Small-caps with upgrade potential

Chief executive Moni Borovitz of Israeli-based technology group MTI Wireless Edge (MWE:83p) was in bullish mood during our results call. He has every reason to be, having reported 19 per cent higher annual pre-tax profit of US$4.05m (£2.9m) despite the impact on sales in certain markets due to the Covid-19 pandemic. Although cost savings flattered the bottom line, Mr Borovitz notes that over US$300,000 of savings made will be permanent.

He also highlights multiple growth drivers that should underpin another year of stellar growth. For example, MTI’s wireless water control and management systems that address water scarcity by using Motorola's IRRInet state-of-the-art communication technologies are proving a hit in French vineyards. Having launched its Tethys product in the country last year, the system is already installed in 500 vineyards, an outcome that is “much better than we expected”.

The technology is proving a big hit in the Americas, too, hardly surprising given the twin effects of climate change and water scarcity. The opening of a new office in Alberta, Canada, places MTI in a good position to win more business. MTI has also been winning new service contracts for municipalities (remote water irrigation systems for parks, for example) in Australia, Israel, and Asia. MTI’s water control division increased operating profit by 23 per cent to US$1.92m in 2020 on slightly lower sales of US$16.2m, and looks well set to deliver another year of strong growth in 2021, and well beyond.

The same is true of MTI’s Summit electronics division, which represents 40 international suppliers of radio frequency/microwave components and sells these products to customers in Israel and Russia (fifth of divisional revenue). The majority of design wins are for defence-related systems and new wireless applications in commercial markets. For example, a key specialist area of expertise is the tethered balloon sector (15 per cent of divisional revenue), a segment that is expected to continue making a strong contribution during 2021. MTI is also cross-selling its wider product offering to clients to boost sales.

MTI Summit has strong operating leverage, whereby increasing amounts of incremental gross margin earned convert into operating profit as sales rise. This explains why the unit delivered 31 per cent higher operating profit of US$1.6m on revenue up 18 per cent to US$13.7m in 2020.

True, MTI’s antenna business only made a small operating profit of $0.16m on revenue of US$11.2m, but it’s winning contracts including one with a new North European customer for military antennas. The business is also starting to pick up larger contracts for 5G backhaul antennas, which support mobile phone operators roll-out of their 5G networks, helping to transfer the data from mobile users to the operator’s network. MTI has sales arrangements with four of the seven manufacturers of mobile infrastructure networks, so is well placed to benefit from an expected surge in demand as operators upgrade their cellular network infrastructure to 5G.

Another feature of MTI’s results was far better-than-expected closing net cash of US$9.4m (7.6p a share), which smashed house broker Allenby Capital’s US$7.6m forecast. Furthermore, with analyst David Johnson expecting pre-tax profit to surge 21 per cent to US$4.9m on 6 per cent higher revenue of US$43.4m in 2021, then cash will continue to build. Indeed, Mr Johnson lifted his 2021 closing net cash estimate by 22 per cent to US$10.4m (8.4p) and his 2022 forecast by 28 per cent to US$12.2m (10p). On this basis, MTI’s shares are rated on a cash-adjusted price/earnings (PE) ratio of 23.5, falling to 20.5 in 2022. In addition, with MTI’s cash position outpacing expectations, it’s not only good for dividend prospects – 2020 final dividend was hiked 25 per cent to 2.5¢ (1.8p) a share – but is value accretive to shareholders.

MTI’s shares have doubled in value since I initiated coverage (Alpha Report: ‘Tapping into 5G and climate change technologies’, 4 Sep 2020), and I feel that the re-rating has 20 per cent further to run to my new 100p upgraded target price. Buy.

Duke Royalty offers earnings upgrade potential

• New investments offer cash-on-cash yield of 14 per cent
• Earnings upgrades on the cards
• Risk to quarterly cash dividend skewed to the upside

Duke Royalty (DUKE:33.5p), 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, has announced two important investments since I suggested buying the shares, at 26.5p, in my 2021 Bargain Shares Portfolio. It also means that we are guaranteed earnings upgrades for the financial year to 31 March 2022 when Duke releases its pre-close trading update next month.

Having exited its investment in Dublin-based telecoms and IT and network specialist Welltel at the end of last year at a 17 per cent premium to book value of £13.2m, Duke has recycled £6.2m of the proceeds into Sutton-in-Ashfield based Fabrikat, a fabricator of steel products for the UK street lighting and guardrail markets. Established in 1985, the company provides local authorities, contractors and developers with its products, so delivers recurring revenue that is less correlated to economic conditions. This mitigates risks.

The funds will be used by Fabrikat to facilitate a management buyout of two shareholders who handed the running of the company over to the incumbent management team in recent years. Duke’s initial 14 per cent royalty rate generates annual cash income of £860,000 for its shareholders and will adjust annually in line with revenue growth/decline within an agreed collar. In addition, Duke has received a 30 per cent equity stake as part of the investment, thus offering further potential upside.  

Duke has also made £4.5m follow-on investment in existing royalty partner United Glass Group (UGG), a UK supplier of bespoke architectural glass to premium residential, educational and heritage products in the UK. The cash will be used by UGG to finance an acquisition and lifts Duke’s royalty income from UGG to £1.7m on a total investment of £12m, representing a cash-on-cash yield of 14.1 per cent. Duke retains a 30 per cent equity stake in UGG.

By my reckoning, Duke has now replaced all the royalty income from Welltel, which means that pro-forma cash royalty income is set to rise to £2.88m a quarter, a sum that comfortably exceeds the company’s projected £2.5m annual operating costs in the 2021/22 financial year. I also estimate that Duke’s operating profit for the 2021/22 financial year is set to exceed house broker Cenkos Securities' £7.5m current estimate by 20 per cent, implying 34 per cent year-on-year growth. Strip out £1.2m of estimated interest costs (7.25 per cent above Libor) on Duke’s pro-forma net debt of £16.3m and my financial models imply that analysts could upgrade their 2021/22 pre-tax profit and EPS estimates by 16 per cent to £7.8m and 2.57p, respectively. The risk to the 0.5p a share quarterly dividend looks skewed to the upside to me.

This has not been lost on investors as Duke’s share price has broken out of the base formed after last year’s stock market crash and is now trading 10 per cent above net asset value (NAV) of 30.6p a share. However, prior to the Covid-19 pandemic the high-yielding shares – dividend yield of 6 per cent – commanded a premium of 1.1 to 1.4 times to NAV. Also, any uptick in trading from royalty partners will drive capital growth as royalty payments are reset upwards to increase portfolio valuations as well as adding value to the equity stakes held in some royalty partners. It’s worth pointing out that Duke’s £93m investment portfolio is modestly geared, and the company has ample credit facilities available to fund further earnings-accretive investments in royalty partners. Buy.

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