Microgen: High Margins And Cash Rich But Not For Me

24 February 2015
By Maynard Paton

Today I’m continuing my hunt for Watch List shares with a look at Microgen (MCGN).

Here are the initial attractions that prompted this research:

High margins: 30% reported for 2013
Cash rich: Latest update reported £25m net cash
Veteran boss: Executive chairman appointed during 1998 and boasts £7m shareholding

As usual, I’m applying a question-and-answer template to help me pinpoint companies that match the criteria set out in How I Invest. I’m looking for as many Yes answers as possible.

Activity: Developer of financial-reporting, data-processing and wealth-management software
Website: www.microgen.com
Share price: 125p
Shares in issue: 74,610,669
Market capitalisation: £93m

Does the business boast a respectable track record?

Good question.

Executive chairman Martyn Ratcliffe took charge in 1998 and operating profits then surged from £1m to £9m between 1999 and 2013. Not bad.

But MCGN’s track record is messy, featuring substantial acquisitions (see later) and various disposals. Sales were £31m in 1999… but were £30m in 2013. Notably, the dividend went missing between 2001 and 2005.

Plus… MCGN’s history is blighted by exceptional items — something ‘one-off’ was reported every year between 2002 and 2009:

Year to 31 December	2002	2003	2004	2005	2006	2007	2008	2009
Operating profit (£k)	2,032	2,254	4,992	7,016	4,701	5,945	4,134	5,944
Exceptional and other items (£k)	(1,495)	(2,667)	(1,633)	(1,686)	(14,528)	(1,976)	327	(3,244)

It’s difficult to tell which ‘one-offs’ relate to operations acquired before the arrival of Mr Ratcliffe — and which ones are really his responsibility.

Progress since 2009 has been much more straightforward, albeit with profits stalling at £9m:

Year to 31 December	2009	2010	2011	2012	2013
Sales (£k)	29,060	33,669	38,776	32,318	29.824
Operating profit (£k)	5,944	8,093	9.599	9,131	9,069
Intangible amortisation (£k)	(391)	(255)	(117)	(118)	-
Exceptional and other items (£k)	(3,244)	-	-	-	(381)
Finance income (£k)	(36)	14	116	174	-
Pre-tax profit (£k)	2,273	7,852	9,598	9,187	8,688
Earnings per share (p)	1.5	7.7	8.9	8.5	7.9
Dividend per share (p)	2.3	3.0	3.3	3.3	3.3
Special dividend per share (p)	4.0	-	5.0	5.2	-

The special dividends are the particular highlight.

Has the business grown mostly without acquisition?

No.

The last balance sheet showed goodwill of £42m, while a substantial £56m was spent on eight separate business purchases between 2000 and 2005.

A trading update in January confirmed the evaluation of “numerous potential larger opportunities” during 2014, including Elektron (EKT)

MCGN confirmed the proposed EKT investment would have been between £12m and £18m — sizeable stuff. The approach was rebuffed by Elektron’s (seemingly untalented) board.

Has the business mostly self-funded its growth?

No.

The share count doubled between 1999 and 2005 as extra shares were issued to fund acquisitions.

Does the business possess an asset-strong balance sheet? 

Yes.

January’s update confirmed cash of £41m, which more than covered borrowings of £16m. However, the same update did reveal a potential £15m-£20m return of cash to shareholders. So net cash could soon be only £5m-£10m.

Something to consider: MCGN’s cash position is flattered by significant deferred income — that is, upfront customer payments for services yet to be delivered (typically via annual subscription fees). Deferred income was a substantial £15m at the end of 2013, so MCGN’s reported cash balances are far from being entirely ‘surplus to requirements’.

There are freeholds of £4m and no final-salary pension obligations.

Does the business convert profits into cash?

Yes, or at least it has in the last five years:

Year to 31 December	2009	2010	2011	2012	2013
Operating profit (£k)	5,944	8,093	9.599	9,131	9,069
Depreciation (£k)	841	649	739	788	790
Cash capital expenditure (£k)	(541)	(586)	(1,171)	(624)	(427)
Working-capital movement (£k)	1,929	2,391	2,089	368	(1,541)
Net cash (£k)	21,969	23,501	26,618	32,188	20,997
Cash dividends paid (p)	(5,372)	(2,084)	(6,645)	(2,691)	(7,016)
Purchase of own shares (p)	-	(6,288)	-	(146)	(10,269)

Good evidence of conservative accounting: i) depreciation generally covers cash capital expenditure, and; ii) no intangible expenditure — all software development written off as incurred.

Impressively, reported earnings during the last five years have been returned entirely to shareholders via dividends of £24m and buybacks of £17m (average buyback price: 111p).

Does the business enjoy a competitive advantage?

Very likely.

MCGN’s Financial Systems division — which supplies wealth-management software to institutions — enjoyed incredible 53% margins during 2013 (before central costs) and has reported 46%-plus margins since 2008.

Such high margins suggest a robust competitive advantage and pricing power over customers.

During 2013, £8m of total group profits of £9m were dependent on the Financial Systems operation.

Does the business produce a respectable return on equity?

Not sure.

The pre-exceptional return on average equity for 2013 was £7m/£60m = almost 12%. Not fantastic.

MCGN’s equity base is dominated by goodwill of £42m, which suggests acquisitions have dampened returns. Excluding goodwill, the return on average equity for 2013 comes to a majestic 33%. So, returns on future retained earnings could be very attractive — assuming no further acquisitions.

Does the business employ capable executives?

Good question.

The prime mover is the aforementioned Martyn Ratcliffe. He was appointed executive chairman during 1998 and MCGN’s messy-then-stable financial history is therefore all down to him.

Does the business employ good-value-for money executives?

Another good question.

Mr Ratcliffe currently enjoys a £275k annual wage… but works only 100 days a year at MCGN. A full 250-working-day year gives him an equivalent full-time salary of around £700k — very generous for a £9m-profit business.

Mr Ratcliffe’s other 150 working days each year are spent as executive chairman of Sagentia (SAG), where he’s on a further £275k per annum.

Something to consider: The number of board remuneration meetings at MCGN came to a mighty 10 in 2013 — and has always exceeded the number of board audit meetings since at least 2006. (There’s a similar bias at SAG.) It seems as if the directors do like to discuss pay rather than accounting — not great.

At least Mr Ratcliffe does not collect a bonus or receive pension contributions (at MCGN).

Does the business employ owner-orientated executives?

Yet another good question.

Mr Ratcliffe enjoys a decent 7%/£7m MCGN shareholding, which is largely unchanged since 2007.

But could he be more interested in SAG? Quite likely — his shareholding there comes to 34%/£17m.

Still, Mr Ratcliffe may have half an eye on MCGN. He owns 2.5 million options that come good in stages if the share price hits 200p, 250p and 300p before November 2018 (the share price is currently 125p.) Plus he must maintain his 7% ordinary shareholding to enjoy the option proceeds.

The aforementioned dividends and buybacks indicate a sensible use of excess cash in recent years.

Does the business enjoy reasonable growth prospects?

Not sure.

Sales at the mega-profitable Financial Systems division are slowly eroding — down from £19m to £15m between 2008 and 2013. Divisional sales down further within July’s interim results, too.

The Aptitude Software division — which develops financial-reporting and data-processing systems — has shown inconsistent revenue: £8m in 2008, £22m in 2011, £15m in 2013. Divisional contribution here currently lower due to spend on ‘Big Data’ development — July’s interims showed Aptitude profits falling from £1,505k to just £838k.

Mr Ratcliffe says: “Tangible results from the Aptitude investment programme will take time… Nevertheless, the new European and North American clients, together with the sales and product development activities, continue to provide exciting opportunities for the future.”

Does the share price stand a good chance of becoming a bargain?

Not sure.

Operating profits for the year to June 2014 were £8.3m. Less standard 20% tax gives earnings of £6.7m or 8.9p per share.

Cash of £41m less borrowings of £16m less deferred income of £15m gives possible surplus net cash of c£10m — about 12p per share.

Enterprise value at 125p/£93m is therefore 113p/£83m.

The P/E on my EV and EPS estimates comes to about 12-13.

That ratio is not an obvious bargain to me, especially given the limited sales/profit growth witnessed during the last few years and the extra investment in ‘Big Data’ currently hurting earnings.

Is it worth watching Microgen?

Probably not.

There are not many Yes answers above.

The Financial Systems division looks to be an appealing ‘cash cow’, while the Aptitude Software operation could one day become attractive — assuming all the ‘Big Data’ spend eventually brings in bumper sales. But there is no official guidance on how much will be spent and for how long. The risk is that prolonged investment could keep a lid on group profits for some time.

I’m unsure about Mr Ratcliffe. He seems to be a deal-maker and/or financial engineer — trying to make 2+2 = 5 from ongoing acquisitions, disposals, strategic reviews and buybacks. His heavy involvement in a fellow quoted small-cap is a major drawback for me. I much prefer my leaders to concentrate simply on building sales organically to produce more profits at just the one business.

All told, not a company for my portfolio.

Maynard Paton

Disclosure: Maynard does not own shares in Microgen.