The FTSE 100 rose +1% to 7617 last week. Meanwhile, the Nasdaq100 and S&P500 were up even more strongly +3.4% and +2.5% which seems to be driven by a shift in messaging from the Fed, instead of “higher for longer” it looks like we are now at the peak of the interest rate cycle and according to the Fed’s “dot plot” graph we should see significant interest rate cuts in 2024. Financial markets in the USA are suggesting six interest rate cuts next year, which would take borrowing from a current range of 5.25 to 5.5% down to c. 3.9%. The US 10Y government bond yield fell to 3.9%, which is a 100 bp fall since the end of October
I wrote last week that we may still see problems in Commercial Real Estate yet to emerge, perhaps the Central Banks can see that some borrowers are showing signs of stress and the CB’s are trying to anticipate weakness in the economy. The FT had a bearish headline on Monday morning about rising corporate bankruptcies.
Cyclical stocks have already been anticipating some of this dovishness, UK housebuilders like BDEV and Taylor Wimpey are up +43% and +38% since 20th October. British Land and Land Securities are up +38% and +26% respectively. Meanwhile, AIM has crossed through its 50-day moving average. One long-term technical indicator I look at is for the 16 day moving average (red) to cross through the 64-day moving average (blue). That hasn’t happened yet on AIM, but it looks like we could see that in early 2024.
After Smart Metering Systems (SMS) bid two weeks ago, last week we had a bid for Smartspace Software (SMRT) at 82p per share, which represents a 144% premium on the previous closing price. The buyer is Skedda, a trade buyer. Yet more evidence to suggest that equity market valuations in the UK markets, particularly AIM, are very attractive at the moment.
AJ Bell, Hargreaves Lansdown and Abrdn (which owns the Interactive Investor platform) share prices’ were all hit last week, then recovered, as the FCA said that they had written to investment platforms to say that they were concerned that customers were not receiving value for money on cash balances. This is part of the FCA’s consumer duty requirement, which came into force at the end of July. Some of this focus on cash balances was known about in advance, Jamie who was previously working at AJB flagged it to me, but also here’s an article in the FT from mid-October. The FCA has demanded more information by the end of January and expects firms to have made the changes to their interest rate policies by the end of February.
The platforms tend to respond to criticism by highlighting that, unlike bank deposits, customers only hold money on platforms for short periods before they invest in equities. I have some sympathy with this point of view, as interest rates started to rise, I moved my money out of a Lloyds savings account (still only paying 1.4%) onto the platforms, where I bought some cash management funds like Fidelity Cash, Lyxor Smart Overnight Return, BlackRock ICS Sterling Liquidity Fund. It’s important to mention that these funds don’t have a government guarantee like banks’ savings account, however, that’s a risk I’m prepared to take in return for an interest rate that is closer to the BoE’s 5.25% overnight rate.
More broadly, the FCA does seem to have taken notice of the greater than 50% EBIT margins and RoCE in the sector. The table below shows that the firms are trading on between 10-20x PER and dividend yields are around 5% and higher, which is surprising for such a profitable area.
That could indicate that investors are fretting about further regulatory intervention, forcing future profits down closer to the cost of equity. St James’s Place, with £158bn of AuM, is down c. -40% YTD, after the company was forced to overhaul its fee structure following pressure from the FCA. I own Hargreaves Lansdown because I think that this is now recognised and “in the price”, the HL. share price has fallen by a double-digit percentage for each of the last four years. Nevertheless, the risk that we could see more of the slow drip of negative announcements which would be frustrating.
Sharepad user Paul Bryant has written this up in more detail. He includes charts from both AJ Bell and Hargreaves Lansdown showing that while revenue from cash balances has increased, the cash balances themselves are only c. 10% of Assets under Administration (AuA). HL. and AJB management appear confident that they are complying with consumer duty regulation, according to Paul’s post AJB’s interest rates now vary from 3.2% to 4.45% and HL’s vary from 3.51% to 4.65%. That is significantly better than the 1.4% Lloyds are offering on savings accounts! NatWest, which is controlled by the government, is only offering 1.74% on balances above £5,000.
Opinion: I think the investment platforms sector is worth following closely. Sharepad users are likely to be customers, and that might give us some insight into what is happening before it becomes more widely appreciated in the market.
My feeling is that regulatory attempts to control prices can often backfire (for instance, the Cruickshank Review into SME banking profitability 20 years ago). Successful platforms enjoy network effects and favourable economics, that is why the word has become so frequently used in management presentations. If the regulator forces platforms to lower margins, that could favour the firm with the largest market share and economies of scale (HL. £158bn AuM), making life harder for a new entrant (PBEE £5bn AuM).
MS International H1 Oct Results
This quirky defence to petrol stations superstructures business reported H1 revenue +36% to £57m and statutory PBT up 2.2x to £7.6m. They seem to be benefiting from a “war dividend”, supplying the US Navy with a 30mm gun and also a ‘VSHORAD’ land-based counter-drone weapon system. Success has been a long time coming though, the Chairman remarks that he first wrote about building systems for the US Navy in 1988. Net cash has doubled to £50m.
Divisional performance: Defence and Security (now 57% of revenue) has grown the top line by 2.4x and operating PBT was £5.7m versus a small H1 loss last year. They say that deliveries are “gaining pace” against contracts to customers.
Forgings (now 16% of revenue) saw a decline in both revenue and profits. This division manufactures fork arms and open die forgings, which they say is well positioned but doesn’t deem that the -75% decline in divisional operating PBT is worth explaining further. Worth noting that Forgins was up +69% in H1 last year, so I would imagine that the explanation lies in “lumpy” contracts and this should recover at some point.
The Petrol Stations business, which includes both superstructures and corporate branding, (together a quarter of revenue) was also down y-o-y in terms of both revenue and profits. They say that the UK government’s decision to delay banning new petrol and diesel engine vehicles until 2035 (previously 2030) has encouraged petrol station customers to invest.
No forecasts: Despite being a £150m market cap company, MS International has no broker forecasts in the market. That doesn’t particularly bother me, as we’ve seen in the past brokers only reflect what management think is their most likely outcome. For example, this time last year Cavendish were forecasting SDI to achieve 9.3p of EPS in FY Apr 2024F. That forecast has now been slashed by -38% to 5.8p FY Apr 2024F. The point being that broker forecasts reflect expectations which can change very rapidly.
MSI’s outlook statement is very bland, saying that they will continue to enhance performance and make progress across the group. The interim dividend has been increased from 2p to 3p per share (the final dividend in 2023 was 13p, so 15p FY dps). To my mind, the DPS increase seems a more valuable signal than management making upbeat comments in the outlook statement, then asking brokers to cut their numbers.
Valuation: Assuming that there is no significant seasonality, if we take H1 EPS and double that gives 68p FY Apr 2024F. Remember too, that the group has £50m of net cash (that represents a third of the current market cap). Deducting the net cash from the market cap gives an adjusted PER of 8.6x, which is much better value than Cohort, which also has defence customers and which I look at below.
Opinion: This has been my third-best performer YTD (behind Burford and Smoove) and last year was my best performer. With the benefit of hindsight, it was obvious that I should have filled my boots with MSI shares in 2020 when the share price fell close to £1 (through Nov 2020). The business was loss-making but had a very healthy cash balance of £16m.
The lesson I take from this is: if a company has a track record of profits and then falls into losses, averaging down can make sense, as long as the company has plenty of net cash. CML, which I wrote about last week has around £20m of cash, so I have averaged down into this year. Another one is FDEV, which in the near terms, looks like a bad mistake and has been my worst performer. FDEV had a cash balance of £20m end of Oct, so although FDEV is losing money at the moment, hopefully, I will be able to write about both CML and FDEV positively in three years’ time too. That’s a hope, not a recommendation though.
Cohort H1 Oct Results
This technology company with NATO and Ministry of Defence (MOD) contracts announced H1 to Oct revenue up +22% to £94m and statutory PBT up 3.4x to £3.7m. Adjusted operating PBT was up +20% to £6m, the adjustments include a lower £1.6m charge for amortisation of intangibles (ie non cash) and a £1.6m lower charge for marking to market forward exchange hedges.
The company had £13m of net cash. Note that there’s £36m of gross cash and cash equivalents on the face of the balance sheet, offset by £22m of bank borrowing on the liability side. I find that combination of cash balances and bank borrowing surprising, as finance costs ran to almost £1m in H1. Some of that may be the £5m pension deficit, but given interest rates have moved higher, I would have thought that the bulk of the finance costs are being paid to their lender, while they also have cash in savings at the bank.
Divisional Performance: Cohort is six military, electronics and intelligence operations in the UK, Germany and Portugal. It is surprisingly large with over a thousand full-time employees. The first three divisions are “Communications and Intelligence” up +32% y-o-y and just under half of group revenue. The other 3 divisions are in “Sensors and Effectors” which grew revenue +15% y-o-y and is just over half of the group revenue.
- EID designs and manufactures advanced communications systems for naval and military customers. Cohort acquired a majority stake in June 2016. www.eid.pt
- MASS is a specialist data technology company serving the defence and security markets, focused on electronic warfare, digital services, and training support. Acquired by Cohort in August 2006. www.mass.co.uk
- MCL designs, sources, and supports advanced electronic and surveillance technology for UK end users including the MOD and other government agencies. MCL has been part of the Group since July 2014. www.marlboroughcomms.com
- Chess Dynamics offers surveillance, tracking and fire-control systems to the defence and security markets. Chess has been part of the Group since December 2018. www.chess-dynamics.com
- ELAC SONAR supplies advanced sonar systems and underwater communications to global customers in the naval marketplace. Acquired by Cohort in December 2020. www.elac-sonar.de
- SEA delivers and supports technology-based products for the defence and transport markets alongside specialist research and training services. Acquired by Cohort in October 2007. www.sea.co.uk
Outlook: The group’s order book stood at £353m at the end of October, and they expect to achieve FY Apr expectations. They say that further out, the pipeline of opportunities is being driven by increased spending on defence in Europe, NATO and Asia-Pacific and see a positive outlook of organic growth in the years ahead.
Valuation: The shares are trading on 14x Apr 2025F and 13x the following year. That looks like good value for a company that has shown a good track record of top-line growth (both organic and acquisitions) over the last decade. The 3-year historic RoCE and EBIT margin are both below 8% but have improved in the most recent year.
Opinion: This looks like quite a complicated company to understand, but Equity Development have published some research notes and there are management presentations on the company’s website. I already own MS International and Solid State, so don’t want to buy too many defence companies for my portfolio. Other than that, Cohort looks like a solid share.
Bruce co-hosts the Investors’ Roundtable Podcast with Roland Head, Mark Simpson and Maynard Paton. To listen you can sign up here: privateinvestors.supercast.com
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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.