Stockwatch: are UK growth stocks overvalued?

Edmond Jackson has some probing questions on the issue of overexuberant valuations among small-caps. He offers some sensible advice too.

Following my recent points about AIM-listed Beeks Financial Cloud Group (LSE:BKS) it is pertinent to examine another small-cap trading on over 30x potential earnings and ask if this is justified – or suggests mean-reversion is more likely. 

Finally, the penny appears to have dropped with the Bank of England governor. Interest rate rises look inevitable to deal with inflation, but they could check economic recovery from the pandemic. In this scenario, investors need to know what they are doing if holding highly-rated stocks. 

Long-term stock-pickers might argue that you cannot reliably guess market moves. Instead, focus on quality emerging businesses, and over the years their growth will reward you despite inevitable shifts in market sentiment. 

• Invest with ii: Top UK Shares | Share Prices Today | Open a Trading Account

I concur, but as someone attuned to valuation, I think it is worth pointing out when and where risks are increasing. Small-caps are also a tight market, hence price movements tend to be amplified. 

A growing business, helping firms transition to digital  

In March 2017 and December 2018, I drew attention to the old St Ives printing group being restructured into marketing services – re-named Kin and Carta (LSE:KCT). Its stock was priced around 80p and 100p respectively, having de-rated from over 400p in 2002 when the core St Ives’ business became pressured. This was divested in July 2018 and the group re-branded that October. 

• Five things investors must know about Britain’s energy crisis
• UK economy springs post-Covid surprise
• How the AIM market took over the world in 2020

I anticipated a potential winner because “digital transformation” looked a timely essential service. A new CEO became effective from August 2018, another catalyst for transformation. Yet due to disappointment with the St Ives printing operations the stock was seen as just another speculation on AIM’s fringe. 

The financial year from early August 2018 had started with various contract wins and a declared strong pipeline. Management cited scope for cross-selling and a deepening focus within sectors served – such as financial services, transport, retail & distribution, healthcare, industrials and agriculture.  

That looked a good spread, as did 55% of revenue deriving from the UK, 36% US and 9% rest-of-world. The rate of global growth for “digital transformation services” was said to be compounding at 18% annually. 

Since then, the stock has nearly quadrupled to over 300p a few weeks ago, currently 275p. Yet all its rally has been from March 2020 after Covid prompted a drop as low as 57p from 107p that February.  

Does this specialist area warrant a longer-term, premium PE? 

Currently, the business is valued at just under £500 million, or four times sales, on a price/earnings (PE) of 41x the expected outcome for the financial year to 31 July 2021. If net profit of £11.3 million then rises to £14.6 million in July 2022, as expected, the PE would ease to 31x.  

It is a big rating, also considering there is no dividend lately and only 2p a share paid out pre-Covid.  

Digital transformation services are quite tricky to assess. They could indeed offer a rare pocket of growth if the UK economy becomes pressured again.

That would justify a stock premium, for scarcity. Yet if things become especially tight, marketing services are still easier to cut than most overheads. Other such groups may diversify into this area – poaching skills – and create more competition. 

On broad fundamentals then, a PE in the twenties might be more appropriate as a median “benchmark” considering risk/reward. 

It begs the questions about  what extent this and other growth stocks have benefited from market exuberance, with traders jumping aboard. How resilient might such capital be if overall sentiment changes? 

Increasing momentum as a result of the pandemic 

The six-year historic table looks mixed, although halved revenue reflects the sale of St Ives’ printing operations. Its key historic upshot is a strong free cash flow profile relative to earnings, but altogether it says this business has everything to prove. 

A £32 million net loss in the July 2020 year related to goodwill impairment in a non-strategic business, plus acquisition and restructuring costs. The core ongoing business raised revenue by 8%, while a restructured one fell 18% but was said to be stabilised and growing.

• Don't be shy, ask ii...how do I tidy up my investment portfolio?
• Check out our award-winning stocks and shares ISA

While the pandemic continued to weigh, management was optimistic of a return to revenue and profit growth in the second half of the 2021 year.  

Interim results to last 31 January then showed £64.1 million continuing operations’ revenue down 10%, albeit a strong pipeline converting into record contracts signed. Continuing operations’ profit was £2.9 million, down from £4.8 million like-for-like. 

The sale of two non-core businesses raised £14 million and a US-based data transformation consultancy was acquired for £5 million equivalent – to complement the launch of K&C Data Labs, already achieving key contract wins. 

This was the first time the CEO was able to assert Kin and Carta as “back in growth mode”. A record number of contracts had been signed, 27% higher than pre-pandemic.

Demand for digital transformation services was said accelerating in all the group’s markets, hence over 100 new employees had been recruited since last November.  

Does that justify a forward PE well over 30x? 

We have yet to see whether this demand from clients is a one-off adjustment (say for a year or two) or something more durable.  

A 15 June update cited demand growth continuing despite effects of the pandemic starting to abate. Circa 10% annual net revenue growth was anticipated, accelerating to 20% in respect of the July 2022 year – with an underlying operating margin of 12-13%. Circa 15% compound annual growth being likely thereafter, with rising margins as the group builds scale. 

That affirms my reckoning for a PE around 20x or possibly higher, lest growth situations become scarcer. 

Since the March interims, the stock had risen from sub-150p over 275p by this June update, then a bullish 22 September update saw it briefly over 300p. Revenue and profit were guided ahead of the top end of market expectations for the July 2021 financial year. 

• Pandemic winner closes in on AIM top 10
• Read the latest Stockwatch articles by Edmond Jackson here

Scope for acquisitive growth was bolstered by end-September news of the divestment of the Ventures business for £18 million cash – to be applied to paying down net debt (£19 million at end-July) and further strengthen the balance sheet. A robust M&A pipeline was proclaimed. 

Adds up to a wary 'Hold'

In a bullish environment for growth stocks, the market has pushed this and other small-caps onto ratings that effectively discount long-term superior growth. That may be rational for an elite few that are still able to grow despite stagflation generally. 

All things considered, and given markets will increasingly anticipate at least one interest rate rise, growth stock ratings look exposed.  

The key question is whether to ride out potential volatility because the underlying business is strong. 

With Beeks Financial Cloud, it looks to me as if they can continue to scale the business radically from £12 million annual revenue, unless it suffers reputational damage or a better technology appears. 

Digital transformation does look to have a robust future, but the question is what extent of protective moat Kin and Carta can construct as competition evolves.  

I think “sell” would be overall harsh at this stage, but on valuation grounds holders should consider locking in some gains. Also maybe apply points raised in this piece to other growth stocks owned. Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.