Every week, analyst Paul Hill picks a gamble, a risky – but potentially very rewarding share – for brave investors. Prestigious clients, long-term contracts and a competitive advantage in the shape of a the ability to offer single, integrated services – so why does this IT services stock have such a poor rating?
Gamble of the week: Netstore (Aim:NES)
Netstore is a UK provider of managed and hosted IT services to medium-sized corporate and government customers. It employs roughly 200 staff, owns four data centres and is forecast to generate sales of £42.2m in the year ending June 2007. Its largest unit, managed services, accounts for 51% of turnover, of which 81% is recurring. Customer contracts typically last for three to five years and include prestigious clients, such as the Office of National Statistics, the Conservative Party, Nationwide Building Society and National Express. Its other two divisions are IT security (accounting for 31% of sales) and consultancy (18%).
Typically, Netstore will design and deploy a customer’s systems, then operate and host its IT infrastructure and software applications on an outsourced basis. This ability to offer a single, integrated service is thought by management to be a competitive advantage.
Strategically, Netstore is aiming to increase the proportion of its managed services revenue to 70%. This will not only improve earnings visibility, but also enhance profit margins – being a highly geared operator, as turnover increases, gross profit margins should rise from their present levels of 48%. Broker Panmure Gordon is predicting underlying earnings per share of 3.2p this year, rising to 3.8p next – putting the shares on a miserly p/e ratio of less than ten. Additionally, at the end of December, there was £1.5m of net funds and around £19m of unutilised tax losses on the balance sheet.
So what’s the reason for the company’s poor rating? Well, Netstore has suffered its fair share of knocks. Back in 2000, the stock traded as high as 160p, only to be hit by a painful recession shortly afterwards. Then, between November 2005 and July 2006, it lost three large contracts with Cisco, T&S Stores (now part of Tesco) and Liverpool City Council – these losses in aggregate reduced revenues by £2m per year. As a result, both the chief operating officer and chief executive resigned, leaving the co-founder, Paul Barry-Walsh, to take up the reins. He swiftly engineered a turnaround that is now starting to work. Sales have picked up and, encouragingly, new business signed up in the first half grew by an impressive 34% on the previous year. Furthermore, in December 2006, Netstore launched an audacious offer for ICM Computer, a disaster recovery specialist – although Netstore was duly outbid by Phoenix IT.
So far, so good, but what are the risks? Despite recent improvements in its core markets, the competition is still fierce from the likes of larger competitors, such as IBM, EDS, BT and numerous others. Nevertheless, the shares look cheap, especially as the board “does not expect any contract losses in the second half”, although it does expect “two large contract renewals shortly thereafter”.
Recommendation: BUY at 31p (market cap £45m)