Almost all of STM's earnings are derived from its Qualifying Recognised Overseas Pension Schemes (Qrops) business, an offshore pension scheme approved by HMRC and used by expatriates and internationally mobile employees whose tax domicile can change as a consequence of employment. STM has an office in Malta as a responsible EU jurisdiction to act as a pension hub for the business, and another in Gibraltar. The business has grown rapidly in the past few years, but new business sales were sluggish in the first four months of 2016 as economic uncertainty surrounding the EU referendum, and competitors' more aggressive pricing, prompted a slowdown in pension transfers from the UK.
This backdrop prompted STM's board to waive the £800 inception fee when clients set up their Qrops plans, and reduce the annual management charge from £900 to £750. It has clearly worked, as run rate in new business has surged to 150 new plans a month. So, having seen the Qrops client base only rise from 9,700 to 10,000 schemes in the first half, the company's pipeline of new applications indicates a year-end figure around 11,200. The point being that the full profit upside of this surge in new business will be seen in 2017.
The other major news is that STM is acquiring Haywards Heath-based London & Colonial (L&C), an independent financial services group, for £5.38m in cash. The initial cash consideration of £4.13m is being funded through a £3.3m bank loan, with the balance released over the next 12 months subject to indemnities. The total consideration represents a small premium to L&C's net asset value of £4.8m and is a smart bit of business. That's because, during our call, STM chief executive Alan Kentish told me that most of L&C's net assets are in cash as the business needs to hold £4m of regulatory capital for its life business. So, by merging STM's own life business with that of L&C, STM can release one set of regulatory capital of £4m, which accounts for more than two-fifths of its own cash pile of £9.3m, or almost 16p a share. There are economies of scale by merging the life operations too.
L&C also has 300 Qrops clients who can be transferred over to STM's own platform, and has a UK Sipp business with 2,000 clients, so the acquisition scales up STM's Qrops business, and diversifies the product range by offering a Sipp to its network of financial intermediaries. There are significant savings to be made as L&C's directors will step down when the deal completes, representing a chunk of the £750,000 annualised cost savings STM is earmarking, and STM can reduce L&C's actuarial fees and professional fees too. This means that once the £4m of regulatory capital is released, STM has effectively got its hands on a business for a bargain basement £1.4m and one that by my reckoning should be able to contribute £500,000 to next year's profits.
Analyst Duncan Hall at house broker FinnCap will update his forecasts for 2017 once the deal completes, so expect an upgrade in his pre-tax profit and EPS estimates of £3.6m and 5p, respectively. Moreover, having adopted a progressive payout policy based on dividend cover in the range of two to three times, the 2016 payout is likely to be raised from 0.9p to 1.3p a share, implying a forward yield of 2.9 per cent. And if STM maintains the return to growth in its Qrops business, then expect another bumper hike in the payout in 2017. A 50 per cent dividend hike is not unrealistic in my view.
So, having first advised buying STM's shares at 35p ('Tapping into a pensions payday', 27 Apr 2015), and last reiterating that advice at 40p ('Cash-rich recovery play', 13 Aug 2016), I now rate them a strong recovery buy at 45p and have a revised target price of 70p ahead of earnings upgrades. Buy.
K3 on a mission
It was difficult not to be impressed by the full-year results performance from retail software company K3 Business Technology (KBT:350p), the Salford-based supplier of software to the retail, manufacturing and logistics sectors and provider of managed IT and web-hosting services. The fact that its share price is making headway back towards last autumn's 19-year high of 377p tells a story in itself. It's a company I know well, having advised buying at 220p a couple of years ago ('Tapping into retail growth', 16 Sep 2014), and last reiterating that advice at 337p ('On the acquisition trail', 5 Jul 2016).
The key takes for me were growth in sales of K3's higher margin own intellectual property software, which now accounts for 25 per cent of the mix and generates a gross margin of 66 per cent; a channel partner network that is clearly gaining traction; and a pipeline of new business which is up 23 per cent to £76m year on year. New orders hit a record of £35.3m and helped drive revenues ahead by 7 per cent to £89m in the 12 months to end-June 2016. But it's the nature of the new business being won that resulted in both adjusted pre-tax profit and EPS shooting up by more than a fifth to £8.8m and 23.5p, respectively. The fact that K3 hit forecasts even though it was hit by an £830,000 writedown after a client went into administration says much about the resilience of the business too.
In the 12-month period, K3's software licence sales increased by 17 per cent to £16.2m, helped by a contribution from the retail segment and its "ax I is fashion" offering. Leading European mail-order fashion retailer, TriStyle Mode GmbH was a notable client win, as were Lacoste and KLiNGEL, just two of 27 customers signed up through K3's channel partner network.
Acquisitions will contribute to another year of growth too. For instance, K3 recently acquired Merac, the author of an electronic point-of-sale and management system for the visitor attractions and leisure sector. It was an earnings accretive deal as K3 has acquired a business that makes annual pre-tax profits of £330,000 on revenue of £1.27m for a cash consideration of £1.4m. It also adds substance to analyst forecasts that K3 can lift EPS by 11 per cent to 26p in the 12 months to end June 2017, a performance that would easily justify another hike in the payout per share to 2p. The payout was lifted by 16 per cent to 1.75p in the year just ended, a reflection of the cash-generative nature of the business.
Analysts believe K3 should be able to report free cash flow of £6m in the current financial year after factoring in capital expenditure north of £5m. This means that even after raising the dividend again the company should be able to cut net debt in half to £4.6m by June 2017. Gearing is only 12 per cent of shareholders' funds, so there is scope for more acquisitions too.
So, with the outlook positive and K3 well funded, I have no hesitation in reiterating my buy advice. On 13.5 times forward earnings, and offering decent upside to my 425p target price, K3's shares are a decent buy at 350p.
Netplay priced to spin higher
Aim-traded shares in Netplay TV (NPT:9.25p) have effectively flatlined since I covered the full-year results in March ('Netplay's shares spin higher', 21 Mar 2016) once you factor dividends in the interim even though the online gaming company is expected to lift full-year adjusted pre-tax profits by 18 per cent to £2.6m and 0.95p, respectively. First-half results revealed that both underlying profits and EPS rose by 30 per cent to £1.44m and 0.52p, so well over half of full-year forecasts are already booked.
Major points worth flagging up include a recovery in trading after a soft second quarter, and ongoing product investment in Netplay's business intelligence data room. This unit supports a data-led approach to marketing following the rollout of Netplay's automated predictive customer retention platform across the SuperCasino and Jackpot247 brands. Enhancements in these capabilities should help deliver improvements in customer acquisition costs and player lifetime values, while the rollout of new games content across both mobile and desktop platforms, and last month's launch of the UK's first Apple TV application which streams Netplay's live roulette products to television, should enhance the player experience. Contract renewals with both ITV and Channel 5 continue to provide its brands a high-profile presence to attract new players.
The other part of the business is a B2B operation specialising in online digital marketing and formed after Netplay made a small acquisition last summer. This unit provides a complementary revenue stream to the consumer division and is trading ahead of expectations to such an extent that the acquisition was effectively acquired on just three times its forecast cash profits this year. Netplay's board is open to deploying some of its £9m cash pile on further acquisitions.
Admittedly, Netplay hasn't been generating the bumper growth of rival 32Red (TTR:134p), a company I initiated coverage on at 51.75p ('Game on', 7 Jul 2013), and last advised running profits at 135p ('Spinning higher', 2 Aug 2016). However, a four point earnings gap between the two is too wide. On 7 times earnings estimates after stripping out net cash, and offering a dividend yield of 6 per cent, Netplay's shares rate a buy.
End game for Ensor
I believe there is upside to Ensor (ESR:66p), a Manchester-based company focused on the manufacturing and supply of physical security products and packaging that has been selling off its divisions in trade sales. The company now has £10.8m of net cash, or 36p a share, and net assets of £17.5m, or 58p a share.
Two major sales were recently completed at a significant premium to book value and I expect the same outcome for Ensor's two remaining businesses: Ellard, a supplier of electric motors and controls for the automation of doors and gates; and Wood Packaging, a specialist supplier of protective covers for furniture transportation, servicing major retail groups as well as the SME markets. Both are being actively marketed and Ensor's board is in discussions with potential buyers.
Ellard has increased sales at a compound annual growth rate (CAGR) of 14 per cent in the past three years and lifted operating profit by 10 per cent to £890,000 on revenues up 15 per cent to £8.5m in the 12 months to end-March 2016. Wood Packaging has been growing faster, increasing sales at a CAGR of 17 per cent in the past three years and yielding an operating profit of £628,000 on sales of £3.6m last year. Trading in the first four months of the current financial year is ahead of the same period in 2015, but even if these businesses only match last year's performance then they are still only being valued at £8m, or five times operating profit. This calculation is based on Ensor's current market value of £19.5m, and after accounting for its cash pile and a land site with residential planning for seven homes in Brackley that's being marketed for sale at £750,000.
So, with the board intending to make a capital distribution to shareholders in due course, I reiterate my previous buy advice ('Four small-caps with upside potential', 26 Jul 2016). Buy.
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