Interactive Investor

Stockwatch: A share to profit from UK financial distress

3rd November 2017 09:28

Edmond Jackson from interactive investor


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Is AIM-listed insolvency services group Begbies Traynor poised for prosperity? The Bank of England's 0.25% interest rate rise to 0.5% merely pars monetary stimulus to its level before the EU referendum; yet a relentless build-up of debt makes any rise liable to tip "zombie" businesses over.

These are firms so indebted they struggle simply to pay interest due, are realistically incapable of repaying the debt, have insufficient working capital to fund growth or absorb rising input prices, yet are kept functioning by very low interest rates and banks not wishing to book losses on loans.

It's anathema to economists who believe in creative-destruction; who have argued stimulus measures lasting well beyond the 2008 crisis have delayed necessary restructuring. It probably helped UK corporate insolvencies last year reach their lowest level since 2004; yet, there appears to have been an inflection point even before the Bank of England's first interest rate rise in a decade.

2017 shows a leap in UK firms in financial distress

It's worth considering the trend in Begbies Traynor "red flag alerts", both in terms of this business, the wider UK economy and your portfolio exposure to domestic small caps.

Last April's Q1 2017 report cited instances of significant financial distress, up over 25% like-for-like, initially in transport/logistics, also wholesaling and food/beverages, sectors exposed to change in discretionary spending as inflation bites against static wages. This marked a jump from a 3% rise in Q4 2016.

The company's 11 July prelims to end-April were no great shakes: adjusted pre-tax profit (on the company's basis) up a modest 9% to £4.9 million despite a slight slip in turnover to £49.7 million, and the total dividend held at 2.2p per share against fairly constant net debt of £10.3 million.

Yet, the stock started to rise from below 50p, despite the outlook statement not saying much beyond anticipating earnings growth in the new financial year, sounding non-committal about business recovery services, which were likely to see a summer lull despite activity levels improving in calendar 2017.

Diversification into property services

Given an uninspiring financial record over the last five years (see table) amid relatively low insolvencies, the group has re-balanced such that, while remaining the UK's leading corporate recovery practitioner, it has diversified into property services that now represent some 30% of revenue/profit.

For example, the June 2016 acquisition of Pugh & Co made the group the largest regional firm of commercial property auctioneers. How ironic if this was to coincide with another inflection point – in the boom in asset values due to monetary stimulus – such that property transactions peak out.

Economic downturn may, however, stimulate auctions as properties change hands or are possessed by lenders, thus it looks "related diversification" which can work out well, if still an attempt to wrest growth from property that's ultimately cyclical. Time will tell.

Distress levels continue in Q2 and Q3

At end-July, the Q2 Red Flag report re-iterated 25% more situations of significant financial distress, like-for-like, with those property-related up 32%, rather supporting my point about how property is exposed after nearly a decade of asset inflation.

Investors chased Begbies shares up to 67p by mid-September which prompted profit-taking – whether on a short-term technical view or a simple earnings basis, the forward price/earnings (PE) ratio having reached the high teens.

Yet, at 66p currently, there's a material 3.75% prospective yield due to Begbies' very strong cash flow record - the table shows annual multiples of earnings per share (EPS) and zilch capital expenditure needs – being a classic "people business" in value-added services, generating plenty of cash for distribution.

The latest 1 November Red Flag report for Q3 cites a 27% like-for-like increase in significant financial distress situations – nearly half being "zombie" companies, many of which will not survive higher interest rates and employment costs. Indeed, if the credit bubble is about to burst, then potentially there could be widespread fall-out and de-risking price falls in domestic smal

UK inflation may ebb again though

It is important to keep a sense of perspective: this first rate rise only removes what some analysts regarded as an unnecessary knee-jerk reaction – cutting to 0.25% post the EU referendum. Possibly inflationary pressures will ease in the medium term towards the 2% target the Bank of England maintains. Reaching 3% inflation in September may reflect retailers unable to hold off raising prices for competitive reasons, after sterling's devaluation, plus energy costs rising.

Latest minutes to the Bank's monetary policy committee show that, despite a likely recovery in wage growth and spare capacity being absorbed, the effects of rising import prices are likely a one-off factor set to diminish over the next few years, supporting a case for lower inflation in 2018.

Thus, interest rates may not rise further by much - if at all - versus a current sensation "the first rise in a decade" represents a tightening trend.

In which scenario the 2017 rise in insolvencies reflects an overdue reckoning of "zombies", amid uncertainty relating to Brexit also consumer confidence wavering. For the medium term there may be no let-up in debt levels as banks find other ways to manage risk e.g. more appropriate marketing.

Recent grants of options but also exercising

The rise in Begbies' shares has met with various directors and senior managers exercising options, and some deciding to cash in while others retain stock. The board appears confident, however, to see virtue in granting 500,000 share options to one executive director and 200,000 options each to seven senior managers, all with an exercise price of 63.12p.

An irritation with such schemes for outside investors, is enabling insiders to manage risk by locking in gains, then re-establish exposure to upside potential with fresh options, deploying capital only when visibly profitable to do so.

Executive chairman Ric Traynor does own 25.8% of the business, which is a very long-term holding otherwise the managers are significantly playing the options game. All such implies no committed view on future prospects, quite like the outlook statement.

Thus, Begbies and its trend of "red flag reports" are worth being aware of as possible tell-tales as to profit warnings ahead, and a way to prosper from them.

Yet, this 25%-plus rise in significant financial distress, reflects long-term "zombies" rather than healthier listed companies, unless in due course there's a multiplier effect that reduces economic demand.

Barring a market slide, however, Begbies' narrative and sound 3.75% yield mean its stock is unlikely to retreat. It certainly looks set to win more corporate recovery work, though quite what will be the trend in commercial property it has aligned itself to rather late in the cycle.

The next update will come with the mid-December interims, ahead of which it looks worth taking an initial position then re-evaluate on the news.

Begbies Traynor Group - financial summary           Consensus estimates
year ended 30 Apr 2013 2014 2015 2016 2017 2018 2019
Turnover (£ million) 51.1 44.1 45.4 50.1 49.7
IFRS3 pre-tax profit (£m) 2.4 4.3 -0.7 0.9 0.6
Normalised pre-tax profit (£m) 6.3 5.2 2.2 0.8 0.7 5.3 6.1
Operating margin (%) 14.2 14.3 7.2 3.4 2.6
IFRS3 earnings/share (p) 1.6 3.7 -0.6 0.4 0.2
Normalised earnings/share (p) 5.9 4.8 2.4 0.3 0.2 3.5 4.1
Earnings per share growth (%) -15.1 -19.8 -48.8 -86.4 -30.3 1,433 14.8
Price/earnings multiple (x)         273 17.8 15.5
Annual average historic P/E (x) 5.8 8.9 15.3 98.3 210
Cash flow/share (p) 6.5 6.1 3.9 6.4 5.2
Capex/share (p) 0.4 0.4 1.3 0.5 0.3
Dividends per share (p) 2.2 2.2 2.2 2.2 2.2 2.3 2.4
Yield (%)         3.5 3.7 3.9
Covered by earnings (x) 2.7 2.2 1.2 0.2 0.1 1.5 1.7
Net tangible assets per share (p) 8.1 8.6 3.1 1.7 -0.4    
Source: Company REFS              

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