One of the risks in business is overtrading. Sales meet or exceed expectations buoyed by strong customer demand, but a company is unable to service the incremental increase in revenues at a maintained operating margin because of the additional costs incurred. In a nutshell, this is what has happened at Wimbledon-based Arena Events (ARE:40p), a specialist provider of temporary physical structures, marquees, grandstands and ice rinks to major sporting, outdoor and leisure events.
Arena’s core rental inventory of 300,000 sq metres of temporary structures and 125,000 demountable seats provides the grandstands and marquees to cater to the needs of visitors to major sporting events including the British Open and US Open golf tournaments, the ATP World Tennis Finals, Henley Royal Regatta, and horse racing festivals at Cheltenham, Aintree, Newmarket and Epsom.
The issue concerns the group’s UK division, which exceeded revenue expectations for the 2018 financial year, but the increase in new and one-off projects led to significantly higher incremental costs to service these contracts. In addition, the cost savings resulting from integrating three warehouses in the UK have taken longer to materialise, and will now be realised in 2019. True, the operational issues are being addressed and have led to several senior management changes within the UK division. However, the impact will be seen when Arena reports its 2019 annual results in April as house broker Cenkos Securities has reduced its previous cash profit estimate of £14m to £12.3m, up from £10m in 2017, and now expects Arena to make a cash profit margin of 9 per cent on revenue of £137m, almost one percentage point lower than the margin earned in 2017.
The £1.7m cash profit shortfall drops straight to the bottom line, which explains why Cenkos’ adjusted pre-tax profit estimate has been cut from £7m to £5.3m. That pre-tax profit outcome is still almost 50 per cent higher than the £3.6m adjusted pre-tax profits Arena made in 2017, and will boost EPS by a quarter to 3.8p, albeit it well shy of the broker’s previous 2018 EPS estimate of 4.8p. Investors reacted badly to the downgrade as Arena’s share price lost a third of its value this morning and, at 40p, is well below the 62.5p level at which I suggested buying back in March ('Alpha Company Research: Arena Events', 26 Mar 2018).
There are positives, though. Both of last summer's acquisitions are performing well. California-based Stuart Rentals, a supplier of tents, staging equipment and flooring, made Arena the third-largest operator in a highly fragmented US market and helped the US division exceed sales expectations. TGP, a Dubai-based exhibition stand design and build company that has multinational clients in the Middle East, doubled Arena’s presence in the region and has importantly given the group an entry point into Saudi Arabia.
After factoring in a full 12-month contribution from these acquisitions and others made last year, funded through a £19m placing of shares at 60p over the summer, organic growth in the existing businesses, and an anticipated restoration of operating margins closer to their historic 10 per cent level, Cenkos expects cash profits to increase by a quarter to £15.6m in 2019. On this basis, expect a rise in Arena’s 2019 pre-tax profits from £5.3m to £8m on 16 per cent higher revenues of £160m to produce EPS of 4.9p.
Admittedly, the 2019 pre-tax and profit forecasts are both £2.7m shy of Cenkos’ previous estimates when I last covered the investment case and rated the shares a buy (‘Arena structured for profitable growth’, 20 September 2019), highlighting a more cautious approach in the timing of contracts and wider economic uncertainty. However, it still represents decent growth prospects nonetheless.
In my opinion, a forward PE ratio of 8 for 2019 doesn’t reflect the realistic chance of Arena delivering EPS growth well north of 25 per cent again in 2019, nor the fact that it has just secured contracts for the 2019 Rugby World Cup and the 2020 Olympics. I would also flag up that Arena has never lost a major contract either, thus de-risking its sales forecasts. This is more a case of the directors addressing the overtrading issues in the UK, which they believe they have done.
Importantly, there are no financial issues for shareholders to be concerned about. Cenkos is pencilling in a closing net debt of £20.5m for 2018, and a small reduction in borrowing to £19.9m by the end of 2020 after factoring in the board declaring dividends per share of 2p in 2018, rising to 2.5p in 2019. So, with cash profits now expected to rise from £12.3m in 2018 to £15.6m in 2019, the closing net debt to cash profit multiple should fall from 1.66 times in 2018 to 1.27 times in 2019, hardly exacting given that Arena’s operating cash flow in 2018 is expected to cover the interest bill almost 10 times over. Furthermore, chief executive Greg Lawless owns 6.7m shares, or 4.43 per cent of the issued share capital, so there is an added incentive for the board to maintain a progressive dividend policy.
So, having taken the reasons for the earnings downgrade into full consideration, and considered the stability of the contracts underpinning Arena’s 2019 revenue stream and beyond, I feel the share price markdown is overdone and once the dust settles investors will realise that too. Recovery buy
■ Simon Thompson's new book Successful Stock Picking Strategies and his second book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £2.95, or £3.75 if you purchase both books. Details of the content of both books can be viewed on www.ypdbooks.com.
