Cello's share price has been making headway since a reassuring pre-close trading update at the end of July, and is now putting last summer's seven-year highs of 106p under pressure. A move above this price level would be significant as there is little in the way of technical resistance to halt a rally back towards the 2007 bull market high around the 150p mark. I feel that the forthcoming results will be the catalyst for such a chart breakout, and with good reason too.
Organic growth and currency tailwinds
Firstly, technology marketing communications business Cello Signal has enjoyed a strong first half. This division accounts for a third of group operating profits in 2015 and specialises in three aspects of marketing which are evolving rapidly in the face of globalisation and digitisation: insight gathering; strategic and creative thinking; and the application of technology.
For instance, Pulsar, its social media analytics software proposition, almost doubled its client base last year, and increased it again by a third to over 250 accounts in the first six months of this year. Sales and renewal rates are robust, and first-half profits and margins will be considerably higher than in the first half of 2015, partly a reflection of the move into profits of the Pulsar unit, but also driven by organic growth. Analyst Johnathan Barrett at brokerage N+1 Singer believes Cello Signal should be able to boost operating margins by almost one percentage point to 10.4 per cent for the full year.
First-half trading in the group's larger and higher-margin Cello Health Communications and its Insight business have been equally strong, reflecting the benefits of product development and expansion. These operations provide clients with access to expertise, processes, IP and market knowledge spanning the pharmaceutical, biotechnology, diagnostics, healthcare equipment and consumer health sectors. 'IQ', Cello Health's quantitative research offering, has grown significantly; and eVillage®, Cello Health's digital research community platform is now a material component of the client proposition.
True, weakness in the small health consumer consulting unit has largely offset progress in the other operations and held back overall profit growth, but action has been taken to reduce the size of the unit, so this headwind has already been addressed. Of far more importance is news that there "has been no noticeable impact on client spending behaviour as a result of the EU referendum, and income pipelines remain robust". That’s a strong signal that Cello is trading at least in line with N+1 Singer's expectations that pre-tax profits will rise from £10m to £10.6m in 2016 to lift adjusted EPS from 8.4p to at least 8.7p. The consensus is actually 9.1p, so there is scope for upside on those estimates. In fact, that looks a distinct possibility when you consider Cello's earnings from international operations: 26 per cent of Cello's revenue is derived from the US; 8 per cent from both Europe and the rest of the world; and the balance is from the UK.
So, with sterling weakening dramatically this year, this is having a positive impact on the sterling value of those overseas earnings. For instance, Cello made around $3.5m of its headline operating profit in the US in 2015, or £2.3m based on an exchange rate of £1:$1.529. However, in the first eight months of this year, the average sterling:US dollar exchange rate has fallen to £1:$1.403 and will decline to £1:$1.372 if the current spot rate holds at £1:US$1.31 for the rest of the year. That's more than 10 per cent below the average cross rate for the 2015 financial year, so this currency tailwind should add around £250,000 to profits from Cello's US operations alone. There will be currency translation benefits from European and other international operations too, suggesting the risk to group earnings is to the upside not only for the current financial year, but also on consensus EPS estimates of 9.9p for 2017. A rating of little over 10 times next year's earnings doesn't seem exacting to me.
Upside to dividend
There is upside to the dividend too. That's because even though the board has hiked the payout per share by at least 10 per cent for the past six years, and raised it every year since 2006, there is scope for a significant hike this year. This reflects the fact that Cello has moved beyond the 'build and buy stage' of its development, and has been using its operating cash flow to pay debt down. Net borrowings declined from £7.2m to £4.2m in 2015 and are forecast to fall to £2.4m by the end of 2016, implying balance sheet gearing of 3 per cent of shareholders' funds.
So with borrowings low, Cello's board has the flexibility to pay out a higher ratio of net earnings to its shareholders. N+1 Singer predict that the dividend per share will increase by 25 per cent from 2.86p in 2015 to 3.6p in 2016, rising again to 3.8p in 2017, based on forecast cover of 2.5 times. On this basis, the prospective dividend yields are 3.4 per cent and 3.6 per cent.
Risks
Of course, there are risks to consider, and economic risk is the greatest one for a cyclical business. Cello has offices in the UK, US, Singapore and Hong Kong, so mitigates risk to some extent by having a broad spread of clients across sector and geography. Clients include multinationals Reckitt Benckiser, Johnson & Johnson, Boston Scientific, Microsoft and Unilever. Cello earns significant earnings from these overseas operations, and from the healthcare and pharmaceutical sector, in particular, so it's well worth quantifying its client relationships and prospects for these specific industries.
Bearing this in mind, Cello clearly 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. A robust forward pipeline of work suggests that Cello's clients have confidence in their marketing investment programmes, and justifiably so given the growth potential in their end markets. Major scientific and technological advances, socio-demographic changes, rising demand for medicines and the increase in novel new drugs being approved, lead analysts to believe that the global pharmaceutical market could be worth $1 trillion in sales by 2020. The clients Cello serves represent a substantial industry sector.
I would also flag up an issue relating to the provision for VAT on amounts payable, including an estimate for interest and penalties, to HMRC in respect of certain supplies to Cello's charity clients. In July, Cello settled a longstanding dispute with HMRC over the VAT treatment of these invoices. It will book a £2.1m one-off charge to do so which may concern some investors, but it has put the matter to rest. Moreover, in accordance with IAS 37 provisions, contingent liabilities and contingent assets, potential recovery from clients has not been recognised in Cello's accounts even though it is now in discussions with clients, with whom it has contractual indemnities, for recovery of the VAT. In effect, any VAT recovered from these clients will help to reduce year-end debt below the £2.4m forecast of N+1 Singer.
True, that will not be the only one-off. Progress in growing Cello's new Health BioConsulting Boston office was being inhibited by employment restrictions on key employees from their former employer, as highlighted by Cello's board in the 2015 annual results. In March 2016, agreement was reached to allow the partial release of these employees from their post-employment restrictions in return for a payment of £900,000, with additional payments contingent on the financial performance of the Cello Health BioConsulting business over the next 12 months. This represents a sensible investment in an important growth area for Cello Health especially as setting up the Boston office largely contributed to £1m of start-up losses incurred last year.
Loss of the key clients is another business risk. Client relationships are crucial and the strength of them is key if Cello is going to hit analysts' profit forecasts. The risk here is mitigated by the client base being broadly spread and by several of Cello's pharmaceutical clients being subject to longer-term master service agreements. Loss of key staff is another issue and one mitigated by making all senior staff subject to financial lock-ins and long-term incentive arrangements, as well as being under contractual non-compete and non-solicit clauses.
Valuation and target price
So, having considered all the risks, and acknowledging the fact that Cello's first-half profits will be flat, I still feel that given the second half weighting and the tailwinds that the Signal, Insight and Health Communications units are now benefiting from, then Cello still offers potential for earnings growth above consensus, albeit helped by a currency headwind. Add to that a positive chart set-up, and one on the verge of signalling a major breakout, and it's not difficult to make an investment case to buy Cello's shares ahead of next week's earnings release.
In terms of my estimate of fair valuation, I am in agreement with Mr Barrett at N+1 Singer that Cello's Signal business is probably worth around eight times cash profits and its health business around 10 times, implying an enterprise value of £112m for the group after factoring in debt on the balance sheet. A fair value per share of between 125p and 130p doesn't seem unreasonable to me, a target rating of 1.6 times book value and one reflecting a double-digit post-tax return on equity.
On a bid-offer spread of 103.5p to 105p, I rate Cello shares a trading buy.
