New technology excites and dislocates

Thursday, 11th August 2016 09:43 - by David Harbage

After seeing the Japanese firm Softbank agreed US$32billion bid for what is probably Britain’s biggest high technology business, micro-chip designer ARM Holdings, last month investors in UK listed companies may be wondering what else is worthy of investigation.

While new technology can incorporate a multitude of different applications and apply across many sectors of industry, the two areas that stand out as making the biggest potential difference – both in terms of application and as profitable ventures – are perhaps in the world of medicine (via biotechnology in particular) and electronics (notably as the internet facilitates). Companies that specialise in biotechnology or early stage medical research tend to be unprofitable and will probably require a mature pharmaceutical company to support its development efforts. The expression ‘jam tomorrow’ has often been applied to this exciting but typically high risk-reward industry, but investors in biotechnology will appreciate the need to diversify across a wide range of projects and take a very long term (ten years plus) perspective.

By contrast, much of new technology in what can loosely be termed the electronics industry has been developed by companies with existing, profitable businesses. The rapid progress of web-based technologies over the past decade is enabling much of what older readers might recall from the 1960s’ television programme ‘Tomorrow’s World’ come about and become reality. As an example, the writer recalls visiting British Telecom’s research & development centre in Martlesham, Suffolk in the late 1990s (which employed 4,000+ staff back then), viewing their scientific efforts to progress mobile telephony and broadband amongst other appealing applications while wondering when mass market take-up (alongside a return on such research & development – termed R&D - expense) would arrive. This article highlights three companies, which represent beneficiaries of the development of such new technologies, and have recently featured in the news concerning stock market listed companies. In particular the development of internet-based capabilities or platforms, allied to increased use of mobile devices (smartphones, tablets et al) by personal and corporate consumers alike, has been evident.

On Monday, Telit Communications announced interim results covering the first half of 2016, which featured guidance for an improvement in trading in the second half of the year and beyond. This company’s Israeli-originated, innovative technology surrounds the ‘Internet of Things’ (IoT) and ‘Machine to Machine’ (M2M) products whereby, via 4G driven Bluetooth, wireless communication enables different devices to be linked, centrally controlled and remotely managed. Proclaiming itself to be a global leader, Telit’s product offering enables asset tracking, industrial monitoring, automated utility meter reading, insurance telematics, consumer household electronics and health monitoring – typically by mobile devices biased to automotive, but across a wide range of other, industries – which has grown from its own  R&D and acquisition of complimentary capabilities. In the first half of this year, the company spent $14m on buying cellular module products from Novatel and Eu3.6m on Bluetooth Smart a developer of low energy hardware for wireless communications. Net debt rose to $29.1m as at 30 June 2016 as a consequence but, with its equity worth £315m, the group remains lowly geared and has scope to make further ‘bolt-on’ purchases.   

While gross profits and margins are apparently high and rising (at $66.6m, 7.4% higher, and 40.1% up from 39.7% respectively), increasing R&D, sales & marketing (S&M) and general administration (GA) expense – leading to slow or no bottom-line earnings growth - has been the prime concern of analysts over the past year. As it turned out, while these costs (R&D is 17.3% of revenue, up from 15.6%, S&M is 18%, up from 16.9% and GA is 7.8%) rose, Telit management indicated that this represented peak levels – as a proportion of turnover. More specifically, CEO Oozi Cats (who owns 20% of the group) advised that operational expenses were targeted to fall by 8-9% relative to revenue by 2018. Addressing investors’ concerns of a slowdown in growth, he also expects stronger demand from the US in the second half of this year - to deliver 20% over 2016 as a whole – pushing overall guidance for sales to rise between 11%-17% and earnings per share (EPS) to jump up between 11%-38%. Notwithstanding its AIM listing, perhaps Telit ‘came of age’ when paying a maiden dividend earlier this year, and investors are now anticipating a return to double digit EPS growth next year of circa 25%, implying an attractive PEG ratio of 0.5x. While the shares appear up with events, after their recent rally in the short term, the longer term outlook for growth in this industry is promising.  

On Tuesday, bookmaker William Hill rejected “as being opportunistic” a bid from Rank (which owns Mecca bingo halls) and 888 Holdings (an online betting firm). A merged entity would be led by the apparent junior partner 888 (market capitalisation £778m, having seen its stock rise by a third over the past year to recently touch an all-time high), rather than the larger tangible asset businesses of Rank (market cap of £811m, whose shares have fallen by 30% in 2016) or William Hill (capitalised at £2,820m, but this ex-FTSE100 constituent had fallen from 410p in March to 247p last month before the takeover speculation took hold). That web and mobile device-based betting represents the higher growth part of these businesses – and is likely to increasingly be the case in the foreseeable future – is not in doubt. The inability of William Hill which has a large presence on the High Street to develop its own online platform and proposition quickly or well enough (at least to the satisfaction of the group’s institutional investors) to compete with the fast changing competitive landscape in the industry resulted in a change in leadership as longstanding company man James Henderson was replaced as CEO by FD Philip Bowcock on 21 July. The perceived management vacuum, and difficulty in making a robust defence of its independence, prompted the “opportunistic” accusation but, provided value is not destroyed by this merger, a FTSE100 size business could emerge.     

Whether the City believes that the management of 888 Holdings has the capability of integrating the complex assets of its larger gaming peers remains to be seen. Clearly, conflicts arise when new technology-driven platforms compete with the traditional shop-based parts; dislocation, if not, breakages occur.  Bringing together differing corporate cultures often leads to squabbles as the disparate business models are shaped (anticipating radical re-engineering, rather than a simple welding together exercise). One company within this web-based technology industry which has established an impressive track record of acquiring at a good price and then integrating well is GVC Holdings (best known for its CasinoClub, Betboo and Sportingbet brands). Its US$1.7bn purchase – which could be termed a reverse takeover, as the worth of the acquired exceeds the acquirer - of bwin.party, completed in February, is set to deliver Eu125m of synergy benefits by the end of 2017 as advised in the enlarged group’s trading update on 13 July. Investors’ confidence in GVC management’s capabilities is largely based on a history of acquisition growth – notably its purchase of Sportingbet (all assets except the Australian business, which William Hill acquired) which has proven most successful. Since reaching a low spot of 372p last December, as the market feared that GVC were embroiled in an auction with 888 for bwin and could overpay, the shares have rocketed to an all-time high of 690p representing a total (market capitalisation) worth of £2bn this week. Some of this strength can be attributed to a move from AIM to the main market on 1 August but, while it might be time to book some profits, the longer term outlook for online gaming (especially in sports betting) looks positive.   

On Wednesday, one of our company stocks featured within the ‘Identify and run with your Winners’ List – monitored monthly – the technology play of digital payments firm Paysafe Group, announced its interim results. Previously known as Optimal Payments, this company also made a reverse takeover when purchasing the larger group Skrill last year; a good complimentary ‘fit’ by reference to product and, in particular, geography. A huge jump in the financial numbers reported by the enlarged business for the first half of 2016 reflected this; nevertheless the revenue and profit forecasts from an overwhelmingly positive group of analysts were comfortably exceeded. Subsequent earnings upgrades for the full year and for calendar 2017 prompted a 6% hike in the share price on the day to 415p – not far short of its all-time peak. Similarities with GVC Holdings extend to its equity worth (£2bn) and its recent move from AIM to a premium listing on the London stock exchange – which led to Paysafe’s inclusion within the FTSE250 index on 21 March 2016. Something which the gaming group can be expected to join (which brings automatic demand from trackers of the mid cap index) later this year.

The fast pace of change in technology makes acquisitions essential, as companies seek to maintain their competitive, first mover advantage. To be behind the pace of development means, at worst, offering an obsolete proposition and, at best, a loss of pricing power. Besides the Eu1.1bn spend (facilitated by a rights issue) on Skrill, the group also made smaller trade purchases including paying $20m for MeritCard a Dallas-based merchant procurer in February. Such a strategy is supported by a fall in net debt (at US$386m, the balance sheet is far from stretched) and free cash flow of $79m. Looking forward, management guided higher, indicating full year revenue would be close to $1bn and profit margins of 29.6% are at least expected to be maintained in the second half of 2016. CEO Joel Leonoff exuded confidence to investors, especially when speaking of the group’s earlier rollout of a next-generation data platform and new global merchant on-boarding capabilities. It is not unusual for high growth companies to reinvest their surplus cash back into their business – rather than distribute cash to shareholders – but investors (perhaps including Old Mutual Mid Cap fund’s manager, whose largest holding was Paysafe – as mentioned in this blog on 25 July) will start to press for a dividend in 2018. Meantime, a 15% jump in EPS next year to 32p underpins the undemanding (market average) price/earnings multiple of 13 times.