Stockwatch: Three reasons to buy this share

How much further upside for recruiters? Booming results from £44 million AIM-listed Penna Consulting are relevant also to consider the wider UK economy and how stocks are being valued in a "momentum market".

Penna's chart shows the stock more than doubling during the second half of 2013 and into 2014 when investors moved into quality cyclicals, correctly anticipating a strong upturn. The table shows profits/earnings/cash flow actually falling for the financial year to end-March 2014, but now they are roaring back.

Latest results show the business throwing off cash

Prelims to end-March 2015 reveal pre-tax profits up 70% to £4.6 million on revenue up 22% to £84.4 million, net cash up 148% to £2.3 million, earnings per share up 131% to 15.1p and the total dividend doubled to 6p. Within these headline figures the recruitment side is the main driver - pre-tax profits up from £1.1 million to £3.0 million - the "talent" side has continued to run at a £0.4 million loss and career services' profit rose only slightly to £3.2 million (central costs were £1.1 million).

Penna contends that combining such services gives it a unique selling point versus straightforward recruiters. The two main divisions each achieve net revenues of about £20 million and profits around £3 million, although margin uplift on the recruitment side has recently been key to group progress.

So a central question is how sustainable this margin improvement can prove, an issue applying to many other cyclical firms. Their stocks have re-rated mainly on a sense of two years' forward earnings and price/earnings (P/E) multiples appropriate to that time frame - see how Penna was marked up 20p to about 170p on its latest results. But "price is what you pay, value is what you get": the proof lies in longer-term cash flows, so if margins contract with any cyclical downturn then such stocks will de-rate. This is especially true of more sensitive businesses like recruiters, where visibility is also limited.

Penna currently says its business has "considerable momentum" and expects "a dramatic rise in volumes and in expenditure per human resources project" as the UK economy continues to grow strongly. Fair enough, and which is likely to see further upside for momentum traders, so long as market sentiment embraces risk and the company delivers. Penna is, indeed, a quality pick among recruiters because it is focused on the UK whose recruitment upturn appears the most vigorous globally; and for a seventh year running Penna has appeared in The Sunday Times' list of 100 best UK companies to work for.

Mind how 2010/11 showed how it can perform less well

Admittedly, the results for the year to end-March 2011 reflected the back-end of a recession, but downturns happen. That year was "exceptionally difficult" due to the government's recruitment freeze (so what could happen now a majority Conservative government is acting swiftly for cuts?), the period had seen "continuing low level of demand for recruitment services" and management was cautious how central and local governments were handling their downsizing programmes.

Recruitment solutions had seen a £1.3 million profit become a £1.5 million loss on revenues down from £73.2 million to £54.1 million. The re-organisation needed to cope was actually how Penna established two major divisions, to better meet the specific needs of clients. Headcount was reduced by 27% and office space by 18%, showing how margins will vary over cycles as management reacts. Such a business is therefore operationally geared, i.e. changes in revenue tend to have a greater impact on profits. Consequently the price/earnings rating for shares in such a business has to be lower than for more resilient growth stocks, the classic sign of a market top being investors losing sight of this and rating cyclicals too highly.

That doesn't apply yet: the table shows Penna's current earnings scenario pretty fairly valued on a P/E of about 10 times, and the business did better in 2009/10, so if management's optimism is correct then it's possible the forecasts could be beaten. But might George Osborne's cuts spoil the party? Penna doesn't quantify its (trend in) public sector exposure on the recruitment side; in career services it speaks of "making significant inroads into retail/FMCG especially supermarkets" - the latter based on outplacement and transition support as supermarkets have reacted to disruption caused by Aldi/Lidl. Financial services are the largest market for Penna's outplacement offering.

On an historic basis the P/E has varied greatly e.g. Company REFS citing an annual average of 9.1 during 2013 when the stock fell to 63p, then 25.6 in 2014 and 20.1 this year. This puts a lot of emphasis on forward earnings, but unless Penna turns cautious in its reporting and/or the market mood changes, the medium-term scenario favours further upside. This is quite an ideal stock for the current environment.

Dividend prospects substantially upgraded

The board is clearly more confident than my citing reasons for caution, according to its dividend policy. Indeed, the dividend is the key upgrade to forecasts by Charles Stanley Securities, Penna's broker - previously 4.3p a share for the current financial year, now 6.3p and rising to 7.25p in the 2016/17 year, based on earnings cover of about 2.5 times. Company broker forecasts normally receive guidance or are at least signed off by a finance director, so this implies Penna is genuinely optimistic on two-year view. A prospective yield of 4% creates quite a prop, assuming earnings forecasts also.

You can agonise over Penna becoming compromised by another downturn, especially in UK public sector recruitment, and if that worries you then avoid. But if the UK economy and recruitment trend remains broadly intact then traders are going to read: "P/E falling into single figures, meaningful yield, bullish management" - and buy.

For more information see penna.com.