Small Cap Value Report (27 Nov 2015) - FRP, CAKE, RSTR, CFYN

Good morning!

I'm conscious that my reports this week haven't been up to scratch, so I'll try to do a half decent one today, before I head into Soho for lunch & a brainstorming session with the boss!

Fairpoint (LON:FRP)

Share price: 173.5p (up 3% today)
No. shares: 45.6m
Market cap: £79.1m

Response to Autumn Statement - as we know, earlier this week George Osborne announced the Govt's intention to clamp down on whiplash claims, and the like. This sounds like it could have a major, negative impact on the various ambulance-chasing claims & legals firms which have been profiting from this area.

This reinforces just what a lucky escape Quindell (LON:QPP) shareholders had. Not only was accounting fraud uncovered at the company (no surprise to those of us who had properly scrutinised the company's accounts, and found numerous red flags over the years), but also it now seems that its core business would be under serious threat from these Government proposals.

Indeed, you only have to look at the hapless (or should that be hopeless?) Aussies that bought Quindell's main operations, Slater & Gordon. Look at its share price, since they inexplicably paid £600m for Quindell's main business, despite the seller clearly being in financial distress.

It's down over 90% , and Tom Winnifrith (who did sterling work in exposing the various accounting frauds at Quindell) reckons that it's heading for zero. I don't know about that, but it certainly shows just what a minefield this personal injury legal claims space is, and reinforces my view that the whole sector is probably best avoided at the moment.

Anyway, getting back to Fairpoint (LON:FRP) let's have a look at what their statement says today.

Fairpoint Group plc ("Fairpoint" or "the Group"), one of the UK's leading providers of consumer professional services (including consumer legal services), notes the comments made by the Chancellor in yesterday's Autumn Statement regarding personal injury claims. The Government's outline proposals, which remain subject to consultation, seek to restrict the ability for sufferers of minor whiplash injuries to claim compensation. The expected implementation timetable is April 2017 following a period of consultation in which the exact nature of the proposals will be defined.  As such the proposed changes will have no impact on the Board's expectations of Group performance for the year to 31 December 2015 or for the year to 31 December 2016.

It stands to reason that, if proposals are likely to be implemented in Apr 2017, then of course they won't have any impact on results for 2015 or 2016. So I'm not particularly impressed with this paragraph.

Fairpoint goes on to say;

The notion of extending the small claims limit has been a topic of debate for some time and following the acquisition of Colemans LLP and its class leading Legal Processing Centre in August 2015, the Group has an operational capability designed specifically in anticipation of such changes.  As such the Group is well positioned to take advantage of these market changes.

The section that I have bolded is rather more interesting. This suggests that not only has Fairpoint anticipated these changes, but it might even benefit from them.

My opinion - this statement is interesting, but it omits the most important information - how much of Fairpoint's business (and in particular its profits) comes from activities which are subject to change?

Unlike Quindell, and others such as Redde (LON:REDD), I don't think Fairpoint has motor injury claims as its main focus, and main money spinner. Its various websites suggest that it owns more broadly based legal practices, covering other areas too, such as family law.

EDIT: Disclosure: I've opened a short position on REDD, due to the factors above, and Aviva announcing that it has crossed from over 14% to over 13% shareholding.

So I was tempted to pick up a few Fairpoint shares this morning, but decided not to in the end. I don't like regulated sectors, especially where regulations are changing. Another factor to consider, is that the zeitgeist is now very much against this type of legal claims company. The Govt has spoken repeatedly about clamping down on the compensation culture, and its stance seems to be hardening.

Therefore, I see this whole area as fraught with risk. Maybe the proposals announced this week might be watered down, as they often are, once industry lobbying has sowed seeds of doubt at Westminster? So it could turn out to be a storm in a teacup.

Overall though, I feel that this now makes companies in this sector (legal services, since that is now Fairpoint's main focus, as the consumer debt side of their business is withering away) very difficult to value. We can't use 2015 or 2016 earnings as the basis to value these shares, because everything could change from 2017 onwards.

More certainty is needed before it can be accurately determined whether these shares are good value or not, in the long run, in my view. Fairpoint is probably the share I would go for, if bottom-fishing in the sector, as management seem excellent, and the valuation before this week's news was already fairly modest. I'm just not yet convinced that this is the right time to go fishing at all.

The other thing to consider, is that all these companies will probably put out reassuring-sounding statements (if they haven't already) but how meaningful are they really? The wording needs very careful scrutiny, as much for what it doesn't say, as what it does. Cleverly constructed words can hide problems sometimes.

Patisserie Holdings (LON:CAKE)

Share price: 325p (down 4.5% today)
No. shares: 100.0m
Market cap: £325.0m

Results for y/e 30 Sep 2015 - this is the chain of upmarket cake & coffee shops, Patisserie Valerie. It's a super format, and is in that lovely space of a self-funding retail roll-out - one of the most lucrative areas for investors, if you spot a good retail format early.

The trouble is, they can also become eye-wateringly expensive during the expansion phase, and of course % growth rates slow down after a while - it's relatively easy to double in size if you only have say 15 shops. But if you have 200, then doubling in size will take longer & be more problematic.

The other thing to consider is that upmarket chains like PV do somewhat limit their market, as there are numerous smaller, less affluent towns, where the format simply wouldn't attract enough better off customers to be viable. Although I note that CAKE also has two other brands, Philpotts, and the rather unattractively named Druckers, plus an artisan bakery subsidiary. So that should allow the group to operate on various levels in the market, which negates my first point really.

P&L - turnover rose 19.9% to £91.9m - so a fairly good growth rate there, but I can't see a split of how much of the growth is organic, and how much is due to new store openings.

The most meaningful profit measure for me is operating profit before exceptionals. This rose 20.2% to £14.6m, so a very good increase in profit there.

EPS calculations are skewed by last year having £858k exceptional costs (the IPO costs, which is perfectly acceptable to treat as exceptional), and I'm pleased to see no exceptionals this year. Also, the tax charge has just over doubled this year, to £3.2m, thus suppressing the EPS comparison of this year vs last year.

These reasons explain why basic EPS has only risen 9.6% to 11.41p. The underlying profit increase is higher than this though, at 20.2% as noted above.

Valuation - diluted EPS this year looks a clean number, ie. no adjustments - in fact, I like these accounts overall - they've not been messed about with, to inflate headline numbers, as so many companies do at the moment.

The PER drops out at a rather scarily high 28.5. Yes it's a lovely business, and has many good characteristics (growth, good cashflow, etc), but can a price this high really be justified? I'm struggling to justify such a high price.

Results seem to have come in bang on forecast, of 11.4p EPS. Broker consensus is for 13.2p in the new year (ending 30 Sep 2016), for a PER of a still very rich 24.6.

This effectively means that you would have to hold this share for another 2-3 years before the valuation came down to something sensible. I can't see how that makes sense. Don't ignore competition either - it's very easy to copy successful formats, and there are other up & coming patisseries chains (such as the wonderfully named, "Paul"), and of course thousands of independent operators.

Balance sheet - successful retailers don't actually need particularly strong balance sheets, because they are (usually) so cash generative. Although in this case, the balance sheet is also excellent - it has moved into a net cash position this year, of £6.1m, which is very impressive considering the capex needed to fund its own expansion.

The current ratio is terrific, at 5.44, with negligible long term creditors (just deferred tax of £1.9m), so this is a very well funded business, with absolutely no issues over both solvency, but also it's a cash cow that can easily fund its own expansion going forwards. Shareholders can therefore look forward to rising earnings, and no dilution from any equity fundraisings, since none should be necessary. Although there is likely to be the usual drip of dilution from share options being exercised.

Operating cashflow - superb, in a word. It generated £15.5m in post-tax operating cashflow, which was almost double what was needed to finance its £8.0m capex in the year. So theoretically, it had the internally-generated financing to expand twice as fast as it actually did.

Dividends - not much at this stage, the yield is just over 1%, but obviously this should rise once the expansion phase is complete, in a few years' time.

Outlook/current trading - sounds good to me;

We delivered our ninth consecutive year of growth in 2015 and this upward trend has continued into 2016 as trading to date remains positive.   We have already opened eight new stores in the seven weeks since the financial year end. We have a well advanced pipeline and a healthy balance sheet which puts your company in a strong position to deliver another year of solid growth in 2016.

My opinion - as you can probably tell from the above, the more I dug into the numbers, the more I like this business! The only problem is that the valuation is too high at the moment.

Mind you, I thought that at the time it floated at 170p, and here we are at close to double that price, 18 months later, so perhaps sometimes you just have to pay up for great quality businesses?

Rightster (LON:RSTR)

Share price: 10.6p (up 8.7% today)
No. shares: 369.1m
Market cap: £39.1m

Update - the way I read this, it seems to say that we put ourselves up for sale, but nobody was interested;

Strategic review update and end of Offer Period
On 17 November 2015, Rightster announced a number of changes to the board, supported by the major shareholders, including the appointment of a new Chairman, CEO and COO.  In light of their evolving plans for the business, the board has made the decision to conclude the strategic review process and focus on seeking further investment in the Company.  Accordingly, the Company is no longer in an offer period under the Takeover Code.

Given that it also says the company needs to raise more money (bolded above), then I'm amazed the share price is up today. Shareholders have a discounted Placing to look forward to, unless they can spin the story so well that people are prepared to pour in more money uncritically.

Risk:reward still looks awful, in my opinion. So it remains a bargepole job unless & until the company can demonstrate that it is commercially viable (i.e. capable of making profit & positive cashflows).

Caffyns (LON:CFYN)

A very quick comment - the interim figures look quite good, but the outlook statement suggests that H2 will be tougher. Note that this group has a high exposure to the Volkswagen group.

Got to dash. Have a great weekend, and see you back here on Monday!

Regards, Paul.

(of the companies mentioned today, I have no long positions, and recently opened a short position on REDD. A fund management company with which I am associated may also hold positions in companies mentioned.

NB. These reports are my personal opinions only, which are subject to change without notice. They are never financial advice or recommendations. The ethos of this site is everyone doing their own research!)