Stockwatch: 6% yield supports capital upside

What really drives valuation: earnings, cash flow or yield? The question is pertinent for AIM-listed Redde, a £450 million accident management and legal services group. Its shares, at 160p, trade on a forward price/earnings (PE) ratio of over 17 - that looks high enough relative to forecasts for earnings to slow - while its cash flow strengths fund a prospective dividend yield of over 6%.

Stocks get characterised as "growth" where a high PE multiple anticipates growth, versus "value" where lower pricing exacts enough yield to compensate for lack of growth appeal. But price should reflect the net present value of all capital gains and dividends alike.

So, after dropping from 210p since the end of last year, does Redde now offer value?

Fundamentals convey a sound business

Perception-wise, such an AIM-listed business has had to contend with the scandal of Quindell plc (now Watchstone), albeit last year, when Redde shares more than doubled. It is, likewise, acquisitive, but lacks signs of aggressive accounting; and while goodwill/intangibles represents 68% of net assets, the balance sheet is overall respectable.

The business did get into difficulties under its old moniker of Helphire plc, Redde implying restoration in Latin. But the table shows a quality turnaround having been achieved with no big gap between statutory and normalised figures, for exceptional charges and the like.

The trend in cash flow per share is generally ahead of earnings, a good sign of cash conversion and supporting shareholder payouts. Admittedly, Redde's dividend record is early stage, but if recession strikes it won't put such a halt to driving; so accidents and the need for replacement vehicles and legal services are essential.

Interim results to end-December 2015 benefited from the "immediately earnings-enhancing" £43 million acquisition of FMG helping adjusted pre-tax profit jump 51% to £17.3 million on turnover up 35% to £165.2 million, while adjusted earnings per share (EPS) rose 13.7% to 4.9p and the interim dividend by 12.5% to 4.5p.

Otherwise, the like-for-like growth rate in credit hire cases was 8.8%, perfectly decent. Management proclaims "growth opportunities" and "the group is increasingly being seen as a leading partner of choice within our industry".

Policy to substantially distribute earnings

The FMG acquisition was said also to "support the group's dividend policy of distributing as much of the group's profits by way of dividend as it can..." with the balance sheet offering scope for this.

Net debt at end-2015 had risen to £9.1 million from £2.9 million with a lower cash balance at that time; however, finance costs shaved only about 1% off operating profit. Debtor days, i.e. how long it takes to collect cash from those owing, reduced from 108 in 2014 to 100 at mid-June 2015 and was 95 at end-February.

Less inspiring for the board's sense of capital growth realities: an end-February share incentive plan involved a modest EPS target of 10.0p in the financial year to June 2018, albeit with a second tranche requiring total shareholder return in the upper quartile of the AIM 100 index.

That implies equity-based bonuses for achieving only single-figure earnings growth considering forecasts for 9.1p and 9.5p (see table) up to June 2017. It's as if the board has conveyed modest expectations and growth investors understandably sold.

Sentiment affected by action against whiplash payouts

The stock's five-month downturn follows last November's Autumn Statement unveiling plans to ban cash payouts for whiplash claims, which have added an average £90 to motor insurance policies.

It's unclear how far this would go - for example, a consultation process is meant to eliminate fraudster claimants/firms without compromising those genuine - but in any case this area contributes less than 2.5% of Redde's revenue. Management has not seen a need to be defensive on the matter as if genuinely responsible for damaging value, just that it coincides with the stock's drop.

A 28 April trading update has cited "continued strong trading volumes for the third quarter of the financial year...operating profits are continuing to exceed the board's original expectations." So the stock's continued fall - testing 150p earlier this week - looks odd on fundamentals.

A test of technical analysis lies ahead

For what charts are worth, a support level of 160p-165p has appeared to develop on a one-year view, dipping below which re-defines it as a resistance level the longer this pertains.

The irony is, this could happen in response to some global event unsettling equities that has little direct effect on a UK business providing vehicle accident management and legal services. A bounce to 160p this week looks positive for encouraging more chart-based buyers, if sustained.

Meanwhile the five-year chart shows an exceptionally strong run that has entered a period of volatile consolidation. Technical analysis, therefore, implies reasons to be cautious, that could have deterred buyers, and it was not good how the stock drifted after a bullish update. But that changes if 160-165p is breached and sustained.

Fundamentals-oriented investors may prefer to exploit such folklore to accumulate stock. Mind, there is unlikely to be key news beyond an end-June pre-close update and prelims in early September; albeit making the stock interesting to buy on these bouts of weakness, especially if the summer portends further jitters over the economic environment.

Among institutions, Woodford Investment Management own 19.9%, alongside Invesco with 28.4% and insurer Aviva on the register with 13.4%. They have not been selling and are unlikely bothered by charts.

For more information see their website.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. 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.