Profit Warning

Equiniti Group Shares Fall 20% On Weak Earnings Forecast

19th November 2019 admin

Equiniti Group shares (LON:EQN) fell by over 20% in early trade this morning as the payments specialist put out a profit warning on its forecast earnings this year. This was perhaps one of the best examples of ‘soft’ profit warnings we have seen, as it was accompanied by a bullish forecast:

The share price movement has been very volatile and the shares have rebounded quite sharply from the lows seen inside the first hour. While it is impossible to time the bottom clearly some people have made a quick profit from this dip. At the time of writing the share price gained even more than the pic, going up to as much as 210p then falling back.

Equiniti is an interesting company which operates on a B2B basis, administering services for firms such as share registrations, pension fund services and payment executions. The range of services over the years has increased steadily to cover many different parts of the enterprise.

Performance for investors has been mixed. The IPO came in 2015 and shares initially fell from their 165p initial price and climbed strongly in 2017, doubling in this year alone. Since reaching 300p there has been little momentum and the price has dropped back down to the 200p range.

What’s gone wrong at Equinity Group?

This is perhaps a soft profit warning, as the trading RNS couches it in pretty good terms:

The Group’s performance in the period has been reassuring and we expect 2019 full year results to be towards the upper end of market expectations* for revenue and towards the lower end for underlying EBITDA due to weaker higher margin UK corporate activity.

Helpfully, the expectations are quantified: revenue is £550m-£567m, underlying EBITDA is £136-142m. We have some further detail about their businesses, which are performing well. We are short of the reasoning for why the UK activity has declined, but the market expectations are in a fairly tight band, so we can presume that the fall has been modest.

Even the outlook is good:

Whilst we expect the uncertainty in the macro environment to continue, Equiniti remains well positioned. We expect further organic growth in the UK as we build on our relationships with our exceptional client base. The US offers a platform for accelerated growth based on market opportunity, the potential to take market share and the opportunity to cross-sell digitised services into our blue-chip client base.

Equiniti: A changing company

Equinity clearly has some goodwill in the market as evidenced by the bounce in share price. Their business deals with the complex transactions many blue-chip operations face and are organised across four divisions: Investment Solutions, Intelligent Solutions, Pension Solutions and US. The number of difference services provided by these divisions is extremely diverse and may take some time to go into.

Growth here has not been organic, and has been by acquisitions and plenty of them. The IPO raised cash to pay down debts, but even then there has been an impressive spree of acquisitions, 14 since 2014. A broker note (available on Research Tree) shows that the latest one is Corporate Stock Transfer (CST), which focuses on stock transfer facilitation in the US market. Acquisitions tend to be of the ‘bolt-on’ variety and are small in cost.

Equinity have a good track record of this: turnover is set to double in the space of six years and margins are set to be broadly maintained, suggesting that acquisitions have been bedded in nicely although with no significant improvement in margins, the synergies promised is yet to come.

Stretching the balance sheet?

Many of these acquisitions were done without diluting shareholders too much: a rights issue came in 2017 and raised an additional £139m in proceeds, but represented a c.10% expansion in the share base. Looking at the accounts, debt has been the main tool: this metric has risen quite sharply.

It comes as no surprise that net tangible asset value is negative due to the amount of goodwill. Many firms here will be asset-light and intangibles rich due to the nature of the business.

In terms of immediate liquidity, the working capital is good: cash and receivables are bigger than current liabilities. The receivable balance has jumped sharply, but then again so has turnover.

Debt is a more relevant topic, and there is plenty of it here. It has increased as the cost of business acquisitions has been much greater than operating cash flows. A snapshot from the annual report shows just how much:

According to the broker note, this is expected to stabilise over the next few years and then start reducing, implying that the spree of acquisitions may slow. With EBITDA set to increase of this period, the leverage ratio gets progressively better.

What we can deduce from the interest charges is that this loan is not expensive: indeed the accounts say LIBOR + 1.75% for both loan and RCF. There is only one covenant, which is helpfully detailed as the net debt ratio to EBITDA being 4.00 or less, clearly on this point business would have to deteriorate quickly or the cash balance depleted for this to be an issue.

Another point is that these loans mature in 2020 and appear almost to the limit in headroom, so for things to continue they need to be extended or alternatively another rights issue could raise cash.

Are Equiniti shares good value?

There are plenty of things to like about Equiniti: they enjoy a strong leadership position in many of the markets they operate in. Much of the advantage can be put down to the proprietary back-end they operate, and therefore this represents a large barrier to entry for competitors. It may be also easy to see that there can be significant operation leverage if the business can be expanded.

They are also growing quickly via acquisitions which appear to be well managed. With large amortisation costs every year, the business generates cash at a better rate than what profits show although the historic cost is real.

So, I have positive impression of the share overall. the negatives being the debt load resulting in a negative tangible asset base and the increasing number of moving parts in the company.

On the price, I don’t think this bargain territory yet, although under 150p I might have changed my mind but I view the potential upside as bigger than the downside. 4/5.

Hydrogen Shares Tumble 30% After Late Profit Warning

15th November 2019 admin

Shares in recruitment specialist Hydrogen (LON:HYDG) fell 30% as the group put out a late profit warning at lunchtime, rocking investors. The news seemed to have been coming, as the share price drifted lower and lower today:

Hydrogen have been listed for some time, since 2006, but the performance of their shares has seen little cheer for investors. The price graph shows that after listing they were above 300p but came down to this level during the financial crisis of 2008 and never recovered after that. We have seen some attempts to grow back but the price has always been slammed back down: the company has good form for issuing profit warnings in the past.

Hydrogen are a recruitment agency, and unlike others who may specialise in sectors, they are cross-sector focusing on mid to higher level roles. Recruitment overall has suffered a very poor year as several firms have found Brexit to have increased uncertainty, leading to some firms holding back on employment drives. Additionally there may be jobs growth, but it is unsure if any of this growth is meaningful for these companies: low-paid, zero-hour roles are not likely to be lucrative any time soon.

What’s gone wrong at Hydrogen Group?

Negative marks for pushing out the RNS at lunchtime, particularly when there was no reason for it. The share price seemed to get wind of this earlier in the day. Further, it is also very brief. We get into the reasons:

As reported in the Group’s Interim Report on 3 September 2019, the Group traded in line with expectations during Q3. Subsequently, trading conditions in two of the Group’s key markets have deteriorated.

These two markets are the UK and Hong Kong. The EMEA/APAC segments make up virtually all Hydrogen’s business, so is likely to be quite relevant. For the UK:

In the UK, demand levels have continued to be impacted by growing political uncertainty. This is now being exacerbated by the impact of the proposed changes to the IR35 legislation on clients’ contract hiring plans.

IR35 refers to new legislation designed to combat tax avoidance by workers. Of course in this time period we have also seen Brexit cancelled. For HK:

In the Asia Pacific region, the public disorder and demonstrations in Hong Kong are now having a material impact on local activity levels.

This tallies up, although I would expect this to not be long-term.

As a result, the Board expects the Group’s full year underlying profit before tax to be below current management expectations.

Hydrogen: One Business, Multiple Challenges

Hydrogen seem to have their hands full at present. This is not a growing business. Profitability has also jumped around:

As we can also see, margins are very thin here. They always are in the recruitment industry, but this is below the level of some of the bigger players. The last set of results was regarded very well by the market, but those gains have since been wiped out and the market cap is very small at £12m.

The business has a record of cash generation albeit in lumps, but this often does not translate into profits:

Part of the reason of this are previous profit warnings which have hit profits by means of restructuring costs and impairments. The last year was good though: a large cashflow allow the firm to pay down debts and pay a dividend. At the time of the last financial statements, the firm is now debt free save for a small invoice discounting facility and the new lease liabilities if you wish to count this.

The solvency looks OK: there is a net cash position, receivables are also in excess of payables. Net tangible asset value is also positive and the whole outfit trades at discount to book value now. The firm also capitalises very little of its spending. Headroom on the borrowing facility is significant: an £18m facility at 1.7% over base rate means it is pretty cheap to borrow. At the interims, the company had performed in line with the previous year.

Additionally this is a group where insiders have plenty of skin in the game: the CEO accounts for over 10% of shares. They have also shown to be active in the market at around these price levels. One senses they are doing a reasonable job in testing conditions.

Are Hydrogen Shares good value?

Relative to the market as a whole, these might seem good: a quarter of the market cap is in cash, the company should still be profitable this year, debt has been cleared and an ex-cash multiple may be around 4 or 5. But companies in this sector tend to be cheap. Gattaca and Staffline are around this level too. Empresaria issued its own profit warning recently and also sits at a similar multiple.

Even companies that have executed quite well are cheap on conventional grounds: a more diversified Robert Walters sit on a ratio of 10. The whole sector seems hit by uncertainties over the future, but also regulations and accounting issues seem not far away.

The Hydrogen board commented at the interims that they would be looking for acquisitions with their money: they may have to be pretty modest ones at this size. It seems more likely they may be acquired: the much bigger Singapore-based HRNet bought stakes in both Gattaca and Staffline at their reduced prices, perhaps the same could happen here.

This is not a car crash of a share, but I feel that many smaller recruitment firms do not have much of a moat and could be easy to outmuscle and not survive a longer period of depressed margins. For those willing to wait there may be a decent sized dividend, if it is not cut. 2/5.

Non-Standard Finance Shares Fall To New Low as Profit Forecasts Cut

15th November 2019 admin

Shares in alternative finance provider Non-Standard Finance dropped to their lowest level ever as a trading update revealed that profits would be lower than anticipated this year. The performance of shares has dragged on throughout the day:

This has been a rather sorry state of affairs for investors. Only listed in 2015, the share price saw a little success in the first year, but since then has struggled to go anywhere near its listing price. Instead the trajectory has been mostly downward since then and the price now is almost a quarter of what it was.

NSF specialise in consumer credit, particularly the smaller, unsecured loans. It has an interesting history, being created by a former executive of Provident Financial who set up for himself backed by investors, and used the newly generated cash to buy up other loan providers. Things almost came full circle last year when NSF mounted a hostile takeover of Provident, but this was abandoned this year.

What’s gone wrong at Non-Standard Finance?

We have an extremely detailed trading update today, including an extra one which states that the current CFO is to leave.

We start with the warning:

Trading overall in the quarter to 30 September 2019 has been softer than expected with solid performances by both branch-based lending and home credit, offset by lower volumes in guarantor loans. As a result, it is expected that the Group’s normalised full year operating profit in 2019 will be lower than expected but still well ahead of 2018.

There is a large difference between normalised and statutory, as normalised results ignore amortisation costs. For a company entirely built on acquisitions this is fairly relevant.

Helpfully, we also have a rationale for the reduction in profit:

However, the expected impact on normalised operating profit of the step-change in provisioning (6%-8% impact) and the trading performance to-date (4%-5% impact ), is that in aggregate, normalised operating profit for 2019 is now expected to be between 10-13% lower than current consensus of analyst forecasts, although still well ahead of 2018.

In a double whammy, the group has also revised its growth targets in all its division downwards, although it expects margins to be roughly the same.

A tough company to appraise

There is quite a lot going on here and it is quite likely that a company such as NSF would polarise opinion. On one hand, there are clearly terrific margins on all its products. A user taking out such a loan would pay a very high level of interest, and as such perhaps get access to finance that they may not have been able to get elsewhere.

On the other hand, there could be an argument that these type of companies give out loans to people who can least afford it, and for things that they do not really need. But for now, we have to ignore the ethical questions.

The play for Provident was a huge one – valuing it at £1.3bn to be paid for by the issuance of new NSF shares. From today’s market cap of £80m we can see that the size of it was colossal.

Traditional valuation metrics don’t really explain the company that well. For instance, cash flow here is entirely negative, as money is lent out in full and is repaid over a much larger period of time. If the business is growing this metric always is negative.

Perhaps the discussion can be summed up from the annual report:

The company has used monies raised to purchase loan books. Monies loaned to customers are funded by debts, the interest rate differential provides for the margin. The second column relates to amortisation costs and exceptional items. We can see why these are excluded, in the first case they are non-cash, representing cash that has already gone and in the case of exceptional costs, not repeated.

It is difficult to appraise a good level of amortisation for acquired loan books. If it is the case that the economy ends up not doing as well, then bad debts increase giving rise to a larger provision fund, meaning that the current loans are worth less. On this point, it may be difficult to forecast, but the reduced anticipated growth may reflect a desire to write better quality loans instead of more of them.

The group carried something like £270m debt at the time of the last annual report, from a limit of £285m. It is mentioned today that there is an additional debt facility, that will be used to fund further growth. Crucially though it does not say how much this will be for, but looking at the interest charge it seems that NSF are paying a high interest rate. This correlates with the experience on Wisealpha where many consumer lending bonds are charged accordingly. Amigo Loans, for instance pays a yield of 7.625% and there are even higher yields such as Lowell (11%).

Are Non-Standard Finance shares good value?

Clearly this may depend upon perspective. The finance cost of the business looks high, but this is split between discretionary and non-discretionary costs. The firm continued to pay a dividend, costing £7.2m which looks very costly in the scheme of things.

There is cash being generated by the loan book as customers repay their loans, but a look at the cashflow statement shows that as the firm continues to write more loans, the cash consumed by operations continues to grow, and is funded by debt. Whether this is sustainable or not thus really depends on debt, but there has not been an issue so far in getting it. This can continue for some time – Provident owe something like £1.7bn, much higher than the debts here. Unlike many other businesses, higher debt does not have to imply greater risk, as on the other side of the coin the firm has an asset generating cash at a much larger rate than the interest rates. It is more the quality of those assets that count.

Impairment thus remains the biggest risk to the business and a big downturn in the cycle could eventually threaten the viability of the whole thing, as debt holders will still want to be paid. Currently the margin for error looks fine for a year or so, but the longer that continues the more uncertain it looks.

Another unknown is legislation, and it is rare that these measures benefit companies, with the exception where other firms are forced to quit markets, reducing competition.

It goes without saying this is quite a risky investment, but not one without a good upside, and if business does recover it may be a better option than holding the debt instrument considering the dividend. It is easy to sit on the fence here, particularly when there are many other competitors to evaluate. 3/5.