SMS index linked contracts are good for dividend growth

When interest rates are near zero, Smart Metering Systems (SMS) is a more profitable business. Its model is to borrow money, then use it to install smart meters and invest in battery storage. In then charges fees for people to use these assets.

The problem for SMS is of course that the cost of borrowing has suddenly jumped. In the six months to June, it spent £63mn on capital expenditure, comprising £50.1mn on smart meters and another £10.2mn on battery storage. However, its operational cash flow was just £30mn. This had to cover the dividend plus the capital requirements. So to cover the difference, SMS took out another £75mn from its rolling credit facility. It has now drawn down £140mn of the £420mn available.

The strategy makes sense because its contracts are inflation linked. So, as interest rates rise so does SMS’s revenue. Year-on-year index-linked annualised recurring revenue rose 18 per cent to £110mn meanwhile adjusted cash profit (Ebitda) rose 24 per cent to £36mn. A profit headwind would arise though if interest rates were to settle above inflation.

It is this rise in interest rates, which explains why SMS has forecast 2024 adjusted cash profit (which doesn't include finance costs) to be slightly ahead of expectations but profit before tax to be merely in line. Despite rising rates, the board is still promising to increase dividends by 10 per cent year-on-year. There is an argument this cash could be used better investing in the business, but it will keep shareholders happy.

The rising interest rates are presumably why SMS share price has been drifting down. However, the existing pipeline of work suggests that adjusted cash profit will double over the next four years. Broker Peel Hunt has SMS on a 2024 free cash flow yield of 8 per cent, which is good value given its expected growth. We stick to buy.

Last IC View: Buy, 911p, 13 Sep 2022