Stockwatch: A growth-at-fair-price play

AIM-listed shares in revolutionary metering services company Smart Metering Systems merit renewed study as management reports strong progress. I initially drew attention at 111p in April 2012 when the forward price/earnings P/E) multiple was near 40 times - looking expensive albeit a good story with profits already kicking in. The price reached 426p last year then dropped to 300p and is currently 333p.

To some extent the chart since flotation in 2011 reflects demand for enterprising stocks as QE buoyed risk-taking, then the market has tried to probe fair value with a more considered view.

Fast-growing firms' P/E's can quickly drop

Company REFS cites an annual average historic P/E multiple over 48 times in 2013 and 2014, dropping near 20 times if last October's projections by Charles Stanley Securities (Cenkos is company broker) are fair. Such a profile also begs a current tactical question: should you put more emphasis on smaller growth stocks relative to big caps and cyclicals?

Plenty of cyclicals are exposed to economic downturn if deflation spreads; likewise big firms will find it harder to achieve revenue growth. Small caps e.g. with a revolutionary technology will be more likely to report exciting progress (assuming a lead position and capable management) and this scarcity value among equities should also support high ratings. In a similar way as "the Nifty Fifty" popular big caps on the New York Stock Exchange drove a bull market in the early 1970s, what few growth stocks exist amid "secular stagnation" could similarly attract favour.

Suite of metering services is now assembled

Gas meters currently provide the principal rental income: over 2014 this segment's revenue rose 41% to £21.9 million. Otherwise, electricity is the much smaller earner with £3.3 million total revenue. Full accreditation has been received for the UK water market, so the group now offers connection and smart metering solutions across the three main areas for utilities, implying substantial scope, although it is early to judge how competition might evolve.

A 30 January trading update said: "SMS has continued to experience a strong performance across all segments of the business and, in particular, has seen growth in the installation of industrial and commercial meters... the total number of gas meters under management has risen about 29% to 607,000 at end-2014." In gas, the group's commercial customers have an 80% UK market share.

Management expects 2014 results in line with expectations i.e. a near doubling of normalised pre-tax profit towards £14 million, relative to circa £300 million market cap. That makes the stock no bargain purchase but if longer-term commercial progress evolves anywhere near the current trend-line then it hints at value.

Acquisitive and organic development

Admittedly, the present financials benefit from last April's £14 million acquisition of Utility Partnership Limited which made £2 million operating profit on £11.1 million turnover in its year to end-July 2013. This appeared a logical move to achieve capability in electricity meters and related technology, and also to improve the company's international scope. Then in July came a contract with British Gas Business to install and maintain about half its gas meter points - a roll-out is expected to complete by 2017. Hence the last interim results included UPL's results from mid-April to end-June, enabling total revenue to rise 44% to £18.9m and pre-tax profit 40% near £4.7m. Significantly, also within these results, recurring meter rental rose 43% to £8.6m or 46% of the total which supports earnings consistency hence the shares' rating.

Net operational cash flow nearly doubled to £12.2 million helping the interim dividend to rise 34% to 0.94p. While the prospective yield is only a tad under 1%, it is rare for a smaller technology share to have this kind of robust financial profile. Earnings cover for the dividend is projected over 5 times, but you can see from the table there is a demanding capital investment programme which arguably is the best way to maximise value. The interims cited a 48% increase in capital investment to £15.5 million.

Mind the current liabilities and debt

While the balance sheet is not high-risk, be aware that at end-June there were £18.8 million current assets (including £4.7 millon cash) versus £23.7 million current liabilities which broke down mainly as £16.6 million trade payables and £7 million debt. There was also £46.3 million longer-term debt, up from £23.2 million (helping investment and the UPL acquisition) although the net interest charge took a modest 12.2% of operating profit. It's possible to justify the debt at this stage of group development, while the trade payables/receivables could do with better explanation. From past accounts, however, the company has always had relatively high trade payables.

Moderate extent of shares issued will help EPS growth

SMS has reached this point without having to make serial share issues in support of "losses" while the company invests - 85.5 million shares issued compares for example with 660 million at AIM-listed IQE, a maker of semiconductor wafers. Big amounts of shares issued can contribute to active trading, which enhances volatility and can reduce the rating. IQE's annual average P/E multiple has fallen progressively from 28 in 2011 to 8 this year despite decent profitability. It's a rough yet useful contrast in favour of small caps with fewer shares issued, making earnings growth arithmetically easier and shareholders possibly less edgy.

Modest PEG rating for a growth story shaping up well

Altogether SMS looks well-positioned as a "growth-at-fair-price" play, its underlying progress since 2012 boding well. On 19 February the electricity division agreed to provide meters and data management services for the UK subsidiary of Total S.A. and an existing customer of the group's gas division. Some 5,000 meters are expected to be installed for Total before April 2016 with scope for this to increase.

See from the table how the growth record qualifies SMS for the price/earnings-to-growth (or PEG) ratio which is a classic measure of growth stocks. Looking forward this is about 0.5 when a variable under 1.0 is normally deemed attractive, so it is likely SMS will feature on statistical searches for growth.

For more information see sms-plc.com.