- When a 33 per cent one-year return is disappointing
- When disappointment isn’t anything to worry about
- 5 high-quality Aim shares
You know it’s been quite a special 12 months for the market when a 33 per cent total return can be classed as disappointing. However, that’s the case with my High Quality Small Cap screen, which saw its return over the past year trounced by the 51 per cent return from the FTSE Small Cap. At least it just about beat the 31 per cent from the Aim All-Share, though.
The performance of the main small-cap index was a result of the strong recovery sparked by news of vaccine breakthroughs last November. Small-caps are seen as particularly sensitive to the wider economy. As such, they generally benefit substantially in the early stages of a recovery. The same is true of the type of 'value' plays that the market has a habit of prematurely writing off during times of strife.
High-quality small-caps have less to gain from these recovery phases. To borrow from recent comments made by fund manager Terry Smith in relation to his fund’s underperformance during the so-called 'value rotation', good-quality companies simply do not have much to recover from.
As such, I don’t think this screen’s underperformance over the past year should not be judged as a disaster. That’s an important consideration for me because I made a number of changes last year to try to improve its output. The changes were based on those I introduced to the large-cap version of the screen a few years ago. That screen’s performance has really pepped up since the changes were made. So in all, I think the criteria changes made to the High Quality Small Cap screen last year are worth sticking with.
The full screening criteria:
- PE ratio above bottom fifth and below top fifth of all stocks screened.
- A genuine value (GV) ratio below the top quarter of stocks screened.
GV ratio = (enterprise value/operating profit)/(forecast EPS growth + dividend yield)
- Earnings growth forecast in each of the next two financial years.
- Interest cover of five times or more.
- Positive free cash flow.
- Market capitalisation over £20m.
- A top-quarter return on equity (RoE) in each of the past three years.
- A top-quarter operating margin in each of the past three years.
- Operating profit growth over the past three years.
Following last year’s rather disappointing showing, the screen now boasts a cumulative total return of 236 per cent in the nine years I’ve run it. That performance is based on annual reshuffles at the time of publication of new screens. The return compares with a 155 per cent return from a 50:50 split between the FTSE Small Cap and FTSE Aim All Share.
|Name||TIDM||Total Return (2 Sep 2020 - 16 Aug 2021)|
|FTSE Small Cap||-||51%|
|FTSE Aim All Share||-||31%|
|FTSE Aim/Small Cap||-||41%|
|High Qual Small Caps||-||33%|
A drawback with investing in small-caps is that they tend to be very expensive to trade. That’s because there is often a big difference between the price shares can be bought at and sold at. The so-called bid-offer spread.
To try to capture this expense I apply a hefty notional annual charge to the screen of 2 per cent. After doing this, the total return drops to 180 per cent. That’s a substantial difference (56 per cent) compared with the cumulative return without charges given above. This illustrates just what a big consideration charges should be to all investors. While adding in an annual charge helps show the impact of real-world costs, like most of the screens run in this column, the intention is to produce ideas for further research rather than an off-the-shelf portfolio.
The results from this year’s screen are entirely Aim-centric. No shares from the FTSE Small Cap index even came close enough to passing the screen to attempt to loosen the criteria in order to broaden out the stocks highlighted.
Some of the amendments I made to the screen’s criteria last year were designed to make it highlight more expensive shares. When looking for 'quality' you tend to get what you pay for. That’s true even with smaller companies where mispricing is more common.
Several of the shares passing the screen this year look very expensive indeed based on conventional metrics. This is not necessarily a bad thing. Stock screens are often most valuable when they lead to a road less travelled. In that vein, I’ve decided to look at the most expensive share on the list in more detail, software company Cerillion (CER).
The full screen results can be found in the table at the end of this article along with a selection of fundamental data. More data is available in the downloadable excel file.
There are definitely things to like about the investment case for software company Cerillion. But these positives are no secret. The shares have produced a 160 per cent total return over the past year, 490 per cent over two years and an astronomical 730 per cent over five years. Can the share price keep going up?
|Cerillion Plc||CER||Packaged Software||850p|
|Size/Debt||Mkt Cap||Net Cash / Debt(-)||Net Debt / Ebitda||Op Cash/ Ebitda|
|Valuation||Fwd PE (+12mths)||Fwd DY (+12mths)||FCF yld (+12mths)||EV/Sales|
|Quality/ Growth||EBIT Margin||ROCE||5yr Sales CAGR||5yr EPS CAGR|
|Forecasts/ Momentum||Fwd EPS grth NTM||Fwd EPS grth STM||3-mth Mom||3-mth Fwd EPS change%|
|Year End 30 Sep||Sales||Pre-tax profit||EPS||DPS|
|Source: FactSet, adjusted PTP and EPS figures|
|NTM = Next twelve months|
|STM = Second twelve months (ie one year from now)|
At this point in Cerillion’s mighty ascent, a big question for any new investor is whether there is enough on offer to justify the lofty valuation of 8.5 times forecast sales? That kind of rating can only really be justified by the prospect of strong growth from a truly exceptional company.
Much of Cerillion’s recent success appears to be linked to investment in 5G. Telecoms companies are key clients. They have been since the business was spun out of Logica in 1999 by founder and chief executive Louis Hall.
The company floated on Aim in 2016 at 76p and Hall still owns over 30 per cent of the shares; a reason for the relatively slim free-float, which FactSet puts at just over 50 per cent. This relatively limited liquidity is likely to have contributed to the stunning gains over recent years.
Cerillion develops, installs and supports a “pre-integrated” suite of enterprise software products. There are 11 different modules that telecoms clients can choose from, all of which sit behind an “integration layer”. The competitive advantage this is intended to provide to Cerillion’s products is a solution that is easier and quicker to set up than alternatives, as well as more reliable, while also being more flexible and more scalable. Enterprise software projects are notorious for their complexity and potential for cost overruns.
The software seems to be well-liked. Typically about 80 per cent of sales each year are from existing customers, with relationships tending to last more than a decade. Cerillion has also won industry accolades from research and advisory group Gartner.
The roll-out of new 5G services has prompted telecoms companies to invest in sprucing up their back-office systems. More complex partnership arrangements associated with 5G networks are also encouraging back-office investment, as is a growing focus by telecoms companies on more profitable business-to-business (B2B) work. And lockdown has pushed the industry to make greater use of automation to handle customers. All of this is helping fuel demand for Cerillion’s software.
During the past 12 months, the company won its two biggest ever orders. An £11.2m contract was signed in September and a $18.4m (£13.2m) deal was landed in March. In addition, Nokia has recently come on board as a customer. At the time of the half-year results the back-order book was up 74 per cent at £42.1m and even after exceptional order wins the order pipeline was ahead by 9 per cent at £131m. Business is booming and broker forecasts have been subject to frequent upgrades.
The company also has a billing product called Skyline that it sells to other industries aside from telecoms, such as healthcare, media and utilities.
While the growth is great, it’s important not to lose sight of the fact that progress is coming from a very low base relative to the company’s market cap of £251m given sales last year of £21m. Sales have grown 40 per cent since 2016 and are forecast to rise 15 per cent this year and 10 per cent the year after. A heck of a lot of growth as well as strong long-term profitability is being assumed by the shares’ valuation.
And while progress is impressive, there are reasons to be a bit circumspect about the quality of sales and earnings.
Really great software businesses tend to generate most of their sales through subscription models. Investors delight in such revenues because they tend to recur and produce healthy cash flow. There is also usually limited extra cost associated with such sales, which means profits often rise faster than revenues.
While a wedge of Cerillion’s revenue does come from its software-as-a-service (Saas) subscription products, in total recurring revenues accounted for only 29 per cent of the total last year. Also margins, while impressive, have been relatively stable since the company’s float. That said, there are hopes that recent large contract wins could push operating margins from about the 20 per cent mark towards 30 per cent.
The company’s other revenues represent things such as licence sales and implementation work. Investors tend to be less keen on these kinds of revenue streams because they are reliant on ongoing business wins. That’s fine when the market is booming, as it is for Cerillion at the moment, but sales can dry up when clients pull in their horns.
There are other issues associated with the quality of Cerillion’s earnings. A lot of the company’s revenue is recognised before it has been invoiced for. This reflects the fact it undertakes long, complex projects that are accounted for as work is done and it also books a lot of its software licence sales upfront.
The risk is that when the services provided are actually invoiced, the client may quibble. Such a situation can lead to payment delays and, in the worst case, restatements of past numbers.
In its last report and accounts, the company flagged contract assets of £8.5m: “Accrued income [that] arise when revenue is recognised, but invoicing is contingent on performance of other performance obligations or on completion of contractual milestones.”
In addition, the company had £2.7m of trade receivables, which are invoices issued but yet to be paid. Together, the accrued income and receivables represented over half the company’s revenue for the year. That’s a lot.
The net cash position of £7.7m needs to be seen in light of the large amounts owing to Cerillion. The company also receives money in advance for some of the work it does and that was reflected in year-end contract liabilities of £5.1m, which helps balance out those contract assets.
The risk of having so much money owing is compounded for Cerillion by the importance of its largest clients. In 2020 its number one client accounted for over a fifth of its sales. The top five accounted for nearly 60 per cent. Difficulties with a single customer could therefore have major consequences for the business. The company's boasts of having more than 90 customers in 45 countries are tempered by this fact. Still, the big orders now rolling should help make the business less reliant on just a handful of big spenders (see chart).
Dangers associated with the concentrated customer base are increased by the fact that the telecoms industry is very mature and many players are financially stretched. This increases the possibility of business failures, consolidation and just slow payment. The rate of technological change in the industry also means work related to older telecoms services is likely to decline. As Cerillion said in its last accounts: “The group has traditionally been dependent on the fixed-line, mobile telecommunications, broadband and TV industries and on fixed line/mobile, broadband and TV volumes and revenues, which may fall generally in the future.”
Quality of revenue and earnings aside, there is also reason to be uncertain. This is based on the company’s own spending and what it may indicate about long-term prospects.
Based on its recent order wins and longevity of its client relationships, Cerillion does seem to have a good product. However, it does not seem to be spending very much on keeping ahead of the game. This may reflect the fact that the cash-strapped nature of telcos means other software companies do not see much reason to compete. But whatever the case, investment last year of just £1.4m (a further £300,000 of development spending was treated as day-to-day costs) was below the £2.0m depreciation and amortisation charge, which excludes amortisation of acquired intangibles.
Such low levels of spending on investment, and particularly research and development (R&D), does not look very "growthy".
Another not very growthy aspect of the business is its healthy dividend record and cash generation. It seems perverse to frame these things as a negative, but when talking about a company priced at 8.5 times forecast sales, investors would typically assume there was a growth opportunity worth pumping every penny into.
Not so with Cerillion. It has built net cash excluding lease liabilities from £400,000 to £7.7m between 2016 and 2020. It also has been a steady and consistent dividend-payer and forked out £1.5m to shareholders last year.
And not wanting to be too churlish, but margins could also be viewed as looking too healthy for what one would typically expect from a rapidly-growing, jam-tomorrow small-cap. Adjusted operating margins last year came in at a rambunctious 19 per cent.
Such solid fundamentals coupled with an extremely rich valuation raises the question of whether investors are mistaking the company for something that it's not?
Dare to believe?
But sure, with a long time horizon and based on recent growth rates, forecast upgrades and hopes of rising margins, a case can be made that Cerillion’s shares are worth paying up for. Several brokers see it that way. The momentum may continue and the company could even become a bid target for a company that sees value in its market position and canny approach to enterprise software.
However, investment is about balancing potential rewards with risk. There seems to be some quite noteworthy risk based on the quality of revenue and earnings, and the level of internal investment. These factors increase the possibility of some kind of disappointment. That could prove very painful given the achingly high valuation. For me, the risk is too great to justify the rating, despites the positives of the investment case.
|5 high-quality Aim shares|
|Name||TIDM||Mkt Cap||Net Cash / Debt(-)*||Price||Fwd PE (+12mths)||Fwd DY (+12mths)||EV/Sales||PEG||Op Cash/ Ebitda||EBIT Margin||ROCE||Fwd EPS grth NTM||Fwd EPS grth STM||3-mth Mom||3-mth Fwd EPS change%|
|MTI Wireless Edge||MWE||£67m||£7m||76p||22||-||1.9||1.7||84%||10%||18%||14%||4.3%||7.9%||-|