It is a story about how the AIM market does contain quality businesses if you look hard enough, but stay vigilant for possible change.
In a pre-close update for its year to 30 September, Cerillion (LSE:CER) has brushed aside fears about the telecoms sector after Spirent Communications (LSE:SPT) and Calnex Solutions (LSE:CLX) warned on profits.
Early this month, Spirent described the telecoms market as “extremely challenged” with big customers delaying expenditure and technology investments. “The uptick in demand we witnessed in the second quarter dissipated over the summer and the anticipated rebound in September has not happened.” This relates to the provision of automated tests for devices and networks.
Calnex is another telecoms tester – serving also cloud computing – and cited order inflow remaining subdued in its first half year to 30 September. A similar theme of project delay applied and the second half to 31 March 2024 was guided “slower than anticipated”.
Such cautions explain Cerillion’s drop from 1,330p to near 1,000p by 10 October, yet an update yesterday conveyed rude health. This company is riding on the back of full-fibre broadband and 5G roll-out, providing software for customer billing and relationship management.
Latest upgrade ticks 20% earnings growth for latest financial year
Momentum of a record first-half year to 31 March continued, with a £15 million contract signed with one customer last June and completion of a major installation for another in July. Consequently, full-year profit is guided “meaningfully ahead” of consensus, where £11.7 million net profit was targeted to deliver earnings per share (EPS) of 39.5p, rising to 44.0p in September 2024.
One 2023 EPS upgrade so far is by 8% to 42.6p, hence with the stock settling up 8% to 1,150p, it implies a trailing price/earnings (PE) ratio of 27 times, nearer 25 perhaps if Carillion’s momentum is sustained into 2024.
A strong element of recurring income helps justify this valuation intrinsically, also the scarcity value technically (supply and demand for the stock). The new customer pipeline continues to grow strongly with “some large opportunities”.
Lumpy revenue and profit but repeat earnings growing
It sounds great if Cerillion’s purple patch of trading persists. The mid-May interim statement noted strong investment in 5G and broadband infrastructure that “will create substantial opportunities for Cerillion as communications service providers seek to monetise those new assets and gain more value from their network real estate”.
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Mind how a lumpy revenue profile means it only needs a timing slip when completing a large deal, for a reported profits “miss” – despite no change to underlying value by way of discounted cash flow.
It is the kind of thing to be steeled for, which could even be a buying opportunity – if any delay does materialise. The risk for any stock on a high valuation is sensitivity to the slightest upset in expectations.
Management stresses how within circa £39 million annual revenue, existing customer sales are significantly greater than last year “reflecting the growing value of the installed base”. So, perhaps we should credit the stock rating also with an aspect of consistency via recurring revenues, hence earnings too.
Cash generation implies scope to raise dividend
The update cites Cerillion’s financial year-on-year net cash up from £20 million to near £25 million, which I estimate at 84p a share.
Yet the dividend projection may be upgraded only to around 11p or so a share, from 10.5p, despite capital expenditure taking only 13% of net operating cash flow per share in the September 2022 year. The table shows five years at least of a strong free cash flow profile that is maturing to be able to pay out more.
Or possibly the board want to retain scope for a meaningful acquisition in a new growth area. Otherwise, the interim cash flow statement showed only £552,000 capitalisation of (software) development costs as the main investment.
Cerillion - financial summary
Year-end 30 Sep
|Turnover (£ million)||8.4||16.0||17.4||18.8||20.8||26.1||32.7|
|Operating margin (%)||5.2||13.1||10.9||13.4||13.5||28.9||32.7|
|Operating profit (£m)||0.4||2.1||1.9||2.5||2.8||7.5||10.7|
|Net profit (£m)||0.3||2.0||1.9||2.3||2.6||6.4||9.3|
|EPS - reported (p)||1.3||6.9||6.5||7.8||8.8||21.7||31.6|
|EPS - normalised (p)||3.4||6.9||6.8||7.8||8.8||21.7||36.7|
|Operating cashflow/share (p)||-3.5||11.7||12.5||17.1||22.2||33.1||41.7|
|Capital expenditure/share (p)||3.2||3.6||5.6||4.1||4.8||4.3||5.4|
|Free cashflow/share (p)||-6.7||8.1||6.9||13.0||17.4||28.8||36.3|
|Dividends per share (p)||3.9||4.2||4.5||4.9||5.5||7.1||9.1|
|Covered by earnings (x)||0.3||1.6||1.4||1.6||3.1||3.5||3.5|
|Return on total capital (%)||2.4||12.0||11.1||14.8||13.0||29.7||34.1|
|Net debt (£m)||-0.4||-1.7||-2.5||-5.0||-2.1||-8.4||-16.2|
|Net assets (£m)||13.0||13.8||14.4||15.5||16.0||20.2||26.7|
|Net assets per share (p)||43.9||46.6||48.9||52.7||54.5||68.8||90.9|
Source: historic company REFS and company accounts.
Questions as to the appropriate valuation multiple
Revenues not yet reaching £40 million imply this niche could have plenty of scope yet for growth. An operating margin over 30% helps justify a near £340 million capitalisation over £300 million and PE multiples in the twenties, although it’s unclear quite whether stiffer competition will materialise.
There is no debt apart from £2.6 million lease liabilities, hence the interim 2023 income statement enjoying £306k net finance income.
In April 2022, I made a “buy” case at 820p after a bullish update – arguing that a PE multiple of 25 times was justified for quality credentials including the margin. It implied potential for the stock to be worth over 1,000p, and indeed it hit 1,500p late June for a gain of over 80%. Then, after a dip, the shares consolidated sideways at around 1,325p before dropping in response to the Spirent and Calnex news.
In April this year, I suggested not to push your luck that a forward PE multiple of 30 times (at the time) would persist, so possibly lock in some gains at 1,205p. Trading is less problematic if a stock is held in a tax-free wrapper such as an ISA or SIPP.
Source: TradingView. Past performance is not a guide to future performance.
On 21 September, Investec Wealth & Investment passed the 9% stake level – apparently from nowhere but could have been near the 3% threshold for disclosure. That’s good, but institutions can buy around the top just as they may sell at the bottom.
Hinges on exactly what scope left for ‘structural growth’
Besides infrastructure upgrades, Cerillion is benefiting from data continuing to move to cloud space. This could last a few years yet.
Mind, a relatively nearer technical risk is how this stock has established a pattern of upgrades. It is not impossible it falls when delivering at results time, simply because the market was expecting another fix. Not to be negative, but I have seen this happen.
The current firm rebound from near 1,000p looks like mean-reverting back to the trend since June, albeit still downward in this context. The long-term chart has a slightly tilted “head and shoulders” from last April.
Cerillion’s long-term challenge is what can the board achieve to replace the current growth spree once consolidation sets in? Otherwise, and given its recurring revenues, the stock might drop to a level exacting a useful yield – helped also by raising the payout. You might not want to be holding it then, if such a status change was to happen between “growth” and “value”.
Bear in mind also, though, that Cerillion’s modest size could make it a takeover target at any time, accentuated by a de-rating.
As yet, Cerillion looks assured of 20% earnings growth for its latest financial year, but that is all we know.
The challenge ahead for UK smaller and mid-cap stocks is exemplified by the Institute of Fiscal Studies’ targeting a moderate recession in the first half of 2024 – lasting for nine months, with gross domestic product falling 0.7% (it was 4.3% in 2022). It does, however, draw on analysis from US bank Citi and, while it accords with my view of a slowdown continuing, no one has a crystal ball.
I therefore conclude “hold”, just be wary.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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