Dillistone Group growth portfolio candidate

Dillistone Group Plc is a leading global provider of software and services to recruitment firms and recruiting teams within major corporations. I have no holding in the company (epic code: DSG).

Market/Index	AIM/AIM All Share	Industry	Software & IT Services
Sales	£8.10m	Earnings	£1.23m
Market Cap	£19.3m	Share Price	105.5p
Norm. EPS	6.92p	Historic P/E	15.2
Est. 2014 growth	21.4%	Prospective P/E	12.6
Est. 2015 growth	11.9%	Prospective P/E	11.2
Rolling PEG	0.7	SGR	10.5%
PBV	3.77	Historic Yield	3.65%
ROE	25.7%	Operating Margin	19.5%
5 yr BV + Div return	29.2%	5 yr FCF return on BV	21.9%

The business is split into two divisions, Dillistone Systems (61% of Group sales) and Voyager Software (39%). Dillistone Systems specialises in the supply of software and services into executive-level recruitment teams. Voyager Software’s clientele are primarily involved in contingent recruitment, including permanent placement, contract placement and the provision of temporary staff.

The majority of their products are delivered through one or more of the following:

1. an upfront licence fee plus a recurring support fee;

2. software as a Service subscription basis, or

3. a hybrid model incorporating an upfront payment and recurring support and hosting fees.

Recurring revenues represented 65% of their £8.1m sales for the year ended 31^st October 2013.  Total revenue grew 14.9% last year, while recurring revenues grew 16.4%.  Management have stated that they are seeing a trend towards purchase of their software and services on a subscription basis (2 above), which may deplete income in the near term, but higher income over the long term.

The company has offices in four countries, the UK, Germany, the US and Australia, employing 100 people.  Income for the UK operation represents 76% of total sales, USA 15% and Australia 9%, although they do sell into about 60 countries from these operations.

The market for recruitment software is extremely fragmented, with a large number of small suppliers operating in all of the Group’s geographical territories.  This creates a highly competitive market, but despite that DSG are able to achieve high levels of return (as shown in the table above), in addition their return on capital employed is a very substantial 48.3%.  A consolidator in this niche market would find it difficult not to be attracted by DSG’s profile.

Although DSG’s 5 year EPS growth has been just 3.5%, recent performance shows substantial improvement with a three year CAGR in EPS of 10.7% and this year expectations are for 21.4% and next year 11.9% growth.  At a share price of 105.5p the company has a rolling one year P/E of 11.9 and rolling one year growth of 16.8%, producing an attractive PEG of 0.7.

With such a high level of operating margin and little or no working capital requirements due to substantial deferred income relating to payments from customers for future services and support, free cash flow (FCF) is very strong.  Free cash flow last year was £1,285k up £502k from the previous year and at 6.8p per share DSG has a FCF yield of 6.4% on a share price of 105.5p, compared to a stock market median of 5%.

Based on an expected dividend of 4.2p this year, DSG is offering an attractive 4% yield and the board states that they are committed to a progressive dividend policy.  Last year’s dividend was covered 1.7x and this year’s dividend is expected to be covered a comfortable 2x.

The directors have a high stake in the business owning 43.4%, with their ex-executive chairman (resigned February 2010) still owning 14%.  Other major investors are Herald Investment Management with 9.7% and Unicorn Asset Management with 4.9%.  

On a discounted cash flow basis I would place a value of around 134p on the shares.  This is based on last year’s FCF of £1.29m growing at 12% pa. for the next 10 years and then 3% in perpetuity.  I have used a discount rate of 13% based on their cost of equity of 10% and applying a 30% premium for a micro-cap.  This provides an attractive margin of safety of 27% for a potential investment.

In summary, Dillistone is a very small company operating in a fragmented niche market with a customer base that is cyclical by nature.  The company does though have very good historical returns, a strong free cash flow and a management committed to deliver solid investment returns through their substantial shareholding in the business.  The cyclical nature of the customer base is offset by the high proportion of recurring revenue and the geographical spread of DSG's sales.

Dillistone is covered by just their house broker W H Ireland and the shares are fairly illiquid with small volumes being traded.  Their interim results are likely to be announced in late September and management do say that though they expect sales to be up on last year, profits are likely to be down slightly due to strengthening of their management team and increased amortisation costs for R&D, but they expect to see profitable growth for the year.