Why I’d buy this small-cap stock now

Today’s full-year results report sets out strong progress with debt reduction. The company used incoming cash flow in the period to pay off a big chunk of its borrowings. And on 31 March, net debt had fallen by around 24% compared to a year earlier, to just under £122m.

That’s still a thumping pile of other people’s money, but I reckon VP will continue to work at paying it down. However, one of the risks with the stock is the underlying cyclicality of operations. If there’s another general economic downturn, big borrowings could become a problem. That’s why I like to see cyclical firms getting into a strong financial position when trading is booming. And, right now, the outlook for the business is bullish.

If VP keeps paying off debt year after year until it’s gone, it can then direct its cash flow straight to reinvesting in equipment. When, and if, that happens, the business will probably be in great shape. And the good news is the financial record shows an improving trend now.

There’s also been a conclusion to the Competition and Markets Authority’s long-running investigation. The bottom line is VP must pay a penalty of £11.2m after a breach of competition law involving three “major” suppliers of groundworks hire equipment.

VP reckons it “fundamentally” disagrees with the CMA’s conclusions but the directors have decided not to fight the findings. In that way, the company and its shareholders will be spared further costs and uncertainty. I reckon that’s a good decision because the process has been dragging on for around four years.

Trading well and a positive outlook

The business is trading well. And looking ahead, the directors reckon the market backdrop for VP is “positive”.  Major infrastructure sectors, such as water, rail and transmission are “primed for escalating growth in the coming year.”  

I think the recovery we’ve been seeing in the building and construction sectors is encouraging. And there’s a potential tailwind for VP from the government’s drive to “build back better” following the pandemic. It’s hard for me to imagine anything other than booming demand for rental equipment in the years ahead. Although I could be wrong in that assessment and lose money with VP’s shares.

Nevertheless, chief executive Neil Stothard said in today’s report the management team is “excited” about the prospects for the business in the coming year. And I’d embrace the cyclical and other risks and buy the small-cap stock now as part of a diversified portfolio.

With the share price near 865p, the forward-looking earnings multiple is around 13 for the current trading year to March 2022. And the anticipated dividend yield is about 3.7%. I reckon that valuation looks undemanding.

However, the FTSE SmallCap company has a long record of annual growth in revenue, earnings, cash flow and shareholder dividends. And the stock has been recovering from the recent crash in the markets.

This cheap share’s record is outstanding

Normally, VP sports a decent yield. But the directors have deferred the decision about paying a full-year dividend pending clarity on our emergence from lockdowns. For context, last year the firm earned 97% of its operating profit from UK operations with the rest coming from abroad.

Chairman Jeremy Pilkington said in the report the figures for the year to 31 March are “satisfactory.” He referred to “modest” gains in margin and profit before tax. And the performance through the year came against a “highly uncertain” economic backdrop, which included the Brexit process and the general election of 2019.

And I agree the performance looks steady. VP has been a good bet for investors. Ten years ago, the shares stood at 177p. Today, they change hands for about 800p, even after dropping back during the coronavirus crisis. That’s a serious capital gain if you held over the decade, with generous income from the dividend on top.

To me, gains like that are one of the main reasons for entertaining small-cap shares. Almost all the way over the past decade you could have justified buying shares in VP on valuation grounds, or as a dividend-led income play. Just like you might select a FTSE 100 company for its income. But how many FTSE 100 income investments go on to deliver capital gains on the scale of what VP has achieved? Not many.

Recovery well under way

Chief executive Neil Stothard explained in the report the company kept open “many” of its operating locations to support critical sectors through the lockdown. However, the directors closed some sites and furloughed around half the UK employees. But things are improving and the company has reopened outlets with employees coming off furlough “as demand has recovered.”

The senior management team has taken a 20% haircut in salary until the end of June. And many staff are working a four-day week until demand builds up to pre-Covid levels. Looking ahead, Stothard expects “a slow, incremental recovery over the coming months.”

And I think that anticipated recovery in operations is the investment opportunity now. This is a solid business with growth potential and a long record of effective execution. However, the stock is still more than 25% down from its level in February, before the coronavirus crisis.

I reckon there’s a decent chance that the VP business will continue to expand over the next decade, just as it did over the previous one. So I see the current situation as a decent-looking entry point for a long-term hold.

I often pay attention to rapid share-price rises, especially when a stock has previously been weak, as in the case of VP. The sudden movement can mark a reversal or improvement in a company’s fortunes, and can also indicate an opportune moment to think about investing in a company’s shares.

Reduced uncertainty and a relief rally

VP had fallen almost 45% since the summer of 2018 and it plunged 33% between April and May 2019 alone. The catalyst appears to have been the release of news that the Competition and Markets Authority (CMA) had provisionally found suspected anti-competitive conduct relating to the supply of groundworks products for hire in the UK. VP is active in that area with its Groundforce business and is, of course, co-operating fully with the investigation.

In today’s report, chairman Jeremy Pilkington explained that the CMA had reached a provisional determination that VP and two other companies, had “acted in a manner deemed to be uncompetitive in the market for certain elements of temporary groundworks.”  The firm is reviewing the alleged breaches and Pilkington expects it to be in a position to respond to the CMA “shortly.” 

Meanwhile, today we learn that a £4.5m exceptional cost provision has been made in the accounts relating to the issue, which the firm describes as “the arithmetic midpoint of a range of possible outcome of between £0 to £9m calculated based upon previous cases.”  There is no admission of culpability at this stage, but I reckon quantifying the potential financial loss goes a long way towards removing the uncertainty. Indeed, we could be seeing something of a relief rally in the shares today.

Growth on track and something to fret about

The figures are good. Revenue came in 26% higher compared to the year before and adjusted earnings per share rose 12%. The directors expressed their ongoing confidence in the outlook by lifting the total dividend by 16%. Apart from the CMA investigation into part of the firm’s operations, things have been going well. On top of organic growth, VP acquired Sandhurst Limited for just under £3.3m on 10 May to bolt on to existing operations, suggesting that the growth agenda remains on track.

Looking forward, chief executive Neil Stothard said in the report that he thinks the firm’s main markets in the UK will continue to be supportive, albeit with “slightly slower” growth than previously because of “political and economic uncertainty.” Around 97% of the adjusted operating profit came from the UK during the year with the rest from international operations, so the home market dominates the accounts.

The valuation looks undemanding at first glance with a forward-looking earnings multiple of around eight for the trading year to March 2020 and a dividend yield of 3.9% covered more than three times by anticipated earnings. However, VP carries big borrowings with net debt running almost five times the level of operating profits. I think that’s too high and could become problematic in any future cyclical downturn. So I’m not piling into the shares on this occasion.

It could be argued, though, the 30%-plus stock price fall since mid-April, a drop which leaves VP dealing on a cheap forward P/E ratio of 7.1 times, more than bakes in the uncertainty created by the CMA probe.

I certainly believe this low rating could also prove the basis for a price spike when full-year results are unpacked on June 4. Several weeks ago, the company advised it “has made further progress both within the UK and the International divisions” since November’s interims and that, as a consequence, numbers for the financial year ended March “will be well ahead” of the prior year. Comments suggesting this momentum has continued could give market appetite for the stock a huge dose of rocket fuel.

Stunning value, BIG dividends

VP also has a long record of earnings growth and so it’s not surprising City analysts are expecting the bottom line to continue swelling — rises of 8% and 11% are forecast for fiscal 2020 and 2021, respectively.

And this isn’t a great surprise, given the company’s resilience in tricky trading conditions and its commitment to M&A action. In the past fortnight, it sealed the £3.3m acquisition of Sandhurst Limited, a supplier of specialist excavator attachments to a wide variety of industries.

In line with these bubbly profits estimates, dividends are expected to continue rising at quite a pace.  As I type, payouts of 32.1p and 34p per share are predicted for this year and next, up from the anticipated 30.2p reward for the year just passed. Consequently, forward yields of 4.6% and 4.8% can be enjoyed.

Safe as houses

What’s more, there’s plenty of reasons to expect the business to make good on these predicted dividends. First of all, these estimates are covered by anticipated earnings of between 3.1 times and 3.3 times through to the close of next year, comfortably above the accepted safety watermark of 2 times.

Net cash flows from operating activities at the business swelled 20% year-on-year as of September, to £29.7m, a result which encouraged it to lift the interim dividend 21% to 8.2p per share.

Such is the strength of VP’s balance sheet that it can continue raising dividends at a rate of knots while pursuing its bold M&A policy. 

There’s a lot to like about VP, I believe. And I wouldn’t be surprised to see fresh financials scheduled for the first week of June prompt a fresh spurt in buying activity.

Many buy-to-let investors have done well over the last 20-30 years, during which time UK house prices have risen massively. But I think this opportunity may have passed, at least for now.

According to mortgage lender Nationwide, house prices in London and the South East are now falling from record highs. Buy-to-let landlords are also facing a cocktail of rising costs, including changes to mortgage tax relief and new energy efficiency requirements. I think there are better opportunities elsewhere.

The ultimate turnaround?

If you’re attracted by the wealth-building potential of property investment, I think FTSE 100 engineering group Melrose Industries (LSE: MRO) is worth considering.

Melrose buys troubled industrial groups, turns them around, and sells them on. Its management has an impressive track record. According to the firm, £1 invested in 2005 would have been worth £18 by March 2018.

Last year, the group made headlines with a hostile takeover of aerospace and automotive group GKN. It’s too soon to say whether Melrose management will be able to repeat previous successes. But progress so far seems positive. The group’s 2018 results were said to be ahead of expectations and showed a reduction in leverage along with promising signs of cash generation.

Profits could soar

Melrose is targeting a medium-term operating profit margin of 11% for the GKN business. The equivalent figure in 2017, prior to the group’s takeover, was just 6.4%.

Melrose says that GKN suffered from problems including poor integration of acquisitions, a complicated management structure and a lack of clear strategy and discipline on spending. By fixing such issues and resolving loss-making contracts, the firm believes it can hit these profit targets with only minimal sales growth.

Melrose stock looks fairly priced to me, on 14 times 2019 forecast profits, and with a 2.5% dividend yield. I think the downside risk is limited at this level. I’d rate the shares as a buy at under 200p.

A better way to play property?

Another way to play the UK property and construction market is by investing in firms which provide the tools and equipment needed for building. One of my top picks in this sector is equipment hire firm VP (LSE: VP).

In a trading update today, the company said that its main UK business was performing well, with “stable demand” from infrastructure, construction and housebuilding customers. This seems to suggest the UK economy is in reasonable health, despite Brexit concerns.

The firm also owns an international business, which operates in the oil and gas industry, and owns a test and measurement business based in Australia. Although smaller, I suppose these operations could help to offset the cyclical risk of a UK downturn.

Happily, there’s no sign of a slowdown yet. Analysts’ forecasts indicate that the group’s earnings are expected to rise by 14% to 93.5p per share this year. This puts VP on a 2019 forecast price/earnings ratio of 10.5, with a dividend yield of 3.0%.

This valuation may seem modest, but I’m concerned we may be at a late stage in the economic cycle. On that basis, I’d rate the shares as a hold at current levels.

You may not have heard of Gateley Holdings (LSE: GTLY) or VP (LSE: VP) so here’s why they’re worthy of your investment cash.

More great news

Gateley is a share I’m particularly excited about. Since it listed on AIM four years ago, it’s been rapidly growing its headcount across the UK and the Middle East to capitalise on the soaring demand for legal services. This has helped to power earnings — and thus dividends — higher over the period.

I’m pleased to say that its strong bottom-line momentum is yet to show signs of running out of steam. Indeed, the release of more excellent trading details on Tuesday illustrated that energy. Revenues soared 20.1% in the six months to October to £46.4m, a period which also saw organic sales rise by 10.2%. Pre-tax profit also jumped 18.6% to £5m.

What’s more, with cash conversion at the firm improving by 2.1% year-on-year to 87.4%, the business elected to hike the interim dividend by an eye-popping 18.2%, to 2.6p per share.

The headcount at Gateley’s core legal operations has risen by almost 50% since its IPO in 2015, underpinning the relentless profit growth of recent years. Looking away from the steady expansion at its bread-and-butter divisions, the company’s foray into other professional services, like tax and accountancy matters, adds another layer of growth potential for the years ahead.

In the meantime, City analysts forecast an earnings increases of 11% for the year to April 2019 and 9% for fiscal 2020. And these projections underpin dividend predictions of 7.8p and 8.4p per share for these respective years, up from 7p last year, yielding a jumbo 5.6% and 6%.

Despite the recent share price bump, Gateley still trades on a low, low forward P/E ratio of 11.4 times. I believe that this rating is far too cheap given the company’s breakneck top-line momentum.

Another income star

Like Gateley, VP has also been splashing the cash to expand its geographical and operational base. The benefits of this programme were laid bare in November’s latest financial statement.

Following the acquisition of Brandon Hire last year, both revenues and profits boomed between April and September — by 42% and 22%, respectively. As a consequence, the half-time dividend was hiked by more than a fifth year-on-year to 8.2p per share.

An expected 10% earnings hike for the full year to this March results in a prediction for a 30.3p total dividend, yielding a chubby 3.1% and suggesting a meaty upgrade from last year’s 26p reward. And the yield moves to 3.3% for fiscal 2020 as a predicted 7% profits rise by City analysts leads to an anticipated 32p dividend.

The rental equipment company has proved immune to the wider implications of Brexit so far. Yet this resilience is not reflected in its low valuation, in my opinion, with a forward P/E multiple of 10.2 times. Like Gateley, I reckon VP is a great budget buy right now, particularly for those seeking excellent dividend growth.

VP’s share price is up by more than 5% at 990p at the time of writing, following a strong set of results. Sales at this £400m company rose by 22% to £303.6m last year, while adjusted pre-tax profit climbed 16% to £40.6m.

Adjusted earnings per share rose by 18% to 81.8p. The dividend was also increased by 18%. This lifted the total payout to 26p per share, while maintaining a conservative three times dividend cover.

These figures put the stock on a trailing P/E of 12.1 with a yield of 2.6%. That looks a reasonable valuation to me, but do today’s figures support an optimistic outlook?

Too much debt?

VP paid £68.8m in cash and debt to acquire rival Brandon Hire Group in November. Management plans to combine Brandon with VP’s Hire Station business to deliver economies of scale.

In total, the firm spent just over £80m on four acquisitions last year and invested a further £64.9m in its rental fleet. This spending resulted in year-end net debt of £179.2m, up from £98.9m one year earlier.

This level of borrowing represents 74% of the value of the firm’s fixed assets, such as property and its rental fleet. I’d normally look for debt to stay below about 50% of fixed assets, to leave room for depreciation and the risk of a market slowdown.

However, the group generated a return on capital employed of 14.8% last year and an operating margin of 11%. Both figures are roughly double those of rival Speedy Hire. These higher returns reflect the group’s specialist focus and suggest to me that this borrowing should be manageable for a short period.

I’d still buy

Analysts expect VP to deliver earnings growth of about 15% in 2018/19, as Brandon contributes a full year’s earnings.

This puts the stock on a forecast P/E of 10 with a prospective yield of 3.1%. Despite my reservations about debt, I’d be happy to keep buying at this level.

My top pick

Although I rate VP highly, my top pick in this sector is construction and regeneration specialist Morgan Sindall Group (LSE: MGNS). There are three reasons for this.

This group has regularly beaten expectations over the last couple of years, and this trend looks set to continue in 2018. Broker consensus earnings forecasts for 2018 have risen from 106p per share in June last year to 138p per share today.

This well-run firm is also operating without debt. A trading update in May confirmed that average daily net cash for the current year is expected to be at least £70m.

The final attraction for me is that the firm is run by part-founder John Morgan, who has a 10.1% shareholding. Having skin in the game means that Mr Morgan’s interests should be well aligned with those of his investors.

I’d buy

Analysts expect the firm’s adjusted earnings to climb around 15% to 139p per share this year. This puts the stock on a forecast P/E of 10.8, with a prospective yield of 3.3%.

Although Morgan Sindall would be exposed to a slowdown in the UK construction sector, my view is that the group’s owner-management and strong financial performance make it a buy at today’s prices.

In 2018 the company is predicted to record another 5% earnings rise, laying the foundation for further payout growth. A dividend of 4.9 euro cents per share is currently forecast, up from 4.02 cents in 2017 and resulting in a decent 4.2% yield.

And with earnings expected to slip 3% higher next year a 5 cent dividend is being tipped, thus nudging the yield to 4.3%.

An added bonus is that Summit Germany can be picked up on a forward P/E multiple of 13 times. This is shockingly cheap in my opinion given the progress the company is making to capitalise on the strong German real estate market — pre-tax profit more than doubled last year to €128.7m. It’s also cheap due to the shortage of residential and commercial developments that should keep earnings on an upward slope well into the future.

Rental royalty

Yields over at VP (LSE: VP) may not outstrip those of the broader market. But the rate at which the business is lifting dividends should put the company well and truly on the radar for those seeking brilliant ways to fund their retirement.

Supported by a chubby record of double-digit percentage earnings growth, the specialist equipment rental group has been able to lift the annual payout by 80% in the five years to fiscal 2017. And when it reports for the period to March 2018, it is expected to put in a similar profits performance, meaning the dividend is also predicted to move to 25.2p per share from 22p the year before.

City analysts are expecting profits to keep piling higher in the medium term at least, with rises of 19% and 9% forecast for fiscal 2019 and 2020 respectively. Accordingly dividends are expected to maintain their northward march also, so figures of 29.3p for this year and 31p for next year are being bandied about by the boffins.

These projections yield 3.3% and 3.5% respectively. However, chunky yields and the prospect of additional dividend hikes down the line are not the only cause for celebration as current payout projections also look pretty safe. Indeed, they are covered between 3.2 times and 3.3 times through to the close of fiscal 2020, sitting comfortably inside the accepted safety terrain of 2 times or above.

The patchy outlook for the UK construction market means that VP isn’t without its degree of risk. However, I would consider an ultra-low forward P/E ratio of 9.5 times to be reflective of this.

Besides, I believe investors can take confidence from the company’s resilience in spite of these trying conditions. It noted in April that it “has experienced consistent demand from its key infrastructure, construction and housebuilding markets.” And the impact of recent acquisition activity reinforces my belief that profits, and thus dividends, should keep on rising.

Record highs

Those of you that followed my advice back in October 2016 will by now be very familiar with Crest Nicholson (LSE: CRST). Not only did the upmarket residential housebuilder go on to achieve its sales target of £1bn for the financial year, but the company also saw its share price soar 56% to record highs of 636.5p just seven months after my recommendation.

But that was then, and this is now, although the success story goes on as full-year results for FY2017 revealed yet another year of growth for the Surrey-based developer, with increases in both sales and the total number of homes built. The FTSE 250-listed group delivered 2,935 new homes in 2017, an increase of 2.3%, at an average selling price of £388,000.

Buying opportunity

During the 12 month period to October 2017, the group delivered a record £1,066m of sales, and remains on course to achieve its £1.4bn target by 2019. Pre-tax profits came in 6% higher than the previous year at £207m with the business benefitting from additional profits generated from joint ventures.

In light of the improved performance, management proposed a final dividend of 21.8p per share, taking the total payout for the year to 33p, representing a substantial 19.6% improvement on the previous year. With the shares now trading at less than seven times forward earnings, and supported by a 7.3% yield, I sense another buying opportunity for income seekers on the hunt for a bargain.

Small-cap special

For those who aren’t afraid to venture into small-cap territory then I believe overlooked VP plc (LSE: VP) could be just the ticket. The £340m group is a specialist rental business providing products and services to a diverse range of markets including infrastructure, construction, housebuilding, and oil and gas, both in the UK and overseas.

Based in the spa town of Harrogate, North Yorkshire, this rapidly-growing business has seen a threefold increase in its share price since 2013, but I believe there’s still plenty more to come, with results for the first six months of the year showing further significant growth for the group.

Oozing value

Late last year VP made its largest acquisition to date with the purchase of Brandon Hire for £41.6m. With its extensive branch network, the national tool and equipment hire business looks to be an excellent geographic fit with VP’s current specialist tool hire operations, and management expects the acquisition to be earnings enhancing within the first 12 months of ownership.

With analysts expecting earnings to rise by a further 44% by FY2020, VP looks to be oozing value trading on an undemanding price/earnings ratio of 11.

Today the company reported yet more growth for the year to the end of December. Revenue for the period expanded 14% on a reported basis to €807m and reported net profit increased by 29% €248m. Adjusted diluted earnings per share ticked higher by 14% giving management the confidence to hike the overall dividend by 10%. 

Unfortunately, it looks as if the market is not pleased with these figures as shares in the company have plunged by more than 10% in early deals, but I believe that this could be a great opportunity to buy. 

Cash cow 

As well as its impressive earnings growth, another of Playtech’s attractive qualities is the group’s cash generation. Free cash flow before dividends for the year was €160m and the firm ended the year with a cash balance, excluding client deposits, of €413m. Management is planning to use these funds for bolt-on acquisitions, which is a crucial part of the company’s growth strategy. 

Still, despite Playtech’s impressive record of growth, and robust balance sheet that can fund more deals, the shares look cheap. 

Based on current City forecasts, the shares are trading at a forward P/E of 11 and support a dividend yield of 4.4%, the payout is covered twice by earnings per share and, as mentioned above, is backed up with €413m of cash. This is why I believe that this company could be a starter investment for those looking for a home for their first £5,000. The shares are cheap, Playtech has a record of rapid expansion in a niche industry, and there’s a market-beating dividend yield on offer. What’s not to like? 

Undervalued growth

Playtech isn’t the only company that I believe is suitable for beginner investors. VP (LSE: VP) is another undervalued income and growth play that I believe won’t let you down. 

City analysts have pencilled in big things for this equipment rental business. Earnings per share are expected to expand by 67.3% to 79.4p for fiscal 2018, before rising 18% to 93.7p for fiscal 2019. This sort of explosive growth usually warrants a high valuation but that’s not the case with VP. Indeed, the shares currently trade at a modest forward P/E of only 10.7 falling to 9.1 for 2019. Analysts also expect the firm’s dividend payout to rise in line with earnings growth. On this basis, the shares are set to yield 3.3% by 2019, which is in line with the market average, but this is unlikely to be the case for long with the payout growing at a double-digit rate every year. 

Like Playtech, VP also has a record of explosive profit growth. If the company hits City forecasts for 2018, it will have increased net profit by more than 100% in the space of five years on revenue growth of 50%. Over the same period, the per share dividend payout will have nearly doubled. As long as VP can keep this record up, and I see no reason why it can’t, it could make a great starter investment for your portfolio.