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Sanderson Group – Initiation of coverage. Buy at 29p – target price 47p

We are initiating coverage of Sanderson Group (“Sanderson” or the “Group”), the software and IT services business specialising in the multi-channel retail and manufacturing markets in the UK and Ireland.

At a time where UK business confidence is still questionable, Sanderson is in the enviable position of having a well established installed base of customers. In the first half of this year (the six months ended March 31st) Sanderson increased its recurring revenues from 51% to 54% of total revenues. A further 41% of revenues came from incremental spend by existing customers, a percentage which has remained stable during the last three years. At the interim stage £1 million of adjusted operating profit (over two thirds of total profits) had been generated before any new customer revenue. For the year ending September we are forecasting total revenues of £27.3 million.

However, this is not to say that Sanderson is not well placed to win new customers and to grow revenues. Since the 2009 year end, the order book has grown during every reporting period and now stands at £3.36 million. This growth promises to accelerate further with sales prospect values at the half year end up by over 20% to nearly £20 million.

Based on our forecasts the Group is trading on a 2012 price to earnings ratio of 5.5 times and an EV/EBITDA multiple also of 5.5 times even after including the £3.7 million pension deficit as debt. This is despite a forecast to deliver earnings per share growth of 30% in 2011 and 12% in 2012. The robust revenue model gives us confidence that these forecasts are beatable and have significant downside protection against a further deterioration in the UK economy.

On a PE ratio basis, the sector (FTSE Actuaries Software & Computer Services Sector) is on a multiple of 19.5 times and yielding 1.5%. Whilst this basket of shares takes into account a wide variety of business sizes and growth profiles, and their earnings may not be on an adjusted basis, we see the enormous discount the market has applied to Sanderson as unwarranted.

Sanderson is growing its margins and paying down debt whilst returning cash to shareholders via the payment of a sustainable dividend. On a forward basis the shares offer a yield of over 3%. Valuing the shares on a modest 10 times current year earnings generates a target price of 47p. Going forward the shrinking debt balance should allow adjusted pre tax margins to push past the 10% level forecast for the 2012 financial year and as the Group continues to deleverage and grow its order book we expect the rating gap between Sanderson and the sector to narrow further. We initiate coverage at 29p with a stance of buy.

Financial records & forecasts