Buy: Oxford Metrics (OMG)
We are wary of the group’s exposure to public sector contracts, but agree that the stickiness of these customers and the gradually rising recurring revenue has the potential to strengthen the long-term outlook, writes Megan Boxall.
It’s not that half-year results from Oxford Metrics were bad. But because management previously promised to double profits and triple recurring revenues between 2016 and 2021, flat adjusted pre-tax profits and only a 23 per cent increase in recurring revenues did not seem quite good enough.
And although infectiously enthusiastic chief executive Nick Bolton has maintained his confidence in the group’s ability to deliver its long-term goal, there is no denying that the performance from infrastructure software business Yotta (23 per cent of revenue) was disappointing. Sales were flat year on year as the growth in annualised recurring revenue did not materialise until later than expected, while continued investment in the new software services business, Alloy, widened the division’s losses.
Therefore, these numbers have called into question the logic in Oxford’s business model. On the one hand, it is running Vicon, a high-margin, fast-growing motion sensor provider for the film and gaming industry. But the group’s overall growth is being held back by the lossmaking infrastructure services arm, which makes most of its money from local councils.
Broker N+1 Singer has trimmed its forecasts for Yotta, although strength in Vicon means it has maintained its annual pre-tax profits and earnings per share forecasts of £5.2m and 3.2p, respectively, in the year to September 2018 (up from £3.9m and 2.7p in 2017).
Sell: De La Rue (DLAR)
The highly public loss of its contract to make UK passports has already had an impact on numbers at De La Rue.
In fact, exclude the £81m one-off gain from switching its pension indexation from the retail prices index to the consumer prices index (which generally means its payments to members will increase at a slightly lower rate) and these results were unimpressive. Costs associated with the group’s volatile paper business dragged adjusted operating profits down 11 per cent to £62.8m, despite a rise in revenues.
But since the year-end, the group has sold its paper business with a 10-year guaranteed supply agreement. This has essentially offloaded the commodity risk that has ravaged operating margins in recent years as the cotton price has increased. Selling the business netted £60.3m, which has been used to stabilise the balance sheet: net debt is down by 59 per cent compared with March last year and now stands at just 0.6 times adjusted cash profits. More importantly, an improvement in the group’s ability to manage inventory has helped with its ability to turn profits to cash. Operating cash inflows therefore rose 14 per cent to £73.5m.
Meanwhile, stripping paper out of the group flatters these numbers. The currency business — which accounts for just under three-quarters of the paper-adjusted revenue — continued to perform well in the period due to strong demand for polymer used in newer banknotes. Polymer sales volumes more than doubled to 810 tonnes as the business added 11 new customers and 22 denominations. Product authentication and traceability saw paper-adjusted revenues rise 31 per cent.
But, even without the paper business, costs are still expected to impact on reported profits in 2019. Broker Investec is therefore forecasting adjusted pre-tax profit of £53.6m, giving earnings per share of 41.9p (from £53.4m and 42.5p 2018).
Hold: WH Smith (SMWH)
In a difficult retail environment WH Smith’s shares are up by a fifth over the past 12 months, while this update prompted the share price to crack the £20 mark once again. The market seems pleased with the stationer’s efforts to diversify its business, but at 2,104p, 19 times forward earnings is still broadly in line with historic averages.
It seems being voted Britain’s worst retailer hasn’t harmed WH Smith’s share price. The stock found further momentum following news that travel sales rose by 3 per cent on an underlying basis, while high street sales were pretty much flat during the third quarter. This is typically the quietest trading period for the group, so it’s impressive to see that gross margins were also up across the board.
The consistently strong performance from the travel business is, so company bosses say, down to continued investment both in UK travel outlets and international units. The group is still on track to open between 15 and 20 new travel sites in the UK this year and recently opened a standalone bookshop at London Bridge Station. This summer, eight new units are slated to open across Madrid Airport, bringing the total number of international outlets to 282.
As for the high street, the retailer is trialling new store concepts to minimise costs and protect margins. Chief executive Stephen Clarke admits there’s “some uncertainty in the broader economic environment” but insists that WH Smith is confident about the outcome for the full year.
Chris Dillow: The half-finished euro
Investors should not be misled by last week’s resolution of Italy’s latest political crisis. The country’s fundamental problem remains, and it poses a threat to the future of the euro in its current form.
The problem is simply a lack of economic growth. Since it joined the euro in 1999 real gross domestic product (GDP) has grown by only 0.3 per cent per year and it is still lower than it was in 2007. Quite apart from the damage done to living standards, especially for young people, this has had two nasty effects.
One is that it has kept government debt high: it is equivalent to 127 per cent of GDP. This isn’t because governments have been profligate recently. They haven’t. In fact, they have run primary budget surpluses for the last 20 years — that is, taxes have exceeded government spending excluding debt interest. Instead, a lack of GDP growth has meant a lack of growth in tax revenues, so governments have been unable to grow their way out of high debt.
The other is that a stagnant economy has led to hostility to established political parties — hence the rise of the Five Star Movement and La Lega. As Harvard University’s Ben Friedman and Australian National University’s Markus Brueckner have both shown, weak economies lead to rising intolerance and to rightwing extremism. The rise of anti-establishment nationalist parties is the direct result of poor economic conditions.
And here’s the problem. In its current form, the euro lacks any meaningful way of getting Italy back to growth. There’s no fiscal union whereby faster-growing economies can support slower-growing ones. And there are insufficient policies to promote growth. The ECB cannot cut interest rates any more, and those governments in the region that have the space to loosen fiscal policy (such as Germany) are loath to do so. This leaves only hectoring demands that Italians change their ways — “more work, less corruption” as European Commission president Jean-Claude Juncker said last week — or calls for “structural reforms”. And as Dietz Vollrath at the University of Houston has consistently pointed out, these have only weak effects. The currency union in its current form is, says Llewellyn Consulting’s Russell Jones, “half-baked”.
Continued stagnation means that there’ll be continued calls for Italy to leave the euro. In the near term, it is unlikely to do so. Leaving the euro would mean replacing the euro with a new currency, which would automatically drop like a stone. That would mean a huge rise in import prices and hence a cut in the real value of both wages and savings, making Italians much worse off. It’s for this reason that only a minority of Italians now want to leave the euro.
As we saw last week, however, if investors believe there’s even a slim chance of this happening, they’ll dump Italian bonds because of the small but horrible risk that these might be redenominated into a currency much weaker than the euro. This would cause falls in share prices as the value of banks’ assets fall and not just in Italy: non-Italians held €685.6bn of Italian bonds at the start of this year.
This could do serious damage. Losses by Italy’s already fragile banks might cause them to curb their lending. Worse still, if it leads to even the slightest fear for their solvency we could see a bank run, as depositors try to withdraw their money. Even if such runs are unjustified, they can cause otherwise healthy banks to fail.
Also, higher bond yields mean higher borrowing costs for the Italian government. That would reduce the already limited room it has to use fiscal policy to stimulate the economy.
The eurozone has the tools to fight such crises, as Berenberg’s Holger Schmieding points out. The ECB could buy Italian bonds to hold yields down. And the European Stability Mechanism can provide finance for the government and to recapitalise the banks if necessary. Neither of these weapons is likely to be used quickly. But the mere possibility that they might eventually be invoked means there’ll come a point at which selling of Italian bonds will become very dangerous. That alone puts a floor under bond prices — although exactly where nobody knows.
Such solutions, however, don’t address the fundamental problem of a lack of real growth. That requires reform of the euro to permit looser fiscal policy in the region. One means of doing this, argues Princeton University’s Ashoka Mody in a forthcoming book, is to restructure government debt. In his book Europe’s Orphan the Financial Times’s Martin Sandbu shows that this can promote growth if accompanied by recapitalising banks. This is partly because it would give Italy space to loosen fiscal policy, and partly because it would reduce the fear of a future crisis and so improve business confidence.
For now, such reforms are a forlorn hope: nobody expects much progress towards them at the EU summit at the end of this month. Mr Jones warns that only a deeper crisis will give them sufficient incentives for progress.
This means investors face an obvious danger — that the eurozone’s crisis could re-emerge any time, with another rise in Italian bonds triggering fears about bank losses.
On top of this structural problem, we have a cyclical one. The eurozone economy is cooling off anyway: purchasing managers say that growth in the region fell to an 18-month low last month. Slower growth means weaker equity returns, political crisis or not.
Chris Dillow is an economics commentator for Investors Chronicle
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