Successful investment involves selling expensive stocks as much as identifying undervalued ones. The trick is to bank profits when fundamentals don’t justify racy valuations and avoid holding on in the vain hope that prices may go higher. Take this stock:
Turkey of the week: Axon Group (AXO), tipped as a BUY by ABN Amro
Axon is one of the world’s top-ten SAP consultancies, with a 1.7% share of the $24bn global SAP services market. The group employs 1,277 staff, serving 173 clients, including BP, Boeing China and Xerox. It is expected to generate revenues of £207m in 2007 amid buoyant trading conditions. In the first half, like-for-like sales rose 30%, with total revenues hitting £96.7m and adjusted earnings per share up 86% to 17p. Axon also said it had “a strong order book and good pipeline” and was looking forward to “another good performance in the second half”.
But although Axon is clearly a quality business, I believe its shares have run ahead of themselves and now look vulnerable. Let me explain why.
Firstly, analysts expect sales of SAP’s Enterprise Resource Planning (ERP) systems will expand by 10%-12% a year for the next few years – much less than the 30% rate presently enjoyed by Axon. Additionally, much of the industry’s growth is expected to come not from Axon’s traditional clients, but from small or mid-sized firms that haven’t yet deployed ERP tools.
Secondly, Axon is dependent on a few large clients, with its top five customers accounting for 54% of first-half revenues. This strategy works well in favourable conditions, but can rapidly unwind in harsher environments. For example, contracts are commonly worth from £5m-£20m in value; so it would only take the postponement of a couple of major assignments for Axon’s results to be adversely affected.
Next, around 88% of the group’s turnover comes from one-off consulting or implementation fees. Again, when the SAP market softens, these non-recurring revenues will be at risk. Finally, Axon is exposed to a weakening dollar, with 35% of sales derived from North America.
Axon is certainly making hay while the sun shines. But investors must remember that this fickle industry was hit heavily after the dotcom crash. When corporates decide to slash discretionary spend, IT budgets do not remain unscathed.
So what is the stock actually worth? Well, for this type of cyclical business, with strong competition from the likes of IBM, EDS and CapGemini, I would value Axon on a 15 times 2007 p/e ratio. That’s about 555p per share, 30% below current levels. So why are the shares so expensive, trading instead on hefty multiples of 21 times earnings and 2.3 times sales? I reckon this is because investors are not yet correctly pricing in the risks facing the business.
I would recommend shareholders take profits and recycle the proceeds into more attractive areas. The chairman and chief executive seem to agree – they have sold stock worth £13.7m and £1.6m respectively over the past year at prices ranging from 600p to 770p.
Recommendation: SELL at 825p