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OPINION

Business as usual

Business as usual
July 18, 2016
Business as usual

I am in no doubt that an economic slowdown is on the cards given expectations that businesses and consumers alike have become, and are likely to remain, more cautious in terms of their spending decisions and investment plans. That's only a realistic assumption to make, and one that confidence surveys are already backing up. But some perspective is needed here: UK employment is at record levels, unemployment rates are at 10-year lows, the UK's exit from the EU is at least two years away, and our manufacturing base has just had a major boost following the 13 per cent devaluation of sterling in the past month. And unlike in 2008 when the Bank of England's policymakers were way behind the curve, the monetary policy committee is on the ball and ready to deploy further monetary easing. It's worth bearing in mind that the newly formed Conservative government led by Theresa May will play its part too and I would anticipate an 'austere-lite' fiscal regime to ensue, and one that should nullify some of the negative impact of an economic slowdown.

That's not to say that I am complacent - it's just that I feel that predictions of a deep UK recession are wide of the mark. Moreover, UK companies with a domestic cyclical bias - housebuilders, large Reits and car dealers are obvious examples - already trade on near-recessionary ratings, so the equity risk premium embedded in their valuations is already discounting an event that in my view is unlikely to transpire. The point being that stockpicking is all about identifying investments where prospects are being undervalued by the market, both to the upside and to the downside, and then exploiting the mispricing. For this group at least, the investment risk is to the upside.

 

Funded for growth post-Brexit

The same is true of some of the finance houses I follow. I made a strong case last week for Bath-based 1pm (OPM:64p), a specialist provider of finance to small- and medium-sized enterprises (SMEs) and a constituent of my 2014 Bargain Shares portfolio. The same can be said for Aim-traded finance house Private & Commercial Finance (PCF:26.5p), whose shares I recommended buying at 25p ('A small-cap gem', 18 Apr 2016). My target price of 35p was duly hit and I subsequently upgraded my 12-month target price range to 35p-40p when I covered the full-year results last month when the price was 31p ('A licence for hefty gains', 13 Jun 2016). I am not changing that view post the Brexit result.

Operating through two divisions, consumer finance (providing finance to consumers mainly for used vehicles) and business finance (providing finance to SMEs for vehicles, plant and equipment), Private & Commercial has more than 11,000 loan agreements in place and increased receivables by 12 per cent to £112m in the 12 months to the end of March 2016. It's good quality lending, as 90 per cent of borrowers are prime credit risk. I would flag up that new business orientations of about £6m-£6.5m per month are evenly split between consumer and corporate customers, which helps to diversify risk, as does the fact that no single customer accounts for more than 0.5 per cent of the loan book. Around £25m of headroom on existing credit facilities should easily fund lending for the coming year, too.

However, the company has just announced that its major shareholder, Bermuda Commercial Bank, has provided the company with a five-year debt facility of up to £83m to grow its portfolio of receivables. The point here is that a price-to-book value of 1.6 times September 2016 forecast net asset value of 15p a share is hardly a punchy valuation for a company that has just posted a fully diluted after-tax return on equity of 13.9 per cent, neither is a rating of 10 times forward earnings estimates full.

Of course, Private & Commercial needs to maintain robust levels of loan growth to hit predictions of another hefty rise in profits in the current year, while the Brexit vote could dampen loan demand in the near term. But I feel that investors are being far too cautious. Loan growth would have to plunge and bad debts soar for the current modest rating to be justified, neither of which looks a likely scenario to me. Buy.

 

Foreign currency tailwind to buoy AB Dynamics

The most interesting points in the pre-close trading update from Aim-traded AB Dynamics (ABDP:425p), a UK designer, manufacturer and supplier of advanced testing systems and measurement products to the global automotive industry, was that the board sees "excellent visibility on revenues well into the next financial year" and points out that 96 per cent of sales are derived from overseas customers. All of a sudden the company has a major pricing edge over rivals, not that it didn't before because analysts have upgraded their earnings estimates three times in the past year on the back of strong demand for its products.

Indeed, when I last updated the investment case in early May ('Bargain Shares updates', 4 May 2016), analyst Richard Hickinbotham at brokerage Cantor Fitzgerald had just upgraded his full-year pre-tax profit forecast by a further 9 per cent to £4.7m (August year-end), his 2017 estimate by 17 per cent to £5.3m and his 2018 forecast by more than a third to £7m. On this basis, expect EPS of 21.6p, 24.6p and 32p, respectively, predictions that look well underpinned by increased investment by the global car industry in new car models with a focus on advanced safety systems and strong sales of both track and lab testing products.

The point being that even before factoring in the benefit of a currency tailwind following sterling's recent devaluation, AB Dynamics' valuation is hardly full. Strip out net funds of 56p a share, and the company's equity is in effect being valued on 15 times likely earnings for the 2017 financial year, and with the risk to earnings to the upside. Expect mid-teens hikes in the payout per share to 3.11p, 3.57p and 4.11p, respectively, in the next three financial years.

So having included the shares in my 2015 Bargain Shares portfolio at 173p, and with AB Dynamics in the grip of a strong earnings upgrade cycle, I feel that the 10 per cent pullback in the share price since my May update is wholly unjustified, so much so that I rate the shares a buy at 425p and have a fair value target of 500p. Buy.

 

On solid foundations

A major benefit of online publishing is that I am able to react to events as and when they occur and offer you my thoughts in real-time and during market hours. It's one reason why I have been able to publish 250 in-depth company articles this year alone.

A great example occurred last week when I spotted that Aim-traded shares in Somero Enterprise (SOM:167p), a Florida-headquartered company that specialises in the design, assembly and sale of patented, laser-guided concrete levelling equipment for commercial floors, had failed to make a move post the EU referendum even though the company is enjoying buoyant trading and 70 per cent of sales are derived from the North American market ('Profiting from sterling's plunge', 11 Jul 2016). I made the point in that article that the impact of the 14 per cent fall in sterling against the US dollar, and 12 per cent fall against the euro since my last update ('Somero on track for a solid year of growth', 7 Jun 2016), was likely to have a major benefit on the company's profits.

The very next day after my article was published, Somero issued a trading update that confirmed a robust showing in the first half and "significantly stronger" trading in June, with positive contributions across the board. In particular, demand from non-residential building construction continues to benefit from customer demand for replacement machines, fleet additions and product upgrades. New product introductions, price increases and a shortage of skilled labour in the concrete contractor industry are all contributing to strong sales, factors that are driving up margins.

The news prompted analyst David Buxton at broker FinnCap to lift his full-year revenue estimate by $1.4m to $76.5m, up from $70.2m (£54.2m) in 2015, and raise his pre-tax profit forecast by 7.5 per cent to $20.3m, up from $17.9m last year. Expect EPS of 22.5¢ which equates to 17.3p. Furthermore, buoyed by robust cash generation, net funds are worth 17.5p a share, so the cash-adjusted forward PE ratio is only 8.6. And analysts at FinnCap predict a rise in the payout per share from 6.9¢ to 7.2¢, equivalent to 5.5p at current exchange rates, or 12 per cent more in sterling terms than a month ago. On this basis, the shares also offer a prospective dividend yield of 3.3 per cent.

Having initiated coverage on Somero's shares at 140p ('On solid foundations', 22 Apr 2015), and with trading buoyant and the business now enjoying a strong currency tailwind on overseas earnings - its European and Chinese markets also account for 8 per cent of revenue each - I am upgrading my fair value target price from 185p to 195p, the equivalent of 10 times current-year likely cash-adjusted earnings. Buy.

 

Trakm8 on the right track

Shares in Dorset-based telematics and data provider Trakm8 (TRAK:225p) have been volatile this year, not helped by a bear raid on the shares following concerns over the group's cash generation and acquisitions.

Results released earlier this month for the 12 months to end-March 2016 should put those concerns to rest. The key take for me was not the anticipated surge in pre-tax profits - which more than doubled to £3.8m - nor the declaration of a maiden 2p-a-share dividend covered six times over by underlying EPS of 12.6p. It was Trakm8's cash generation. Around £4.4m of cash was generated from operations, representing a high percentage of annual cash profits of £4.8m, so after accounting for capital expenditure of £2.5m, mainly research and development, the company reported free cash flow of £1.9m. Importantly, there was no evidence of a squeeze on receivables on debtor books acquired from the two acquisitions made last year: Route Monkey, a software provider specialising in solutions that optimise fleet route planning; and Bodmin-based DCS Systems, a designer and distributor of camera systems for motor vehicles, bicycles and security markets. In fact, cash flows from both acquisitions - £400,000 for DCS and £500,000 for Route Monkey - mirrors their profit contributions.

True, there is a degree of uncertainty over the outlook post-Brexit, but the company continues to win new orders, including one with German insurer Allianz for an initial contract of 5,000 devices announced alongside the results. After factoring in a full 12-month contribution from both acquisitions, analyst Lorne Daniel at FinnCap believes Trakm8 can lift current-year revenues by a third to £34m to deliver cash profits of £7.7m, pre-tax profits of £6.4m and EPS of 17p. I feel comfortable with those estimates and believe that a forward PE ratio of 13 is too low for a company with decent prospects of driving EPS up by a third this year.

Interestingly, the share price looks to have successfully retested support around the 200p level, so having initiated coverage at 92p ('Zoning in on a profitable price move', 16 Feb 2015), and last rated them a buy at 290p ('Poised to track higher', 4 May 2016), I remain a buyer of the shares.