The technical set is certainly encouraging. Communisis’ share price appears to have completed a multi-month consolidation period and has just taken out the June and July highs around 66p. Furthermore, the moving average convergence divergence indicator, otherwise known as the MACD, has given a buy signal and one that should be trusted as the rising indicator is both positive and above its signal line. The trend-following momentum indicator shows the relationship between two moving averages of prices and is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the signal line, is then plotted on top of the MACD, functioning as a trigger for buy and sell signals. It’s one I keenly monitor when analysing the technical set-up for any company.
In addition, Communisis’ share price has recovered above the rising short-term 20-day moving average trend (currently positioned around 62p). That’s always a positive sign if the break-out is to be the real deal. Importantly, the 14-day relative-strength indicator (RSI) has a reading in the mid-60s, indicating that the current rally is being launched from a level from which the share price is not too overbought so increasing the chances of a continuation of the rally.
Strong fundamental case
Clearly, the fundamental case for investing also has to stack up to warrant a buy recommendation. There is good news too. The combination of the contribution from acquisitions, which I analysed in detail in my June article, and organic revenue growth have all helped to drive up turnover by 28 per cent to £116m in the six months to end June 2014. In turn, this lifted underlying operating profit by £1m to £6.1m. However, the true margin earned was significantly more than the headline numbers suggest as Communisis incurred transactional costs on some significant contract wins in the period.
Moreover, these new contracts underpin some pretty robust analyst earnings growth forecasts. That’s because Communisis’ management team applies stringent criteria to all 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 these new contracts are well in excess of both the cost of equity and the blended cost of the company's capital so enhance earnings per share.
This highly disciplined approach has already paid off because in the first half this year Communisis won a major contract extension for the provision of external brand building services to a major client, consumer product giant Procter & Gamble (US: PG. - P&G). The agreement covers a range of P&G brands focused on retail across Europe and will now run until 31 December 2019. The company was also awarded a new 10-year outsourcing arrangement with Lloyds Banking Group (LLOY) to handle all the in-bound imaging and mail processing services for the bank. So, although Communisis expensed the costs of winning these contracts, the upside will be a boost to margins as profits are earned from the new business and the company makes headway towards its 10 per cent operating margin target.
Indeed, the combination of the contribution from acquisitions, better margins on new business wins and organic revenue growth are the main reasons why analyst Mr Barrett at N+1 Singer believes that Communisis will grow revenues from £270m to £310m this year to drive up pre-tax profits by 28 per cent to £14.9m. On this basis, adjusted EPS rises from 4.7p to 5.8p to underpin an 11 per cent forecast rise in the dividend to 2p a share.
Furthermore, with the full contribution from acquisitions being seen next year, analysts predict a step up in revenues to £329m to lift pre-tax profits by a further 25 per cent to £18.7m. On this basis, expect EPS of 7.2p and a well covered raised payout of 2.2p a share, implying the shares are priced on less than 10 times prospective earnings for 2015 and offer a forward dividend yield of almost 3 per cent. That is hardly an expensive rating for a company set to grow EPS by more than half this year and next. Furthermore, it’s easy to see how these profits can be achieved as margins on legacy contracts are replaced with more profitable new business, and restructuring benefits feed through.
Well funded for growth
For a company winning significant new contracts, and making some important bolt-on and complementary acquisitions, funding of all this new business is just as important as the contracts themselves. There is no point winning new business if a company is unable to fund the working capital needs to service the contracts in the first place.
On this score, Communisis looks well capitalised to fund the expected growth. The 18-page interim results investor presentation on Communisis’ website is enlightening for a number of reasons. For one, it highlights the point that there is sufficient headroom on debt facilities with Communisis’ net debt of £33m at the end of June well within total debt facilities of £70m. But working capital spikes during any financial period and more important are average debt utilisation levels. These were around £45m during the latest six month period and operating profit covered finance charges almost four times over. It’s reassuring too that net debt has only been around two times cash profits for the past 12 months to end June.
Using a standard debt:equity ratio, it is clear that the company’s balance sheet is not overgeared as net borrowings represent only 23 per cent of shareholders funds of £140m. Analysts at N+1 Singer expect net debt to peak out at £40m at the December year-end, reflecting the funding requirements of these large contracts, before falling back to around £29m by December 2015. On this basis, peak borrowings will represent less than a third of shareholders funds and equate to only 1.5 times forecast cash profits of £27m for this year.
So with debt under control, and operating cashflow robust – there was a cash inflow of £6.7m in the first half this year – those aforementioned analyst dividend forecasts look very realistic in my view. It also means that as long as Communisis generates the cash profits forecast – analysts are predicting a figure around £31.6m for 2015 – then there is an obvious catalyst to re-rate the shares. Let me explain.
Re-rating beckons
Communisis currently has 195m shares in issue and a market capitalisation of £132m with the shares being offered in the market at 67.5p. Factor in a year-end net debt of £40m, and this gives an enterprise value of £172m, or 6.3 times cash profits. Applying the same multiple to next year’s cash profit forecasts of £31.6m gives an enterprise value of £199m. From this sum deduct estimated net debt of £29m at the end of next year and if investors maintain their rating on Communisis shares then the equity in the company would be valued at £170m, or 87p a share. That’s pretty close to my fair value share price target of 85p, assuming of course that Communisis’ management team, under the leadership of chief executive Andy Blundell, delivers on these revenue and earnings forecasts.
True, there is integration risk for the recent acquisitions, and execution risk for the major contract wins, but with the shares offering 24 per cent share price upside to my fair value target price, we are being richly rewarded to take on that risk. There could even be upside to my target once growth investors start targeting the shares.
Needless to say, it goes without saying that priced on a bid-offer spread of 67p to 67.5p, I rate Communisis’ shares a very decent medium-term buy. The timeframe to achieve my target is six months to incorporate both the third quarter trading update in November and the full-year pre-close statement in January.
■ 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'
