Eight genuine growth plays

2018 performance

Source: Thomson Datastream

This performance pick-up was much needed, particularly after a truly ghastly 2017 share selection. Among the horrors highlighted that year was high-profile fraud Patisserie Valerie. At the time I updated on screen performance last year, Patisserie’s shares had been suspended and the full extent of the horror was not yet known or possible to factor in (without risk of defamation, at least). I therefore wasn’t able to provide full performance numbers. But I can now revisit the 2017 result to include a total loss from Patisserie that more than doubles the already-horrendous total return I reported this time 12 months ago to a negative 21 per cent. That compared with a negative 2.2 from the FTSE All-Share over the same period and a negative 5.4 per cent from the Aim 100. Utterly horrid.

While the poor run by the screen over the three years to late 2018 was noteworthy, previous years were far better. Add in the good run of the most recent 12 months and the cumulative total return from the screen in the seven years I have monitored it now stands at 119 per cent. This compares with 73 per cent from the All-Share over the same period and 62 per cent from the Aim 100. While the purpose of the screens in this column is to present ideas for further research rather than off-the-shelf portfolios, if I factor in a 1.5 per cent annual charge to represent real world dealing costs, the cumulative total return from the screen drops to 97 per cent.

This screen is pretty simple in its approach. It looks for strong historic and forecast earnings growth and a lower-than-average price/earnings growth (PEG) ratio. The PEG ratio is a rough-and-ready way to assess what price investors are being asked to pay for the growth on offer. It is calculated by dividing a share’s price/earnings (PE) ratio by the company’s EPS growth rate. The growth rate used by this screen to calculate the PEG ratio is based on the average forecast growth for the next two financial years.

The full screening criteria are as follows:

■ Both a three-year EPS compound annual growth rate (CAGR) and a forecast growth rate for the next two reporting years of 15 per cent or more.

■ Forecast EPS growth for each of the next two reporting years that is greater than the median average.

■ Forecast EPS growth rate for the next financial year (FY+2) at least half the rate forecast for the current financial year (FY+1), or more than 10 per cent in each year.

■ EPS forecasts higher today than they were three months ago.

■ A PEG ratio among the lowest half of index constituents (either FTSE All-Share or Aim 100).

The screen is run separately on the FTSE All-Share and Aim 100 indices. This year it found eight stocks meeting its criteria. All the stocks, along with some fundamentals, are listed in the table below. I’ve taken a look at the stock with the best forecast upgrades in the past three months. While the company, YouGov, has an interesting growth story, it is perhaps just as interesting for illustrating one of the important considerations investors need to have in mind when assessing the adjusted earnings reported by acquisitive companies. 

Eight genuine growth plays

Source: S&P CapitalIQ

YouGov

A year ago, shares in survey and data analysis specialist YouGov (YOU) traded at a very high multiple to adjusted earnings. Now the multiple looks stratospheric. While the share price has risen over the past 12 months, the main reason for the hike in valuation comes down to a change in the company’s policy for making adjustments to profits (see table). 

The recent change is cosmetic to the extent that there is no effect on the ‘statutory’ numbers that accounting standards require the company to report. But that does not necessarily mean the issue will not weigh on the share price.

YouGov has decided to include amortisation charges when it calculates adjusted earnings after many years of not doing so. Amortisation is a charge that companies take against income in order to reflect historical spending on intangible assets. Including this charge looks sensible because YouGov’s amortisation mainly relates to investment in technology and growth of its 8.3m panel, both of which are essential to the success of the business. Very little of its amortisation is of the type that is only created due to acquisition accounting, which is amortisation that is best adjusted for (a fuller explanation can be found in the online version of this article).

In theory, the market should have understood the adjustments that the company was previously making and should therefore have no problem with the presentational rejig. However, in practice, markets are not always quite so considered. Indeed, while an 11 per cent fall from the shares’ late August high of 617p may just be a reflection of a broader turn in sentiment against growth companies, it is impossible to rule out an impact from presentational changes.

Not all amortisation is equal

Often, only a small amount of a company’s real intangible value is visible as an asset on its balance sheet. Much of the money companies spend on intangible aspects of their operations can be treated as a cost that is immediately deducted from income, as opposed to being treated as an investment in an asset that’s recorded on the balance sheet and amortised over its useful life. Accounting rules chiefly dictate how companies treat such spending.

For example, the marketing expenditure needed to build a brand will normally be regarded as a cost, despite the significant long-term intangible value it can create for a company and shareholders. Much research and development is also considered a cost rather than a long-term investment. For this reason, many of the most valuable companies on the market can be regarded as having significant “phantom” assets that do not appear on their balance sheets. 

But an odd situation arises when a company acquires another business. In this situation, the acquirer has to put a value on things such as brand, and record it as intangible assets on its balance sheet. But if it had spent the money to generate the intangible value itself, the spending would have been treated as a cost and no asset would have been created. 

This means acquisitive companies frequently find themselves in a situation where they are reporting an amortisation charge for an acquired intangible asset at the same time as the spending needed to maintain and grow the intangible is treated as a cost. Effectively, the spending on the acquired intangible is being double counted in the income statement: once as a cost; once as amortisation. Ironically, this double counting happens at the same time as the value of the 'asset' on the balance sheet is steadily whittled away to zero, and it is turned into a phantom.

For this reason, acquisitive companies often produce profit numbers that are adjusted for amortisation. YouGov has made nine acquisitions over the past decade, helping to facilitate its geographic expansion and a more than fourfold increase in panel members from 2m to over 8m. 

But while there is sense in ignoring amortisation related to intangible assets that only exist because of an acquisition, it is still much harder to see a good reason for ignoring other amortisation. That’s true both of amortisation related to intangible assets that have been created internally and also of amortisation on intangible assets that have been acquired but would have been created internally had the acquired business always been part of the larger group. 

Hard to ignore

In the case of YouGov, much of its amortisation can be regarded as a reflection of ongoing investment needs as opposed to double counting (see pie chart). Also, investment in intangible assets is key to supporting growth. Of last year’s £12.2m capital expenditure, panel recruitment and software accounted for £8.8m, which compared with just £2.7m spent on tangible plant, property and equipment. What’s more, YouGov views the size and engagement of its 8.3m-strong panel as a key competitive advantage, together with its technology.

It can therefore be seen as a credit to the company that it has decided to include all amortisation charges in its adjusted profit calculations. It still adjusts for smaller items related to restructuring and acquisition costs, as well as fair value movements on investments. Further down the income statement, pre-tax profits are adjusted for share-based payments, which are a very real cost to shareholders and represent a bigger cost. Share-based payments have amounted to £6m over the past two financial years. 

The adjusted verdict

The question shareholders now face is whether the new, and arguably improved, lower adjusted profit numbers will prove a drag on the share price. In theory, the market should have understood the adjustments the company was previously making and should therefore have no problem with the presentational rejig. In practice, markets are not always quite so considered. Indeed, while an 11 per cent fall from the shares’ late August high of 617p may just be a reflection of a broader turn in sentiment against growth companies, it’s impossible to rule out an impact from presentational changes.

The table below shows how broker Numis has had to change its forecasts of adjusted EPS following YouGov’s adoption of the new policy. The numbers on the left are forecasts following the 2018 full-year results under the old adjustment regime and numbers on the right are the forecast following the 2019 results last month when the new adjustment method was adopted. 

*Forecast “Old adj” numbers, reported “New adj” numbers. **Forecasts.

Source: Numis

Much to like

There are certainly things to like about YouGov’s business. The increased importance being put on data analysis in marketing is feeding into demand for the company’s services. Its end markets were estimated to be worth $46bn in 2017, with the US accounting for $21bn. 

YouGov boasts a strong and growing presence in the US, which is its largest market at 41 per cent of sales and 42 per cent of profit in 2019. And there is also good growth coming from the UK, YouGov’s second largest geography at 29 per cent of sales and 38 per cent of profit. Overall sales rose 17 per cent in its 2019 financial year to £137m and adjusted profit before tax was up 26 per cent to £20.5m.

During the year, the company completed a five-year plan and has unveiled ambitious new targets stretching out to 2023. The goals for the new plan include doubling of both revenue and adjusted operating profit margins, which stood at 11 per cent in 2018 and rose to 13 per cent last year (under the old system for adjustments, 11 per cent was also where the adjusted operating margin stood at the start of the last five-year plan in 2014, getting to 17 per cent in 2018).

YouGov also hopes to achieve a 30 per cent earnings per share (EPS) compound annual growth rate (CAGR) over the period and management will only see its new long-term incentive plan (LTIP) pay out in full if 35 per cent CAGR is achieved. Dilution from the new LTIP is expected to stay below 10 per cent, but that still represents a hefty cost to shareholders.

The growth targets look high, but encouragement can be taken from the recently completed five-year plan, which saw YouGov achieve EPS CAGR of 29 per cent compared with a target of 25 per cent – albeit based on the old profit adjustment policy.

YouGov’s aim is to become the world's leading provider of high-quality market and opinion data and insights. Internationally, it competes against a number of much larger and better recognised firms, including US-listed giant Gartner, which is nearly 25 times its size in terms of sales. YouGov ranks itself 11th out of 39 research firms based on media mentions but as number one in the UK. 

The five-year plan that finished last year has helped move YouGov from undertaking project-based work to offering subscription services to clients, at the same time as moving into higher-margin areas. Margins have also benefited from the group’s increased scale thanks to its ability to make more use of its investments in panelists and data analysis. 

The company is now trying to get more value from its data by making it easier for clients to adapt to their needs and providing better audience insights that are easier to act on. The company is also embracing tougher data privacy standards – GDPR – in an attempt to create a competitive advantage.

If valuation does prove a hurdle for the shares, it should not do so for too long if the company can deliver on its ambitions. All other things being equal, achieving the margin target should take the group’s adjusted return on capital employed (ROCE) from the already high current level of 18 per cent to an eye-catching 30 per cent. Coupled with the anticipated growth, that looks a compelling proposition for any investor. And there’s a good slug of net cash on the year-end balance sheet at £38m. The cash position has been helped by falling working capital needs, including a welcome drop in money owed by clients (debtors) despite the impressive sales growth.

Still, the valuation means any disappointments could be painfully felt by shareholders. Not only is YouGov up against some big players, but it faces ever-present risks from cyber attacks, data breaches and regulation. That said, the valuation looks less stretched when compared with the multiple of 47 times forecast earnings commanded by Gartner’s shares.