Duke Royalty (DUKE:23p), an Aim-traded company that makes its money by providing capital to companies in exchange for rights to a small percentage of their future revenues over a typical term of 25-40 years, has issued results for the 12 months to 31 March 2020. They reveal the short-term financial hit from the Covid-19 pandemic on the portfolio, and the opportunity, too.
The company booked non-cash write-down of £12.6m on its royalty portfolio and a £2.9m impairment on its loan book. Adjust for these write-offs and adjusted earnings rose from £3m to £5.2m to lift earnings per share (EPS) by a third to 2.44p. The higher earnings reflect £20.4m worth of new investments which helped Duke deliver a 65 per cent rise in net operating cash flow to £6.8m (3.17p a share) and free cash flow of £5.4m (2.5p).
In the final quarter of the financial year to 31 March 2020, Duke generated cash receipts of over £2.8m, representing a normalised pre-COVID trading environment. Receipts then declined to £2m in the first quarter of the 2020/21 financial year due to the impact of the lockdown and the decision to assist some royalty partners by allowing them to defer royalty payments, hence the impairment charges. However, as lockdown restrictions eased, Duke’s royalty partners have experienced a significant upturn in trading.
Indeed, during our results call the directors forecast cash receipts of £2.4m for the current quarter, a sum that covers all of Duke’s annual operating costs of £1.8m. They also confirmed that seven of the 11 royalty partners are expected to make full cash payments, and of the four that have deferred part of their payments one should be in position to make up the shortfall shortly. They also noted that some royalty partners are performing well such as Mirriad, a supplier of motorhome and caravan parts to both Original Equipment Manufacturers and in the secondary aftermarket. The company accounts for 11 per cent of the investment portfolio.
It’s also worth noting that Duke has just made its first portfolio exit, realising £2m from its investment in Dublin-based B2B technology platform Xtremepush, further validating its funding model. The investment produced a healthy internal rate of return of 22 per cent and Duke still retains warrants over 3 per cent of Xtremepush's shares, thus offering further potential capital upside in the future.
Admittedly, the impairments mean that the portfolio’s £88m fair value is £10m shy of the total amount Duke has invested. However, as royalty companies recover from the enforced lockdown, then it’s realistic to expect valuation uplifts as cash receipts rebound especially as head of finance Hugo Evans says he was “brutal” in the fair value assessment of the portfolio.
In addition, Duke is making follow-on investments as royalty partners take advantage of acquisition opportunities. For instance, its largest investment, Welltel, Dublin based telecoms, IT and network specialist, made two over the summer with the company’s backing. Duke’s total investment in Welltel, one of the fastest growing technology companies in Ireland, is now generating cash receipts of £1.8m per annum, a cash yield of 13.2 per cent on its £13.5m investment which accounts for 14 per cent of the portfolio.
There are no broker forecasts in the market, but it’s not hard to envisage Duke producing free cash flow of £7m (2.9p a share) in the 12 months to 31 March 2021, a healthy sum in relation to the company’s market capitalisation of £56.7m. In turn, this bodes well for the 0.5p-a-share scrip quarterly dividend (8 per cent dividend yield) to be replaced by a cash pay-out. When this happens, it will undoubtedly attract income seekers once again, the catalyst for a re-rating to wipe out the 26 per cent share price discount to net asset value (NAV) of 31p, with scope for further upside driven by portfolio revaluations as Covid-19 induced write-downs are reversed.
So, although Duke’s share price has fallen heavily from the 29p level of my last buy call following the Covid-related assets write-downs which reduced NAV per share by around 6p (‘Targeting tech stocks’, 10 August 2020), I can see potential catalysts on the horizon to reverse the paper losses. Buy.
Pennant’s recovery underway
Pennant (PEN:33p), an Aim-traded supplier of products and services that train and assist engineers in the defence and civilian sectors, had already flagged its interim results in last month’s pre-close trading update (‘In search of value opportunities’, 17 August 2020).
Of far more interest to me than the Covid-19 pandemic induced first half underlying operating loss of £2m on revenue down 14 per cent is the scale of the recovery potential. That’s because the company has a strong order book (up 9 per cent to £36m since May) and an operational structure that can fulfil the order backlog without recourse to capital expenditure, so highlighting its operating leverage as revenue recovers. Chief executive Phil Walker shed some light here during my results call this morning. In particular, 10 contracts in that order book back up second half revenue of £8.3m and a forecast second half operating profit of £1m. They also support revenue of at least £14.4m in 2021 without accounting for any new contract awards.
Pennant has been winning new business, too, around £3m of awards since the 30 June period end including £1.5m of training aids from a long standing Middle East customer “with the expectation of further purchases to follow to a value of £5m in total.” Around half the £3m orders won will be delivered in 2021, so the contracted order for delivery next year is now around £16m. It could be even higher because Mr Walker notes that the “£3.5m balance of the Middle East contract needs to be placed by the end of the first half of 2021.”
Also, the company has repurposed its longstanding contract to provide electro-mechanical trainers and computer-based training for the Ajax fighting vehicles to the British Army. The contract value has increased by £1.5m to £13.5m, of which £2m is scheduled for delivery in the second half, rising to £2.3m in 2021.
Importantly, the order book is supported by two valuable government contracts with the Canadian and Australian defence departments to use Pennant’s Oracle-based OmegaPS software product that reduce the support cost of major capital equipment. These two contracts should contribute £2.75m in second half revenue, rising to £6.1m in 2021. In addition, the delayed contract to design and build a full-size representation of a training aid for Leonardo Helicopters is expected to contribute £400,000 to second half revenue, rising to £2.5m in 2021. The delay in this contract is the main reason for this year’s profit shortfall.
It’s well worth noting that this year’s earnings enhancing acquisition of Absolute Data Group (ADG), a Brisbane-based software company that complements Pennant’s existing OmegaPS software business, is working out well. ADG helps its client base (military aviation, commercial aerospace, and marine, rail, nuclear and automotive sectors) to manage vast quantities of maintenance and training data. Pennant’s chief executive Phil Walker informed me during this morning's results call that ADG has a contracted order book worth £3.5m, noting that it also has around US$5m of active opportunities in the pipeline, effectively cross selling the software to existing clients of its OmegaPS software business. ADG’s order book already supports revenue of £1.2m in 2021, up from a forecast £1m contribution this year, thus diversifying and enhances recurring revenue and reduces the reliance on substantial engineered-to-order contracts. The software can also be installed remotely.
Pennant’s cash flow generation improved markedly in the first half, too, buoyed by £5.9m of positive working capital movements which offset a £2.1m operating cash outflow. This helps explain why the company ended the six-month period with net cash of £2m (excluding £1m of finance leases), reversing a £2.2m net debt position at the start of 2020. The working capital inflow was buoyed by a £2m payment from General Dynamics after Pennant passed a key design review (for the Hull trainer). Since the period end, the company has passed a second design review (for the Turret trainer), and its £1.8m invoice will be settled next month.
Importantly, Pennant has an untapped £4m low-cost bank facility with HSBC, so has the balance sheet flexibility to fulfil its working capital requirements as business ramps up again. The international spread of contracts is another positive as it not only diversifies customer concentration risk, but offers shareholders exposure to valuable foreign currency earnings in a period of sterling weakness. For instance, ADG’s North American trading subsidiary accounts for two-thirds of its annual sales.
The bottom line is that having taken £1m costs out of the business this year, the full benefit of which will be seen in 2021, and the company continuing to win new contracts, I expect a strong profit rebound in 2021. That possibility is simply not being priced into Pennant’s £11.5m market capitalisation. Although there are no forecasts in the market, assuming the company delivers £16m of revenue in 2021 and factoring in its lower operating cost base, then the company could potentially produce a trading profit of £2.7m to £3m in 2021.
Moreover, with the benefit of £2.8m unrealised tax losses, the corporation tax charge will be minimal. Effectively, Pennant is priced on close to four times 2021 trading profit (according to my financial models), a bargain basement valuation for a company that also announced this morning more than £20m of single sourced contracts in its project pipeline. The shares are primed to make a strong recovery and continue to rate a buy.
Record’s massive contract win
Currency manager Record (REC:37p) has announced that, subject to contract, the company has been selected for a massive dynamic hedging mandate worth US$8bn. The annualised fee rate for this mandate is consistent with Record's other dynamic hedging mandates, based on the size of allocation.
Analysts estimate that the company earns around 16 basis points per annum on its dynamic hedging mandates, or five times the margin on passive hedging. The contract win also means that dynamic hedging mandates will more than treble in value to US$10.9bn to account for 15 per cent of Record’s proforma assets under administration equivalent (AUMe) of US$71.3bn based on first quarter figures. It could be even higher still because equity markets have been on a tear since the start of the 2020/21 financial year and that’s positive for both AUMe and management fees. Record reports its second quarter results to 30 September 2020 on 19 October 2020.
After taking account today’s massive contract win, analysts at Panmure have upgraded their earnings estimates massively, so much so that they expect Record to report underlying pre-tax profit of £9.2m on revenue of £29.7m in the 2021/22 financial year, up from £6.4m on revenue of £25.2m in the 2020/21 financial year. Please note that analysts take a conservative view to performance fees, offering scope for further outperformance. On this basis, expect earnings per share (EPS) of 2.6p (13 per cent upgrade), rising to 3.7p (60 per cent upgrade), respectively, to support identical dividends.
A forward price/earnings (PE) ratio of 10 for the 2021/22 financial year is a harsh valuation given that new chief executive Leslie Hill is clearly making an impact and 30 per cent of Record’s market capitalisation is backed by net cash of £22.3m (11p a share). Prospective dividend yields of 7 per cent, rising to 10 per cent, are attractive, too, in such a low interest rate environment.
The shares are slightly below my last buy call when I covered the annual results (‘Six small-cap buys’, 22 June 2020) and have produced a modest total return since I included them in my 2018 Bargain Shares portfolio. I am in no doubt they are worth buying at this level. Buy.
Finally, my next column will be published at 12pm on Tuesday, 22 September.
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