Stockwatch: A quasi annuity share with a high rating

by Edmond Jackson from interactive investor |

After a 700% profit, then correctly predicting a sharp decline, our analyst gives his current view. 

Have the AIM-listed shares of Smart Metering Systems (LSE:SMS), the UK's largest installer/manager of smart meters for energy suppliers, finally found a support level – from which to rise?

Founder raises stake from 4.1% to 5.0%

Smart Metering Systems floated at 60p in July 2011 and the table shows a strongly advancing financial performance until the price hit 852p in January 2018, putting the shares on nearly 50 times earnings.

But smartmeters ran into controversy, the first generation unable to cope with changing energy supplier, and the current second generation are also not without glitches.  Such an interruption versus a high rating, also SMS's finances being complex to interpret, triggered a volatile downtrend where stock-on-loan (i.e. shorted) has crept up especially this year to near 3.5%.

With a market capitalisation of £464 million, there appears enough liquidity (and lender willingness) for this, and I note Marshall Wace appearing for the first time as a shorter of stock with a 0.53% position on 1 October.  This hedge fund is well-experienced and can be a useful benchmark, though is by no means infallible.  Otherwise, recent "holdings" updates on the regulatory news service (RNS) since the 17 September interim results have shown two investors raising their stakes and one reducing.

Interestingly, SMS's founder Steve Timoney bought another 1% on 3 October: there's no price in the RNS and the stock had plunged from 470p on 11 September to 310p on 23 September, with the statement showing that on 18 September Merian Global cut from 11.9% to 9.3%.  

So, it looks like an overhang appeared and stakes were brokered.  Timoney did cash in along the way though, both at flotation and from a 27.8% holding in 2013.  In terms of objectivity, as the founder he will "believe in the company," although he should know it too.

It's an intriguing contrast – with wider relevance - between one of Scotland's most prominent entrepreneurs and one of England's most experienced hedge funds: which type of trader should you follow?

Source: TradingView Past performance is not a guide to future performance

Hopes for a high-quality "annuity" type share

At 408p currently, SMS trades on 30x the consensus earnings per share (EPS) forecast for 2019 and 26x the 2020 forecast.  It also trades on a prospective dividend yield of 1.7%, and twice underlying net asset value (NAV), or 2.3 times tangible NAV.  It's a rating that, despite the chart fall, doesn't leave any scope for the narrative to disappoint; and my current concern as a stock analyst – possibly reflected in Marshall Wace's position too – is further bad economic news globally prompting more risk aversion that weighs on highly rated small caps.  

Underlying stories don't have to change, but small-company ratings may continue to slip as the economy turns down.  More positively, those able to distinguish themselves can rocket in a recession - see Next (LSE:NXT) and Domestic & General in the early 1990's.

A chief selling point for SMS equity has been the expectation of high-quality financial returns, besides growth prospects: developing a portfolio of meter/data assets offering index-linked, recurring revenues for its lifetime – supplemented by support services – thus a quasi annuity share with a high rating.  

Yet the industry story ran into trouble in terms of first-generation meter reliability, and SMS's recent interims coincided with news how the UK rollout has been delayed by four years – to 2024 – with its estimated total coast soaring to £13.5 billion.

You could, however, see this as teething trouble; like smartphones' steadily replacing landline usage, smartmeters will take over.  The risk isn't existential like questions over HS2.  Once technical issues are resolved then home refurbishments and new-build will extend their usage despite a rump of indignant home-owners currently.

I note that Octopus Energy – a supplier I've switched to this year due to consistently high ratings for service quality, besides pricing value – signed up SMS last January for second-generation smartmeters.  I'm one of those still resisting smartmeters, but when I examined Octopus they appeared shrewd cookies – 100% green energy – attuned to where energy supply is heading. 

Messy financial results but a new wave ahead

On the positive side, first-half 2019 saw revenue advance 16% to £54.2 million like-for-like with annualised recurring revenue up 24% to 85.9 million.  But due to a hefty depreciation charge - up from £10 million to £17.2 million – reported operating profit slumped to £2.4 million, where adding back depreciation means a 12% fall to £20.6 million.

There were then £5.2 million exceptional items, meaning that while SMS was able to show a 9% rise in normalised EDITBA, its reported post-tax loss was £1.4 million, or underlying profit down 60% to £3.9 million.  Even if you say this is just a snapshot in time, most investors seek cleaner numbers.

Disruption was blamed on "industry-wide technical issues, slowing installation" albeit "signs of expected recovery emerging," as SMS's domestic meter portfolio passed 1 million.  A mixed picture continues however: while 2019 revenue was guided ahead of market expectations, profit will be below.

A potential news item of interest to speculators is management entertaining a minority sale of meter assets "to boost liquidity and demonstrate value in the metering asset base".  

An order book for some 2 million meter installations – backed by over 500 engineers and £50 million cash – should at least underpin revenue growth, with the mass rollout of second-generation meters implying a new wave ahead.  Operationally, SMS looks like it's at an inflection point and I suspect this is a chief rationale for the founder's share buying.

Smart Metering Systems - financial summary            
year ended 31 Dec 2013 2014 2015 2016 2017 2018
             
Turnover (£ million) 27.9 42.4 53.9 67.2 79.6 98.5
IFRS3 pre-tax profit (£m) 7.5 11.0 17.5 18.2 18.0 5.4
Normalised pre-tax profit (£m) 7.5 11.7 17.5 18.7 22.2 25.1
Operating margin (%) 29.3 31.5 36.3 31.3 28.3 11.3
IFRS3 earnings/share (p) 7.4 10.1 16.8 17.0 16.0 3.9
Normalised earnings/share (p) 7.4 10.8 16.8 17.5 19.7 18.3
Earnings per share growth (%) 26.4 45.1 55.7 4.5 12.6 -7.1
Price/earnings multiple (x)           22.4
Annual average historic P/E (x) 48.8 48.4 32.0 26.0 35.0 44.3
Cash flow/share (p) 7.5 27.6 26.0 32.6 43.6 34.9
Capex/share (p) 29.2 42.7 48.6 47.2 140 118
Dividends per share (p) 1.9 2.6 3.0 3.6 4.5 6.0
Yield (%)           1.5
Covered by earnings (x) 4.3 4.4 5.9 5.0 4.7 3.0
Net tangible assets per share (p) 24.5 27.4 43.4 58.1 190 184
             
Source: historic Company REFS & company accounts            

Higher interest charges weigh

Portfolio investors are likely to judge SMS's overall context where, in terms of financing its growth opportunity, they will note that end-June net debt had risen 31% to £186.6 million or 84% of net assets.  That meant finance costs leapt 76% to £4 million which were covered 1.9x by operating profit, but were uncovered if you respect £5.2 million exceptional items.  It hints at changes in the underlying debt mix and, indeed, looking at the balance sheet, £172 million near-term debt has been replaced by £234.7 million long-term debt. Also, end-June cash had risen from £30 million to near £50 million.

Possibly, the much higher interest charge relates to timing of debt restructure, and this extent of interest charge is justified in a roll-out phase as a means to end. But, in such a context, I then question a progressive dividend policy.  Presumably the board wants to flag confidence in evolving a dependable, annuity-type share, but the interim cash flow statement shows nearly £5 million going out in dividends, additional to £50.2 million investment, while cash generated from operations is down from £21.6 million to £15 million. The dividend is effectively being paid with the help of £65.4 million new borrowings.

Looking under the bonnet like this rather perturbs me, especially at a time when the economic environment generally appears to be weakening.  Holding this share implies confidence that smartmeter rollout won't be compromised again.  At least SMS has access to a £420 million banking facility over five years from December 2018, so is backed to accelerate installation in line with demand. 

Rating the stock is complex

I initially drew attention to SMS shares at 111p in April 2012, then again at 324p in February 2015; SMS being an easy-to-grasp growth story with high recurring income. Then, as it became more highly rated, at 560p in February 2017 I began to wonder about a potential rollercoaster. The price then dipped to 480p before soaring to 875p by end-of-year, only to turn volatile again and slump in the second half of 2018. That September, I thought it rated "Avoid" on 30 times projected earnings versus questions being posed about smart meter reliabilities – especially if you want to switch energy provider.

Taking another look again after a near-term chart capitulation, founder's buying and Marshall Wace's shorting, SMS's rather complex fundamentals justify these contrasting trades.  

Personally, in the short term, I recognise speculative upside based on meter sales' news, longer-term also according to how the roll-out and SMS's results evolve.  So, this share has definitely become more interesting and merits attention with fresh money according to news.  

It is still pretty high-risk, significantly because its valuation leaves little room for disappointment.  So, while I'm tempted to conclude with a 'speculative buy' case, I'd caution most investors: Avoid.

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

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