The figures were pretty much as analyst Johnathan Barrett at brokerage N+1 Singer had forecast, and which I highlighted in my last article, with pre-tax profits up slightly to £10.2m to deliver fully diluted EPS of 8.48p and support a 19 per cent hike in the payout to 3.4p a share, reflecting the board's new policy of declaring 40 per cent of net profits as dividends.
However, of far more importance is potential for the company's social media product Pulsar to gain critical mass following the opening of a much larger and dedicated sales office in the US earlier this year. The insight and market research industry has been disrupted by digital technology, centred on the growth of social media as a primary channel for gaining access to large but highly targeted samples at low cost and high speed. Cello's product precisely targets this new growth innovation in the industry.
The overall market for such social media analytics work is forecast to ramp up from $1.6bn (£1.28bn) in 2015 to $5.4bn by 2020, according to analysts, and Cello already has a wide exposure to the global tech client community through its consumer research activity, with clients including Apple and Facebook. If this business can gain traction in the US then it offers scope for Cello to increase pre-tax profits this year by more than the 12 per cent growth rate analysts currently predict.
Also, having acquired Defined Healthcare Research, a business delivering scientific strategic advisory services to a wide range of US, European and global biotech and healthcare clients, post the period end and raised £14.1m net proceeds in a placing at 97p a share at the same time, the board are on the look out to deploy a cash rich balance sheet on further earnings accretive acquisitions. That's worth noting as an uptick in corporate activity offers potential for earnings upgrades. In the circumstances, my previous target price is starting to look conservative and I continue to rate Cello's shares a buy at 122p ahead of news on future acquisitions, and likely analyst upgrades. Buy.
Registering strong growth
Mind + Machines (MMX:9p), a service provider in the domain name industry focused on the new top-level domain (TLD) space, has issued a bullish business update ahead of releasing its full-year results on Tuesday, 25 April. It's one that fully vindicates my decision to include the shares, at 8p, in last year's Bargain shares portfolio. I subsequently advised tendering 13.2 per cent of your holdings back to the company at 13p last year, the proceeds of which can be used to exploit the unwarranted subsequent pull back in the share price ('How the 2016 Bargain share portfolio fared, 3 February 2017).
In last week's trading update, chief executive Toby Hall revealed he fully expects the company's .vip domain registrations to continue the heady growth rates seen since launch in May 2016 and exceed the 1m mark later this year, up from the current level of 586,000. Following .vip's success in China, the company is now looking to target other territories within Asia and has announced that Japan's leading registrar group, GMO, has commenced marketing .vip into the country.
Not that sales momentum in China is stalling. For instance, the company has booked $160,000 of gross sales of .vip premium inventory released through the auctions of .vip premium names held by eName, one of the leading registrars in China, in the first five days of the month-long auction. The importance of the Asian market should not be underestimated. Having had no exposure in the country at the start of last year, China-based revenue is forecast to account for 59 per cent of the total last year.
Mind + Machines has also announced a strengthening of its distribution and sales channels team by appointing a new business development director who will focus on the monetisation of premium inventory across its portfolio of TLDs in North America. In January, the company announced a revised premium inventory renewal pricing policy which will result in improved premium pricing being released to its retail partners in the second and third quarters of the current year and support further margin gains. In addition, Mind + Machines' valuable .boston TLD is scheduled to be released for 'general availability' in September. Geographic TLDs form an important segment of Minds + Machines' portfolio of 29 TLDs, which includes: .london, .miami and .bayern.
The bottom line is that a substantial cost-cutting and streamlining of Minds + Machines into a pure-play registry business offering lucrative income from a valuable portfolio of TLDs is being significantly underpriced in the current valuation. By my reckoning, Minds + Machines retains net cash and trade receivables of around $23.3m, or 2.7p a share, and its portfolio of 29 TLDs is in the books for $40.3m, or 4.6p a share. In other words, the shares are only rated on a modest premium to book value even though the TLD portfolio is being successfully monetised, and the business has made a sustainable move into profit. Buy.
Volvere's bumper results
Another constituent of my 2016 Bargain shares portfolio, Aim-traded investment company Volvere (VLE:585p), has issued a bullish updated ahead of the release of full-year results at the end of May. The company expects to lift pre-tax profits by a third to £1.8m driven by a 20 per cent rise in revenues to £33.2m and is pencilling in an 8 per cent increase in its net asset value per share to a record high of 614p.
I would flag up that Volvere has cash and marketable securities worth £20.1m on its balance sheet, up from £16.3m a year earlier, a sum that accounts for 80 per cent of equity shareholder funds after adjusting for non-controlling interests. In other words, it has almost 500p a share of cash on the balance sheet.
Moreover, the latest reported net asset value figure looks very conservative as it implies a valuation of only £6.5m for the company's three main investee companies. These include an 80 per cent holding in Impetus Automotive, a provider of consulting services to the automotive sector. Impetus posted a £900,000 rise in pre-tax profits to £1.5m on revenues up 43 per cent to £17.4m last year, an impressive return on the £1.3m the company paid for its stake in 2015. Volvere's wholly owned digital CCTV viewing business, Sira Defence and Security, is making good progress too, posting a 33 per cent increase in pre-tax profits to £160,000 on 23 per cent higher revenues of £380,000.
True, profits slipped at frozen pie and pasty maker Shire Foods, a company in which Volvere owns an 80 per cent shareholding. Higher raw material costs following sterling's devaluation, and the decision of a customer to bring manufacturing in-house impacted the performance, but the business still turned in almost £1m of pre-tax profits on flat revenues of £15.4m.
Combined these three businesses are being valued by Volvere on just 4.5 times their aggregate net profits, a valuation that is clearly way below their open market values if sold. So, with the investment risk skewed to the upside, and the company cashed up to make further value-enhancing acquisitions, I feel the shares - up a third on an offer-to-bid basis since I initiated coverage 13 months ago - are well supported. Run profits.
Oily gains
Aim-traded shares in Faroe Petroleum (FPM:91.75p), an independent oil and gas company primarily focused on exploration, appraisal and production opportunities in Norway and the UK, rallied 20 per cent to hit Peel Hunt's 115p target price after I rated them a buy at 96p at the end of last year ('A quartet of small-cap value plays', 28 December 2016) before profit taking set in. I previously advised buying at 68.75p last summer after the company raised £66m in a placing at 70p to fund the acquisition of the production assets of DONG Energy, having initiated coverage at 75p a couple of years ago ('A slick operator', 5 February 2015).
The addition of the five Norwegian North Sea producing oil and gas fields acquired in that transaction, adding almost 10,000 barrels of oil equivalent (boe) per day to Faroe's production, were the primary reason why the company's total average economic output rose two thirds to almost 17,400 boe last year with the cost per barrel edging up slightly to US$25. Cash profits generated from production are being used to help fund the exploration budget of £45m this year, and there is a generous 78 per cent tax rebate from the Norwegian government on exploration expenditure too. Faroe can also tap a NOK1bn four year exploration finance facility giving it around £95m of additional cash for its investment programme.
Furthermore, unrestricted cash of £97m on the balance sheet, a sum worth 27.5p a share, and a seven-year reserve lending facility of around £200m puts the company in a very strong position to make further selective acquisitions on the Norwegian and UK continental shelves. Chief executive Graham Stewart has outlined a goal to ramp up daily production to between 40,000 to 50,000 boe within five years, a clear indication that further acquisitions are on the cards.
It's only fair to say that the sharp pull back in Faroe's share price from last month's 115p highs has mirrored the sell-off in the oil price which peaked out in late February too, highlighting the strong correlation between the two. Indeed, it was the potential for the oil price to recover which prompted me to recommend buying the shares in the first place. That's understandable given a higher oil price has implications for the commercial viability of the exploration programme, and the profits to be earned from production. Some recent disappointment on the exploration front hasn't helped investor sentiment either, but this should not detract from the long-term track record of the company's highly experienced management team.
Moreover, even at US$48 a barrel, down from US$55 a month ago, I feel that the shares should not be trading 38 per cent below the 145p a share risked net asset value estimate of analysts at Peel Hunt, given Faroe's substantial balance sheet strength, and potential for a successful exploration-led growth strategy to deliver shareholder value. Medium-term buy.
Manx Telecom's rising dividend
Shares in Manx Telecom (MANX:197p), the incumbent telecoms operator on the Isle of Man, have flatlined since I last rated them a buy at 202p ('Clear cut investments', 19 September 2016), albeit they are well ahead of the 164p level at which I initiated coverage when the shares listed on the Alternative Investment Market ('High-yield telecoms play', 15 May 2014). A key reason for doing so was the potential for a stable and rising dividend income for the shares paid out from Manx Telecom's substantial operating cashflow, and scope to grow the bottom line by recycling some of the company's annual cash profits of £27.2m into investment in its data centres, super fast broadband, and fixed and mobile telecoms offerings.
The cash generation of the company is well worth considering given that it posted a flat profit performance last year, much as analysts had predicted, but was still able to lift the dividend per share by 5 per cent to 10.9p. The cost of that payout is £12.3m which is easily covered by underlying free cashflow of £16.4m, and still leaves enough cash left over to service the £2.3m annual interest bill on £69m of gross borrowings and maintain free cash on the balance sheet of £16m. There are decent prospects of further growth in the dividend as a programme to reduce costs and improve customer experience should generate net cash savings of £500,000 from next year onwards, according to analysts Jason Hudson and Andrew Bryant at brokerage Liberum Capital. They predict that capital expenditure will then normalise, so boosting free cashflow. This is supportive of a further increase in the payout to 11.5p this year, rising to 12.1p in 2018. Analysts at investment bank Barclays expect similar growth too.
The point being that based on these estimates you can lock into a 5.8 per cent income this year, rising to 6.1 per cent next year, with potential for capital growth too if the shares achieve my 225p target price. For income seekers, that's a decent return and one worth having. And if you buy now you also get last year's final dividend of 7.2p which goes ex-dividend on Thursday, 25 May. Income buy.
Potential windfall for wafer maker
The directors of solar wafer maker PV Crystalox Solar (PVCS:21.75p) painted a bleak trading outlook for the year ahead in their full-year results. That's something we have become used to given the harsh market conditions for multicrystalline silicon products which has seen massive over-capacity in China depress prices for both cells and wafers.
So, in line with the board's cash conservation strategy, the directors have decided to close the UK ingot production facilities and source ingots from a third party instead. The two redundant plants have not been fully utilised for many years and their carrying value had already been written down in the accounts. In the circumstances, it may seem odd that the company was able to turn in a pre-tax profit of €1.7m in 2016, a sharp improvement from the hefty €13.6m loss reported the prior year, on revenue down 12 per cent to €56.6m.
The main reason for this was because wafer producers enjoyed a brief respite in the early months of 2016 when silicon pricing was low, wafer prices were stable and industry demand was stronger. This enabled the company to maintain an average wafer sales price above the cash cost of production for last year, and trade excess polysilcon inventory to reduce stock levels, the net effect of which was a surge in net funds from €12.7m to €28.8m, and a halving of stocks to €11.2m. Effectively, stocks and cash are worth 21.5p a share and account for almost all of the company's net asset value as well as fully backing the share price. That said, given the negative trading outlook, some investors decided to book profits post results as a cash rich balance sheet and improved working capital management are not enough in themselves to justify holding the shares. However, there is a catalyst on the horizon that warrants keeping an interest here: the potential for a massive cash windfall.
That's because the evidentiary hearing for arbitration between the solar wafer maker and one of its customers, a leading photovoltaic company, will start later this week at the International Court of Arbitration of the International Chamber of Commerce after a mediation process failed to find a solution acceptable to both parties. The unnamed photovoltaic company failed to purchase wafers in line with its obligations under a long-term sales contract with PV Crystalox, hence the decision of the board to take the matter to arbitration.
The result of the process will be known in the third quarter this year, and PV Crystalox's board continues to maintain that if a judgment is found in its favour then compensation could be a "multiple of its market capitalisation". So, with the shares priced in line with the value of cash and inventories on its balance sheet, and the company in cash-conservation mode having extricated itself from its last remaining long-term polysilicon purchase contract, then even after accounting for another year of operating losses, the potential upside from a successful International Court of Arbitration ruling makes it worth holding onto the shares.
In the circumstances, if you followed my earlier buy advice at 20.25p ('Exploiting undervalued situations', 31 October 2016), or for that matter at any time since I included the shares at 19p in my 2014 Bargain Shares Portfolio, I would continue to hold on ahead of the arbitration's announcement given potential for it to deliver huge financial returns for shareholders. Hold.
Arbuthnot primed for profit growth
It was difficult not to be impressed by the first-half results from Arbuthnot Banking Group (ARBB:1,459p). The bank's net asset value per share rose by 23 per cent to 1,534p last year and that's after paying out special dividends of 325p in 2016. The bumper dividend was funded from some of the £148m proceeds from last summer's sell down of the bank's stake in challenger bank Secure Trust Bank (STB:2,149p). Arbuthnot still retains an 18.6 per cent shareholding worth £72.5m, a sum equating to a third of its own market capitalisation, and is using the remainder of the cash realised to bulk up its banking operations.
The 51 per cent increase in full-year profits to £9.1m from Arbuthnot Latham, its private banking arm, was eye-catching too, and that's before factoring in upside from a number of recent acquisitions. These include the purchase of a private banking loan portfolio worth £44.9m from banking group Duncan Lawrie. The loans are secured on property worth £104m, so have a low loan-to-value ratio, and offer an attractive yield of 5.2 per cent. Arbuthnot also managed to negotiate a £2.2m discount on the deal.
In the coming weeks, the company will complete the acquisition of Renaissance Asset Finance (RAF), a provider of finance for a range of specialist assets including vintage cars, which adds £55m of customer loans to the portfolio. Arbuthnot has also used £53m of its cash windfall to acquire a prime property in the West End of London, comprising 22,500 sq ft of office space and 7,000 sq ft of retail space. The property generates an annual rental income of around £1.8m and will be used by Arbuthnot Latham to develop a presence in the West End in the future.
Importantly, Arbuthnot is very well funded as £1bn of its customer deposits cover the loan book about 1.3 times over which is highly supportive of the ongoing growth in loan balances. Moreover, assuming Arbuthnot Latham continues to recycle customer deposits into lending at an economic net interest margin, it will be value accretive to shareholders which is why analysts at Hardman & Co expect Arbuthnot's adjusted EPS to more than double to 55.4p in 2017, rising again to 93p in 2018.
If these targets are hit then it should generate further upside on the shares which I included in my 2015 Bargain Shares portfolio at 1,459p, since when the board has paid out total dividends of 383p excluding the recently declared final dividend of 18p which goes ex-dividend on 13 April. So, having last advised running profits around the current price ('A quartet of small-cap value plays', 28 December 2016), I feel a price target closer to book value of 1,534p is in order. Run profits.
Oversold and misunderstood
I had an enlightening result call with Andrew Walwyn, chief executive of Satellite Solutions Worldwide (SAT:8.25p), a satellite internet service provider offering an alternative high-speed broadband service and one that has been growing rapidly by acquisition.
Last summer the company acquired Norwegian-based Breiband, the only provider of radio and satellite broadband in the country and one that has a 13,000-strong customer base; SkyMesh, a Brisbane-based national provider of satellite broadband to 28,000 residential and business customers in Australia; and UK rival Avonline, a satellite broadband business with a customer base of 9,500, of which 92 per cent are consumers. These three businesses generate over £21m of annual revenue and £4m of cash profits which largely explains why the company's revenues almost trebled to £21.5m in the 12 months to end November 2016 and its recurring revenues increased from £5.7m to £18.1m. Scaling up the user base has turned the company cash profitable too with underlying cash profits of £1.24m reported in the 12-month trading period better than I had anticipated.
Satellite Solutions didn't achieve pre-tax profitability though as £2.1m of acquisition and fundraising fees, almost £4m of non-cash depreciation and amortisation costs, £616,000 of share-based payments and fair value adjustments, and £818,000 of finance costs led to a £6.2m pre-tax loss. That may have disappointed some investors, but by my reckoning it was actually operating close to pre-tax break-even on an underlying basis if you exclude the one-off acquisition costs, the £3m amortisation charge and £450,000 redemption premium embedded in the finance charge which relates to debt provided by the Business Growth Fund (BGF). The finance charge was not broken down in the notes to the results statement, nor was the net debt position, an oversight I would hope will be rectified at future results' announcements so that investors can get a clearer picture of the company's finances.
It's worth detailing the BGF funding as it has a bearing on the accounts. That's because the BGF subscribed for £9.6m of unsecured loan notes last year at a fixed coupon of 10 per cent and repayable in May 2024, or earlier subject to an early repayment charge of 12 months' interest; and also £2.4m of convertible loan notes which carry a 10 per cent coupon and are convertible into 26.66m shares at 9p each. This funding alongside a £12m equity raise at 6p a share last summer helped finance the aforementioned three major acquisitions. The loan notes have a redemption premium of £5.5m and the company issued BGF with warrants on 74m shares with a strike price of 7.5p a share. These warrants are exercisable between July 2019 and August 2021.
The point being that Satellite Solutions accounts for the £5.5m BGF redemption premium through its income statement, hence the £450,000 charge taken in the 2016 accounts, even though it is likely to be entirely funded from the £5.55m cash inflow from the exercise of the 74m BGF warrants which have an exercise price of 7.5p, below the current share price.
But is it priced in already?
Of course, for BGF to be tempted to exercise these call warrants the company needs to continue to grow its cash profits and turn profitable at the pre-tax level too. Bearing this in mind, Mr Walwyn says he is comfortable with predictions that the business can quadruple cash profits to £5m plus this year and that outcome is not dependent on making any more acquisitions. The company has added 6,000 new customers since the end of November, taking the total to 85,000, albeit this includes 5,500 from three acquisitions announced earlier this month which are complementary to the existing Norwegian and Australian businesses.
These three new acquisitions are being funded from a new £5m revolving credit facility with HSBC, the interest rate on which is 3.99 per cent above LIBOR, and add more than £1.8m of annualised revenue. The aggregate consideration of £1.75m satisfied in cash and shares. It makes strategic sense to continue seeking out more bolt-on deals because as customer numbers rise, there will be incremental benefits to operating margins from cost savings, economies of scale and streamlining management structures.
Moreover, given Satellite Solutions grew revenues by 12 per cent organically last year, and has maintained this growth rate in the first two months since the financial year-end, Mr Walwyn is comfortable of achieving the target of 100,000 customers by November this year purely through organic growth from this point onwards. That's reassuring as maintaining double-digit organic growth rates materially de-risks the investment case and improves the chances of the company delivering the major increase in cash profitability needed to cover the interest charge on both the HSBC facility and BGF debt facilities, and generate additional cashflow to recycle back into the business.
I would highlight that because of the nature of the debt facilities I am not concerned that the balance sheet is highly geared - net borrowings of £9.8m equates to balance sheet gearing of 126 per cent of shareholder funds - or that the working capital position is negative: current liabilities exceed current assets by almost £6m.
That said some investors may be, which could be one reason why the shares have been marked down by 17 per cent from their record high of 10p following the release of the full-year results on Monday last week. It's also fair to say that some investors will have focused on the hefty headline loss last year, rather than concentrating on the strong likelihood of a sharp increase in cash profits, and a move into pre-tax profits this year. The absence of analyst coverage is not helpful either although I understand from the directors that Numis Securities, who have replaced Arden Partners as nominated advisor and house broker, will shortly be initiating coverage.
So, having first recommended buying the shares at 5.5p a year ago ('Blue sky tech play', 21 March 2016), reiterated that advice at 7p last summer ('Priced for blue sky gains', 31 August 2016), and rated the shares a buy at 9.75p at the start of this year ('A quartet of Aim-traded buys', 9 January 2017), I feel the mark down in the share price post results is overdone. I rate the shares a buy at 8.25p and feel a target of 10.5p to value the equity at £70m on a fully diluted basis is not unreasonable.
I have made this valuation after taking into account conversion of BGF's £2.4m convertible loan stock into 26.66m new shares, the exercise of the 74m BGF warrants, and director options over 29.5m shares. After factoring in year-end net debt of £9.8m, and adjusting for the debt funded acquisitions made since then, this implies a target multiple of 15 times likely cash profits this year to enterprise value, a fair valuation in my view. Buy.
MORE FROM SIMON THOMPSON...
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The archive of all the share recommendations I made in 2016 is available here
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