Small Cap Value Report (26 Jan 2016) - Credit, TRAK, RST, XLM, MCGN, OPM

Good morning!

Market wobbles & credit conditions

Just when we thought it was safe to get back in the water! Things are looking wobbly again - the US rally has fizzled out for now, and the S&P500 futures are now hovering around a key support level of 1867.

The rally in oil has also quickly reversed, and China took another tumble overnight, see this chart courtesy of IG;

Market gyrations are one thing, but more people are becoming aware of the pressures building up in bond markets - where junk bonds are problematic, and there are likely to be widespread defaults in bonds related to the resources sector.

Have you looked at the share prices of banks lately? They are down very heavily. That is a warning sign to my mind - clearly the market thinks that there's trouble ahead. I think that makes sense - as mentioned the other day, 7 years of near-zero interest rates has undoubtedly caused gigantic misallocation of capital (e.g. apparently China has 65 million empty flats!), and when some sort of trigger occurs to start defaults happening, then bad debts begin to appear.

At that point everyone starts worrying about contagion, and counter-party risk, so credit availability tightens, and weaker financial institutions get into solvency trouble. In other words a re-run of what happened in 2008. I'm not saying it will necessarily be as bad as that, but I am getting increasingly worried about credit conditions.

Bank balance sheets are much stronger than they were in 2008, but I think we could well see tighter credit availability - which would be likely to push us into another recession. Therefore I think it's a good time to look closely at everything in your portfolio, and consider whether earnings might now have peaked - does the valuation still stack up if earnings were to drop say 20-50%? Almost certainly not, in many cases.

This could be scaremongering, and everything might turn out fine, we don't know. I always like to consider what-if scenarios though, and at the moment I'm wavering between thinking things are probably going to be alright, and waves of worry about the risks.

I'm keeping my eyes peeled for more cautious outlook statements from companies, as that is one of the canaries in the mine, along with forward-looking economic data, such as PMI reports each month.

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Oil

Not my area of specialism, but I want to flag an excellent post from one of our top commenters here, janebolacha, in the comments section of yesterday's report. Jane pointed out that US shale producers had greatly lowered costs, and can quickly stop & start production. This might therefore cap the upside on the oil price in the future, as when it rises to a certain point (perhaps $50-60?) then the shale producers will crank up production to meet demand.

That changes the likely earnings & valuations of oil companies in the future, and means previous profits may never be reached again.

Furthermore, we are probably fairly close to a tipping point where electric cars become commercially viable - it's all about the price of batteries, and the range, and it's getting close now to being economic. If you haven't seen it, this video from a Stanford University lecturer about the future for oil is absolutely riveting - investors that I've sent the link to before have loved it, so highly recommended. Here is the link - do watch it if you can find the time, or indeed I suggest making the time, as it's well worth it. He suggests that virtually the whole oil industry will have gone by 2030!

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Trakm8 Holdings (LON:TRAK)

Share price: 240p (down 9.4% today)
No. shares: 34.0m
Market cap: £81.6m

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

Director audiocast - it took a lot of time & effort to put it together, but I recorded and published a one hour interview with the Exec. Chairman (and with FD standing by, but not needed in the end) of telematics company TrakM8 last night. You can listen, if you wish, using this link.

Unlike other, commercial, company interviews, my interviews are done by an investor, for investors. So the questions are sourced from the investor community itself - anyone can ask questions, whether bullish or bearish on the company. I just put the (often tough) questions to the company, and occasionally pose a follow-up question. So it's not promotional, it's informational, and so far the response to this series of interviews has been very positive, so I'll keep doing more of them.

There was an amazing response, with 50 questions submitted. I eliminated 3, as one was silly ("where can I short this share?!"), one was just personal abuse directed at me - it happens, I'm used to it, the shares world just seems to attract some very odd characters who enjoy spouting venom towards anyone who has a profile, and the last disallowed question was something pointless & irrelevant.

The other 47 questions were posed by me to the Chairman of TRAK, and I thought his answers were thoughtful, clear, and intelligent.

The bear raid was basically shown to have little basis in fact, specifically;

Net/gross cash - the company accepted that they made a mistake, in the bullet points with recent interim results, incorrectly describing gross cash as net cash. They apologised, and so this issue is now put to bed. The figures on the actual balance sheet itself, were of course correct.

Discrepancy between reported Box accounts, and the reverse takeover RNS of Box by TrakM8 - the c.£115k discrepancy was due to audit requirement to change from GAAP accounting to IFRS accounting. So a complete non-issue.

Lack of free cashflow - incorrect. The company explained that its cashflow is positive. Its business model involves low margin up-front sales of the telematics units, but there then follows a high margin, sticky monthly revenue stream. So rapid growth means short term depressed cashflow, which then reverses as growth slows. Again, not an issue.

Growth is all by acquisition - er, except that it isn't. The company achieved over 70% organic growth last year.

Route Monkey acquisition was crazy, along with its accounts - the Chairman calmly explained that of course they had done detailed due diligence, and that the odd revenue recognition policies of RM when in private ownership would be restated. Although he explained that the company had a history of good cash collection on its extended debtor book - which was due to the company working on extended projects for customers, and then eventually billing them at the end, when the client was happy with everything. That's a poor way of doing things, and I'm sure that within TrakM8 a better structure (e.g. with stage payments) will be agreed. The price paid for RM is based on expectations for what it will earn in future, not what it has done in the past.

Therefore, I think that covers all the bear points, which have clearly been shown up to be a storm in a teacup. I do wish people would properly research these things, and give a company the chance to explain questions, rather than firing off an ill-judged dodgy dossier online, designed to make novice investors panic sell their shares.

Hopefully I have redressed the balance, and given everyone an opportunity to ask the questions they want. People can then decide for themselves what to make of the responses. I remain bullish on the shares, but that's just my personal opinion.

I'm not planning on entering into any more public dialogue with bears on this share, as it's just been a can of worms, and has caused me a lot of unnecessary & unpleasant stress.

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Restore (LON:RST)

Share price: 286.5p (unchanged today)
No. shares: 96.0m
Market cap: £275.0m

Trading update - for the 31 Dec 2015 full year.

I do like it when companies put a simple first paragraph giving the key conclusion - performance against market expectations, which is what Restore has done today, so thank you for that - to the company and its advisers. All companies should follow this approach please.

Restore plc, the UK office services provider ("Restore" or "the Group"), confirms that trading for the year ended 31 December 2015 was in line with expectations.

This approach is very considerate, and shows understanding that investors have a one hour window between 7-8am, when we're still cranking our brains into action after usually not enough sleep, to absorb maybe 10-20 different company announcements, and form a view on which (if any) we need to take buy or sell action on.

Therefore a key conclusion at the start, allows us to check it, then move on, and revisit the detail below at our leisure.

There should of course also be outlook comments either at the start, or the end of the announcement (not buried in the detail, in the middle).

Outlook - a fairly generic positive-sounding comment, but reminding us that visibility of earnings is good, because a lot of business they do is on recurring revenue contracts;

"We are pleased by another year of good performance by the Group, with significant increases in revenue, profits and earnings per share. As expected at the time of acquisition, several acquired businesses have required substantial restructuring and these are now showing a marked improvement in profitability under our ownership. We continue to strengthen our position as a key supplier of services to UK offices and we have an excellent platform for further profitable growth with strong visibility of earnings." 

My opinion - this company looks quite good, but I'm not keen on groups which grow by acquisition, hence creating an appearance of growth, but all too often funded by increasing debt.

It's on 19.3 times forecast 2015 earnings, which considering it has some (but not excessive, last time I checked) debt, looks on the pricey side.

It's not for me - the price looks too high in my view, although that's probably because the market is factoring in improved profitability at acquired companies (as noted above), and rewarding a company that appears to be well managed, and making sensible acquisitions.

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XLMedia (LON:XLM)

Strategic review - the company is basically saying that it's fed up with its low valuation, and points out that it has performed well;

Since the Company's initial public offering in March 2014, the Company has consistently reported strong financial performance, continually invested in organic growth opportunities, completed several successful earnings enhancing acquisitions and declared $21.25 million in dividends to shareholders.  Notwithstanding this and the Company's financial strength, the directors of the Company (the "Board") have determined it is appropriate to evaluate opportunities to maximise value for the Company's shareholders.

So today's announcement flags up that anyone interested in either buying the company, or coming up with merger proposals, should get in touch with Canaccord.

My opinion - this is all very well, but it's no wonder the market ascribes a low valuation to XL Media, because (a) it's Israeli and on AIM, and (b) the company is not transparent about where its profits come from!

So it's hardly surprising that investors don't trust it, as we've been burned so many times before in situations like this.

I have to understand a business model, and verify it, to invest in a company. In this case the profits seem to come from promotional websites which drive paying customers to other companies. Great. Let's have some examples then - what have they got to hide? Something doesn't smell right here to me. I think the figures are real, but possibly not sustainable. We need more transparency from the company please, on where specifically its profits come from - website names, and amounts, so we can check them out.

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Microgen (LON:MCGN)

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

Trading update - an in line update for 2015;

Trading in the final months of the year continued satisfactorily and Microgen anticipates reporting results in line with Board expectations

Net cash is £5.4m

This business has historically been an absolute cash cow - paying out bumper special divis, from memory. It's a while since I last looked at this company, and as I am rushing for a train this morning (a day of meetings in London), will have to come back to it at another time. All looks fine in this update though, so that's good.

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Carpetright (LON:CPR)

After many years of being seriously over-valued, the valuation is finally coming down to earth, and is actually starting to look quite sensible now.

This one may be worth a look - it fell today, but the update showed sales in Jan 2016 returning to good growth after wobbles in Dec. Margins were down, due to promotional activity. I'll come back to this one when time permits.

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1pm (LON:OPM)

Interim figures look good today - strong growth in profits.

This company has been successfully plugging the gap left by the banks in SME lending.

Am not sure this is the right time of the cycle to be buying into a company like this - if we do see a recession, then its bad debts are likely to rise.

Overall, I'd be reluctant to get involved in this, unless & until the macro clouds have lifted. Remember that profits quickly turn to losses at lenders like this, if a recession bites. Banks shares are in freefall at the moment, as mentioned in the preamble above, so that makes me worry that credit conditions are getting worse, not better. Whether that filters down to SMEs, who knows? I'd say it's likely to, but perhaps after a time lag?

I know the company has personal guarantees, etc, from borrowers - but those are often unenforceable when people's small businesses go bust, as entrepreneurs have already sunk all their assets into the business, and the courts might block any enforcement of a PG if it would involve making a family homeless.

If the economy remains sound, then 1PM is likely to continue growing, and reporting better profits. So if you're sanguine about the outlook, then this could be a nice company to own perhaps?

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