Admittedly, it’s been a difficult year for small cap investing, but there have been a fair number of success stories of which one is Renew Holdings (RNWH: 295p), an Aim-traded engineering services group specialising in the UK infrastructure market. I issued a strong buy recommendation on the shares in mid-August when the price was 258p, targeting a fair value of 330p (‘A small cap break-out’, 14 August 2014). By early October the share price peaked at 327p so it was hardly a surprise that some readers wanted to bank their quick-fire gains.
However, I feel there is a decent chance of another run up to that 330p level especially as Renew is over achieving, having just delivered record full-year profits and EPS which were 5 per cent above analyst’s expectations. The figures were certainly eye-catching with revenues, pre-tax profits and EPS up around two thirds to £464m, £16.4m and 20.8p, respectively. And with the year-end order book increasing by a fifth to £439m, and with chairman RJ Harrison OBE noting that the company has entered the new financial year in a “strong position”, then near-term prospects are sound. They look good for the medium-term too as Renew’s board is targeting group revenue of £500m and operating margin of at least 4.5 per cent within the next three years, implying operating profits of at least £22.5m. The 39 per cent hike in the full-year dividend to 5p a share is an indication of the confidence of the senior management team.
True, a number of earnings enhancing acquisitions have helped drive this growth, but the company’s finances are in decent shape with net debt of £16m at the September year-end covered 1.2 times by cash profits. And with the full benefit of this year’s acquisitions to be seen in the current fiscal year, analysts predict another strong operational performance. Based on underlying revenue growth of 8 per cent, and factoring in the focus on margin gains, expect pre-tax profits to rise to £19.6m to lift EPS to 24.9p in the 12 months to end September 2015. On this basis, the payout is forecast to be lifted by a fifth to 6p a share, so the forward PE ratio is 12 and the prospective dividend yield is 2 per cent.
Reflecting the upbeat trading prospects, and better than expected results, I would run your gains for now. Hold.
Tapping into e-commerce profits
Aim-traded software company Sanderson (SND:69p), a specialist in multi-channel retail and manufacturing markets in the UK, has released an upbeat set of full-year results and ones that fully warrant maintaining a positive stance on the shares and a target price in the range 80p to 85p. I initiated coverage when the price was 33.5p three and a half years ago ('A valuable stock check', 18 Jul 2011) and last updated the investment case at the time of pre-close trading update (‘Tapping into cloud based profits’, 27 October 2014).
A key take for me in the results release was the company’s robust cash flow performance: operating cash flow pre-working capital movements jumped 20 per cent to £2.9m and resulted in closing net funds of £6.16m, up £2.5m on a year earlier. That cash pile is worth 11.5p a share and, with the benefit of a strong balance sheet, chairman Christopher Winn notes the company will continue to look at selective acquisitions to supplement organic growth.
In the meantime, shareholders can satisfy themselves with a 20 per cent boost to their dividend to 1.8p a share which is covered 2.5 times by adjusted EPS of 4.6p. This means the shares are trading on a cash-adjusted PE ratio of 12.5 and offer a dividend yield of around 2.6 per cent. That’s a significant discount to other small cap software companies: Tracsis (TRCS:385p), Craneware (CRW:475p) and Netcall (NET:59p) are all rated on 20 times earnings or above. The average dividend yield for the FTSE Aim technology index is a meagre 0.5 per cent, or less than fifth of Sanderson’s yield, so there is value here too.
I also feel the earnings multiple anomaly has scope to correct itself if Sanderson can maintain the organic growth in its business. Order intake was up 20 per cent year-on-year, but after stripping out the contribution from acquisitions the growth rate was still in double digits. This reflects a strong tailwind from its mobile and e-commerce customers. In particular, last autumn’s acquisition of One iota, a provider of mobile applications for retailers, is seeing significant earnings upside by offering its technologies to Sanderson’s enlarged client base.
For the year ahead, analyst Peter McNally at Charles Stanley Stockbrokers predicts Sanderson’s pre-tax profit will rise from £2.7m to £3.1m on revenues up 5.5 per cent to £17.3m. However, he sees “good potential for our estimates to be beaten in the year ahead”. I would agree and see no reason to alter my positive stance on the shares. Trading on a bid-offer spread of 67p to 69p, I rate Sanderson shares a buy.
Accumulate Accumuli
Aim-traded Accumuli (ACM:24p), a leading independent specialist in IT security and risk management, has reported an upbeat trading outlook alongside half-year results to end September 2014 which revealed a 40 per cent increase in underlying operating profit on revenues up a third.
With trading in the latter months of the period “particularly buoyant”, and given the second half traditionally outperforms the first half, then guidance is for pre-tax profits and EPS to rise by over a third to £3.4m and 1.7p in the 12 months to end March 2014. In fact, Accumuli has recently won a number of financial services sector contracts which are worth £900,000 in gross profit, the vast majority of which will be earned in the current financial year which underpins those forecasts.
Having recommended buying the shares around the current level in the spring ('Profit from cyber warfare', 23 April 2014), if anything the investment case is stronger now than it was then. That’s because the company's area of expertise is becoming increasingly critical for businesses combating the threat of cyber attacks compromising the confidentiality of information they hold and process. It’s worth flagging up that Accumuli’s Customer Intimacy programme is clearly working. The main focus here is on driving recurring revenues and increasing the amount of cross-selling of the company’s products. In the past year, recurring revenue have risen by 10 per cent and over a fifth of all customers now take more than one product from the company, up from 15 per cent a year ago.
Importantly, the valuation is attractive too: after stripping out 2.2p a share of net cash on the balance sheet, the prospective PE ratio is 13. That’s hardly punchy for a company generating double-digit earnings growth and whose shares are priced on a PEG ratio below 0.5. The dividend yield is not bad either for a software company: analyst Andrew Darley at brokerage finnCap predicts Accumuli will raise its payout by a third to 0.68p a share in the current fiscal year, implying a prospective dividend yield of 2.8 per cent.
So although the shares are marginally up on my last buy recommendation (‘Time to accumulate Accumuli’, 15 October 2014), I do feel that my 30p to 33p target price is not out of place. Trading on a bid-offer spread of 23p to 24p, I continue to rate Accumuli shares a buy.
Thalassa profit warning
There are major lessons to be learned for all of us from the unravelling fiasco unfolding at Aim-traded marine seismic equipment provider Thalassa (THAL: 55p). To recap, I was so uncomfortable with corporate governance concerning a related property transaction involving the chairman Duncan Soukup that I advised readers exit their holdings seven weeks ago (‘A conundrum to solve’, 7 October 2014). Other investors were clearly of the same view as shares in the company had slumped by over 11 per cent to 114p by the time my article was published. My investment column undoubtedly contributed to a sharp sell-off in the shares. It also prompted the board of Thalassa to have a meeting to discuss the issues I had raised.
By the time they released a London Stock Exchange announcement in defence, the shares had fallen to 80p (‘Thalassa defends its actions’, 22 October 2014). At the time net funds covered two thirds of the share price and the market capitalisation was almost 40 per cent below book value, so I concluded that “if you didn't manage to sell out, then I would hold onto the shares at the current price of 80p”. Given the modest drift in the price thereafter it’s fair to assume that most readers had already bailed.
It was just as well because yesterday the company announced a major profit warning resulting from its failure to convert a number of contracts and due to legal issues concerning a significant contract in the Russian Artic, delivery of which is being impeded by the current EU and US sanctions or export restrictions on Russia. So instead of delivering pre-tax profits of $4.5m and EPS of around 10p as analysts had predicted only a couple of months ago, Thalassa is heading for a small loss of $400,000 according to brokers. Expectations of revenues of $26.3m have been slashed to only $15.5m, or half the level reported in 2013.
To compound matters, analyst John Cummins at brokerage WH Ireland has slashed his 2015 estimates too, predicting a modest profit of $1m on turnover of $18.7m in 2015. The one positive is the company’s cash pile of $15m, or around £9.6m at current exchange rates. That’s the equivalent of 38p a share, or 70 per cent of the current share price of 54p.
But given the problems converting its pipeline – Thalassa’s board cites the fall in the oil price, economic uncertainty and ongoing budget reviews being carried out by energy companies as the key reasons – I see little reason to even hold the shares, let alone buy them even at this depressed level.
There are several lessons for me to learn from this affair. Firstly, I was too optimistic at the start of the year. Having seen Thalassa shares more than double on my buy recommendation in March 2013 to hit my 300p original target price I should have banked the gains instead of trying to eke out some more. Secondly, the implications of the EU/US sanctions of Russia, and the sharp falls in the oil price, have impacted the business far more than anyone could have foreseen, but my failure (and that of analysts for that matter) to recognise this geopolitical risk was a major oversight.
Thirdly, the company had a share issue at 250p in October 2013, the proceeds of which were to be used to fund the large pipeline of future work. It was well backed by institutions. However, for the equity raise to enhance shareholder returns then Thalassa needed to steadily convert potential contracts into firm orders to deliver the profits to support its share price rating. The fact that it failed to do so led to a revenue warning in September. In hindsight, I should have bailed out at that point even though the share price had slumped to 150p, rather than issue my sell advice at 114p a month later.
Ultimately, the reason for investing in any company comes down to confidence and trust. In the case of Thalassa, it’s going to be a long time before either of these are restored in the minds of a large number of investors, myself included, and that’s a good enough reason not to hold the shares.
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
