Paul Hill, one of Britain’s most successful investors, suggests a share for the brave. This week: an accounting firm with a chequered past but a potentially bright future.
Gamble of the week:Tenon (Aim, TNO: 20.5p)
Tenon is one of the UK’s top ten accounting firms and a leading provider of financial services to owner-managed companies, with turnovers of £2m-£20m. This is a sector often neglected by the big four accounting firms, such as PriceWaterhouseCoopers. Tenon’s core activities are tax advice, audit, corporate recovery and mergers and acquisitions, making it a one-stop shop for its clients.
However, Tenon has had a very chequered past. Five years ago, it set about buying a plethora of smaller accountancy firms and bolting them together. The shares surged to 150p in anticipation of bumper profits. Unfortunately, the strategy backfired, as insurmountable cultural differences arose while attempting to integrate the acquisitions. Tenon was forced into taking a series of heavy restructuring charges. Since then, the company has been far more focused – but consistent, profitable growth has still proved elusive.
On 13 January 2006, Tenon’s shares surged 20% to 30p after the board announced the CEO and financial director were considering making an offer for the group. This approach flushed out a number of other interested buyers. No takeover has since been agreed, which implies that a transaction is off the cards. If so, I suspect the board couldn’t agree with the management buyout team on an exit price for the shareholders. At around 25p, it would appear there are several firms interested in taking Tenon private. In my opinion, this puts a floor on the share price. Tenon reported sales and earnings per share (EPS) from continuing activities of £52m and 0.8p respectively for the six months to December 2005. Encouragingly, sales grew by 10%, although profits slipped due to higher staff costs. Management initiated an efficiency drive and have, they say, “significantly reduced the cost base going forward”. If this is the case, then there must be every chance of lifting operating margins from 6% to historical levels of 10%-plus.
Assuming this happens, annualised EPS would hit around 3p-plus per diluted share without any change in revenues. Vantis, a competitor, achieves profit margins of 16%, so 10% should be achievable in this high-margin industry. Management also said that they have won a number of major new clients since the beginning of 2006. My guess is that the City has become tired of all the past disappointments, which has led to the share-price’s demise. At 260p, Vantis’ shares trade on a 2006 p/e of 15.5 times, which gives an indication of the potential upside for Tenon if it can get its act together. With the right management team and an appropriate cost structure, I see Tenon achieving an EPS of 3p, which, on a conservative rating of ten, would push the share price to 30p.
I suspect the main reason for the lack of takeover news has been that the board believes the sale price should be higher than 30p, while the management buyout team, on the other hand, isn’t prepared to pay for the promise of jam tomorrow. Hence the price gap, particularly as debt levels at £27m are already high, leaving less scope for further gearing.
But at 20.5p, Tenon does look materially undervalued, assuming the latest efficiency drive bears fruit. I see a 50% upside in the share price with only limited downside from current levels.
Recommendation: BUY at 20.5p
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