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Bug busting potential gains

Bug busting potential gains
April 20, 2015
Bug busting potential gains

Of course, identifying such value situations and profiting from them are two different things entirely. Sometimes shares can be priced well below the fair value of the constituent parts of a company for long periods of time, and with good reason. So, clearly a catalyst is needed to focus the mind of investors and close the valuation gap, the most obvious of which is a disposal for well above the carry value in the accounts. This is relevant to me right now, because one company on my watchlist, Bioquell (BQE: 124p), a provider of specialist microbiological control technologies to the international healthcare, life science and defence markets, has just announced the sale of its specialist testing services subsidiary, TRaC, to a company backed by venture capital company 3i.

The rational for the disposal is quite compelling. Chairman Nigel Keen rightly points out that having grown TRaC into a highly successful specialist testing business in the past decade, and having received several approaches from potential buyers earlier this year, it became increasingly clear that the time is right to sell the unit to crystallise the significant value created for Bioquell's shareholders. Moreover, the share price failed to properly reflect the improved prospects of the other part of the company, a biodecontamination business which is now benefiting from an improved product mix and a slimmed-down cost base. I would wholeheartedly agree and even though Bioquell's share price has surged by half to 124p since news of the asset sale was announced, in my view there is considerable upside remaining.

 

Sum-of-the-parts valuations

I have good reason for thinking this way because the company is selling TRaC for an eye-catching £44.5m, or 20.8 times the net profit of £2.1m made by that business last financial year. The cash consideration equates to 105p per Bioquell share. In addition, full-year results from the company reveal that its net cash has trebled to £3.4m since the start of this year. In other words, after accounting for the £1m expenses of the transaction, proceeds from the TRaC disposal and cash on Bioquell's balance sheet account for £47m of the current market capitalisation of £53m.

This means that the company's core biodecontamination business is being attributed a value of only £6m, and that's for an operation that posted revenues of £27.3m and cash profits of £3.9m last fiscal year. Moreover, the board has already stated that the majority of the net cash proceeds from the sale of TRaC, suject to shareholder approval being granted at an EGM on 5 May 2015, will be returned to shareholders. It doesn't take a genius to work out that the retained businesses, which is predicted to report pre-tax profit of £1.3m this year, according to analysts at broker N+1 Singer, are worth more than £6m. Please note the pre-tax profit figure for the retained operations is calculated after deducting non-cash depreciation and amortisation charges whereas the cash profit figure is stated before these items.

It's also worth pointing out that TRaC only accounted for £10.5m of Bioquell's net assets of £31m at the end of last year so this will give rise to an exceptional profit of £35.4m on the disposal. To put it another way, if Bioquell's board pay out all of that £35.4m profit - a sum of 82p a share - back to shareholders, then I reckon pro-forma net assets will be £28.6m, or 66p a share, including retained cash of around £11.6m, or 27p a share. That's very solid asset backing and means that the implied value of only £6m for these retained operations, or 80 per cent less than their book value based on Bioquell's current share price, is an absolute bargain.

Of course, it helps if there is a growth angle to garner further investor interest in the company. Fortunately, Bioquell ticks the right boxes.

  

Bug busting profits

Andover-based Bioquell generates a large chunk of its revenues by selling biocontamination control technology products, based around hydrogen peroxide vapour (HPV). These are highly efficacious at eradicating micro-organisms such as bacteria and viruses at room temperature and are principally used by bio-pharmaceutical, biotechnology and research institutions to provide sterile equipment and/or sterile facilities. Bioquell has operations in the US, France, Ireland, Singapore and China, and most clients are based overseas.

HPV-based products are also used to eradicate 'superbugs' from hospitals. Independent scientific research from Johns Hopkins, one of America's top hospitals, has demonstrated that 'bioquelling' hospital equipment and facilities resulted in a two-thirds reduction in the risk of patients contracting hospital acquired infection.

There is growing interest in this area from the healthcare sector, which faces increasing difficulties treating patients who contract bacterial infections that no longer respond to antibiotics. The first O'Neill report, commission by the World Health Organisation and released at the end of last year, estimates that by 2050 more people will die as a result of antimicrobial resistance than cancer. Bearing this in mind, Bioquell's technology has been shown in published scientific studies to reduce hospital acquired infection rates. Not surprisingly it's proving popular: revenues from the company's healthcare unit rose by a quarter to £4.3m last year, to account for 15 per cent of the biodecontamination business.

Expect this positive trend to be maintained, too, as new products are launched in this area including BQ-50 - a new, small, fully automated product to rapidly eradicate pathogens from surfaces in hospitals, and one drawing on technologies and components which Bioquell developed for a US military development programme a few years ago.

There is also increasing demand from the defence sector for Bioquell's specialist chemical, biological, radiological and nuclear filtration systems and environmental control equipment for military vehicles and fixed systems. Interest in these products has been buoyed over the past year by increased sectarian conflicts in the Middle East as well as instability in eastern Europe close to the Russian border. In addition, the use of chemical weapons in Syria was a sharp reminder that chemical warfare agents still exist; and are used. Last year, revenues from Bioquell's defence sector related operations more than doubled from £1.7m to £4.1m.

 

Improved prospects for life sciences

Importantly, in the past few years, the company has also been investing substantial sums in developing new products - comprising rental, service and consumables - with the aim of increasing the proportion of recurring revenues, particularly in the life sciences sector which accounts for two-thirds of the biodecontamination division's annual revenues of £27m.

All these new HPV-related products have been designed to incorporate the use of captive hydrogen peroxide consumable cartridges. To date, decent progress is being made in increasing the number of regulatory approvals for these consumables internationally, and the supply chain is being broadened to enable Bioquell to supply consumables cost effectively to a greater proportion of its customers. Also, existing technologies have been repackaged to migrate the business from an equipment-based offering to boost the provision of specialist decontamination services. This not only enhances the quality of Bioquell's earnings, but boosts the proportion of recurring revenues in the mix, too.

Interestingly, Bioquell's core biodecontamination business is now at a major inflexion point. The company took around £1.5m of costs out of the operation last year by reorganising management and sales teams in certain regions. And with all the major investment already incurred, capital expenditure is set to fall sharply this year. The net result is that with ample manufacturing capacity available to ramp up sales, the biodecontamination business is now highly operationally geared. This means that a larger proportion of profits will fall to the bottom line as revenues rise because the company's fixed costs and labour costs are already paid for. So, as new products are launched, and the healthcare and defence businesses continue to prosper, there is scope for Bioquell's profits to ramp up.

 

A fairer valuation

Healthcare analyst Elizabeth Klein at N+1 Singer believes that Bioquell's biodecontamination business is worth at least £19m at the very least, or £67m based on peer group valuations and enterprise value-to-sales multiples. Those are chunky sums as at the lower end of the scale this implies a value of 44p a share, or 155p in a takeover situation. So, with the biodecontamination business in effect only being valued at £6m, or 14p a share, I can see significant share price upside. In fact, I estimate fair value for the company's equity pre-cash return is nearer 155p, or 25 per cent above the current share price.

The risk:reward ratio really looks appealing given that £47m of Bioquell's current market capitalisation of £53m will be in cash by early next month when the deal completes and we are guaranteed a cash return of a very high proportion of the current share price after the TRaC disposal has been completed. Details of the capital return have yet to be announced, so my prediction of a figure around 82p a share is just that, a forecast. It could be more.

For good measure, and having consolidated share price gains made after news of the TRaC disposal became public, Bioquell's share price is now on the verge of giving a point-and-figure and swing-chart buy signal if it can take out the 126p intra-day hit post that announcement. Beyond that a run-up to the 155p to 159p level, coinciding with the highs from 18 months ago and my three-month target price, is the logical chart-based price target.

So, with both the fundamental and technical set-up positive, I rate Bioquell's shares a very strong buy on a bid-offer spread of 123p to 124p.

■ 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'