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Inflexion points

Simon Thompson highlights a trio of small-cap shares that are about move into profitability.
September 20, 2017

Aim-traded Bango (BGO:248p), a provider of a state-of-the-art mobile payment platform that enables smartphone users to charge purchases made in app stores straight to their mobile phone account, produced an eye-catching set of first-half numbers this week.

The directors also reiterated guidance that the business will hit operating profitability on a monthly basis in the second half. Profits will accelerate sharply thereafter given the company’s high operating leverage: operating costs are stable at around £5.4m a year, and Bango has already invested over £30m in its payment platform and stress tested it to take transaction levels of around £5bn. This means that having hit an inflexion point then a high percentage of incremental fees earned from processing payment transactions will now drop straight down to the bottom line.

The exit run-rate of end-user spend (EUS) processed through its payment platform hit £300m at the end of June, up from £195m at the start of the year, and has since accelerated to over £400m at the end of August, or 42 per cent ahead of analyst Ian McInally’s forecast at house broker Cenkos Securities. This prompted him to raise his end-2017 and 2018 EUS forecasts by 8.8 per cent and 19 per cent, respectively, to £452m and £913m, but even those numbers could prove conservative given the strong drivers behind the ongoing growth.

For example, chief executive Ray Anderson told me during our results call that two Middle Eastern mobile operators who migrated their Google Play routes to Bango’s platform in the first half saw a 35 per cent increase in their EUS immediately, highlighting the benefits of the company’s big data product, Bango Boost, which enables more cost effective and targeted marketing programmes of a client’s content and services. This can only lead to further migration of established Google Play routes to the Bango Platform. Mr Anderson has identified “sources of migrations that can bring in billions of dollars of EUS”.

The groundbreaking direct carrier billing agreement (DCB) with Amazon Japan, which started in June, is also noteworthy. Firstly, it enables customers with a KDDI or NTT DOCOMO mobile phone account to pay for goods purchased from Amazon.co.jp by charging the cost of them to their mobile phone account. These two carriers account for three-quarters of the Japanese market, and have a combined 123m customers, so this is potentially a transformational deal for Bango. That’s because over half of all e-commerce transactions in Japan are currently completed by a mobile platform, reflecting low levels of credit card penetration, and highlighting the potential to tap into Amazon's e-commerce revenue of ¥999bn (£6.7bn) in 2016. It’s only reasonable to expect Amazon to enter into similar agreements with Bango in other territories if the Japanese arrangement works out.

Furthermore, following the announcement of the Amazon deal, other online international retailers who want to tap into the huge Japanese retail market have been in contact with Bango with a view to using its mobile payment platform. Bango is also targeting the payment platform in other similar mobile centric countries in the Asia Pacific Rim, Singapore and Taiwan being notable areas.

The other key take for me was the closing cash position of £5.6m which will be sufficient to fund the business without the need to tap shareholders, according to finance director Rachel Elias-Jones, who is also comfortable with analyst forecasts that point towards Bango generating cash profit of £3m on a total EUS of £591m in 2018. But that could be a drop in the ocean if Bango continues to double EUS year on year, as it has done for the past three years.

To put the growth potential into perspective, industry experts believe that the DCB market could generate transactional value in excess of $25bn (£18.4bn) by 2020. Based on a market share of 8 per cent this would give Bango an annualised end-user-spend of $2bn in three years time. Assuming its gross margin declines from 1.79 per cent in the first half of this year to 1.4 per cent by 2020, reflecting the lower fees earned on high volume routes, then on £1.5bn-worth of transactions its gross profit could soar to £20m and generate north of £10m of post-tax profit, a chunky sum relative to Bango's current market capitalisation of £155m. I would also point out that Bango has accumulated tax losses of £35m to offset against future profit, reflecting the substantial spend in its platform and marketing channels, so shareholders can expect a chunk of future profit to be tax free.

Admittedly, Bango’s shares have risen 166 per cent since I first advised buying at 93p ('Bang on the money', 26 Sep 2016), so investors are now cottoning onto the growth potential. However, I feel that my target price of 300p, valuing the equity at £200m, or 10 times my estimate of 2020 net profits, is not unrealistic. So, having last advised buying at 225p (‘Repeat buying opportunities’, 29 Aug 2017), I continue to rate Bango’s shares a strong buy.

 

Funded for robust growth

Half-year results from specialist asset manager Gresham House (GHE:335p), a constituent of my 2016 Bargain Shares Portfolio, made for a good read and suggest that house broker Liberum Capital’s fair value of 448p a share is achievable. The target is based on a valuation of one times the company’s net asset value of £29.7m, or 238p a share, plus 4 per cent of forecast closing assets under management (AUM) of £658m at the end of the 2018 financial year, a sum worth £26.3m, or 210p a share.

Gresham House is certainly making strong progress to Liberum’s target having lifted AUM by 50 per cent to £532m in the six months to the end of June 2017, all of which was organic, an outcome that doubled management fee income to £2.4m and cut the adjusted operating loss by a third to £800,000. Guidance from the management team led by chief executive Tony Dalwood, who has orchestrated the transformation of the business since coming on board three years ago, suggests the business hitting run-rate profitability in the second half of this year, far sooner than Liberum had forecast. A number of mandate wins and fund launches underpin the move into profitability.

For example, the first close of its British Strategic Investment Fund (BSIF), a closed-ended Guernsey Limited Partnership with a 12-year life, raised £150m of capital from pension funds, endowments and family offices. The fund is focused on generating attractive returns in a cost-effective manner from relatively illiquid investments in UK housing and infrastructure-related assets that have low correlation to traditional asset classes and a positive link to inflation. The aim is to achieve an annualised net total return of between 8 and 10 per cent including an annual income yield in the range 3 to 5 per cent. A final close is planned for the second half of 2018 and is supportive of further growth in fee income.

Gresham House’s forestry funds are putting in a solid performance, too. AUM here increased by 5 per cent to £258m in the first half, having risen by 20 per cent last year, with the final close of the Gresham House Forestry Fund, which raised £15m at first close in October 2016, set for the second half. This fund is targeting net returns of 10 per cent a year, and an annual distribution of between 2 per cent and 4 per cent from timber sales. The move into forestry came about after the purchase of forestry asset manager Aitchesse for an initial consideration of £4m plus earn-outs of up to £3.7m. Importantly, the acquisition is delivering investment returns ahead of Gresham House’s long-term hurdle rate of 15 per cent. So too is an asset management contract with private equity investment trust LMS Capital (LMS:47p) which Gresham House took over just over a year ago.

I would flag up that the company’s net asset value of £29.7m includes net cash of almost £11m following the recent £7.25m disposal of a legacy commercial property in Speke, Liverpool; a shareholding worth £6.5m in investment company Gresham House Strategic (GHS:850p), another constituent of my 2016 Bargain Shares Oortfolio and one in which Gresham House’s asset management arm has the investment mandate; £2m deferred consideration due from Persimmon (PSN) on a land sale; and a £2.25m legacy land site, nearby to the one sold to Persimmon, which will be sold in time.

 

A fair valuation

The point being that it’s only reasonable to value Gresham House’s fast-growing fund management business as a separate entity to these other assets, hence the rationale behind Liberum’s fair value estimate. So, based on Gresham House’s market value of £42m, this means that its asset management business is effectively being valued at only £12m, or 2.2 times total AUM. That’s a harsh valuation for a business that’s about to hit run-rate profitability and will shortly complete the acquisition of renewable and infrastructure group Hazel Capital. This will add more than £100m of AUM to the total including Venture Capital Trusts (VCTs) and Enterprise Investment Schemes that have been structured to generate attractive yields with downside protection provided by strong real asset backing.

For example, Hazel Renewable Energy VCTs launched in 2010 and have achieved market leading performance, boasting net returns in excess of 50 per cent before any tax benefits. Ahead of completion, which will be funded in a mixture of cash and shares, Gresham House is providing growth capital in the form of a secured loan of up to £4.6m to Hazel Capital in order for it to develop its immediate pipeline of energy storage system projects.

Bargain Shares Portfolio 2016 performance 
Company nameTIDMOpening offer price (p) 5.02.16 Latest bid price (p) 19.09.17Dividends (p)Total return (%)
VolvereVLE419725073.0%
Bioquell (see note one)BQE125215072.0%
BowlevenBLVN18.93528.75051.8%
Mind + Machines (see note three)MMX811.25043.5%
Juridica (see note two)JIL36.1143227.4%
Oakley Capital (see note 5)OCL146.51684.517.7%
Gresham House Strategic (see note six)GHS796842157.7%
Walker Crips (see note 4)WCW44.9461.856.6%
Gresham HouseGHE312.533005.6%
French ConnectionFCCN45.7430-5.9%
Average return    29.9%
Deutsche Bank FTSE All-Share ETF index tracker (LSE:XASX) 341411.416.2825.4%

Notes:

1. Simon Thompson advised buying Bioquell's shares at 149p in February 2016. Bioquell bought back 50 per cent of shares in issue at 200p each in June 2016 through a tender offer and Simon recommended buying back the shares in the market at 145p to give an average buy-in price of 125p (‘Bargain shares updates’, 22 June 2016).
2. Simon Thompson advised buying Juridica's shares at 41.2p in February 2016. Juridica subsequently paid out a special dividend of 8p a share in June 2016 and Simon recommended buying shares in the market at 61p using the cash proceeds to take the average buy in price to 36.1p (‘Brexit winners', 1 August 2016). Juridica then paid out a special dividend of 32p a share in September 2016 and total return reflects this distribution. Simon advised to sell at 14p ('Taking Q1 profits and running gains', 4 April 2017), hence the price quoted in the table. Please note that Juridica has since paid out a further special dividend of 8p a share and current share price is 7.5p.
3. Simon Thompson advised buying Mind + Machines shares at 8p in February 2016. Mind + Machines subsequently bought back 13.22 per cent of the shares in issue at 13p a share. The total return reflects this capital distribution.
4. Walker Crips has paid out dividends of 1.85p since 5 February 2016.
5. Oakley Capital paid out a maiden dividend of 4.5p on 30 January 2017.

6. Gresham House Strategic paid out a dividend of 15p on 21 July 2017.

So, with a move into profitability imminent, Gresham House well funded to make further acquisitions and maintain its strong organic growth, the company has passed an inflexion point which I expect investors to acknowledge in time. True, the shares have been a slow burner since I included them at 312.5p in my 2016 Bargain Shares Portfolio – the price was unmoved when I updated the portfolio earlier this year (How the 2016 Bargain share portfolio has fared’, 6 Feb 2017) –  but a rerating looks well overdue. From a technical perspective, a break-out above the November 2015 high of 352.5p would be a strong buy signal, and one pointing towards a rally to the 2011 summer highs around 432p, which neatly coincides with my raised target price. Buy.

 

Making the right connection

Shares in high street clothing retailer French Connection (FCCN:44p) are the other laggard in my 2016 Bargain Shares Portfolio, having flatlined for the past 19 months. The key to a rerating is the same as it was back then: cutting losses on the retail side which are proving a major drag on its hugely profitable wholesale and licence operations, so that the company can move back into profit.

Admittedly, progress has been slow, but seasonal first-half pre-tax losses did narrow from £7.9m to £5.7m, reflecting a better retail performance and a slimmed down estate, and guidance from chairman, chief executive and 41 per cent shareholder Stephen Marks is encouraging. He says that “we have definitely seen momentum build in the first half with improvements across all the divisions despite difficult trading conditions. With full price sales in retail up during the early part of the second half, combined with the strong winter 2017 order books in wholesale and very strong reaction to the spring 2018 collection, I am confident that we will see a good performance during the rest of the year.” We have been here before, but it’s worth noting that Mr Marks now believes “we have made significant steps to achieve that goal [return the group to profitability] in the near future".

I still maintain the view that if this can be achieved then the shares will warrant a far higher rating than book value of 46p a share, especially as 15 per cent of the market capitalisation of £43m is cash, and this will build in the second half as stocks are sold. So, having last rated the shares a speculative buy at 36.5p ('Going for growth', 20 Mar 2017), I am maintaining that stance. Buy.

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com for £14.99, plus £2.95 postage and packaging, or by telephoning YPDBooks on 01904 431 213 to place an order. It is being sold through no other source. Simon has published an article outlining the content: Secrets to successful stock picking