Share re-purchases - Stocks on the cusp?

Thursday, 22nd September 2016 09:51 - by David Harbage

Two recent pieces of news flow from stock exchange listed companies caught the writer’s eye, as they seemed to represent critical points in each company’s development and whose share price appears to be on the threshold of making a significant move (one way or the other) as a consequence.

Minds & Machines Group is a £93 million equity market capitalised business, set up to capture the potential of the expansion of the internet’s top level domain names, which began its life on London’s Alternative Investment Market (AIM) in March 2014. The prospect of huge global demand for the new names – beyond the traditional country codes (such as .co.uk) and verisign (.com or .org or .net) – which could highlight specific locations (such as .london) or interests (.garden) excited investors. Having raised monies to purchase and progress its portfolio of particular names, investors have experienced an 18 month period of confusing inactivity after auctions determined the ownership of the prime batch of new leading names. This period was characterised by contract squabbles between registries (owners) and registrars (distributors), which contributed to poor marketing and initial demand falling short of expectations.

Responding to evidence of greater risk aversion (amongst domestic private clients in particular) for unprofitable, cash-consuming ‘jam tomorrow’ stocks, this year the board of Minds & Machines reconsidered its business model and appointed a new CEO Mr Toby Hall. However, focusing on reducing operating costs (from US$10m in 2015 to $6m in 2017), by becoming an owner-operator only, rationalising its American operations and leaving distributors to procure new billings would not have been sufficient to deliver positive cash generation if revenue growth had continued at the pace seen in 2015. However, as the interim results announced yesterday indicate, the launch of its .vip top-level domain on 17 May 2016 provided a much needed boost and transformed the group’s immediate prospects. In particular, .vip’s first 3 weeks on sale saw 405,000 domains under management (DUM) and $5.5m of billings; by contrast the group’s total DUM as at 30 June 2016 & 2015 were 728,940 & 217,200 respectively. Billings for those two half years were $8m and $2m respectively and gross margin has risen from 47% to 86%.

Much of the demand for .vip arose in Asia, and China (which currently accounts for 47% of all new domains, globally) in particular. Minds & Machines management expects China to account for 45% of group revenue by the end of 2016; for reference DUM was split Europe 62%, US 38% at the beginning of 2016. After a slow start, appetite for new domains has markedly picked up in the last six months: while the number of country code sites rose 3.9% to 149.6m and verisign sites rose 2.4% to 143.2m, new domains jumped 104% from 11.2m to 22.8m. In part, this can be attributed to a smoother distribution channel as well as better marketing by the new domain owners.    

In the half year to 30 June 2016, revenue increased from $3.6m in the first half of 2015 to $7.4m while operating costs fell from $4.9m to $3.6m. After restructuring costs (notably $2m on closing the unprofitable retail registrar arm) a maiden pre-tax profit, albeit of just $0.1m, was achieved. The cash balance had fallen from $34.7m to $29.1m in the first half of 2016, but confidence about the direction of future cash flows (and the absence of further auction purchases) prompted Minds & Machines to announce a £13m share re-purchase. This will be effected via a tender offer to existing shareholders (100m shares @13p), which sits alongside an interesting £5.5m investment (again @13p per share) by a Chinese asset manager, Hony Capital. Investors are faced with an opportunity to exit at 13p, free of costs, or believe in the potential for growth in new domains on the internet. Some will decide that a more steady investment, featuring a project with more transparent profits and dividends, would suit them better. By contrast, one domestic institutional investor which is backing the management to deliver is London and Capital Management who have acquired another 5m shares to take their stake in the company to 15.1%. Since listing two and a half years ago, Mind & Machine’s share register has been dominated by private clients and can be viewed as being an ‘under owned’ stock by reference to mainstream UK fund managers. Perhaps that is about to change.

Another company who have recently announced an intention to buy their own shares is FTSE250 index constituent and national, volume house builder, Redrow. After reporting final results, which beat analysts’ forecasts, for the year to 30 June earlier in September, the board announced plans to seek shareholder approval at its forthcoming annual general meeting (AGM) to repurchase up to 10% of the company’s stock. The board of directors consider the current share price undervalues the company’s worth and believe that the purchase and cancellation of up to 10% of its equity would enhance the value of the remainder. This judgement appears sound given that Redrow possessed net debt of £139m as at 30 June (which has been falling, from £154m, over the past six months) as compared to its current enterprise value (EV which is borrowings plus the equity) of £1,668m; financial gearing is less than 10%, debt represents less than 10% of total capital. The cost of servicing debt is currently very low for a company of Redrow’s size and any new borrowing facilities would lower the overall expense. By contrast, return on equity was 26.8% in the first half of 2016 (ahead of the group’s target for 25% in 2018). Based on forecasts for equity earnings in the current trading year to June 2017, the stock stands on a price-to-earnings (PE) multiple of 8 – which equates to an income yield of 12.5%. By reducing the number of shares in issue by 10% (at an approximate cost of £150m), this would double the company’s absolute level of debt (towards £290m) but enhance the earnings per share (EPS) which can be attributed to the reduced number of shares in issue and therefore boost the equity’s apparent worth.   

Such behaviour to ‘move up a gear’ financially is the action of a confident management, which expects a sustainable level of profitability in the medium term. Besides being indicative of its trading prospects, the move to buy-back shares and increase the level of indebtedness could also represent an opportunistic foray into securing more debt capital - at a time of historically low interest rates – over the longer term. House builders are currently earning supra-normal levels of profit (driven by high selling prices after judicious land buying) and most are increasing returns to shareholders via different methods. However, in Redrow’s case, another legal issue raises its head: as Mr Steve Morgan owns 40.4% of the company’s equity, any reduction in the overall issued equity will increase his stake – obliging the chairman to make an offer for the whole group. As this is not Mr Morgan’s current intent, a special waiver of this obligation is necessary. In the absence of the business’ founder selling any shares, Mr Morgan’s stake could represent 44.88% after the share repurchase exercise and some will speculate about the possibility of the group being taken private or being vulnerable to a takeover.

One can debate the possibility of either event, or another corporate development, with personal circumstance considerations surrounding the near 64 year old boss coming into the fray. It takes two to make a market or have an argument, but one particular question is certainly worth pondering: how should one value a £1.5m equity capitalised business (or £1.65m enterprise) with a dominant stakeholder? To be more specific, could it be worth more or less than a comparable business with greater liquidity (ease of dealing) and a more open diversified list of owners? While it could be seen that making an acceptable offer to a near majority shareholder would almost secure the business, the market might take a different view and consider the prospect of a successful takeover to be more remote. This is perhaps evidenced by Redrow shares being on a lower valuation than its peer group – by approximately 10%, based on projected earnings – despite its recent pleasing trading update. Whether a trade buyer or other corporate exit is more or less likely for the Flintshire-based builder is arguable, but an investor who deems Minds & Machines to be too high risk reward might find the domestic builder’s magnitude of profit and dividends more palatable.            

It is interesting to note that in the case of Redrow, the share buyback proposal was not announced on the same day as the trading results. Coming nine days later, one might expect the proposal to have resulted from a considerable number of private meetings of the company’s directors and its leading institutional shareholders. Readers would be right to expect that a frequently asked question would have surrounded a strategy for getting the shares re-rated, with part of the answer incorporating an element of a re-engineered balance sheet. Finally, leaving aside the above two major (impacting a minimum of 10% of their equity base) instances of proposed share repurchase activity, there will be other instances of company stocks appearing to be on the cusp or threshold of moving from one state of investor sentiment to another. Future editions of this blog will take a look at some of these and may even proffer a view (but never a recommendation).