Underpinning the Creston bull-run
Shares in small-cap marketing communications company Creston (CRE: 124p) stand a very good chance of returning to my previous target of 135p and beyond, a price level that was achieved at the end of last year after I initiated coverage at 118p in the late autumn (‘Buy the break out’, 4 November 2014). That’s because I feel investors will react positively to the company’s acquisition of a 51 per cent stake in How Splendid, a London-based digital design and development consultancy.
By deploying its cash pile on the acquisition, Creston’s senior management team have clearly taken note of previous criticism that it has not been using its balance sheet efficiently. And it looks a sound deal as Splendid is growing at a rapid rate, so much so that analysts at brokerage N+1 Singer predict that operating profits will have more than doubled to £2.7m in the financial year to end March 2015.
Founded in 2003, Splendid's service offering is focused on the user experience between a brand and a customer. Its delivery can range from developing a client's future digital strategy for consumer and brand interaction, to working alongside system integrators to ensure systems are optimised for a consumer's usage. Employing a team of specialists, designers and developers, Splendid also designs, builds and manages client websites. Multinational blue-chip clients include Barclaycard, Boots, eBay and Star Alliance.
The acquisition is in line with Creston's strategy to grow its digital marketing consultancy business, a segment which accounts for over half of the company’s revenue. It is also expected to create significant cross selling and referral opportunities, while at the same time complementing Creston’s marketing communications strength and integrated digital services capability.
Importantly, Splendid's existing management team are incentivised to maintain this heady growth rate. The initial consideration for the 51 per cent shareholding is £8.7m, funded by net funds of £8.3m on Creston’s balance sheet at the end of its March 2015 fiscal year-end, implying an exit multiple of 7 times operating profit. Consideration of the remaining 49 per cent shareholding is subject to call options issued to Creston and are based on the average profit before tax and interest in the year in which the call option is exercised and the two years preceding.
The first call option is exercisable from April 2017 for a 24 per cent stake in Splendid valued up to £8.6m, and the second call option is exercisable from April 2019 for a 25 per cent stake valued up to £11.9m. So assuming Splendid can increase operating profits by around 7 per cent a year over the next four financial years, then by April 2019 it should be making north of £3.5m operating profit. That makes a maximum acquisition cost of £29.2m for 100 per cent of the equity a sensible price in my view. It’s worth pointing out that Splendid has net current assets of £2.1m, including net funds of £1m, so part of the cash consideration is being self funded by the acquisition itself.
Sharp earnings upgrades
The growth potential from the acquired business, and the funding structure of the acquisition, has led to some very sharp earnings upgrades. Analyst Fiona Orford-Williams at Edison Investment Research has upgraded her EPS estimate for the financial year to March 2016 by 7 per cent to 14.1p and now expects a 28 per cent hike in pre-tax profits to £12.8m based on a 15 per cent rise in revenues to £88m.
Analyst Johnathan Barrett at brokerage N+1 Singer is reviewing his own estimates but sees potential for a 13 per cent upgrade on his fiscal 2016 EPS estimate of 13.1p, implying top of the range EPS of 14.8p. And with cash generation set to return the company to a net funds position – Edison predict net cash of £1.3m by March 2016 – then there is scope for a higher increase in the payout to shareholders. Edison is looking for a dividend per share of 4.5p in fiscal 2016, up from 4.1p forecast in the financial year just ended and 3.9p in fiscal 2014, implying a prospective dividend yield of 3.6 per cent. Creston releases its 2015 financial results on Tuesday, 9 June 2015.
Trading on a forward PE ratio of less than 9, and on a 35 per cent discount to net asset value per share of 192p, Creston’s shares rate a buy on a bid-offer spread of 122p to 124p ahead of those financial results. My new target price is 150p, or the equivalent of 10 times upgraded earnings estimates for the March 2016 fiscal year. Please note that I last advised running profits at the tail end of last year (‘Small cap trading updates’, 22 December 2014), so this represents an upgrade to both my recommendation and target price.
K3 Business profit ramp up
Aim-traded retail software company K3 Business Technology (KBT: 226p), the Salford-based supplier of software to the retail, manufacturing and logistics sectors and provider of managed IT and web hosting services, has announced the bolt-on acquisition of Willow Starcom, a wholly owned subsidiary of software minnow Access Intelligence (ACC: 2.76p).
The cash consideration of £1.75m is being funded from K3’s existing banking facilities and the acquisition will be earnings enhancing in the first full year of ownership. Established in 1990, Willow Starcom provides remotely managed, on-premise and cloud-hosted IT support solutions together with related hardware, software support and consultancy. It has particular expertise in Microsoft products and is a Microsoft Hosting Partner. Other key areas of expertise are data storage, remote access and virtualisation. Willow Starcom operates in two data centres in the Manchester area and has around 240 customers across a variety of sectors.
It looks a good fit too. K3’s chief executive David Bolton points out that Willow Starcom generates a high proportion of recurring revenues, is highly complementary to K3's existing hosting and managed services activities, and the business can be very readily integrated. The acquisition not only “broadens our existing offering within hosting and managed services and brings additional expertise and skills to our team, but there is significant potential to expand our hosting and managed services activities and this acquisition is part of our strategy to realise that growth opportunity.”
Willow Starcom posted cash profits of £370,000 on revenues of £2.66m in its last financial year, so after factoring in its contribution, head of research Andrew Darley at brokerage finnCap has upgraded his June 2016 fiscal year-end profit and EPS estimates by 3 per cent to £10m and 25.3p, respectively, based on revenues of £90m. For the current financial year to end June 2015, Mr Darley expects K3 to grow pre-tax profits by 13 per cent to £7.5m based on an 11 per cent rise in revenues to £80m to produce EPS of 19.5p, so the company is expected to report a major step change in profitability again next financial year.
Growth profile well underpinned
This forecast sales and profit growth is being underpinned by licence fee renewals, support contracts and hosting income; an increasing focus on K3's own IP, which is driving margins higher and boosting recurring revenues from a base of over 3,100 customers; and a focus on growing the SYSPRO and Sage businesses and selling hosting services to a larger proportion of customers. Oxfordshire-based K3′s core business offering is a Microsoft Dynamics-based range of retail software that provides a single platform for the entire business. The company is Microsoft's largest Dynamics Retail reseller in the UK.
Clearly, there is execution risk in achieving the ramp up in sales and profits next year, but with K3’s shares only trading on 11 times earnings estimates, falling to nine times fiscal 2016 forecasts – a 38 per cent discount to the small-cap software sector average – then I feel this risk is more than factored into the current rating. There are no financial concerns either as pro-forma net debt of £13.8m equates to a modest 25 per cent of shareholders' funds.
Offering 21 per cent upside to my target price of 275p - below finnCap's target of 330p and also below the 289p target of Katherine Thompson of Edison Investment Research - I continue to rate K3's shares a value buy on a bid-offer spread of 225p to 226p. Please note that I initiated coverage when the shares were 220p ('Tapping into retail growth', 16 Sep 2014), and last updated the investment case around the current price post the interim results (‘Blow out results’, 18 March 2015).
MORE FROM SIMON THOMPSON...
Please note that I have published articles on the following 18 companies since the start of last week:
■ Nationwide Accident Repair Services: Accept bid; SeaEnergy: Buy at 21.5p; Netplay TV: Buy at 9.5p; Stanley Gibbons: Buy at 253p ('Profiting from M&A', 13 Apr 2015)
■ Getech: Buy at 61p, target 80p; Cohort: Buy at 280p, target 300p; Faroe Petroleum: Buy at 86.5p, target 100p; Gama Aviation: Hold at 272.5p ('Flying high', 14 Apr 2014)
■ Entu: Buy at 145p, target 165p; Flowtech Fluidpower: Buy at 121p, target 150p ('Riding the new listings gravy train', 15 Apr 2015)
■ Inland Homes: Buy at 64.5p, target 80p; Walker Crips: Buy at 45p, target 54p; Software Radio Technology: Buy at 32p, target range 40p to 43p ('Decision time', 16 Apr 2015)
■ Bioquell: Buy at 124p, target range 155p to 159p ('Bug busting profit potential', 20 Apr 2015)
■ Stadium: Run profits at 123p, target 140p; Trifast: Buy at 108p, target 140p; First Property: Run profits at 39p ('Running bumper profits', 20 Apr 2015)
■ Somero Enterprises: Buy at 140p, target 185p ('On solid foundations’, 22 April 2015)
■ 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'
