Targeting companies on the upgrade

Companies in upgrade cycles have many characteristics, the most obvious being that almost without fail the industry backdrop is favourable. For instance, restocking and reinvestment cycles after a sector has gone through a lean period are important as this can produce a tailwind for sales, and profits.

Operational leverage is important too, and it pays to seek out companies whose profits accelerate more quickly than sales, so an increasing amount of incremental revenue drops down to the bottom line in a positive trading environment. Impressive cash generators are ideal candidates because a company that converts a high percentage of profit to operating cash flow can reinvest it back in the business to boost shareholder returns while at the same time rewarding investors with a progressive dividend policy. Several of the companies I outline below are displaying all these characteristics.

Hargreaves Services eye-watering earnings upgrade cycle

• Buoyant trading at German metals trading subsidiary.
• Land sales at Hatfield and Blindwells.
• All bank debt eliminated.
• Full-year dividend of 20.2p a share expected.

Hargreaves Services (HSP:370p), a diversified industrial services group and brownfield land developer, has released a raft of positive trading updates since I last suggested buying the shares at 296p (‘Four potential small-cap bargains’, 7 February 2021). They have prompted eye-watering earnings upgrades, too, which explains why the share price has surpassed my 350p target and is 80 per cent higher than when I initiated coverage (Alpha Report: ‘A high yielder offering significant hidden value’, 19 March 2020). All parts of the group are firing on all cylinders.

HRMS, Hargreaves German metals trading subsidiary, is clearly benefiting from both favourable market conditions and improved efficiency at its carbon pulverisation plant. HRMS is a key supplier of specialist raw materials to major European customers in the steel, foundry, smelting, ferroalloy, sugar, limestone, insulation, refractory and ceramic industries. In late April, analysts raised their 2020/21 group pre-tax profit and earnings per share (EPS) estimates by 42 per cent to £10m and 28.1p, respectively, on the back of HRMS’ buoyant trading performance.

A week later they raised earnings estimates again (by 24 per cent) after Hargreaves’ Unity joint venture completed the early sale of 79 acres of the 628-acres of land being developed at the former Hatfield Colliery site near Doncaster. A national retailer paid £25m for the land and plans to build an 800,000 square feet distribution centre.

Furthermore, such is the demand from European customers for specialist raw materials, partly driven by global steelmakers, HRMS profit contribution will now smash the £5m upgraded forecast analysts pushed through in late April. Investec has taken note and more than doubled HRMS’ profit contribution to £10.5m, implying group pre-tax profits will more than treble from £5.3m to £17.9m to deliver EPS of 50.2p for the year just ended.

There has been good news on borrowings, too. The group ended the financial year with net cash of £16.3m compared with £28.1m of net debt in May 2020, buoyed by an estimated £42m of free cash flow (130p a share). The elimination of all bank debt coupled with the receipt of dividends from HRMS means that shareholders can look forward to an annual dividend per share of 20.2p when Hargreaves announces annual results on 28 July, and at least the same pay-out again in the 2021/22 financial year. On this basis, the shares offer a healthy dividend yield of 5.3 per cent, trade on a price/earnings (PE) ratio of 7.5 and six per cent below book value.

It’s also worth flagging up that the buoyant housing market in Scotland de-risks Hargreaves’ development of Blindwells, a major 1,600-unit residential development site located 15 miles to the east of Edinburgh. Persimmon (PSN) has agreed to buy 12.9 acres for £9.3m to develop 192 new homes with completion slated for the second half of the financial year to 31 May 2022. Hargreaves completed the sale of a slightly larger parcel to Bellway (BWY) on similar terms earlier this year.

Hargreaves is winning new contracts in other parts of the business, too, the latest being the subcontract for specialist earthworks on a 30km stretch of the new HS2 railway. It will involve the movement of nearly 15m cubic metres of chalk and clay over the next four years.  Hargreaves also landed a five-year materials handling and maintenance contract at the Selby plant of power generator Drax which commenced in April.

The point is that although analysts have pencilled in group pre-tax profit and EPS of £9.2m and 26.8p, respectively, for the 2021/22 financial year, if trading at HRMS continues at current buoyant levels then the contribution from that one subsidiary alone could exceed the entire group profit estimate. Hargreaves’ earnings upgrade cycle has further to run and it’s reasonable to expect massive upgrades in due course.

In the circumstances, I am raising my target price to 450p. Buy.

RBG’s earnings continue to build

• RBG completes Memery Capital acquisition.
• Analysts upgrade EPS forecasts by 24 per cent for 2022.

RBG (RBGP:134p), a professional services group that owns law firm Rosenblatt, a nascent litigation funding arm LionFish and specialist finance boutique Convex Capital, has completed the £30m acquisition of London-based Memery Capital, a legal services firm operating in corporate finance, real estate, dispute resolution and commercial law.

When I last covered the investment case (‘Three under-priced opportunities’, 26 April 2021), house broker N+1 Singer had just upgraded its 2021 revenue estimate from £28m to £30.3m and was pencilling in pre-tax profit of £8.2m, up from £5.8m in 2020, to deliver EPS of 7.6p (5.1p in 2020) and a 50 per cent hike in the dividend to 4.5p a share. Analysts have pushed through material upgrades again.

That’s because the structure of the acquisition is highly beneficiary to RBG’s shareholders as RGB settled the consideration £11.2m in shares, and £12m in cash (funded through a £10m three-year term debt facility) with an additional £6.8m of deferred cash payments due in May 2021. Memery made a profit of £8m (before profit shares and members’ remuneration) on revenue of £23.2m in the latest financial year, so RBG’s shareholders will be capturing the vast majority of those earnings with modest dilution.

In fact, N+1 Singer has pushed through 10 per cent and 36 per cent profit upgrades for the 2021 and 2021 financial years, implying pre-tax profits of £9.1m and £13m, respectively, on revenue of £45m and £56m. On this basis, expect 2021 and 2022 EPS of 7.9p and 11p (4 and 24 per cent upgrades) to support dividends of 4.75p and 6.58p, respectively. Please note that the upgrades also factor in £1m higher revenue contribution from Convex (to £7m and £8m in 2021 and 2022), reflecting the buoyant UK/European small and mid-cap corporate finance market.

This means that the shares, at 133p, trade on a 2022 PE ratio of 12, a hefty discount to RBG’s peer group average PE ratio of 17 for law firms DWF (DWF), Gateley (GTLY), Ince (INCE), Keystone Law (KEYS) and Knights Group (KGH). They also trade well below the average 2022 PE ratio of 18.3 for professional services/corporate finance firms FRP Advisory (FRP), Begbies Traynor (BEG) and K3 Capital (K3C). Furthermore, RBG’s 2021 prospective dividend yield of 3.6 per cent is 50 per cent higher than its law firm peers even though its 2022 pay-out is forecast to rise 38 per cent, implying a forward dividend yield of 4.9 per cent.

RBG’s shares have  doubled in value since I initiated coverage last summer, at 68p (Alpha Report: ‘Back a winning legal team’, 2 June 2020) and I see scope for the re-rating to continue to my target price of 175p. Buy.

Kape makes strong start to 2021

• New US$220m debt facility includes US$90m acquisition facility.
• Borrowings expected to be wiped out by end of 2022.
• Business adding 25,000 new customers per month.
• New product launches and cross-selling initiatives helping to drive up average order values.

Cyber security software provider Kape Technologies (KAPE: 315p) has issued a bullish trading update and announced a new senior secured bank facility on enhanced terms.

Kape is bang on track to deliver 2021 revenues of $197m-$202m (representing 65 per cent growth) and underlying cash profit of $73m-$76m (90 per cent growth), in line with guidance at the time of the US$149m earnings accretive acquisition of Webselenese (‘Tap into an eye-catching earnings cycle’, 8 March 2021). Webselenese is an independent digital platform that provides 8.5m users with unbiased insight driven content focused on cyber security and privacy trends that attracts software vendors (McAfee, NortonLifeLock, Dashlane and Kape). Kape has launched multiple cross-company initiatives since making the acquisition which are enabling it to benefit from Webselenese's substantial technology knowhow as well as enhancing the group’s product development and go-to-market capabilities.

Kape’s digital privacy division continues to deliver bumper growth. Since the start of 2021, the business has added 25,000 new customers per month to take the total to 2.61m paying subscribers, with growth rates expected to accelerate. The directors also report that over 12 per cent of new Cyberghost customers and 20 per cent of new Intego users are purchasing more than one product.

New products are helping to drive growth, too. For instance, Kape launched its Privacy First Anti-Virus for PC, which will initially be Intego branded, and in the coming months will be rolled out to both CyberGhost and Private Internet Access users as part of a wider initiative.

Adoption of Kape’s cyber security software (which protects data security and privacy against piracy and phishing attacks), and virtual private network (VPN) solutions (which encrypt and secure internet connections) have been rising notably in both North America and Europe, regions that account for three-quarters of Kape’s revenue.

The new US$220m debt facility is priced at a keen 2 per cent margin above the applicable reference rate and includes a US$90m acquisition facility. It replaces the existing US$40m term loan and US$120m bridging loan facility that funded the Webselence acquisition. Analysts at Progressive Equity are forecasting 2021 closing net debt of US$77.7m and predict 2022 operating cash flow of US$92.7m will wipe out borrowings by the end of next year. The deleveraging of the balance sheet is important as it means that more of the economic interest in the entity transfers from debt holders to shareholders.

The shares have achieved my 325p target price, having risen by a third in the past three months, and have produced a 555 per cent total return since I included the company in my 2017 Bargain Shares portfolio. However, I feel that a 2022 PE ratio of 13 offers scope for further upside. Not only is the company forecast to deliver 87 per cent and 28 per cent EPS growth in 2021 and 2022, so there is a strong earnings tailwind, but clearly Kape’s management are on the look out for more earnings accretive acquisitions.

I am raising my target price to 375p based on a target 2022 PE ratio of 16.5 and enterprise valuation to cash profit multiple of 13 times. Buy.

Bloomsbury’s page turning performance

• Annual profits exceed analysts upgraded forecasts.
• Raised profit guidance for new financial year.
• Special dividend of 9.78p and 10 per cent higher final pay-out of 7.58p.
• Net cash up 74 per cent to £54.4m.
• Acquisition of genre fiction publisher Head of Zeus.

Bloomsbury Publishing (BMY: 340p), the publisher of JK Rowling’s best-selling Harry Potter books, had already raised profit guidance twice ahead of its annual results, prompting analysts to push through EPS upgrades of 19 per cent in January and 29 per cent in March. The company didn’t disappoint on results day either, delivering pre-tax profit of £19.2m (4 per cent ahead of upgraded forecast) on 14 per cent higher revenue of £185m.

Moreover, the board have upgraded guidance for the 2021/22 financial year, too. Analysts at Investec duly raised their pre-tax profit estimate by 12 per cent to £19.3m, although such is the strength of trading that I wouldn’t bet against further upgrades materialising as the year progresses.

Bloomsbury’s consumer division was the key driver of the outperformnance, delivering 61 per cent higher pre-tax profit of £14.2m. Bestsellers include Why I'm No Longer Talking to White People About Race, by Reni Eddo-Lodge, and Sarah J. Mass titles, Crescent City: House of Earth and Blood and A Court of Silver Flames, both of which reached Number One on the New York Times bestseller list. The enduring appeal of J.K. Rowling’s Harry Potter books shows no sign of waning either even though the first book was published 23 years ago. The titles put in another magic performance, posting seven per cent sales growth.

Ongoing growth of digital revenue has also made Bloomsbury’s business more resilient as it repositions from mainly being a consumer publisher to a digital business-to-business publisher in the academic and professional information market. Bloomsbury’s Digital Resources increased revenue by almost half to £12.4m and quadrupled its pre-tax profit contribution to £2.9m.

The group is a prodigious cash generator, one reason why I included the shares, at 229p, in my 2019 Bargain Share Portfolio. Buoyed by an eye-catching 142 per cent cash conversion, up from 111 per cent in 2021, net cash surged by 74 per cent to £54.5m (67p a share), thus enabling the board to hike the final pay-out by 10 per cent to 7.58p a share and declare a special dividend of 9.78p a share. The board have already paid out total dividends of 16.2p a share since I advised buying in early 2019.

Note 1: Simon advised taking profits on TMT Investments at 580c a share to bank 140 per cent gain including dividend of 20c ('Takeovers, tender offers and taking profits', 9 September 2019), and subsequently advised buying back the shares  at 318c ('On the hunt for recovery buys', 6 July 2020). 

Note 2: Simon advised taking profits on Futura Medical at 34p a share on Monday, 14 October 2019 ('Bargain Shares: golden opportunities', 14 October 2019). The selling price is used in the performance table.

Note 3: Simon advised selling Mercia Asset Management at 27.5p a share on Monday, 9 December 2019 ('Taking stock and profits', 9 December 2019). The selling price is used in the performance table.

Source: London Stock Exchange opening offer prices at 8am on Friday, 1 February 2019 and latest bid prices or on date when Simon advised exiting the holding.

The robust cash performance is also funding bolt-on complementary acquisitions, the latest being announced alongside the results. Bloomsbury is paying £8.45m for Head of Zeus, the publisher behind best-selling authors Dan Jones, Cixin Liu, Victoria Hislop and Lesley Thomson.

The raft of earnings upgrades has sent the shares above the 330p target price I outlined at the time of the January profit upgrade (‘Five small-caps with earnings upgrade tailwinds’, 2 February 2021) and they now trade on a cash-adjusted PE ratio of 14 for the 2021/22 financial year. However, with cash being recycled into acquisitions, BDR growing strongly and the consumer division continuing to deliver best-selling titles, I expect the earnings upgrade cycle to continue.

My new target price is 400p which if achieved will take the total return on the holding to 89 per cent. Buy.

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