Small Cap Value Report (24 Nov 2016) - BLV, LTHM, MTC

Good morning!

Apologies for there being no report yesterday, I was under the weather so had a sick day. I know the service from me is a little unreliable, but it's still pretty good coverage considering it's just one person working all year round.

Plus I don't think anyone is complaining, considering the series of big winners we've had here (e.g. BOO, AVS, LVD), in what is turning out to be a blockbuster year. My broker even quipped that if I find any more takeovers, the FCA will probably come knocking. Still, when you have a portfolio of 40 value/GARP shares, there do tend to be plenty of takeover bids.

There's a very clear trend now of overseas (esp. American) companies buying up cheap UK companies, since sterling weakened. Let's hope there are lots more!

Letting agents

The Autumn Statement earlier this week has put the cat amongst the pigeons for letting agents, as the Government is proposing to ban fees to tenants. Although it should be noted that proposals like this are often watered-down, or dropped altogether, during the consultation period. No doubt lobbyists will be paid handsomely to nobble the proposals.

I've been sounding out opinion on Twitter, and it seems mixed. Some people think that landlords will just jack up rents to recoup their additional costs. My view is that, even if that is the case, it's still a much better idea to have the landlord paying the letting agent, since the agent works for them. Also, there's greater transparency with no fees for tenants - the rent is transparent, but often the fees are not.

I rent a flat in Hove, and was recently appalled at being charged £70+VAT just for a one year renewal document. This would have take all of 5 minutes for the agent to prepare. I texted my landlady and suggested we draw up the document ourselves next time. She agreed, as she had also had to pay £70. So that's £140 the agent earned from a few minutes work, and hitting a few buttons on her keyboard. As I quipped to my landlady, "we're in the wrong game!". She laughed, and said that she's just been saying the same thing to her mother-in-law.

Belvoir Lettings (LON:BLV) has issued an interesting RNS on this matter today, saying;

At this stage, Belvoir cannot fully predict the likely financial impact on the results for the year ended December 2017 and beyond.  Based on the Group's experience following a similar decision in Scotland in 2012, however, the Board anticipates that mitigating action should be possible over time and indeed it should be noted that no franchisees were lost in Scotland as a consequence.

The Board believes that less than 10% of the income derived by franchisees is from fees to tenants and, due to the broader revenue streams to the Group, the impact on total Group gross profit is anticipated to be less than 8%.  The impact may well be far greater for many of the large number of independent letting agents. 

Whilst this may sound reassuring, I don't see it this way. Lettings agents are largely fixed costs businesses. So losing 8-10% of their income, which is 100% profit, is likely to have a devastating impact on the bottom line. Over time though, as noted, they'll presumably be able to pass on the additional costs to landlords.

Countrywide (LON:CWD) also puts out an update today, which points to slowing residential property transactions;

As expected when we reported our Interim results, transactional activity in the residential property market has remained challenged.

A combination of changes in stamp duty and the EU referendum in June means transaction levels are currently running significantly below 2015.

Bank of England mortgage approvals in Q3 2016 were 12% below last year.  We now expect transaction volumes for 2016 to be 6% down on 2015 and while too early to say definitively, it is likely that the level of market transactions in 2017 will be lower than 2016. 

So with sales volumes down, and now lettings fees to tenants likely to be scrapped, it looks like estate agents are going to have a lean time going forwards. There's additional pressure from new entrants in the online space, offering a much cheaper (although arguable quality) service.

I chuckled at the Dire Straits song reference from Peel Hunt today, who gave this clever & amusing title to their latest note on Countrywide - "Money for nothin' and checks for free". It does indeed look as if estate agents are in dire straits.

Speaking to a couple of friends who are very experienced property magnates, they both told me that the mid to upper end residential sales market in London is absolutely dead. Therefore they see Foxtons (LON:FOXT) as facing a very nasty outlook. For that reason, I closed my long on it, and went short.

Countrywide also made this interesting comment about an improvement in supply of rented housing easing the upward pressure on rents;

The lettings market was affected by the rush to beat the changes in stamp duty at the end of Q1, resulting in a larger than usual supply of rental properties.

Stock has increased more than tenant numbers, meaning more choice for tenants slowing rental growth, with rents falling in some areas.

Overall though tenant numbers have increased slightly compared to last year and we expect the slowdown in the sales market to support the growth in the size of the rental market in the medium term.

Whether that's a temporary factor or not, who knows?

Clearly something has to be done about the chaotic state of UK housing. It's ridiculous in the South East anyway - rents are far too high for most people, and availability is a big problem. Yet we have all these empty flats, owned by speculators. What a crazy situation.

Overall then, with estate agents facing 2 headwinds, I'll be avoiding buying any of them, and may open some new shorts in this sector. I've never understood why estate agents are so reviled as people. Personally I've chosen good ones in the past, and had excellent service from them. In my view estate agents are a bit like PR people - usually very pleasant, but take most of what they say with a pinch of salt!

James Latham (LON:LTHM)

Share price: 700p (up 5.6% today)
No. shares: 19.6m
Market cap: £137.2m

Half year results for the 6 months to 30 Sep 2016 - these figures look good to me. I note from the StockReport that broker estimates are for a fall of about 11% in EPS this year. In the past brokers have been too pessimistic about this company, and it looks as if that may be the case for y/e 31 Mar 2017 as well.

From what I can make out, this company seems to mainly be a distributor for imported wood products. So forex is a key issue for it - weaker sterling means higher cost prices. Judging from these interim figures, it seems that Lathams has been able to pass on the higher prices to customers.

Although it sounds to me as if the impact on margins has possibly been deferred somewhat (maybe through forex hedging, although this is not specifically mentioned in today's RNS, it seems to be implied from the comments below);

Management information shows growing revenue for October and the first half of November, at slightly lower margins.

The weakness of sterling, whilst increasing prices, could put pressure on margins in the coming months.

Market conditions continue to be difficult in some areas, while improving in others.  We are in a good position with our wide range of customers and we are trading comfortably in line with market expectations.

We are progressing with our plans to relocate our two oldest depots.  Construction work has started on the new Yate site and terms have been agreed for the new Wigston site, subject to planning.

Given what the company says above, it's perhaps best to be a little cautious.

Valuation - going by the broker consensus of 47.1p EPS for this year, the PER is 14.9.

That may not look cheap but as I always say when reporting on this company, investors are also getting an "inefficient" balance sheet, stuffed with surplus working capital.

Current assets are £89.2m (including £16.1m cash), but current liabilities are only £27.3, which is a current ratio of 3.27 - extremely healthy. If you reset that to say 1.3, which would be a perfectly acceptable position, then theoretically that implies there is £53.7m in excess working capital - i.e. liquid assets. That's a big chunk of the £137.2m market cap. This is dormant value - at some point, something might happen to unlock that value. Or it may not. However, it loads the dice in your favour.

Pension deficit - it's not all plain sailing though. As you would expect, the deficit has shot up, more than doubling from when last reported, to £23.2m. This will probably have since reduced, due to bond yields rising recently from extreme lows around 30 Sep 2016.

Dividends - there's a well-covered divi here, yielding c.2.5%. Not madly exciting, but it looks very safe, due to strong earnings cover, and a balance sheet stuffed with cash.

My opinion - it's long been a favourite company of mine, but I found it too illiquid to buy, so don't hold any. With a big housebuilding programme being required for many years to come, I imagine Lathams should be well-placed to benefit. It's got a fabulous balance sheet, and seems very well managed.

Bear in mind that margins may come under pressure in future, but so far the company seems to be coping absolutely fine.

Mothercare (LON:MTC)

Share price: 105p (down 5.8% today)
No. shares: 170.9m
Market cap: £179.4m

Interim results - 28 weeks to 8 Oct 2016 - a strange 28 week reporting period, although the prior year comparatives are also 28 weeks (as opposed to the more normal 26 weeks), so they are comparable.

This is a difficult company to analyse, as there are lots of moving parts, and it's now into the 2nd year of a restructuring which, so far seems to have just steadied the ship, as opposed to delivering good results. This has been reflected in a poor share price performance, which now has little recovery potential priced in, as hopes for recovery dissipated.

You would clearly have to be quite brave to buy this share, given this unnerving chart.

Today's drop in share price isn't encouraging either - if investors don't like a share on results day, then that could indicate more selling to come.

H1 results - the UK business is still a problem, generating a £8.8m underlying loss on turnover of £231.1m - so still looking a pretty marginal operation. Although better performance is expected in H2.

International is really the core business. It generated a £20.8m underlying profit in H1, on international revenues of £405.6m. That looks a reasonably OK performance - profit was down £4.1m on last year's H1.

I note from the narrative that forex hedging seems to have blunted the improvement in profitability which should flow through from sterling's weakness. So that could provide potential upside to future results.

There are more exceptionals and "non-underlying" charges, of £6.7m.

Digital sales - I nearly fell off my chair when reading that 40% of UK sales are now digital. However, this is not really true. The narrative later points out that 44% of digital sales are actually from customers using Mothercare's iPads in store! So that's clearly not digital sales at all, it's just that a customer is happening to use an iPad whilst in the store.

Broker downgrades - Peel Hunt has today cut their EPS forecast for this year from 10.7p to 9.2p. Although some of the reason for under-performance in H1 is temporary - e.g. the 8 week period of disruption in the UK business, due to a warehouse reorganisation.

Store refits - c.60% of UK stores are now refitted. So it's all the more worrying that the UK operation is still loss-making.

Outlook comments - sound alright. Here's an excerpt;

"Finally, we are making good progress with the reorganisation and focus within our International business.  While sales are still volatile across the globe, many of our markets have now returned to growth.

We are putting retail space down and exporting our learnings and good practice from the UK into International online, which has grown by +46% in local currency.

"While conditions in the first half have been challenging, the second half has started in line with our plans and the business is well prepared for the important peak season.  We expect to make further progress in the second half which will partially compensate for the effect of the headwinds experienced in H1.

Dividends - it's not paying any at the moment.

Balance sheet - is dominated by the pension deficit, which has ballooned for the reasons we're familiar with - ultra-low bond yields makes the liabilities much bigger. The £106.5m deficit is worrying.

Other than that, the rest of the balance sheet looks OK-ish. There's a bit of bank debt, but not at alarming levels.

My opinion - I'm on the fence on this one. It's tempting to pick up a few for a future improvement in performance. There again, the UK business seems to be going nowhere. There must be so much competition online these days.

Forex movements are likely to hurt the UK business, but benefit translation of overseas earnings, once forex hedging has expired.

At some point this share could make a decent investment. I'm just not convinced this is the right time, but who knows? So overall, I'm probably neutral on it right now.