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OPINION

Small-cap watch

Small-cap watch
December 6, 2016
Small-cap watch

A good example is Aim-traded Sanderson (SND:72p), a software and IT services business specialising in multichannel retail and manufacturing markets in the UK and Ireland. When I initiated coverage at 33.5p ('A valuable stock check', 18 Jul 2011), the shares were under the radar of most investors which is why they were rated on a forward PE ratio of six and 25 per cent below book value. That’s no longer the case as the price has more than doubled and the shares are now rated on a 60 per cent premium to book value and on 13 times earnings just reported for the financial year to end September 2016.

Growth in earnings aside, the re-rating can be attributed to a multiple expansion as investors are more comfortable attributing a higher rating to Sanderson’s profits given management’s tendency to hit, or surpass, forecasts. Indeed, the company has just delivered 12 per cent growth in both full-year adjusted operating profits and EPS to £3.7m and 5.5p, respectively, on revenues slightly ahead of expectations at £21.3m.

The key take for me was the order intake which shot up by over a fifth to £12.3m, of which 30 per cent came from new business customers, or twice the level in the previous year. It’s easy to understand why the company’s offering is proving popular as Sanderson makes its money by providing customers’ software products and services which have the tangible benefit of reducing costs or improving the efficiency of their business. For instance, it works in partnership with clients to deliver e-commerce systems which underpin their online operations and enable them to cross and upsell products, offer a secure payment process, and integrate online offerings with other parts of their business. A 25 per cent hike in the closing order book to £3m, and news that “there has not been any loss of confidence either from existing or prospective customers” since the EU Referendum, is note worthy as is guidance for another 10 per cent rise in profits in the current financial year.

I would also flag up the highly cash generative nature of the business which has enabled the board to pay out dividends of £1.2m, in addition to settling £1.66m of acquisition payments, and still maintain a net funds position barely unchanged at £4.34m, a sum worth almost 8p a share. This robust cash generation is funding a 14 per cent hike in the full-year dividend to 2.4p a share, representing a 200 per cent rise in the payout since I commenced coverage, and is providing the board with the firepower to consider “a number of selective acquisition opportunities” to augment organic growth.

A growing recurring revenue base accounting for half of annual turnover is worth considering as the gross margin earned here covers 60 per cent of the company’s overheads, and supports a fair chunk of analysts’ estimates too. And it’s the solidity of earnings, and the strong likelihood of another decent rise that’s not being priced into the valuation. That’s because net of cash on the balance sheet the company is being harshly rated on a modest 9.5 times operating profit, or a third below that of rivals. Analysts at brokerage N+1 Singer have an intrinsic value of 108p a share, and WH Ireland has a target price of 92p, neither of which seem unreasonable to me. Buy.

Amino has ammunition for further upside

Sanderson is not the only technology company on my watchlist that’s been in the news. Amino Technologies (AMO:174p), the Cambridge-based provider of digital entertainment solutions for IPTV, internet TV and in-home multimedia distribution, has secured a contract with North American IPTV service provider Com Net Inc (CNI) to roll out its FUSION "Internet of Things" (IoT) solution across CNI's network of over 20 locally-focused operators.

Acting as both hosting and service provider via its fibre network, CNI will initially deploy FUSION to four operators with plans to offer the service across its entire operator customer base. In addition to offering its telco operators a revenue share model enabling them to monetize the IoT platform through flexible consumer subscription models, CNI will manage Amino’s accompanying cloud-based subscriber management system and operator-branded mobile and web applications for the operators. Analyst Andrew Darley at brokerage finnCap says the contract highlights the ability of Amino to offer tier one level of technology and service provision to its tier 2 and 3 telco customers, thus helping them to maximise end user spend and minimise churn rates.

I would also flag up that with more than half of revenue derived from North America, and almost a third from Europe, sterling's devaluation is providing a strong currency headwind for Amino’s overseas earnings, so much so that with the benefit of a record intake, Amino announced in a pre-close trading update that it will beat earnings expectations ('Value plays', 18 Oct 2016). So, after factoring in the contribution from acquisitions, Mr Darley is pencilling in a two thirds rise in EPS to 12.2p for the financial year just ended to support a 10 per cent hike in the dividend per share to 6.1p. It’s only realistic to expect this tailwind to benefit Amino in the new financial year too which is why Mr Darley expects Amino’s EPS to increase to 12.9p and support a dividend of 6.7p a share.

On this basis, Amino’s shares are rated on a forward PE ratio of 13.5 and offer a 3.9 per cent prospective dividend yield. That’s a fair rating. So having risen by 17 per cent since my last article to hit my 175p target price, and more than doubled since I initiated coverage ('Set up for a buying opportunity', 10 Jun 2013), I am comfortable running profits on the shares towards Mr Darley’s 200p target price. Run profits.

Renew hits target price

It has proved the right decision to stay long of Renew Holdings (RNWH:425p), an Aim-traded engineering services group specialising in the UK infrastructure market, and on the nuclear, rail and water industries in particular. I first recommended buying the shares at 258p ('A small-cap breakout', 14 Aug 2014), and last reiterated that advice at 375p as I firmly believed that my target price of 420p was achievable if full-year results lived up to expectations. ('On the earnings beat', 7 Nov 2016).

In the event, a 14 per cent increase in full-year adjusted pre-tax profits to £22.3m was 5 per cent ahead of that forecast by analyst Nick Spoliar at brokerage WH Ireland, and Renew’s closing order book hit a record £516m to provide over 60 per cent revenue cover for the new financial year. For good measure, the company ended the year in a net cash position of £4.8m, reversing a net debt of £4.8m a year earlier, and the board hiked the dividend by 14 per cent to 8p a share. And with the benefit of a cash rich balance sheet the board have wasted no time at all by deploying the surplus funds on the acquisition of private equity owned-St Albans-based Giffin Holdings, a specialist in mechanical, electrical and power services within the rail sector. It’s a good strategic fit as Renew will now be able to offer power services in areas in which it already operates in the rail sector. It has also acquired a profitable business that reported record revenues of £22m and pre-tax profit of £700,000 in its last financial year.

After factoring in the contribution from the acquisition, and taking into account current trading, Mr Spoliar at WH Ireland believes Renew can lift EPS by 16 per cent to 31.7p in the 12 months to end September 2016 based on an 8 per cent hike in revenues to £570m, and reflecting modest operating margin expansion. On this basis, the shares are now rated on 13.5 times earnings estimates, and offer a prospective dividend yield of 2.1 per cent based on another hike in the payout to 9p a share. That’s a far more reasonable rating, but one that still provides scope for further upside given the ongoing growth in both revenues and margins, and the company’s focus on the more lucrative segments of the UK infrastructure market. Run profits.

Value in Grainger’s shares

Just over a year ago, I outlined the case to invest in the UK's largest listed residential property owner and manager, Grainger (GRI: 220p) (‘Quadruple play’, 22 Oct 2015). My interest was sparked by the decision of Aim-traded activist investment company Crystal Amber (CRS: 181p), one of the constituents of my 2015 Bargain share portfolio, to take a 3.4 per cent shareholding in the company and one that accounts for 16 per cent of Crystal Amber’s latest net asset value of 200p a share.

In the event, the re-rating of Crystal Amber’s shares this year has been driven by the soaring share price of Aim-traded Hurricane Energy (HUR:40p), the UK-based oil and gas group focused on hydrocarbon resources in naturally fractured basement reservoirs. Crystal Amber’s 15.3 per cent stake in Hurricane now accounts for 35 per cent of its net asset value. Little has changed since my last update on Crystal Amber ('On a tear', 13 Sep 2016), and I still recommend running profits at 182p given the potential for the chunky holding in Hurricane to continue to outperform.

However, Grainger’s full-year results are worthy of comment as the company delivered a 9 per cent rise in its EPRA triple net asset value to 287p a share, buoyed by a 5 per cent plus property valuation hike in the portfolio, and sales that averaged over 8 per cent above book value. Importantly, Grainger’s board is well on track to achieve its target of investing £850m in the private rented sector (PRS) by 2020, of which £389m has already been secured and a further £347m is in the legal or planning process. The loan-to-value ratio on the portfolio has fallen by 10 percentage points to 36 per cent since the end of March, reflecting over £450m of proceeds from non-core property sales, leaving Grainger’s balance sheet modestly geared and capable of funding this hefty PRS investment. Moreover, a post year end refinancing has helped reduce the cost of debt by 70 basis points to 3.9 per cent, highlighting the financial upside from using low-cost credit lines to fund high yielding PRS investments.

I am in no doubt that Grainger is onto a winner given the dynamics of the PRS market, structural changes in home ownership in the UK, and the pressures of a growing population on the housing stock. For instance, a decade ago only one in ten households in England rented privately. However, with property prices becoming unaffordable for many, one in five households now rent and in London, it is one in four, and rising. To put the scale of the housing shortage into perspective, analysts at PwC predict that 1.8m new rental homes will be required by 2025 just to meet demand.

In the circumstances, it’s hardly surprising that Grainger’s board believe that the combination of structural demand, positive support for the build-to-rent sector and institutional investment in PRS housing presents “a very compelling opportunity”. There is an opportunity for a progressive dividend too after the board lifted the full-year payout by two thirds to 4.5p, funded from recurring EPS of 10.2p, reflecting a new policy of paying out half of net rental income as dividends. Add to that potential for a narrowing of the share price discount to book value and I maintain my positive stance on Grainger’s shares.

Finally, my next column will appear at 12pm on Monday, 12 December on my home page,