Small Cap Value Report (20 Jan 2016) - SPRP, SDM, COS, KBT, SNTY

Good morning!

I did 5 more quick company updates last night, so here is a link to yesterday's full report.

Difficult market conditions

I don't suppose any readers need reminding that it's ugly out there at the moment. Probably like most people, I'm weighing up whether I should be cutting positions more, or just ride out this downturn? The trouble is, cutting positions often means that you miss out on the explosive rallies which are a feature of bear markets (and this is increasingly looking like a bear market). So better to sell after the big rallies, rather than panic and sell right at the lows, perhaps? Oh, for a crystal ball!

Bargains are appearing, and I have been (perhaps foolishly?) buying shares that I particularly like, at attractive prices. The trouble is that a PER may look low at first sight, but if earnings have peaked and are now likely to fall, if Western economies go into recession again, then we don't really know where we stand about future earnings, and hence valuing a share.

That will be a key theme in my interview with Somero Enterprises Inc (LON:SOM) management this afternoon - last call for your questions, using this form please.

We could be getting close to the point where markets rally strongly (it's amazing how quickly sentiment can turn when some good news comes out). Or we could be on the cusp of things getting worse, if there's some shock to the system. Are things really so bad, to justify such a big sell-off?

Thinking back to 2008, what really clobbered the markets was when systemically important financial institutions started failing, or needing bailouts. This time around, banks' balance sheets are very much stronger, and politicians & civil servants know what to do - they have to act fast, and shore up big financial organisations, to prevent contagion. So it seems to me perhaps unlikely that things will get as bad as 2008 this time around, but I reserve the right to retract that remark at any time!

What am I doing with my own portfolio? On my long-term, ungeared portfolio, I've trimmed a couple of positions slightly, but that's it. On my shorter term trading accounts, I've cut the gearing right back, and hedged with short positions. So far that's worked well.

As I've mentioned many times before, I had a terrible time in 2008 - I pretty much lost everything, and had to start all over again. The big mistake I made was combining gearing with illiquid assets (big positions in micro caps). That made it impossible to exit from positions, as they collapsed in price.

Therefore I urge readers to avoid making the same mistake as me. If you are leveraged heavily, in micro caps, then you're an accident waiting to happen. The bid just dries up completely when the market goes into a steep fall. I had a small reminder of this today, when trying to trim back on a few really tiny companies. Trying to sell £10k worth of shares proved impossible - the most I could sell was £1k worth in each company! So imagine if you have much bigger positions, geared up, in tiny companies, and you're desperate to sell to meet margin calls. You then get into a death spiral, as each small sale knocks the price down another 10%, thus triggering an even bigger margin call, and so on until you're forced out of the positions at whatever price can be obtained. Forget stop losses too - they're not honoured in illiquid positions.

I can remember having to accept 10-20% haircuts on the market price to get rid of even £20k of stock in micro caps back in 2008. So above all else, remember that it's gearing which is the killer. If you're ungeared, then you can ride out a downturn, and come out the other side still in the game. If you're geared, it's game over. "Gear today, gone tomorrow", as the saying goes. I know this is repetition, but it is my mission to ensure that other people don't make the stupid mistakes I made in 2008, so I'll never tire of warning about the dangers of gearing, especially in illiquid shares, and especially in market conditions like these now.

At some point, I think there could be a massive, global de-gearing, and collapse in asset prices. UK residential property is an accident waiting to happen, as we know. The other thing to remember with geared positions in the stock market, is that at times of market turmoil, the spread betting & CFD providers hike up the margin requirement, to protect themselves from bad debts.

I recall in 2008 fighting a rearguard action on my spread bet accounts, having just straightened them out, when one SB company decided to hike the margin on my largest position from 20% to 40% overnight! It put me on margin call for a mid-sized 6-figure sum. That was interesting.

Therefore, with geared positions, in a time of market turmoil, it's about selling whilst you can, rather than holding on to an increasingly desperate position. Better to take some short term pain, and live to fight another day, than go down in a blaze of glory.

Anyway, on with today's results & trading updates, if anyone is interested!

Sprue Aegis (LON:SPRP)

Share price: 324.5p (down 4.1% today)
No. shares: 45.9m
Market cap: £148.9m

Trading update - this mostly reads well, apart from a question mark over the outlook. Key points;

• 2015 ahead of expectations, "another record year"
• Revenue up 35%
• Operating profit up 16% to £12.1m
• France big in H1, "softened considerably" in H2
• Huge adverse forex impact - reduced profit by £7.6m
• Net cash of £22.4m (48.8p per share) despite inventory build up re factory upheaval

Outlook - 2016 is expected to be in line, but H2-weighted (normal seasonal pattern, they say).

My opinion - a smashing company, that has traded very well in recent years, driven partly by legislation requiring the fitting of smoke alarms - so a one-off, long-life sale. I wonder therefore whether current very strong trading is sustainable?

The H2-weighted outlook for 2016 introduces risk, and my worry is that being up against tough comparatives, the interim figures later this year may be badly received.

Overall, I feel it's probably priced about right, hence not of interest to me. The company would need to out-perform against current expectations to justify the share price having another leg up, in my view.

There could be upside from the cash pile - a special divi maybe, or an exciting acquisition to spur earnings growth? Overall then it seems a good company, probably fairly priced for now. In current market conditions, it will take a lot for any share to swim against the outgoing tide.

Stadium (LON:SDM)

Share price: 95.5p (up 3.2% today)
No. shares: 36.5m
Market cap: £34.9m

Trading update - this looks quite good, hence this share being a rare riser today, in an otherwise grotty market.

...trading for the year ended 31 December 2015 is in line with market expectations.

Although note that 2015 expectations were reduced twice during 2015, so the company has only hit lowered expectations.

Outlook - upbeat, although it's early days for 2016;

Encouragingly, the strong trading performance experienced in the latter part of last year has continued into the New Year. Further, the integration of Stontronics, a UK based manufacturer and distributor of power supply units, which was acquired in August 2015, is proceeding in line with plan.

Valuation - the fwd PER is low, at 7.5, but that's based on quite a big jump in 2016 earnings, presumably based on the acquisition mentioned above.

My opinion - I'll reserve judgement until the full year figures are out. The interim balance sheet was starting to look a bit weak, dominated by goodwill. There's also a pension deficit. I see they raised fresh equity at 110p to fund another acquisition.

I'm generally not keen on groups which grow by acquisition, as things often end up going wrong at a later date. Based on today's update though, Stadium appears to be trading well at the moment.

Collagen Solutions (LON:COS)

Share price: 7.65p (down 11.3% today)
No. shares: 171.4m
Market cap: £13.1m

Profit warning - a jam tomorrow share that has not lived up to expectations (quelle surprise!)

The total estimated effect will be to reduce the revenue for the year to approximately £2.8 million compared with previous market consensus expectations of £3.6 million and LBITDA now expected to be approximately £750,000 compared with a consensus of £602,000.

Outlook comments are upbeat, as they always have to be with jam tomorrow shares, and note the Chairman's intention to buy more shares, which is helpful, if in meaningful size;

"I remain very confident about the future based on the recent strengthening of our Commercial Team in the US and Europe and this will be strengthened further in Asia in this quarter. Additionally, our pipeline is the strongest it has been during my tenure as Chairman. I am prepared to back this sense of confidence by increasing my holding in the Company over the coming days."

My opinion - I'm so bored with jam tomorrow shares. Practically all of them go wrong! Yet punters keep queuing up for more. Madness.

K3 Business Technology (LON:KBT)

Share price: 345p (unchanged today)
No. shares: 31.9m
Market cap: £110.1m

Trading update - this software company updates for its H1, ending 31 Dec 2015.

The statement sounds upbeat, but the crux is that H1 profits are in line with management expectations. Revenue was flat, but profits "show a significant increase year-on-year", so better margins and/or cost-cutting I suppose.

Net debt reduced by £1.7m in 6 months, to £10.4m.

Outlook comments sound upbeat;

K3 remains well positioned to attain market forecasts for the financial year, with high levels of recurring revenues as well as a strong pipeline of prospects.

My opinion - the weak balance sheet has put me off in the past, but the company seems to be performing pretty well. I'll have a proper look at the interim results when they come out in mid-March.

Synety (LON:SNTY)

Share price: 74p (down 6.3% today)
No. shares: 13.5m
Market cap: £10.0m

(at the time of writing, I hold a long position in this share)

Trading update - for  calendar 2015. It reads quite well, with the key points being;

The Board is pleased to announce performance slightly ahead of expectations.
Key financial metrics:-
o  Group revenues up 105% to £3.33m
o  US revenue up sevenfold to £0.5m
o  Cash balance at year-end £1.58m
o  Operating cash-burn reduced by 25% in 2H 2015, compared to 1H 2015

Various other details are given.

Cash position - as expected, the cash position is getting tight again. Nobody should be surprised by that - the company has a history of not raising enough money, and I've mentioned in these reports last year that another fundraising would be necessary.

The company had just over £3.0m at 30 Jun 2015, and today it reports £1.58m. So the cash burn has been just over £1.4m in the last 6 months. Turnover is rising rapidly, and cash burn is reducing, therefore on current trends it's probably got enough cash last until the autumn of 2016.

Obviously everyone holding the stock is going to be worried that management might once again mess up the next fundraising, and have to do it at a huge discount again.

My opinion - I had a fascinating discussion with fellow long-term holders of this share today, both very shrewd investors. One is exasperated, and fearful of another discounted fundraising. The other (who is not given to exuberance at all) told me he sees this as the best risk:reward position for this share in all the time it's been listed - it's cheap (£10m market cap), the product is proven, achieving >100% turnover growth, and the company is not a million miles away from breakeven.

As he pointed out, imagine if we knew nothing of this company's history, and it was new IPO today. We would think £10m was an absolute bargain for a rapidly growing, high recurring revenue, high margin tech stock. The price would be multiples of the current market cap.

There's no doubt in my mind that this company is now going to succeed commercially, as it's well on the way, and the valuation will look very different once it begins self-funding expansion, and the operational gearing of high margin sales drops into rapidly growing profit.

The only question mark is how many shares will be in issue, and what price they will be at, when it does reach breakeven. If you look at major shareholder trades, the biggest shareholder (Helium Rising Stars) has been adding in the market, and crossed over 17% of the whole company in Jan 2016.

Whilst of course I can't second guess their motivation, it suggests to me that the mood has changed for the better, and that big shareholders would probably be a lot more receptive to one final, small fundraising to push it over the line to breakeven.

Therefore, on balance, I'm fairly convinced this company is now on the home straight, but I am also worried about what terms the final fundraising will be on. As long as there's an open offer for existing holders to participate in, then I'll happily cough up a bit more dosh to see the company succeed.

This share is much too speculative for most people. I'm only commenting on it because it's been covered extensively here before, and obviously so far has been a very poor performer. I'm comfortable that it'll turn out alright in the end though, and today's statement reinforces that. I'm not going to buy any more until the funding issue is addressed though.

All done for today! See you in the morning.

Regards, Paul.

(these reports are my personal opinions only, subject to change without notice, and are not recommendations or advice - the onus is on readers to do your own research.

I hold long positions as disclosed above, and no short positions in companies mentioned today)