Four stocks to watch in February
DOMINO PRINTING SCIENCES
Domino Printing Sciences has a reputation as a growth company. Founded in 1979, the market value of the enterprise 35 years later is almost £1 billion. It's a specialist manufacturer of digital printers, used across a wide range of industries to print variable data such as barcodes and sell-by-dates on products and packaging.
Variable data is increasingly required to meet regulatory requirements for product identification, for keeping track of items in warehouses and distribution networks, and in promotions.
The company employs the 'hidden champion' strategy.
It designs, manufactures and supports printers that are integrated into their customers' businesses, making the company a valuable partner with a niche it can exploit around the world.
In 2013, revenues rose 8%, but adjusted operating profit fell 2% because, the company says, it's investing heavily in the fastest-growing parts of its business. In theory, growth should follow investment. High returns on capital, a strong financial position and Domino's global operations all suggest it is a strong competitor with good long-term prospects.
But the shares are hitting new highs. At £8.32, the company is valued at 22 times adjusted earnings, an earnings yield of just 5%. Although they may well be worth it, the value's not obvious at these levels.
ELECTRONIC DATA PROCESSING
Electronic Data Processsing (EDP) is a software developer with two main products. Quantum VS is a suite of software modules for builders' merchants and electrical wholesalers, providing product catalogue, accounting, stock control, purchasing and sales capabilities. Vecta is sales intelligence and customer relationship management software.
Both are modern cloud-based (internet) services. Quantum VS is embedded in the operations of a significant number of UK building and electrical wholesalers, a market the company has served for decades.
Vecta is also delivered over the cloud, but it's less specialised. It complements other systems including Quantum VS, and although many o1f0its customers are from EDP's traditional base of distributors, it's applicable to a wider range of customers including, for example, Suzuki (UK).
EDP is investing about £1 million a year adding modules-to the software. It's also translating the Vecta interface with the aim of making it a global brand. Although business software is a crowded market, Quantum VS is slowly supplanting older software EDP has sold to distributors, and it seems to be entrenched in a profitable niche.
Vecta appeals to a bigger market, but is less specialised and probably more vulnerable to competition.
Since EDP has nearly £6 million in cash and says it can fund operating costs, including research and development, from contracted revenue (annual software licences and hosting fees), the company is more than adequately financed. The cash should increase in 2014 as the company expects to sell property valued at nearly £1.5 million.
EDP may waste the money, perhaps on expensive acquisitions – but it probably won't. The last acquisition the company made was Vecta in 2006; it paid a special dividend to investors in 2013 and the company's biggest shareholder, who has the most to lose if the company is profligate, is its chairman.
If it has more money than it can invest either in software development or profitable acquisitions, it should return more cash to shareholders.
Although EDP's 2013 results were flat, a couple of f1acts hint at growth. It's implemented Vecta at 'a number of substantial European businesses', and it says Quantum VS is aimed at food distributors as well as its traditional customers in the building and electrical trades.
A share price of 75p values the company at just seven times earnings, equivalent to an earnings yield of 13%. That's good value, even without the growth. The company is tiny, though. Subtract most of the cash from EDP's market capitalisation and its market value is little more than £5 million.
With a market value of £4.5 billion, Sage is at the other end of the scale for UK software companies. In 2013, it increased turnover 3% and adjusted profit 6%, but it expects to raise average revenue growth to 6% by 2015.
Sage is a software house principally supplying accounting and payroll software and the enterprise resource planning software that links it to the other business functions. Increasingly it serves those functions, such as sales, as well. Over 800,000 small and medium-sized businesses in the UK use Sage software, and many more globally.
It's a not-so-hidden champion, dominating the UK market – but profitable markets attract competition and rivals have taken advantage of the industry shift to cloud computing to position themselves as cheaper or more modern solutions.
Sage has developed cloud capabilities of its own, and has categorised its products to decide whether to invest in them, harvest their cash flows, or dispose of them which, so long as it makes the right decisions, should improve profitability.
A price of 400p puts investors in a difficult position, valuing the company at 15 times earnings, equivalent to an earnings yield of 7%. Normally that's a lot to pay, but Sage is an impressive business, a consistently profitable stalwart targeting modest but probably sustainable sales growth. Those don't generally come cheap.
Like Domino Printing, Victrex is another company that does one thing so well it has developed a global market. Almost all turnover (98%) is earned abroad. It develops new applications for PEEK (a lightweight plastic that can withstand very high temperatures) and similar high-performance materials.
In 2013, for the second year running, turnover and profits were flat, but the impressive thing about Victrex is not just the growth prior to that, but the potential for growth. Its materials can be used wherever performance is critical, from lighter aircraft components that improve fuel efficiency to human spinal implants that encourage bone growth.
To grow, Victrex must sell existing products in new territories and develop new applications, or entirely new materials. This requires high levels of investment; as with Domino, the company describes 2013 as a year of investment. The main risk is that a rival might develop a better or cheaper material for the same applications, so investment is critical to maintaining a competitive advantage. That would be concerning if it cost so much to stay ahead that profitability suffered.
Victrex is highly profitable, which has enabled it to accumulate a net cash balance worth as much as a year's profit. This is the signature of an impressive business. The problem is that everybody seems to believe it. At £18.00, the share price values the £1.5 billion enterprise at 20 times earnings, equivalent to a 5% earnings yield.
This company is not for bargain hunters.
Victrex belongs in the same category as Domino Printing. It's a good company, but the price isn't compelling. Prices change more radically than companies though, which is why I have put these two on the Watchlist, waiting in anticipation of the market valuing them at less than 15 times earnings in a typical year, equivalent to an earnings yield of 7% or more.
This feature was written for our sister website Money Observer
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