The stockmarket is often a reliable predictor of the economic climate. But rather than warning of a coming recession, the recent crash could end up being a root cause of a future slump, particularly if it scares consumers into stopping spending or leads to another period of destocking by companies. Yet I believe this grim scenario is already baked into downtrodden valuations. That means some high-quality companies are now trading at bargain-basement levels.
Logica (LSE:LOG), rated a BUY by Panmure Gordon
Logica, the European IT outsourcer (44% sales) and systems integrator, has seen its shares plummet due to poor sentiment and a mixed set of interim reports on 5 August. The bears focused on the negatives of declining operating profits triggered by one-off restructuring costs and difficulties in its Benelux unit (12% sales). But setting aside these minor hiccups, what seems to have been forgotten is that Logica has been winning market share. First-half revenues and orders were up 5% and 13% respectively, while the outsourcing backlog closed at a record £2.8bn. It was bolstered by blue-ribbon contracts secured with Dutch retailer Ahold, oil giant Shell and a £157m deal with the Serious Organised Crime Agency.
Better still, despite the moribund public sector (28% of sales), which fell by 5%, corporate-related activity jumped an impressive 10%. That underlines the fact that the business-to-business IT sector is still firing on all cylinders – as evidenced by strong performances from SAP and Autonomy in July.
Moreover, with more financial regulation (eg, Basel III) coming down the pipe across Europe, Logica could benefit further. “These things are cyclical,” says CEO Andy Green. “We have a very well-balanced business. During 2008/2009, government work kept us going and now the baton has switched to the private sector.”
Investors basically need to look through the immediate gloom and see the bigger picture. For many organisations, IT is an essential plank to their existence and prospects, rather than being a discretionary item. Software purchases can always be delayed, but for vendors such as Logica, who are able to provide clients with quality as well as cost savings, the outlook is still bright.
What’s more, Logica seems to be one of the few players able to deliver hugely challenging IT projects. The latest of these is the release of the government’s flagship £75.6m national-crime database, which went live in June. It contains details of up to 15 million criminals, suspects and victims. The police have hailed the service as the “most secure” ever developed as it allows 56 forces to share intelligence and identify patterns of criminal behaviour across the country. That will be a very handy bit of kit to help thwart Britain’s copy-cat riots.
Moving onto the pennies, Green is forecasting top-line growth and margin improvement in the second half, with consensus pitched at sales and underlying earnings per share (EPS) of £3.9bn and 13p for 2011. That puts the shares on a mean price/earnings (p/e) multiple of 6.5, while also offering a tasty 5% dividend yield. Given this I would value the group on a ten-times earnings before interest, tax and amortisation (EBITA) multiple. After adjusting for net debt of £431m and a £57m pension deficit, this generates a fair value of 140p per share.
The main worry in the short term is the effect of government austerity measures on orders. That said, if officials are serious about reducing deficits, then they’re going to need assistance from the likes of Logica to enhance productivity and reduce overheads without affecting front-line services. Other concerns relate to the risks associated with managing complex contracts, foreign-currency fluctuations and competition from India.
Nonetheless, the rating looks far too cheap for a coveted tech stock that could also become a takeover candidate. Panmure Gordon has a 156p price target, and third-quarter (Q3) results are out on 2 November.
Rating: BUY at 85p
2. MKS Instruments (Nasdaq:MKSI), rated OVERWEIGHT by Barclays Capital
MKS Instruments is a provider of niche parts and process controllers to manufacturers of capital equipment within the semiconductor industry (62% of sales). Here it’s the market leader, having roughly a 34% share of its addressable market. It booked a 2010 turnover of $853m, with just over half being derived from outside America, underpinned by its cutting-edge science, which is protected by 650 patents.
Yet in July the stock slumped because of a temporary deceleration in orders. As a result the board trimmed its guidance for Q3 EPS to between 40 and 60 cents on turnover of $180m-$210m. Chief executive officer Leo Berlinghieri added that there was some softening in the chip sector after a few quarters of strong shipments in smartphones, tablets and other mobile devices.
But a small air-pocket in demand should not be a surprise in this cyclical industry. What’s more, the firm is diversifying its product reach and incorporating its clever instrumentation into other exciting areas, such as flat-panel displays, solar cells and data storage. Better still, regardless of any recession, MKS has a cast-iron balance sheet that should enable it to ride out most storms comfortably. Indeed, with cash of $496m (or $9.30per share) and net tangible assets of $15 per share, it could even take advantage of present low valuations to snap up rivals.
Wall Street is forecasting a second-half turnover and adjusted EPS of $379m and $0.95 respectively. That puts the shares on a “six-month run-rate” p/e ratio of 12.2, dropping to a mouthwatering eight, if the cash pile is stripped out. Instead, I would value the group on an eight times enterprise value to EBITA multiple. Adjusting for the net funds, that produces an intrinsic worth of over $31 per share.
Any prolonged downturn would inevitably affect margins through lower capacity utilisation and pricing. For British investors there’s foreign exchange risk to consider too. Nonetheless, MKS Instruments has top-notch products and should be a long-term beneficiary of the growth in electronics. Barclays Capital has a price target of $32 per share.
Rating: BUY at $23.1
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments. See www.moneyweek.com/PGI, or phone 020-7633 3634 for more.