Pennant growth portfolio candidate

Pennant International provides a range of services that extend across e-Learning, Computer Based Training, Emulation and Simulation, Technical Documentation, Media Services, Cartography, Supportability Engineering Software products and related services. I have no holding in this company (epic code: PEN) 

Market/Index	AIM	Industry	Software & IT Services
Sales	£14.5m	Earnings	£1.17m
Market Cap	£19.3m	Share Price	72p
Norm. EPS	4.52p	Historic P/E	15.9
Est. 2013 growth	45.2%	Prospective P/E	11.0
Est. 2014 growth	8.2%	Prospective P/E	10.1
Rolling PEG	0.5	SGR	12.5%
PBV	3.58	Historic Yield	2.63%
ROE	23.1%	Operating Margin	11.0%
5 yr BV + Div return	9.5%	5 yr FCF return on BV	12.4%

PEN was one of the recent additions to the growth portfolio candidates list here.  It is a small company listed on AIM, that amongst other services & products provides training and simulation to the defence industry.  It operates through three divisions - Training Systems (57% of sales), Data Services (18%) and Software Services (25%).

Its most recent announcement on 19 June stated that it had received a £1.3m export order for the supply of a software based training capability, but more importantly the directors stated that they expected to exceed current market expectations.  This had the effect of moving the SP from 64.5p  at the time I produced the candidate list to 75.5p and their brokers WH Ireland (the only broker that follows them), increased their price target to 99p up from 90p; since then the price has moved back a little.  It should be noted that there is a low level of free float in the shares, with the directors holding just over 50% of the shares in issue.

Pennant has shown good growth over the past three years as more companies outsource their training needs.  Sales have grown by 15% pa and EPS by a substantial 53%.  Operating margins have increased over the past year to 11%, but there should be more to go at here for this type of business, as the switching cost for the customer can be prohibitively expensive.  Return on equity is good at 23.1% and is probably indicative of a company with an economic moat that I would ascribe to switching costs and their intellectual property (see description of economic moats here).  This narrow moat has the ability to be widened, as their training and simulation systems become more widely adopted and they benefit from network effects within their customers.

Free cash flow (FCF) was weak last year, as receivables increased by over £1m.  This would normally be of concern, but the directors state that only £7k is past due, so I'm assuming this is a timing issue.

The majority of their sales are within the UK (77%) and 57% of sales are from the Training Systems division.  The customer base is somewhat concentrated, not unusual for a small company, with just 4 customers representing 71% of turnover and one of those customers represents 29% of total revenues.

Expectations are for 6.6p this year and 7.1p next year and the dividend yield on the current price is forecast to exceed 3%.

Interims are due to be announced on the 5 August, opportunity to check on those receivables and the outlook, so should make interesting reading.  I would judge the current intrinsic value for the business at about 90p.  I have used the average free cash flow for the past 3 years (see comment above on FCF) and assumed growth of 20% pa for 2 years, 10% pa for the following 8; 2.5% pa in perpetuity and a discount rate of 12%. 

A small company in an interesting growth niche, with the directors owning a good stake in the business, that should ensure an owners' mentality with respect to strategy and execution.  There are some risks attached though that may be summarised as - size, concentrated customer base, current high level of receivables, company not widely followed by analysts and a 4-5% bid/offer spread in the SP.