15 January 2015
By Maynard Paton
Legendary American investor Peter Lynch was always very keen on dull small-caps with dull names and dull operations. His theory was that such obscure businesses would not attract much industry competition or market enthusiasm, and so would be better investments for patient investors.
Electronic Data Processing (EDP) certainly has the dull name and the dull operations, but sadly its dull financial history has meant its share price has also been, well, rather dull.
But don’t stop reading just yet!
…because this small-cap dullard intends to pay a 5p dividend in future years — and shareholders such as me remain in line to collect a not-so-dull 8%-plus income.
Additional excitement comes in the form of EDP’s cost-saving measures, which I reckon could support an underlying P/E of just 6.
In fact, if you mix in contracted revenues, surplus assets, upfront customer payments — plus an intriguing shareholder register — then all of a sudden this £8m software supplier to builders merchants might not be that dull after all.
Well, the possible excitement has already tempted me… I first bought EDP during September 2012 and last bought during April 2013, paying as high as 62p and as low as 49p. My average buy price is 55p and compares to a recent mid-price of 66p.
At A Glance
- Developer of operational software for distributors and wholesalers
- Accounts showcase asset-strong balance sheet and worthwhile cash flow
- Cost-cutting supports generous dividend intention and possible lowly P/E
- Major shareholders may ‘engage’ with management to enhance returns
Shareholders are still waiting for the Quantum leap
Electronic Data Processing (EDP) was established during 1965 as a supplier of early mainframe computer services. The firm ventured into software development in the 1970s and launched a program designed specifically for distributors and wholesalers in the 1980s.
Some 30 years on, EDP continues to service builders merchants, electrical wholesalers and food distributors with a product called Quantum.
EDP’s website has all the details, but from what I can gather, the Quantum system looks quite comprehensive with its telesales support, stock-level management, order processes and bookkeeping controls.
EDP broadened its offering slightly in 2006 by acquiring Vecta, a sales monitoring and reporting application used by a wide variety of smaller companies. Vecta’s website has more details of this product.
One attraction to EDP is its software is sold to customers through agreements lasting up to five years. The latest annual results indicated 80% of total revenues came from “contracted recurring” sales, which I trust can provide some predictability to future progress.
EDP floated in 1985 and, as far as my 15-year archives go, the group’s heyday occurred during 1999 when sales surpassed £10m and operating profits hit £1.3m. Losses were then reported during the dotcom crash and profits have generally bobbed around the £0.6m mark ever since.
The shares, which almost touched 400p during the tech madness of early 2000, have since been ‘rangebound’ between 40p and 80p for the last 14 years. However, returns have been bolstered by the occasional disposal from what was a substantial freehold estate.
I did say the financial track record was dull
This table summarises EDP’s stagnant financial history since the banking crash:
|Year to 30 September||2010||2011||2012||2013||2014|
|Operating profit (£k)||553||506||688||709||355|
|Finance income (£k)||31||55||78||85||46|
|Other items (£k)||-||335||(849)||-||-|
|Pre-tax profit (£k)||584||896||(83)||794||401|
|Earnings per share (p)||3.38||5.69||(0.45)||4.68||3.21|
|Dividend per share (p)||2.71||2.71||2.71||2.00||2.00|
|Special dividend per share (p)||-||-||-||5.00||3.00|
Issued last month, EDP’s results for 2014 were not great.
Annual sales fell nearly 6% due to “delays to a number of discrete customer orders” during the first half, although the top line thankfully returned to “more normal levels” in the second half. Nonetheless, the revenue shortfall did cause a substantial profit reduction.
All told, the 2014 statement was not exactly brimming with confidence. These choice quotes will keep a lid on near-term expectations (my bold):
“Whilst Quantum provides an excellent choice for the majority of the existing users of our legacy applications it is unrealistic to expect that all of them will migrate. We therefore expect to see higher ‘churn’ of customers in coming years than has traditionally been the case.“
“We are continuing to see keen price competition in the markets for both Quantum VS and Vecta.”
“We reported at the half year that one of our major customers acquired a competitor software business. They have recently completed their transition to that business’s product which will impact our revenues in the current financial year by approximately £300,000.”
Another disappointment was news that a protracted and substantial property sale had fallen apart.
Still, the overall outlook wasn’t exactly terminal:
“We have a strong product and services offering, a robust business model and considerable financial strength which will enable us to meet the challenges we will face in the forthcoming year. Having strengthened our sales team we expect to be well positioned to take advantage of those new business opportunities which do arise.”
Plus, there are cost savings to be made.
“We have identified annual cost savings (after strengthening our new business sales team) within the business amounting to £200,000 which have already been implemented after the period end. We expect to achieve further annual cost savings of circa £75,000 in 12 to 24 months’ time as we reduce the property costs associated with operating our current satellite office locations.”
However, by far the most reassuring part of the results was the intention to maintain the annual dividend at a generous 5p per share for “future years”.
The Buffett boys from Boyles have bought big and bold
The dividend is a fascinating feature of EDP.
Stuck at 2.713p per share for six years, the total payout suddenly jumped to 7p for 2013, dropped to 5p for 2014 and, as I say, should be maintained at 5p for 2015 and beyond.
Those 7p and 5p payments included special dividends, and I suspect a trio of North American shareholders have applied some polite pressure on EDP to improve their (and my!) returns.
This table lists the three institutions involved and their latest shareholdings:
|Boyles Asset Management||2,136,000||17.05|
|Ewing Morris & Co||649,855||5.19|
Details on all three investors are scant, but the website of Boyles does claim its fund is run on the principles of the Warren Buffett Partnerships of the 1950s and 1960s. Notably, one of the managers from Boyles published this insightful recap of its EDP investment:
“In the prior fund we managed, we owned a small UK software company named Electronic Data Processing (LSE: EDP). The company is small and its stock relatively illiquid. With our increased capital base at Boyles, we were unsure if we’d be able to meaningfully participate in a company that we believed was materially mispriced in the marketplace. When we began operations at Boyles, one of your intrepid managing partners began cold-calling some of EDP’s large stockholders, which were primarily listed trusts in the UK that operate like closed-end funds. One such owner of a large block was an entity with nearly £525 million in equity. When it was clear that the chief investment officer of that organization knew very little about the current circumstances surrounding its £1.11 million position in EDP—representing a mere 0.21% of the organization’s equity—the conversation shifted to one about Boyles acquiring the firm’s stake. It was agreed that two days later Boyles would have a bid prepared.
During this period the stock had traded as high as 64p per share and was generally in a range of 60p to 64p. The potential seller recommended to us that the deal be done at the mid-point of the bid/ask at the time or perhaps even higher than the ask, given the large nature of the block. After we indicated our bid was 55p we received a verbal accosting about our unreasonableness, our poor conduct, and our general approach to dealmaking. After we reiterated that it was our best and final offer, the conversation came to an abrupt close. The story naturally didn’t finish there, as just 24 hours later the firm came back to us “with their tail between their legs” and asked if the offer was still on the table. We closed the block transaction at 55p later that week.”
After that, I get the impression Boyles will not be afraid of engaging with EDP.
Indeed, just ten days after Boyles first notified the market of a disclosable holding, EDP declared the first of those two special dividends. Coincidence? I am not so sure.
Nor am I so sure it is a coincidence that Ewing Morris and Oleson Value have since cropped up on the shareholder register.
You see, I am convinced the only real way these two North American funds discovered what is an obscure sub-£10m UK share was from coat-tailing Boyles.
As such, I’m hopeful there is an informal ‘concert party’ at play here that’s prepared to kick up a fuss to enhance shareholder returns.
Further evidence of potential activity going on behind the scenes involves some recent management changes.
A week after those disappointing 2014 results, EDP announced its veteran Sales Director was stepping down from the board in order to “concentrate solely on the development of the Quantum business”. The group also confirmed the forthcoming retirement of another long-time executive.
It certainly crossed my mind that a board re-jig was needed to help revive sales and profits.
This must be the only investment where
I own more shares than the chief exec
By far the most prominent board member within EDP is Sir Michael Heller.
For one thing, he must be among the market’s longest-serving directors — he has been an EDP board fixture since 1965! He’s also a substantial EDP shareholder with a 21%/£1.7m stake.
Sir Michael is the executive chairman of London & Associated Properties, a quoted property group that has unfortunately struggled since the banking crash. Frustrated investors in London & Associated may not be surprised to learn Sir Michael has not fared too well with EDP’s property of late either.
In particular, EDP had to write down some freeholds by a third during 2012 — and a £1.4m sale agreed back then was eventually called off last year. Just so you know, Sir Michael’s non-exec counterpart at EDP is family member Andrew Heller.
There’s plenty of board tenure among EDP’s somewhat ordinary executives.
Julian Wassell became chief executive in 2007 following a ten-year stint as finance director, while fellow executive Chris Spicer joined the board back in 2001. Finance director James Storey was appointed in 2010.
What the executives are lacking, however, are meaningful shareholdings. EDP’s executive trio own just 21,000 shares — equivalent to £13,860 at 66p. Even I own more than that. Management’s options, however, run to 4% of the share count.
Basic pay looks acceptable, and I see total executive bonuses are allocated from a flat 10% of adjusted operating profits each year. The downside of such flat-rate schemes is that a bonus will be paid regardless of whether profits go up or down, but at least outside investors know exactly what to expect each year.
(Something I will study in the upcoming annual report is whether that 10% bonus pool will be reduced following the aforementioned board changes.)
Perhaps the most intriguing event involving this unremarkable board was its attempt to launch a management buy-out. Early-stage discussions were revealed in July 2008, but within six months the banking crash had scuppered any potential deal. Still, I suppose it is possible the board could one day dust off the MBO plan.
Any potential buy-out plan is made easier
because EDP carries lots of cash and no debt
At the last count cash was £5m, although the surplus cash figure I use for valuation purposes is £3m after making an allowance for deferred income (upfront customer payments) of almost £2m.
Also carried on the balance sheet are surplus freehold properties with a £1.7m book value.
Tot up the cash and surplus freeholds and you get £4.7m — representing more than 50% of the £8.2m market cap!
Another plus point is cash flow, which has helped the overall cash position improve by more than £2m during the last five years:
|Year to 30 September||2010||2011||2012||2013||2014|
|Operating profit (£k)||553||506||688||709||355|
|Depreciation and amortisation (£k)||368||371||371||351||374|
|Cash capital expenditure (£k)||(199)||(357)||(291)||(359)||(336)|
|Working-capital movement (£k)||(173)||189||(45)||(279)||(541)|
|Net cash (£k)||2,811||5,149||5,648||5,667||4,984|
Similar to Getech, cash capital expenditure is reassuringly covered by the depreciation and amortisation charged to headline earnings.
Working-capital movements do not look too troubling either, with the outflow of cash reported for 2014 due (I think) to lower upfront customer payments following the aforementioned loss of a major client.
Elsewhere in the figures, there’s a pension-scheme liability of almost £2m — although EDP does claim “the most recent triennial valuation…showed a small surplus on an ongoing funding basis.”
I won’t bore you with the finer details, but essentially the difference is due to accounting rules ignoring the future payouts of the scheme’s with-profits insurance policy. For now I am going with the “small surplus” and therefore ignoring the scheme for valuation purposes, but I do need to study EDP’s forthcoming annual report to confirm what exactly is going on.
I will also need to check the annual report to understand more about the group’s tax charge. December’s preliminary results revealed a tax refund due to R&D tax credits and, similar to Getech, future credits could significantly bolster reported earnings.
Something EDP should work on is its operating margin. Profitability on average comes in at about 10% of sales, although I’ve seen many other quoted software firms enjoy margins of 15% or more.
The main drag on margins is staff costs. Though EDP has commendably cut staff numbers over time, the average employee cost has increased and the total payment to staff remains at around 50% of revenue:
|Year to 30 September||2010||2011||2012||2013||2014|
|Staff numbers||76||73||68||70||(to be disclosed)|
|Staff cost (£k)||2,917||2,949||2,976||3,100||(to be disclosed)|
|Sales per staff (£)||73,421||76,712||85,368||83,243||-|
|Staff costs/sales (%)||52.3||52.7||51.3||53.2||-|
The 2013 annual report showed sales and admin staff at 18, versus a hefty 52 involved in development and support. But December’s preliminary results did reveal the sales teams had been “strengthened”, which I trust can help turnover advance and margins improve.
So is that 5p dividend and 8%-plus income actually possible?
The obvious value attraction is based on EDP’s intention to keep the dividend at 5p per share. A 66p share price thus gives an 8%-plus income.
But is that 5p payout sustainable when 2014 earnings were 3.21p per share? Well, the aforementioned annual cost savings should help earnings get back towards covering the payment.
Here’s how I think operating profits could look next year:
|Year to 30 September 2015||(£k)||Calculated?|
|Sales||5,772||'Normal' sales from H2 2014 doubled up.|
|Less loss of major customer||(300)||As per 2014 results statement|
|Less cost of sales||(438)||92% gross margin as per 2007-2014|
|Less operating expenses||(4,719)||As per 2014 results|
However, add back a whole bunch of savings mentioned in the 2014 results to that £315k…
- Post-year-end cost savings of £200k;
- Future cost savings of £75k;
- Freehold-related savings of £87k, and;
- A one-off 2014 pension cost of £60k
…and I reckon total operating profits might rebound to £737k.
After standard 20% tax, my sums suggest earnings could revive to 4.71p per share. But if the R&D tax credits ensure no tax is payable (as they did for 2014), then earnings could be 5.88p per share — and would cover the dividend.
Either way, I feel there is a deep margin of safety with the 66p shares supporting a £8.2m mkt cap…
Because subtracting the group’s £4.7m of surplus cash and freeholds, EDP’s enterprise value is £3.5m, or 28p per share. And divide that by my 4.71p per share earnings guess, the P/E for the underlying business comes to just 6.
I can’t believe it has taken 50 years to get to £5m
I suppose the greatest risk to this investment is the business continues to remain very dull and simply stagnates. I mean, it has been going since 1965 and yet here we are — 50 years later — with revenues of only £5m!
So EDP is hardly a sparkling long-term performer and there’s no clear sign yet of any significant business upturn. Indeed, if the top-line continues to tread water, I guess that range-bound share price may well extend for some time to come.
Another pitfall for me is EDP wasting its cash on duff acquisitions. The latest results said “We will review future dividends according to the acquisition opportunities that arise…”, which leaves the door open to reduce that 5p payment.
That said, EDP has regularly suggested it’s been looking for purchases yet the last one that went ahead occurred way back in 2006. The one before that occurred in 2000.
Something to consider from those two acquisitions is that they came with aggregate annual sales of £5.4m — that is, just shy of the sales recorded for 2014. That goes to show how EDP’s other operations have dwindled away over time.
I wonder if this share is too dull to excite Peter Lynch?
Yes, EDP is a dull company with a dull name – but the track record is also dull and as a result, so is the long-term share price. Still, I’m pleased I’ve managed to eke out a respectable return during my time as a shareholder with the help of those special dividends.
Dull it may be, but the business isn’t actually all that bad. It enjoys recurring income and good cash flow, and I am convinced the asset-flush balance sheet can perhaps support a bid approach.
After all, the directors themselves once considered a buy-out, and a former customer has just bought a rival supplier. And you never know, those three North American funds might become restless for some corporate action.
Indeed, I am sure those funds have already engaged EDP about the dividend and I hope they can influence developments further for small-time players such as me. The shares do look undervalued, assuming those cost-cuts come through.
For now though, I’m trusting EDP’s enhanced sales team and those cost savings can get profits back on track and support my 8%-plus income.
Finally, whether I will ever add to my portfolio’s 3% holding is a good question to which I do not have a firm answer. I would prefer my new money to go into a more obviously successful business, but I feel this dullard does have merit at 66p.
Until next time, I wish you happy and profitable investing!
Disclosure: Maynard owns shares in Electronic Data Processing.