Pennant International Group - An Encouraging Path

http://www.pennantplc.co.uk/


Pennant Group (LSE:PEN) has enjoyed a strong couple of years as it has succeeded in ramping up both revenues and profits. This has fed down through to the share price with the share price more than tripling - Pennant is up 30% over the past year. Pennant, which describes itself as an "AIM quoted supplier of integrated logistic support solutions, products and services", looks set to continue its upward trend in the medium term as the company drifts towards a fairer valuation. Pennant currently trades just off of all-time highs at 91.5p, but the share price action still looks encouraging. With 26.4m shares in issue, the company is valued by the market at £24.17m.


The technical position of Pennant is strong, even considering the very strong price movement. Naturally you would expect profit taking to occur along a strong share price chart, and that has been the case with various levels of consolidation. Indeed, the last move up in January has since been 'consolidated out', and that can be seen by the both the MACD and RSI returning to their respective equilibriums. I would expect the next material price move to define the short-term outlook. Any breakout from the triangle shown should be the precursor to a larger move. To the upside, this would target as high as 110p initially, whereas to the downside it would target 80p again, where I would expect it to find the residual support. 100p will certainly require a strong move to break through, so it could ultimately continue to consolidate just below that band of resistance. Any confirmed break of 100p is likely to see a very strong upward swing.

For a company with a ~£24m market cap, it is encouraging to see that there have been several institutions invested in the company - one of those includes Rathbone Nominees, who hold a 9% stake currently. One downside is that the board holds a large percentage of the shares, with the Chairman, Finance Director and CEO holding around 50% of the total shares between them. It's a downside because it reduces liquidity and often means that they don't purchase shares on the open market, but on the other hand it aligns their interests with that of shareholders.

I appreciate that Pennant's definition of its operations is rather murky - it is essentially a software/hardware company that deals with simulation, data and software programs, and a range of services that are related to the design and operation of these. Pennant reports its operations according to three divisions (as below), with the main target markets including: Rail Transport, Defence and Aerospace.

- Training Systems = Provides and supports specialist training systems based on software emulation, hardware simulation and virtual reality in the defence sector
- Data Services = Provides high quality graphics, virtual reality software plus technical documentation
- Software Services = Owns rights to the 'market-leading' OmegaPS software suite. This software is used to reduce the cost of major capital equipment used in the defence, aerospace and transport sectors. Revenues are generated from licence sales, maintenance agreements and consultancy fees

I'll continue on a different path for this review, by looking at the most recent set of results straight away - these were released in March and were for the 2013 calendar year. The headline comment for the results read "Strong trading performance gathering further momentum". Chairman Christopher Powell commented: "I am pleased to report a year of further significant growth in both revenues and profits, enabling the Directors to recommend a 30% increase in the Final Dividend. Furthermore, the current order book provides good visibility of revenues for 2014 and the level of tendering and associated contact with prospective customers, particularly in the Training Systems Division, enables us to plan with confidence for the medium and longer term."

That was very much reflected in the results, with revenues jumping 29% to £18.7m and pre-tax profits tracking higher by 40% to £2.25m. Basic EPS also jumped by 44% to reach 6.43p, and the diluted EPS was marginally lower at 6.33p. Other important points included:

- Net cash at the period end of £1.16m. This was lower than the corresponding period due to dividend payments. There is slight exchange rate risk with Pennant holding cash in Canadian Dollars, Australian Dollars and US Dollars, but the impact is unlikely to be major, going forward. During 2013, all three of these currencies weakened during the British Pound due to the relatively strong UK economy. The cash balance was therefore hit by this, but not by a concerning level
- Total dividend of 2.6p. 1.8p of that will be going ex-dividend on April 9th. The dividend is cover 2.5x earnings
- Cash generation of £165k was weak, but was down to short-term working capital requirements. Stage payments will continue to improve cash generation during H1 2014. The cash generation showed a marked improvement upon that achieved during H2 2013 when working capital also restricted it
- Gross margin of 34.5%

However, the financial part of the results is only half the story, and the narrative is often just as important. What has led to this step-change in Pennant's financial performance were a series of contracts that were won during the year, and total to provide over £20m in possible revenues. In March 2013, the company won a milestone £16m, 5 year contract with the Australian division of blue chip defence company BAE Systems, and this was followed up by a 3 year contract with the Ministry of Defence for up to £5m in revenues. That was further followed by a £1.3m training contract later in the year - the combined values of these led to Pennant upgrading their expectations for the year. Whilst the values and clients of these contracts are clearly impressive, what is more important is that is enhances Pennant's earnings quality. The contract lengths are long, and therefore provide much needed visibility to operations, which tend to lack visibility. For example, the £16m BAE contract includes a clause that carries the potential for over 20 years of subsequent extensions. This should mean that the market values Pennant on a higher PER in the future. Most of the revenues forecast for 2014 are already contracted for, hence there is the possibility of beating targets if new contracts are signed during late H1 or early H2.

Looking over the divisional report, most of that growth seems to have been derived from the training systems division, who reported revenues up 44%. This was the division that was subject to the large contract wins, so this looks like the real growth area. It's made more impressive as the contract wins followed historic successful completions of a £12m helicopter training machines contract, and a contract for a parachute flight simulator. The bottom line is that it proves that Pennant is gaining recognition within the sector, and having references to draw from is ultimately very valuable. The training systems division contributed the majority of operating profits. The next most significant division was software services that saw revenues up 17%. That result was aided by support contracts for OmegaPS with the Canadian Department for National Defence, and the Australian Department of Defence. Lastly, the data services division saw a 6% rise in revenues, but a drop in operating profits. There is some diversity within operations, which is beneficial, although it remains the case that training services is the key division.

The balance sheet of Pennant is also strong with total tangible assets covering total liabilities almost 2.5x over. Most of the assets are current as well, which is encouraging - cash generation returning to normal levels should strengthen the cash backing going forward. There were however, net receivables of around £2.7m and that was significantly higher than in the corresponding year. Receivables had also risen faster than payables, which is normally a red flag. That is not an issue though given the client list, and the fact that it will probably correct itself in the medium-term. The client list is blue chip and thus the risk of not receiving payment is low - the payables figure may well be due to the stage payment nature of the revenue.

At 91.5p, Pennant is trading on a diluted PER of 14.5, which is not particularly demanding given the sector of operation, and the strong trading performance over the last few years. Furthermore, the dividend issued is enticing as the trailing yield amounts to 2.84%, which is above the sector average. Indeed, the company actually trades on a discount to the sector PER average as well, which stands at a lofty 22. Of course, this is all irrelevant if next years results are forecast to be poor. The chart below shows the historic, and forecast figures from broker WH Ireland.


To be more specific, 2014 is expected to show revenues higher at £20.1m, a pre-tax profit of £2.4m, and corresponding earnings per share of 7.1p. A dividend of 2.78p is also pencilled in. Those figures are favourable, as it would put Pennant on a PER of just 12.9, and on a prospective yield of 3%. For 2015, WH Ireland expects moderately improved revenues of £21.4m, profits of £2.6m, earnings of 7.7p and a dividend of 3p. Those numbers would put Pennant on a 2015 PER of just 11.9x and a dividend yield of 3.3%, which is far too low given the solid growth achieved.

I reckon those figures are pretty conservative, especially since most of this years revenues are already accounted for. Any multi-million pound contract win and those forecasts will be beaten, and given the underwhelming rating of the shares, they should head higher. However, being cautious and assuming that there are no major contract wins, the valuation still looks low. As noted earlier, these figures are much better than the sector average, and seeing as the overall market is still bullish, it is easy to see Pennant trading on a 2014 PER of 16-18, given the improved earnings quality. Dependent upon momentum, it could overshoot that. That would put a share price range of 114p - 128p. Even at the top of that range, investors would still lock in a decent dividend yield of 2.17%. I think the dividend forecasts are also on the conservative side. The key to unlocking a significantly higher range would be further contract wins and that is almost certainly why WH Ireland is anticipating slowing growth - it's difficult for a broker to forecast large contract wins, so they avoid doing so. Regardless, following the results, WH Ireland upgraded their target price from 99p to 115p, which would suggest ~25% of upside.

A fairly similar company to Pennant, also listed on the LSE, is Simigon (LSE:SIM). Simigon also operates in the simulation and training space, although it has a higher gross margin. The company has a market cap of £14.42m and a share price of 30.50p, having also enjoyed a strong trading performance. 2013 forecasts for Simigon are for EPS of 1.29p, which puts the shares on a lofty PER of 23.6. EPS for 2014 is expected to be 1.47p, which is a PER of 20.7 (compared to Pennant's 12.9x). Simigon also has a strong balance sheet, with substantial cash resources of £4.8m, which puts them on a PER of 18.2 if you strip out £3.3m of the cash balance. That is still substantially higher than Pennant's PER.

Another catch is that Simigon is an Israeli company, so is almost certainly trading at a discount compared to what it would trade at if it was a British company. That perception issue is not helped by the lack of a dividend, despite the large cash pile and strong cash generation. It is therefore feasible to think that it would trade on a higher PER if it was British. Nonetheless, the company remains in an uptrend, and this brief comparison shows the comparatively low rating that Pennant is being given by the market.

Slight concerns have been raised over the finance directors' (John Waller) decision to step down at the end of the 2014 calendar year, but that orderly handover strongly suggests that there is nothing untoward associated with the move - after all, he is 65 thus around the retirement age.

What reasons are there to remain confident in the future? There are certain parts of the narrative that I have excluded until now. Even though the timing of major contracts is difficult to predict, Chairman Powell was confident enough to say:

"A number of major new contracts have been won and completed to customer satisfaction, enhancing the Group's profile and reputation. As a result, the Group is currently actively involved in a number of significant opportunities with existing and prospective customers. These opportunities, together with the size and visibility from the current order book give confidence for the future."

"I am pleased to report a year of further significant growth in both revenues and profits, enabling the Directors to recommend a 30% increase in the Final Dividend. Furthermore, the current order book provides good visibility of revenues for 2014 and the level of tendering and associated contact with prospective customers, particularly in the Training Systems Division, enables us to plan with confidence for the medium and longer term."

That confidence is very encouraging, as after all, it will only take one or two significant contracts for the company to beat market expectations. Pennant has a strong balance sheet, is profitable, and is on a rating that has clear headroom to the upside. The technical position of the shares is strong, and any breakout past 100p is likely to lead to a much more substantial move to the upside. The company has made very positive progress over the past two years, and for that reason, the current rating, and a higher rating, is more than justified. Any further major contract wins (that have been referred to as being possible) would prompt to broker upgrades. Trading at an undeserved discount to the sector average, a first target of 120p-130p looks feasible, and for that reason I have put a Buy tag on Pennant International.

UPDATE (19/09/14) - I recently moved Pennant from Buy to No Rating at circa 94p including accrued dividends, after a pedestrian set of results combined with a lack of contract wins. Whilst a material contract win was announced post-results, there is now the risk that revenue stacking will actually just be revenue replacement - in other words, the large contracts may not stack on top of each other substantially enough to drive significant revenue growth. The chart also remains neutral, although the chance of a takeover offer or division sale does remain a distinct possibility, especially given the recent incentivisation scheme to key directors

4 comments:

  1. Nice spot. I'm purely a technical trader, and the outlook is excellent. Run you winners makes sense

    ReplyDelete
  2. Very good article el1te

    ReplyDelete
  3. Pennant International seems like a very sturdy pick El1te. The sort of thing that I would go for :)

    CraigJ

    ReplyDelete