Up 50% in a year, this small company still has lots to go for, argues analyst Edmond Jackson. Here’s what he’d do with his successful tip now.
What extent of premium rating is justified if a stock is relatively impervious to recession in these uncertain times?
Recalling the early 1990s downturn, many investors lost faith in equities, yet there were still a few big winners such as Next (LSE:NXT) and Domestic & General insurance (nowadays owned by private equity). Even when prospects darken, there is always an outperformer somewhere.
Cerillion (LSE:CER) is a software provider for customer billing and relationship management, booming on the back of full-fibre and 5G roll-out. With annual revenues approaching just £40 million, it only needs modest crumbs off this feast, being in quite a niche, to prosper. But how justified is a 12-month forward price/earnings (PE) ratio over 30 times as the stock edges above 1,200p?
A year ago, and after first tipping this stock at 245p in April 2020, I repeated my “buy” case for Cerillion at 820p after an update in respect of its half-year to 31 March. The stock had already quadrupled since the spring 2020 market low during Covid, but was sustaining a mid-20% revenue growth rate, and operational gearing was evident in the way EBITDA (close to operating profit) was up 48% to over £7 million.
Affirming cash generation, net cash had soared 114% to £16.5 million. Respecting an operating margin near 30% I targeted earnings per share (EPS) to climb towards 40p and judged a 25 times PE multiple was justified for such quality credentials – also recurring incomes for consistency – hence target a stock price of over 1,000p.
Bumper update as OpenReach rolls out full fibre and 5G
Yesterday, a similar update in respect of the six-month period ended 31 March 2023 affirming “very strong trading with new records set”, nudged Cerillion over 1,200p, putting the shares on a 12-month forward PE around 30 times. Revenue momentum increased 27% to near £21 million, with adjusted EBITDA up 38% to £10 million. Net cash rose 43% to near £24 million.
“The excellent performance reflects strong demand from customers, against a wider back-drop of continuing strength in demand for telecoms services and substantial ongoing investment in 5G and fibre rollout.”
Even if there is modest recession later this year, as interest rate rises finally take effect on the economy, it seems unlikely this technology roll-out will stall. BT has repeatedly stressed that its Open Reach subsidiary is pulling out stops to advance the upgrades as swiftly as possible, hence Cerillion being able to say its “pipeline remains strong”.
Perhaps a more serious recession would affect companies’ capital spending, although typically it is tax-deductible.
This purple patch could last a few further years given it will take until 2025 for 5G to overtake 4G in the UK, and only EE and Three are committed to nationwide 5G coverage by 2028. Truly long-term investors can also look forward to 6G and so on.
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With over a third of revenue deriving from just three clients in the last financial year, that can be viewed as a risk - but also an opportunity as this is a relatively small business and has scope to expand. From six customers in 1999 (Cerillion was formed from a buyout of the customer care and billing product division of Logica), installations have grown to over 80 worldwide, with a broad range of cloud solutions (SaaS), managed services and on-premises, enterprise software.
Technology replacement still does run in cycles, hence I would expect a PE of over 30 eventually to be seen as over-cooked. The stock market will be sensitive to any signs of moderation in demand for Cerillion’s services.
There is a small dividend of around 10p a share, albeit a sub-1% yield hence a focus on growth.
Near £10 million profit seems over half the full-year expectation
In response to latest update, the stock yesterday edged up a modest 15p to 1,215p, settling back at 1,205p given no fresh expectations beyond full-year trading guided “in line” with consensus.
The market expectation is for £11 million net profit on £38 million revenue, deriving EPS of near 38p, hence a 32 times PE. There appears to be a slight first-half weighting, albeit possible management is guiding conservatively for the full year – then to come in slightly ahead, which is a typical tactic generally.
Given this is a relatively small company able to land quite lumpy contracts, it might only need one to start accounting for in the second half to March 2024. Only a fortnight ago, Cerillion declared a “major” new £10 million contract with an existing telecoms client operating in Europe, the Middle East and Africa (EMEA). While this has a 10-year term, it would however “support current consensus market forecasts” this year.
This financial year is, anyway, effectively one of consolidation in EPS terms, with only around 3% growth expected before 14% to 43p in the September 2024 year – if consensus is fair – in which case the PE eases to 28 times.
While I would not fuss about the timing of revenue and profit recognition in the near term, as a conservative analyst this strikes me as “pricing for perfection”.
Cerillion - financial summary
Year-end 30 Sep
|Turnover (£ million)||8.4||16.0||17.4||18.8||20.8||26.1||32.7|
|Operating margin (%)||5.2||13.1||10.9||13.4||13.5||28.9||32.7|
|Operating profit (£m)||0.4||2.1||1.9||2.5||2.8||7.5||10.7|
|Net profit (£m)||0.3||2.0||1.9||2.3||2.6||6.4||9.3|
|EPS - reported (p)||1.3||6.9||6.5||7.8||8.8||21.7||31.6|
|EPS - normalised (p)||3.4||6.9||6.8||7.8||8.8||21.7||36.7|
|Operating cashflow/share (p)||-3.5||11.7||12.5||17.1||22.2||33.1||41.7|
|Capital expenditure/share (p)||3.2||3.6||5.6||4.1||4.8||4.3||5.4|
|Free cashflow/share (p)||-6.7||8.1||6.9||13.0||17.4||28.8||36.3|
|Dividends per share (p)||3.9||4.2||4.5||4.9||5.5||7.1||9.1|
|Covered by earnings (x)||0.3||1.6||1.4||1.6||3.1||3.5||3.5|
|Return on total capital (%)||2.4||12.0||11.1||14.8||13.0||29.7||34.1|
|Net debt (£m)||-0.4||-1.7||-2.5||-5.0||-2.1||-8.4||-16.2|
|Net assets (£m)||13.0||13.8||14.4||15.5||16.0||20.2||26.7|
|Net assets per share (p)||43.9||46.6||48.9||52.7||54.5||68.8||90.9|
Source: historic company REFS and company accounts
Why has the stock leapt 20% in the last fortnight?
A parochial reason is AIM-listed stocks being prone to relative volatility. But given the 31 March contract did not justify a financial upgrading, I think the essential reason is technology growth stocks marching with the US Nasdaq index.
US growth stocks have rallied on hopes of the Federal Reserve pivoting to lower interest rates in the wake of Silicon Valley Bank’s (SVB) failure. At the very least, it is hoped that interest rate rises are almost over, with the US federal funds rate currently in a 4.75% to 5.0% area.
Post-SVB, the Nasdaq has risen over 11% to 13,190, nearly back to last August’s 13,577 level, despite being well down from 16,311 at end-2021 when expectations started to shift towards higher interest rates.
It all largely hinges on how successful the Fed’s monetary fight against inflation is, where a recent “core” number has offered hope, but there could still be a way to go.
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Consensus among economists appears in line with Fed guidance in March for another quarter point rate raise by the end of this year; yet stock traders seem more bullish, assuming the Fed will ease at much sign of economic weakness.
I suspect they remain of a mindset ingrained since the 2008 financial crisis and the Fed’s management of markets with Quantitative Easing and ultra-low interest rates, although inflation since Covid has changed this.
I do not think central banks will achieve their 2% inflation targets. More realistically, we will have to cope with mid-single-digit inflation in years ahead. That would still be a big difference relative to zilch inflation in recent decades, and quite where growth stock ratings would settle is unclear. “Growth” is valued higher than “value” during low inflation, and vice-versa.
You could take a more positive view: artificial intelligence for example, proving the next force for deflation, hence inflation falling rapidly and growth stocks back in favour.
Take some profits within a long-term ‘hold’ stance?
Weighing probabilities, however, I would not push your luck for a 30 times PE to persist here. So despite Carillion shaping up as a sound long-term business, I am wary the macro situation may have over-juiced growth ratings for now.
According to economic view and risk appetite, you might therefore want to consider locking in some gains. That may apply more to stock held in a tax-free wrapper, now obviously we are just past the tax year-end. Long term: Hold.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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