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'Bottom Up' Investing 3 of 5

For bottom-up investors the individual company entries are the first port of call. After analysis, any company of interest can be put in context by looking at the REFS on line tables.

All investment analysts have their own investment beliefs, preferences and particular ways of analysing an investment.

The value of Jim Slater’s Zulu Principle approach can be demonstrated, for example, by taking Debtmatters – an Investing for Growth recommendation in the past - to show how to decide whether or not a growth share is a worthwhile candidate for one’s portfolio.

(Note: this illustration is based on REFS on line data from the 11th July 2006 and should not be construed as a recommendation. Also the REFS on line data is dynamic and changes from day to day).

One might notice the shares of Debtmatters in the table of growth companies with very high growth rates, or more likely in the table of shares with ‘Low PEGs for Growth Companies’. In this particular case Debtmatters has a very low and attractive PEG of 0.12.

Alternatively, your broker might have drawn the company to your attention, stressing the rapidly growing underlying market for IVAs (Individual Voluntary Arrangements), which for individuals is a less drastic alternative to bankruptcy and which is Debtmatters’ main source of revenue.

Over the last few years consumers have embarked upon an unprecedented spending spree. The upshot is that UK consumer debt is now running at almost £1.2 trillion. The number of IVAs registered with the DTI in the year ending 2005 exceeded 20,000, almost double the number in 2004.

Based on current monthly run rates these are expected to double again to in excess of 40,000 in 2006. Meanwhile, company figures released for the year to March 2006 show that Debtmatters increased its new IVA case run-rate faster still.

Your appetite whetted, you now need to check the REFS on line financial statistics in more detail.

First, you should glance at the REFS graph. It gives you an instant overview of a share that has performed exceptionally well since it listed on AIM in June 2005 at 65 pence.

EPS have been growing at a heady pace which seems set to continue, for example up by 623% in the FY 2006 and forecast to grow by a further 191% in FY 2007. Relative strength has been excellent at +270% over the last twelve months, +96.3% over the last six, +24% over the last three and +9.2% during the last month (to July 11th 2006). Clearly the strong momentum is continuing.

The average PER over the last two years has been 96.7 and 76.2 reflecting its historic meteoric growth in earnings, so the company usually commands a high multiple. However, the prospective PER of 14.5 is now well below the normal limit of 20 specified for growth shares in the Zulu Principle.

What is more Debtmatters is continuing to grow at an extraordinary rate, which makes the share look exceptional value. This enables one to soften other criteria, like cash flow and balance sheet strength (more on this below).

Next, one should check the KEY STATISTICS. The market cap of £91.8m puts Debtmatters in the top 150 companies by market capitalisation on the AIM Index (i.e. within the top 10%).

Promotion to the Main Market seems unlikely in the short term, so there is no need to look at REFS on line’s table of Promotion Candidates. However, at the company’s present rate of growth Debtmatters may consider such a move in a couple of years.

A prospective dividend yield of just 0.21% plus a blackish moon tells you that low dividend yields are typical for the sector. However, this is not a major drawback for a great growth share, especially for one at a relatively early growth phase. Currently for Debtmatters it is much more profitable to invest in the expansion of the business rather than re-distribute cash as dividends to shareholders.

The prospective PER is surprisingly low for such a high rate of growth in earnings. Moreover, the PEG (as mentioned above) is exceptionally attractive at 0.12, as evidenced by the almost full black moons against the market and the sector.

The forecast growth rate in EPS (earnings per share) of 191% for FY 2007 is still very high although lower in relation to the past. It is three months since Debtmatters’ financial year began, so the 118% forecast growth rate in EPS is a blend of the consensus forecast of 191% for FY 2007 and 42.3% for FY 2008.

Now, take a look at the individual brokers' forecasts. In this instance, there are four, which is impressive for company of Debtmatters’ small size.

Charles Stanley’s and Daniel Stewart’s EPS forecasts are consistent at just over 23 pence for FY 2007 and around 33 pence for FY 2008. The brokers clearly like the stock with two buy ratings and one strong buy (plus one is still embargoed).

Next, check past increases in EPS in the large panel of historic figures: 2005 - 3600%, 2006 - 623%, 2007 (forecast) - 191% and 2008 (forecast) – 42.3%. Although the forecast growth for EPS is projected to fall to 42.3% in FY 2008 this is still attractive and well above the prospective PER of 14.5. In addition one should expect the growth rate to ease given that the company started from a very low base of earnings in 2004.

Also, check the OUTLOOK statement. In April the company said that it expected results for the year ended 31st March to be ‘ahead of market expectations’. This followed a statement at the AGM in February when the company expected the full year results to be at the upper end of analysts expectations.

Operating margins have risen strongly as the company has taken advantage of increased scale and operational efficiencies. Between 2004 and 2005 the operating margin rose from 4.05% to 23.6% and in the year to March 2006 the pre-tax profit margin rose from 21% to 36%.

The rocketing turnover primarily as a result of the dramatic increase in IVA revenues (£1.73 million in the year to March 2005 compared with £7.79 million in 2006) coupled with the very strong growth in margins is behind the dramatic increase in profitability which is forecast to rise from £2.8 million in 2006 to £8.3 million in the year to March 2007.

Not unnaturally, the brokers expect growth to taper off over the next couple of years. However, the earnings enhancing acquisition of Loanmakers (refer below to NEWSFLOW) for which according to house broker Charles Stanley the company is paying seven times earnings (before interest and tax) should give a further boost to organic growth and profits and possibly lead to broker upgrades.

As the black moons indicate, both return on capital employed (ROCE) and margins are excellent. The five year historic results panel shows clearly that margins, in particular, have been growing at a very attractive rate.

This is a very healthy sign and is almost certainly an ongoing feature as turnover is increasing by leaps and bounds. In fact one of the most striking features of the Debtmatters REFS page is the predominance of black moons in the growth statistics panel, especially for the PEG, EPS growth rate, ROCE and operating margin.

Now look at the GEARING, COVER panel. Gearing is high at 208%. However, borrowings are only £0.53 million and interest cover is a healthy 12 times. Cash flow per share is also negative. Here, one has to take into account both the company’s early stage of development and the nature of its business model. It can take up to a year to recover the outlay on an IVA (i.e. advertising, set up costs and administration).

Debtmatters has grown so rapidly that most of the 4,500 IVA cases on its books are yet to earn it a positive return, in particular from recurring revenues (monitoring fees). Reassuringly, its larger competitor Debt Free Direct, which is about 12 months ahead in terms of its stage of development, has seen net cash from trading turn positive due to significant monitoring fees from its 5,500 cases.

Now looking at the value statistics panel. Debtmatters is not an asset situation, so one should not be overly concerned with PBV (price-to-book-value) or PTBV (price-to-tangible-book-value).

The PCF (price-to-cash-flow) is also negative and as discussed above reflects the cash outflow associated with the setting up of IVAs as one would expect with a company at this stage of its development.

By contrast Loanmakers is strongly cash positive which will reduce Debtmatters working capital requirements. Also, as discussed above cash flow per share, which is negative, should start to turn positive within the next 12 months.

As indicated by the white moon, a PSR (price-to sales ratio) of 53 is extremely high. High PSRs often accompany the high margins of companies with a very successful selling formula.

With a growth share of this caliber and the rate at which Debtmatters’ turnover is rocketing this should plummet over the next year to a much more comfortable level.

Next, look at the panel of historic figures and, in particular, at turnover and turnover per share.

The growth in both is strong and consistent. The excellent and growing operating margin figures have already been checked and ROCE and ROE (return on equity) are also consistently well above average, suggesting a degree of competitive advantage and an extremely lucrative and profitable business model.

The accounts look very clean given that there is no difference between FRS3 EPS (the statutory reported earnings figure) and normalised EPS (adjusted to reflect the underlying business eliminating one-off exceptional items).

A normal tax rate of circa 30% projected for FY 2007 and 2008 is also reassuring. Creative accounting is unlikely to have been at work.

Capex (capital expenditure) is low because Debtmatters is a ‘people’s business’, which means that once the company turns cash positive a smaller proportion of available cash should be absorbed in future years. In the case of Debtmatters future cash generation by FY 2008 should be very healthy, leaving a substantial balance of 'owners’ earnings' each year.

The next point of interest is SHARE CAPITAL, HOLDINGS and DEALINGS. As can readily be seen, Gerry Ratcliffe, the CEO is the dominant shareholder with 62.5% of the shares.

No share transactions are showing for any directors over the last six months. Only if there is heavy cluster selling, should alarm bells ring.

A final look at NEWSFLOW shows that the company has just completed a major acquisition of Loanmakers for an initial £10 million, a complementary business and FSA registered master broker handling secured loans. With the placing of six million shares at 330 pence and a share price of 373 pence the market clearly likes the look of the deal at a cost of seven times earnings (before interest and tax).

The KEY DATES panel tells you that the AGM was due at the end of July 2006. There could well be another bullish statement then which should provide a further boost to market sentiment.

All in all, one can conclude that after allowing for its early stage of development and the nature of its business Debtmatters meets many of the criteria specified for growth stocks within the Zulu Principle, particularly in relation to the growth statistics and is therefore a strong candidate for one’s portfolio pre-supposing that one is comfortable with the company’s business model which is yet to turn cash positive (refer above).

The next step is to obtain the Annual and Interim Reports, brokers' circulars and press cuttings before coming to a final decision.

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