Gamble of the week: well-performing small cap

This small-cap IT outsourcing company serving mainly SMEs recently announced profits above City expectations, and looks like an obvious takeover target.

The small-cap sector has been absolutely hammered by the fall-out from the credit crunch. The sector has fallen by more than 30% in the past 12 months as investors have sold out of their positions in perceived riskier plays. However, as much of the selling has been due to technical rather than fundamental issues, there invariably comes a point when buying opportunities appear.

Business Systems Group (Aim:BSG)

One such is Business Systems Group, an IT-outsourcing group serving small and medium-sized organisations, including Charles Stanley, Marie Curie Cancer and Vail Williams.

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Last month BSG announced full-year results that beat City hopes sales and underlying earnings per share came in at £31.4m and 1.2p. What's more, its quality of earnings improved as well, with recurring revenues jumping from £7.1m to £8.4m due to impressive growth in its managed services unit. The directors expect this trend to continue, as BSG picks up more long-term contracts to deliver IT helpdesk, maintenance and hosting functions.

The eventual goal is to generate around half of the group's gross profit from managed services - and thus to not only cover all its fixed costs, but also insulate itself from more volatile trading at its hardware arm which supplies clients with equipment from the likes of HP, IBM and Cisco.

What seems overlooked by the City, is that as at the end of March, BSG had net funds of £9.3m, or equivalent to around 11.5p per share. If the distortive impact of this cash pile was excluded, then the stock's historical p/e ratio would fall from 11.7 to only 2.5 (on a fully-taxed basis), which looks far too cheap particularly as there is still £3.4m of unused tax losses.

As always, of course, there are risks. A hard recession would undoubtedly hit profits, and its 'solutions' division, which develops software applications for customers, also faces challenges from lower cost rivals. On top of this, rising power prices could trim profit margins at its data centre operation.And the shares can also be illiquid with only a 25% free float available on Aim.

That said, at these depressed levels, BSG looks an obvious takeover candidate, with potential buyers including either a larger rival or even the existing management team. Assuming this was the case, then I would estimate its break-up value to be easily north of 18p per share.

Recommendation: SPECULATIVE BUY at 13.75p (market cap £10.7m)

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.