A good example is Aim-traded uPVC window company Safestyle (SFE:274p), a company I initiated coverage on at 138p after it floated on the London junior market ('Window of opportunity', 23 Dec 2013), and last recommended running profits at 279p following a positive trading update for the first four months of this year ('Breakout looms', 13 May 2016).
Since then the company has paid a final dividend of 6.8p per share for the 2015 financial year and matched it with a special payout of the same order. This means that if you followed my original buy recommendation you will have banked total dividends of 31.8p a share to give a total return of 120 per cent in 33 months. There have not been too many companies in the retail sector that have made an annualised return of 33 per cent since the end of 2013, but Safestyle is one of them.
The reason why the holding has generated such stellar returns was clearly evident in half-year results to end-June 2016. A combination of a 3.3 per cent rise in installations and a 9 per cent increase in the average order value drove Safestyle's revenues up by almost 13 per cent to a record £83.5m. The growth in installations largely reflects the introduction of a 24-month interest-free credit offer, while the higher order value reflects price increases introduced at the start of this year to offset the cost of the cheap finance being offered to customers. Despite increasing prices the company still has significant competitive advantages over rivals as it is able to fabricate a quality product at a price point 20 per cent lower than its national competitors, so much so that its market share has grown from 4 per cent to 10 per cent since 2004.
I expect this trend to continue as Safestyle has seen no negative impact on sales from the EU referendum and its closing order book of £25.1m, up 18 per cent year-on-year, was at a record level. New offices in Guildford and Norwich have increased its geographic presence in the affluent south of England, which accounts for 42 per cent of sales, and Safestyle has been tapping into additional avenues of growth by expanding its range to offer coloured windows and a new conservatory refurbishment product. Interestingly, industry data from FENSA indicates that the replacement window market has returned to growth for the first time since 2013, another positive indicator for Safestyle's trading prospects.
The point is that this growth is still not fully priced in. That's because analysts expect Safestyle's full-year revenues to grow by almost 11 per cent to £165m, implying second-half revenue growth of 9 per cent, and deliver a mid-teens percentage rise in both pre-tax profits to £20.2m and EPS of 20.2p. In turn, this supports a 13 per cent hike in the payout per share to 11.5p as analysts predict. Moreover, because this is a hugely cash generative business - almost 90 per cent of first-half cash profits of £11.1m were converted into operating cash flow - Safestyle continues to build cash even after paying out normal dividends. It is expected to end 2016 with net funds of £13m, or 16p a share, only down £3.2m on the closing balance at the end of 2015 despite paying out £15.3m of dividends including October's half-year payout of 3.75p a share. I wouldn't bet against another special payout in due course.
The bottom line is that on 13 times earnings estimates after stripping out net cash, and offering a prospective dividend yield of 4.2 per cent, the rating fails to price in the huge competitive advantage Safestyle has potential for both organic growth and further market share gains, and the distinct possibility of more special dividends. I rate the shares a buy at 275p and my target price is 300p.
A jewel in the Irish Sea
Of course, not all investments can make the eye-watering returns of companies like Safestyle, but it's all about balancing the risk with the rewards. For instance, shares in Manx Telecom (MANX:202p), the incumbent telecoms operator on the Isle of Man, have risen by 23 per cent since I advised buying at 164p when company listed on the Alternative Investment Market ('High-yield telecoms play', 15 May 2014).
That may seem a modest performance, but the major reason for holding the shares is for the solid dividend and the possibility of capital growth too. And that's what the board has delivered by paying out total dividends of 20.3p a share since I initiated coverage 28 months ago, excluding the raised interim dividend of 3.7p a share declared in last week's results. So not only is there a forward dividend yield of 5.5 per cent to lock into based on a full-year payout being raised by 5 per cent to 10.9p a share, but dividend policy is progressive too. Indeed, with debt levels reduced from £56m to £53m in the first six months of this year, and likely to fall to £51.5m by the year-end, annual operating cash flow forecasts of £25.4m easily cover normal interest costs of £2.3m and capital expenditure of £9.8m and the £12m cost of that payout too. Analysts at Liberum Capital are comfortable in predicting a 5 per cent rise in the payout to 11.5p a share in 2017.
Importantly, the economic backdrop remains favourable on the Isle of Man with unemployment rates below 2 per cent, the economy growing for 32 consecutive years and forecast to continue to do so. The rollout of high-speed broadband, a 4G network and expansion of its data centres - a business segment that now accounts for over 40 per cent of revenues - have improved the product offering and diversified the revenue mix. Higher 4G adoption rates, and increased penetration of super fast broadband services, should lead to a decent second half, while the loss of a data centre customer following an acquisition made by that company should not detract from the long-term prospects offered by this business segment.
There are not too many investments that offer a solid 5.5 per cent prospective dividend yield with potential for growth, but Manx Telecom is certainly one of them. I last recommended running profits when the price was 215p post the full-year results since when the company has paid out a 6.9p-a-share dividend ('A jewel in the Irish Sea', 31 Mar 2016), and still feel the shares can deliver reasonable returns over the next year. I have a fair value target price of 225p based on an enterprise value to cash profits multiple of 11 times. Buy.
A fluid performance
Aim-traded shares in Skelmersdale-based Flowtech Fluidpower (FLO:133p), the UK's leading specialist supplier of technical fluid power products, have re-rated 30 per cent since I spotted a trading opportunity at the start of last month ('Priced for a fluid re-rating', 3 Aug 2016).
The company offers a huge range of original equipment manufacturer (OEM) and own-brand products to over 3,600 distributors and resellers. It's a sizeable operation as Flowtech's catalogue contains 52,000 individual product lines and is distributed to more than 85,000 industrial maintenance, repair and overhaul end users from facilities in the UK and Benelux. Recognised as the definitive source for fluid power products, over 80 per cent of products are stocked and can be delivered next day by national courier service, providing a 'best in industry' service offering.
Having advised buying the shares at 118p at the time it joined Aim ('A fluid performance', 2 Jun 2014), I have a sound understanding of the business and felt that investors were overreacting by selling down the shares between June and August on expectations that Flowtech's financial performance would mirror the 6 per cent revenue decline seen across the industry this year based on data from The British Fluid Power Distributors Association. They were clearly anticipating a major profit warning. I wasn't expecting one at all and neither were analysts. In the event, Flowtech has just reported flat underlying revenues in the six months to end June 2016 and top-line growth of 28 per cent after factoring in the impact of earnings-accretive acquisitions.
Investors may have been concerned with the fall in sterling since the EU referendum too. Between 30 and 40 per cent of Flowtech's UK purchasing is denominated in foreign currency, so the decline in sterling against the euro and US dollar is an issue. However, Flowtech's management made significant inventory purchases in China ahead of the EU Referendum, thus gaining better pricing from Chinese suppliers before sterling started to weaken. This pre-emptive move has insulated the business from margin pressure near term and reassuringly the board is "confident of maintaining overall margins through a mixture of selling price increases and supplier support". This was certainly the case during previous bouts of sterling weakness, most notably in 2009 to 2010, when Flowtech was able to maintain margins by passing on price increases to customers, reflecting the strength of its business model.
I would also flag up that profit streams from several earnings-accretive acquisitions made since the start of last year significantly de-risk analyst forecasts. In the first half, Flowtech increased pre-tax profit by 15 per cent to £3.8m on revenue of £27.4m, and analysts at both FinnCap and Liberum Capital expect a similar profit outcome in the second half to deliver a 15 per cent hike in adjusted EPS to 14.2p, and support a slightly raised dividend of 5.5p. On this basis, the shares are rated on 9.5 times forward earnings, offer a prospective dividend yield of 4 per cent, and are rated just below book value.
To put the rating into perspective, Flowtech's forward earnings multiple is six points lower than other distribution companies which have lower quality earnings and profit margins. The discount isn't justified by financial concerns as Flowtech's net debt of £14.1m is less than a quarter of its shareholders funds and equates to only 1.6 times cash profits estimates.
So, with management guidance positive, and investors reappraising the company's prospects in a positive light, I feel my target price of 157p is achievable. Buy.
Fairpoint disappoints
A common theme about the companies I have mentioned above is their robust cash flow generation and ability to support a progressive dividend policy. Fairpoint (FRP:105p), a provider of consumer professional services including debt solutions and legal services, had similar traits when I advised buying the shares at 98.25p in my 2013 Bargain Shares Portfolio, since when the company has paid out 22.75p in dividends. The price had doubled by the end of last year, but has fallen sharply since then. The decision to wind down its debt management plan and claims management operations earlier than expected, and at a one-off cost of £8m, to focus solely on consumer legal services has clearly not helped sentiment ('Fairpoint exits debt solutions', 27 Jul 2016).
The issue now is that Fairpoint's legal services business is suffering from lower conveyancing volumes post the EU referendum, a segment of the business that accounts for 6 per cent of its turnover. Given the impact of this lost revenue on the bottom line house broker Shore Capital has cut its full-year adjusted pre-tax profit estimates by 12 per cent to £8m, down from £10.5m in 2015. True, an annual payout of 6.8p is covered two times over by downgraded adjusted EPS estimates of 13.6p and Fairpoint has £8.6m of headroom on debt facilities, so the dividend looks safe. However, I just can't see a catalyst to spark a higher rating and upside looks limited. Panmure cut its target price from 130p to 115p. Sell.
