James Faulkner on WatsHot in the small cap markets: Begbies Traynor, Judges Scientific and dotDigital
One company that will surely prove an interesting one to watch in the coming months and years is business insolvency practitioner Begbies Traynor (BEG). Readers of this column will be well-versed in the distortive effects of overly accommodative monetary policy, one of which is to perpetuate the existence of ‘zombie’ companies.
Taking a look at the long-term share price performance of Begbies, we can see that this has not done the firm a world of good, it relying on a steady stream of insolvencies to keep it busy. However, the chart is an interesting one as the shares seem to have consolidated well in recent years and appear to be starting to tacitly recover from a low base. Indeed, if we believe the economic narrative in the press, we are on the cusp of a rate rise here in the UK, which should prove positive for Begbies.
That said, Begbies remains cautious in terms of outlook, but I note that the second quarter showed a large increase in SMEs in financial distress, up 60,000 to 237,000 compared with the same time last year. In the meantime, investors can enjoy a healthy dividend yield (>4%) which appears well covered by earnings and which looks secure. There is net debt of £14.5 million, but this is well covered (c.5x) by EBITA and Begbies has shown itself capable of coping with a reduced level of business activity for some time now. With the P/E just into double figures, there could be significant long-term upside here assuming Begbies is trading at the bottom of the cycle.
Judges Scientific (JDG)
I have already commented in this column on the perils of jumping on the bandwagon of ‘growth’ stocks priced to perfection – with ASOS being a recent case in point. Judges Scientific (JDG) has long been a company I have admired. Indeed, I recommended the shares on the old WatsHot site and exited at a considerable profit – only to see the shares continue to rise even further over the following year. However, at its peak Judges was trading on a P/E of >20 times while earnings growth appeared to have slowed. This should have had the warning bells ringing for investors, but it took a profit warning to really knock the stock off its perch.
As usual, acquisitions are driving top-line growth, but I note that organic growth was just 3.2% during the six months to end-June. Judges is essentially a buy-and-build story, a very successful one, which has given small but specialised scientific equipment manufacturers a platform to grow as part of a larger group. The strong earnings momentum delivered in recent years has therefore been a product of some very clever M&A activity, but the fact that Judges is now a much larger entity means that future acquisitions will have to be larger in order to generate the same level of returns. This increases risk, both in terms of execution and valuation, as Judges may be forced to pay higher prices as it moves up the valuation ladder. Given that Judges is also a big exporter, it was also clear that a strong pound wasn’t doing it any favours. This is essentially why I would have avoided the shares up until now.
But having fallen from a peak of 2,400p to 1,302.5p, are the shares worth a look now? Well, the line that really gets me worried is this one: “Order intake during the six-month period (excluding Scientifica) was 4.8% below that recorded during the first half of 2013; total intake (including Scientifica) was 11% below the level required to meet our sales budget for the year without consuming our order book.”
This could potentially hold out the prospect of more problems further down the line, but is the valuation tempting enough given that Judges has managed to ride out other bumps in the past? Broker Shore Capital’s revised EPS forecast of 85p puts the stock on 15.3 times and there is a small amount of net debt. Judges has always done a good job of generating cash and using it to fund acquisitions internally, but I think that future acquisitions are likely to require greater reliance on debt as they increase in scale. The long-term outlook is good, with exposure to several rapidly growing niche markets, and I remain convinced that Judges is an astute operator. However, given current forecast uncertainty, today’s price looks more like fair value rather than great value.
Another past recommendation of mine that has really zoomed ahead of late is dotDigital (DOTD), the e-mail marketing specialist. The firm is reinvesting a proportion of its cash in additional sales and marketing to further accelerate growth. The focus will be on additional sales and marketing resource with particular emphasis on channel sales and overseas sales development. A New York office is now up and running and management hope to accelerate activities there as well as identifying strategic channel partners in both the UK and further afield. Further investment in the the firm’s Software as a Service (SaaS) platform and hardware infrastructure are also planned to ensure the firm maintains its competitive advantage.
While it has not ruled out growth by acquisition, the focus is on organic growth by a continued increase in revenues from existing customers and signing new larger clients on longer contracts. A recent trading update saw the company post a 32% increase in revenue at its core dotMailer SaaS product, to £16.1 million, driven by an increase in average monthly recurring spend and several notable new client wins. The company now anticipates that full year EBITDA will be slightly ahead of the current market forecast of £4.3 million. Net cash grew to £9.3 million from £6.1 million at the end of June 2013, highlighting continued strong cash generation.
The group’s stated strategy of investing to drive further organic growth and focusing on medium- to large- higher value corporate customers seems to be doing well, with average monthly recurring spend per client 35% higher year-on-year. Meanwhile, a recently launched platform addition, the Magento connector, has driven further new wins with higher average recurring spend. In the US, the new office generated a 200% increase in revenues (albeit from a small base) with an encouraging pipeline. Finally, the number of clients signing up to longer-term contracts continues to increase, thereby improving future earnings visibility.
dotDigital is looking more fairly priced given the historic and projected growth, with shares trading on c.22 times FY15 consensus forecasts. This is against FY15 and FY16 pre-tax profit growth forecasts of 65% and 56% respectively and there is significant net cash that could be put to use. While the shares are no longer the compelling value that they were at the time of my initial recommendation, they are certainly worth holding onto in light of the significant US opportunity.