Edmond Jackson's Stockwatch: Dividend underpins prospects at De La Rue

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How much notice should you take of the dividend yield when judging turnarounds? The market may price such a stock modestly as compensation for risks, but if they improve then the stock will re-rate otherwise the yield would be a giveaway.

While this is a simple view of market dynamics it is often a reliable one, and the interplay shows why judging shares is not a binary choice of "income versus capital growth".

Indeed an ideal investment is to lock in a useful yield and enjoy long-term capital upside. I re-iterate to mind the risks with turnarounds though.

The Mid 250-listed currency printer, ID and security group De la Rue is one such quandary.

At 850p the shares trade towards the lower end of a three-year range during which De La Rue has been restructuring.

A late 2010 plunge on the chart related to a crisis with print quality control and the chief executive departing.

The group has made good progress taking out costs but lately overcapacity in banknote pricing has meant tougher pricing in the activity that contributes about two-thirds of De La Rue's revenue and operating profit.

A trading update last October cited this problem intensifying, after which the stock festered to a three-year low of 745p last February. At this time the chief executive departed for another company which was quite a sense of déjà vu, it being hard to avoid a sense he might see better prospects elsewhere.

The chairman emphasised that De La Rue was in a stronger position compared to three years ago. He has stepped up to the role of executive chairman until a new boss is confirmed - which is expected fairly soon. How this person gets to grips and may introduce fresh initiative will be a key factor.

"Efficiencies ahead"

Otherwise the results for the year to 29 March 2014 affirm a successful turnaround with underlying pre-tax profit up 51% to £77.3 million on revenue up 6% to £513.3 million.

Management says that "with a culture of continuous improvement embedded in our business there will be further efficiencies ahead."

A 43% jump in underlying operating profit to £90.5 million reflected benefits from an improvement plan which realised £20 million savings during the period bringing the annual total to £40 million - substantial in context of revenue of maybe £540 million this current financial year.

There has also been a good profits recovery in Identity Systems with underlying operating profit up 35% to £22 million despite revenue down 8% to £77.6 million - largely influenced by one-off sales to HM Passport Office in the prior year.

Further operating efficiencies boosted performance across Identity Systems and its international side saw a large number of contracts completed.

Mind that a 58% recovery in underlying earnings per share (EPS) to 60.7p (levels seen in 2009-10) was necessary otherwise the 42.3p a share dividend would be uncovered.

Constrained dividend

The EPS result is also in line with broker estimates varying from 59p to 67p and Company REFS' modelling puts it at 64.4p, so there is scope for difference.

The prospective price/earnings multiple is 13-14 times which appears fair, and a 5% yield about 1.5 times covered should limit downside.

The historic cash flow profile is volatile however, and while operating cash flow has risen 35.7% to £99.1 million, the cash conversion rate from operating profit has slipped and net debt has risen to £89.9 million to meet expenditure needs. So the dividend could be seen as rather constrained with more proof of overall vigour needed. Given patience though, it can underpin upside in the stock.

While the 12-month order book at end-March was up only a modest 5% year on year, currency orders rose 8% reflecting contract wins albeit at lower contribution levels.

Significant scope

Future updates will be worth watching as it is possible the price pressures ease; no situation in business is permanent; in which case the stock would respond.

Its underlying progress has initiatives such as polymer substrates in banknotes, threads and holograms for security; latest software solutions to help governments collect tax revenue; and the group is the world's largest producer of passports where there is a status change underway to ePassports. Altogether these represent scope to rebalance the group if overcapacity in banknote pricing persists.

Admittedly this is a longer-term rationale and it would help if the directors backed their confident talk with better-size shareholdings - especially now the company is out of its closed period on dealings.

All the recent months' news has shown is a small exercising of options at 441p to buy 1,329 shares. The stock's volatility suggests the market does not quite know what to make of it all: initially the price jumped from 810p near 890p after the results then retreated to 843p and is currently about 850p.

Investec, an independent broker, has a target of 915p a share representing possibly a 12-13% annual return including the dividend. If a new chief executive can enhance progress and overcapacity ultimately eases then De La Rue stock can shape up as a useful longer-term play, so watch this space.

For more information see delarue.com.