This company is well-positioned to exploit fallout from Brexit, and is a useful portfolio hedge, argues companies analyst Edmond Jackson.
Updates from AIM-listed insolvency adviser and corporate recovery specialist Begbies Traynor are a pertinent study of the UK economy, and it offers a modest hedge (normal market size: 7,500 shares) against downturn.
I first drew attention at 44p in April 2014, although the financial trend thereafter (see table) was uninspiring as the economy did well, Begbies' stock bumping along sideways until a rise began from H2 2016.
I noted prospects again around 67p last November as the Bank of England turned the corner on ultra-low interest rates and levels of corporate financial distress had soared in 2017. The stock reached 76p early this year but has since been in a sideways range, currently 71p after a firm AGM update on 20 September.
Care is needed given a forward price/earnings (PE) ratio likely in the mid-teens, a prospective yield only just over 3% and nothing to rely on by way of net tangible assets. Yet the group continues to augment its capabilities, well beyond the circa £8 million pre-tax profit it was making after the last recession.
Differing views of normalised earnings
The stock would appear cheap according to the company's presentation of normalised earnings, dear according to databases.
Prelims to end-April 2018 cite adjusted pre-tax profit up from £4.9 million to £5.6 million, versus £0.6 million up to £2.3 million on a statutory basis, with a similar big gap in earnings per share (EPS): 4p adjusted basic versus 1.3p basic, for the last year.
Company REFS cites normalised EPS of just 0.2p for the 2017 versus the company presenting 3.3p, and since REFS has not updated the 2018 results I’ve left out (whatever is their sense of) normalised EPS to avoid confusion.
Currently the historic PE multiple varies from 54.6 times (statutory earnings) and 17.8 times (the company's view). There's a question here about which one to respect, and whether investment value fair or expensive.
Begbies' sense of £5.6 million pre-tax profit writes back not only amortisation of intangible assets acquired (inevitable in “people” businesses) i.e. £1.9 million, but also £1.4 million transaction costs involved. A relatively smaller element of refinancing costs also get added back (zero last year).
It would appear Company REFS' view adds back only these refinancing costs, and the broker forecast only the amortisation charge, although in one logical sense it's fair to look through all these costs to see underlying performance.
In another though, be aware that when a business group scales up by acquisition they facilitate an impression of year-on-year growth that’s unrealistic organically, and costs are involved to achieve this.
Furthermore, small companies often may not present like-for-like organic figures: Begbies wraps acquisitions with existing businesses to present continuing operations which is not the same. Management would probably say acquisitions are a key plank of development, which is fair to some degree.
Thus, the 31 July broker estimate for £2.9 million normalised pre-tax profit this current financial year, and EPS of 3.9p, likely takes a conservative view of assuming no acquisitions given the financial upshot is too speculative.
Realistically, though, management continues to cite "selective acquisitions" as part of its strategy and had £3.5 million cash at end-July. Hardly a war chest and has been part-used from £6.7 million in April 2017, although debt has been cut from £17 million to £11 million also.
It seems fair to look for moderate EPS growth this current year hence a PE in the mid-teens and, with more testing times likely for UK firms in the medium term, I'm comfortable about Begbies' rating and prospects.
Corporate debt is the crux issue for insolvency risk
Stockmarket bears typically opine: "Nothing has been learned from the last financial crisis; central banks' stimulus has pushed up debt levels even further, such that when interest rates do rise there will be major casualties; any recession being likely deep and long-lasting because central banks including the UK's have got themselves into a position where fundamentally low rates leave no scope for a sudden cut to have much effect."
Yet there are contrasting claims about UK corporate debt. I've seen a 2016 study contend it had fallen by over 20% relative to GDP since the financial crisis, whereas in the US it fell 10% then was regained as firms pursued acquisitions and share buybacks.
UK net debt has been mitigated by a trend for firms to hold more cash e.g. due to uncertainty regarding Brexit. Then only last June, Pictet Asset Management warned global corporate debt is at 20-year highs, its chart of corporate net debt to EDITDA showing the UK's borrowing "rising steeply and the US near peak levels of leverage". Pretty much the opposite!
Corporate debt also needs distinguishing from UK public debt which has more than doubled since 2008, over 85.2% of GDP as of last June, also household debt which has ballooned over £1.6 trillion, driven by consumer credit and student debt. Constraints on government/consumer spending can still affect total demand within the UK economy, hence a financial risk to firms. So the macro context certainly does involve debt risks.
More specifically, what of Begbies' updates on the UK corporate sector?
|Begbies Traynor Group - financial summary||Estimates|
|year ended 30 Apr||2013||2014||2015||2016||2017||2018||2019|
|Turnover (£ million)||51.1||44.1||45.4||50.1||49.7||52.4|
|IFRS3 pre-tax profit (£m)||2.4||4.3||-0.7||0.9||0.6||2.3|
|Normalised pre-tax profit (£m)||6.3||5.2||2.2||0.8||0.7||2.9|
|Operating margin (%)||14.2||14.3||7.2||3.4||3.3||5.3|
|IFRS3 earnings/share (p)||1.6||3.7||-0.6||0.4||0.2||1.3|
|Normalised earnings/share (p)||5.9||4.8||2.4||0.3||0.2||4.0||3.9|
|Price/earnings multiple (x)||17.8||18.2|
|Annual average historic P/E (x)||5.8||9.4||15.2||98.9||218|
|Cash flow/share (p)||6.5||6.1||3.9||6.4||5.2|
|Dividends per share (p)||2.2||2.2||2.2||2.2||2.2||2.4||2.4|
|Covered by earnings (x)||2.7||2.2||1.2||0.2||0.1||1.7||1.6|
|Net tangible assets per share (p)||8.1||8.6||3.1||1.7||-0.4||0.8|
Source: Company REFS Past performance is not a guide to future performance
Red Flag Alerts versus genuine insolvency statistics
Mind ambiguity here too! Begbies is perhaps best known for its quarterly Red Flag Alerts, although precisely what constitutes firms in "significant financial distress" isn't clear. The company is prone to switch emphasis – like it did in its 20 September AGM trading update – to claims about trends in the UK insolvency market, where "government statistics cite a 6% rise in corporate insolvency appointments to 7,915 in H1 2018".
Management added: "we anticipate continuing our track record of earnings growth...as we benefit from an improving market in counter-cyclical activities, whilst increasing our market share..." with recent acquisitions making first full-year contributions.
Yet the medium-term trend in Red Flag Alerts appears to show risk mitigating. From Q1 2017, UK corporate levels of significant financial distress jumped 25% like-for-like – initially in transport/logistics, also wholesaling and food/beverages, as inflation bit against relatively static wages. (The Q1 2016 like-for-like rise had only been 3%.)
Then Q2 2017 saw this 25% hike continue, which pushed up Begbies shares into a 70p range. Q3 2017 saw financial distress increase 27% like-for-like, nearly half involving "zombie" companies i.e. which would not survive higher interest rates and employment costs. The rate continued to rise, up 36% like-for-like in Q4 2017 and, after November's interest rate rise 258,349, UK businesses ended 2017 “in negative net worth".
Begbies then drew a link with Article 50 being triggered on Brexit, saying as of end Q1 2018, 477,210 UK businesses were in "financial distress", up 33% on 30 March 2017. But in Q2 of this year the distress rate slowed to 9% and was actually down 1% on Q1, as if the factors involved have claimed the larger part of their zombie victims and fresh economic deterioration is needed e.g. in consumer demand, to have wider adverse effect.
Possibly the 2017 distress trend was driven by zombie firms that should have been eliminated by the 2009 recession - only ultra-low interest rates gave them temporary breathing space. On such a reading, Begbies' shares have broadly consolidated until the economy genuinely turns down.
Begbies still of interest for fresh money
Strict value investors may find this stock frustrating yet I think it remains a firm 'hold' given maturity of the business cycle, high levels of debt in the UK economy and short to medium-term risks with Brexit.
Probability suggests Begbies' time is approaching and it continues to enhance its capabilities to help manage corporate distress. With fresh money it seems wise to see how Project Fear 2 proves in reality, keeping aware of this useful portfolio hedge. Hold.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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