Four stocks to watch in March
Domino Printing Sciences
It would have been better but for the strong pound, but Domino increased revenue 4% to £350 million and adjusted profit 8% in the year to 31 October 2014. Net debt, including roughly capitalised operating lease commitments, fell to insignificant levels.
Domino reported buoyant market conditions in the first half of the year and a more subdued second half; it expects profit to be flat in 2015 because of uncertain demand in China and high levels of spending on investment. Last year Domino opened a new factory in India; it opens another in China this year, and is also constructing a factory and warehouse next to its head office in Cambridge.
The company designs and manufactures printers and consumables such as ink. The printers primarily print monochrome variable data, bar codes, QR codes and sell-by dates onto packaging or products at high speed during the manufacturing process. An installed base of over 200,000 printers gives Domino an entrenched position in printing, packaging and manufacturing businesses around the world, and high levels of profitability suggest its products and services are highly valued by customers.
Domino has also taken a bold step into an adjacent market by developing its first range of full-colour digital label printers. Conventional printing methods are expensive for short runs because of the cost of making plates, and as the cost of inkjet technology falls in comparison, printers are switching. But the company says it's faced a 'considerable learning curve' in developing full-colour digital printers, and although customers approve, the rate of transition to digital printing is uncertain.
Initial sales of Domino's digital presses may indicate change in the label-printing market is gathering pace. In 2013, the year Domino launched its full-colour printer, it sold nine for a total of £3 million in revenue; this rose to 19 in 2014, earning £7 million of Domino's £350 million total revenue.
A share price of 680p values the enterprise at £775 million, or 17 times adjusted profit, which is justified only if the company can maintain profitability and turn the investment into growth. It has only achieved that in fits and starts over the past three or four years, while it has absorbed the cost of developing digital label printers. However, it should earn more income from them in future.
Turnover and adjusted profit fell about 5% at Sage in the year to 30 September 2014, but management claimed it had made progress towards its goal of lifting the organic growth rate from 3 to 6% by the end of 2015, while improving organic operating profit margins.
Sage's organic growth rate, which excludes disposals and assumes constant currency rates, was 5% in 2014. Earnings per share increased 8%, due mainly to a £90 million share buyback programme that reduced the number of shares in issue.
In common with many other software companies, Sage is making the transition from selling software for local installation to hosting it on the internet. Cloud-based software reduces the IT burden on customers, and also benefits software companies. Sage expects to earn more from customers on subscriptions because they are tied into upgrades; moreover, the customer relationship is strengthened, allowing Sage to sell more products.
But changing technology means Sage must engineer, maintain and sell new and legacy products, to give customers the choice of whether, how and when to adopt the cloud. It may also give nimbler upstarts an opportunity to take some of Sage's customers as they consider their options.
Sage has a large installed base, and inertia should give it an advantage.
It's a dominant provider of payroll, accounting and other business software to small and medium-sized enterprises in the UK and parts of Europe, and a significant supplier in the US and other regions. The company claims 48,500 accountants recommend Sage to their clients; if it serves those customers well, it may be able to maintain its leadership and grow by acquisition in areas and product categories where it is less dominant.
Judging by its strategy, customers ought to be happy. Sage attempts to strengthen ties with them by providing business advice as well as customer support, and it invested 10% of revenue in research and development last year. It says it designs products for individual markets, rather than just translating generic software.
However, the buyback plus Sage's relatively modest growth targets may reflect the fact that it's a maturing business. In markets where it is less strong, it probably faces more competition.
A share price of 475p values the enterprise at nearly £6 billion. At 20 times adjusted profit, the earnings yield is 5%. Investors are paying quite a high price for current earnings, perhaps because they see many years of steady but unspectacular growth ahead.
In the year ending November 2014 SThree, a recruitment and staffing company, increased revenue by 18% and grew adjusted profit 30%, although the company continued to report weak cash flow, and net debt (including roughly capitalised operating lease obligations) increased.
SThree provides specialist permanent and contract staff. Originally an information and communications technology specialist, it now supplies staff to banks, financial institutions and energy, engineering and life sciences businesses. Growth mostly came from an increase in the number of contract staff SThree placed; these now account for 61% of gross profit.
The company's newer businesses, involving finding staff for energy and life sciences firms, also performed well.
The company's strategy may differentiate it from those of other recruitment companies, at least in terms of zeal. SThree has, perhaps admirably, eschewed acquisitions, preferring to foster entrepreneurial ventures in its own ranks, building new businesses to grow in niches and territories where it believes companies will pay more to get the specialist staff they need.
The company has gone through a two-year period of retrenchment, though. It has closed unprofitable offices in Brazil, India and Canada,and, at some cost, reduced its teams in Switzerland and the Benelux countries. The cost of retrenchment has reduced cash flow, which also worsens when the company expands the contract side of its business, because SThree pays contractors in advance of receiving income from clients.
Receivables – amounts owed to SThree – also increased in 2014 because of the growth of its energy business. Energy clients are, apparently, slow payers.
However, the restructuring is complete and the cash should follow. A share price of 335p values the enterprise at over £500 million, about 19 times adjusted 2014 profit. The earnings yield is a fully valued 5%.
Victrex returned to growth in the full year to 30 September 2014, after a few years in which it invested but didn't increase profit significantly. Revenue increased 14% and adjusted profit rose 9%. The company has an enormous cash balance, half of which is about to be returned in a special dividend.
Management believes the evolution of its strategy is beginning to bear even more fruit. For decades Victrex has produced Victrex PEEK, a very tough and lightweight plastic often supplied as a resin. Largely it has allowed other companies to develop applications for PEEK in the aerospace, automotive, oil and gas, electronics and medical device industries.
Now Victrex is working with customers to develop new forms of PEEK for major new applications, most of them medical. It wants to be more than merely a manufacturer, although that activity has been highly profitable.
Victrex has been a leading supplier of PEEK since, as part of ICI, it invented the plastic in 1979; but profitability has fallen slightly in recent years, albeit to levels most companies would still envy. In 2014, return on capital was 27%. The cost of building a third PEEK factory, which is nearing completion, has been a drag on profit, but once the company is benefiting from its increased manufacturing capacity, returns may improve.
In partnering with customers to produce materials for medical devices, Victrex is concentrating on the biggest customers of its most profitable division; this may be a response to increasing opportunities, as the advantages of PEEK as a replacement for metal in products as diverse as bearings, subsea oil pipes, and dentures are recognised. It may also be a response to competition from other materials manufacturers, as the opportunity to profit from PEEK becomes more obvious.
Either way, Victrex's pedigree is reflected in a high share price. A price of £20.50 values the enterprise at £1.7 billion, about 21 times adjusted profit. The earnings yield is 4%.
This feature was written for our sister publication Money Observer
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
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