in the current financial year. So having taken the earnings growth and cash generation into consideration, not to mention the real possibility of further upgrades, then I feel a cash adjusted PE ratio of 18 for fiscal 2015 seems a far more appropriate rating.
This implies a value on Tristel’s equity of at least 90p a share. So, offering almost 20 per cent upside to my target price, I continue to rate the shares a strong buy on a bid offer spread of 74p to 77p. A revisit to the late June high of 90p is firmly on the cards.
■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'
