A Portfolio of AIM Shares (4); Alternative Networks and F W Thorpe

Note: For the preliminary filters used to select AIM stocks, see http://thejoyfulinvestor.blogspot.co.uk/2013_09_08_archive.html

Alternative Networks PLC

Avaya voice over IP phone, courtesy Wikipedia

 

London-based Alternative Networks (AN) has developed a successful business as an intermediary between telephone providers and small and medium sized enterprises (SMEs). AN helps SMEs configure their fixed line phone, mobile phone and data streaming requirements. The company provides a complete service for its customers, from the provision and installation of telephone equipment through to billing, security and after-sales service. As an added inducement, AN, which receives discounts as a wholesale telephone user, offers SMEs savings on their telephone bills. 

AN relies on its relations and fixed-term contracts with the large mobile phone operators (Vodafone and O2) and fixed phone suppliers (BT, Cable & Wireless and Verizon) to obtain wholesale discounts. 

AN derives 37% of its revenue from mobile phones, 32% from fixed line and 31% from what it calls 'Advanced Solutions' - computer-based voice, data and billing services. Advanced Solutions are the intellectual property of AN. 

AN was listed on the AIM market in 2005. Its shares are currently free of inheritance tax; the 'free float' is 52% of its outstanding shares and the bid to offer spread is a reasonable 1%. The company is capitalised at 171 million pounds. 

James Murray, Executive Chairman and founder of AN, holds 30% of AN's shares. He is 43 years old. 

AN (in blue) has been an excellent investment for its shareholders, outperforming by a wide margin the FTSE All Share Index (in green) since floatation:

 

Graph courtesy Yahoo, click to enlarge

 

This reflects AN's success in its niche market: 

1. Earnings per share have increased at a compound rate of 15% per annum, well ahead of the 10% p.a. compound growth rate in revenue since 2006. Dividend payments have increased correspondingly.

2. The return on retained earnings these last six years, at 22%, is close to the historic ROE of 23%. And net margins are a healthy 11%. 

3. Equity per share has compounded at 11% per annum since 2006. 

4. The company has always held a net cash balance since floatation. This stood at 15 million pounds at March 2013.  

5. AN's net operating cash flow in the past five years covered the dividend 2.7 times, leaving 31 million pounds for acquisitions, a special dividend and share buybacks. 

6. AN presents a clean balance sheet. It offers its employees a defined contribution pension scheme and does not carry the risks associated with a defined benefit pension scheme.

 

In the 2013 Interim Report, revenues declined by 4% and EPS improved by 4% compared to the first half of 2012. Murray assures us that the decline in revenues belies an improving trend in revenues and he has promised a 10% increase in the dividend for both 2013 and 2014 fiscal years. 

Growth, Murray writes, " will be achieved in three key ways:-

We will step up our efforts to target larger customers . . . with an emphasis on selling managed data services. We will also focus on cross selling IP and data services into our legacy Enterprise customer base taking predominantly mobile and fixed voice.

We will use our Synapse portal product, a vital service differentiator, to make further inroads into the Business markets segment of our customer base (80 - 500 employees).

We will make more use of our wholesale and partner channels, leveraging our billing products and channel clients." (Chairman's statement in the Interim report)

And  AN will continue to acquire smaller competitors.

At the current offer price of 352p, AN's shares are on an historic PER of 18 and yield 3.4%. My valuation model gives a valuation of 300p for the shares.* The shares traded at a 12-month high of 355p (3 October 2013) and a low of 198p (October 2012).

*Assumptions: EPS growth of 10% p.a., equity per share growth of 11% p.a., ROE of 22%, average PER of 15, dividend payout 60%; discount rate of 11.8% (3.8% SLXX + 3% operating risk + 5% margin of safety), all for the years 2013-17.

 

The main risks for the company are: 

1. That the regulators depress retail telephone prices without the providers lowering wholesale prices. This would squeeze AN's margins. This has already had an impact in the first half of 2013. 

2.  Telephony's rapidly changing technology means that unpredictable changes in demand could affect AN's business model. 

3.  AN depends on its good relations with mobile and fixed line operators, which are very large businesses, quite capable of entering AN's market if they so wish.  

4. Revenues have stalled in the past year and a half. Despite Murray's protestations, does this suggest that the company has exhausted its potential market? While owner-managers are wonderfully committed to their business, they are often the last person to acknowledge that the good times have come to an end.

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F W Thorpe PLC

 

LED flute light, courtesy F W Thorpe website

From telephones to lighting.

Founded in 1936, F W Thorpe, the Midlands-based lighting specialist, floated on AIM in 2006. The current Chairman, A B Thorpe, is a grandson of the founder, and the Thorpe family controls 51% of outstanding shares. 

The shares in Thorpe are currently free of inheritance tax, the 'free float' is 44% of outstanding shares and the shares trade on a bid to offer spread of 7%. Thorpe has a stock market valuation of 135 million pounds. 

In the 2012 Annual Report, Thorpe describes its business most succinctly:

 

"We specialise in designing and manufacturing professional lighting equipment. We currently employ approximately 470 people and although each company works autonomously, our skills and markets are complementary. Our focus is for long-term growth and stability achieved by developing market leading products backed by excellent customer service."

 

By far the largest component of the lighting business is Thorlux, specialising in commercial and industrial lighting systems. Thorlux contributed 82% of Thorpe's sales in 2013 and virtually all its profit.  

Thorpe shares (in red) have more than doubled in the last 5 years, a superior performance to the FTSE All Share Index (in pale orange):

 

Courtesy the Investors Chronicle, click to enlarge

 

The company has consistently maintained healthy margins and it has increased revenues over the past 10 years, even during the financial crisis. Its net cash position and freedom from debt has been another feature of the business. Consider: 

1. Earnings per share have grown at a compound 13% per annum since 2004 on revenues that have increased by 6% p.a. The net margin in 2013 was 21%.  

2. Equity per share has grown by a compound 14% per annum since 2004. This was achieved by retaining a very high proportion of its profits until this year. 

3. The historic return on equity of 13% is similar to the return on retained earnings of 14%. Thorpe is a business that requires regular capital spending on plant and facilities. It has also launched new businesses and acquired others.  

4.  Thorpe has no debt, but has 34 million pounds cash on its balance sheet, or one-quarter of its market capitalisation. 20 millions of the 34 millions are customer deposits. 

5. In the past five years net operating cash flow after capital expenditure amounted to 26 million pounds, which covered the dividend 2.2 times. 

6. The defined benefit pension scheme was closed to new entrants in 1995. Consequently, the actuarial estimates of pension liabilities are relatively stable and fully provided for. 

Thorpe's main business is driven by the refurbishing and building of premises for commercial and industrial use. The development of Light Emitting Diode (LED) lights, which promise lower consumption, longer life and more flexibility than fluorescent and incandescent lighting, has also significantly improved demand. 25% of Thorpe's sales are now LED and the company has invested in new plant to increase its manufacturing capacity.  

Sales and profits were slightly lower in 2013 than 2012. The Chairman explains that this is the result of: 

1. Not being able to produce as many LED lights as customers required. Hence the new plant. 

2. A lower order book than 2012 at the beginning of the year.  

3. Continued start-up costs at its new venture, TRT Lighting, which specialises in lighting for tunnels, streets and open spaces. This unit lost 0.5 million pounds and will continue to lose money "for some while" (the Chairman). 

Management seems to be distracted by its small units. TRT is loss making and its main customer the public sector, to the evident frustration of the Chairman, is accustomed to buying imported lighting. Compact Lighting (retail and display) made a loss and it has a new sales director. Sugg Lighting, which specialises in refurbishing heritage lighting is also loss making and it has a new management team. Here there is cheaper competition from 'family businesses'. Solite Europe, the largest supplier of lighting to hospitals and laboratories in the UK, has a new sales director. And in 2012, Thorpe purchased Portland Lighting, the largest UK manufacturer of sign lighting. Both Portland Lighting and another subsidiary, Philip Payne, which specialises in exit signs, are said to be doing well. All together, these six units billed just 11 million pounds in sales and made 0.3 million pounds profit in 2013.

86% of Thorpe's sales go to the UK, but Thorlux also has offices in Ireland, Germany and Australia. The export market is not growing as well as the company hoped. The Chairman wags the proverbial finger at the Munich office and reckons both it and Australia must do better. 

With Thorpe's shares trading on a PER of 14 and yielding 2%, are they worth buying at 115p? My valuation model values Thorpe shares at about 100p.* But this assumes that, with the new LED production capacity and actions taken in three of the units, Thorpe will recover its stride and past earnings growth, though at a more sedate 8% p.a.

*EPS growth of 8%, equity per share growth 12%, ROE 13%, average PER of 12, dividend payout 36% of earnings, discount rate of 9.8% for 2014-18.

Thorpe is a conservatively run business. Nevertheless, there are risks: 

1. The overall lighting market for UK producers is shrinking, according to The Electric Lighting Equipment Manufacturing market research 2013. And "It is clear from this study [Plimsoll report 2013] the lighting market is going through a period of great change and the market is highly competitive."  This will not be news to Thorpe.  

2. LED lighting is becoming the standard for many of Thorpe's customers. And the Chairman notes that there are many new companies - start-ups - in the LED market. Also, many LED lights are imported. This could lead to more competitive pricing and loss of business. 

3. New lighting technology could move demand from LEDs. But, given the conservative nature of the lighting business, Thorpe should have plenty of time to respond to such a change. 

4. Investors are confronted with a bid to offer spread of 7% for Thorpe shares. This is an all too common feature of AIM and discourages investors.