Evening Fool

Wednesday, 13 May 1998

Market Close
FTSE 100   5972.9   +16.2  (+0.27%) 

Catch-22
Is sterling strong or weak?

How quickly the news changes. Less than 2 weeks ago, the continued strength of sterling was seen to be hurting UK exporters, some perhaps terminally. There was virtually no way the Bank of England could possibly raise interest rates, which would have had the effect of pushing sterling even higher. It appeared interest rates had reached their peak at 7.25% and the next move was down.

In a classic Catch-22 situation, because interest rates were seen as moving down, not surprisingly sterling weakened as the speculators poured their billions into another currency. Then today we see that average wage earnings year on year rose by 4.9%, well above the government's 2.5% inflation target. The Bank of England's quarterly inflation report warned that decisions on monetary policy remain "finely balanced" but said that it expects to hit the inflation target, notwithstanding sterling's recent weakness.

So which is it then -- is sterling strong, or is it weak? Are interest rates going up or down? And at what level will the Footsie finish the year? These questions, Fools, are not for you and I to answer. Leave it to natural market forces, and keep searching for the companies that will inexorably keep their earnings rising, no matter what the state of sterling, interest rates, inflation, the World Cup or the market.

Conquerors

Information Technology sector companies continued to flourish as their reporting season continued, with Sage Group taking centre stage today. Sage is the leading supplier of accounting software and associated products for personal computers. This rather unremarkable sounding description of the company belies the fact that Sage is capitalised at over £1.6 billion, putting it firmly within the top 150 biggest companies by that measure in the country.

For the 6 months ended March 1998, Sage reported strong, largely organic growth. Sales rose 21% to £88.8m and earnings per share (EPS) jumped 22% to 14.68p. The shares ticked up 45p to 1388p. Part of the beauty of the company is that it has a strong competitive advantage, evidenced by its high operating margin of 29.3%. The fact that 100% of operating earnings are translated into cash also gives investors some reassurance that the Sage accountants aren't playing games with their own software.

Sage have recently entered the US market, having announced in January that they were purchasing State of the Art for a consideration of £160m. This was funded partly by a placing of new shares at 960p. Those institutions lucky enough to pick up some of those shares are now sitting on a handy little 45% paper profit in just under 4 months. Nice work if you can get it!

With trailing EPS now of 26.08p, Sage trade at a price to earnings ratio (P/E) of 53. At that level, although we are looking at a solid company with good growth prospects, much of any future good news would appear to have been already factored into the share price.

Colt Telecom buzzed up 143p to 1683p after reporting its first quarter results. The company, which is building a fibre optic-based telecommunications service, reported first quarter turnover up 137% to £35.5m. This was sequentially up 34% over the fourth quarter of 1997. The company's net loss was £10m, up from a loss of £6.7m in the corresponding period of 1997. Companies such as Colt are notoriously difficult to value in these early loss making periods. They are spending a huge amount of cash in building what they hope will be a network that will service Europe's major business and financial centres.

One way of attempting to get some sort of handle of the value of the company is to look at its price to sales ratio (PSR). If you assume that the company can sequentially grow its revenues at 25% for the rest of this year, we will be looking at Colt having 1998 sales of about £204.7m. They are currently capitalised at around £1.85 billion, giving them a forward PSR of about 9. Whilst this is still quite rich, it perhaps gives some perspective into why a company with full year 1997 sales of just £82m is so highly valued.

Vanquished

Virtually no day goes by where a company does not make some sort of announcement that sends their share price into free-fall. Today was not really an exception, except that there were three big fallers.

Games Workshop designs, manufactures and sells metal model soldiers used for war games. The company also produces a top selling war games magazine. They sell their products through independent retailers and their own Games Workshop stores. These adult games are said to be rather addictive, leading to a large number of repeat purchases. Gamers apparently continually buy and paint new pieces as the size and complexity of the game increases with the level of addiction. The business, whilst hardly mainstream, appears to satisfy a strong niche market, and hence is often seen as one that has a competitive advantage over other games manufacturers and retailers.

Back in February, Games Workshop warned that the strength of sterling was affecting their business and announced earnings growth of just over 4%. Whilst the share price dipped, it was unusually resilient given the market was expecting full year earnings growth of around 20%. In fact, brokers' estimates remained remarkably unchanged. A closer look at the numbers, using a simple table like that used in this column previously (see MMT Computing yesterday, would have enabled Fools to deduce that for Games Workshop to achieve earnings estimates of around 27p for the full year, the company would have to have grown earnings by 31% over last year's corresponding second half period. With the strength of sterling only just abating in the last week or two, that was always going to be a tall order.

In a trading statement released today, Games Workshop warned that it expects results for the current financial year to be "slightly below market expectations." The shares, which had risen to 858p from a low point this calendar year of 583p, fell a whopping 225p to 633p. The market is invariably at its harshest when one of their darlings disappoints. Fuelling today's crash was the fact that it wasn't really the strength of sterling that was doing the real damage. In fact, sales in the UK, where obviously the strength of the currency is not an issue with local consumers, have continued to be weak. Also, the company said that they have been having "modest stock management difficulties arising from the Group's move to new premises in October 1997." Suddenly investors are having second thoughts about the sustainability of the game that not so long ago appeared to have addictive long-term growth qualities.

Games Workshop said that it expects to resume its strong growth in year 1998/99. The market at the moment is unwilling to accept this on face value. If I were an investor, I'd be most worried about the stock management side of the company. Sterling strength is unavoidable -- poor stock management isn't.

Churchill China cracked down 50p to 283p after warning again that first half profits would be below those achieved in the corresponding period last year. Today's AGM statement is a virtual repeat of what the company said when it released its preliminary results in the middle of March this year. The only and vital added word was "well" when talking about how far below last year the first half results would be.

The third company to hit the skids today was Vanguard Medica Group. The biotechnology company which was previously capitalised at around £185m on trailing sales of just £1.5m (for a PSR of a whopping 123) dived 159p to 433p after announcing that pharma giant SmithKline Beecham has terminated a key partnership with the company. Vanguard is now seeking new commercial partners for its anti-migraine compound, which is in the latter stages of clinical testing.

And Finally...

On page 200 of BBC2's Ceefax, I thought I saw one of the funniest comments ever -- "Giant tea bag plans to float." No, I hadn't accidentally flicked to the Delia Smith recipe pages -- this was indeed Finance. I immediately had visions of a tea bag being floated down the Thames, all no doubt part of the Greenwich millennium celebrations. Or perhaps Whittard of Chelsea, the specialist tea retailer, were planning some publicity stunt in an attempt to boost their flagging like for like store sales. But alas, it was only my slight case of dyslexia that gave a humorous spin to the story. It was in fact referring to Tetley Tea Group, the world's second largest tea bag manufacturer, which is planning to float on the London Stock Exchange later this year.

See you on the message boards.

Bruce Jackson (TMF Googly)

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