WHEN Ben Gordon was appointed chief executive of Mothercare in December 2002, the baby-care and children’s retailer was on the brink of going bust. After three profit warnings in a year, the company was stretching its banking covenants to bursting point. Its shops looked tired, shelves were often empty and staff were disillusioned.
“The stores were in a lot of turmoil back then,” said Gordon. Even Mothercare’s cash management was questionable despite its financial woes, the group had allowed the amount of money kept in its tills to rise from £5m to almost £6m.
Today the business is in rude health under the 47-year-old father of three. It has cash in the bank, virtually no debt and only a small pension deficit; and that is despite splashing out £85m to buy Early Learning Centre to extend its reach in Britain.
Overseas its expansion has been even quicker. This year Mothercare will move into China and add to its presence in other territories, including India and the Middle East. Web, catalogue and home-delivery sales are booming too up 20%-25% year on year and now account for 15% of its UK business.
Shares in Mothercare have almost quadrupled from less than 100p when Gordon joined, to close at 398p on Friday.
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But despite Mothercare’s impressive turnround it remains one of Britain’s most undervalued firms, according to a report from Grant Thornton, the accountant, that aims to identify the stock-market’s “hidden gems”.
Mothercare is in 13th place in Grant Thornton’s Hidden Gems index, which identifies 50 companies that have performed strongly but have not received sufficient credit.
Now in its seventh year, the index has a strong record of picking winners that have gone on to outperform. In the past 12 months last year’s top 10 recorded an average rise of 2.9%, compared with a market that fell by 7.6%. The index has also been used as a shopping list for acquisitions. During the past two years, 12 of the firms featured in the index have received takeover bids including North-gate Information Solutions; Emap; Gyrus Group; Burren Energy; Amstrad; Wilson Bow-den; Wincanton and UTV in the last 12 months alone.
Tipping a retail share such as Mothercare just as the economy is heading for a slowdown may appear foolhardy, but City analysts remain bullish about Mothercare’s prospects. In theory, pregnant women and new mothers should be among the last to rein back on their spending.
With a market value of only £348m, Mothercare is typical in size of the companies that feature in this year’s index; 80% have a market value of less than £1 billion and there are just four FTSE 100 companies in the top 50 compared with 10 last year.
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Smaller companies are typically underresearched compared with their FTSE 100 brethren. With investment banks no longer able to pay for analyst research from the fees they generate from floats and takeovers, they are forced to finance it through sales to potential investors, including pension and life funds or hedge funds. This can limit the types of stocks many analysts cover, meaning smaller stocks are often overlooked.
David Maxwell, a partner at Grant Thornton, said: “It looks like many cash-productive businesses on the stock market could command a higher share price than they do, but are constrained by their size or sector. Often the only time they can get recognition is when they are bid for.”
One sector that does stand out in this year’s index is oil producers and oil-services companies boosted by the high oil price.
Two oil-services businesses, Hunting and Expro International, feature in the top five, and a third, Abbot which is poised to be taken over by First Reserve Corp, an American private-equity group is in the top 10. Meanwhile, oil and gas producers Venture Production, Burren Energy and Dana Petroleum all feature in the top 20.
The best hidden gem this year is Creston, the communications marketing services firm. Its clients include Glaxo Smith Kline, Royal Mail and Alton Towers. The business metamorphosed from glazing company to property firm to cash shell, before reinventing itself as a media business in 2001. Today it is in effect a holding company for 12 marketing, advertising, market research and PR agencies with a strong track record of delivering profit and earnings growth.
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Creston is unusual among media companies because 85% of its revenues can be regarded as resilient as they are either generated from long-term so-called “evergreen” contracts or are derived from repeat business.
Cash flow is only one way to measure performance, but argua-bly it should be more important this year amid the stock-market turbulence. In nervous times cash-flow statements are less susceptible to buffing up than earnings, which are often heavily adjusted to allow for distorting one-off events such as the sale of a division or a restructuring.
“Historically, the importance of cash flow has not been terribly well understood and the equity market has chosen to concentrate on earnings,” said Maxwell.
“Market signs are clearly pointing at even more bearish conditions with a focus on the prospect of broken debt covenants for the first time in at least five years. Cash flow, represented by consistent cash generation, low gearing or both, is likely to be more important as a determinant of equity value than for some time,” he added.
Grant Thornton starts its calculations for the Hidden Gems index by examining a company’s cash-flow generation over three years and up to three years of analysts’ forecasts. The market rating is calculated by dividing the share price by the average annual cash flow per share.
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Further number-crunching compares a firm’s performance against its sector to produce a Hidden Gems index score. The top 50 are set out in the table.
The cash flow per share growth from this year’s top 50 companies averaged 645% more than three times the 199% achieved by market stocks examined by Grant Thornton which qualify for the index.
Despite such impressive cash flow, the shares for the top 50 companies in the Hidden Gems index are trading at a multiple of only 7.4 times forecast free cash flow almost half the average of 12.7 for the market.