Stockwatch: a useful hedge in a UK portfolio

A respected fund manager has bought into this small-cap which could prosper amid the gloom.

The prospect of the majority of the UK being in lockdown for several months ahead begs the question how many private businesses will finally be pushed over the edge. Looking at trading updates from publicly-listed companies does not reflect the wider economy, as these are typically well-capitalised with strong market positions. Smaller businesses face a tougher prospect and there are also “zombies” propped up by low interest rates persisting since the 2008 crisis. 

The situation looked ominous by end-October 

For those in the hospitality sector especially, this latest lockdown could be the final blow. A Red Flag Alert report from AIM-listed corporate recovery specialist Begbies Traynor (LSE:BEG) cited the third quarter of 2021 having the biggest quarterly leap in UK financially distressed businesses since 2017 – up 6% to 557,000, despite a legal backlog thwarting winding-up petitions.  

They were led – somewhat ironically – by food and drug retailers (up 14%), construction (11%) and real estate and property (11%). The automotive supply chain has seen a 10% rise, but a no-deal Brexit would be calamitous. 

There has also been a 10% increase in distressed bars and restaurants since end-March and by 5% in the third quarter. I have less sympathy for this sector which has expanded hugely and needed an extent of culling – similarly online retailers up 11% versus 9% for wider retail. Even left-wing economists such as Professor Jonathan Portes have criticised the government’s extension of the furlough scheme because it inhibits necessary restructuring – an upshot of recessions. 

Amati Global Investors declare a 6% stake after interims 

Admittedly, Begbies is a modest £113 million company, with its stock currently at 87p. However, Amati ought to know what it is doing given such a stake will be relatively illiquid. They acquired this position a day after the 8 December results to 31 October showed an 11% revenue advance to £37.5 million – albeit with acquisitions representing 9% - with adjusted pre-tax profit up 25% to £5 million.

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Encouragingly, operating margins rose near 15% after a meagre track record (see table) of mid-single digit percentages and return on capital of only very low single digits.  

Mind, however, the normalised approach strips out £3.1 million costs of making acquisitions, on top of a more regular £1.5 million amortisation charge for intangibles arising on acquisitions (the premium to net tangible assets which is common in “people” businesses such as advisory). A £0.9 million reported operating profit is unrepresentative of the ongoing situation but £3 million+ costs are real.  

Note 3 to the accounts clarifies £2.6 million of these costs as “deemed remuneration” i.e. earn-outs from prior acquisitions. It shows how you cannot compare normalised profit from acquirers, the same as wholly organically-driven businesses, when acquirers have to keep paying down such costs. Not to argue against acquisitions per se, just to be aware.  

The latest transaction in June was relatively small: a portfolio of 503 Scottish personal insolvency cases including a team of five fee earners, for £0.5 million (partly according to future performance). 

Should top-line progress be better in these times? 

A sceptic might say, Begbies involves polarised views of pre-tax profit - £0.9 million reported versus £5 million normalised – where the true position seems quite nebulous. You might therefore wonder at the consensus forecast for £8 million net profit this financial year to 30 April 2021, rising over £10 million in 2022. Most likely the company’s broker will have acceded to the “normalised” view. 

This is important given a high historic price/earnings (PE) ratio of 37x, which reduces to about 15x and 10x in respect of the April 2021 and 2022 years.

More positively, an 11% increase in the interim dividend is in context of a steadily rising record and forecasts, for a prospective yield around 3.5%. That is a plus compared with high yields you cannot trust, or stocks that have passed the dividend.    

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But when it is tricky to discern true earning power, it would be encouraging to see better organic top line growth than 2%. Moreover, it was flat in April 2020 year despite acquisitions boosting the reported level by 17%. 

In fairness, the interim results’ narrative cites “a downside impact from the first few months of lockdown, followed by a subdued insolvency market resulting from the government’s Covid-19 financial support measures”.  

This means taking a quite speculative view of where Begbies could be over the next 12 months and longer, than regarding its stock as genuinely investment grade.  

Business recovery constitutes three-quarters of group profit

Looking back to the April 2020 year results, 70% of group revenue derived from “business recovery and financial advisory,” which also represented 75% of profit before central costs. Property advice and transaction services constituted the remainder, growing revenue by 25% albeit profit only 1%. Yes, integrating estate agent and auction services with corporate recovery made strategic sense as property often needs dealing with. But property services’ returns can be pretty volatile and this side was hit during the spring lockdown, hence may be again in early 2021.

Amati probably takes the view that trading conditions should evolve in Begbies’ overall favour, especially once government support measures ease. Despite the number of corporate insolvencies falling by 30% in the six months to end-September, rises must be baked in.

£25 million unbilled income needs clarifying better

Not surprisingly, intangibles represent 93% of £66 million net assets at Begbies. Some £8 million of long-term debt is substantially offset by £6 million cash, however there are also nearly £8 million lease liabilities. 

£36 million trade receivables are notable, albeit hardly changed year on year, versus £25 million trade payables, usually any imbalance is the other way round due to companies delaying payment. Does this imply a risk of fees going sour if clients cannot pay? Note 7 breaks down overall trade receivables as constituting £25 million unbilled income – over three times expectations for normalised net profit this year – which needs clarifying better.

Stock is effectively in a consolidation phase

No trend is apparent despite last springtime’s aberration of a sharp drop from an 80p range, then rebound to 112p followed by a drift back. The market awaits more definitive insight, but a third-quarter update to end-January is not due until early March 2021. 

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So, this stock asks for conviction of buyers, given it remains quite speculative despite a good dividend record, and yet speculators would more likely await confirmation from the chart – that an uptrend is established. It is no straightforward play on a rising insolvency market linked to Covid-19, and possibly a hard Brexit. Yet I imagine Amati views it as a small but useful hedge in a UK portfolio, and on such rationale it rates: Buy. 

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