Three AIM shares geared up for success

Many growth companies on AIM are trading at a premium rating and it can be difficult to discern value at their current share prices. Investors need to look elsewhere for greater value, and this can come from companies that have not yet reached profitability.

Companies with a relatively high proportion of fixed costs can take some time to achieve a profit, but when they do a large chunk of their revenue can fall straight through to profit in the future. If the company has gained momentum, then the profit can increase rapidly over the coming years.

These type of companies have a fixed cost overhead base that does not need significant increases in costs as a company grows. It also helps if the gross margins of the business are high.

A past example of how this operational gearing can work is woundcare company Advanced Medical Solutions (AMS).

AMS was launched in 1991 and floated (under a different name) on the USM in 1994 and moved to the Main Market in 1996. In November 1999, AMS raised £7 million through a 16-for-31 rights issue at 22p a share. AMS moved to AIM on 30 April 2002. At that point, £2.2 million was raised at 8.5p a share. To put that in perspective, in 2016 the underlying earnings per share were 7.66p.

The share price was around the level of the 2002 fundraising at the beginning of 2005, which was the year AMS moved into profit. In 2005, revenues were just over double the 2000 level at £12.9 million and the pre-tax profit was £276,000. The reported 2016 profit was more than £19 million on revenues of £82.6 million.

To make it clear, not all of this growth is organic, but the move into profit made it possible to make significant acquisitions. AMS is one of the top 40 companies on AIM and it is trading on around 40 times earnings.

Don’t ignore unpopular stocks

The important thing to understand about AMS is that many investors were cautious about whether it would move into profit, and if it did, when it was going to happen. The fact that the share price had peaked at above 300p during 1997 indicates that there were a lot of disappointed investors who were still sceptical as AMS moved towards profitability. It was not until near the end of 2006 that there was a concerted re-rating of the shares and it was this year that the share price moved above 300p again.

This shows that just because a company is out of favour, and one of the smaller companies on the market, it does not mean that it cannot be successful in the future.

Boku Inc (BOKU), which floated on AIM at the beginning of this week, is a good example of how operational gearing could lead to rapid profit growth if the business achieves expectations.

Boku develops technology which enables people to pay for services via their mobile. This is an international business with the technology used by the likes of Apple and Google.

An $8.8 million operating loss on revenues of $21.7 million is forecast for 2017. A small rise in gross margin is anticipated by 2020, but overheads are expected to be barely higher at $26.3 million. This means that the forecast 2020 revenues of $49.1 million are expected to generate a $15.9 million operating profit, so nearly all the growth in revenues falls through to profit. That is highly unusual but provides a clear example of how operational gearing works.

The problem is that the valuation already assumes much of this profit growth. The share price has already moved from the placing price of 59p a share, when Boku was valued at £125 million, to 81p a share. Boku raised £15 million from the flotation, but existing shareholders sold £30 million worth of shares – not always a good sign.

There is no guarantee that these forecasts will be correct. Any forecasts at the time of a flotation need to be treated with caution. This is also a fast-moving sector so things can change over three years.

A digital winner?

There are companies more like AMS prior to profitability when the share price does not reflect confidence in a sharp move into profit, and subsequent profit growth.

An example of a business that is progressing towards profit, although the expectation of that profit has been moving further away, is 7digital (7DIG). The company provides the technology that enables streaming of audio and video content by its radio, online, social media and telecoms clients.

7digital had been expected to make a profit this year, but it was pushed out to next year. This has been a consistent element of the company’s history since the core business reversed into UBC in 2014, and even before then. The reversal valued 7digital at £16.5 million and it was partly financed with a placing at 27p a share.

The current market capitalisation of the combined company is less than the deal value and even more cash has been raised since then. The share price is around one-fifth of that reversal placing price.

Part of the delay in the move to profit can be put down to the decline in revenues from download customers as well as slower than hoped for growth in streaming revenues.

Yet, this is an enormous market because streaming surpassed CD sales in 2015. The acquisitions of Snowite and 24/7 Entertainment, helped to boost revenues and move them nearer to breakeven level. The focus on larger, more financially stable customers helps to increase the quality of earnings.

Revenues are expected to rise from £19.1 million to £24.9 million in 2018 and this is expected to enable an underlying loss of £2.9 million, after a step change in costs during 2017, turn into an underlying pre-tax profit of £2.1 million. That £5 million turnaround is based on an improvement in gross margin on the higher revenues and holding back overheads so they barely increase. Cash should be generated from operations in 2019 but the need for additional debt should be limited.

At the current share price, 7digital is trading on less than five times forecast earnings for 2018, and that falls to three on the 2019 forecast. It is understandable that investors are cautious because of the past disappointments.

It is sensible to discount the forecasts, but the current rating appears to be too pessimistic, particularly if 7digital can start generating cash so that no more share issues are required for working capital.

Betting on profit turnaround

Loss-making online gaming software provider GAN (GAN) is also reaching a point where it could move into profit in the next couple of years.

GAN will benefit from the decision by the State of Pennsylvania to make real money online gaming legal. GAN already has a full US gaming licence from New Jersey, and the other states where online gaming is legal are Nevada and Delaware. That accounts for around one-tenth of the US population. Michigan and New York are thought to be considering legalising online gaming.

There are two clients of real money gaming in New Jersey and a further 10 in Europe. GAN has signed up 13 US casino operators to its simulated gaming service, which is used by casinos as a promotional tool. GAN says that the GameSTACK real money gaming system is deployed with Parx Casino in readiness for launch in Pennsylvania

GAN generates its income from a revenue share with its casino operator customers. There is not just a relatively fixed cost base but, in 2016, that underlying cost base was reduced from £9 million to £8.7 million and there was a further decline in the first half of 2017.

GAN is still expected to make a pre-tax loss this year and next year based on forecasts prior to the Pennsylvania announcement. These forecasts could be upgraded if more casinos sign up for online gaming.

One thing to be aware of is that GAN is likely to seek a US listing in the next year. That would probably involve a switch from AIM to the new listing rather than retaining a UK quotation. It makes sense for the business to be listed in the US, which is likely to be its principal market and it could generate a bounce for the share price. 

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.