Description

 Rm plc. is a small UK educational company that has unleveraged return on equity close to 70% and return on capital of 29%. The  company that  has just finished  5 year restructuring is trading at 11% yield not including significant cash position on the balance sheet. No matter how you look at it, it is simply to cheap.

What is Rm plc. ?

Rm plc. was fouded as Reasearch Machines in 1973 by two Oxbridge graduates as mail supplier of electronic components. Over the years it profoundly changed its business. As of 1994 it has been a public company floated on the LSE.

The company has a strong and diverse portfolio of niche brands in education market. It has a leading market position across all divisions. Its unparalleled distribution channel and strong  long-term relationship with UK schools and government gives them an edge over competitors. No one else in the market has the breadth of products and services for school like RM.

The company three operating divisions are: a) RM Resources b) RM Results c) RM Education.

RM Resources is the most profitable division within the Group with roughly half of the operating profits.  Following the restructuring of the Group,  RM Resources now consists of only one operating business - TTS that sells innovative curriculum appropriate products mostly through direct marketing business model.  It is mostly done via catalogue while  online orders make up the rest of the sales. Online sales have now grown to 30% of direct marketing sales, double from two years ago. This includes variety of  19 thousand products: games,children  books, children furniture, school office equipment, cleaning  etc.  Basically everything needed for preschools, primary schools and secondary schools. Either by school personel  or  children. A good proportion of these products are RM’s own products or products sourced exclusively from selected supplier base which allows them to keep the margins high. For more info on the products  visit their web site and check it out: http://www.tts-group.co.uk/ . Apart from  direct marketing sales, RM also sells products through UK and international distributors, however that represents smaller share  of the revenue.

Due to top line growth in the last two years, shift to online selling, cost reduction program that includes exit from Spacecraft  business and its loss-making manufacturing part of the business as well as  improving supply chain and inventory management, operating profit margins reached  17.5% in 2015. As of fiscal 2015, RM Resources generated  £63.5 million in revenue and £11 million in adj. operating earnings.

RM Results is the largest provider of IT software and services that enable on-screen marking  and on-screen testing of high-stake school exams in the UK as well as management and analysis of educational data. RM Results does it  through a combination of proprietary and third party arrangements.  What is e-marking? In short, e-marking or onscreen marking  is the use of digital technology in the education or accreditation sector designed for marking or grading an exam or assessment.  The student  written exam papers are scanned, securely stored and downloaded by examiner to his  own computer where he examines it using set of tools provided by the software he uses. Also, throughout the process, e-marking can be monitored and checked by exam boards.

RM Results comprises of two businesses:  Assessment and Data Services. Assessment part of the business accounts for more than 2/3 of RM Results revenue. Also, it is more profitable and therefore the strategy is to primarily grow that side of the business.  Rm Assessor is the most widely used e-marking platform in the world although vast majority is used in UK. This is a growing business: there is a long-term trend from paper-based  toward  onscreen testing  in e-assessment market. Largest customers are government ministeries, exam boards and professional awarding bodies.  Operating margins are roughly within the range of RM Resources division but this business uses far less capital – its ROCE  is more than double that of RM Resources and nearly triple that of RM Education. Due to operating leverage and improving business mix, margins are steadily growing over the years.  In 2015 the division made £30.7 million in sales and earned £5.5 million.

Rm Education is in the business of supplying  UK schools and colleges with complete range of technology offerings, software and services . It is the lowest margin division grouped in three categories: Managed Services (40% of division revenue), Digital Platforms(10%) and Infrastructure(50%). This includes  various products like RM Flex - ICT support service tailored to support specific school needs and goals, RM Broadband - internet service, RM SafeClix -  online safety, Network solutions – everything from Network management to cloud technologies, RM Integris - management information system, RM Books – ebooks, RM Unify- online platform that enables faster access to  school content and data in the cloud, RM Easeteach – interactive teaching and learning application suitable for wide range class teaching devices like projectors and whiteboards....

RM Education is the UK market leader with roughly 2000 customers and employs the majority of RM plc.  people.  With close to £80 million in sales in 2015 it is still  the largest RM’s business. It generated £ 5.5 million in operating profits.  It is the division  that has gone through significant changes  in recent years which I will discuss further below.

Geography

With 90% of combined revenue, UK is by far the largest RMs market but it varies across divisions. Rm Education basically gets all of its revenue from UK while other divisions have some European and Middle Eastern presence. Although 10% of international revenue doesn’t seem much, it is worth mentioning that it is a significant rise from 4% two years ago and in 1H of 2016 the  trend has continued thus somewhat offseting domestic weaknesses.

 Turnaround

In the last 5 years Rm plc. has gone through a successful transition that left  smaller company with a much better businesses and earnings quality. Management disposed numerous non-core, loss-making and low margin operations across all divisions. That is most visible in RM Education which moved away from  low margin business of manufacturing  hardware and selling PCs.  As a result RM Education revenue dropped 70% from the peak  but margins are now higher ( due to change in accounting it is hard to say by how much exactly – before 2012 corporate costs were included in segmental data) . This drop  was not just a result of leaving PC sale and manufacturing business but also of reduction in new school openings under „Building School for future“ scheme.

Moreover, until 2010 RM went on a decade long acquisition spree spending on average close to 6 million pounds annually.  Among acquired businesses were some good investments like TTS, bought in 2004 for £12 million but also some that over the years didnt make  any profit.  RM Resources sold its loss-making DACTA business ( distribution of LEGO, BRIO and TOLO eduational products) and ISIS Concepts, classroom furnitures biz ( which, for obvious reasons, recently changed its name to Zioxi). ISIS was acquired  for £2.6 million in 2009 and sold for £205k in 2012. Moreover they sold their stakes in Lego JV and Spacecraft ( bought for £4.4 mil, sold for £0.8 mil).

So now Rm plc has a new business model: it is acquisition-free, low capex and asset light business. Company has  succesfully repositioned itself toward software and services business. Headcount has decreased by 40% representing  £50 million cut in employment costs while  inventory management has improved.   As a result, Company's return on capital  has significantly increased as well as margins.

As the table shows, the return on capital has tripled across divisions. Capital needs are significantly lower than before.  This is not the  bottom of a capex cycle, this is a new reality! The management is confident that “going forward capital expenditure will remain close to current levels”( CEO David Brooks).

Why opportunity exists?

Opportunity exists for several reasons: a) low volume stock more suitiable for personal accounts  b) revenue has been  declining  for years and the market did not acknowledge the restructuring of the company  c) no quaterly results d) due to wide portfolio of businesses there are  no quite comparable peers .

 Valuation

Using 2015 EBITDA 21 million minus 0.9 mil of stock-based compensation  minus CAPEX of 1.7 mil minus 1.1 of financial costs and 20% tax gets us to £13.8 mil and yield of 11%. Including cash it goes to  to 15%.

You can add various types of quasi-debt to enterprise value: capitalized operating leases³, pension deficit⁴ or even  payables related to long-term contracts⁵ and it still looks like a good investment opportunity. On EV/EBIT basis it trades between 5x and 6x depending on what you include in enterprise value.  So margin of safety exists in this situation.

Using peer multiples is a bit tricky since there is no quite the same company as RM plc. RM has different competitors in different industries. RM Resources business competes with Findel Education of Findel plc. and with Consortium owned by publicly traded Connect Group. The competitor of RM Results is Pearson plc. Using their multiples⁶ and depending on how you define the debt, RMs stock should trade 30-90% higher.

I believe FCF yield of 6 or 7 percent would be more appropriate. Or from EV/EBIT perspective, at least 10x.

 Return of capital

The Company has a history of returning capital to shareholders. Even though Company approved share repurchase program 10 years ago that was supposed to retire up to 10% of issued share capital, this was not the usual path of returning capital to shareholders. It was through dividends. RM has progressively increased its dividends before the restructuring in  2011 and the same happened  in the last five years  when dividend increased from 3 pence to 5 pence  reproaching pre-restructuring levels  in 2015. Besides normal dividend, RM paid hefty £15m special dividend in 2014. I would prefer stock purchases but given that 80% of the company is owned by 10 largest institutional investors and liquidity is so low,  it is not that easy to repurchase large number of shares.  Anyhow, increasing dividends are always a good sign of the  financial strength of any Company.

The largest customer of the company is UK government. As this chart shows, UK Education expenditure has been pretty much flat over  the last 6-7 years and in the sharp contrast with the period under Blair/Brown government. Conservatives are not as willing to spend on education as Labour is. Since stock price is a present value of future cash flows until the Judgment Day (or bankruptcy), it is reasonable to assume interchangeable periods of higher and lower education spending. Greatest economic crisis that struck UK after Great Depression played a role in it, including  George Osborne policy of fiscal tightening that has come to an end. Even with Conservatives forming the Government, education spending should pick up. At least for one reason:  in 2020 there will be half a million more pupils in primary and secondary schools in UK which is an equivalent to a thousand average size schools.

 This valuation doesn’t rely on growth  in UK education spending.

Conclusion

This is an illiquid stock so if you are cursed with many millions in your account this is not the right opportunity for you. On the other hand, if you are not, consider investing in RM plc. Due to recent run-up in price this is not as great investment opportunity as it is was couple of weeks ago when I started to write about it but  ( at least) 50% upside is a pretty good return as well.  

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¹Minus stock based compensations

²Adjusted operating profit for 2015 from this table differ from the numbers company gave us due to the fact that before 2012 corporate costs were not shown separately, they were included in segmental profits. To compare apples to appIes  I allocated corporate costs proportionally – on a revenue basis.  So operating profit and ROCE ( defined as segmental operating profit/segmental assets)  for 2015 are just my approximation. It is also worth mentioning that RM has certain operating lease contracts that distort returns on capital. But it is the trend that matters.

³Since the company has some short term operating leases these should be included in EV calculation. Discounting lease obligation over the lenght of their life won’t do given their short term nature so it is more appropriate to use multiples. I used the 8X just because it is the most conservative.

⁴Even though in the first half of fiscal 2016 RM included one-off additional payment of £8m, pension deficit increased by 1.1m to 23.3m driven primarily by a reduction in discount rate that offset  cash contribution. So it is an issue but it is an issue that runs across the board. There are many UK (and US) companies with the same or bigger problems and their valuations do not seem to reflect that. To tackle the problem, which was exacerbated with Brexit, UK regulator is currently reviewing new ways for calculating future promises.

 ⁵Due to the fact that cash generation is expected to be lower than operating profit, given  the reversal of favourable working capital position related to long-term contracts , adding 21.7 million to the  EV calculation should  be considered .

⁶ EV/EBIT multiples or adjusted EV/EBIT+operating lease expense+pension contribution. Given the large difference in capital requirements, EV/EBITDA is not a good metric. 

Catalyst

F16 results, revenue stabilization

increased dividends, special dividend