Small Cap Value Report (11 Jun 2015) - AVS

Good morning! This is turning out to be a cracking week, with a lot of my favourite stocks reporting good, or at least acceptable results & trading updates. That's encouraging, as I've had a run of relatively poor performance for about a year, with my long term positions anyway, where I was beginning to think I was a magnet for profit warnings!

I was discussing this the other day with a fund manager, and we agreed that with small & micro caps, to be on the safe side, you have to assume that everything will warn on profits at least once every five years. That's a good rule of thumb anyway, and valuations should allow for this - i.e. small caps should be at a discount to the market as a whole, to accommodate the higher risk.

So it's a real problem at the moment when most small caps seem to be priced to perfection. I'm just not prepared to pay 20 times earnings for businesses that have historically been priced on 10-14 times, which is the situation I'm finding with many small caps that I research at the moment.

Happily, as we have so many to choose from (well over a thousand UK small caps), there are still bargains to be found, but it's getting harder to unearth them. Often I'm finding it's stocks where there is no broker coverage at all, or where the broker forecasts are lagging way behind reality of improving trading updates, that present the best opportunities, one of which is:

Avesco (LON:AVS)

Share price: 179p (up 27% today)
No. shares: 19.1m
Market Cap: £34.2m

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

Interim results - for the six months to 31 Mar 2015.

I've been banging the drum about this share quite a lot this year, because the trading updates were flagging a much improved performance, but the share price was only modestly rising. Really good figures out today have put a rocket under it, up 27%, so the question now is whether to top-slice my position or not? I had a price target of 200p in the back of my mind, so it's not a million miles away from that. Let's get stuck into the numbers!

Revenue for H1 was only up 1% on prior year, but the important thing to note is that there were no major events in H1 this year (historically the business has been very lumpy, producing good results from major sporting events, and poor results in between).

Trading profit for H1 was £5.5m, up from £4.7m in H1 last year.

Basic EPS drops out at 13.3p for H1 this year, against a loss of 12.4p last year, despite a heavy tax charge this year (caused by big taxable profits in USA, where the rate is 40%, which cannot be offset against losses in other countries). The tax charge should reduce next year & thereafter, so to achieve 13.3p EPS in H1 despite this problem, is creditable.

Also bear in mind that big share buybacks have been done, so the number of shares in issue has dropped considerably from 26.4m in 2012, to 19.1m now. That has an obvious benefit to EPS and the dividend yield, and also means that forecasts based on historic EPS numbers will throw out incorrect results, unless you adjust for this factor.

Outlook - all sounds very positive indeed, hence the big share price rise this morning, e.g.

(insert)

I could have highlighted the whole thing, as it's all positive!

Valuation - looking back at last year, trading was heavily weighted to H1, but reading the outlook statement above, it sounds as if H2 is going to be strong this year too. Therefore with 13.3p EPS already in the bag, it seems to me that the full year might be heading towards say 20-25p EPS.

Is this an exceptional, one-off year? It doesn't seem so. The improvement in performance has come from stemming the previous heavy losses in the German division, which have been "almost eliminated". The Asia Pacific division is still struggling to reach breakeven, which is taking longer than expected. So potentially more upside once those divisions are fully turned around, but the main restructuring has now been done, and is clearly coming through in much better trading.

Broker consensus of 10.3p EPS this year, and 15.9p next year look far too conservative to me, so I am hopeful of further broker upgrades in time. Although even on current broker forecasts, the stock still looks good value.

Dividends - there's been a terrific trend in divi payments here in recent years, and that continues today, with the interim divi up a third from 1.5p to 2.0p. Total divis for this year are forecast at 7p, giving a yield of 3.9% at today's higher share price.

Balance Sheet - bear in mind that this is an asset hire business, so it has lots of fixed assets, partially funded with debt. Net debt rose to £25.1m in the period, which looks acceptable to me, as it's only about 1 times EBITDA. The assets have a relatively short life, so are depreciated fast. Hence continuous heavy capex is required. Therefore it's best not to get too carried away with the huge EBITDA figure!

NTAV is 180p per share, and I can't see any valid reason why this share is trading below NTAV. It should be at a considerable premium, in my view. Most equipment hire companies seem to be priced at around 2 times NTAV, or higher. So there's a clear valuation gap here, probably due to Avesco's historically sub-par performance. Although that now seems to be coming good, following restructuring last year.

Freehold property - this is in the books at depreciated cost, of £6.8m. I've heard that the open market value of the group's land assets could now be significantly above book value, but you would need to DYOR on that, as I have only heard it secondhand, verbally, from a friend who looked into it a few months ago.

Director shareholdings - Directors have been buyers earlier this year. The Chairman had taken his stake up to near the maximum (of 30% - where you are obliged to launch a takeover bid, unless a whitewash is secured from the Takeover Panel). That seemed to me a bullish sign (he was buying at c.120p), so was one of the factors that made me want to continue buying at the time.

Note the announcement today that the Chairman (who is of retirement age, I believe) has sold 540,000 shares at 175p. Disappointing? Not when you see who has bought them - the whole lot has been bought by other members of the senior management team at Avesco! To my mind that's a remarkably bullish turn of events.

I should add that Director remuneration looks high to me. So a thumbs down there. Still, with the shares doing what they've done this year, I'd be more inclined to give the Directors a hearty clap on the back & buy them a pint, rather than moan about their salaries!

My opinion - I've suppressed the temptation to top-slice my holding into this morning's rise, as I think this stock could be heading for the 250-300p range, with a (say) 1-2 year view, if and only if my assumptions on earnings beating forecast are correct.

Note that this share is fiendishly illiquid, due to it being very tightly held. So it can be very tricky to buy and sell. It took me about a month to build up a not particularly large holding in it, earlier this year - I just waited for red days, and picked up scraps of stock when sellers emerged.

After a cracking run like this there are bound to be some holders who want to bank their profits, so I am expecting a pullback at some point. Having said that, the fundamentals seem to fully justify this move - the (inefficient) stock market in micro caps is just catching up with events, in my view.

Today's video covers: CareTech (CTH), Volex (VLX), Mulberry (MUL), Versarien (VRS), and Gate Ventures (GATE)

See you tomorrow!

Regards, Paul.

(of the companies mentioned today, Paul has long positions in AVS, VRS, and no short positions. A fund management company with which Paul is associated may also hold positions in companies mentioned)