Stockwatch: This share is cheap enough

Does this growth stock's pricing offer a good opportunity to buy in? AIM-listed dotDigital has retreated over 20% from an all-time high of 54p in the New Year after interims for the six months ended December 2015 cautioned of marginally slower revenue growth.

This is not related to weaker demand, but rather to "slower-than-expected investments in 2015/16 boosting operating profit in the current year but implying marginally slower revenue growth in 2016/17." It appears a fair explanation, since aspects of revenue can depend on making specific technology available for clients.

The stockmarket's sensitivity to any whiff of a warning - and dotDigital having traded on price/earnings (PE) multiples in a 20-30 range - meant some de-rating was inevitable. But when growing fast from a small base it's easy for percentages to change without much bearing on the long-term investment case.

'Software as a service' accelerating

dotDigital provides email marketing and other "Software as a service" (SAAS) related technology to digital marketing professionals: quite a tricky area to decipher, hence the progression of financial statements and their quality are indicative.

The table shows a five-year context of revenue rising from £9.0 million to £21.4 million, and recent interim results for second-half 2015 achieved 29% revenue growth to £12.9 million, with over 200 new clients signed and the average monthly recurring spend up 31% from £400 to £525. Pre-tax profit jumped 30% to £3.3 million on continuing operations with earnings per share up 35%.

While the UK is dotDigital's mainstay, international growth is primarily the US, with Asia-Pacific increasing. US revenue leapt 91% to $2.1 million (£1.5 million) with the strong dollar likely enhancing margins: e.g. in the group's year to end-June 2015 the UK contributed 85% of revenue albeit 66% of profit, while Rest of World was 15% of revenue, but 34% of profit.

Financial growth in the order of 30% affirms the classic case for smaller technology stocks: that a preferred commercial offering can transform value as it catches on. dotDigital is partnered with Magento, a well-regarded e-commerce software and platform, for its dotmailer marketing automation product - used by some 250 clients and with annualised revenue of just over £3 million.

An Asia-Pacific office opened in Australia last July. Where international expansion was once seen as a key risk factor for smaller companies, in online services it is more likely essential. The perennial risk with such a technology play is a better rival product emerging, however, the momentum here implies a competitive advantage. dotDigital is taking market share, its services said to offer rich functionality and ease of use.

Healthy financial parameters

The business model is strongly cash generative: the interim cash flow statement shows net cash from operations up 139% to over £3.3 million, helping balance sheet cash up 55.9% to £14.8 million.

Monthly subscription-type revenues offer high visibility; in the last financial year recurring revenues were 76%. Such a profile means the stock is going to trade on a high rating, also for scarcity value in a low-growth environment. Company REFS shows the annual average PE (on historic earnings) rising from the mid-teens in 2012/13, to about 25 times in 2014/15, averaging 29 times this year.

Despite interim investing activities 16.6% lower to £1.1 million (due to less expenditure on tangible fixed assets) there is no interim dividend. The board says it last increased its final dividend by 80% and policy is to review dividends at the year-end. Versus a prospective yield in the order of only 1%, the table shows earnings cover over four times going forward, however, the dividend track record is early so a conservative approach seems fair.

Return on capital over 35% argues for earnings retention to maximise long-term value, but only if the spare cash is applied (and well). Possibly, the board is creating flexibility for acquisitions without having to dilute shareholders or start resorting to debt.

The tax charge is low, due to research & development credits rather than HMRC taking a different view of profitability. In the latest accounts taxation was just 9.6%, relative to 13.9% like-for-like, the explanation given in note 8 to October's prelims, where a £747,000 Research and Development enhanced claim reduced total income tax to £262,000. Normalising for this benefit, the tax rate would have been 25.4% for the 2014/15 year.

So, overall this is a very clean set of financial statements that positions the business well for growth and higher payouts eventually.

Board is commendable, but with risk also

The board is ideally-structured for a smaller technology company: the co-founders remain in "presidential" roles, while a proven CEO, Simone Barratt, has evolved from a non-executive director role in late 2012 to chief executive from October 2014.

This helps retain creative flair and access to founders while ensuring managerial discipline; the CEO has 15 years' experience in e-commerce and online marketing, turning start-ups into multi-million-dollar enterprises, and has international expansion experience in Europe and Asia-Pacific.

There are two other non-executive directors and a non-executive chairman. Keeping further executives off the board beyond the chief financial officer helps its over-seeing role, although he is currently in an interim CEO role also - for six months after the CEO had surgery in the New Year and is working remotely.

Other managerial roles have been re-jigged also, but only until the CEO is established back in the driving seat, although such a change can be a risk for an international technology business.

Fairly priced, but a quality tuck-away

dotDigital's interims affirm a "quality business at a fair price", an investment approach that usually works well. It shows not all AIM stocks are highly speculative. Unless the market has another crisis it is unlikely to get priced much cheaper, indeed its technology looks capable of thriving in a recession.

There has been a concerted directors' sale at 42.3p, albeit just to meet institutional demand - and they continue to own over 20%. It's hardly surprising professional investors are buying.

For more information see their website.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.