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A trio of small-cap buys

Simon Thompson initiates coverage on one small cap company, and sees significant share price upside on another two.
July 13, 2017

I had a very interesting, not to mention lengthy, results call with the directors of Redditch-based Solid State (SOLI:410p), a supplier and design-led manufacturer of specialist industrial and rugged computers, battery power packs to the electronics market, microwave systems and advanced antenna products. The £34m market cap company listed on the Alternative Investment Market (Aim) over 20 years ago and is still be a minnow of the stock market, but it has a client base of around 800 companies, many of which are multi-nationals and no fewer than three-quarters are repeat business, thus highlighting a high level of customer satisfaction. It's been on and off my radar for the past couple of years, but I passed it partly on valuation grounds, but was also deterred by a lacklustre earnings outlook. On both counts, it is now of interest.

For starters, the share price has retreated from a March high around 540p, so the shares are now rated on a far more reasonable 12 times earnings for the year just ended, during which time adjusted pre-tax profits rose 6 per cent to £3.1m on revenue ahead by 9 per cent to £40m. That's a fair performance, but not one to get me excited. However, what sparked my interest was news of an order book up 16 per cent year-on-year to a record £20.7m, of which over two-thirds is due for delivery in the current financial year, thus supporting conservative looking guidance of another 6 per cent or so rise in profits this year, too. Importantly, there are reasons to believe that analyst Eric Burns at house broker WH Ireland is erring on the side of caution in his estimates. 

Firstly, the directors informed me that one of the two previously delayed antenna contracts in Solid State's communications business - a specialist in a range of applications, including high quality kit for military surveillance - has been secured and the other is expected to be, too. This segment accounts for 7 per cent of Solid State's turnover and a high percentage of work is for governments, including the UK Ministry of Defence. Operating from a purpose-built facility in Leominster, the focus is to scale the unit up for growth by boosting sales support and engineering resources. Current contracts here include mechanical testing, refurbishment and upgrade of the antennas used by the UK Met Office weather network.

Prospects for the company's batteries business are improving,too. This segment accounts for 18 per cent of revenue, and the unit specialises in supplying advanced battery packs for use in the most demanding environments, including pipeline inspection in the oil and gas industry, military and security applications, and in the medical and aerospace sector. Bearing in mind this industry bias, it's worth noting that demand from the oil & gas sector, accounting for between 30 and 40 per cent of the battery division's revenues, is recovering strongly after a lengthy period of contraction. True, some of this is restocking after oil exploration clients reined in their budgets during the prolonged downturn, but the directors informed me that there is a "degree of optimism" and they are now seeing interest from the likes of international companies bidding on state-funded oil programmes.

Solid State's rugged and industrial computer business, accounting for a third of its total revenues, is seeing increased demand, too - in this case on the back of digital marketing initiatives and invetsment in additional sales resources. The directors also highlighted how the expansion of the company's added value services in its component distribution division and, in particular, the formation of a component sourcing and obsolescence team, is set to add a brand new source of recurring revenue. In other words, trading prospects for all three manufacturing business, which account for almost 70 per cent of the company's profits, are positive as the record order intake would suggest.

I can reveal that chief executive Gary Marsh confirmed during our call that the company's lower-margin distribution business, which is focused mainly on specialist electronic components and displays, is trading ahead of industry-wide growth forecasts, which point to a 4.3 per cent expansion in the 12 months to the end of March 2018. In fact, the divisional order book is at a record high as is the order intake in the first two months of the new financial year. Products sold here include those for embedded processing, control and communications (both wireless and wired), power management, and LED lighting from globally recognised manufacturers.

The other take for me is that the company has sensibly exited its self-funded security tagging business after the Ministry of Justice mothballed its plans. The potential of this business was the reason why investors got overexcited in 2014 and 2015, during which time the company's share price rocketed. The exit led to a below the line net loss of £400,000 on discontinued activities, but, more importantly, management time can now fully focus on the afore-mentioned growth segments of the business without this distraction. Furthermore, with an ungeared balance sheet boasting net funds of £900,000, and the business cash-generative, expect news on the acquisition front. A number of targets are being actively considered, the contribution from which can only be supportive of earnings upgrades on WH Ireland's conservative forecasts.

In the meantime, and following requests from institutional shareholders, the board is instigating a new dividend policy to target cover of between 2.5 and 2.75 times. The payout was held at 12p a share for the financial year just ended, implying a dividend yield of close to 3 per cent, but is clearly set to rise in the future if current trading trends are maintained, as seems highly likely in my view.

Trading on around two times book value, valued on 12 times historic earnings, and offering a decent dividend yield, I feel the de-rating of Solid State's shares has gone too far and is out of sync with the trading outlook outlined to me by the insiders. Offering decent upside to my 480p target price, Solid State's shares rate a buy.

 

Avation primed for take-off 

The pre-close trading update from aircraft leasing company Avation  (AVAP:220p) is well worth noting for several reasons, not least because the board has announced a 85 per cent hike in the full-year payout to 6¢ a share, materially higher than the 3.6¢ forecast of analysts John Cummins at house broker WH Ireland, and a sum worth 4.65p at current exchange rates. The payout goes ex-dividend on Thursday 20 July.


The board can certainly afford to be generous as they have just delivered a 32 per cent increase in aircraft leasing revenue to $94m (£73m) in the 12 months to the end of June 2017, a performance that supports WH Ireland's expectations of an 18 per cent rise in pre-tax profits to $21.5m to produce EPS of around 25.7p based on an average exchange rate of £1:$1.268. The company has also just completed the sale of six of its existing leased ATR 72 aircraft to a single commercial lessor, Chorus Aviation Inc. (TSX: CHR), in a transaction pitched at a premium to book value - and one that released $31m (£23.8m) in net cash proceeds. The gain on that disposal also supports further upside to WH Ireland's spot book value estimate of 310¢ a share, a sum worth 240p. This means that Avation's shares trade on a discount to conservative-looking book value, on a modest 8.5 times earnings, and offer a 2.1 per cent dividend yield. That's cracking value in my view and the investment case becomes even more compelling once you consider recent developments in the ATR market.

That's because at the end of last month, aircraft manufacturer ATR signed a Letter of Intent with Sha'anxi Tianju Investment Group for the purchase of 10 ATR 42-600s to develop a commuter service in Xinjiang, China. The first deliveries are expected to start as soon as possible in 2018. Avation's finance director Richard Wolanski told me that "this is likely to have a bigger impact on Avation and the value of our forward order and ATR option book (38 positions in total) than either of the Indigo or Iran deals", both of which I outlined in my last update when I rated the shares a buy at 203p ('Five small-cap opportunities', 23 May 2017). He has a point as improving connectivity between smaller towns at the lowest operating costs is now a key priority of the Chinese government, so much so that a 'Belt and Road Initiative' has been launched to improve infrastructure, thus supporting economic development and increasing the demand for air transportation.

Bearing this in mind, Mr Wolanski points out that "over half of routes in China carry 100 passengers or less, which is the key market for the ATR with its 42 and 72 seat offerings, so the opportunity in China is for potentially 100's of aircraft". ATR aircraft are widely recognized as the most fuel-efficient aircraft in the regional market, especially for the short-haul sectors. He adds that "essentially Iran, Indigo (and other Indian demand) and the opening of China all represent the same thing, huge new demand for the ATR aircraft which is in limited supply with only 85 units being produced each year". In turn, this demand supports the opportunity for Avation, which "is the lessor that has the largest holder of ATR options and orders at the current time". 

In other words, if demand in China takes off, as seems highly likely, then Avation's portfolio of planes and options is set to become even more valuable. In the circumstances, I am upgrading my fair value price target from 250p to 275p and now rate Avation shares, which have been taxi-ing below May's all-time high of 231p, a strong buy ahead of the full-year results on Thursday 7 September.

 

Unloved and underrated 

Aim-traded shares in 1pm (OPM:44p), a specialist Aim-traded provider of finance to small- and medium-sized enterprises (SMEs) and a constituent of my 2014 Bargain Shares Portfolio, have dipped below the 45p placing and open offer price of an equity raise in May, not to mention the 50p level at which I reiterated my buy advice at the time ('Five small-cap opportunities', 23 May 2017).


However, the share price underperformance is clearly at odds with the company's financial performance, as last week's pre-close trading update highlights. Not only is 1pm set to deliver a 28 per cent hike in full-year pre-tax profit to £4.3m in the 12 months to the end of May 2017, bang in line with analyst estimates, the business also continues to "experience strong levels of demand for finance from the SME sector across its growing range of products, including asset finance (finance lease and hire purchase) for 'hard' and 'soft' assets, business loans, vehicles broking and, latterly, invoice finance". 

New lease and loan business originated and funded increased by 64 per cent to £50.8m in the 12-month trading period, and underpinned the 17 per cent growth in the company's own loan portfolio to £77.5m. Importantly, credit quality remains sound with aggregate impairments of £1.2m representing 2 per cent of the net portfolio outstanding. 

Moreover, the £13m equity raise is being sensibly used to part fund two acquisitions in the invoice factoring and discounting market, thus diversifying the company's revenue mix. Including earn-outs, the consideration of £18m being paid by 1pm represents a reasonable nine times the combined pre-tax profits of these two acquisitions, both of which are expected to be earnings-accretive within two years post completion. The bottom line is that the company's current valuation is completely out of sync with the robust trading outlook, with the shares rated on a single-digit forward earnings multiple and a 10 per cent discount to book value. Buy.

Finally, I am on annual leave all this week and my next column will appear on our website on Tuesday 18 July.