Never mind the margin - watch the wives

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Following the resilient update from Lookers (LOOK) (car dealers, earlier this week) it is worth considering positive news also from Sanderson (SND), the IT group I wrote favourably about in early August.

For more read: Find Sanderson on your radar

'At about 11.5p mid-price, there is an attractive risk/reward profile and a good chance Sanderson proves a rewarding recovery situation.' Since then the price has twice breached 20p, up to 22p earlier this week in response to a trading update, and is now 17.5p.
 
The wider significance of Sanderson's update is IT spending being a useful indicator of corporate spending, especially among small to medium-sized enterprises (often referred to as SMEs). This appears to be resilient signalling the UK recession is not getting worse and may be easing in this area.
 
For its financial year to end-September 2009, management says trading performance will be 'slightly ahead of expectations' and in contrast with the general instability and uncertainty which prevailed across the wider economy in the late summer of 2008, the group 'has enjoyed a strong finish to the financial year just ended.'
 
Furthermore, the new financial year from October has seen this improved trading momentum continue, with various key new orders having been either won or in the latter stages of negotiation.
 
The latest update re-iterated the group's cash generative qualities with 'strong pre-contracted recurring revenues' although this has been Sanderson's pitch for a few years and it didn't limit downside in its shares from a 50p to 75p range in 2005-07, then a slump from 2008-09.

Small cap cyclicals tend to be easily hit by fear, in their tight market, and with Sanderson it took until the end of this last April for the reason to be confirmed: deferral of larger, more profitable orders which meant lower gross margins.
 
So for the six months to end-March 2009, even though group revenue was held at £13.0 million, normalised operating profit slid to £1.1 million from £2.0 million. Other charges relating to goodwill impairment and derivatives extended the pre-tax loss to £2.1 million.
 
In situations like this there is likely a phased investor relations effort: firstly to crank down expectations (with sufficient headroom, so more likely they can be met) then be in a position to report like Sanderson is doing now, it is performing better than expected.

I do not mean to sleight management's achievement or deny there is recovery but this latest update has not provided insight on the key issue for investors: restoring the higher margin elements of group revenue. For the shares to properly recover it is necessary to understand how the new margins profile is panning out.
 
In fairness to Sanderson, it is premature to expect meaningful guidance at this nascent stage of recovery, but future updates need to provide it. Hopefully the interim statement in early December will be able to cast more light on the margin mix evolving.
 
A 30 October note from Charles Stanley, Sanderson's broker, may be the latest guide to Sanderson's budgeting (since it is normal practice for analysts/managers to discuss forecasts beforehand).

The note cites cost cutting as the driver behind the expectation of second half operating profit of £1.5 million and higher order intake as likely to lead to significantly improved first half results in 2010. Well, cost cutting can only go so far before revenue/margins become critical.
 
Yield is cited as an attraction despite forecasting a full year dividend cut of 0.45p a share, down from 2.7p in 2007 and 1.4p last year. Obviously, with the current yield at about 2.5%, the 'attraction' assumes Sanderson can rebuild its earnings and payout.
 
Adjusting forecasts for one-off issues, Charles Stanley projects £1.7 million pre-tax profit for the latest financial year then £2.1 million in the current year and £2.8 million in 2010/11, with earnings per share building from 3.7p to 6.1p over this period.

So the prospective price-earnings multiple is barely five times and if Sanderson can firm up its recovery I think this ought to double - such that on a two-year view a 50p share price target looks reasonable.
 
So you can be pragmatic to exploit swings in the fortunes of small cap cyclical even if the investment case is not the best available. In September's piece, 'Is the party over for UK-listed technology shares?' I considered how new themes of mobile computing and web-enabling solutions may mean stock-pickers need to prioritise US firms with a lead in this area.

So it is ironic how Polar Capital Technology Investment Trust, which argues for this theme, owns 4.6% of Sanderson - although it is tiny exposure for an investment trust. I believe Polar's entry point was some years ago in a placing and most likely the shares are seen as undervalued now.
 
The story also shows how concerted directors' dealings can usefully indicate a turning point in the business, and the shares later follow. When their wives trade, it seems worth paying even closer attention - for if hubby gets things wrong then he is in deep trouble.

On 7 August the chairman's wife bought 150,000 shares at 16p, which followed the senior non-executive director adding 25,000 at 13p to hold 125,000 overall. The finance director's wife (the most crucial indicator of all?) nipped in sooner at 10.4p in early August, when the chairman snapped up 465,000 shares at 10.4p also - to hold 2,088,199 shares and a similar amount of options.
 
Sanderson shares merit retaining also watching for another buying opportunity.

You can find more information via www.sanderson.com.