After a period of poor results, how can you tell whether a stock is a basket case or a genuine recovery play? For me, the former is usually characterised by crippling debts and disgruntled customers (eg, Connaught). The latter typically has a secure balance sheet and will have just started to win blue-ribbon contracts, which can be used to secure additional work.
Enter Innovation. It sells IT and outsourcing services to the insurance, fleet and automotive sectors, and serves around 800 customers globally, including AXA, RSA, Ford and Toyota. It processes around four million vehicle insurance claims annually.
Over the past three years, its results have been punctured as the effects of the credit crunch have hammered its clients. However, there is now light at the end of the tunnel. Last week the firm bagged a landmark £25m five-year contract with Enterprise Rent-A-Car, the world’s largest rental outfit. This comes hot on the heels of similar deals in South Africa, for £31m, and in the US, for £5.75m. So with costs being reined in and another three or four opportunities in the pipeline, the results should start to bounce back soon.
Innovation Group (LSE: TIG)
Outsourcing generates recurring income representing 88% of turnover. That gives investors solid earnings visibility. The City is forecasting 2010 sales and underlying earnings per share of £158m and 0.56p respectively, rising to £169m and 0.98p for the year ending September 2011.
Yet the shares are trading on a bottom-of-the-cycle 2011 price-to-earnings multiple of 10.1. That looks too cheap for such a high-tech outsourcing business with strong prospects. I’d value the group on a ten-times EBITA multiple – assuming sustainable margins of 8% and adding in the £22.4m of net funds. That generates an intrinsic worth of over 16p per share.
So what are the possible speed-bumps? Well, being a leading outsourcer, there is always a chance that agreements will turn sour. For example, Allstate Insurance of Canada has filed a C$75m (or £47m) lawsuit against the company. Innovation has counterclaimed, seeking damages of C$31m.
Next, with 79% of sales derived from outside of Britain, foreign-exchange losses are always a risk. And finally, the firm is a comparative minnow in the industry, and could be squeezed by its bigger rivals. All the same, with a strong position in its niche market, at these depressed levels Innovation could readily become a takeover target for the likes of IBM or Accenture.
Recommendation: speculative BUY at 11p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments