Bargain shares update

A good example is Andover-based Bioquell (BQE:200p), a provider of specialist microbiological control technologies to the international healthcare, life science and defence markets. Bioquell’s patented ‘Hydrogen Peroxide Vapour’ (HPV) technology is seen as the gold standard for bio-decontamination and is used in pharmaceutical manufacturing and life science research laboratories to eradicate contamination, and in critical care facilities in hospitals to control the spread of infection.

Around 18 months ago, I felt Bioquell’s growth potential was being undervalued by the market, so included the shares in my 2016 Bargain Shares Portfolio at 149p. I subsequently recommended selling half your holdings back to the company in June last year when Bioquell bought back 50 per cent of shares in issue through a tender offer at 200p a share following the sale of one of its businesses. However, I was still bullish on the company’s trading prospects, so recommended using the proceeds from the tender offer to buy back the shares in the market at around 145p to reduce your average buy-in price to only 125p (‘Bargain shares updates’, 22 Jun 2016). The industry backdrop was certainly favourable at the time as a number of different drivers were positively affecting Bioquell’s business, including the need for customers to achieve regulatory compliance, the increasing threat posed by antibiotic resistance and continuing growth in research and small-scale production associated with cell-based healthcare products.

However, despite the obvious operational progress being made, the holding was still only a few percentage points in the black when I updated the portfolio in February this year ('How the 2016 Bargain Shares Portfolio fared', 3 Feb 2017), and again at the time of the full-year results in March ('Five value opportunities', 15 Mar 2017), thus offering substantial upside to my 180p target price. A trading update at the annual meeting in May was bullish enough and helped the price rally to 166p by the end of that month when I last published an update ('Small-cap trading updates', 24 May 2017), supported by comments from chairman Ian Johnson that "the outlook for the balance of the year remains favourable. In the past six months some radical changes have been made in the structure and focus of the business, resulting in a reduction in the cost base and greater emphasis on the opportunities in the life sciences market." I also noted that over three-quarters of Bioquell's sales are generated overseas so sterling's ongoing devaluation is benefiting margins, as are cost reductions from a restructuring programme. At the time, analyst Chris Glasper at house broker N+1 Singer was pencilling in a sharp rise in pre-tax profit from £1.6m in 2016 to £1.9m this year on revenue up 6.5 per cent to £28.2m, to deliver a 23 per cent hike in EPS to 6.9p.

Those forecasts are dead in the water and so is my 180p target price which has been smashed. That’s because the company has just reported pre-tax profit of £1.4m for the first six months of the year alone, up from just £400,000 in the same period of 2016, on revenues up by almost a fifth to £14.3m. Moreover, management’s guidance is to expect a similar revenue performance in the second half, which leads Mr Glasper to believe a 15 to 25 per cent profit upgrade is in order, implying pre-tax profit at the top end could rise by almost half to £2.4m this year to deliver EPS of 8.6p.

The margin performance was notable with gross margins up from 46 per cent to 52 per cent, partly reflecting favourable exchange rates but also savings in the production process and strong trading in the bio-decontamination service business. New products are playing their part too including an ergonomic fixed, wall-mounted bio-decontamination system that has proved very popular since launch in the fourth quarter of 2016; and Bioquell QUBE, a novel, modular aseptic work-station incorporating HPV technology used to provide an aseptic environment for a range of applications including: sterility testing; the production of toxic, intravenous oncology drugs; and the production of small-scale cell-based healthcare products. Revenues from that product alone more than doubled to £1.6m in the first half of this year.

The other key take me for me in the half-year results was Bioquell’s robust cash-flow performance and tight working capital management which resulted in net cash from operating activities trebling to £3.8m and net funds increasing from £7.3m to £11.8m, and that’s after taking into account £300,000 spent on a share buyback. Net cash now equates to 52p a share, or just over a quarter of the share price, so after factoring in likely earnings upgrades the shares are currently rated on 17 times cash-adjusted forward earnings, a rating that should offer scope for further upside.

Indeed, with the industry backdrop favourable, new product launches clearly delivering, the company in an earnings upgrade cycle, and the board set to continue making earnings accretive share buybacks in the second half, then I continue to rate view the investment case favourably. In fact, I have a new target price range of between 225p and 250p based on a current year enterprise value to cash profit multiple of between 8.2 to 9.2 times. Buy.

Renewals buoyant at Mind + Machines

Bioquell is not the only constituent of my 2016 Bargain Shares Portfolio to report strong trading. The same is true of Minds + Machines (MMX:12.5p), a service provider in the domain name industry focused on the new top-level domain (TLD) space. The share price has risen by 56 per cent since I included the shares at 8p in last year’s portfolio, and although the price has flatlined since my last update ('Small-cap gems', 13 Jun 2017), there look to be very decent prospects of further upside for a number of reasons.

Firstly, the company has just revealed that first year renewals of its .vip domain are running at 75 per cent with over 317,000 registrations taken in the first month alone. That’s not only well ahead of competing Chinese-focused new TLDs, but is ahead of industry leader Verisign (.com and .net domains) which just reported renewal rates of 68 per cent. This is important because revenues from .vip accounted for 59 per cent of the company's gross billings last year, so with renewal rates robust, and after factoring in renewals across Minds + Machines' entire portfolio of 29 TLDs, analyst Harold Evans at FinnCap believes the company’s full-year renewal revenue could rise by 60 per cent to $6.1m (£4.7m) and exceed its operating costs, thus achieving a key target of the board. The launch of Mind + Machines’ .boston geographic TLD is scheduled for later this year and can only be positive for future billings too.

Secondly, a couple of months ago the company appointed US investment bank Headwaters MB to review various strategic options to maximise value for shareholders including a posssible acquisition by or sale/merger of the company (‘Corporate activity boosts bargain shares’, 31 May 2017). Discussions are ongoing with “a number of interested parties from Asia, North America and Europe” and I firmly believe that any deal will place a value on the equity well in excess of the 13p a share that Goldstream Capital Management paid last year for its 6 per cent stake. Goldstream is owned by Hony Capital, a leading Chinese private equity company. As Mr Evans rightly points out with operating costs set to be covered by renewal revenue then Mind + Machines is “potentially a high-margin business – a 50 per cent operating margin is not unrealistic in the coming years”. He also calculates that even if the .vip domains under management are maintained at the current level of 824,000, this could generate $8.8m (£6.9m) of annual billings, and suggests a valuation of £57m for .vip alone. To put this valuation into some perspective, Mind + Machines’ entire portfolio of 29 TLDs including .vip is only in the books for $45.6m, or £35m at current exchange rates, and the company also has net funds of £12m on the balance sheet.

In my view, a valuation of 18p a share is not out of place in the event of a major corporate transaction taking place and I continue to rate the shares a buy at 12.5p ahead of the next update on the strategic review which will be given at the time of the half-year results in September. Buy.

Bowleven repeat buying opportunity

I included shares in small-cap Africa-focused oil and gas exploration group Bowleven (BLVN:26p) at just shy of 19p in my 2016 Bargain Shares Portfolio and was so convinced of the potential for further upside that I recommended buying them again in my 2017 portfolio at 27.75p. The share price subsequently rallied to 37.75p in March this year, or almost double my original entry point, but has come off the boil and is now below the 30.75p level at which I last reiterated my buy advice ('Corporate activity boosts Bargain shares', 31 May 2017).

However, the investment case has not changed even if the share price has given back some of those hefty gains. Namely, activist shareholder Crown Ocean Capital, a Monaco-based private investment vehicle which has taken a 25 per cent stake in the company and is now running affairs having ousted the former board, is pursuing a strategy of turning Bowleven into a holding company that does not pursue any new exploration activity; is streamlining costs with monthly overheads being slashed to $350,000 in the second half this year; and is relying on contractors for any additional support needed to ensure a proper stewardship over the company's Etinde and Bomono assets in Cameroon.

Once all the development options for the gas monetisation of both the Etinde and Bomono assets have been determined, Bowleven's board will be able to assess the cash requirements of the business and whether surplus assets can be returned to shareholders. Clearly, there will be a cash return given that the £83m market cap company had net funds of $90m (£69m) at the end of March 2017 and has access to a $40m (£30.5m) net drilling and testing carry that should cover its share of two appraisal wells on Etinde. In addition, Bowleven is due to receive a further $25m (£19m) on achieving the final investment decision at the Etinde project. Also, the new board remains in discussions with the Cameroon authorities in relation to the outstanding approval of the Bomono farm-in which will allow Bomono hydrocarbons to be produced into the Victoria Oil & Gas (VOG:46p) Gas du Cameroon pipeline and connect Bomono into the domestic gas market through the existing pipeline infrastructure.

The bottom line is that exploration assets with a carrying value of $217m in Bowleven’s last accounts, a sum equating to double its current market capitalisation, are effectively in the price for free. That’s anomalous and any positive news on the capital return would undoubtedly act as a catalyst for a sharp rerating. So, ahead of the company releasing its half-year results in September, I continue to rate Bowleven’s shares a buy.

MORE FROM SIMON THOMPSON... 

A comprehensive list of all the investment columns I have written in 2017 is available here.

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