Iomart is a great company, but it’s taking a big chance

Cloud computing is going to be huge. That’s my contention, and I’m sticking with it. I think the companies which provide cloud infrastructure, and which sell cloud services, will dominate in the next decade.

And the cloud isn’t a chin-stroking speculation about the future any more. I’m writing to you this week from my trusty Chromebook, over Google’s cloud-based word processor.

Which companies are going to profit from the move to the cloud? Well, in June, I wrote about Iomart (LSE: IOM), the Glaswegian data-centre operator. I gave ten reasons why IOM was such a class company. And in this game, six months is a long time. A lot has changed. So let’s catch up with proceedings.

The business is flying

IOM has grown like crazy over the last few years. The whole industry is consolidating in a series of big and small deals, and IOM has been a key mover in that trend.

Acquisitions have been a fantastic way of growing and improving the service. In this sort of business, it’s easy to strip out costs, which creates economies of scale when you combine businesses. We’re talking about big data-centres hosting client websites, data-rooms, or even clients’ own software and computing capacity. For IOM, the process of integration seems to have ticked along very nicely indeed.

Figures reported for the half-year ending 30 September 2013 showed revenues up by some 23%. Analysts expect that to be reflected in the full-year figures too. That suggests profits will come in at just under £14m for the year ending 31 March 2014, valuing the shares on a multiple of about 26 times earnings.

Now, of course, that’s a racy multiple. But if the group can continue to grow earnings at anywhere near its recent pace, that multiple can quickly come down.

For instance, analysts are predicting next year’s earnings (to March 2015) will increase 26% to £17.5m, which will reduce the valuation to 20 times earnings. Keep going with that sort of growth, and pretty soon the valuation starts to look cheap.

But you have to ask yourself, is this sort of growth realistic? In this case, I’d say yes. Looking back over recent years, profit has been growing even faster than the 26% analysts are projecting.

And from what I can see, the potential for growth is even greater in the future.

But be in no doubt, there are risks to IOM’s high-growth strategy.

Brave or foolhardy?

In October, IOM announced its biggest, boldest takeover yet – a £23m deal to take over Backup Technology (BTL), a rival data-centre company.

Previous acquisitions had been a lot smaller – we’re talking about a few million here and there. It could afford to pay for these acquisitions out of operating cash flow, but the Backup deal is much more ambitious; it has been financed by the Royal Bank of Scotland, and it adds a significant chunk of debt to Iomart’s balance sheet.

Also, bear in mind that Backup only turned over about £5m last year. Yes, it is true that on that modest turnover, the business created earnings of £2.4m, but you can’t get away from the fact that IOM is now paying a hefty £23m. That sounds very, very rich to me.

An analyst’s note from Jonathan Imlah and Bob Liao at Canaccord reads: “At more than ten times historical EBITDA, compared with an average of four-to-six times for the majority of its previous deals, today’s acquisition looks pricey”.

In fact, following the deal announcement, it wasn’t much of a surprise to see IOM’s shares slip. When I first looked at IOM in June last year, the shares were trading at about £2.36; before this announcement, they’d been up at an impressive £3.15. But as markets digested the scale of this purchase (and the fact that senior directors were taking the opportunity to reduce holdings) the shares have eased back to the £2.60-£2.70 range.

So, how will this all turn out for shareholders?

Let’s run with it

The fact that IOM paid so much for Backup (and RBS was keen to put in place the funding) should be seen as a good thing. Industry insiders know all about the sort of growth involved with this sector – and the margins, too.

In fact, when I first wrote about IOM, I said that it wasn’t only the top-line growth that attracted me, but the widening margins too. It’s a fantastic position to be in.

Nobody is going to sell a business with such a great potential without a full and fair valuation. The fact that it looks expensive on paper is neither here nor there.

I can actually see IOM continuing to beat analyst forecasts – I’ve seen this sort of thing with other successful stock-market darlings many times before.

At the moment, Backup uses leased data-centre space – and that’s expensive. As CEO Angus MacSween says, “the business will transfer operations to Iomart’s estate once those contracts expire in around one year”. Bang. Suddenly a load of costs disappear, and margins grow even more.

Not only that, but MacSween continues: “”We have been tracking [BTL] for two or three years. They are a very lightweight organisation in terms of sales and marketing so we are hoping to inject a wee bit more into that and hopefully get them growing a bit faster than they have been.”

Essentially, what he’s saying is, with our marketing operations, we can increase BTL turnover “a wee bit faster”, and I suspect it’ll be a wee bit more than a wee bit!

From what I can see, IOM will probably be able to beat analysts’ forecasts for the year ending March 2015. Things are coming together for IOM now: the cost of running the data-centres is falling, and the value of the services they offer customers is going up – going up considerably.

This is not only because clients are increasingly seeing the benefits of the cloud, but also because with each integrated rival, IOM’s range of services grows. The range of clients increases too. This looks like a business right in its sweet spot.

Of course, there are risks, not least of which is this ambitious growth strategy. Having paid a whopping £23m for what, to all intents and purposes, is a small rival, one can see how things could go wrong.

We’ve certainly seen things go wrong for bigger technology companies in the recent past. Probably the most acrimonious of which was Hewlett Packard’s takeover of Autonomy, a case that’s still rattling round the courts.

But overall, I’m prepared to run with IOM. The fact that the market has treated the stock with scepticism is actually a good sign, and it allows investors an opportunity to hop aboard at a reasonable valuation.

Yes, I know that 26 times earnings is hardly bargain basement; but on the assumption that we can hope for top-line growth and margin improvement, I expect to see that valuation multiple drop quickly.

Exciting times, in an exciting industry!

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