Stockwatch: Follow hedgie into this share

What does Toscafund see in general merchandiser Findel? The buccaneering hedge fund has kept raising its stake in the FTSE SmallCap shares, lately to 29.2% since the prelim results.

That's close to the 29.9% ceiling before a takeover bid becomes mandatory. At about 212p a share the business is capitalised at £183 million, although Findel is still relatively illiquid - Toscafund is effectively locked in, so it must have a strong conviction. Founded by a former head of equities research at Credit Lyonnais, Toscafund has a volatile history. Early on it profited immensely from a big stake in Hornby, but timed housebuilders badly and was hit hard by the 2008 crisis. Lately it bought into Quindell around its low, but quickly seized some profits and currently holds 4.8%. In pursuit of higher returns, its actions can, therefore, be mercurial.

Fundamentals and chart combine attractively

The 'buy' case on Findel is essentially predicated on continuing to improve underlying performance, a modest price/earnings multiple (according to forecasts) and the long-term prospect of restoring dividends. The five-year chart is a vivid example of cyclical/turnaround stocks emerging from recession, as quantitative easing boosted risk appetite - a strong rally from a 55p low in 2012 when Findel was very high-risk, over-reaching to 320p by early 2014, then a period of consolidation.

Two years ago I drew attention at 178p, suggesting the stock could double if management rebuilt earnings, cut debt and restored the dividend. Turnaround actions were already reducing risks and the forward price/earnings (P/E) multiple was a modest eight times - a situation that applies once again, with the UK consumer recovery looking more robust as wage growth finally kicks in. It would take another economic downturn to set the group back.

Results show profits rebounding, high gearing and modest cash flow

The latest financial year to 27 March saw operating profit from continuing operations rise 20% to £36.6 million, up 28% to £26.5 million at the pre-tax level, which is substantive for a small cap. It mainly reflects how Express Gifts, the group's principal earner, is doing well. Group revenue growth was more modest, up 2.8% to £481.4 million, and overall net debt was flat at £206.6 million - relative to net assets of £82.7 million, of which £50.2 million comprised intangibles. A fall in net operating cash flow from £14.6 million to £7.9 million hasn’t helped debt reduction, this rather being a price of success at Express Gifts as it grew sales by 4.7% to £302 million and operating profit by 9.0% to £33.5 million.

This business operates via a revolving account similar to a credit card, with a high minimum monthly payment then flexibility thereafter. Its financial profile, therefore, doesn’t engender strong cash flow, which Findel needs to reduce debt further and ultimately to restore dividends. It is likely a key reason the P/E multiple remains modest, hence the group cash flow profile is important to watch.

Express Gifts faces the challenge of a strong US dollar raising input prices, although this is well recognised and management has still been able to grow product sales by 7.1% in the first 11 weeks of the current financial year - in context of 3.3% total sales growth. Sales are helped by offering the ability to personalise goods free-of-charge - a competitive advantage versus other UK home shopping retailers - with over 40% of customers taking advantage of this. This business is seen to offer the best growth prospects "as we continue to grow the depth and breadth of our ranges and improve the customer experience."

Challenges continue for education supplies and sports-kit

Findel educational supplies saw annual sales ease 6.5% with flat profit of £4.2 million amid tighter cost control, with further time required to translate managerial efforts into better results. Government spending plans are said to be positive due to a 2.1% expected increase in primary school pupils and demographics suggesting more schoolchildren, especially in London and the South East.

Kitbag, a sports-kit supplier, has boosted annual sales by 11.7% and cut losses from £4.1 million to £1.2 million by renegotiating unprofitable contracts. A strategic review concluded it has a range of profitable opportunities but will remain loss-making for another year. Sports Direct and JD Sports have shown it amply possible to prosper from sports kit supply, especially around major fixtures, although this is a competitive industry.

These two businesses put Findel in the category of "good progress but much remains to be done" - potentially positive if the economic context remains firm. Both will likely remain a drag in the short to medium term, but should eventually improve performance and hence help improve the stock’s rating. One might conjure with 12 times EPS of 25p or 10 times 30p, as realistic in the longer term, hence a 300p target.

Exceptional items weigh on IFSR3 results

The reason for discrepancies in profit/EPS reporting (see table) is mainly goodwill impairment charges, clarified in note 2 to the accounts - over the last two years a total £6.1 million for Express Gifts, £11.8 million for Kitbag and a whopping £24.7 million for Findel Education (mainly in the last year). A further £3.7 million charges related to the Kleeneze network marketing business, now sold, and £5.7 million due to flaws in customer legacy processes at Express Gifts. These exceptionals should henceforth reduce significantly, which should also improve the stock's rating.

Dividend requires patience

There is also a resolution at the 30 July AGM to increase the level of distributable reserves, paving the way to resume dividends, although it appears preferable to prioritise debt reduction - and first of all achieve a better cash flow profile. The chief risk is Findel not sufficiently improving its balance sheet before another recession and interest rates rise - net finance costs took 28% of 2014/15 operating profit. So any dividend may be modest when it arrives, until debt can be substantially cut.

Findel is, therefore, a patient turnaround, less exciting for aggressive investors, but the long-term upside does look attractive. Meanwhile, Toscafund is exploiting the cool sentiment to add as much as it can.

For more information see findel.co.uk.