Exploiting hidden value

With this thought in mind, there is a glaring valuation anomaly on offer in the shares of cash-rich insurance sector investment company BP Marsh & Partners (BPM:230p). It's a business I know well, having initiated coverage over five years ago at 88p ('Hyper value small-cap buy', 22 Jan 2012), and last rated the shares a buy at 230p ('Investment company watch', 31 Jul 2017). A pre-close trading update ahead of the half-year results on Tuesday 17 October suggests my bullish stance is likely to be vindicated for a number of reasons, the most obvious of which is that the company’s net asset value (NAV) per share is set to rise sharply again.

Having sold off its stake in Besso Insurance, a top 20 independent Lloyd's broking group, a deal I commented on at the time ('Four undervalued growth plays', 24 Apr 2017), BP Marsh has been shrewdly investing the £22m cash raised. The company invested £7.3m to increase its stake from 43.1 per cent to 60.87 per cent in LEBC, an independent financial advisory firm. This effectively values LEBC’s entire equity at £40m, or a third more than the implied value in BP Marsh’s last set of accounts and suggests a valuation of 20 times LEBC’s historic trading profit, a rating that’s in line with that of listed rival Mattioli Woods (MTW).

However, LEBC has been so successfully targeting the ‘at-retirement market’ following the introduction of the Retail Distribution Review that its trading profit has almost trebled to £2.1m in the three years to the end of September 2016. This is attracting attention from other investors as chairman Brian Marsh revealed during an earlier conversation that “every now and again we are passed an enquiry to buy LEBC” and the January 2017 valuation “is a long way below these approaches". At the very least we can expect a £4.2m uplift, worth 14p a share, to BP Marsh’s last reported NAV of £79.7m, or 276p a share, from the holding in LEBC.

There are also sound prospects for valuation gains on the company’s 18.6 per cent holding in Nexus Underwriting, an independent speciality Managing General Agency. This investment was valued in BP Marsh’s last accounts at £13.9m, placing a value of £74m on Nexus’s equity, the equivalent of 15 times last year’s cash profit. To put this into perspective, earlier this year Hyperion Insurance sold its majority stake in CFC Underwriting to a consortium of private investors and the management team on a multiple of 22 times cash profit.

Furthermore, Nexus’s board has been raising guidance. This is partly due to three debt funded acquisitions: Zon Re Accident Reinsurance, a US-based Reinsurance Underwriting Agency; marine cargo specialist Vectura Underwriting; and trade credit specialist Equinox Global. But there is strong organic growth coming through, too, which is why Nexus’s board predicts this year’s cash profit will more than double to £11m on gross premium income of £160m, a performance that makes the £74.7m implied valuation of Nexus’s equity in BP Marsh’s last accounts not only overly conservative, but ripe for a major uplift. I would also flag up that none of the companies BP Marsh invests in have insurance risk to the US hurricane season, but clearly they will benefit from a tightening of the insurance market when the major insurers start hiking premiums as they always do after paying out billions of dollars of claims.

The bottom line is that I can see BP Marsh’s NAV heading towards 300p a share when it next reports, suggesting the share price is trading on an unwarranted discount to book value. And because the board have a policy of buying back shares when the share price discount to NAV exceeds 25 per cent, then this effectively creates a floor around the current share price. Add to that a 1.5 per cent dividend yield, a £13m cash pile worth 44p a share that’s still to be invested, and BP Marsh’s shares rate a strong buy in my view ahead of next month’s results. My target price range between 260p and 275p is not unreasonable. Buy.

Volvere hits another record high

Shares in Aim-traded investment company Volvere (VLE:810p) surged to another record high post a bumper set of half-year results, thus vindicating my stance to run profits on this fantastic holding ahead of the numbers ('Corporate activity boosts Bargain shares', 31 May 2017). The shares have now risen by 90 per cent since I included them in my 2016 Bargain Shares Portfolio, and there is scope for more upside, too, so much so that I now rate them a buy again.

The key take for me was the performance of Impetus Automotive, a provider of consulting services to the automotive sector in which Volvere has an 83 per cent stake. In its first full year under Volvere's ownership, Impetus delivered £1.49m of pre-tax profit on revenue of £17.4m in 2016 before inter-group management and interest charges, an eye-catching performance that reflected an improved client focus, staff efficiency and better back-office systems. However, in the first six months of the 2017 financial year, Impetus has surpassed those numbers, reporting a trebling of pre-tax profit to £1.54m on revenue up by more than half to £12.2m. The growth is all organic and has been bolstered by a contract for the management and delivery of a large automotive manufacturer's learning and development activities in the UK. Impetus is being seriously undervalued in Volvere’s accounts, too, as only £3.3m of the company’s NAV of £26.6m is attributed to Impetus, or just 1.3 times the subsidiary’s rolling 12-month rolling pre-tax profit, suggesting that a sizeable valuation uplift is in order.

Admittedly, 80 per cent owned frozen pie and pasty maker Shire Foods felt the impact of higher raw material costs following sterling's devaluation, and the decision of a customer to bring manufacturing in-house impacted the performance. First-half revenue was slightly ahead of the same period last year, but the business dipped slightly into the red in the first half. However, profit is heavily skewed to the colder winter months when Shire makes all its profits, and guidance is for a better second-half performance. So, although Shire is up against it to match last year’s pre-tax profit of £1.15m on relatively flat revenue of £15.2m, it’s still profitable and a carrying value of £5.4m for this business in Volvere’s accounts seems far too conservative to me.

Volvere’s balance sheet remains as strong as ever, boasting net cash balances of £20.5m, a sum equating to 503p a share, dwarfing gross borrowings of £2m, and accounting for three-quarters of its net NAV of £26.9m, or 623p a share after adjusting for minority interests. That’s rock-solid asset backing and so too are the conservatively valued holdings in Impetus and Shire Foods. In my view, these two companies could be sold for 2.5 times their combined NAV of £8.8m in a trade sale scenario. Adjust for cash on Volvere’s balance sheet, and this implies an adjusted NAV of almost 1,000p a share. Buy.

A royal investment worth buying into

Aim-traded shares of property investment company Palace Capital (PCA:350p) has announced a very interesting acquisition and one that should be value accretive to shareholders in the coming years.

The company’s strategy is focused on maximising shareholder returns through carefully selected corporate and direct property acquisitions in key regional UK towns and cities, enhancing recurring income through active asset management and generating capital growth through refurbishment and development initiatives. Bearing this in mind, the company is acquiring a portfolio of 21 freehold commercial properties, comprising of 15 office buildings, four retail properties and two industrial holdings, over 90 per cent of which are located in the Home Counties. These properties are valued at £48.46m, generate an annual income of £3.6m and are all freehold. As part of the deal, Palace Capital is also buying 61 houses and four flats that are predominantly located in the London Borough of Hillingdon. The residential units are fully let, generate an income of £800,000 a year and have been valued by surveyors at £23.3m. These residential units will be in due course sold, subject to price of course, by the end of next summer.

The directors believe the portfolio of commercial properties being acquired has historically been under-managed, so providing potential to improve the rental income through active management as well as enhancing some of the assets by applying for planning permission for a change of use. The properties are geographically complementary as half of Palace Capital’s existing portfolio is located in the south and south west of England.

They have a point as the £48.46m commercial portfolio currently generates an annual income of £3.6m on combined space of 255,374 sq ft, or an average of just £11.45 sq ft. That’s low given the southern bias of the locations, and a void rate of 14.7 per cent has scope to narrow sharply through active management of these vacant properties. The implied initial yield of 7.4 per cent seems fair to me.

The company has structured the deal by acquiring the issue share capital of the target, RT Warren, for £53.3m and will keep in place a £14.5m Barclays loan secured on the properties that is due to expire in January, and is charged at a margin of 1.95 per cent above Libor. The directors intend to renew the facility, assuming acceptable terms can be agreed with Barclays, but to cover the possibility of redeeming it in full they have raised £70m through a placing and open offer of new shares at 340p each – representing a 12 per cent discount to the company’s previous share price of 385p. The open offer is on the basis of one new share at 340p for every 20 held. On this basis, the company’s pro-forma loan-to-value ratio net of cash is under 35 per cent, a comfortable level, thus offering scope to pull off further opportunistic deals.

Furthermore, having announced a final dividend of 9.5p a share on 28 July 2017, the board intends to pay a half-year dividend of 9.5p a share on 29 December 2017 (ex-dividend date: 7 December 2017). This means the rolling 12-month payout is 19p a share, implying a dividend yield of 5.4 per cent. The directors have also stated that they will move to a quarterly payout next year with the first dividend paid in April.

Admittedly, the shares have fallen back on the news towards the placing price and the 335p level where I initiated coverage last autumn ('A royal investment', 17 Oct 2016), and are now below the 395p level at which I last reiterated my buy stance ('A trio of small-cap buys', 22 Aug 2017). I feel the reaction is mainly due to the fact that the company is issuing 21.58m new shares, a sizeable increase on the 25.15m shares currently in issue. However, by my reckoning, after adjusting for the discount to market value Palace Capital has negotiated on the purchase, its NAV per share for the March 2018 year-end is still likely to be north of 400p a share, implying the shares are being priced on an attractive 14 per cent discount.

In the circumstances, I feel the pullback is a buying opportunity. That’s because you can lock in a solid dividend yield of 5.4 per cent, and have realistic prospects for capital growth through a narrowing of the share price discount to NAV and further valuation uplifts resulting from the active management strategies employed by Palace Capital’s shrewd board of directors. Buy.

Cello on acquisition trail

There were no surprises in the half-year results from pharmaceutical and consumer strategic marketing company Cello (CLL:133p) as the numbers were effectively pre-announced in the pre-close trading statement over the summer: adjusted pre-tax profit rose by 8 per cent to £4.6m, buoyed by a strong performance from Cello’s Health business, a performance that warrants analysts maintaining forecasts that point towards a 12.7 per cent rise in full-year pre-tax profit to £11.5m.

However, there were still some noteworthy takes from the release, the most exciting of which is the potential for the company's social media product, Pulsar, which is now gaining 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 social media analytics work is forecast to ramp up from $1.6bn (£1.28bn) in 2015 to $5.4bn by 2020, according to industry 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.

Pulsar is growing strongly and now has 290 clients in the UK, and 20 in the US. Buoyed by an increasing number of clients in the pharmaceutical industry, the business increased its monthly recurring revenue by 65 per cent to £430,000 in the 12 months to the end of June 2017. A renewal rate of 80 per cent indicates a high level of customer satisfaction and warrants the further investment planned by Cello to tap into the opportunity in the US market. Interestingly, based on calculations by analyst Guy Hewett at broking house finnCap, the Pulsar business is effectively in the price for free despite the “potential to be a very valuable asset in a rapidly evolving market”. He also notes that Cello’s shares are trading on a 30 per cent discount to the wider healthcare consulting peers.

Acquisitions are set to play an important part in Cello’s earnings growth story too after the company raised £14.2m net proceeds at 97p a share in a placing in February, of which $5.25m (£3.9m) was earmarked for the purchase of Defined Healthcare Research, a business delivering scientific strategic advisory services to a wide range of US, European and global biotech and healthcare clients. I commented on this deal in my last article ('Five growth opportunities', 30 May 2017).

Since the half year-end, Cello has acquired New Jersey-based Advantage Healthcare, a consultancy providing critical analysis and insights in biopharmaceuticals. Advantage Healthcare adds further depth to Cello Health's ability to work from the early stages of drug development and across the life cycle to assist clients in meeting their most mission critical challenges. The acquisition also reinforces Cello Health's commitment to the core US market and its aim of becoming a leading global health services company. In fact, about 40 per cent of Cello Health’s gross profit are now derived from North America, and rising. The initial cash consideration was $1.5m with a $3m earn-out payable dependent on future financial performance, a fair price for a business that made $300,000 of operating profit last year.

Moreover, expect further acquisitions to bolster Cello’s Health division as the company not only has ample headroom on a £25m debt facility, but a seasonal working capital outflow in the first half is expected to unwind in the second half, which should result in the company reversing its current net debt position of £6.8m to end the 2017 financial year with net funds of £5.2m, according to Mr Hewett at finnCap.

So, although the shares have hit my 130p target price, prompting me to advise running profits at 137p ('Five growth opportunities', 30 May 2017), having initiated coverage at 105p last autumn ('Marketing a breakout', 5 Sep 2016), I feel that it’s still worth running profits on your holdings as the forward PE ratio of 15.5 has potential to drop sharply if Cello uses its cash and low interest debt facilities wisely to make earnings-accretive acquisitions. Furthermore, based on forecasts of a hike in the full-year payout from 3.4p to 3.6p a share covered more than two times over by adjusted EPS of 8.1p, as analyst Johnathan Barrett at brokerage N+1 Singer predicts, there is a decent 2.7 per cent prospective dividend yield for income seekers. Run profits.

Toys 'R' Us bankruptcy protection

The move by private equity owned and highly indebted global toy retail giant Toys 'R' Us to file for Chapter 11 Bankruptcy protection in the US has an impact on Character (CCT:490p), the owner of a portfolio of 10 long-lasting iconic toy brands targeting the niche pre-school market.

The company makes its money by licensing brands, developing products and then distributing them after outsourcing manufacturing to China. Top-performing brands include Peppa Pig, licenced from Entertainment One (ETO), the largest film distributor in Canada and the UK and the distributor and joint-venture owner of the brand; Minecraft which is owned by Microsoft (US:MSFT) and out-licensed to Jazzwares; Little Live Pets by Moose Enterprises; and Teletubbies owned by DHX Media, the most recognised pre-school brand in the world. Tinky Winky, Dipsy, Laa-Laa and Po are still working their magic in Teletubbyland, and for Character's range of products too as Teletubbies was the company’s third-best performer in the first half.

It's a global business as half the product range is for international companies, and a quarter of sales are overseas. The 10 iconic brands account for over two-thirds of its annual sales, and a key customer, accounting for 8 per cent of Character’s annual sales of £120m last year, is Toys 'R' Us. Character’s total exposure is mainly to Toys 'R' Us UK, which is not included in the bankruptcy protection, with less than 3 per cent of its total sales exposed to the North American business.

Bearing this in mind, analyst Peter Smedley at brokerage Panmure Gordon notes that “in the event that credit protection is withdrawn, then the company would likely redirect uninsured Toys 'R' Us-bound orders to other toy market retailers”. The Chapter 11 bankruptcy protection of Toys 'R' Us has come about post Character’s 31 August financial year-end, so has no impact on the performance for that period. Indeed, the directors have stated that it has traded in line with analyst profit estimates for the 12-month period: analyst David Johnson at Allenby Capital forecasts a modest rise in reported pre-tax profit to £13.5m on revenue of £116m to produce a 5 per cent-plus rise in EPS to 53p and support a hike in the dividend per share from 15p to 19p.

The company had net funds of £18.6m at the end of the first half to the end of February 2017, so even after taking into account the seasonal outflow of stock build ahead of the Christmas trading period, Mr Smedley at Panmure Gordon still expects it to have ended the financial year with net funds of £14m, a sum worth 67p a share. This is a solid funding position and Mr Smedley believes that “none of Character’s financing arrangements (such as bank overdrafts, finance advances, import loans) are entangled with the Toys 'R' Us bankruptcy risk.”

Quantifying the financial impact

Of course, the problems at a major customer clearly impacts earnings visibility for the new financial year to the end of August 2018. The directors of Character have said that “at this early stage, we do not know the extent to which this will impact our trading position with them both in the UK and internationally”. However, it’s only reasonable to assume that toy suppliers will cut back their exposure to the beleaguered US chain in the coming months.

In this happens and uninsured Toys 'R' Us-bound orders are redirected to other toy market retailers then this will have an impact on pricing and margins. This explains why Mr Johnson at Allenby Capital has prudently reduced his current year revenue estimate by 9 per cent to £117.8m and lowered his pre-tax profit estimate from £14.6m to £13.7m. Still, that outcome should lift EPS modestly to around 54p and support another double-digit rise in the dividend to 23p a share, too. On that basis, the shares are rated on a modest nine times forward earnings and offer an attractive 4.8 per cent prospective dividend yield.

Importantly, this looks more of a company-specific problem for Toys 'R' Us, rather an industry one, as the global toy industry has actually been growing by low single digits in the past few years. The problems at Toys 'R' Us have come about following a highly leveraged buyout of the giant toy retailer over a decade ago which has left it with $4.9bn of debt, of which 40 per cent is due to mature in the next few years. Funding that debt mountain has been exacerbated by the intense competition the group faced from online retailers and big supermarkets, such as Amazon and Walmart.

It’s therefore reassuring to know that Character continues to win new business, having announced over the summer that the brand owner of Teletubbies has awarded it a master toy licence for a further three years for worldwide manufacturing rights and UK distribution. Earlier this month, Character was appointed the master toy distributor in the UK and Ireland for the globally popular Pokémon brand. The agreement between Character and the global master toy licensee, Wicked Cool Toys based in the US, will see action figures, playsets, plush, role play and other toys based on the hit Pokémon animated series, join Character's portfolio from summer 2018.

Investors appear to be taking a sensible approach which is why Character’s share price are only 5 per cent below the 520p level at which I last advised buying ('Value opportunities', 30 Jan 2017), having first recommended buying at 415p ('Playtime', 1 Jun 2015), since when the board has paid out dividends of 35p. I am comfortable maintaining a positive stance because the cash-rich company is not only well funded to take a hit on Toys 'R' Us – when Woolworths collapsed in 2008 the loss there was about £2m – but even after prudent downgrades the shares are still only trading on single-digit earnings multiple.

As an aside, it’s worth noting that a large proportion of Character’s input costs are effectively in US dollars, so the 13 per cent recovery in sterling against the US dollar this year will ease some of the currency led input cost pressures it has been facing since the start of 2016.

I have also taken into consideration news that finance director Mark Dowding has recently left the company due to “a loss of confidence in him by the senior executive team”. This is clearly not ideal, but I am assured the reason behind him leaving the company has nothing to do with the trading performance of the business, nor its finances. Kiran Shah, joint managing director and 10 per cent shareholder, will assume the responsibilities of finance director, a role he previously held within the business until February last year, so he is an able replacement.

So, having taking all these factors into account, I am happy running profits on the holding with a view to upgrading my stance back to an outright buy when the company announces results in early December. By then we will have a clearer view of the financial ramifications of the Toys 'R' Us bankruptcy protection. If the fallout is no worse than Allenby Capital’s models suggest, then my previous fair value price range between 625p and 675p will come back into play again. Run profits.

Epwin shares worth holding onto

Five weeks ago, I recommended holding onto your shares in Epwin (EPWN:80p), a manufacturer of extrusions, mouldings and fabricated low-maintenance building products, following a profit warning (‘Targeting a break-out’, 21 Aug 2017) that led analyst Andy Hanson at house broker Zeus Capital to cut his full-year pre-tax profit forecast by almost 8 per cent to £22.8m, and next year’s estimate by 9 per cent to £23.5m after taking into account input cost pressures, particularly in resin and hardware, and ongoing weak markets.

The news sent the share price tumbling from 97p to 67p, well below the 103p mark at which I first advised buying when the company joined London’s junior market ('Moulded for gains', 29 Jul 2014). Even after taking into account total dividends of 17.2p a share declared in the interim, the holding was under water. However, I felt the bad news, and possibility of further downgrades was more than priced in. And so too have other investors which is why Epwin’s shares have rallied 20 per cent to 80p even though Mr Hanson cut his forecasts again, predicting pre-tax profit of £21.3m in 2017, falling to £19m in 2018, post this month’s half-year results.

This reduces EPS forecasts to 12.3p and 10.9p, respectively, for this year and next, implying Epwin’s shares are currently rated on seven times next year’s earnings estimates. Those forecasts easily cover a maintained dividend of 6.6p a share, implying a dividend yield of 8.2 per cent, but more importantly so too does cash-flow cover: Mr Hanson predicts Epwin will generate free cash flow of £10m this year from operating cash flow of almost £23m, a sum that covers the £9.5m cost of the payout. The directors also made the valid point that the company’s net borrowings of £28.2m equate to less than one times its annual cash profit (Zeus's cash profit forecast is £30.5m for 2017, falling to £28.3m in 2018), and the business has significant headroom on its debt facilities to invest.

Reassurance on the dividend aside – the board were confident enough to edge up the half-year payout to 2.23p a share – the other reason why the shares have rebounded is because the administrators of Entu (ENTU), a company accounting for 5 per cent of Epwin’s revenue, have indicated that they will continue to trade and invest in the business. Epwin is supplying products on a cash basis and is writing off £3.9m as a bad debt to Entu, of which the cash cost is £2.5m, but this is a sum it can easily absorb and by maintaining the trading relationship Ewpwin will be able to recover some of the write-off through future profits.

I also feel that investors are taking a sensible approach to the other major issue that has created uncertainty. Namely, one of Epwin’s customers, building products distributor SIG (SHI:177p), has sold its building plastics business to a rival, GAP Plastics. SIG’s business accounts for 5 per cent of Epwin’s forecast revenue of £293m, so there is a risk that GAP Plastics may substitute some volume for its own in-house products. However, a sizeable proportion of the volume supplied here is specified by the client, so these contracts can be relatively sticky to unwind, and it’s unclear how much extrusion capacity GAP Plastics has available to take on this business. All is not lost here, either.

I would also flag up that Epwin’s management team have taken action to rationalise their manufacturing facilities including the consolidation of sealed glass unit fabrication from two sites into one in Northampton. The cost of these actions is around £2.5m but with a two-year payback period, thus offsetting the full financial impact of the anticipated decline in sales next year, which points to revenues falling from £293m to £279m, according to Zeus Capital’s latest estimates.

The bottom line is that although the trading backdrop remains challenging, a factor I have been fully aware of when making my past recommendations, and earnings expectations have been reined back again, the 8.2 per cent dividend yield, and a forward PE ratio of seven for 2018 are clearly supportive.

In the circumstances, I would continue to hold Epwin’s shares, at 80p, if you have been following my advice. Please note that the half-year payout of 2.23p a share has now gone ex-dividend and is payable on Friday 20 October. Hold.

■ 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