activist investor, Downing LLP, growth investor, HTEC, Jeremy Lewis, Kalibrate Technologies, Robert Goddard, Stephen McLeod, UNG, Universe Group, value investor
I first published a write-up on Universe Group (UNG:LN) almost 2 years ago: A Universe of Stocks… This was back when the shares were trading at GBP 2.375p, after a long & relentless 9 year decline. At that point, despite the scary chart, I believed the company had finally reached an inflection point…
This perception wasn’t just built on hope value: The core HTEC division was an obvious jewel in the crown, a new management team was already delivering on its promises, and (if necessary) the shareholder register promised potential activist intervention. The company’s substantial undervaluation was obvious – and its evolution from manufacturing & product sales to a software/transaction solutions provider, focused on increasing recurring revenues, promised significant intrinsic value upside potential in the future. Based on the company’s metrics at the time (adjusted for somewhat excessive debt), I pegged Fair Value at 8.4p per share. I also predicted its loss-making CEM unit would be closed down, or sold – contingent on that, I suggested a Secondary Fair Value of 11.0p per share was also possible.
Just 2 weeks later, the story took a big step forward. Universe announced a placing & a GBP 0.2 million loan issuance – initially for debt reduction, which I was pleased to see. Unfortunately, the resulting enhancement of intrinsic value was relatively small (in my opinion), whereas the dilution impact was substantial: UNG’s undervalued share price/market cap meant a colossal 63% increase in outstanding shares was required to raise just GBP 1.7 M of equity funding. Which knocked my Fair Value targets back to 5.1p & 6.8p per share, respectively. However, management also stated they were ‘exploring a range of options’ for the CEM business – which I took as confirmation it would soon be shut down/sold off, so I was happy to merge/average my price targets into a new Fair Value of 5.9p per share. Despite the dilution, this still offered a highly attractive 164% upside potential! Fast forward two years, the company’s made steady progress…
As expected, the CEM unit was sold in Dec-2012, followed by two strategic bolt-on acquisitions (Indigo & RST) in 2013. A new & updated product offering was completed in 2012 & enjoyed a very successful 2013 customer roll-out. Revenue reached a H2-2013 run-rate of GBP 18.6 M, vs. continuing ops. revenue of 10.5 M in 2011. And with the turn-around complete, the CEO Stephen McLeod departed in Sep-2013 to pursue other projects (Robert Goddard remains as Chairman) – to be replaced by Jeremy Lewis, an ex-investment banker & a technology/software company CFO/CEO for the past 15 years. The share price has also lived up to its potential – it’s now trading in excess of my price target, at 6.125p – that’s a 158% gain vs. my original write-up at 2.375p per share! In fact, the shares almost reached my original 8.4p fair value target, with a Nov-2013 high of 8.25p per share. Which begs the obvious question – what’s an appropriate fair value target for UNG now?!
Well, we’ve clearly reached a point now where multiple investor constituencies are potentially interested/invested in the company – we can approach Universe accordingly, i.e. from a number of different valuation perspectives. Why don’t we start with my old reliable:
The Value Investor Perspective
OK, we should first note the significant step-up in revenue last year (obviously acquisition-related) – H1-2013 revenue was GBP 6.6 million, while H2 revenue jumped to GBP 9.3 M. We could annualize H2 revenue, but I’d prefer to build a run-rate from the ground up, even if I arrive at much the same figure in the end. Let’s present a table & then explain:
We know 2012 & 2013 revenue, and management provides a bridge between them: An underlying (i.e. ex-acquisition) revenue increase of GBP 2.2 M, Indigo revenue of 1.3 M (for 7 months) & RST revenue of 0.5 M (for 2 mths). [When acquired, revenues of 2.1 & 3.0 M were noted for Indigo & RST, respectively. Notionally, this would imply 1.7 M of additional 2013 revenue, which compares nicely with the actual 1.8 M reported]. For 2014, we’ll make three adjustments:
i) We’ll annualize Indigo’s 2013 revenue, to 2.2 M.
ii) For RST, annualizing a mere 2 months of revenue (to 3.2 M) seems unwise – let’s assume an unchanged 3.0 M of annual revenue.
iii) Management highlights the volume of 2013 project work (for the deployment of new GEM payment terminals to customers), and cites it as the main reason for the underlying revenue increase. They also note this level of project work may not be repeated – which I find somewhat perplexing, with the number of terminal deployments expected to increase 25% for 2014. It seems quite conservative to assume a 50% reversal (i.e. 1.1 M) in the 2013 underlying revenue increase.
This gives us a 2014 revenue run-rate of 18.1 M (in the end, very similar to the H2-2013 annualized run-rate of 18.6 M). Sure, that’s based on a number of (fairly reasonable) assumptions, but we can also hope for some organic (and/or new acquisition-related) growth to provide us with a decent margin of error. The exercise also allowed me to consider each operating profit component. Which is useful, because the company’s 2013 operating margin of 8.5% puzzles me… Consider this table:
There’s some noise, but in general we have sustained margin improvement since Goddard/McLeod arrived (in 2011) – but H2-2013 is an obvious outlier at 6.4%. There’s two likely explanations:
a) Reading the results & digging into the figures, there’s no issue with SG&A – in fact, it improved to 26.1% of sales in 2013. The shortfall actually lies with gross margin, presumably reflecting lower project work margins.
ii) The integration of the new acquisitions is progressing nicely, but it’s unusual to see no exceptional expense. Surely, one would expect a not insignificant level of disruption/integration cost from two acquisitions in just 6 months?
Now, since we’re assuming a reduction in project work/revenue for 2014, it’s also fair to assume gross margin will improve. And we note Indigo’s actually a more profitable company (with a 20.5% EBITDA margin) than UNG, while RST was modestly profitable when acquired – it seems reasonable to presume they can, on average, approximate Universe’s own margin in 2014. We can also assume a reduced/zero level of acquisition-related expense, while the company will ideally enjoy some new economies of scale & a decent level of organic growth – all of which would provide a real margin kicker. [This is a good place to highlight management prefers to adopt a cautious outlook each year]. Overall, I’m going to make the daring assumption the business reverts to a 10.4% operating margin (almost GBP 1.9 million) in 2014. That deserves a 0.875 Price/Sales multiple.
Before going further, we need to make some share adjustments. Year to date, we’ve seen some option exercises & the settlement of an Indigo deferred consideration liability, increasing the share count to 220 million shares. We should also account for potential dilution from 18 M options outstanding – some may never vest, but we’ll prudently assume 100% are exercised as of today. That would expand the share count to 238 M, with UNG receiving GBP 399 K in cash (assuming the yr-end 2.2p weighted average exercise price).
Now, looking at the balance sheet, we can also add a (positive) debt adjustment. Total yr-end borrowings were 1.6 M & option proceeds would reduce this to 1.2 M (vs. a 2013 average of 1.7 M). [NB: UNG has no pension liability, and outstanding deferred/contingent consideration liabilities can be easily funded with equity issuance & 2014 cash generation]. That should reduce 2014 interest expense to about 101 K (vs. 146 K), which equates to just 5% of operating profit – Universe could add another 3.6 M of debt & still limit this interest ratio to a reasonable 15%. As per usual, let’s be conservative & haircut this debt adjustment by 50%. Which gives us:
(GBP 18.1 M Revenue * 0.875 P/S + 3.6 M Debt Adjustment * 50%) / (220 M Shares + 18 M Options) = GBP 7.4p per share
The Growth Investor Perspective
While indebtedness & earnings quality are also important, the main determinant of an appropriate Price/Earnings ratio is obviously the underlying earnings growth rate. Sounds simple… Let’s take another look at the progress since 2011:
NB: Assume all figures are Continuing Ops.
Ulp…so what earnings should we be looking at exactly?! Growth in 2014 diluted EPS was actually negative! [Due to the ramp-up in outstanding shares, caused by the full year impact of the 2012 placing & the 2013 share issuance for acquisitions. Plus the majority of management’s share options were suddenly in-the-money – though investors enjoying huge price gains can hardly complain!]. But otherwise, revenue & earnings growth look attractive right across the board for the past two years. And the impact of the placing’s unfortunate, I suspect management would have achieved much of the 2012 revenue & margin expansion regardless. However, the 2013 acquisitions were a big contributor – which many (value-minded) investors would tend to discount. I wouldn’t necessarily agree: A steady diet of bolt-on acquisitions, done right, can be an attractive multi-year growth strategy. [And with a little quantitative & qualitative analysis, I believe it’s mostly possible to avoid the more egregious type of serial acquirer]. Really, we could be arguing about angels on the head of the pin for hours here…
Broker analysts perform a lovely end-run around this problem – they simply throw out a 2015 (& 2016…I’ve even seen 2019!?) EPS estimate & then gasp over how cheap the P/E ratio is based on today’s share price. Tempting, but I’m pretty sure I’d be laughed off this blog if I tried something like that…hmm, makes you think, eh?! But there’s method to my earlier madness – we already know there’s a decent jump in revenue & operating profit coming, all things being equal. And if that delivers a nice bump in 2014 diluted EPS, we’ll have 3 great years of overall revenue/earnings growth – which surely makes Universe an attractive growth stock, deserving of a decent P/E multiple? Let’s give it a whirl:
Right: Scroll up for a reminder how I derived my revenue run-rate & a 10.4% operating margin for 2014. Interest expense improves, but to a lesser degree (since no option proceeds are assumed). The tax charge is reduced due to GBP 1.4 million of un-utilized tax losses – which is probably conservative, R&D tax credits may provide some benefit. I won’t bore you with my diluted shares calculation, but it’s lower than my previous example due to averaging & the smaller number of options regarded as dilutive (for EPS purposes). This gives us a 2014 diluted EPS of 0.73p, and an 18% EPS growth rate. [Again, based on my prior revenue run-rate & a return to a 10.4% operating margin, plus no assumption for organic revenue growth/earnings]. Which looks good – the consensus estimates I’ve seen were all ’round 0.75-0.8p (Bloomberg has 0.8p).
I certainly wouldn’t use it for stock-screening/picking (you’ll just end up in dangerous waters), but I’d generally agree a PEG ratio of 1.0 is a good anchor for fixing P/E ratios. [Huh, I always thought Jim Slater invented the PEG ratio?!] But I can’t help myself, let’s apply a (totally arbitrary) 25% haircut to my 2014 EPS growth rate – I mean, UNG’s 2014 interims aren’t even due for 3 months yet! That PEGs us at a 13.6 P/E multiple:
GBP 0.73p Diluted 2014 EPS Estimate * 13.6 P/E = GBP 10.0p per share
The Activist Investor Perspective
The activist investor looks below the surface, and occasionally discovers a very different company & intrinsic valuation…that’s what I found with Universe Group. Obviously, HTEC was a jewel in the crown, just waiting to be discovered – but there’s a bigger picture to paint here now. Take a look at this table:
The current level of research expenditure’s almost double UNG’s operating profit!? Which doesn’t even include product development & intangibles (no goodwill) amortization. All told, the company’s R&D spend is actually GBP 3 million a year! Maybe not so much in absolute terms, but it’s a colossal 19% of sales – in comparison, the S&P 500 spends a median 1.4% of sales on R&D (and only 30% of S&P companies spend more than 10% of sales). And if you throw in depreciation (much of it spent on IT), Universe is currently devoting almost 23% of sales to (re)-investment.
Judging by HTEC’s 35 year history, its leadership in the sector, plus its record of innovation, I’m comfortable betting a (major) portion of this investment will deliver an attractive pay-off for years to come – helping management to lock in multi-year recurring revenue contracts (& lock out competitors), to increase overall revenues, to expand operating margins, or a combination of all three. But the accounting rules dictate the company’s research spending must be expensed as it occurs. Now this makes perfect sense in many instances, research often has no clear objective or pay-off (Google’s ’20 percent time’) – but with Universe, we can be damn sure they hope & expect their research will lead to a product development outcome. I think it’s quite reasonable to presume this research has, on average, a 3 year life – sure, a percentage will have no obvious/lasting value, but more will have a lifetime value well in excess of 3 years. We can obviously treat all prior research expenditure as a ‘free option’ at this point, and amortize the 2013 expense accordingly (by adding back two thirds of the spend), which reveals an underlying 18.9% adjusted operating profit margin.
Approaching this from a cash flow angle will give us additional confirmation this perspective makes sense:
Operating cash flow, at GBP 2.5 M, is an attractive 15.5% of sales. To arrive at operating free cash flow (Op FCF, a cash proxy for operating profit), we deduct PP&E & development expenditure. [NB: 0.8 M of (leased) PP&E’s extracted from the accounting notes, as it’s not included on the cash flow statement]. This amounts to just 3.1% of sales, since the company is currently spending well in excess of its depreciation & amortization rates. But we know this PP&E & development spending will make a necessary & valuable contribution for years to come, not to forget the contribution from the 2.5 M of research expenditure already included in cash from operations. [By necessity, I’m assuming the cash outflow for research actually equals the research expensed in the P&L]. As above, let’s add back two thirds of all this investment – to arrive at an adjusted Op FCF of 3.5 M, or 21.8% of sales.
On average, we’re looking at an underlying 20.4% margin, which deserves a 2.0 P/S multiple. Let’s now apply this to our 18.1 M revenue run-rate for 2014, plus we’ll also add debt & option exercise adjustments (as before). Since interest expense would now amount to just 3% of a higher underlying operating profit (of 3.7 M), Universe could add another 9.1 M of debt with endangering its financial stability – but we’ll apply the usual 50% haircut:
(GBP 18.1 M Revenue * 2.0 P/S + 9.1 M Debt Adj. * 50%) / (220 M Shares + 18 M Options) = GBP 17.1p per share
Now, each of these investor perspectives & valuations obviously have their respective merits – I can’t necessarily predict which might hold sway in the market. But I suspect growth investors are now steadily replacing value investors in Universe. As for the activist investor perspective, ideally we’ll see this valuation ultimately reflected in the market if/when the company’s chunky investment spending pays off – then again, we could just as easily see an acquirer (or an activist) seek to unlock that value first…
And UNG’s market cap has become increasingly interesting in this regard. Two years ago, with a sub-3 million market cap, Universe had contracts with ExxonMobil, Valero, Wm Morrison, etc. – think how much easier it is now for them to potentially win new clients & business with a market cap five times as large. And their size now brings them up on the radar for corporate acquirers – Kalibrate Technologies (KLBT:LN), a recent IPO trading on a much higher (2.2 P/S) valuation, seems like an obvious candidate (an acquisition would nicely diversely diversify product & geographic revenues for both companies). Of course, the focus on providing payment & loyalty systems to many of the UK’s petrol & convenience store retailers also identifies UNG as a potential tip of the spear acquisition for a wider universe of software, data analysis & payment companies. I’d expect most corporate acquirers would quickly capture a 20%+ operating margin – similar to the underlying margin I’ve identified – via cost savings & revenue synergies.
But Universe may ultimately be most tempting to a private equity acquirer. The company offers an attractive EBITDA margin & inherently strong cash flow, while long-term recurring revenue contracts provide the perfect foundation for leveraging up the business. And research & investment could obviously be scaled back significantly without any serious or immediate impact. But that would be short-sighted, Universe’s real beauty lies in its expansion potential. Consider the geographic opportunity alone: Less than 25% of UNG’s revenues are European, presumably originating from Ireland and/or existing UK-based clients. A savvy PE investor would utilize additional leverage & the company’s existing profitability to embark on a multi-year expansion strategy into continental Europe, hand-in-hand with a UK/Irish consolidation strategy, before readying the company for a (larger/more highly valued) return to the public market in due course.
But for the moment, let’s just recap (& average) our three investor perspectives:
(Value 7.4p per share + Growth 10.0p per share + Activist 17.1p per share) / 3 = GBP 11.5p Fair Value per UNG share
Versus the current 6.125p share price, this offers 88% Upside Potential.
I suspect Universe’s three major shareholders (owning 41%, in aggregate) have similar perspective(s): Ennismore Fund Management has been a dedicated long-term shareholder, while Downing LLP & Amati Global Investors have initiated/substantially increased their stakes in 2012. Despite the near-tripling of the share price, none of them have sold any UNG shares since then – in fact, Downing’s continued to add to its holding, as recently as May. I’ve also increased my shareholding recently, from 3.2% to 3.6% of my portfolio.
- Universe Group (UNG:LN): GBP 6.125p
- Market Cap: GBP 13.5 M
- Price/Earnings: 9.9
- Price/Sales: 0.7 (based on current revenue run-rate)
- Tgt Fair Value: GBP 11.5p
- Tgt Mkt Cap: GBP 25.3 M
- Tgt P/E: 18.5 (15.7 P/E, based on est. 0.73p diluted 2014 EPS)
- Tgt P/S: 1.4 (based on current revenue run-rate)
- Upside Potential: 88%
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