D-Day for Dart, Anite, Games Workshop

Confidence

Three companies in the Thrifty 30 have risen more than 50% since I added them to the portfolio, so it’s decision day. Should they stay, or should they go?

There’s nothing magical about 50% except it’s the minimum return I expect for holding a share for up to three years. Obviously these investments have ‘matured’ early, as the Thrifty 30 is little more than a year old.  If I am to keep them, I must believe they’re likely to rise another 50% in the next three years or so. In other words, they’re still undervalued by the market.

Otherwise I’d be better off finding new companies with the level of potential I’m seeking.

Games Workshop (GAW) manufactures and sells toy soldiers, models and rulebooks for its fantasy Warhammer and Lord of the Rings universes. When they breached my target price, the shares cost a titanic 18 times earnings averaged over the last ten years, though they’ve fallen very slightly since. I wouldn’t normally add a company at that kind of valuation. Expressed as a yield, it’s less than 6%.

But Games Workshop is a peculiar company, and it’s had a peculiar decade. Its Lord of the Rings game was a runaway success as the films were released, which encouraged the company to expand recklessly. If you buy management’s line, this was a serious misjudgement, which cost it almost all its profit between 2006 and 2009.

Tom Kirby, the architect of a decade of prosperity in the 90’s, and a decade of boom and bust in 2000’s, is now chairman. His replacement as chief executive, Mark Wells is even more hair-shirted in his evangelism for “The Hobby”. And this is the attraction of Games Workshop: if only it had stuck to meeting the needs of its war-gaming acolytes instead of chasing the mass market, it could have saved shareholders a lot of pain and remained consistently profitable throughout the last decade. That could be the story of the next ten years, it will be if Wells has his way, so average earnings over the last ten years may undervalue the company. Assuming this year’s earnings are more typical, the shares are still in bargain territory. Its PE is nine.

The justification for taking such an optimistic view is that Games Workshop doesn’t have much competition. In a broad sense it’s competing against computer games, and particularly online multiplayer war games. But if you accept, that there will always be people who enjoy battling each other in person, using models they’ve painted, then Games Workshop owns the market, at least for Warhammer and Lord of the Rings.

I’m sticking with it, which means I’ll next review it when it publishes its annual report next summer, or when the price reaches 655p, whichever happens first.

Dart (DTG) is another company I’ve grown to admire. Its market, air passengers and road freight, is more competitive, but under chairman, chief executive and majority shareholder Philip Meeson, it’s made fewer mistakes.

There can be few industries with profits more sensitive to changes in the rate of economic growth or contraction so I reckon Dart’s long-term average earnings are more pertinent than Games Workshop’s. Despite the fact it’s well run, its future profits are likely to be more variable. Dart shares cost 12 times average earnings, which is just outside bargain territory and though its a wrench to consider dropping the company from the team, I fear that time is coming. Although I said Dart was cheap less than two months ago, the price then was just 66p and the shares cost ten times earnings. Now it’s breached 84p, I’m not so confident.

It feels premature to bow out, though, so I’m going to hang on for around 125p.

You only need to read my last profile of Anite (AIE) to recognise that I’d added the share without realising how speculative its mobile ‘phone testing business is. To an insider, the coming of 4G LTE standard might be inevitable, and Anite’s role in testing the network and handsets secure, but technological change is normal in the industry, which adds risk, and now the company’s shares are not obviously cheap, they cost about twelve times average earnings over the last 10 years,  it’s a good time to get the Thrifty 30 out. I ejected them from the portfolio on Friday at a price of 52.5p.

Sometimes companies emerge from bargain territory in a nether region where they are not obviously cheap, but not expensive. That’s been the Thrifty 30’s experience with all three of these shares. The only companies worth owning at such a ‘fair’ price, are really good ones so that’s the subtle judgement I must make. Based on what I’ve read, mostly in the annual reports, I just don’t have the confidence in Anite that I have in Games Workshop and Dart.

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Anite passes test, just

Backing VHS

Looking back, I was somewhat reluctant when I added Anite (AIE) to the Thrifty 30 portfolio in October.

The company seemed to be financially strong, but a valuation based on past earnings was hazy at best because it’s not the company it was. Having sold off disparate software businesses, it now focuses exclusively on developing and licensing software for two markets: testing mobile ‘phone networks and handsets, and managing travel bookings, administration, accounting and marketing.

Anite’s Financial position has deteriorated since then. Its F_Score is 6 out of 9 and including exceptional items the company made a loss in the year to April 2010, as it invested heavily in its new mobile testing suite and sold less software and fewer licenses due to slowdowns in its markets.

Nevertheless, the shares have done well. They’re up 27% and Anite has paid a small dividend, with the final dividend to follow.

Directors bought nearly a million shares between them in April at about 32p, 3p less than the price when I added them to the Thrifty, with a further purchase of 85,000 shares in July. In August, Michael Kingswood, managing director of Anite Travel, sold 50,000 (about half his shares) at 42p.

Their (aggregate) enthusiasm, and investors’, is probably related to the adoption by mobile network operators of a new standard for mobile broadband, 4G LTE, which requires new handsets and networks, and therefore major investment in testing.

According to Anite, most of the major mobile operators have pledged to adopt 4G over the next three years, but there is a competing standard, WiMAX. Having covered both bases since 2007, Anite has decided LTE will dominate, and closed its WiMAX business, incurring a large part of this year’s exceptional losses. Neither does the adoption of 4G mean it will dominate its predecessors in terms of subscribers for the foreseeable future. According to this chart in the Economist, 4G will only account for a small fraction of 6.5bn or so global mobile subscriptions in 2014. Anite’s strategy is to grab a bigger piece of the market than it has with 2G and 3G, by being early with the testing software and gear.

A cursory search of the Internet vindicates Anite’s decision to back LTE. Although WiMAX gained an early lead in Taiwan and the USA, LTE now seems to be the favourite. Last week the FT reported large numbers of operators adopting, switching, or considering LTE and Intel, which makes WiMAX chips for mobile handhelds, has closed its WiMAX programme office in Taiwan. The company, which championed WiMAX, now at least sees the standards co-existing. Reportedly there is little to choose technologically between the two standards but LTE is favoured by most of the big handset makers like Nokia and Sony Ericsson. Most of them, says Anite, are customers.

While this is comforting news, and speculation that LTE will do a ‘VHS’ on WiMAX may be a factor in the company’s recent popularity, it’s all in the future. WiMAX currently has 4.7m subscribers to LTE’s 10,000.

Chief executive, Christopher Humphrey, must be sweating a bit. In addition to options on just over a million shares, most of them currently “in the money”, he stands to gain up to 3m shares by 2012, or 1% of the company (which has a market capitalisation of over £100m), if he meets his targets, and a further 1m shares in a Share Matching Scheme. As with so much about Anite, I’m in two minds about these payments. He’s well incentivised, but I wonder if they’re contingent on his skill, or the outcome of the battle between the two standards and the adoption of 4G generally. Also, the industry is cyclical, at least to a degree, as new standards bring waves of new investment. If so, periodic growth is almost inevitable, and doesn’t necessarily justify big incentives.

I haven’t warmed to Anite. In this year’s report there’s no mention a previously mooted disposal of Anite Travel, where consolidation means fewer customers, but I’m assuming its future lies in its mobile testing, the bigger of the two businesses and where the company is investing most heavily. It’s a technical and fast changing market and rather like Chime, I got into Anite before I really knew enough about it. But we’re in now and I’m loathed to dispose of a holding until the numbers prove me wrong (or right!). The shares cost ten times average earnings over the last ten years, so numerically at least it’s cheap and relatively strong.

It’s a company to own if you have a strong conviction about mobile broadband and I don’t even own a 3G ‘phone. My work-issue mobile gets such little use, the mothership once cut it off because it thought the account was inactive. Being a cheapskate, I take advantage of the fact that there are free wireless networks in most of the places I go, and the Little Chefs in between.

I’m keeping Anite in the portfolio, but it will be first to go if I find a more typical Thrifty-30 style company and I have no free berths for it.

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In practice:

A little patience, a lot of profit

Anite (AIE) presents something of a dilemma. The figures are very enticing. For financial strength, the company scores a perfect nine. It’s cheap too, the share price is just eight times its average profits over the last ten years. Beneath lies a more complicated story, though.

The company engineers and licenses software. It’s main focus is testing mobile ‘phone handsets and networks. About a third of its revenues, and a slightly larger proportion of profit comes from software for the travel industry, managing reservations, administration, accounting and marketing for tour, cruise, ferry and rail companies.

Both businesses serve big names in their sectors, Vodafone, Samsung, Thomson/First Choice, and TUI/MyTravel for example. By licensing the software, implementing it, managing it and sometimes hosting it, Anite reduces the time it takes to develop new mobile ‘phone models, monitors and analyses the performance of mobile phone networks so operators can increase efficiency, and automates holiday and travel bookings.

But for the last two years earnings have been running at about half the level they were in the previous eight years, and management expects them to dip again in the half year to October.

A decline in earnings is often a good reason to consider a company for investment, if it’s likely to be a temporary decline. That’s when investors can profit, buying shares cheaply, as others with less patience sell. A little patience can lead to a lot of profit when a company recovers.

In its annual report, and a statement in September, Anite gives a number of plausible reasons for a temporary decline:

1. Recession in the mobile and travel industries, and reduced investment by customers.
2. Lost sales when TUI took over another customer, MyTravel, and when two customers, First Choice and Thomson, merged.
3. The delayed adoption by mobile phone networks of 4G LTE, the next generation data network.

It is a sign of strength that Anite is still profitable while telecoms and travel are in recession, and customers are holding back on investment rather than expanding. But there is room for doubt.

Anite is investing in 4G LTE, which will compete with wireless network hotspots for mobile internet users,  and the company admits there’s no way of predicting the take-up of the next generation handsets it will test. It plans to regain lost revenue from tour operators by persuading customers to upgrade to its newest system and annual licenses. We don’t, of course, know to what extent this will happen.

More scary, perhaps, is Anite’s evolution from what chairman Clay Brendish describes as a “troubled and fragmented IT services company’ to a ‘focused international software company’, a deliberate strategy that seems to have frustrated investors because it’s taken so long.

It might not be over. While Anite touts the growth prospects of its testing divisions which it thinks are less open to competition, it’s more sanguine about travel, and may sell it off, as it sold Anite Public Sector in 2008 and Anite International, ten overseas IT consultancies offloaded from 2004.

Shrinking is often good business, if a leaner, less indebted, more profitable company results. Anite’s F_Score suggests that it could be all of those things, it’s certainly stronger than it was last year, but the fact that it is a different business, it acquired Nemo, its network testing division, in 2006, means its long-term earnings record is not very useful as a guide to future earnings.

Since that’s the basis of Anite’s low ten year price earnings ratio of about eight, I have less confidence in its apparent cheapness than its financial strength. Based on its more recent record, its price earnings ratio is more like twelve.

Nevertheless, I think  the mobile telecoms and travel industries have a profitable future so two of the three foundations of a good investment are in place. The company’s financially strong and its businesses seem viable. The third, its valuation, is more speculative, but the shares could be in bargain territory and if they’re not, I doubt they’re overpriced..

Sometimes you can’t have everything, and although Anite’s shares have a mountain of worry to climb, they’re going in the Thrifty 30 model portfolio at Friday’s close (35p).

Notes:
First transaction: 9 September 2009
Valuation date: 1 October 2009
Cost includes £10 broker fee and £5 stamp duty
Cash earns no interest
Dividends and sale proceeds are credited to the cash balance

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In theory:

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