This cash-rich, high-yield stock is also a takeover target

Aim-traded financial software provider Arcontech (ARC:74p) reported £56,000 lower first-half pre-tax profit of £0.37mn on revenue down from £1.45mn to £1.35mn, but pre-tax profit was almost 13 per cent higher than in the second half of its 2021-22 financial year.

The revenue decline was as anticipated after one customer decided to scale back its market data spend, and another opted not to renew its contract because it is switching to a solution in a legacy, bundled contract. That said, it’s rare for Arcontech to lose contracts. Of far more importance is news that the company is now “starting to see small amounts of growth and is confident that this will continue”, says chairman Geoff Wicks. That’s a positive development following several years of inactivity during the Covid-19 pandemic when the lack of face-to-face access to financial institution customers severely hindered its sales teams.

Arcontech makes its money by providing software products and bespoke solutions for the collection, processing, distribution and presentation of time-sensitive financial markets data. It is a software house as it doesn’t deliver any market data, but instead provides the means for clients (who are in the main large banks) to do so. Arcontech’s blue-chip client base of financial organisations includes Barclays, Citi, JPMorgan, Lloyds, Morgan Stanley, Santander and the Bank of England.

It’s a high-margin asset-light software business that boasts an equally high recurring revenue stream, reflecting the fact that customers sign multi-year contracts, which provide Arcontech with a high proportion of repeat income. In fact, all the income in the first half was recurring. True, the market still remains difficult and some financial institutions are taking a close look at their cost bases to make savings as they streamline their operations. However, analyst Michael Hill at house broker FinnCap believes that some individual contracts in the sales pipeline could exceed the entire £0.1mn revenue uplift he is forecasting in the 2023-24 financial year. That’s worth noting as the company makes an incremental operating profit margin north of 60 per cent on new contracts, implying scope for hefty earnings upgrades if they are landed.

Solid free cash flow generation

In the meantime, shareholders are benefiting from the company’s impressive cash generation. In the six months to 31 December 2022, free cash flow of £0.3mn covered more than two-thirds of the £0.43mn cash cost of the annual dividend of 3.25p a share paid in the period and meant that net cash increased by 5 per cent to £5.9mn (44p) year-on-year. FinnCap pencils in 10 per cent growth in the payout in the current financial year, implying the shares offer a prospective dividend yield of 4.8 per cent. The broking house also forecasts net cash of £6.1mn (45.5p) at the 30 June 2023 financial year-end, a sum that equates to two-thirds of Arcontech’s market capitalisation.

Effectively, an operational business that is forecast to make bottom-of-the-cycle full-year pre-tax profit of £0.65mn on annual revenue of £2.65mn is in the price for £3.8mn. Of course, we need a share price catalyst to spark a re-rating, the obvious of which is a return to revenue and profit growth. 

Furthermore, with the shares so lowly rated – Arcontech is priced on only 1.4 times book value, enterprise valuation to operating profit multiple of six and offers a prospective pre-tax return on capital employed of 9.5 per cent – then it’s possible that the company will fall prey to a larger predator. Either way, the shares have decent recovery potential, having drifted from the 82p level when I covered the annual results (‘Tapping into a prodigious free cash flow generation’, 12 September 2022). Recovery buy.

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