Interactive Investor

Stockwatch: a 9% yield and nearest example to an ‘annuity’ share

This company pays a reliable and generous dividend, and is one that analyst Edmond Jackson has covered before. There’s enough here for him to upgrade his rating to ‘buy’.

27th February 2024 11:00

Edmond Jackson from interactive investor

If economies improve as interest rates ease in due course, does that imply the 9% yield offered by AIM-listed Duke Capital Ltd (LSE:DUKE) is overly generous? In other words, is now the time to accumulate?

This is a rather unique company, providing aspects of debt and equity capital to small and medium-sized enterprises, hence a bit tricky to benchmark. After founding in 2015 it listed in 2017, although at a size of £127 million with its shares at 31p to buy, you could say the concept is growing only modestly. It is a share chiefly for income-seekers. Yields elsewhere in high single-digits are either high-risk or involve declining industries such as tobacco.

Duke’s website asserts circa £200 million invested, with 15 current “partner” firms after six exits, so there’s a fair balance of diversification and focus on what one would hope are best-available situations. The company has paid out £46 million to shareholders so far.

Duke Capital - financial summary
Year end 31 Mar

 201820192020202120222023
Turnover (£ million)1.86.0-2.321.628.831.0
Operating profit (£m)-0.91.9-10.616.621.420.4
Net profit (£m)-0.91.8-8.914.020.419.6
Operating margin (%)-47.831.945476.774.465.7
Reported earnings/share (p)-1.31.1-4.05.86.04.9
Normalised earnings/share (p)-1.31.0-3.86.46.25.0
Operational cashflow/share (p)0.42.43.13.73.34.3
Capital expenditure/share (p)0.00.00.00.00.00.0
Free cashflow/share (p)0.42.43.13.73.34.3
Dividend per share (p)2.00.00.01.12.42.8
Covered by earnings (x)-0.70.00.05.52.51.8
Return on total capital (%)-2.62.2-11.715.911.79.2
Cash (£m)6.014.020.616.026.541.7
Net debt (£m)-5.0-2.4-5.11.121.212.2
Net assets (£m)32.272.174.085.8133164
Net assets per share (p)32.035.130.034.738.140.3

Source: company accounts.

In July 2028, I reviewed Duke as a relatively new listing, rating it a speculative “buy” at 49p: “In principle it is aimed astutely at investors hungry for yield, in practice only time will tell how risky are its returns,” I said.

In September 2019 at 47p, I reviewed the financial interests taken which seemed quite a revival of the 1980s “mini conglomerate” approach. I had some concern about a big jump in directors’ fees and shareholder payouts being close to the full amount of cash generated, otherwise debt would need to rise to grow the financial base. “Having allowed time to show what it can do, there are aspects I like and dislike”, hence I moderated my stance to a “hold”.

The shares have traded volatile sideways so would not interest a chartist, yet are well supported given the dividend’s rise to 2.8p a share in respect of the March 2023 financial year, implying a 9.0% yield. The same payout is targeted in respect of the March 2024 year covered 1.4x by earnings – which if maintained to 2025, implies a 2.9p dividend.

For total shareholder return, Duke has yet to excite, but the concept of “annuity share” comes to mind – in other words, as reliable and material a yield as you are likely to get from the stock market. Management cites 12 consecutive quarters of higher recurring cash revenue.

Not your usual commercial lender

Duke has not benefited from a higher net interest margin (the difference between interest gained from borrowers, versus money paid out to depositors) after interest rates have risen. It is no deposit taker, its lending hinge on raising debt/equity or re-investing cash flow. This rather limits scope for deploying capital; it cannot run the extent of leveraged operation like a bank.

Last September’s interim balance sheet supported around £60 million of debt, chiefly long term, relative to £6 million cash, generating £3.3 million finance costs – up from £2.0 million – and took a hefty 47% of operating profit. Such a set-up thus suffers from high interest rates, although management remains confident despite believing high rates “are set to remain for some time” and any cuts will not happen until “well into” the next financial year from 1 April.

Note eight “equity investments” concerns me, in relation to a £3.5 million write-down that has gone through the income statement. It relates to two “investments in mining entities from previous investment objectives”, but why was a small and relatively focused financial operator engaging mining at all? Any seasoned investor knows mining is inherently high risk and Duke is a small, listed company establishing its track record. I also cannot reconcile these mining situations with the company’s website, where the “Partners” page cites a history of 21 situations – 15 current and 6 exited – albeit none mining-related. Meanwhile, the July 2023 annual report cited “a diverse portfolio with exposure to 62 underlying operating companies”.

I begin to wonder if this is a deal-breaker for investing in Duke at all, given well-remunerated financial professionals should know better. A listed company is not meant to be a learning curve for them.

Yet the future is what counts, and if a 9% yield is adequately supported then the market is not going to moralise over the past. If Duke’s track record evolves satisfactorily from here, its equity ought to rise given a 9% yield would seem over-generous; yet buyers today would have locked in such a yield.

Exposure to the US, Canada and Europe

Duke is also not your usual UK-reliant small cap, and perhaps its mining interests relate to Canada. Indeed, the last trading update on 29 December cited a further £5 million equivalent “invested” in Creo-Tech Industrial Group Inc (electro-mechanical and industrial engineering), taking its overall exposure to £16 million equivalent. This does not, however, appear to be equity, the release citing refinancing existing senior debt.

This I find a plus point both for security of income from Duke and risk of its financial portfolio. While the UK remains the world’s fifth-largest economy and we should resist a tendency to “do ourselves down”, criticism such as inherently weak productivity sticks. Meanwhile, the US economy has grown consistently well over decades, averaging around 3% GDP growth despite recessions.

An inflationary environment has helped the partner companies

When the interim results reported total cash revenue up 35% to £14 million, with earnings per share and free cash flow both up 23%, management conceded this was helped by an ability to raise revenues in an inflationary environment – implicitly by pricing. Duke’s business model involves a royalty on revenues.

The corollary is falling inflation having some opposite effect; hence I am concerned at conveying Duke’s financial momentum as durable. It will be interesting to see if numbers have been affected by the UK slipping into recession at the end of last year, when Duke updates imminently on its third quarter, including guidance on the fourth quarter to 31 March.

A 23% discount to net asset value, with scant goodwill

This adds comfort about the share’s risk/reward profile, although such extent of discount can also be experienced by private equity-oriented investment companies.

It does significantly price in the risk of how a serious recession would pull the rug on cash flow (affecting payouts) and possibly lead to write-downs of carrying values where equity is involved. That element, however, is only around £12 million on Duke’s balance sheet, versus around £185 million in royalty-based investment and loans.

So, I do like these twin aspects of net asset value discount, plus the 9% yield that looks robust in key aspects – even if by no means guaranteed. This share is therefore not strictly an annuity.

I like less another example (when I examine Duke) of directors and shareholders in different boats. The interims cited a 15% like-for-like rise in directors’ fees to near £1.1 million during the period, well ahead of inflation. As ever with vehicles like this, it is a question of whether the board has sufficiently aligned shareholders’ interests with managers.

I upgrade to “buy” given a modest exposure looks worthwhile. Consider if better to wait for the next update.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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