Small Cap Value Report (Thu 15 Jun 2017) - PURP, PRSM, DFS, SPRP,

Good morning, it's Paul here!

Many thanks to Graham for covering Mon-Wed SCVRs here. That allowed me some time off, to relax with family, who visited me for a couple of days.

A few overview comments, before I get stuck into some companies reporting on trading, and results.

Growth companies & BMUS

The extraordinary bull market which we have seen in growth companies seems to be having a serious wobble at the moment. The big question is whether this is (yet another) good time to buy the dip, or whether things are turning bearish? I don't know the answer to that, as it depends on the sentiment of other people. Although I'm leaning towards being more cautious now.

Personally, I decided to bank some of the stupendous profits (186% in 2 years, with no gearing) on BMUS. Why get greedy? So I sold everything that looked fully priced or more. I've only kept 3 conviction, long-term holds, and a few other smaller bits & pieces.

The nice thing about selling out & holding cash, is that you can change your mind and buy back in at any time. Plus of course your cash increases in buying power, if the market does continue falling.

There have been some really sharp corrections in tech stocks lately. I see that the US FANG stocks have had a wobble. Also, some UK growth companies that I follow have dropped sharply - e.g. Purplebricks (LON:PURP) was 450p a few days ago, and is now 370p - an 18% fall.

Another wildly pricey growth stock, Blue Prism (LON:PRSM) (in which I hold a short position currently), peaked only days ago at c.950p, and today has dropped to 724p, a 24% drop, on no news.

This is a reminder of how volatile prices can be in growth companies, especially when everyone is trying to buy or sell at the same time. Companies like PRSM and PURP look staggeringly expensive on conventional metrics, and are almost impossible to value accurately. Hence when sentiment turns in either direction, price moves can be blisteringly rapid, and overshoot in both directions.

Consumer spending turning negative?

There are some troubling facts & figures emerging, which seem to point to consumers drawing in our collective horns. Inflation of 2.9%, and average wages rising at 2.4%, means that real incomes are now negative. That would usually translate into a higher % fall in discretionary spending.

Add the fact that we now have massive political uncertainty too, and my view of things consumer-related is now leaning towards a negative view. For that reason, I'm out, or almost out, of all conventional retailers & hospitality stocks. The only exception being Revolution Bars (LON:RBG) as the pain has already been taken there, and it could be a beneficiary of Govt spending shifting towards electoral bribes for younger people.

I've opened up some whacking great shorts on Marks and Spencer (LON:MKS) , Debenhams (LON:DEB) and Restaurant (LON:RTN) - because I cannot imagine how any of those stocks avoid profit warnings. They not only face consumers tightening our belts, but also some horrible upward cost pressures. Companies talk about mitigating cost pressures, which can maybe succeed in year 1. However, what happens in years 2, and 3, when incremental rises in Living Wage occur? Plus staff at higher levels seek differentials to be maintained, causing wage inflation all the way up? Employers can't keep cutting rotas every year, because they will then lose customers, and sales fall.

The operational gearing in retailing & hospitality is wonderful in a growing economy, but savage in a downturn. Also, brokers tend to remain too optimistic at the start of a downturn, under-estimating the operational gearing.

So apparently cheap forward PERs and generous divis can quickly turn into cancelled divis, a high PER, and even a struggle to survive, if the balance sheet is laden with debt.

If consumer spending bounces back, then I'll close the shorts & go long again. It's so important to be flexible, and keep an open mind. The opposite is clinging on to losing positions, and hoping that everything will turn out OK. That can be disastrous, as I know only too well from awful previous mistakes.

DFS Furniture (LON:DFS)

Share price: 198.25p (down 21.3% today)
No. shares: 211.5m
Market cap: £419.3m

Trading update (profit warning) - this is a very important announcement, as it clearly has read-across to other big ticket retailers. DFS is obviously a furniture & upholstery retailer. Its year end is July 2017.

Softer H2 trading had already been flagged up by the company;

In our half year results announcement on 30 March 2017, we highlighted the expectation of a softer market environment in the second half of our financial year.

However, things have recently turned worse than expected;

The trading environment has however recently weakened beyond our expectation, with significant declines in store footfall leading to a material reduction in customer orders.

So that sounds pretty bad. DFS reckons it's not just them suffering;

We believe these demand effects are market-wide, in line with industry indicators, and are linked to customer uncertainty regarding the general election and the uncertain macroeconomic environment.

As stated previously, the upholstery market does see short-term demand fluctuations from time-to-time, within an overall historical trend of long-term growth. 

The financial impact is given, which is helpful, as follows;

Driven by these short-term revenue effects, we therefore now anticipate EBITDA over the full year to be lower than market expectations for the current year, and in the range of £82m-£87m. 

However, the company failed to give a footnote indicating what market expectations currently are. That's so frustrating, as I can't currently get hold of any broker notes on this company. I'll update this section when some requested broker notes reach me.

James on Research Tree has posted an article saying that last year's EBITDA was £94.4m, so the drop to £82-87m this year is a 8-13% fall. Not great. However, as the shortfall is happening near the end of this financial year, then this implies a much worse impact on next year's figures if this proves to be a sustained fall in demand.

Outlook comments today are as follows;

Notwithstanding this, we have maintained our investment in the business and we are confident that we will outperform the market over the longer term, driven by our scale, business model and proven growth levers.

We believe our expectations for the next financial year are realistic based on consumer confidence remaining broadly in line with current levels, given its consequent impact on upholstery demand.  We expect continued strong cash generation that has allowed the recent announcement of a £20m special dividend in addition to our ordinary dividend.

I can't square that at all with the sudden drop in consumer confidence which they report above. So personally, I'm taking that with a pinch of salt.

My opinion - I wouldn't touch this sector at the moment. The last thing I would want to invest in, when consumer demand is softening, is a retailer of big ticket items. They have horrendous operational gearing, and political/Brexit chaos is likely to pertain for some time.

DFS also has a horrendous balance sheet, with too much debt. NTAV is negative at £242.9m. Therefore I'd say the divis could be unsafe, if trading worsens further. It could even face a solvency crisis, if profits melt away and banking covenants are breached.

Therefore, if consumer confidence remains fragile, I'd be more inclined to go short of this stock, than long.

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Sprue Aegis (LON:SPRP)

Share price: 215p (up 10.3% today)
No. shares: 45.9m
Market cap: £98.7m

AGM trading statement - this company sells smoke alarms in several countries.

Its profitability has been volatile in recent years. This stock is an exception to the perceived wisdom of selling after a profit warning - the share price has almost doubled since it warned on profits in Apr 2016.

This sounds good, but bear in mind that H1 last year was very bad, so a big improvement this year is expected already;

"Sprue has made a positive start to the year with an expected strong return to profitability in H1 2017 building on the steady progress delivered by the Company in the second half of 2016.

The combination of a significant improvement in gross margin and a net reduction in overheads is expected to contribute to a much improved financial performance by the Group in H1 2017 compared to H1 2016.

Overall, it's an in line update, so I'm not entirely sure why the share price has risen 10%;

Despite the recent modest currency fluctuations (Sterling v US Dollar and Sterling v Euro), the Group remains well positioned to deliver full year adjusted operating profit in line with market expectations.

Perhaps it's these upbeat comments, although this sounds like re-announcing already-known things;

The new manufacturing and distribution arrangements announced by the Company on 31 March 2017 are progressing well. 

These transformational initiatives will further strengthen our offering in the key markets we serve across Europe and greatly enhance our ability to accelerate growth and maximise shareholder value in the medium to longer term."

There are some positive phrases in there. I like the word "transformational", and the bit about accelerating growth. That could be why shareholders are prepared to pay up for this share?

Note that the company has a strong balance sheet, with a decent cash pile.

Also it pays generous divis, with a current yield of just under 5% - that's clearly attractive, especially as the divis could continue growing if growth initiatives are successful.

My opinion - overall, this share looks pretty good. Providing of course that there aren't any more slip-ups such as occurred in 2016. There was a big problem then with faulty batteries from a supplier, which led to a big product recall.

It looks fully priced for now, but if growth does accelerate, then there could be further upside perhaps?