Is a 17% drop in the AIM-listed shares of healthcare-led marketing services group Cello Group (CLL) worth buying into?
Capitalised at around £120 million, Cello has fallen over the last six months to a one-year low of 111.5p from the 130p range it sustained from mid-2017 to early 2018. That compares with the 40% slide seen over 14 months for FTSE 100 (UKX)-listed WPP (WPP), which tends to be a bellwether for marketing services.
WPP’s setbacks involve structural change, with multinational clients taking work in-house, whereas Cello’s main business supporting healthcare firms is strengthening.
I’ve covered this share since first drawing attention to it six years ago at 35p. In a sense it was a useful tuck-away, so now looks appropriate to re-examine.
After recovering somewhat to 126p before the 22 March prelims for 2017, the stock has dropped again.
The story is mixed because Cello has a consumer/digital marketing side that’s probably more cyclical and didn’t perform as well (albeit with lumpy revenues). On valuation, the PE rating has eased from 16 to 13 times – quite fairly perhaps.
Streamlining towards healthcare marketing services
Demographics, advances in medicine, expansion of private care and electoral demands on governments, combine to make healthcare-related services an attractive space.
Cello’s 2017 performance reflects this: reported gross profit (i.e. net fee income, the chief measure of an agency business) was up 10.6% to £102.5 million, which divides up as a 26.4% rise to £60.2 million for Cello Health, while Cello Signal (consumer/digital marketing) saw gross profit down 6.1% to £41 million.
Operating margins compare at roughly 18% for Health versus 10% for Signal, both slightly down as staff were added for expansion.
Two lumpy one-off contracts for Signal in 2016 resulted in tough comparatives, although “there has also been a more cautious approach by some UK clients in 2017, towards commissioning project work”.
The impact has been mitigated by taking out costs, e.g. consolidating all Scottish work from one office (hence a £1.5 million exceptional cost).
Normalising for currency translation in a year of a stronger dollar, and on a like-for-like basis, gross profit from Health rose 9.2% to £52.8 million but Signal was down 6.8% to £40.8 million.
It’s tempting to wonder if management should divest Signal and genuinely focus on Health, which could add to Cello’s long-term attractions as a bid target.
But there are existing synergies, with Signal “successfully migrating into a position to support Cello Health” e.g. its social media software being sold into the global healthcare market.
The company said: “Signal’s digital capability has a very specific role within Cello Group…. we are focusing on utilising its digital innovation to grow our health client base.”
However, as yet, Signal’s health-related activity has grown only to about 14% of its gross profit.
A plc name change to Cello Health Group underlines the healthcare emphasis, where “an increasingly integrated client offering is expanding reach within long-standing pharmaceutical customers”.
In terms of outlook, late 2017 bookings for 2018 work were strong, providing momentum into the new trading year.” A “substantial” number of new clients have been added in biotechnology, after acquisitions expanded the service offering.
So it’s a robust narrative, apparently less likely to warn in the short to medium term, even if there is an element of cyclical risk. Demand for marketing services dials into firms’ inclination to invest, which relates to the general economy.
With 51% of gross profit UK-derived, Cello can’t shake off any slowdown here. The US represents 29.5% of total gross profit and 45.1% for Cello Health.
Valuation tends to emphasise earnings
This being a smaller company not without cyclical risks, the board is wisely keeping earnings cover for the dividend over two times. Even so, a prospective yield just shy of 3% won’t tempt income buyers, possibly contributing to the stock’s fall.
An improvement in trade receivables and year-end cash has helped the balance sheet move into positive net tangible assets of 8.3p per share, although goodwill dominates it after Cello acquired “people businesses”.
The cash flow track record (see table) is healthy, although after-tax operational cash flow is down 44% in the results.
Cello Group – financial summary Estimates year ended 31 Dec 2013 2014 2015 2016 2017 2018 Turnover (£ million) 160 170 157 165 169 IFRS3 pre-tax profit (£m) 5.5 3.8 5.0 -1.7 5.8 Normalised pre-tax profit (£m) 8.3 7.6 8.2 6.6 11.3 Operating margin (%) 5.6 4.7 5.5 4.2 IFRS3 earnings/share (p) 4.3 2.6 3.8 -2.9 4.1 Normalised earnings/share (p) 7.7 7.0 7.3 6.4 8.4 Earnings per share growth (%) 1.7 8.7 3.8 -12.7 Price/earnings multiple (x) Historic annual average P/E (x) 11.2 13.0 13.0 19.0 15.0 Cash flow/share (p) 10.7 2.3 7.8 5.3 Capex/share (p) 1.6 1.7 1.4 2.6 Dividend per share (p) 2.0 3.1 2.6 3.0 3.5 3.8 Dividend yield (%) 3.1 3.4 Covered by earnings (x) 4.0 2.4 2.9 2.2 3.3 Net tangible assets per share (p) -5.1 -6.4 -4.6 -4.6 8.3
Source: Company REFS Past performance is not a guide to future performance
Thus investors are left looking mainly to earnings per share, where figures are mixed according to headline/basic definitions. Databases such as Company REFS are taking their own view, a bit lower than the company’s.
This relates to what profits are justifiably “normal”. Under note 3 to Cello’s accounts, “non-headline administrative costs” include £1.9 million for restructuring, £2.7 million for start-ups, £1.4 million for acquisition-related employee remuneration and £430,000 for share options.
Such costs don’t relate to profitability of the underlying business so it’s fair to separate them; but some investors would say remuneration is a cost to owners.
While headline pre-tax profit rose 11.9% to £11.4 million, dilution following a £14.2 million net placing at 97p/share in January 2017 (to acquire Defined Healthcare Research, Inc and Cancer Progress LLC) meant headline earnings per share slipped 8.4% to 7.9p.
Again this is a glitch that while expected, made the results look a mixed bag. Anyway the brokers’ consensus for 2018 EPS near 8.5p seems fair enough, implying a forward PE near 13 times, versus 16 at January’s 134p share price high.
A figure of 13 actually equates with Cello’s annual average historic PE for 2015 and 2016, so the stock’s 2017 advance from 97p to 136p, averaging an historic PE of 19, could be seen as a small cap enjoying froth in a mature bull market. Bottom line: the rating looks about right.
£4.6 million deferred considerations versus £13.0 million cash
Shares in acquisitive companies can also drop if major deferred considerations lurk; are the reported figures a form of borrowing from the future, and are such liabilities manageable?
Cello’s have risen from £2.9 million at end-2016 but are amply covered by cash, so another placing is not required.
Debt mainly comprises £11.3 million longer-term, where finance costs were covered 17.2 times by operating profit, so the group is not exposed in the event of higher interest rates and a trading downturn. Despite a goodwill-weighted balance sheet, financially it’s strong.
There’s a decent spread of clients although with “no client greater than 10% of revenues at Cello Signal” a loss or two could conspire with a downturn to mean a profit warning, but that applies to many smaller plcs.
At 113p, Cello is not therefore an outright “buy”, traders may find livelier situations amid market volatility, but its investment rationale remains intact and underlying progress should enable fresh highs over 130p eventually.
A lack of short-term appeal is therefore useful. Add, or keep on the watch list if market jitters persist.
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