They may have very different business models, but the companies have several things in common. Firstly, their share prices are all in blue-sky territory, so there is no technical overhead resistance. Secondly, investors have adjusted upwards the sterling valuation of the equity in these companies to factor in the slide in sterling this year, and understandably so, given their substantial overseas interests. And thirdly, all the companies are in earnings upcycles, so they offer potential for ongoing multiple expansion and further earnings beats.
As readers of my columns will be aware, I regularly reappraise the investment case of companies on my watchlist to take into consideration any new information that has come to light and which has a bearing on my fair value target price. Somero Enterprises is a good example as the landslide victory for the Republican Party in the US election has created a 'Trump' effect for companies with exposure to US infrastructure. Indeed, since my article a fortnight ago ('Exploiting earnings potential', 14 Nov 2016), the shares have rerated sharply and have hit my 230p upgraded target price. As a result, they have risen by almost two-thirds since I initiated coverage at 140p ('On solid foundations', 22 Apr 2015), and are now priced on 10.6 times cash-adjusted earnings estimates for 2017. That's still not expensive in my view, and certainly doesn't factor in any upgrade potential from the anticipated $1 trillion (£800bn) infrastructure programme outlined by President-elect Donald Trump.
In the circumstances, I would run profits on Somero's shares, the same advice I maintain on the holdings in AB Dynamics, Burford Capital, and Trifast, which are showing total returns of 186 per cent, 250 per cent, and 275 per cent, respectively, since I initiated coverage. Shares in both Avation and Alpha Real Trust are still worth buying.
Exploiting strong foreign-exchange tailwinds
Another company that has been benefiting from a positive currency effect is eastern European property fund manager First Property (FPO:47p). I recommended buying the shares at 18.5p in my 2011 Bargain Shares Portfolio since when the board has paid out dividends of 6.865p a share, so the holding is up 191 per cent. I last rated them a buy at 46p ahead of last week's half-year results ('High fives', 4 Oct 2016).
I had good reason, too, as the company had just announced an 11 per cent rise in its funds under management since its March 2016 financial year-end, a performance that reflected additional property purchases in the UK for the Shipbuilding Industries Pension Scheme (SIPS) fund, and currency gains on directly held overseas properties. Furthermore, the SIPS mandate had recently been increased from £125m to £170m, which could add £200,000 to profit in a full year once fully invested.
Earnings upgrades looked nailed on as analyst Chris Thomas at house broker Arden Partners had conservatively based his pre-tax profit and EPS forecast of £7.2m and 4.6p, respectively, for the 12 months to the end of March 2017 on a £/€ rate of 1.33, or 14 per cent above than the current rate of 1.17. I felt that at the very least "a profit upgrade over £1m was in order". I was being too conservative as the currency tailwind added £620,000 to first-half profit alone, so after factoring in savings in funding costs, and contributions from new investments that came to light in last week's half-year results, Mr Thomas has raised his full-year pre-tax profit forecast by £2m to £9.2m. Moreover, this new estimate only assumes the company will replicate its first-half pre-tax profit of £4.57m based on an average £/€ rate of 1.217. However, with the current cross rate well below that level, there is definite potential for more upgrades.
Importantly, this is not just a currency-led upgrade as First Property's third-party assets under management grew a fifth to £234m in the first half to the end of September 2016, including £96m managed in the SIPS fund, and since then a further £14.6m has been invested and £47m of property is subject to offers, so the full £170m SIPS mandate could be fully invested by March 2017. In addition, First Property has the firepower to add to its directly held portfolio of 11 eastern European high-yielding commercial properties in Poland and Romania that are worth a combined £170m, including five properties worth £67m held by 74 per cent-owned subsidiary, Fprop Opportunities.
These properties contributed £5.65m to First Property's first-half profit before central overheads, reflecting the significant yield differential between the weighted average interest rate of 2.59 per cent on the €141m (£122m) debt secured on the €199m (£170m) portfolio, and the 9.8 per cent rental yield being earned. Bearing in mind the high investment returns being made, First Property has more than £14m of cash on its balance sheet available for new investments, either acting as a co-investor or for direct purchases of its own, so it could boost profits significantly if this capital is deployed as equity on debt-funded acquisitions of more eastern European high-yielding commercial properties.
The bottom line is that with First Property's shares trading in line with book value, rated on a modest 8.4 times EPS estimates, falling to less than eight times EPS estimates for the financial year to March 2018, and offering a 3.3 per cent prospective dividend yield based on a payout of 1.55p a share, investors have yet to fully factor in the massive earnings upgrade. I would also flag up that Mr Thomas's new estimates are solely based on rental income from the current portfolio and fund management fees on existing mandates, so the forecast risk is skewed to the upside.
Needless to say, I rate First Property's shares a strong buy and believe my 56p target price could prove conservative. Buy.
Record a currency winner
An obvious beneficiary from the heightened volatility in foreign-exchange markets is currency manager Record (REC:32.25p). I highlighted the investment potential a month ago when the share price was around 27.5p after the company issued an upbeat pre-close trading statement ('On the financial beat', 25 Oct 2016), and one that led analysts at Edison Investment Research to upgrade their full-year EPS estimates by 17 per cent to 2.63p, and raise their 2018 estimate by more than a quarter to 2.93p.
The upgrade looks warranted as the company has been growing client numbers, up from 54 to 61 in the past 12 months, and has increased assets under management equivalent from $53bn to $55.8bn in the second quarter to end-September 2016, buoyed by $1.3bn of additional passive hedging mandates and $1.4bn of positive market movements.
Given the positive momentum in the second quarter, the key take for me in the half-year results was news that the business has been seeing "a growing level of new business discussions, in particular towards the end of the period. This can be attributed to marked currency volatility on the one hand, and positive performance across all return-seeking strategies on the other." There is a degree of diversification in the objectives clients are looking to meet across passive hedging, active hedging and return-seeking objectives, and in some cases combinations of these.
The growing interest in currency hedging from potential clients shouldn't be that surprising given some of the massive moves recently seen in global currency markets: the Japanese yen has lost 7 per cent against the US dollar since the end of October, and there is growing speculation that the euro could fall another 5 per cent to hit parity with the greenback, the main driver of which is the increasing likelihood of a hike in the Federal Funds rate at December's meeting of the US central bank's rate setting committee. The spike in US government bond yields after the US Presidential election, and one that reflects the massive capital investment that will be required by the state to support the Republican Party's expansionary fiscal policies, is also a driver of these currency moves as it has increased the positive yield differential between US Treasuries and sovereign bonds in Japan and Europe, which offer wafer thin yields at best. Frankly, I can't see this situation being reversed anytime soon, another positive for Record's business prospects.
I would also point out that the board are committed to at least maintaining the dividend per share at 1.65p and "will give consideration to returning at least part of any excess of current year earnings per share over this payout to shareholders, potentially in the form of special dividends". The directors can certainly afford to do so as the debt-free company has cash and money market instruments worth £36.2m on its balance sheet, a sum worth 16.3p a share or half the current share price. Or, to put it another way, if the board were to distribute all of this year's forecast EPS of 2.63p then this would raise the dividend yield from 5 per cent to 8.1 per cent. The potential for a special dividend is an obvious attraction, and so is a cash-adjusted forward PE ratio of six, which is far too low even before considering the potential for more mandate wins.
So, although the shares are only showing a small positive return since I included them in my 2015 Bargain Shares Portfolio at 34.3p, and that's after factoring in dividends of 2.55p a share but excluding the half-year payout of 0.825p (ex-dividend: 1 December), I feel the risk is firmly to the upside. Buy.
Regent Pacific's share price aroused
Just over a year ago, I highlighted a trading opportunity to exploit in Aim-traded Plethora Solutions (PLE), a UK-based speciality pharmaceutical company dedicated to the development and marketing of products for the treatment and management of urological disorders ('The takeover game', 11 Nov 2015). Plethora's principal product is PSD502™, a prescription treatment for male premature ejaculation that obtained marketing authorisation from the European Commission in November 2013.
At the time, Plethora had received a bid approach from Hong Kong-listed Regent Pacific (Hong Kong Stock Code: 575). Regent Pacific and its concert parties held 29.88 per cent of Plethora's issued share capital and their offer was pitched at 15.7076 new Regent Pacific shares for each Plethora share. Regent Pacific's share price was HK$0.10, so using a sterling to Hong Kong dollar exchange rate of £1:HK$11.71, the offer valued each Plethora share at 13.4p, or more than double the company's share price of 5p in the London market. I recommended buying Plethora's shares, accepting the new Regent Pacific paper and then selling them in Hong Kong when they trading at HK$0.079 to bank a 122 per cent return ('On the takeover trail', 14 Mar 2016).
Obviously, I wasn't the only one exploiting this arbitrage opportunity, which is why Regent Pacific's share price subsequently deflated, but the price has perked up of late, so much so that at HK$0.071, and with the Hong Kong dollar appreciating by 21 per cent to £1:HK$9.64, the holding is worth 11.6p per old Plethora share. As this was only meant to be a short-term arbitrage play, I would recommend banking at least some of the 131 per cent paper profit if you still own shares in Regent Pacific, which some of you clearly do from your correspondence.
Trakm8 warns
Investors have reacted savagely to the latest trading update from Dorset-based telematics and data provider Trakm8 (TRAK:140p), marking the share price down by 25 per cent this morning after the company posted a sharp fall in first half profits. The board also warned of the possibility of a shortfall on second half profits in the event of a few large orders being pushed back into the next financial year.
The current order book still supports expectations that Trakm8 can deliver full-year adjusted pre-tax profit of £5.9m, up from £3.8m in the prior year, to generate a 25 per cent rise in full-year EPS to 15.7p in the 12 months to end March 2017. However, this is based on a second half weighting “more pronounced than in previous years” given that Trakm8’s first half adjusted operating profit declined by 61 per cent from £1.52m to £590,000 on revenues up 12 per cent to £13.2m. Increased investment in engineering, sales and marketing expenditure in the six months to end September 2016 accounted for £1.5m of the £1.8m increase in overheads which surged by 44 per cent to just shy of £6m. Of this additional investment, over £600,000 was spent on marketing and additional staff to boost sales teams, the consequence of which is that “the pipeline of new opportunities is considerably greater than before.”
But analyst Lorne Daniel at house broker finnCap is taking the worst case scenario and has pulled back his pre-tax profit forecast from £5.9m to £3.8m, implying a flat performance on the prior year, and cut his revenue estimate from £34m to £32m. Moreover, with a higher average share count for the full 12 month period, reflecting the dilutive impact of a placing at this time last year to fund an acquisition, and a higher tax charge too, then Mr Daniel’s new EPS estimate is now 20 per cent lower than last year at around 9.9p, representing a thumping 37 per cent downgrade on his previous expectations.
When I last updated the investment case, and rated the shares a buy at 215p ('Priced to trak higher', 8 Sep 2016), having originally recommended buying at 92p ('Zoning in on a profitable price move', 16 Feb 2015), I noted that the fall in sterling against the euro and US dollar since the EU referendum had added £500,000 to Trakm8's annual cost of sales for the current financial year to the end of March 2017. The company sources electrical components from global manufacturers, mostly in the Far East, and is unable to pass this added cost onto clients given the competitive nature of the industry. finnCap lowered its pre-tax profit and EPS expectations by 8 per cent at the time, but I still felt that if the company could deliver on the new downgraded forecasts then there was upside in the share price on valuation grounds. However, the brokerage’s new EPS estimate of 9.9p is now a thumping 42 per cent below forecasts only three months ago and that has clearly changed the valuation argument.
Investors will not have been impressed either by Trakm8’s weak cash flow performance which resulted in net debt quadrupling to £4.4m since the March 2016 financial year-end. This is partly due to the lower profits booked in the latest six month period, but also reflects an increase in the company’s working capital requirements due to a number of customers moving to a software as a service (SaaS) financial model (principally in fleet telematics) whereby the customer pays a monthly rental fee rather than including a one-off amount for hardware at the start of the contract. As a result, Trakm8 incurs its manufacturing and installation costs at the start of the contract so there is an initial mismatch of costs and cash flows.
It wasn’t all bad news as Trakm8 announced yet another contract win alongside its first half results with Smart Driver Club, the innovative UK vehicle services company, to supply devices and data services for the launch of its Smartbubble service solution. Trakm8 will provide its latest generation T10 Micro devices to the company and has a launch order of 6,000 devices to be delivered in the current financial year. It’s only fair to say that Trakm8 reported 17 per cent organic growth in orders in the first half, so is clearly winning new business.
However, that’s not enough to turn the tide of negative sentiment fuelled by two earnings downgrades, a weak cashflow performance, and a currency headwind. Sell.
