Regenersis - Growth at a Reasonable Price

http://www.regenersis.com/

Regenersis Logo

Since the UK stock markets have failed to make progress over the past 6-9 months, with AIM performing considerably worse than US small cap markets, I have purposely been concentrating on smaller companies whose potential is more closely linked to operational progress rather than wider market movements. That has led to the site portfolio having a strong small cap focus, which has performed well to date. Regenersis is a company whose market capitalisation is considerably above the level that I have been looking at over the course of 2014 and, in line with the wider markets, the share price has failed to make progress - in fact, it tumbled materially last week as the company unveiled that foreign exchange pressures would hit 2015 results. The share price is therefore down nearly 11% over the past year. However, at current levels, there looks to be an interesting growth at a reasonable price (GARP) play.

Technicals

As with most points in time when there is a large share price movement, long-term trends tend to have been broken through and the technicals, especially on an intra-day level, are very useful guides towards future short-term movements. In Regenersis' case the long-term uptrend was broken through convincingly and the chart has 'stepped-down', albeit the closing low is still over 10% above the previously minor low (circa 200p). That is important as it means that the overall price movements are still upwards. The RSI and MACD suggest that the stock is very oversold, and that could tempt traders into the stock to trade any further bounce. Volumes during trading on Friday were low, which means that not too much can be read into the reversal off the 250p resistance. If the market does continue to sell the stock down towards 200p, it would strongly suggest (graphically) that the market reckons that Regenersis' growth phase has stalled. I reckon that is not the case.

There are a few other interesting points to note. There was initially a questionable move back in January when Hanover Investors, a company linked to two Regenersis directors, sold around £17.5m worth of shares at 300p. That is nearly always a bearish signal, and in Regenersis' case, following that signal would have been correct. However, it's important to note that the line of stock that Hanover sold was considerable in percentage terms, hence there were several institutions who were happy to purchase large amounts of stock at that share price (admittedly, pre-placing). The placing is of course the second point. The fact that Regenersis managed to raise £100m at a minimal share price discount in H1 proves that institutional backing for the company is strong, and that is shown in the shareholder list. That placing was completed at 345p, which is substantially above the current share price of 232p. Essentially, investors are now able to purchase shares at a 33% discount to that placing price. The final point relates to recent share purchases again. Hanover re-bought £498k in recent trading sessions with the CFO purchasing £29.4k at 235p/share. It will be interesting to watch for any further director trades at the depressed share price levels.

As previously, the short-term picture is also important to check from a timing perspective. The share price appears to have formed a double-bottom the day after the results were released since the share price rose considerably having finished the formation. That shows strong support for Regenersis at the circa 220p levels. Resistance was encountered at 250p and that is likely linked to investors still selling down their holdings as they react to the results statement. Since the share price is so oversold on a number of indicators, it would not be surprising to see further upward movement back to 250p as a first port of call. With support likely at 220p the immediate risk/reward on a timing front looks good.

Operations

Regenersis is classified as a Support Services company, but in reality the company is a technology play with the sectors of operation spanning both Technology Hardware and Software. The company has been growing aggressively both organically and by acquisition over the past few years and it now operates in 22 countries - predominantly in Europe and Emerging Markets such as India and Argentina.

The previously core operations of the group revolved around Depot Solutions, which largely focused around the repair of consumer electronics such as mobile phones by partnering with major mobile phone operators. However, Regenersis quickly outgrew that core focus and was partly forced to since the margin erosion that has since been faced as eaten into operating profits within the division. Indeed, Regenersis recently exited a range of business in developed markets for the Depot Solutions as a result of margins being squeezed to as low as 1%, which is a pitifully low return. That said, low margins are a characteristic within this division, and that keeps Regenersis innovating. IP does play a role to an extent.

For example, the company has recently been investing in new technologies to move up the value chain into higher margin businesses. That should see margins from the division increase incrementally, but very slowly towards 6%. Therefore, it's a division that is relatively unexciting from an investors' viewpoint, and it is the underlying platform for the rest of the company. Further offerings are also being rolled out within this division. Motherboard level repair and screen scratch polishing have been cross-sold into the portfolio of offerings with the latter being used with the partnership with Nokia. A further driver of the Depot Solutions division is an initiative called Kaizen where small operational efficiencies at a factory level are identified and rolled out across the depots progressively.

Despite those improvements, it is a low margin business, so the real interest revolves around Regenersis' Advanced Solutions division. Advanced solutions is comprised of several businesses that are all higher margin, and are also higher growth with less competition:
- Digital Care = This was a business rolled out in Poland that is an insurance and warranty business
- Recommerce = This business is being steadily wound down after increased competition following Regenersis' start-up. Recommerce involved taking devices, performing a repair and selling at a discounted rate in other countries where demand is higher for older models (i.e. emerging markets). Margins have touted to have declined from 20% to 5% very rapidly as a result of competition and virtually zero contribution is predicted for FY 2015
- In-Field Testing (IFT) = This involves products to test devices in-field for problems, thereby eliminating returns to factories that have no fault. This addresses 150 million set-top boxes that are returned annually
- Data Erasure = Ability to provide a data erasure offering to corporates to guarantee 100% deletion of data across all devices

Within these segments, there are a few additional points to touch upon, that could be real drivers for the growth. Digital Care in particular is intriguing in that the business, which is only really rolled out in Poland, has exceeded expectations thereby proving popular with consumers. The offering sees Regenersis selling specific cover for certain damage aspects including screen damage. That specific cover means that theft and certain other points are not included, but allows a very low comparable price point to be charged, and that has seen Regenersis sign up the three major Polish mobile operators. A major point is that Digital Care introduces a higher quality earnings stream to the company since it carries a healthy 25% margin and has multi-year contracts that generates good visibility and diversifies earnings.

A further point in interest is within Data Erasure, as this is new exposure to the Group. But first it's key to look at the M&A activity of the company, as the company has been very active on the front. The reason for the activity is likely derived from CFO Jog Dhody who has an M&A background and that is partly reflected in either the full or partial acquisition of companies such as DigiCorp, Bitronic, Xcaliber Technologies and Blancco amongst a raft of other companies.

Blancco is the data erasure focal point, as it is the Finland based, global leader that Regenersis acquired earlier in the year alongside the £100m placing, and experienced a 25% annual compound growth rate between 2008 and 2013.There is a big driver for Blancco's offering, and that revolves around legislation that will be brought into European law in due course, which will require companies that handle consumer/employee data to ensure, and provide evidence of data erasure when a device/server or other technology nears the end of its useful life. Blancco does exactly that and is an offering that encompasses all platforms, with the "largest range of certification" - it's a turn-key service for corporates and other competitors' offerings are not as strong.

The new laws are a serious matter too, with corporates potentially liable for fines of up to 5% of their global annual turnover if they fail to comply. This is and will continue to drive adoption of Blancco's offering, and the opportunity is significant, not least because there are considerable cross-selling opportunities. Future growth from Blancco may also be derived from consumer device data erasure, or increasing the technology price point, which Jog Dhody believes is too low given the exceptional renewal rates of 99.6%.

The price point for the acquisition was 60 million euros, which amounted to circa 14x EBIT. The earnings quality is high given that the customer base is very large and includes many blue-chip clients such as NATO, Dell, NASA, Siemens, Toyota, Deutsche Bank and many others. Thus, the price paid for Blancco, the industry leader, does not look dear, especially given the potential to use Blancco to bolt-on certain acquisitions, as per Regenersis' intentions. "Blanco is an excellent anchor for further M&A." The integration of Blancco has started well with the business performing ahead of expectations. A further smaller acquisition was made of SafeIT, who specialise in cloud data erasure, so Regenersis are very much in the mode of building up a comprehensive offering to enhance the chances of customer retention - the market leading position and partnership with competitor Kroll are both key as well.

Financials

It's easy to become too interested in the operations of Regenersis since they are both extensive and high in detail, but simply looking at the financial performance is often a decent indication of the company's progress (excluding future potential). When looking at the share price chart, you have to assume dire news to generate such a significant drop (from 320p to 220p), so it's crucial to understand the results and what they represent. Here is a significant point

- Headline operating profits for 2014 hit consensus, but 2015 profits were revised down as a result of foreign exchange headwinds

Starting with this point makes sense, since this appears to be the core reason for the 2015 downward revision that led to the company suggesting that 2015 estimates should be guided down by approximately 8% at both the operating profit and adjusted earnings levels. As a result of the company operating in emerging markets, Regenersis is prone to exchange rate fluctuations when converting local currency revenues and profits back into sterling revenues and profits, so that leads to profit levels being hampered if sterling is strong during any particular period, to a significant degree. That is what has happened to Regenersis as a number of currencies such as the Mexican Peso and even the US dollar has weakened versus the pound, and the downward revision is likely as a result of potential further sterling strength and the extreme difficulty in predicting exchange rate movements.

Despite this exchange rate risk, this is a point that investors can keep track of, simply by monitoring the exchange rates, so the extent of the reaction is puzzling and prompts a deeper look. Before that, these are the exchange rates noted at the year-end and the current rate, to refer back to in the future. Ultimately, if the exchange rates become more favourable (i.e. the rates drop), then Regenersis will benefit, and vice versa.

Whilst some investors may be deterred by the prospect of the Bank of England raising interest rates as that tends to help the GBP strengthen, the major movers in FY2014 were in fact the South African Rand (ZAR) and the Argentine Peso (ARS). That is related to intra-country problems so there are wider issues at play that need to be noted. During FY2014, all major exchange rate movements bar the Indian Rupee (INR) were unfavourable. Despite trading in the New Year being in line at the local currency level, the translation to sterling meant that results would now potentially be below expectations.

These were the headline figures:
- Revenues up 10% to £197.5m. Up 18% in constant currency
- Headline operating profits up 16% to £11m. Up 22% in constant currency
- Actual operating profits considerably lower as a result of exceptional acquisition and restructuring costs totalling £9.4m
- Net cash at year-end of £20.6m
- Adjusted EPS down 4% to 16.2p as a result of the equity raise during the year. Trailing PER of 14.3

Divisionally, it's the strong performance at Advanced Solutions that is most attractive since headline operating profit more than doubled to £7.5m during the year with margins expanding by around 25%, which is a level considered as sustainable. Whilst corporate costs also more than doubled, and CAPEX grew substantially, that was part of setting up a footing for further growth and also driving efficiencies - nonetheless, CAPEX is set to continue on an upward trend as innovation is core. Sales in Western Europe did drop materially as a result of very low margin business being exited with Depot Solutions.

Chairman Matthew Peacock commented, "Overall the year just ended was transformative in terms of the shape of the Group and its prospects for the future. The Group has become an exciting Advanced Solutions-led business growing via organic progress and M&A. The formula for this development over the last few years has been our focus on the three "game changers" - people, global integration, and M&A - and we will continue to follow this approach next year and beyond. I am looking forward to further expanding a number of strong performing divisions (organically and via bolt-on M&A) which are demonstrating a proven track record of growth."

Although the trailing PER is 14.3, which is very reasonable for a company on Regenersis' growth profile as since 2010 revenues have more than doubled, this does not account for the total number of shares in issue, rather it uses the weighted average. That makes the trailing PER not particularly useful and makes it important to look at revised forecasts. Pre-results, the company was trading on a PER of around 20 hence the scale of the fall is somewhat understandable taking a historic viewpoint.

The balance sheet is in decent shape with £20.6m in cash as mentioned before. Deductions do need to be made from that to account for further acquisition costs post year-end of £3.6m, so it's prudent to use a cash level of £17m in any calculations. Below were the other points.

- Banking facilities of £39m available through HSBC provide firepower for further M&A to boost future EPS
- Adjusted Current assets/Current liabilities of 1.4, which is sound
- Non-current assets are largely intangibles. I usually ignore these, but given the sector, there is inherent value. Being cautious and writing down the value of the intangibles (Excl. goodwill) by 50%, this value is circa £14.3m
- Current assets = 1.17x total liabilities
- Net tangible assets + discounted intangibles of approximately £30m. That does not stack up highly against the market capitalisation, but combined with the debt pile is reasonable

With respect to forecasts, Regenersis is covered by Arden, Panmure, Cenkos and Equity Development. The average forward EPS forecast is for 18.1p EPS and a 4.85p dividend, albeit those figures are dragged down by Arden - stripping out Arden and the consensus EPS rises to 18.6p with a dividend of 5p. Regardless, even including Arden the PER amounts to 12.8 and is over one point lower if stripping out the cash. Excluding Arden the PER stands at 12.5. The dividend remains uninspiring at 2.16%, but that is not the attraction.

For 2016, consensus estimates are 21.5p of EPS with a 5.5p dividend which translates through to a PER of 10.8 and a yield of 2.37%. For a company that performed above expectations last year (in constant currency), with a track record of growth, and with 2015/2016 forward PEGs of considerably below 1, that is good value. Furthermore, with a sizeable cash balance of circa £17m, decent underlying cash generation, and a large debt facility with HSBC, there is genuine scope for earnings enhancing acquisitions to be made and lead to upward revisions in forecasts. The forward sector average PER is in excess of 18, so Regenersis has reversed to well below that level, and to an extent, understandably.

Of course, future forecasts will likely also be reliant on some exchange rate movements, but investors can keep track of that, and there should be a level of natural currency smoothing as the number of countries operated in rises.

A Market Overreaction to FOREX issues?

Although Regenersis was highly priced before the profit warning for 2015, there was some decent reasoning for that as the company was in a high growth phase with excellent future prospects, albeit there was a considerable amount of low margin Depot Solutions business. Nevertheless, the transition towards higher margin business and the acquisition of Blancco in particular have enhanced the outlook for the company, and a circa 30% decline on the back of an 8% reduction in headline operating profits looks extreme. Whilst the market may be taking the viewpoint that the currency issues are out of their control and could prompt a further warning, Regenersis effectively has circa £56m at its disposal in a 30/70 mixture of cash and debt that it can and likely will deploy in further M&A, which has the potential to boost earnings without a change in the number of shares in issue, further reducing the prospective PERs. Advanced Solutions is becoming an increasingly larger proportion of the operating profits, and has attractive growth potential.

The potential share price growth rate that companies with larger market capitalisations such as Regenersis will likely be much lower than with some of the small caps covered on the site, but the current valuation for Regenersis appears attractive, and the drop appears overcooked. An initial 275p price target is reasonable, and would only amount to a 2015 PER of around 14.8 or 2016 PER of 12.8, yet implies nearly 20% share price upside. A short-term share price bounce also appears to be likely (as long as market conditions allow). I have therefore put a Buy tag on Regenersis at 232p and may increase into a second slot if the very short-term share price action is weak.

UPDATE (09/10/14) - I have moved Regenersis from Buy to No Rating at a share price of 233.90p. Although the financials are still very attractive, wider markets will dictate share price movement in the interim and as noted in the Q3 portfolio review, it is best to remain flexible

UPDATE (21/10/14) - Position re-opened at 196.75p. Valuation-based investment case remains in place

UPDATE (19/11/14) - Although I remain interested in the company, the sharp fall today meant that a trailing stop loss was fallen through at 218.75p. The fall does not appear to have been prompted by publicly available news, but it is concerning that a 0.5% short position has opened on Regenersis; this is a deterrent for now, so I will seek clarity on the reasoning for that before re-opening a position. EDIT: + 2.68p in dividends accrued over the period held, leading to an effective close bid price of 221.43p.

5 comments:

  1. Excellent appraisal of rgs. I saw the drop last week too and I thought it was harsh but I did not progress further because the ftse100 was tanking and everyone seems to be weak in this market. Its a stockpickers market for sure and I wouldn't want to be holding a basket of large caps or tech stocks like wandisco!

    CraigJ

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  2. Thanks el1te. Fab info and proper research unlike some 'tippers' who wave their finger in the air

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  3. The balance sheet is the only issue for me as if they spend all the debt on acquisitions then they will have a hard time paying it off. Then again, they have over 15 million gbp in cash so it will be a bulky acquisition to need to use that debt. So maybe it is not a problem at all

    Fantastic piece
    Ric

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  4. Thanks for your in-depth analysis of RGS. It has certainly shed light on what seems has been a market over reaction, and also on the potential the company has for growth. Despite the Forex losses, the company has still hit double digit growth. Your analysis also helps erode my concerns with this stock, as am currently heavily invested and suffering large losses. Will hold as long as possible. Light at the end of the tunnel....

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  5. Be mindful of continual "restructuring" costs in this business. There's a bit of a hire-and-fire culture at Executive level, and a lot of inefficiencies are covered via exceptional items.

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