It may seem obvious, but the first thing I look out for is the opportunity to buy into a company’s equity on a reasonable earnings multiple and one that reflects its likely growth expectations. That’s why it pays to avoid being sucked in by the PR hype which is aimed at getting the highest price as high as possible for the current owners. The primary focus on any investment is what matters most: the entry price, and one that offers a ‘margin of safety’. It also explains why on average more new listings underperform from the first day of trading: investors have simply overpaid.
I also look for a solid commitment from the board to pay a decent dividend pre-listing of the shares. That’s because if a company can grow its earnings at a modest rate year-on-year, then there is a decent chance the payout will be raised over time. In an environment where investors are being deprived of yield, and being forced up the risk scale to achieve a worthwhile return on their capital, there is an obvious attraction of being able to buy equity on a an above average earnings yield (the reciprocal of the PE ratio), and preferably close to the book value, as this is highly supportive of a solid source of future dividends. I avoid highly geared newly listed companies generally and if possible prefer cash rich ones as this mitigates financial risk.
Of course, cash generation is critical for any company, so it’s worth making sure that free cash flow per share covers the potential payout being promised. It’s also worth looking at a company’s non-cash charges in the income statement – amortisation and depreciation costs to be precise – as these items depress reported pre-tax profits, but not the cash flow which ultimately pays the dividend.
Sparking an interest
And that’s why my interest was sparked by November’s listing on the Alternative Investment Market of Entu (ENTU: 145p), a UK supplier and installer of windows, doors, solar panels and other energy efficient products (‘Yielding to efficiency gains’, 10 November 2014). At the time of the listing last autumn the company’s equity was being priced on little over 8 times fiscal 2014 earnings estimates based on a flotation price of 100p, implying a bumper earnings yield of over 12 per cent which in turn supported a commitment by the board to pay out around two thirds of those earnings as a dividend in fiscal 2015. My view was that it was worth locking into a prospective dividend of 8p a share as it wouldn’t take too much capital appreciation to generate a double digit annual return on the investment.
For good measure the company offered exposure to the UK's repair, maintenance and improvement (RMI) market at a favourable point in the economic and housing cycle. It always helps to target businesses with a good news story to tell and one underpinned by an industry moving in the right direction. The company was also being brought to the London junior market by Zeus Capital, the same broker behind the successful floats of uPVC windows group Safestyle (SFE: 190p), building material supplier Epwin (EPWN: 98p), and Flowtech Fluidpower (FLO: 121p), the UK's leading specialist supplier of technical fluid power products. I have recommended buying shares in all three companies post their Aim flotations.
Buying into a solid income stream
I was also heartened to see that Entu’s chief executive Ian Blackhurst and finance director Darren Cornwall both had a sizeable interest in their company, with around 12.5 per cent of the equity between them. This ensured that the board had a vested interest in rewarding outside shareholders. Importantly, this wasn’t just a case of raiding all the company’s net earnings to pay shareholders their dividend. Entu also has a growth angle as analysts expect the company to deliver a near 10 per cent hike in pre-tax profits and EPS to £11.1m and 13.3p, respectively, based on a 7 per cent increase in revenues to £127m in the financial year to end October 2015.
In other words, strip out the proposed 8p a share dividend, and Entu’s board will still retain over 5p a share of its forecast post-tax earnings this year. This ticked another box, and one that most companies find fiendishly difficult to achieve: the ability to grow net assets per share (through retained profits) while paying out a rising income stream to shareholders. Entu is already delivering on this basis as the board has paid out a special dividend of 1.5p a share last month to reward shareholders for a 57 per cent rise in EPS to 12.3p last year even though those profits were earned before the company actually listed. Furthermore, with net cash on its balance sheet of £5.8m at the start of this year, up from £1.8m at the end of October 2013, or the equivalent of 9p a share, the company is in an enviable position to augment its organic growth with select bolt-on complementary acquisitions. That’s another trait I look out for in new listings to underpin the earnings growth story.
Bolt-on acquisitions
And that’s exactly what Entu’s board has been doing. A few weeks ago the company announced the acquisition of Astley Facades, a business specialising in energy efficient exterior wall insulation, render and specialist cladding for new-build construction and the refurbishment of existing building stock. The strategic buy broadens Entu’s product portfolio and the range of customers it serves. It will also enable the company to develop a platform to scale up the products offered by Astley nationally across high and low-rise properties for both commercial and domestic buildings. It’s a low risk purchase as the consideration is only £200,000 for a company that generated revenues of £12.2m in the last financial year and which is currently operating at break-even. A few points of margin improvement on that multi-million pound turnover could make this a very shrewd buy indeed.
Furthermore, I would expect further deals given that Entu's has an asset-light business model - it doesn't actually manufacture products, so has minimal working capital requirements because inventory is largely held against firm orders which significantly reduces the capital tied up in stocks. As a result the company is able to turn a high proportion of its operating cash flow into free cash flow which in turn boosts its cash pile, some of which is used for dividends, but the rest can be recycled into value accretive acquisitions. This is another financial characteristic I look for in new listings: a company’s ability to generate free cash by converting a high percentage of its operating profits into operating cash flow.
Target prices smashed
So with Entu’s cash flow robust, earnings rising at a decent lick, and the board paying out dividends earlier than expected, it’s hardly surprising that investors have been warming to the investment case. In fact, the share price has taken out my initial target price of 130p, and after factoring in dividends the holding has returned 38 per cent since I initiated coverage in mid-November. But I feel there should be more upside to come as Entu’s shares are still only rated on 11 times adjusted earnings estimates for the 12 months to end October 2015 (or 10 times on a cash adjusted basis) and are well supported by a healthy 5.5 per cent dividend yield. And with bolt-on acquisitions set to lift earnings even higher, then there is even the prospect of Entu entering into an earnings upgrade cycle as the year progresses.
In the circumstances, and taking all the above factors in consideration, I am raising my target price to 165p, a price level valuing Entu’s equity on 12 times cash adjusted earnings and implying a forward dividend yield of 4.8 per cent. Buy.
Profits flow at Flowtech
Skelmersdale-based Flowtech Fluidpower (FLO: 121p), the UK's leading specialist supplier of technical fluid power products, exhibited similar financial traits as Entu which tempted me to initiate coverage on the shares last summer when the price was 118p (‘Powered up for a fluid performance’, 2 June 2014). They subsequently hit a high of 145.5p in December and I last updated the investment case when the price was 130p ahead of yesterday’s full-year results for 2014 (‘A fluid performance’, 2 February 2015). And they were bang in line with analyst estimates as Flowtech delivered a 18 per cent hike in revenues to £37.8m and increased adjusted pre-tax profits by a third to £6m. Cash generation proved robust, so much so that closing net debt of £6.7m was 10 per cent lower than had been predicted. In turn, the board have declared a 5p a share dividend (ex-dividend date of 3 June for final pay-out of 3.33p a share), covered 2.2 times by EPS of 11.4p.
However, it hasn’t all been plain sailing as the company does have some exposure to the offshore oil and gas capital expenditure market which in turn feeds through to the maintenance, repair and overhaul (MRO) market it services, specifically through Knowsley-based subsidiary Primary Fluid Power, a designer and maker of hydraulic systems and purifiers, and distributor of hydraulic components. That business was acquired by Flowtech last autumn in a £8.1m deal, the terms of which I outlined in my update a couple of months ago (‘A fluid performance’, 2 February 2015). The company is also facing a currency headwind as the sterling:euro exchange rate has risen by around 10 cents to £1:€1.388 since the start of this year.
After factoring in these dual headwinds, analyst Andy Hanson at house broker Zeus Capital has clipped his 2015 revenue forecast from £45.4m to £43m and now expects full-year pre-tax profits of £6.9m, rather than £7.3m at the time of my last update, but still well ahead of the £6m profits just reported for last year. It also translates into EPS of 12.7p, or almost 10 per cent higher than in 2014, and should pave the way for a 6 per cent hike in the dividend per share to 5.3p. On this basis, the shares are being rated on just 9.5 times earnings estimates, a hefty 45 per cent discount to the distribution sector average rating according to Mr Hanson, and 25 per cent below the rating on Trifast (TRI: 103.5p), one of my long-term favourites.
Decent earnings and dividend growth predicted
And like Entu, there is a decent yield on offer. The current dividend yield is 4.1 per cent, a full percentage point above the sector average, rising to 4.4 per cent this year if Flowtech’s board raise the payout by 6 per cent. That forecast payout looks well underpinned too as free cash flow is expected to treble to £4.9m this year, or the equivalent of 11.5p a share. That’s because a higher proportion of this year’s forecast operating profit of £7.1m, up from £6.1m in 2014, should convert into operating cash flow mainly to reflect the absence of the last year’s IPO costs.
So although any downgrade should always be looked at closely, I feel in this case that it shouldn’t overshadow the double digit profit growth Flowtech is expected to deliver this year. Mr Hanson points out that “the order book has already started to normalise regaining much of its lost ground.....and the ability to source orders from other sectors should be beneficial.” I would agree and would add that a modest historic PE ratio of 10.5 more than factors in the negative impact of the oil price slump on the MRO market. In fact, that lowly share price rating implies Flowtech has gone ex-growth which is completely at odds with the 10 per cent EPS growth predicted by analysts this year.
In my book, Flowtech’s shares still rate a decent income buy on a bid-offer spread of 120p to 121p and offering 25 per cent upside to my new target price of 150p, albeit that is slightly below my previous target of 165p to reflect the aforementioned headwinds.
■ Simon Thompson's 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 £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
