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OPINION

Communicating well

Communicating well
April 16, 2014
Communicating well
IC TIP: Buy at 69p

The price was little changed when I re-initiated coverage in February this year, but the investment case was much stronger and the valuation on offer far more attractive to tempt me to buy back in (‘Making the right communications’, 3 February 2014). My renewed confidence reflects a raft of contract wins for the company, the latest being a contract extension for the provision of external brand building services to the consumer product giant Procter & Gamble (P&G) until 31 December 2019. The group is a major client of Communisis and the contract covers a range of P&G brands focused on retail across Europe.

It’s worth pointing out that this contract has enabled the company to develop the infrastructure needed to grow overseas activities both with P&G and with other consumer goods brands. As a result of the long-term nature of these contracts, it improves both sales visibility and the quality of earnings for Communisis which in turn should enable the shares to be attributed a higher rating by investors. The company is also deriving a growing proportion of total revenues from the consumer goods sector; the segment generated a fifth of its revenues from FMCG companies in 2013, up from only 8 per cent in 2012.

Importantly, Communisis is now making strong progress in its strategy to ramp up the contribution from international contracts towards its medium-term target of 20 per cent of total revenues. Last year, overseas revenues increased from 7 per cent to 18 per cent of turnover. The company currently supports clients in 15 countries operating from 11 European sites, principally providing external brand building services to P&G.

And that’s not the only significant contract win in recent months as Communisis landed a new 10-year outsourcing arrangement with Lloyds Banking Group (LLOY) to handle all the in-bound imaging and mail processing services for the bank. The company is taking on 14 Lloyds sites in the UK to deal with more than 30m incoming documents each year from the bank's customers. These documents will be scanned into a digital format, indexed and distributed to the relevant bank department for processing. Financial services accounted for 43 per cent of Communisis revenues in 2013 and the contribution will only increase as the new contracts with Nationwide Building Society and Lloyds become fully operational.

Another benefit of all these high-profile contract wins is to raise the profile of Communisis. This can only be positive for when the company tenders for similar such arrangements with other large multi-nationals looking to outsource in this area. In fact, Communisis is one of the few operators capable of supporting such large contracts, a fact not lost on investors who are starting to warm to the merits of the company.

Their attention looks fully justified given the stringent criteria Communisis management team apply to new contracts being tendered for. Namely, they have to be consistent with an internal objective of delivering double-digit operating margins on sales, generating an internal rate of return of 20 per cent on capital employed and have a maximum payback period of three years. Namely, the rates of return on the new contracts are well in excess of both the cost of equity and the blended cost of the company's capital so enhance earnings.

 

Contract wins drive earnings growth

To put the size of these new contracts into some context, analyst Johnathan Barrett at brokerage N+1 Singer forecasts that Communisis will grow revenues by over 11 per cent to £306m this year to drive up cash profits from £20.8m to £24.2m. On this basis, adjusted pre-tax profits rise from £11.6m in 2013 to £15.1m this year as margins on legacy contracts are replaced with more profitable new business and restructuring benefits come through. In turn, this is expected to drive current year EPS up by a third from 4.7p to 5.9p. The respective forecasts for 2015 are for revenues of £321m, cash profits of £28m, pre-tax profits of £18.4m and EPS of 7.1p. On this basis, the shares are trading on 11.7 times earnings estimates, falling to less than times next year’s forecasts.

It’s worth considering too that the company is well financed to service all these new contracts which underpin the anticipated profit growth and improved quality of earnings. Following an equity raise to provide the working capital to fund the raft of new contract wins, net debt ended last year at £25.7m, or a modest 18 per cent of shareholders funds. Borrowings are also well within the company’s credit lines. These consist of a £55m revolving bank facility which runs until March 2018, and a £5m overdraft that is renewable annually.

So, with earnings set to ramp up sharply and finances under control, the board have scope to continue with their progressive dividend policy. N+1 Singer are pencilling in a 2p a share dividend this year, up from 1.8p in 2013, rising to 2.2p a share in 2015. The prospective yields are 2.9 per cent and 3.2 per cent, respectively.

In my opinion, a rating of 10 times earnings estimates is very attractive for a company that is expected to grow EPS at a compound annual growth rate in excess of 18 per cent over a three-year period (2013-2016). It is also a business where contract momentum is building and costs have already been significantly reduced during a previous restructuring of the company’s operations. So with the benefit of a slimmed down fixed cost base, and a policy of tendering for work that must create value for shareholders, any new contract wins will have the effect of enhancing earnings per share. As a result, I would not be surprised at all to see EPS upgrades later this year as the pipeline of potential new work converts into firm contracts.

 

Favourable technical set up

The chart set is also favourable for further share price gains towards my new target price of 85p. The 14-day relative strength indicator (RSI) has a reading around 50, so is not over bought and offers scope for the price to run up higher. For good measure, the price retreat from the February highs around 75p has been gentle and the price has found very strong support around the 65p level and is holding its 20-day moving average too. A close at 70p or above would indicate that the consolidation period is over and the share price is setting itself for a break-out on both the swing and point & figure chart (one point per box). It's one well worth following and on a bid-offer spread of 67p to 68p, the shares rate a value buy.

Please note that I am working my way through a long list of companies on my watchlist that have reported results or made announcements recently including: IQE (IQE), Pure Wafer (PUR), Eros (EROS), Inland (INL), Netplay TV (NPT), API (API) H&T (HAT) and Record (REC).