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A trio of small-cap buys

Simon Thompson highlights three small-cap investment opportunities
October 31, 2017

This is an opportune time to revisit the investment case of care home operator CareTech (CTH:433p) which has just issued an inline pre-close trading update for the 12 months to end September 2017 ahead of releasing its results in early December.

After factoring in a number of acquisitions, all of which have “performed ahead of expectations in part as a result of being part of a larger group”, analyst John Cummins at brokerage WH Ireland expects both the company’s revenues and pre-tax profits to rise by 12 per cent to £167m and £29.2m, respectively. True, the initial dilutive impact of a £39m oversubscribed placing at 355p a share at the end of March, the proceeds from which are being used to fund a pipeline of bolt-on acquisitions, means that EPS will come in around 33.8p, down from 38p in the 2016 financial year.

However, that still leaves a likely 4 per cent hike in the dividend to 9.6p a share, a payout well underpinned by the company’s robust operating cashflow and a lowly geared balance sheet: closing year-end net debt of £147m, down from £157m 12 months earlier, represents a loan-to-value ratio of less than 50 per cent on CareTech’s freehold estate which has a valuation well north of £300m.

Importantly, care home fee rate discussions with local authorities have been positive, and the company continues to create value by repositioning its net capacity of 2,534 places, a 9 per cent increase year on year, to enhance both fees and margins. A stable occupancy rate of 93 per cent in the mature homes is an indication of the strong demand for the specialist social care services offered by the company, while a blended occupancy rate of 86 per cent suggests scope to boost profits by filling more care home places in the acquisitions made.

A good example of CareTech’s acquisition strategy is the £16.9m purchase over the summer of Selborne Care, a provider of specialist residential care, supported living and day care services for adults with learning disabilities and challenging behaviours. Selborne operates 57 residential beds across eight homes in the Midlands and south west England, which has given the company an increased footprint in adult services in these regions.

There is also potential to leverage the Selborne brand by adding additional facilities to these homes, and then tap into demand from local authority clients where Selborne has existing relationships. The geographic fit aside, Selborne owns freehold property worth £12.4m so the £16.9m purchase price is well underpinned by the bricks and mortar value of the properties, not to mention profits too: the purchase price equates to a very reasonable seven times cash profits.

CareTech’s pre-close trading update also highlighted a “sizeable pipeline of opportunities” to complement solid organic growth, suggesting that further earnings accretive deals are on the cards. Even without them, Mr Cummins at WH Ireland expects revenues to rise 9.5 per cent to £183m in the 2017/18 financial year to boost pre-tax profits by 12 per cent to £32.6m and deliver EPS of almost 35p.

On this basis, the shares are rated 12.5 times forward earnings and offer a 2.2 per cent prospective dividend yield based on the payout per share being raised to 9.9p. A progressive dividend policy was a key bull point when I initiated coverage in March 2015 when the share price was 230p ('Time to take care', 16 Mar 2015). Since then the board has paid out annual dividends per share of 8.4p for the 2015 financial year, 9.25p for the 2016 financial year and an interim payout of 3.3p.

True, CareTech’s share price hit the target price range of 412p to 450p I outlined when I recommended buying at 362p seven months ago ('Five small-cap buys', 29 Mar 2017), and that’s why I advised running profits at profits at 440p when I last covered the company over four months ago ('Check into small-cap value plays', 20 Jun 2017). Longer term followers have done really well too as the holding has produced a 97 per cent total return since I initiated coverage ('Time to take care', 16 Mar 2015).

However, with further bolt-on deals in the pipeline, and the pre-close trading outlook pointing towards a continuation of double digit revenue growth, then I feel a higher target is now in order. WH Ireland’s 500p target price is not unreasonable in my view, implying an enterprise valuation of 12 times cash profits. So, ahead of the forthcoming full-year results I rate CareTech’s shares, offered at 433p in the market, a trading buy.

 

Bug busting earnings growth

This is also an opportune time to reassess the merits of my 2016 Bargain Shares Portfolio constituent Bioquell (BQE:245p), a provider of specialist microbiological control technologies to the international healthcare, life science and defence markets. I included the shares in the 2016 portfolio at an average buy-in price of 125p and last advised buying in the summer when I upgraded my target price from 180p to a range between 225p and 250p ('Bargain shares opportunities', 1 Aug 2017). Bioquell’s share price is now at the top of that range, and with good reason.

That’s because Bioquell reported pre-tax profit of £1.4m for the first six months of the year, up from just £400,000 in the same period of 2016, on revenues up by almost a fifth to £14.3m. Management guidance over the summer pointed towards a similar revenue performance in the second half, which in turn prompted analyst Chris Glasper at N+1 Singer to push through material earnings upgrades of 28 per cent for 2017, implying pre-tax profit will now rise by half to £2.4m this year on revenues of £28.3m to deliver EPS of 8.6p, up from 5.6p in 2016.

Mr Glasper also hiked his 2018 EPS forecasts by 16 per cent to 9.7p based on pre-tax profits of £2.7m on revenues of £29.8m. On this basis, the shares are trading on a forward PE ratio of 25, but you also need to take the company’s cash pile into account as this has been growing quickly too, reflecting a robust cash-flow performance and tight working capital management. In fact, net cash from operating activities trebled to £3.8m in the first half of 2017 which sent net funds soaring from £7.3m to £11.8m, a sum worth 52p a share. This means that Bioquell’s shares are now rated on 19.7 times cash-adjusted 2018 earnings estimates, a fair rating but one that is not in my view factoring in the possibility of even more upgrades from a number of different sources.

Firstly, more than three quarters of Bioquell's sales are generated overseas so sterling's ongoing devaluation has been benefiting margins, as are cost reductions from a restructuring programme. Bearing this in mind, although sterling is only slightly below the end of June closing rate of £1:€1.14, its average rate in the past four months is £1:€1.116, or four percentage points below the average rate of £1:€1.162 in the first six months of this year. Euro sales accounted for 27 per cent of the total in the first half, so sterling’s weakness since the end of June will have had a major beneficial impact on translation of the profits earnied back into sterling of these euro denominated sales. I don’t feel this is fully reflected in N+1 Singer’s upgraded estimates.

Secondly, new products are driving up revenues and at higher gross margins too – gross margins strengthened from 46.3 per cent to 51.6 per cent in the first half.  For instance, sales of Bioquell QUBE, a novel, modular aseptic work-station incorporating HPV technology used to provide an aseptic environment for sterility testing and the production of toxic, intravenous oncology drugs, more than doubled to £1.6m in the first six months of this year. An ergonomic fixed, wall-mounted bio-decontamination system has proved very popular since launch in the fourth quarter of last year too.

Thirdly, the industry backdrop remains favourable as a number of drivers are 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.

In the circumstances, I can see a scenario unfolding whereby Bioquell’s pre-close trading statement in mid-January leads to yet more earnings upgrades, a possibility that’s not being priced into the shares at present. So, although the share price has hit N+1 Singer’s intrinsic value of 245p, I feel the momentum being exhibited by the business, combined with a favourable currency matrix, skews the risk heavily to the upside and my new target price is 270p. Trading buy.

 

Arbuthnot Banking lending soars

Shares in Arbuthnot Banking Group (ARBB:1,315p) have edged up slightly since I rated them a buy at 1,252p during the summer, placing a target price of 1,533p on the equity at the time ('Value opportunities', 19 Jul 2017). The company paid an interim dividend of 14p a share at the end of last month to take the running total to 397p since I included the shares, at 1,459p, in my 2015 Bargain Shares portfolio. A third-quarter trading statement is certainly supportive of my 1,533p target price.

The company’s private banking arm, Arbuthnot Latham, increased its underlying pre-tax profit by 75 per cent to £4.9m in the first half with loans rising by a third to £880m. In a third-quarter trading statement, the bank confirmed that the loan portfolio is maintaining that heady growth rate, and the lending pipeline remains robust. Reassuringly, the bank refuses to chase volume at the expense of relaxing its lending criteria, a point highlighted by a low level of impairments and a comfortable loan-to-value ratio on its residential and commercial property loan book.

Importantly, Arbuthnot is well funded with customer deposits covering the loan book almost 1.4 times over and providing ample funding for further lending. Also, net interest margins are benefiting from lower funding costs with the blended cost of funds falling by almost a third to 0.49 per cent on the same period in 2016, underlining the positive impact on profits of recycling customer deposits into lending at an economic net interest margin.

This helps explain why analysts at Hardman & Co expect Arbuthnot's pre-tax profits to more than double this year from £4m to £8.3m based on a 29 per cent rise in operating income to £53.6m, increasing to £14.3m and £67.5m, respectively, in 2018. On this basis, expect adjusted EPS to treble to 52.2p this year, rising sharply again to 86.7p in 2018. The point being that if Arbuthnot delivers anything like the growth predicted, and maintain credit quality, then a share price in-line with book value of 1,533p is in order.

There is rock solid asset backing as 30 per cent of Arbuthnot’s market value of £200m is backed up by a 18.6 per cent retained stake in challenger bank Secure Trust Bank (STB:1,895p); the company used £53m of the cash windfall from selling down that stake to acquire a prime property in London that’s bringing in £1.8m rent; and purchased a private banking loan portfolio, worth £44.9m, from banking group Duncan Lawrie that is secured on property of £104m, and yields 5.2 per cent. 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