Stockwatch: time to upgrade this small-cap

8th October 2021 11:46

Edmond Jackson from interactive investor

Our stock picker has found a stock to own if you are losing confidence in the government’s pandemic recovery plan for the economy.

Today’s supply disruptions and tomorrow’s higher wage costs coincide with the government winding down Covid support measures for business. It must inevitably mean listed company profit warnings and more stress for private firms already struggling.

A potential beneficiary is £198 million Begbies Traynor (LSE:BEG) given its focus on insolvency and corporate recovery, and property services (given restructurings often have a property element).

Its 23 September AGM statement cited double-digit growth in revenue and profit in the new financial year from 1 May, albeit helped by acquisitions and a resurgence in activity from last year’s lockdowns.

Insolvency appointments have increased monthly, and “we expect this trajectory will continue in the final quarter of this calendar year (second-half of the financial year) as support measures are progressively removed”.

Supply chain issues and inflation will add to stresses

Aggregate demand in the economy will also be affected as people buckle down to the “winter of discontent” narrative. While Boris Johnson blusters about a higher-wage economy that guarantees inflation, the Bank of England cannot raise interest rates without tipping more indebted firms over the edge.

Despite New Zealand’s central bank raising rates this week, against only 3.3% inflation, the authorities in more indebted countries have a vested interest to “inflate away” public and private debt – so may tolerate it going higher.

I drew attention to Begbies last December as a “Buy” at 87p, moderating to “Hold” last May at near 140p. So, with the price having marked time and the group’s operating prospects seemingly improving, is it time to upgrade again?

Acquisitions help prop respectable earnings growth

At 131p, the stock trades on 14.7 times the consensus for normalised earnings per share (EPS) of 8.9p projected for the year to 30 April 2022, based on £11.9 million profit. The price/earnings (PE) multiple reduces to 13.4x if £13.3 million net profit is achieved in the 2023 year, for EPS of 9.8p.

That is a big uplift on past performance (see table) that management says it is “on course” to achieve – with the next guidance likely at December’s interims. Yet the group was fundamentally re-rated by three earnings-enhancing acquisitions in the last financial year and the circa £10 million purchase of a Midlands-based finance broker last May.

Otherwise, steady acquisitions have helped Begbies achieve compound annual growth in adjusted EPS of 20%, including 10% organic growth. For a first time, the group is in a circa £3 million net cash than debt position, albeit boosted by a £22 million share placing at 105.5p last March, besides cash flow from operations. There is also an 8% compound growth rate in the dividend that Covid did not interrupt.

It will take a few years, however, to see exactly what competitive advantage and synergies have resulted from these deals, versus their near-term earnings boost.

In the meantime, investors have to decide whether to accept the moderately sanitised “normalised” profit presentation. It reasonably adjusts for goodwill amortisation charges modern accounting puts through the income statement, and which affect “people businesses” especially. But note 4 to the April 2021 accounts shows £6.5 million acquisition costs added back also, note 3 breaks down as £0.4 million transaction costs and £5.4 million deemed remuneration (up from £3.9 million in 2020). While normalising earnings aims to see through to underlying performance, these are genuine costs.

Acquisitions may also help smooth cyclicality

Whether Begbies should be rated as a growth stock or cyclical, is possibly the crux right now.

The group’s long-term history suggests it is cyclical. Begbies floated in 2004 as an insolvency specialist, as if fortuitously before the 2008 Credit Crunch. Its chart shows the stock anyway rising from about 50p to 200p by 2006, reaching this high again in mid-2008. Ironically, there was then a long slide to a 20p area by October 2011, as a decline in the group’s tax advisory side more than offset insolvency help, itself compromised by government support for firms.

In other words, the business did not necessarily benefit from hard times. It remains tricky to discern how “advisory” revenues break down, and credit broking would probably suffer in a recession.

Not surprisingly then, acquisitions have been sought to diversify the service mix in a way that makes strategic sense – increasing market share in insolvency, with further expansion in property and professional services to develop the overall offering.

“Our increased scale and capabilities provide us with ability to assist UK businesses as the economy recovers from the challenges of the last 18 months.”

That can appear a bit odd for insolvency services, but includes the effect of government support tailing off.

A “buy” case worked well last December based on interims to 31 October citing the biggest quarterly leap in UK financially distressed businesses since 2017.

Begbies Traynor Group - financial summary
Year ended 30 Apr

	2015	2016	2017	2018	2019	2020	2021
Turnover (£ million)	45.4	50.1	49.7	52.4	60.1	70.5	83.8
Operating margin (%)	0.7	3.7	2.9	5.3	7.3	5.5	3.3
Operating profit (£m)	0.3	1.9	1.4	2.8	4.4	3.9	2.8
Net profit (£m)	-1.6	0.5	-0.3	1.4	2.3	0.9	0.2
EPS - reported (p)	-0.6	0.4	0.2	1.3	1.9	0.7	0.1
EPS - normalised (p)	1.4	0.9	1.3	2.0	2.9	2.4	3.5
Price/earnings ratio (x)							37.4
Return on equity (%)	-1.0	0.7	0.4	2.5	3.9	1.5	0.2
Operating cashflow/share (p)	3.9	6.2	5.2	6.6	4.9	1.3	9.5
Capital expenditure/share (p)	1.3	0.5	0.3	0.4	0.9	0.6	0.9
Free cashflow/share (p)	2.6	5.8	4.9	6.2	4.0	0.7	8.6
Dividends per share (p)	2.2	2.2	2.2	2.4	2.6	2.8	3.0
Yield (%)							2.2
Covered by earnings (x)	-0.3	0.2	0.1	0.5	0.7	0.3	0.04
Cash (£m)	9.2	7.6	6.7	3.5	4.0	7.3	8.0
Net debt (£m)	12.8	10.4	10.3	15.7	14.6	11.1	5.8
Net assets (£m)	61.0	60.2	58.1	56.2	58.1	65.6	86.3
Net assets per share (p)	55.7	54.3	54.4	51.1	50.8	51.3	57.2

Source: historic company REFS and company accounts

The last ‘Red Flag’ report was mixed

Last 28 July, Begbies’ regular quarterly research report on corporate financial stress – in respect of the second quarter of the 2021 calendar year – cited a 10% fall in businesses in “significant financial distress” – to 650,000 compared with 723,000 in the first quarter.

This was said, however, because the economy had re-opened and enabled some companies to pay down some of their more critical debt in order to avoid court action. Distress levels were still the second-highest recorded by this research – around 24% more than the comparable period in 2020.

Property led the sectors, up 35%, ahead of financial services, travel and construction – which partly justifies Begbies’ strategic focus. Court activity has risen as creditors, especially landlords, become more aggressive in chasing debts.

Begbies’ central message was that despite the re-opening of retail and hospitality, “the number of zombie businesses remains considerable, with many in a fragile state”. I have noticed management pushing this theme for a good while, although very low interest rates have kept the zombies on life support.

If the Bank of England decides not to raise rates in the face of inflation – given the economy remains challenged – maybe too much distress will be averted. Yet several City economists disagree with my cynical view, inflation may be tolerated to temper debt. They reckon on possibly three rate rises by end-2022. It’s unclear quite what carnage would ensue.

‘Buy’ if you are losing faith in Boris’ promises

Waiting for evidence in Red Flag reports – which necessarily lag reality – means Begbies shares could rise in anticipation, according to news generally. Buying is admittedly rather speculative.

If you think current strains are a necessary aspect of transition – both out of the pandemic and EU – and will resolve adequately enough, then Begbies is probably fair value. Its services are cyclical and you cannot be sure if some aspect of them will compensate for a downturn in others.

But on the insolvencies front it ought to prosper, and inflation marks a difference with a decade ago. Boris Johnson’s goal for a “higher-wage economy” will bake it in, even if supply chain-related inflation eases. Markets could anyway price for higher interest rates even if the Bank of England dithers. In that scenario, a modest exposure to this stock could work well on a two-year view. Buy.

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

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