A Portfolio of AIM Shares (7): Matchtech Group PLC; Brooks Macdonald Group PLC

Note: For the preliminary filters used to select AIM stocks, see http://thejoyfulinvestor.blogspot.co.uk/2013_09_08_archive.html

As I wrote in an earlier article (http://thejoyfulinvestor.blogspot.co.uk/2013_08_04_archive.html), long-term investors will prefer the steadier income streams from non-cyclical industries to the risks associated with cyclical industries. But an investor in AIM shares would be wise to select a portfolio of at least 10 stocks. And there are not many good non-cyclical stocks listed on AIM.

Consequently, I have included companies engaged in cyclical industries, recruitment and investment management, as possible components of an AIM portfolio.

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Matchtech Group PLC

Engineers at the Menai Bridge, Anglesey (1868) by John Lucas, courtesy Wikipedia

Matchtech Group was founded in 1984 by George Materna as a recruitment agency for technical staff. Matchtech now claims to be the largest UK recruitment agency for engineers and the 14th largest UK recruitment agency overall. While the company has been profitable since floatation and revenues have grown by 14% per annum, earnings fell in the wake of the financial crisis and are only now returning to pre-crisis levels.

Southampton-based Matchtech listed on AIM in 2006 with a placing of shares at a price of 310p. The company's shares are currently eligible for 100% business relief for inheritance tax and the 'free float' is 50%. Materna, the founder and Chairman, owns one-third of the company. Matchtech is valued by the market at 133 million pounds and it trades on a bid to offer spread of 1.6%.

As one would expect with a company engaged in a cyclical business, Matchtech's shares (in blue) have been much more volatile than the FTSE All Share (in green):

Courtesy Yahoo, click to enlarge

Matchtech has a simple business model. It has 280 consultants (the sales force) that obtain orders for permanent or temporary technical staff from concerns throughout the UK. It recruits candidates from its websites and matches their CVs with their clients' requirements. Matchtech collects a one-off fee for permanent placements and an ongoing fee for contract placements. Over two-thirds of its income is derived from contract (i.e. temporary) placements.

In all, Matchtech had 1,600 fee-paying clients in 2013 and the largest accounted for 7% of its net fee income. Over 70% of the company's revenues come from providing technical staff to the engineering sector, leaving 29% from the rest - IT ('Connectus'), business professionals ('Barclay Meade') and 'welfare-to-work' ('Alderwoods'). Each of its four businesses is run independently, with their own management, sales force and websites. 

In September 2013, Matchtech acquired Provenis for 4 million pounds, issuing shares to that value to fund the purchase. Provenis specialises in the Oracle-based ERP (Enterprise Resource Planning) software for large businesses. Matchtech sees it as a complimentary service to Connectus's IT software. Provenis generated operating profits of 1 million pounds on sales of 14 million pounds in 2011.  

Demand for Matchtech's services is related to the number of job vacancies in the UK:

Click on graph to enlarge

The revenue, earnings and cash cycle for Matchtech is reflected in the following data:

Matchtech	2006	2007	2008	2009	2010	2011	2012	2013
Earnings per share pence	26	29	38	34	26	20	23	32
Revenue growth %	+27%	+29%	+27%	+4%	-2%	+14%	+23%	+10%
Net Fee Income growth %	+29%	+36%	+23%	-9%	-13%	+14%	+21%	+6%
Net Debt pounds Mn	10	9	3	1	4	16	14	10

Earnings have followed the job vacancy cycle, with an increase through 2006 to 2008, followed by a reductions post-crisis that continued through FY 2011 (the fiscal year ends in July). Since then earnings have recovered and, provided job vacancies continue to grow, are likely to continue on an upward trend. In 2013 the company made an after tax profit of 7.5 million pounds on revenues of 409 million and net fee income of 38 million.

The company's billings are over ten times its net fee income. This has significant funding implications. As the company pays contracted staff before it receives payment for their services from its clients, Matchtech must finance the difference, and this accounts for the swings on net debt (capital expenditure and other investments were negligible in this period).

Taking the last five-year period, net operating cash flow of 8 million pounds fell far short of the dividends it paid of 20 million. The sudden increase in debt in 2011 was blamed by the company on a surge of business towards the end of the fiscal year. But earnings fell to a six-year low as well. Debtor days have since improved from 53 to 49 days and profits have improved as well, though margins are still well below pre-crisis levels.

Matchtech has plenty of head room in borrowings, which are currently 32% of equity. It factors its receivables and it has a 50-million pound facility on which it is paying a reasonable 2% over Barclays Base Rate. The company's return on equity is a healthy 23%. The company has no defined benefit pension scheme to provide for. And it is the largest recruitment agency in the engineering sector.  

At an offer price of 556p, Matchtech shares are trading on a PE ratio of 17 and yield 3.2%. Unfortunately, valuation models are difficult to apply to cyclical companies.

However, the prospective investor will consider:

1. Matchtech is near the beginning of an upturn in its business and this is reflected in the recent surge in its share price. It has increased by 145% in the past 12 months.

2. The long-term market for technical staff is growing.

3. The recruitment market is easy to break into and, consequently, competition is fierce.

4. The only significant director transaction was a sale worth 100K at 502p on 15 October.

5 The acquisition of Provenis should boost the company's revenues and profits.

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Brooks Macdonald Group PLC

£££

Brooks Macdonald Group (BMG) was founded in 1991 to provide private client investment services. BMG's main source of income is derived from commissions and fees for providing discretionary management services for private clients, trusts, charities and pensions funds.

In March 2005, the London-based group placed 3 million shares at 140p a share on AIM. Since then, the value of the shares has risen tenfold as the company grew its business rapidly via acquisitions, organic growth and, after the financial crisis, rising stock markets.

BMG shares are currently eligible for 100% business relief for inheritance tax and they trade on a bid to offer spread of 4%. The company is today valued by the market at 191 million pounds. BMG has a 'free float' of 72% of outstanding shares, with the remaining in the hands of the founder CEO, Chris Macdonald, and directors.

Although BMG is in a cyclical business, it has soared, with barely a pause, through the financial crisis and beyond. This is thanks to its rapid rate of growth based on a low initial level of activity. The following graph compares BMG's shares (in blue) with the FTSE 100 (in red) and Charles Stanley (in green), which is a mature company in the same line of business as BMG:

Graph courtesy of Yahoo, click to enlarge.

Although the scale of the graph minimises the changes in Charles Stanley shares related to the FTSE 100, the investment management company underperforms in bear markets and outperforms in bull markets, as one would expect.

The spectacular increase in BMG's share price is the result of its spectacular growth in earnings, dividends and funds under management (from the 2013 Annual Report):

Click to enlarge

Past growth has come from:

1. Geographical spread via new offices and acquisitions. Since 2008, BMG has added offices in Tunbridge Wells, Edinburgh, Hale, Taunton, York, Jersey, Guernsey and Leamington Spa to its offices in London, Hampshire and Manchester.

2. Acquisitions: The largest was the 2012 purchase of Spearpoint in the Channel Islands for 32 million pounds financed with cash and a share placing. At a stroke, BMG increased its funds under management from 5 billion to over 6 billion pounds, while adding nearly 4 million pounds to pre-tax profits and access to the international market for investment services. Another, smaller acquisition in 2010 gave BMG access to property and land management. Bolt-on acquisitions have added business and staff, which now total 400.

3. Growing reputation: In a market where reputation is everything, BMG has gained the trust of 540 firms that introduce investors to the company. Last year BMG received two awards of the year for its private investor and wealth management services.

4. BMG has made a speciality of Self Invested Pension Plans (SIPPs), which has been a growth segment of its market.

5. Its OEIC funds, which are small, have performed better than their indices and most competitors.

6. A buoyant stock market, which has doubled since its 2008/9 lows, has helped to lift the value of funds under management.

At BMG's present offer price of 1450p, the shares trade on a PE ratio of 20 (adjusted for acquisition costs) and yield 1.6%. But, if Spearpoint's contribution is included on an annualised basis, adjusted earnings per share rise to 84p and the PE ratio falls to 17.

By comparison, Charles Stanley shares trade on a PE ratio of 30. And that company's profits are back where they were in 2009, and its return on equity is just 9% compared to BMG's 19%. No doubt, one explanation for the very different valuations is that Charles Stanley shares yield twice as much as BMGs.

BMG's margins are expected to fall in 2014 as a combination of IT spending, increasing regulatory requirements and the impact of the Retail Distribution Review (RDR) on commissions all work to reduce profitability. The CEO was upbeat in BMG's October release:

"We remain confident in our ability to grow funds under management and, remain optimistic about the opportunities for the Group". 

BMG's future depends more on the stock market than in the past. A continuation of the bull market will lift its income and its shares, while it is unlikely to escape the next bear market as it did the last. Investors will draw their own conclusions on the likely direction of the stock market from the following chart of the FTSE All Share Index for the period 1973 to 2013:

Courtesy Yahoo, click to enlarge

A prospective investor in BMG will consider:

1. The company is lowly rated compared to its competitors, while its earnings growth and return on equity is better.

2.  RDR is a threat to the profitability of all investment managers. BMG claims that the reduction in commissions of 5 million pounds will be offset by an equal cost now included in administration. The CEO added a warning (2013 Annual Report):

"On 1 January 2013 RDR came into force. This was a substantial change to the whole of the financial services industry with a focus on transparency of charging, greater consumer clarity and the raising of professional standards and corporate stability. These are changes that we fully support but the costs associated with increased regulation have become and remain substantial. Whilst we feel that these costs have peaked in terms of percentage of turnover, they have not been passed on to clients. This is something that we and, we believe, the whole of the industry will have to consider over the coming years."

3.  BMG has no defined contribution pension scheme to provide for. And its balance sheet is bolstered by 18 million pounds net cash, almost 10% of its market valuation. In the past five years, operating cash flow net of capital expenditure has covered the dividend 3.5 times. The company has preferred to spend its cash on acquisitions rather than returning cash to shareholders. Given the results, this is an excellent use of its funds.

4. The CEO sees an opportunity in pensions' auto enrolment:

"The growth of SIPPs continues and this is now further supported by legislative change around auto enrolment. We will be looking to launch a specific auto enrolment service later this year utilising our own funds and this will apply both on and offshore. This is an opportunity we are increasingly excited about."

5. Ultimately, BMG's future depends on the stock market. A prolonged bull run will make today's valuation seem cheap. A sudden bear market will likely cause a more than proportional drop in the share price. Valuation models help little with such uncertainty.