Interactive Investor

A trio of AIM shares for your ISA

27th March 2015 17:25

Andrew Hore from interactive investor

In the second article on potential ISA investments I am focusing on AIM-quoted companies that have strong growth prospects that offer value over the longer-term. Although it is easy to trade shares in ISAs these companies have been chosen as long-term investments for inclusion in an ISA. The investments being made in the businesses mean that the real benefits could take a couple of years to show through in profit terms.

dotdigital (DOTD)

31.5p

Email marketing services provider dotdigital is increasingly becoming an international business. The investment required to grow the business in the US and Australia is holding back short-term profitability, but this should pay off in a couple of years time.

At the moment dotdigital has an office on the east coast of the US and it plans further offices in Chicago and Los Angeles. An office in Australia is also planned and this is seen as the first step in the strategy to expand in Asia Pacific.

The company is increasingly focused on larger customers and average spend per customer is increasing. Up until now, dotdigital has offered its service at one price, but there are plans to offer additional services at a premium rate.

In the six months to December 2014, revenues grew from £7.6 million to £10 million with the US contribution more than doubling to £1.1 million. Recurring revenues jumped from £5.8 million to £7.4 milllion. Higher admin expenses offset some of this revenue growth but pre-tax profit still improved from £2.16 millon to £2.54 million.

Dotdigital is a strongly cash generative business. There is expected to be net cash of £11.6 million at the end of June 2015 with cash generated from operations more than covering the required investment over the next couple of years.

Management changes may cause concern to some investors but it is being smoothly managed and Peter Simmonds has made his own decision to step down as chief executive. For the next few months he will remain as deputy chief executive in order to assist the new chief executive Simone Barratt, who has a background in the marketing sector and brings additional skills to the role. Simmonds has been selling shares, which has probably helped to hold back the share price, but Barratt has added to her holding.

The share price has doubled in the past two years, but it has not moved significantly in the past year. Profit forecasts have been trimmed in recent months due to the increasing cost base and the lag in winning new business due to this investment. Even so, in the year to June 2015 profit is expected to increase from £3.6 milion to £4.8 million, although a higher tax charge will hold back earnings per share growth. The next financial year will be another one where investment will hold back profit to £5.6 million even though revenues are forecast to increase by around 30% to £27.5 million.

The full benefits of the investment in growing the international operations could show through in 2016-17 when a profit of £8.5 million would mean a reduction in the earnings multiple to 13. Not high for a cash generative company with strong growth prospects.

Benchmark (BMK)

93.5p

Aquaculture-focused business Benchmark (BMK) joined AIM at the end of 2013 and it has used its quotation to make strategic acquisitions to grow the business. The main strategic objective of Benchmark has been to reduce disease through developing vaccines but the recent move into salmon genetics takes it into an additional area.

Benchmark acquired a fourth leg for its business by acquiring salmon genetics and breeding businesses SalmoBreed and Stofnfiskur at the beginning of this year. This makes Benchmark the world’s second largest salmon egg producer. The two businesses have spare capacity so Benchmark can improve marketing and sell more in additional markets around the world.

Norway-based SalmoBreed develops genetic material for salmon eggs that improves disease resistance and growth. The initial sales focus has been Norway, but there are opportunities to sell around the world. Benchmark plans to change the current royalty based model to one generating revenues directly from the sale of eggs.

Iceland-based salmon breeding company Stofnfiskur supplies salmon eggs outside the natural season. The company is currently using 35% of its capacity. Minority shareholders retain 18.16% of the company.

The acquisitions cost an initial £40.2 million with potential deferred consideration of up to £11.2 million. Bechmark is cash generative but a lot of the cash is being ploughed back into the business. A £70 million placing at 85p a share financed the acquisitions and provides £10 million for the development of the BioCampus Facility in Edinburgh in order to expand capacity.

Aquaculture is a fast-growing market and it is valued at more than $110 billion, which is larger than the farmed cattle market - and it is growing much faster. The depletion of the oceans' fish stocks means that the farmed fish market is likely to continue to grow rapidly on the back of a growing global population and rising demand for seafood. The salmon sector has been growing at around 6% a year.

The animal health division is predominantly focused on aquaculture, but it is moving into the land-based animals sector as well. For example it is investing in the HypoCat cat allergy vaccine programme.

One of the things to note is that Cenkos and Equity Development produce significantly different pre-tax profit forecasts, because the latter strips out amortisation, although the earnings per share forecasts are produced on a similar basis and this year they are expected to be at least 4p. Equity Development believes that earnings per share could almost treble to 11.8p by the year to September 2018, thanks to the growing markets and new product launches. That reduces the prospective multiple from 23 in 2014-15 to eight in 2017-18.

Benchmark has a relatively high short-term rating but the recent decline in the share price is an opportunity to buy shares in a quality business.

K3 Business Technology (KBT)

226p

K3 Business Technology supplies enterprise software with a particular focus on retail and manufacturing. K3 has developed its own IP that enhances Microsoft Dynamics AX software and gives K3 a unique selling proposition when competing for clients. The initial focus for the Microsoft AX\IS product is the fashion retail sector but additional versions are being developed for other sectors.

The key to improving profitability is for K3 to sell more of its own IP, which currently accounts for 18% of group revenues. Gross margins on K3 IP were 67.8% last year, while the overall gross margin was 54.1%.

K3’s strong relationship with Microsoft puts it in a position where it could grow significantly outside of the UK. K3 is one of 25 companies around the world that is a member of Microsoft's Global Independent Software Vendor programme and it is generating increasing revenues from its Microsoft Dynamics AX business, with international sales starting to be made via resellers.

K3 also sells non-Microsoft software, such as SYSPRO, to the manufacturing sector. As K3 wins additional software business it also cross-sells its hosting services, which adds to the recurring revenues base.

In the six months to December 2014, revenues grew from £34.5 million to £41.7 million, while underlying pre-tax profit has improved from £3.16 millon to £3.55 million. Software licence sales were one-third higher. Additional managed hosting business will benefit the second half.

Net debt rose to £12.1 million at the end of 2014 due to high activity levels in December. Cash generation could reduce that net debt figure to less than £7 million by the end of June 2016. The dividend is 1.3p a share and this should increase steadily.

K3 is still on course to improve its full year profit from £6.6 million to £7.6 million in 2014-15 and then to £9.6 million next year when the benefits from the increased cost base start to show through. These forecasts could prove conservative if international sales grow faster.

The shares are trading on just over eight times prospective 2015-16 earnings. Other software companies of a similar size are more likely to be on a rating in the teens.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

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