9th August 2022 10:02
Edmond Jackson from interactive investor
Following a grim warning from the UK central bank, companies analyst Edmond Jackson believes a stagflationary debt crisis is increasingly likely. If it happens, this stock could be one to own.
A key upshot of my macro piece last Friday was the risk of a stagflationary debt crisis, unless the Bank of England’s prediction for double-digit inflation and five consecutive quarters of UK slowdown is flawed.
While comparisons can be drawn with the 1970s – of recklessly excessive stimulus measures followed by an energy supply shock, hence high inflation – what differs is far higher public and private debt currently after central banks kept interest rates so low after the 2008 crisis.
If interest rates do now edge higher for a length of time, more indebted firms will face insolvency.
A key beneficiary, however, would be £230 million AIM-listed Begbies Traynor Group (LSE:BEG). While it has diversified to some extent by acquisitions, to mitigate cyclicality, a Google search on its local offices affirms the broad sense of it being an “insolvency practitioner”. The group appears to have a UK market share for such services moderately over 10%.
Last Friday, Begbies published its quarterly Red Flag Alert Report in respect of the 2022 second quarter.
This cited a like-for-like 37% increase in the number of UK businesses in critical financial distress, led by areas of consumer discretionary spending – bars and restaurants soaring 70% and general retailers by 48%. As if affirming the stock market’s cautious ratings of housebuilding and construction shares, construction-related distress leapt 36%.
It reflects relatively smaller unlisted companies, yet a knock-on effect within industries and the wider economy seems inevitable.
At least the number of companies overall in significant financial distress is up only 3% on the first quarter of 2022.
But with like-for-like county court judgments up 5% in the first half of 2022, as creditors tried to recover debts, distress is likely to grow.
Hopes for economic rebound after the Covid lockdowns have been dashed by ongoing supply chain issues, with the Ukraine war driving up raw material and energy costs while reducing business and consumer confidence.
There is a stark warning about how energy-intensive sectors such as manufacturing could become unviable as price caps are removed. “Business energy tariffs have at least trebled, and for many it will be much worse,” the company says.
I have previously drawn attention to Begbies as a ‘buy’ at 87p in December 2020 after interims to 31 October cited the biggest increase in UK financially distressed businesses since 2017.
While the stock had risen to 140p by May 2021, I nevertheless adjusted to ‘hold’, chiefly due to the challenge for valuation. Not only had this group been busily acquisitive, hence an aspect of deferred payments according to performance, but insolvencies often have a deferred element paid out of the administration process which may take years.
Remarkably, there were claims of a Roaring Twenties period ahead as people would let rip post-Covid.
I find it reflects the valuation challenge, how 15 months later this stock has not advanced more significantly given all the bad news manifesting for the UK economy.
Part of the concern may be that Begbies has diversified, for example, into property advisory and transaction services, which makes abundant sense given company administrations often have a property angle, but you can imagine an extended recession as likely also to slow demand.
Note two to the last annual accounts also shows how business recovery and financial advisory services are lumped together, which is fair enough for simplicity and given an extent of overlap. Begbies’ acquisitions strategy has for some years, however, sought to mitigate the sense of this stock as a recessionary play. That also makes it harder to gauge the extent that these newer services are compromised if the Bank of England’s forecast is realistic.
But I won’t quibble excessively as the business recovery and financial advisory side represents 74% of group revenue and 81% of operating profit (before shared and central costs).
This subjective interpretation of profit is, I believe, the chief reason the stock is only re-testing levels seen in mid-2008.
Annual results to 30 April 2022 were ahead of original expectations – adjusted pre-tax profit jumped 55% to £17.8 million on revenue up 31% at £110 million. This was significantly driven by acquisitions, however, with organic revenue growth a relatively modest 7%.
It was a very wide disparity from reported profit, which nearly doubled to just over £4.0 million, but seemingly high taxation meant a £0.5 million net loss. HMRC applying an apparent 67% tax rate by way of £2.7 million showed it viewed true profit as materially higher, and there was also £1.8 million deferred tax due to a tax rate change.
Where did true profit lie? The adjusted/normalised disparity was due to separating £8.3 million transaction costs (up from £6.5 million) plus £5.5 million amortisation of intangible assets due to acquisitions (up from £3.1 million).
See how the financial summary table shows this gap widening since the April 2020 year as acquisitions increased. While amortisation is a required accounting treatment, some investors may still question the charge being so material; likewise “transaction costs”.
Begbies Traynor Group – financial summary
year ended 30 Apr
Source: historic company REFS and company accounts
This is significant for discerning the true operating margin i.e. quality of business. Begbies proclaimed it rose from near 15% to 17% in the results, but on a reported earnings basis the trend has been modest single-digit percentages.
Within transaction costs lies “deemed remuneration” which reflects payments to business vendors to continue working – charged to Begbies’ income statement over time.
One way around this is to compare operating cash flow per share with adjusted/reported earnings per share (EPS) and is why I have included a longer-than-usual financial summary going back to 2015. This shows cash flow per share much stronger even than Begbies’ sense of adjusted EPS. But mind how note 9 to the April 2022 accounts shows the cash flow number boosted by £1.6 million share-based payments plus £2.3 million deemed remuneration.
A true sense of profit/earnings is arguably somewhere in between the adjusted and reported figures, which becomes tricky when discerning forecasts.
Consensus already exists for a substantial hike in net profit over £15 million for the current year and nearer £16 million to April 2023.
That, however, could reflect guidance from Begbies given to the company’s broker and assumes Begbies’ sense of adjusted earnings. On this basis, EPS of around 10p implies a forward price/earnings (PE) ratio of near 15x.
I am inclined to regard the valuation at around 148p a share as nearer 20x earnings as I do not accept the extent of adjustments.
Yet Begbies’ current rise could be said to be logical given the possible severity of recession ahead. A premium to earning power, despite only a circa 2.5% prospective yield, might be justified by scarcity of businesses prospering at all.
A charting view would likely regard 150p-plus as signalling a long-term break-out – the share price has attempted this a handful of times since September last year – hence a fresh “buy”.
Since I regard a stagflationary debt crisis as increasingly likely, I am going to overcome hesitancy on valuation to suggest on a modest scale: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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9th August 2022 10:02