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High yielding cash rich small cap gems

High yielding cash rich small cap gems
September 29, 2016
High yielding cash rich small cap gems

It clearly didn't need to as a raft of initiatives across the business have been keeping sales ticking over very nicely and at higher margins too. Indeed, retail gross margins rose by a thumping 330 basis points in the six-month period and with administration costs flat, this helped drive pre-tax profits up by 30 per cent to £3.7m, or £300,000 higher than analyst John Stevenson at brokerage Peel Hunt had predicted, on total sales of £68m.

Analyst expectations of a 15 per cent rise in pre-tax profits to £6.8m on sales of £125.9m in the 12 months to end January 2017 look well within reach. They are looking conservative estimates too as it implies a flat second-half profit performance even though company has made a good start to the second half, posting underlying sales growth of 3.7 per cent in the eight weeks since the half-year end and against tough comparatives as like-for-like sales growth was well over 10 per cent at the same stage last year. In addition, the increase in gross margins will benefit the second half too. So, how is the company achieving such an impressive operational and financial performance?

 

Raft of initiatives pay off

Initiatives paying off include investment in e-commerce, and specifically a fully responsive website, to more effectively serve customers via mobile devices. This has helped improve customer conversion rates and deliver higher average transaction values. In fact, e-commerce sales rose 9 per cent year-on-year in the first half to account for over 10 per cent of Moss Bros' total sales with mobile traffic now representing a quarter of online sales, and rising.

The customer offering is also benefiting from the sale of third-party menswear through Moss Bros fascia. For instance, for the spring/summer season the company is adding Ted Baker and French Connection lines. It's also reaping the upside from the launch of sub brands - Moss London, Moss 1851 and Moss Esquire - in the autumn of 2014. These sub brands, combining with Savoy Taylors Guild, have created a complementary customer offer across a range of fits and prices. It's going down well as chief executive Brian Bick notes a positive response to both the company’s autumn and winter collections, and also to its new Moss Bros' 'Tailor Me' personalisation service. This is a simplified set of bespoke options offering a custom made suit, ready for collection within 30 days of placing an order, reflecting the retailer's ability to innovate and improve its customer offer.

The store refit programme continues to deliver hefty returns too and is a key driver behind the strong like-for-like sales performance. Having updated 21 of the 125 stores in the 12 months to end January 2016, Moss Bros is spending a further £3.3m on store refurbishments this year. Seven stores were refitted in the first half and another nine are scheduled to have a makeover by the end of January 2017. This means around 98 outlets in the estate will be trading in the new format in four months time. It makes financial sense to continue with this capital investment programme as I understand that the refurbished outlets have a cash pay-back period on investment of just three years. They are clearly delivering decent like-for-like sales outperformance, too, hence the continued growth being seen in Moss Bros' sales figures.

Importantly, the company has the cash to fund this investment programme as net funds increased by £3.9m to £21.1m in the latest six-month period, buoyed by a stellar cash flow performance and that was after investing £5m in property and paying out £3.7m in dividends. And shareholders are seeing the benefit of this as the first-half dividend was raised from 1.8p to 1.91p a share, a payout well covered by EPS of 3p. Analysts expect a full-year payout of 5.8p, implying the shares offer an attractive dividend yield of 5.7 per cent.

True, that full-year payout is ahead of EPS estimates of 5.3p, but the £5.3m cash cost is easily covered by forecast cash profits of £13.3m. The reason why the company can pay out more than its net earnings, invest in its store estate, and still maintain a high level of net funds, is because its pre-tax profits are stated after a non-cash depreciation and amortisation charge of £6.8m. This means that cash profits are almost double reported pre-tax profits, the difference between the two effectively being cash that can be recycled back to shareholders or into store refits.

 

Valuing the business

Admittedly, Moss Bros' shares have re-rated strongly since I first spotted a buying opportunity at 38p ('Dressed for success', 20 Feb 2012). Indeed, after stripping out net funds of 21p a share they are now trading on 15.5 times full-year earnings estimates. However, that multiple drops to 13.5 times EPS estimates of 6.1p for the financial year to end January 2018 based on revenues rising from £125m to £130.8m and delivering pre-tax profits of £7.9m. Given the momentum in the business I feel those forecasts are achievable.

Moreover, although Moss Bros' equity is now being valued at £103m, up from £37m when I initiated coverage, its enterprise value (market capitalisation less net cash) is still attractive at 6.2 times likely cash profits of £13.3m for the 12 months to January 2017, falling to 5.5 times cash profit estimates of £14.7m the year after. This is my preferred way of valuing the business given the cash-rich balance sheet and chunky non-cash charges that subdue the pre-tax profit line. In my view, a fairer valuation is around 7.5 times cash profits to enterprise value for the next financial year implying an equity value of £130m, or 130p a share.

Offering almost 30 per cent upside to my target price, and with the trading performance underpinning expectations of 15 per cent annual earnings growth both this year and next, I have no reason to alter the positive stance ('A smart performance', 25 May 2016). Buy.

 

Building profitable growth

A development update from from Watkin Jones (WJG:120p), a leading construction company specialising in purpose-built student accommodation (PBSA), made for a reassuring read, and one that adds further weight to my view that this could be one of the IPO winners this year. I am not the only one thinking this way as the shares have risen to a post IPO high of 120p since my last update at 110p ('Buying into student digs', 14 Jun 2016), and are well up on the 103p level at which I initiated coverage at the time of the flotation (‘A profitable education’, 3 Apr 2016)..

A key take for me is the increasing visibility of forward revenues and not just for the full-year to end September 2016. The company has announced the completion of 10 developments, encompassing 3,819 student beds, for hand over ahead of the start of the 2016/17 academic year and is on track to deliver a further seven schemes ahead of the 2017/18 academic year, all of which have been forward sold.

The benefit of forward selling sites is to reduce the working capital needs of the company materially as in effect the end purchaser, usually a blue-chip institution, funds the development and is billed on a monthly basis, as opposed to a non-forward sold development where revenue is only received on sale of the asset post completion. Watkin Jones also enters into asset management contracts, usually for a seven-year term, with these investors when the properties are handed over on completion of the build.

Moreover, chief executive Mary Watkin Jones says that the company currently has a pipeline of 19 developments with 6,317 beds targeted for delivery during 2017 and 2018, and is acquiring two sites which will add a further 418 beds in 2018. Bearing this in mind there has been a spate of good news on planning applications as the company has just received planning consent for the redevelopment of Northumbria Police's old headquarters in Newcastle's city centre. The proposed scheme consists of 225 beds, has a gross development value of £17m, and is anticipated to be completed in 2018. The company has also received planning consent to progress with the redevelopment of land currently being used as a car park on Hunter Street in Chester. The scheme of 77 beds has a gross development value of £6.5m and is scheduled to be completed in the summer of 2018. This adds to the 330 student beds being developed by the company in Chester due for delivery next summer.

 

Rock solid profit growth

The point is that the high visibility of revenues from these schemes underpins analysts forecasts which suggest turnover will rise by 11 per cent to £270m in the 12 months to end September 2016. And with gross margins expanding from 18 per cent to 19.5 per cent this should underpin a 20 per cent rise in full-year pre-tax profits to £39.5m and deliver a 22 per cent rise in EPS to 12.4p. On this basis the shares are only trading on less than 10 times earnings estimates. Furthermore, analyst Andy Hanson at house broker Zeus Capital believes that gross margins can expand to 22 per cent on similar revenues in the 12 months to end September 2017, a rock solid prediction in my view given management's track record of delivering schemes both on time and on budget. If Watkin Jones hits those 2017 numbers, it will add a further £7m to gross profit and with operating costs only expected to rise by £2.6m, ongoing margin expansion should drive pre-tax profits up by a further 10 per cent to £43.6m and deliver EPS of 13.7p.

I would also flag up that net cash is expected to be around £36.4m at the end of this month, a sum worth 14p a share, reflecting the completion of the 10 aforementioned developments and cash released from work in progress and inventories. Robust balance sheet strength, and the availability of £50m of credit lines secured ahead of flotation, means that the company is incredibly well funded and is likely to remain so as Zeus Capital forecasts net funds will rise again to more than £65m by September 2017 based on the seven aformentioned schemes all being completed ahead of the 2017/18 academic year.

Robust cashflow generation underpins the board's guidance for a final of 2.67p a share to be declared in the forthcoming full-year results, having already declared a dividend of 1.33p a share at the interim stage. The company looks well on track to increase the dividend to 6.3p a share in the 2017 financial year in line with the guidance given at the time of the listing in April. That forecast payout is covered two times over by earnings estimates and means the shares are not only offer an attractive prospective dividend yield of 5.25 per cent, but are rated on a modest 8.8 times likely EPS of 13.7p for the 2017 financial year too.

So, with the company's PBSA's developments on track, and cash generation robust, I feel that investors are likely to continue to warm to the investment case and remain a buyer of the shares ahead of the full-year results scheduled to be released in a few months. My initial target price of 140p could prove conservative as Mr Hanson at Zeus Capital rightly points out that even at a share price of 160p the forward PE ratio is only 12 for the financial year to September 2017. Buy.