I have been taking a very close look at Scisys (SSY:102p), a supplier of bespoke software systems to the media, broadcast, space, defence and commercial sectors.
My interest was sparked at the end of last year when the £29.7m market cap company made the acquisition of Munich-based Annova Systems, a supplier of software-based editorial solutions, principally to the Northern European media sector. Annova has developed some rather smart software, OpenMedia, to enable story-centric workflows for news to be created for distribution on any medium. It’s proving popular as its customer base includes major public and commercial broadcasters in Germany, Switzerland, France, Belgium and Turkey. It’s proving a hit in the UK, too, as a couple of years ago Annova won a large 12-year contract with the BBC to replace its previous newsroom system with OpenMedia.
It was a chunky deal for Scisys which funded €10m (£8.7m) of the initial €11.35m consideration through a five-year unsecured bank loan with Deutsche Bank, repayable in quarterly instalments of €500,000 with interest charged at 2.9 per cent a year. There is also a maximum €16.5m three-year earn-out of which €2m was paid in August after a live pilot milestone on the BBC project successfully completed. Scisys paid 90 per cent of that €2m sum in cash and satisfied the balance by issuing the vendors with €200,000-worth of new shares which have a 36-month lock-in period.
I have been patiently biding my time waiting to see how the acquisition performed. The news is rather good as during my lengthy call with chief executive Klaus Heidrich and finance director Chris Cheetham, the directors told me that Annova cash profits for the 2016 financial year actually exceeded the €1.1m to €1.2m the company had forecast at the time of November’s acquisition. I also needed to know more about the earn-out schedule and Scisys ability to fund the future payments. It was therefore reassuring to discover that Annova’s cash profits will have to average more than €1.5m for each of the 2017 to 2018 financial years before anymore earn-outs are paid. Mr Cheetham is forecasting an average cash profit contribution of €1.7m to €1.8m for the two financial years. On the basis of these forecasts, Scisys will pay a total consideration of €18m for Annova including all earn-outs, or the equivalent of 10 times cash profits. Clearly, if Annova continues to exceed expectations then the earn-out will rise, but I would expect Scisys share price to rise even faster on the back of such positive news.
Mr Cheetham also pointed out that the company’s net debt was cut from £10.2m to £9m in the first half of 2017, and has been reduced further after the June half-year end after Scisys received a £1.1m payment on a €2m contract with the South African Broadcasting Corporation, which involves the rollout out of Scisys’s cutting edge technology dira radio software solution. This software offers an array of functions for radio broadcasters including automatically recording feeds, researching sounds, writing a script, editing an item or planning programmes.
The fact that earn-outs are being made from cash flow from Scisys’s businesses is important, and reassuring too. That’s because it reduces the need for the company to issue shares to meet the Annova deferred consideration of which the equity element is capped at 24 per cent, and means that shareholders’ interests are not being diluted. Scisys raised £1.5m of three-year loan notes by tapping a £5m loan facility through Lesmoir-Gordon, Boyle & Co (LGB) to fund the balance of the initial Annova consideration last November, and this is charged a coupon rate of between 7 to 8 per cent. That may seem high, but interest on debt is tax deductable and the interest rate being charged is still well below the company’s cost of equity. Mr Cheetham says that cash generation and tapping the LGB facility should cover the forecast earn-out payments while at the same time the company is making the €500,000 quarterly capital payments to pay back the Deutsche Bank unsecured loan.
Numbers add up
Bearing the Deutsche Bank debt repayment schedule in mind, and after taking into account the growing profit contribution from Annova, analyst Lorne Daniel at house broker finnCap expects the company’s net debt to decline further to £7.1m by the year-end, falling to £4m at the end of 2018 based on Scisys cash profits increasing from £4m to £5.5m this year, rising to £6m in 2018. The debt reduction is based on free cash 6flow of £5.7m this year and £3.8m in 2018. The point being that as long as Scisys continues to recycle its cash flow into paying off borrowings, then the equity element of its enterprise value will increase pro-rata as more of the value in the business comes under ownership of shareholders rather than debt holders.
Or to put it another way, based on 29.1m shares in issue, the company currently has a market value of £29.7m and an enterprise value of £38.7m. That enterprise valuation equates to exactly seven times this year’s forecast cash profits of £5.5m. So, if cash profits can rise to £6m next year and net debt is reduced to £4m as finnCap predicts, and I will discuss below why this is a sensible prediction, then using the same seven times cash profit multiple gives an enterprise value of £42m. But with net debt only accounting for £4m of the enterprise value, this means the equity element is worth £38m, or 130p a share. That’s almost 30 per cent higher than Scisys’s current share price.
However, even that could be a conservative valuation because there is scope for multiple expansion. That’s because investors are far more likely to value a company’s earnings on a higher multiple if it’s doing well, and they expect it to continue to do so. Clearly, if Scisys delivers a 33 per cent hike in pre-tax profits to £4m this year, rising to £4.4m in 2018 – the respective EPS estimates are 10.2p and 11.2p – then there is strong earnings momentum for investors to warm too and a currency tailwind too as more than half of the company’s revenues are in euros. There is also a progressive dividend: the half-year payout was lifted by 11 per cent to 0.59p a share, in line with finnCap’s prediction of a rise in the full-year payout from 1.96p to 2.16p a share.
On this basis, Scisys's shares are rated on a 2017 forward PE ratio of 10 and offer a prospective dividend yield of 2.1 per cent, and rising: the board has lifted the payout per share by at least 10 per cent a year since 2013. They have a vested interest to continue to do so as the five main board directors control 7.6m of the 29.1m shares in issue, so have substantial skin in the game.
Of course, the company has to hit those profit forecasts for other investors to attribute a higher valuation than 100p a share to the equity. The good news is that having gone through the business case with a fine toothcomb, I feel finnCap’s forecasts are very well supported.
Understanding the profit drivers
In the first six months of this year, Scisys lifted revenues by almost 24 per cent to £27.2m, and ended June with a record order book of £64m, of which £22m was booked to be delivered in the second half, leaving only £5m of sales to find to hit finnCap’s prediction that the company will lift full-year revenues from £45.7m to £54m.
Since then the company has been winning a raft of contracts including two deals for Annova with German broadcasters worth a total of €3.3m, further buoying Annova's order book which was around £30m to £31m at the end of June. Work on both contracts commenced last month and are due to be completed by the end of 2018 and March 2019, respectively. Scisys media and broadcast unit also signed up its first French customer, RTL, at the end of the first half for the first phase of a potential three-phase project.
It’s not just the media divisions that have been winning awards, Scisys’s enterprise solutions and defence business has won a place on the Metropolitan Police Solution Provider Framework (SPF), only one of seven organisations to win a place to pitch for business on the £30m a year contract. The company has worked with the Metropolitan Police for many years including providing software for tracking missing persons, and working on data warehousing. Given Scisys’s long-standing relationship with the Metropolitan Police, and the fact that it’s one of only two small companies selected, this suggests that it’s in the running for contract awards.
Furthermore, I understand from Mr Cheetham that the company’s bid pipeline is “better than any we have seen before”, optimism that looks warranted when you consider that its space division, which delivers mission management and control software, won a €5.6m contract this year for two European Space Agency (ESA) programmes, and the directors are “confident of extending our footprint in the Galileo satellite navigation programme”. Scisys has been involved with the Galileo project since the late 1990s and is well placed to secure “substantial contract extensions in the second half of this year”. Other new project starts include the software design, coding and verification for aspects of the ESA’s rover mission to Mars, ExoMars.
These contract wins augur well for the remainder of this year, and offer substance to finnCap’s predictions of 10 per cent pre-tax profit growth in 2018. Please note that there is a seasonal bias to profits as they are heavily second-half weighted. Analyst Lorne Daniel at brokerage finnCap says this is partly because the company builds contingencies into its budgets that are then released in the fourth quarter; it recruits new engineers in the first half who then generate more billable time in the second half; and media customers tend to have budget surpluses in the fourth quarter that are often used to buy additional high-margin licences. The second-half weighting is worth flagging, especially if contracts are subsequently delayed, but equally the current order book offers solid sales visibility which in turn mitigates this particular risk.
The bottom line is that I am comfortable with finnCap’s forecasts, having run through the order book and contracts for each of Scisys’s divisions in quite some depth. I also believe that the impact of the company’s debt reduction programme is being overlooked by investors as I have highlighted in my enterprise value calculations. Moreover, it’s not as if the balance sheet is overgeared to start with: net debt of £9m at the end of June 2017 equates to gearing of 41 per cent of shareholders' funds. Based on the aforementioned year-end net debt forecast of £7.1m, balance sheet gearing will fall to around 33 per cent in a few months' time, a very comfortable level.
In the circumstances, I feel that there is a valuation anomaly here to exploit: the shares are rated on only 10 times earnings forecasts for calendar 2017, falling to nine times 2018 earnings estimates; are priced on a modest 1.6 times net asset value per share of 72.5p; and offer a prospective dividend yield of 2.1 per cent, rising to 2.3 per cent in 2018. finnCap’s 155p target price, which values the equity at 14 times 2018 earnings estimates and places an enterprise valuation of £52m on the company after factoring in net debt of £7m at the end of 2017, is a far more sensible valuation as it equates to 8.5 times likely cash profits of £6m in 2018.
So, offering 50 per cent-plus upside to that target price of 155p, I rate the investment case very positively, and I expect other investors to come to the same conclusion in the coming months, if as expected, Scisys continues to win more contract awards, thus derisking 2018 earnings expectations even further.
Interestingly, from a technical perspective, a share price move above last November’s 11-year high of 118p would signal a major chart break-out, and one I believe is on the cards, another reason I rate the shares a buy on a bid-offer spread of 99p to 102p. Please note that 72 per cent of the shares in issue are held by the top 12 shareholders, so this limits liquidity and can acerbate price moves, but it’s still possible to deal in bargain sizes of 10,000 shares. Buy.
Character Group warns
Shares in Character Group (CCT:370p), the owner of a portfolio of 10 long-lasting iconic toy brands targeting the niche pre-school market, plunged by 20 per cent this morning after the company warned on profits for the financial year to end August 2018.
A contributing factor to the warning has been one of the world’s largest toy retailers, Toys R Us, entering into Chapter 11 bankruptcy protection in the US and Canada. Toys R Us accounted for eight per cent of Character’s annual sales of £120m in its financial year to end August 2017. This has had subsequent knock-on impact in every market where Character trades, including the UK. The company also notes that international customers are taking a “very conservative approach to purchases”, a segment that accounts for a quarter of the company’s sales.
The warning comes less than weeks after I covered the Toys R Us bankruptcy and advised running profits on your holdings at 490p (‘Exploiting hidden value’, 25 Sep 2017), having first recommended buying at 415p ('Playtime', 1 Jun 2015). After taking into account 35p a share of dividends banked since I initiated coverage in the summer of 2015, the holding is slightly under water. The question is whether the mark down in the share price is warranted?
In light of today’s trading update, analyst Peter Smedley at brokerage Panmure Gordon slashed his adjusted pre-tax profit estimate from £14.5m to £10.5m for the 12 months to end August 2018, based on revenues falling by 10 per cent to £108m, reflecting the tough market conditions in “the key October to December trading period and the board’s prudent view on the environment continuing until the end of the first half in February.”
On this basis, Mr Smedley cut his EPS estimate by 30 per cent to 38.1p, implying Character’s shares are priced on 9.5 times downgraded earnings estimates. However, the company’s cash pile of £14m, a sum worth 67p a share, has to be taken into account too, implying the cash-adjusted forward PE ratio of 8. Also, the board “are committed to maintaining our progressive dividend policy and continuing our share buy-back programme, as and when appropriate.”
Mr Smedley still expects the dividend per share to be hiked from 13p to 17p when Character reports its full-year results for the 12 months to end August 2017, and is maintaining expectations of a 21p payout the new financial year. On this basis, the prospective dividend yields are 4.6 per cent and 5.7 per cent. I would also point out that if the board use a quarter of the £14m cash pile to buy back 1m of the 21m shares in issue at the current share price, then this will lift EPS estimate by 5 per cent. It would make sense to do so as a share buy-back programme is not just earnings accretive, but is highly supportive of the company’s progressive dividend as it reduces the cash cost of the total payout, thus underpinning analysts’ predictions of a 21p a share payout in the current financial year.
The other point worth noting is that in recent months the company has announced a raft of licenses and distribution agreements that point towards a strong recovery from the spring of 2018 onwards. For instance, Character has renewed its Master Toy license for Peppa Pig, licensed from Entertainment One (ETO), the largest film distributor in Canada and the UK and the distributor and joint-venture owner of the brand, for another three years from January 2018. Historically, this license has accounted for 20 per cent of Character’s total sales. It has also signed a license extension with brand owner DHX Media to distribute Teletubbies, the most recognised pre-school brand in the world. Teletubbies was the company’s third-best performer in the first half. And last month Character was appointed the master toy distributor in UK and Ireland for the globally popular Pokémon brand. The agreement with global master toy licensee, Wicked Cool Toys, will see action figures, play sets, role play and other toys based on the hit Pokémon animated series, join Character's portfolio from summer 2018.
Taking these and other agreements into account, Mr Smedley is forecasting a recovery in trading in the 2018/19 financial year when he expects pre-tax profits to recover to £12.5m on revenues of £118m to produce EPS of 45.3p and deliver a raised dividend of 25p a share.
From my lens at least, a likely improvement in trading conditions next year is not being adequately reflected in the current valuation. Add to that decent prospects for chunky dividends, and a highly earnings accretive share buy-back programme that should reduce the current year hit on EPS – if the company used half its cash pile to buy back shares then this would lead to a 9 per cent EPS upgrade – and I would recommend holding onto your shares if you have been following my advice. 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