For example, the company has incorporated a Gibraltar Life Insurance Company, STM Life, which provides life insurance bonds - wrappers in which a variety of investments, including investment funds, can be held. STM has also developed a specialist international pensions division which specialises in Qualifying Recognised Overseas Pension Schemes (QROPS), Qualifying Non UK Pension Schemes (QNUPS) and Employer Funded Retirement Benefit Schemes (EFRBS).
It's a high-growth area to be operating in, and a very profitable one too as was abundantly clear from the company's fiscal 2014 results released in mid-March. But what put me off initiating coverage on the shares was the overhang of a convertible loan note (CLN) issue. But that has now been resolved after the company repaid £700,000 of these CLNs in full and converted a further £1.55m into shares priced at 26p each last week. This increased its issued share capital by just shy of 6m shares to 59.4m shares, but more importantly it now means that only £300,000 of the CLNs are outstanding and these can be easily repaid from cash resources when they mature in March 2016. These outstanding CLNs accrue interest at the rate of 7 per cent a year.
So, by my reckoning, STM now has pro-forma cash of £5m on its balance sheet and only £300,000 of debt to give net funds of £4.7m, or the equivalent of almost 8p a share. Net asset value is £23.8m, or 40p a share, so net funds account for just under a fifth of book value. Moreover, with the share price trading on an unwarranted 13 per cent discount to book value then net funds also account for 22 per cent of the current share price. Historically, the company has run a large cash balance, a significant proportion of which relates to its life insurance bonds business. However, the need to do so is about to change as the business moves from its investment phase to become a major cash generator.
A pension payday for STM
Firstly, it was apparent that the pension business is in a strong growth phase as STM takes advantage of the appetite for QROPS, an offshore pension scheme approved by HMRC and used by expatriates and internationally mobile employees whose tax domicile can change as a consequence of employment. STM established an office in Malta as a responsible EU jurisdiction to act as a pension hub for the business and has since been benefiting from work previously directed to its Guernsey office following a review of Channel Islands jurisdiction by HMRC.
STM's business currently has a monthly run-rate averaging 250 new schemes, with the average size of each exceeding £100,000. The company charges customers a set-up fee and annual charges on a scheme basis. Given that QROPS is a long-term retirement vehicle it's only reasonable to expect high customer retention rates. To generate new business, STM targets its marketing through international independent financial adviser (IFA) groups. The product offering is an administration service only, with the fund management responsibilities falling to the client, or its IFA, so this is purely a plain vanilla product offering based on the price STM charges the client and the service it offers. It's clearly proving popular as STM's fiscal 2014 results revealed that revenue from all its pension operations shot up by over a third to £8m to account for half of total turnover. Revenue from STM's operations in Gibraltar, which is now viewed as an established QROPS market, surged by 150 per cent to £2.5m, and those from Malta increased by 13 per cent to £5.5m.
Furthermore, if the company can maintain a run rate of 3,000 new schemes each year then this will produce annual management charges of £1.8m. That's a significant sum in relation to STM's annual revenue of £15.9m last year. True, there are marketing costs, regulatory support and investment in customer service to factor in, but nonetheless a significant proportion of the incremental revenue will flow down to the bottom line given that STM's pension platform has reached critical mass and it can easily scale up the business.
In fact, analyst Duncan Hall at brokerage finnCap predicts that STM pension's business is on course to increase the number of schemes in place from 4,300 last year to 7,100 by the end of 2015 and to over 10,000 in 2016. On that basis, expect revenue to increase by 20 per cent to £9.7m in 2015 and to £10.3m in 2016 to produce cash profit of £2.6m and £3.3m, respectively. Those are chunky profits for a cash-rich small-cap company with a market capitalisation of only £20m.
STM life growth driver
The second reason why STM's growth profile is set to change is the contribution from STM Life, a flexible life assurance bond whereby assets can be introduced into a wrapper and the administration is carried out by STM. The product offering is complementary to STM's customers and is applicable to the tax jurisdictions in which the company operates in. STM Life has a capital solvency requirement which explains the high net cash balances on the company's balance sheet, but as the investment phase is now largely complete in this particular business, and the CLNs have been retired, then this ultra conservative balance sheet management approach becomes far less necessary.
Indeed, STM Life now has over 800 schemes, having taken on 400 new schemes in 2014. Annual fees per established scheme are generally on a flat fee basis, around £700 each, but the set-up costs - around £2,000 per scheme last year - vary as larger scheme fees are negotiable. The Life business addresses a huge international market and, although it's early days, STM Life more than doubled revenue to £1.4m in 2014.
The growth in STM Life and the pensions operation is important because the company's corporate and trust administration business, handling personal trust and corporate secretarial functions, has been under pressure due to the impact of the economic downturn in the UK and Europe, and the attention of tax authorities on offshore finance centres and regulators. This unit is only expected to generate cash profit of £300,000 on revenue of around £5.5m this year. To put that into perspective, finnCap predicts cash profit from the pension operation will increase from £1.8m to £2.6m this year and profit from the small STM Life business will rise by 50 per cent to £150,000.
Another profit surge
Still, even after accounting for the lacklustre performance from STM's corporate and trust administration business, the net effect is that after accounting for a depreciation charge of £300,000 and total finance costs of £200,000, STM's pre-tax profit is on course to rise by over half from £1.7m in 2014 to £2.7m in 2015 based on a £1.8m increase in revenue to £17.7m. On that basis, expect EPS to almost double from 2p to 3.8p. In 2014, the company's pre-tax profit surged almost sixfold to £1.7m, reflecting the growing contribution from the pensions and STM life businesses, so there is a strong earnings trend here that's clearly taking off.
Moreover, with STM creating a recurring revenue stream from its pension business, then this is underpinning incremental increases in income in later years too. Indeed, deferred income of £2.3m at the 2014 year-end was 50 per cent higher than at the end of 2013, all of which is wholly linked to the pension business. In line with the accounting policy for the pensions business, first year fees are reflected as turnover upon invoicing whereas second year fees and beyond are deferred. So, as the pension business matures and enters into its second and third years, deferred income will continue to increase to provide visibility for future revenue. In turn, the earnings multiple investors are willing to apply to STM's equity should increase too given the higher quality of the earnings stream.
To add to the attraction, the increase in recurring revenue means that margins are on the rise too. In fact, based on a modest £900,000 increase in revenue to £18.6m in 2016, expect pre-tax profit to rise by over a third to £3.7m, helped in part by the sharp reduction in finance charges following the redemption of the CLNs. On that basis, EPS surges from 3.7p to 5p in 2016, implying that the shares are trading on only 9.5 times current year earnings estimates (or seven times on a cash-adjusted basis), falling to only seven times 2016 earnings estimates (or 5.5 times on a cash-adjusted basis). That's a very modest rating for a company that's set to lift EPS by 150 per cent over the next two financial years.
If that was not compelling enough, the board now has the authority to use some of its bumper cash pile to buy back shares, having been given permission by shareholders following a change in the articles of association at the start of this year. In addition, the board hopes "to reintroduce a progressive dividend policy" in due course, so there is also the scope for an income stream with a generous payout ratio. Indeed, analyst Duncan Hall at finnCap believes that STM's cash balances could swell to as high as £9m, or 15p a share, by the end of 2016. There is certainly an incentive for the board to return some of this cash through dividends as chief executive Colin Porter owns 2.47 per cent of the equity, finance director Therese Neish owns 0.8 per cent and Alan Kentish, director of business and product development, has a 12.15 per cent stake.
A point worth noting
Of course no investment is without risk and I would flag up that there is a legacy issue which will be hitting the news in a couple of months' time. That's because in 2012 the Jersey Financial Services Commission undertook an investigation into compliance procedures at STM Fiduciaire. The investigation concluded that STM Fiduciaire had acted swiftly to address the perceived failings and that no clients had been put at risk.
STM Fiduciaire felt that matters had been brought to a satisfactory conclusion. However, The Attorney General for the States of Jersey intends to pursue the prosecution of one of STM Fiduciaire's former employees and, as employer at the time, STM Fiduciaire will be jointly charged as a defendant. The Jersey court date starts on 23 June 2015; the result of which will be notified to the market at the earliest opportunity.
STM Fiduciaire has engaged advisers and will vigorously defend the actions of its former employee and itself. It's worth pointing out that in the event of the Jersey Court ruling against STM Fiduciaire, any fine will be manageable and payable out of STM Fiduciaire's existing resources.
Commenting on this case, chief executive Colin Porter, a barrister and solicitor, points out that: "STM Fiduciaire moved quickly to address the perceived failings of a well-regarded former employee (as highlighted by the regulator in early 2012). We are satisfied that we took all possible steps in 2012 and 2013 to work closely with the relevant authorities in Jersey to resolve the matter, and that they had fully endorsed STM Fiduciaire's remedial actions at that time. We are disappointed that this prosecution is being brought four years after the alleged incident. STM Fiduciaire continues to maintain an open, transparent and ongoing relationship with the regulator."
I feel this issue is worth flagging up, but I would also point out that it has no bearing whatsoever on the investment case. In fact, I reckon STM is on course to generate a net cash inflow of £1.7m this year, which will easily cover any fine and the costs incurred from the above court case.
Chart break-out looms
To add to the attraction, STM's share price is on the cusp on a major chart break-out if it can move above 35p, a price level that halted progress last month and also last summer. It think it's only a matter of time before this resistance level is blown away to pave the way for a run up to the 2009 high of 47.5p, the obvious next target. A share price advance of that magnitude would be based on fundamentals, too as, at the 47.5p price level, the shares would still only be rated on 9.5 times 2016 earnings estimates and on a modest 1.2 times book value of 40p a share.
The technical indicators are very supportive of an imminent break-out: the 14-day relative strength indicator is in the mid-60s, so it is not that overbought; the moving average convergence divergence momentum oscillator is on the point of issuing a buy signal; and the share price is positioned bang in line with the 20-day rising moving average, so is not overextended above its short-term trend line.
In my book, that makes STM's Aim-traded shares a strong buy on a bid-offer spread of 33p to 35p, with almost 40 per cent share price offer to my year-end target price of 47.5p on the table. Buy.
MORE FROM SIMON THOMPSON...
Please note that I have published articles on the following 20 companies in the past fortnight:
■ Nationwide Accident Repair Services: Accept bid; SeaEnergy: Buy at 21.5p; Netplay TV: Buy at 9.5p; Stanley Gibbons: Buy at 253p ('Profiting from M&A', 13 Apr 2015)
■ Getech: Buy at 61p, target 80p; Cohort: Buy at 280p, target 300p; Faroe Petroleum: Buy at 86.5p, target 100p; Gama Aviation: Hold at 272.5p ('Flying high', 14 Apr 2014)
■ Entu: Buy at 145p, target 165p; Flowtech Fluidpower: Buy at 121p, target 150p ('Riding the new listings gravy train', 15 Apr 2015)
■ Inland Homes: Buy at 64.5p, target 80p; Walker Crips: Buy at 45p, target 54p; Software Radio Technology: Buy at 32p, target range 40p to 43p ('Decision time', 16 Apr 2015)
■ Bioquell: Buy at 124p, target range 155p to 159p ('Bug busting profit potential', 20 Apr 2015)
■ Stadium: Run profits at 123p, target 140p; Trifast: Buy at 108p, target 140p; First Property: Run profits at 39p ('Running bumper profits', 20 Apr 2015)
■ Somero Enterprises: Buy at 140p, target 185p ('On solid foundations', 22 Apr 2015)
■ Creston: Buy at 124p, target 150p; K3 Business Technology: Buy at 226p, target 275p ('On the acquisition trail', 23 Apr 2015)
■ 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 £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
