Gamble of the week: all is not lost for this software stock
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'One strike and you're out' is the City's current mantra for any company that misses expectations. Yet despite a cautious trading update, this business software and consultancy provider still looks good.
Touchstone Group (Aim:TSE)
“One strike and you’re out” is the City’s current mantra for any company that misses expectations. So it was no surprise to see shares of IT consultant Touchstone being whacked 13% last Friday after it released a cautious trading update. It said that despite “profits in the H2 (second half) being stronger than in H1”, higher costs and lengthening bid cycles would result in underlying earnings being “slightly below expectations and less than last year”. Obviously this was disappointing, but all is not yet lost.
Touchstone provides business software and consultancy services to companies such as British Energy, Speedy Hire and PricewaterhouseCoopers. About two-thirds of turnover comes from implementing Microsoft Dynamics software, which is rapidly growing at the expense of pricier systems, such as SAP, Oracle and Sage. Touchstone is Microsoft Dynamics’s top partner in the UK, and generated H1 sales that were up an impressive 38% on the prior year.
Furthermore, 31% of Touchstone’s revenues are derived from maintenance contracts, providing a reasonable level of forward visibility. Management also states that “order books are strong, and the sales pipeline continues to improve”, all indicating that future performance is likely to pick up. Finally, the balance sheet is solid with net funds of £2m as at the end of September.
House broker Brewin Dolphin has not yet revised its forecasts lower following last week’s profits warning. I suspect the group will hit turnover and underlying earnings per share of £30.5m and 15p respectively this year, rising to £32.5m and 16.4p in 2008/2009. That puts the stock on attractive p/e ratings of only 7.3 and 6.7, which looks far too cheap for a hi-tech business paying a 3% dividend yield.
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So what do we need to watch out for? Other than its relatively small size, the major risk is if corporates, especially in the beaten up financial services sector, decide to postpone system updates in light of an economic slowdown. But with Microsoft brutally undercutting its rivals on price, I’d expect top-line growth to continue. Also most of the applications that Touchstone installs generate huge cost savings for its clients. So while there may be contract slippage in the near term, I suspect these projects will still be completed going forward – so it’s a matter of when, not if.
Finally, with some of its rivals (eg, Maxima and Axon) recently releasing softer trading updates, I believe consolidation across the industry is inevitable – potentially leading to a takeover. In fact, the board has opened the door to offers by saying that “a strategic review” is underway “to enhance shareholder value”.
Recommendation: SPECULATIVE BUY at 107.5p (market cap of £13.2m)
Paul Hill also runs a highly successful share-tipping service; click here to find out more: Precision Guided Investments.
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