Sagentia Group - What is fair value?

http://www.sagentia.com

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Long-term value continues to be difficult to identify at the current point in time, mainly because many companies have already had some forward growth factored in by investors. It is also made more difficult by most value filters being based on historic figures meaning that valuations look artificially stretched. However, Sagentia Group (LSE:SAG) is one company that has a fairly low valuation, or so it would seem on a first glance. The company has progressed in leaps and bounds over the past few years and the share price reflects that, currently standing at 150.5p. Is the reality that it is a company the market has missed, or is there a less obvious reason for the seemingly low valuation? Sagentia, which is part of the Support Services sector, has 38.34m shares in issue giving it a market cap of £57.7m.


From a technical perspective Sagentia has been a consistently strong performer. However, recently it is struggling to break out of the long-term upward resistance which is at around 155p and rising. The technical outlook would look much more positive if it can break above this level as it would signal the start of the next 'leg up'. In one of the text boxes I've written how there are two possible scenarios. The first is that it could continue to track the resistance band higher with the second being that it consolidates sideways and falls back, potentially indicating a cooling off period. Such is the nature of past movements, that to expect a strong movement to the downside is unlikely.

Directors hold a significant proportion of shares with Chairman Martyn Radcliffe holding 33% of the share capital and with former finance director Neil Elton and a senior independent director holding a further 1.44% between them. That doesn't sound like a huge amount, but in the context of a £57m+ business, it still equates to a large holding. Radcliffe has had a very impressive past. He is the chairman of Microgen (LSE:MCGN) and RM (LSE:RM.) so he has plenty of experience in roles of listed firms. In addition, he was formerly the Senior Vice-President of Dell's European-Middle East-Asia (EMEA) divisions, which is reassuring. In terms of institutions, as the share price has traveled upwards, Legal & General have been reducing their stake (to 10%) and Charles Stanley has reduced their stake to below 5%. Due to this, the shares are illiquid although the spread is very reasonable.

Sagentia describes itself as an international technology consulting company. The company provides outsourced consultancy services for the medical and commercial markets. In plain English, that effectively means that the company is a consultancy for other firms who need help during the product cycle. The product cycle has four main stages.
1. Front end innovation
2. Concept generation and technology invention
3. Technology & Product development
4. Delivery and transfer to manufacture
The consultancy given covers a wide range of areas, and Sagentia essentially helps firms solve problems that can arise within the stages, or just assist customers in completing the stages. That can include research and development consulting or market analysis. The company is based in Harston near Cambridge and has recently relocated their US office to Boston. However, the company does derive revenues from two other non-core activities. The spare space of their Harston office is let out, and they also have a small IT services business.

The company has over 150 staff, the majority of which are fee-earning meaning that they are contracted on a needs basis. The company has historically been backed by a very healthy balance sheet and that is down to the highly cash generative nature of the business. During the 2012 financial year, the group had so much surplus cash that it undertook a share buy-back at an average of 82.8p/share, which cost £4.5m. Moreover, it has been able to pursue acquisitive growth. In February 2013 Sagentia acquired QDA Ltd, another Cambridge based company. The profile of the takeover was low with only £20,000 in initial consideration. Performance related earn-outs can release more cash to QDA although this is capped at £180,000. This deal is definitely not one that will transform the company.

What may have a more prominent impact is the acquisition of OTM Consulting Ltd in July 2013. The Surrey based company is an international technology management consultancy for the oil, gas and alternative energy industries, hiring over 50 staff. OTM has a strong blue-chip client based which includes well-known trans-national companies such as Shell, Total and Statoil. During the 2012 calendar year, it turned over £4.3m bringing in pre-tax profits of £0.8m so the acquisition will definitely be reflected in the next set of financial results. The acquisition also opens up the oil and gas sector to Sagentia so it may be able to cross-sell services and strengthen the ties obtained through OTM. The deal cost Sagentia a total of £6.5m with £5.3m of that in cash and the rest in shares. £1.1m will be directed straight back to the group as it is on OTM's balance sheet. The shares also come with a 3 year lock-in so the shares cannot be disposed of until July 2016. Despite the deal knocking the cash of Sagentia's balance sheet, it remains robust. It's not the cheapest deal, but it is fair and any method to boost earnings at a reasonable price should be welcomed. After all, boosting earnings is a better use of the cash than it just sitting in a bank account or short term deposits.

So far, so good. Now turning to the 2012 full year results. Revenues came in slightly lower at £22.3m with a revenue split of 47% commercial markets, and 53% medical markets. The geographical split was 49% North America, 37% UK and 13% Rest of Europe. Currency exposure was therefore predominantly limited to the Euro and US Dollar, which is fine. The majority of this revenue was from core consultancy operations, although the Harston office rent and IT services brought in around £2.75m of that figure. A very reasonable pre-tax profit of £3m was booked and that takes into account a £500k exceptional charge related to settlement terms with the former group CEO. EPS came in at 8.1p with diluted EPS around 5% lower.

A maiden (token, really) dividend of 1p was issued. However, the 2012 FY results were also adversely impacted by the suspension of a major contract part way through the year. Nonetheless, there were substantial net funds on the balance sheet which provides good asset backing in itself.  One of the biggest advantages that Sagentia has are its tax losses. Tax losses allow a company to offset future profits so that tax is not paid on them. As at December 2012, the tax losses of the company stood at £23m, but that will have fallen comfortably sub £20m by now. However, at the current rate of growth, these tax losses should continue to be useful into 2015. Ahead of the 2013 interim results, Sagentia also released a very positive sounding trading update. It said, "Although the board remain cautious in the current economic climate ... it is now anticipated that first half revenues and profit will comfortably exceed management expectations."

The interims reflected this belief. One important point to note before reading this is that financials from OTM Ltd are not included. These were the key points:
- Revenues up 36% to £14.5m
- Pre-tax profits up 49% to £2.7m
- Basic EPS up 54% to 7.1p. Diluted EPS of 6.6p
- Strong balance sheet. Net funds of £14.7m (+£400k after year end)
- Net payables of £2.44m
- Cash generation from operating activities of £2.7m. Total cash flow of +£1.32m

This particularly strong performance was shown despite non-core revenues from IT support and Harston rental income declining whilst the space is re-marketed. FOREX movements benefited the pre-tax profits by approximately £200k (although this has reversed since). Medical and commercial revenues also evened out so that they each represented 50% of the core operations. Importantly, the value of the Harston property was set out. A report by Savills showed the value of the property to lie between £12.9m and £18m (for a sale and lease back scenario), the mid-point being £15m. At the time of the interims, this gave the company substantial asset backing amounting to £28.4m or 75.1p. Theoretically, at the current point in time, the core and IT businesses are being valued at 75.4p. Given that FY expectations are for £4.8m in pre-tax profits and total EPS of 11.5p, it doesn't take much to realise that the valuation really is hardly demanding.

Adding back the changes resulting from the OTM acquisition and the picture is slightly less bright. Taking the £28.4m figure, subtracting the £2.44m in net payables, £4.2m for the acquisition consideration reaches a value of £21.76m in the interims. That will have improved since when you factor in operating cash flows since. The £21.76m figure roughly equates to 60p/share of tangible asset backing which leaves 90.5p for the core business. At 11.5p EPS, that is a PE ratio of around 8, which really is undemanding given the current economic outlook.  Of course, excess cash on the balance sheet doesn't do much to help investors so you could apply a discount, but equally there is the possibility of a dividend hike if the financials continue to improve.

Borrowings on the balance sheet of £5.8m were predominantly (86%) non-current which gives added flexibility. This situation was improved in September with a new loan facility for £10m arranged. The outstanding £5.8m of debt will immediately be repaid. That loan was secured solely on the Harston property and no operating covenants were placed. The only condition is that cash balances must be at least £2m - that should be easily achievable. On a more minor note, Sagentia also hedged against a rise in interest rates through taking out a new interest rate swap at a lower interest rate fix.

So that is all good, Sagentia is clearly a good value pick? Not exactly. First and foremost the company notes that whilst the H1 performance was exceptionally good, it was down to exceptional reasons. It was driven by a number of large projects, some which have now completed. The outlook part of the report read:

"Some of these projects have now come to completion and, while the sales pipeline remains satisfactory, as a project based consultancy, the customer profile can create revenue variability. As such, the Board remains cautious and retains a prudent perspective for the second half. Nevertheless, after such a strong start to 2013 and with the one-off benefit of the Royalty Settlement, the Board anticipates the results for the year to exceed its previous expectations."

That cautious approach to H2 and comments regarding sector visibility don't ring well and probably means the company will continue to be valued on a modest PER. Taking a look at the historic financial performance below, that is a fair assumption. It has been erratic to say the least.
So yes, the 2013 results will definitely show an uplift back towards the £30m revenue figure. However, is this sustainable or is it just another blip? The underlying performance of the group has improved since the crisis with positive operating cash flows and post-tax profits, but once again you have to question whether any uplift is a blip or not. The argument against it being a blip is that they are finally growing through acquisitive growth, which should shine through immediately. There are a few other concerns though.

The first of these is that there is revenue risk due to client proportions. Sagentia's top 5 clients account for 47% of revenues with the top 10 clients accounting for 71%. As was seen in 2012 when the major medical contract was suspended, that can have a profound impact upon the company's financial performance for any particular year. Those percentages are actually up on 2012 which is a cause for concern. The diversification that OTM will bring will be much welcomed, but it won't be enough to offset this risk. Combined with the 'limited visibility', it once again means that Sagentia will probably continue to be valued on a low PER.

The second is linked to this point. "The Board considers that the reported operating margin level is towards the top-end of comparable companies in the industry and balancing investment and profitability is in the best interests of shareholders in the medium term." Seeing as the sector is highly competitive, this sounds like they are experiencing the effect of these pressures and believe that the way to maintain growth and their position is to cut margins and lower prices for clients. That's not good news and also represents a risk.

The final, less important point is that Neil Elton, the finance director, resigned from his post in November 2013 in order to 'pursue a new challenge'. The real reason for these departures is rarely told to the market so it could be that he was offered a better job or for another reason. In any circumstances, this isn't a particularly good piece of news given that he was largely responsible for the much improved group performance. The reason can be inferred by seeing whether or not he sells his shares in Sagentia in the short-term. Rebecca Hemsted has taken over in an orderly handover which was completed in January. Neil Elton leaves the company on February 14th.

In essence, even though the company looks favourably priced on valuation grounds, there are a few significant risks going forward that take the shine off this proposition. On the contrary, there are a number of positives such as the chance of a progressive dividend and the positive impact of acquisitions, but seeing as the share price has risen substantially over the past few years, rapid upside is unlikely to be easily achieved.

The two brokers that cover the company also have price targets that suggest that the undervaluation is not at large as it first seems. House broker Numis has a Buy rating with a 165p and Westhouse Securities is slightly lower at 163p. At 163p, the implied target is just 8.3% which is hardly stellar, especially when you consider the bid-ask spread. There is certainly a possibility that these targets will get upgraded in time, but for now, the rating of Sagentia looks fair and there isn't enough medium-term upside given what the market currently knows. No Rating.

5 comments:

  1. As usual excellent research and analysis, thanks

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  2. Comprehensive balanced stuff. I have come across sagentia before and I almost bought in before I saw the rise over the last few years. I hate buying into companies that have risen hundreds of percent as you can be buying at the top

    CraigJ

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  3. I sold my shares in Sagentia back in November after following a similar thought process to this

    Good job

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  4. El1te,

    What a superb analysis. I only looked into SAG recently and got very excited by the valuation at first glance but, when I dug a little deeper my enthusiasm waned as a realised 2013 was an exceptionally good year; and now that I've read your analysis today - which far exceeded my own - I've really cooled off the idea.

    That's for spotting things I missed and then expressing it in a way that even I can understand. It's much appreciated.

    Keep up the good work and very best regards,

    Libero

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    Replies
    1. Thanks Libero, much appreciated

      El1te

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