In a bullish pre-close trading update ahead of full-year results on Thursday, 9 March, the board revealed that the company’s net gaming revenue (NGR) shot up by 28 per cent to a record £62.3m last year. True, the contribution of Roxy Palace which was acquired for £8.4m in the summer of 2015 flattered the figures, but organic growth of 19 per cent was still mightily impressive. Moreover, since the year-end NGR has risen by over 20 per cent, so momentum is hardly flagging.
The significant cost benefits generated from the acquisition combined with ongoing growth in 32Red’s markets, over three quarters of which are reassuringly regulated, and a move into profit in its fledgling Italian operations, underpins a likely doubling of 32Red’s cash profits to £10.5m in 2016. On this basis, expect pre-tax profits to rise from £3.3m to £8.9m to deliver EPS of 9.4p. The conversion rate of cashflow to profits is impressive too which is why the cash pile is expected to have held steady at £8.3m even after the board paid out a 3p a share special dividend in March at a cost of £2.5m, and an interim dividend of 1.3p last autumn. Analysts predict a final payout of 2p a share, implying a normal dividend yield of 2.1 per cent.
They are also forecasting another strong year of growth: analysts at Edison Investment Research maintain expectations of a £5m increase in 32Red’s cash profits to £15.5m in 2017 based on NGR growing by 21 per cent to £76m. On this basis, expect a near 50 per cent rise in both pre-tax profits and EPS to £13.3m and 13.9p, respectively. I feel these estimates have foundation once you factor in the absence of losses from Italy, margin gains on rising revenues resulting from operational leverage, and the more favourable terms that 32Red has with its online platform providers. There are also cross selling opportunities to exploit from Roxy Palace’s international and more recreational customer base. So, as cash profits rise, so does free cash flow which is why analysts are pencilling in a doubling of 32Red’s net funds to £17m by the year-end, a sum worth 20p a share, and that’s after factoring in another hike in the dividend to 3.6p a share. In turn, this offers scope to recycle the burgeoning cash pile into bolt-on acquisitions.
Admittedly, 32Red’s shares have only risen by 10 per cent since the interim results in September when I rated them a buy at 141p (‘Game on’, 22 September 2016), albeit they are showing a hefty 220 per cent return since I initiated coverage at 51.75p ('Game on', 7 July 2013) after factoring in dividends of 13.8p a share. I attribute the recent sluggish performance to the general sector uncertainty ahead of the UK government’s Triennial review of the gaming sector. However, the review will be undoubtedly focused on high street betting shops and curbing their highly profitable fixed odds betting terminal activities.
Furthermore, as I highlighted in my last article, we already know that HMRC is consulting on the precise way that Point of Consumption Tax (POCT) will be extended to free play from August 2017, which is likely to change game play and impact margins. But the market is already discounting this as analysts at Edison have factored in a 2-3 point increase in the effective POCT rate in their aforementioned forecasts. The point being is that I expect 32Red to come out relatively unscathed from the Triennial review, and the risk premium embedded in the share price to unwind, thus offering scope for a return to the March 2016 all-time high of 186p. Buy.
Cello to ring up acquisitive gains
32Red is not the only company on my watchlist to have seen its share price trade sideways since the autumn. The same is true of shares in Aim-traded pharmaceutical and consumer strategic marketing company Cello (CLL:106p) which I advised buying at 105p, targeting a fair value range between 125p to 130p ('Marketing a breakout', 5 September 2016).
A pre-close trading update ahead of full-year results on Wednesday, 22 March 2017 was much as I had expected. Analyst Johnathan Barrett at brokerage N+1 Singer is forecasting slightly higher pre-tax profits of £10.2m on revenues of £88m, EPS of 8.4p and a 17 per cent hike in the payout to 3.4p a share, reflecting the board’s new policy of declaring 40 per cent of net profits as dividends. Please note that these forecasts exclude £1m of restructuring costs and a non-cash £5m write-down on Cello’s small health consumer consulting unit that has been proving a drag on profits as I highlighted when I iniated coverage.
However, of far more importance is news that Cello is acquiring Defined Healthcare Research, a business delivering scientific strategic advisory services to a wide range of US, European and global biotech and healthcare clients. Founded 20 years ago, the New Jersey-based company complements Cello’s existing capabilities in consulting, market research, and science-based communications and will accelerate its push into the biotech and development stage healthcare market as well as reinforcing its position in the core US market. Cello already has strong client relationships, servicing the needs of 23 of the largest 25 pharmaceutical clients globally, of which 18 have been clients for four years or more, as well as a growing number of biotech clients, particularly in the US.
The initial consideration of £4.2m cash and just shy of 400,000 new Cello shares seems a fair price given the target posted operating profit of US$900,000 (£720,000) on revenue of US$6.6m in 2016. An earn-out of US$3.25m is dependent on Defined Healthcare’s performance over the next three financial years and should keep the vendors incentivised. To satisfy the cash consideration, Cello raised £14.1m net proceeds in a placing at 97p a share which is interesting because it didn’t need to as the company’s net debt is only £5m, having being paid down substantially in recent years.
Mr Barrett at N+1 Singer believes the equity raise signals a clear “statement of intent to make further acquisitions which we expect in healthcare and most likely in the US”. US revenues account for around 45 per cent of the total post the acquisition, and Mr Barrett feels that “strategically they need to be higher”. I agree and believe that the prospect of positive newsflow from selective bolt-on acquisitions should underpin a decent uplift on the current enterprise value to cash profits multiple of less than eight times. Buy.
Epwin on solid foundations
Aim-traded shares in Epwin (EPWN:106p), a manufacturer of extrusions, mouldings and fabricated low maintenance building products, have also failed to join the equity market rally since the company’s interim results ('Delivering results', 15 September 2016). I advised buying the shares at 110p at the time and feel an overdue re-rating looks highly likely in the coming months. That’s because a pre-close trading update ahead of full-year results on Thursday, 6 April 2017 points towards pre-tax profits rising by 24 per cent to £24.3m in 2016 to deliver a 17 per cent rise in EPS to 14.2p and support a modest rise in the payout per share to 6.6p.
This profit growth is clearly at odds with that of rivals who are also selling into the moribund repair, maintenance and improvement (RMI) market, and is being driven by the board’s shrewd decision to use the company’s lowly geared balance sheet to make earnings accretive acquisitions, a key reason why it listed on the Alternative Investment Market at 100p a share a couple of summers ago when I advised buying ('Moulded for gains', 29 July 2014). Indeed, Epwin has invested £50m including future earn-outs acquiring three companies: Wrexham-based Ecodek, a leading manufacturer and supplier of wood plastic composite; Tamworth-based Stormking, a leading supplier of moulded GRP building components to the housebuilding and construction industry in the UK; and National Plastics, a national distributor of building plastics to the trade. These businesses contributed £18.4m of revenue and £3.7m of operating profit on a margin of 20 per cent in the first half, and I understand that their performance since then “continues to be encouraging”, so underpinning the aforementioned full-year profit forecasts.
True, there is no doubting that some of its end markets remain challenging, prospects of a rebound in the RMI market look slim, and the weakness of sterling is leading to cost pressures. However, this all looks factored into a PE ratio of 7, a rating at odds with a company that is set to report a 21 per cent post tax return on equity. The modest rating is certainly not justified by any financial concerns: analyst Andy Hanson at house broker Zeus Capital estimates operating profits of £24.6m covered finance charges more than 17 times over and Epwin ended last year with net borrowings of only £21.3m, representing less than its operating profits. Cash generation remains strong, so much so that free cash flow of £12.1m is likely to improve this year as capital expenditure is reined back from £12.5m to £7.5m according to Mr Hanson’s models, leaving room for the company to recycle even more of this cash flow back to shareholders.
But even without another dividend hike, the lowly rated shares still offer an attractive yield north of 6 per cent with the payout covered more than two times. That represents value in my book and I maintain my target price of 140p. Buy.
Boot’ful investment
Small-cap property and construction company Henry Boot (BHY:211p) has delivered a trading update ahead of market expectations for the second time in the past six months, and one that has led analyst Nick Spoliar at brokerage WH Ireland to edge up his profit forecasts by around 5 per cent. He now expects the company to increase revenues by more than three quarters to £300m in the 12 months to end December 2016 and lift pre-tax profits by a fifth to £39.2m. On this basis, expect adjusted EPS to rise by more than 25 per cent to 22.1p and support a 16 per cent rise in the payout to 7p a share. Analyst Daniel Cowan at Investec Securities has similar estimates. To put the scale of the upgrades into some perspective, when I last recommended buying the shares at 208p in late summer ('A quartet of small-cap buys', 30 August 2016), analysts were expecting full-year adjusted EPS of around 20p, up from 17.5p in 2015, so the earnings beat is significant. It has also been driven by a number of factors.
Henry Boot’s board highlighted that home buyer interest at the joint venture residential development, The Chocolate Factory in York, remains keen, so much so that the company booked 44 completions at the scheme during December. It also reports that land development division Hallam Land, which had 15,183 plots across 47 sites for sale, and a further 9,500 plots across 18 sites subject to planning applications at the interim stage, closed a number of deals before the year-end. Despite this strong deal flow, Mr Spoliar expects Hallam Land’s closing strategic land bank to be 3 to 5 per cent ahead of the prior year, thus underlining the substantial value to be released when these land assets are sold on the open market given that land is held at the lower of cost or net realisable value. For good measure, construction work on The Aberdeen Exhibition and Conference Centre, a £333m property development, is running ahead of schedule, so resulting in a marginally higher profit contribution in last year’s figures.
Trading on 9.5 times earnings, well below sum-of-the-parts valuations of 294p a share, offering a forward dividend yield of 3.3 per cent, and supported by a lowly geared asset rich balance sheet, the investment case remains attractive. Buy.
MORE FROM SIMON THOMPSON...
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