Stockwatch: In the right place and a top pick in the sector

by Edmond Jackson from interactive investor |

Already a successful long-term share tip for our companies analyst, an ongoing shift to healthcare marketing and dollar earnings are defensive qualities for this AIM company. 

Can £133 million AIM-listed healthcare marketing services stock Cello Health (LSE:CLL) break out of a volatile-sideways trading range in the last two years?

It has declared "strong" underlying performance with rising margin such that "the board is confident of achieving a successful result in 2019 at least in line with current market expectations," tempting upgrades.

Over the years, management has presented healthcare marketing as a growth theme which is fair up to a point, and it does constitute 95% of operating profit versus the lower-margin consumer marketing side.  Using language carefully I would say it should prove more recession resilient than other marketing services stocks.

We can't tell know what a hard Brexit could do to 12% of revenue deriving from continental Europe, but that's no big deal. I've drawn attention to Cello various times in the last seven years as a tuck-away versus the general sense of AIM small caps as high risk.  And it's worked well, the stock having risen from 35p in January 2012 to test a 130p range by May 2017, although the trend has since turned volatile sideways.

The end-2018 markets' slide saw Cello briefly below 100p, but it also tested 113p in March 2018 and again last June.  Though I don't take my cue from charts, this one says conviction and the trend has broken down, so let's consider why.

Accounting for costs, and a modest dividend yield

I believe these are the two key reasons why this stock has been in a consolidation phase. 

Cello's business mix continues to evolve towards higher-margin healthcare services marketing versus consumer, and 2019 performance seems overall encouraging now that acquisitions have integrated.

There's a niggle in the accounting presentation, however, that makes a material difference to the stock's rating: at 126p, it trades on 14 times 2018 earnings if you disregard acquisition/integration costs – what Cello calls "headline" earnings (or I've ascribed in the table below as normalised), but over 20 times net of such costs, at the IFRS3 reported level.

The table shows an ingrained material disparity which isn't going away if management continues to invest for growth.  According to note 8 in the accounts, headline earnings per share (EPS) "excludes restructuring costs, start-up losses, amortisation of intangibles, acquisition related costs and share option charges."

Yes, it can be helpful to look through these to underlying performance, but it introduces frustration about capitalising costs.

Regarding yield, management cites 13 years of consecutive dividend increases and the 2018 results showed pre-tax operational cash flow up 180% to £11.2 million.  

But even if the payout rises through 4p this year, it would still represent a modest yield - just over 3% - which is no prop if earnings prospects were to falter anytime.  

If perception did refocus around yield, then 5% would imply a share price drop to about 80p.  It's a people business, so besides the debatable price/earnings (PE) and unconvincing yield, net tangible assets are scant.

So, with marketing services stocks pressured, Cello's vague risk/reward profile has made it harder to attract conviction buyers.  The accounting makes its PE look fair to full, hence uncertain upside versus downside risk below 100p.  June, for example, saw a drop from about 135p to 112p on no company specific news just wariness generally.

Cello Health - financial summary            
year ended 31 Dec 2013 2014 2015 2016 2017 2018
Turnover (£ million) 160 170 157 165 170 166
IFRS3 pre-tax profit (£m) 5.5 3.8 5.0 -1.7 5.8 8.4
Normalised pre-tax profit (£m) 8.3 7.6 8.2 6.6 11.4 12.2
Operating margin (%) 5.6 4.7 5.5 4.2 3.6 5.3
IFRS3 earnings/share (p) 4.3 2.6 3.8 -2.9 4.0 6.1
Normalised earnings/share (p) 7.7 7.0 7.3 6.4 7.9 9.0
Earnings per share growth (%) 1.7 8.7 3.8 -12.7 23.4 13.9
Price/earnings multiple (x)           14.0
Cash flow/share (p) 10.7 2.3 7.8 5.3 4.6 12.7
Capex/share (p) 1.6 1.7 1.4 2.6 1.5 1.2
Dividend per share (p) 2.0 3.1 2.6 3.0 3.5 3.9
Dividend yield (%)           3.1
Covered by earnings (x) 4.0 2.4 2.9 2.2 2.3 2.3
Net tangible assets per share (p) -5.1 -6.4 -4.6 -4.6 8.4 11.2
Sources: historic Company REFS date, company accounts            

Results this year affirm medium-term development

The stock has turned higher again since the end of June, helped by the tone of the first half-year update.

It would have helped to quantify that "strong" headline EPS growth could mean high single-digits, while "good" growth in revenue, headline profit and margins, just single digits.  

Management likely prefers a bit of ambiguity, considering the Signal marketing services side tends to be second-half weighted and times are obviously uncertain.

It follows robust 2018 results with the headline EPS measure the board wants us to focus on, up 13.7% to 9p, thus in line with a 14x PE currently, although note the 3.85p dividend was ensured covered 1.6x at the reported EPS level after the various costs (and depreciation/amortisation) also the modest 2.3% revenue growth at constant currency to £104.8 million.  

You therefore wonder to what extent the 2017 acquisitions' integration has worked through to bolster profit, versus mediocre top line "growth". 

Half of 2018 revenue derived from the UK, 12% rest-of-Europe, 29% the US and 9% was rest-of-world.  I've not read any agency-type listed company explain how they are prepared to cope with what conceivable tariff there might be if Brexit happens, but at least this one's EU exposure is sub-teens and margin losses could even be offset by exchange rate factors (including US dollar strength) should sterling weaken further.  

International expansion continues with Philadelphia and Berlin offices now opened.  

The board contends that pharma/biotech represents "a stable attractive market for the long term" as scientific advances, R&D and commercialisation support demand for a one-stop shop for commercial advisory and communications skills.  

Cello's "Signal" side is a full-service marketing agency which also partly supports healthcare with digital and social media skills, a group re-naming to "Cello Health plc" underlining the priority.

So, holding the stock is part-acceptance of this claim that healthcare marketing services will be resilient.  Scrolling back to the 2009 results in the aftermath of the financial crisis, and despite headline pre-tax profit falling 27% to £5.1 million, "healthcare research has shown particular resilience" (at a time when the group was a broader-based market research consultancy) based on "continued strength in the pharmaceutical core". 

The company also talks about expanding into "the growing OTC [over-the-counter] and brand-oriented market for drugs and therapies, particularly in the USA."

Industry strengths mean I retain a positive stance

Given this precedent from the last economic crisis, and Cello's strengthening its healthcare exposure, I believe it is the most significant factor for this stock.  

The risk I rehearse, of a refocus on dividend yield, won’t happen if Cello's operational narrative remains fair.

The extent of costs' capitalising is annoying, but management is making useful investment moves and their accounting is within the rules.  

So I'll protest but not lose sight of how this group is well-placed and a preferred pick within the marketing services sector.

The balance sheet is declared "strong", justifiably so despite goodwill/intangibles representing 86% of net assets. Cash has declined 20% but, helped by good working capital performance, is a useful £10.4 million (to finance growth and support dividends even if trading deteriorates) and cash may have been applied to cut long-term debt to £4 million.

There is a good balance between trade payables and trade receivables - receivables at 114% of payables – so scant chance that profit is supported by late payments.

Net finance costs took barely 4% of operating profit and the £3.7 million cost of dividends was supported by 13.4 million cash generated before tax.  

Investment has been relatively modest in the last year, business purchases reducing from £5.3 million to £0.3 million and property/plant/equipment spend slightly easier at £1.3 million.  

Staff costs are by far the highest cost element at £68.2 million, up 4%, within a total £96.1 million total admin costs.

So, the financial profile is conducive to growth in shareholder value that merits a PE at least in the low teens.  

Broadly, Cello shares are fairly priced and the stock remains at risk should stock markets dive. Yet, commercially "Cello Health" is in the right place and a de-rating might tempt takeover interest. Buy.

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

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