Stockwatch: Buy 5.3% yield with your eyes open

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Stockwatch: Buy 5.3% yield with your eyes open
How can it happen in the era of "corporate governance"? AIM-listed Redcentric (RCN) plunged nearly 80% to 40p after the IT contractor admitted it had smudged profit and debt levels on the balance sheet. This is the visceral fear for investors in listed companies, unresolved by the 1990s crusade for cleaner figures.

At least the audit committee has finally detected the mis-stating of accounts, but you wonder how PricewaterhouseCoopers could repeatedly miss it during annual audits - even the extent of debt, which is verifiable at the bank.

Looking over the accounts, Redcentric's numbers didn't throw up any red flags, but there was an amber one: since listing, the group has executed rapid growth over a relatively short period of time. It highlights how acquisitions can obfuscate the underlying trend.

Morals aside, does this leave Redcentric as a struggling share or a recovery stock?

Buy back in

The shares have bounced to around 75p after MXC Capital snapped up 5.2% from shell-shocked institutions at an average price of 59.68p. MXC now owns a 10.8% stake in the company, including its options.

This "merchant bank" was founded by Tony Weaver, Redcentric's chief executive until the end of 2014, since when he served as a non-executive director - which doesn't square with "independent".

A cynical view is to take heart from MXC buying freshly back in, though directors aren't buying yetNearly five months ago, MXC cut all its risk by selling 5.8 million shares to own just 49,108, retaining its share options.

On the same day, the present chief executive Fraser Fisher exercised 200,000 options at 70p and sold all those shares at 180p, holding a modest 90,557 shares. Then on 9 September, he exercised a further 285,000 options also at 70p, selling all the resulting shares at 182p.

The departed finance director hasn't owned any shares at all; page 26 of the latest annual report shows he had 1.1 million share options at 112p and 16,822 at 107p, being paid a total £310,000.

A cynical view is to take heart from MXC buying freshly back in, although mind no directors or senior managers are buying yet.

Another bit of odd timing was the ex-CEO departing his non-executive directorship on 1 November to concentrate on work as a partner at MXC Capital, which remains Redcentric's acquisitions adviser.

MXC's chairman has said the bank was "shocked...but we strongly believe in the fundamental quality of Redcentric's business and remain confident of its future prospects."

Forensic review

The stock is apparently trading on a forward price/earnings (PE) multiple of 6-7 times, yielding up to 7%, due to another visceral fear: "Rarely is there just one skeleton in the cupboard".

It also appears uncertain whether the finance director acted alone in misrepresentations over years; for unless theft is involved then it's a huge risk for no special gain. It doesn't make personal motivational sense.

The revelation comes in a context of other directors recently crystallising their equity value. If responsibility ends up spread more widely then it may affect customer and banking relations; but if the chief executive ends up forced out, at least there is a recently-appointed chief operating officer in place, previously international director of Computacenter, an IT infrastructure services provider.

The commercial/financial context may also be robust enough to withstand moderately mis-stated accounts. Redcentric listed in April 2013 as a demerger from Redstone plc - now Castleton Technology (CTP) - and manages "critical IT services" for over 2,000 mid-size companies.

Acquisitions largely explain intangibles representing 95% of the end-March balance sheetIt enjoys strong cash flow due to high levels of recurring monthly billing - for 82% recurring revenue with 62% operating cash conversion - although in the last financial year development costs kept net operating cash flow steady at just over £15 million.

The 7 November update cites end-September net debt of £30 million, which does not appear excessive despite the prospect of revised banking covenants. The last annual cash flow statement had shown a £23.3 million increase in debt linked to £19.4 million spent on buying subsidiaries, net of cash acquired; also £9.0 million spent on property/plant equipment.

Acquisitions largely explain intangibles representing 95% of the end-March balance sheet, typical of this kind of business.

At the June prelims the chairman declared: "A significant opportunity for Redcentric to establish itself as a market leader in IT managed services for the mid-market....it is a highly fragmented market, which provides opportunity to augment organic growth with acquisitive growth."

Cyclical risks yet scope to sustain dividend

We've just seen how Gattaca (GATC), the engineering and technology recruiter, has cited UK permanent hiring down 7% and contract by 2% during August to October, after its financial year revealed a 17% fall in IT-related, net fee income.

As yet, Redcentric says new business sales and recognition into revenue have been in line with management's expectations. The worst-case scenario would be a UK slowdown and further credibility issues for Redcentric, albeit speculative.

Redcentric has hoisted its flag as one of those acquisitive stocks where promoters emphasise EBITDAIf business remains firm, Redcentric should at least maintain a 4.0p dividend (as shown in the table where the per-share dividend plus capex is covered by cash flow) equating to a 5.3% yield with the shares at 75p.

Mind, the time to complete a forensic review, appoint a finance director and recalculate bank covenants may defer acquisitions the chairman entertains.

The last annual results show acquisitions responsible for doubling organic revenue growth from 8% to 16% whereas statutory annual profit slipped 5.0% to £7.4 million and diluted earnings per share by 35.5% to 3.43p.

Redcentric has hoisted its flag as one of those acquisitive stocks where promoters emphasise earnings before interest, tax, depreciation and amortisation (EBITDA), - pre-amortisation and integration costs - in support of a growth profile.

If fall-out from the accounting issues means Redcentric ends up in a proverbial "year of consolidation", normalised profit forecasts could suffer, with the market exacting at least a 5% yield, thereby capping the share price recovery.

Speculative buy

Usually an investor would avoid any share declaring accounting irregularities - finance director overboard doesn't convincingly resolve matters.

But with so much money chasing equities, Redcentric may continue to rise in the story management has put out: misstatements apply to past years and forward prospects are intact.

'Buy' with your eyes open therefore; the next update has effectively to exonerate the existing board.

For more information see the website.

Redcentric - financial summary Consensus estimates
year ended 31 Mar 2014 2015 2016 2017 2018
Turnover (£ million) 58.3 94.3 110    
IFRS3 pre-tax profit (£m) -2.6 7.8 7.4    
Normalised pre-tax profit (£m) 1.0 8.9 14.9 21.4 24.3
Operating margin (%) 2.4 10.2 14.5    
IFRS3 earnings/share (p) 2.0 5.3 3.4    
Normalised earnings/share (p) 5.9 6.1 8.3 11.1 12.6
Earnings per share growth (%)   3.6 37.1 34.1 13.3
Price/earnings multiple (x)     9.0 6.8 6.0
Annual average historic P/E (x) 20.3 27.0 23.4    
Cash flow/share (p) 7.0 10.5 10.4    
Capex/share (p) 5.0 4.2 6.2    
Dividend per share (p)   2.0 4.0 4.9 5.3
Yield (%)     5.3 6.5 7.1
Covered by earnings (x)   3.2 2.2 2.3 2.4
Net tangible assets per share (p) -0.3 8.4 3.6    
Source: Company REFS

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.

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