Small Cap Value Report (12 Feb 2016) - MONI

Good morning!

Apologies again for intermittent service this week - hopefully we should be back to normal next week.

Trading opportunities

Thankfully it's been very quiet for company news in the last few days. Probably like most readers, I've been pondering whether the world is going to hell in a handcart, which is what market weakness in the last 7 weeks seems to be telling us. Or whether it's all an over-reaction, and a buying opportunity?

Overall I'm thinking in terms of taking advantage of irrationally oversold situations - where you can find quick 20-30% profits aplenty - remember that bear markets are frequently punctuated with explosive (but short-lived) rallies. So this is a trader's market, rather than a buy & hold market, in my view - i.e. the quick rebounds are there to be grabbed, and then banked a few days later, in my view, as they often reverse again.

It's also a time to be keeping some powder dry, for those wonderful opportunities. Remember that small caps are mostly very illiquid - so it only takes one clumsy (or forced) seller to slam the price down a huge percentage. If the company concerned has recently put out a positive or in line trading update, then the danger of a profit warning is slight, so such plunges can be buying opportunities, if you've done your research properly.

Whilst everyone else is wondering what's gone wrong, and is frightened by the price suddenly dropping 20%, I'm backing up the truck and buying heavily. So far so good, in most cases recently, it's worked very well. Shares are for buying and selling, not getting married to. So personally I'm perfectly happy to bank a profit at any point, if a well-timed buy is showing a nice paper profit. There's no shame in banking a gain, especially when markets are as turbulent & unpredictable as right now.

Chatting to a friend last week, we agreed that it makes sense to have a core holding in a company you like, but to also have a trading holding in the same share, which you are happy to buy and sell on short term moves - banking profits on a big rally day, then buying them back after several days of falls, and signs of panic selling in the market. It won't always work, but all you need to achieve is a 60:40 win:lose ratio (which was my result last year) to notch up a more than satisfactory overall result. It's not about being right all the time, it's about being more right than wrong, and making sure the losses are relatively small, and the winners relatively large.

Earnings forecasts - higher risk

The other thing to bear in mind, is that we cannot now just assume that earnings will continue rising. Lots of companies are making reference in their trading updates to an uncertain economic outlook. Therefore I think we need to think about every share in our portfolio, and whether the current valuation would still stack up if the company saw its turnover fall, and that then causing a geared impact on profitability. Remember that, in recessions, earnings don't just fall slightly, then can absolutely collapse, taking the share price with them.

This could be false alarm, as we don't know what the global economy is going to do. All I would say, is that there are probably more storm clouds now, than we've had for several years, so it's sensible to be quite cautious at the moment, and definitely not a time to be gung ho generally about companies thrashing forecasts. I suspect we might have passed a tipping point, where at least in the shortish term, the error in forecast earnings is now more on the downside. But time will tell, things can change quite rapidly, so one has to keep these things constantly under review.

Valuing companies on a forward PER is getting higher risk now though, as the forecasts cannot be relied upon so much in uncertain economic times such as this.

Monitise (LON:MONI)

Share price: 1,74p (up 3.7% today)
No. shares: 2,204.4m
Market cap: £38.4m

Interim results to 31 Dec 2015 - I wouldn't normally bother reporting on this basket case of a company, but there's nothing else to cover today.

You only have to look at the Reserves section of the Balance Sheet to see the extraordinary shareholder value destruction which Monitise has been responsible for. Accumulated losses are a staggering £601.2m. What the company fundamentally got wrong, is that they did this modern thing of creating a business first, on a wave of blue sky optimism, then worried about how to make profits second. That's not usually a good idea.

Now that the optimistic shareholders are gone, or at least their chequebooks are firmly closed for new funding, Monitise is now in a desperate race to cut its costs enough to reach breakeven before the money runs out.

Given that the market cap is now only £38.4m, then this share could be a potentially interesting punt - if the company is indeed able to reach breakeven before the cash runs out, and can grow sales from that base, then the basis for valuing the shares would suddenly (and possibly dramatically) change for the better. For this reason I think it's always worth having a look at bombed-out fallen angel shares like this one, as very selectively, you might occasionally find a future multi-bagger.

Cash position - the company says today;

Gross cash at 31 December 2015 of £53.4m and prospective EBITDA positive trading for H2 FY 2016 means the business is sufficiently well funded to meet its future plans 

That sounds great, considering the market cap is only £38.4m. However, it's highly misleading in my view. These are the problems;

Cash burn - in H1, Monitise burned through a staggering £35.4m, in just 6 months! So £53.4m gross cash is not quite so exciting when it's depleting so rapidly (although costs have been aggressively cut, see more below).

Liabilities - it's all very well sitting on a cash pile, but if that money is already ear-marked to be paid out for various things (i.e. liabilities) then it's not really your cash. So you have to look at the overall balance sheet position. In this case, net current assets (i.e. working capital) is positive, but only £31.0m.

There's another £18.2m in long-term creditors, so the most prudent way to look at a balance sheet, which I always use for cash-burning businesses (i.e. current assets, less all creditors) drops out at a positive balance of only £12.8m.

A few more months' cash burn, and that surplus working capital will be gone. Therefore I think the only rational way to look at Monitise, is to assume that all its cash is spoken for, and there probably won't be any surplus for shareholders in a winding up, or any ability to return cash to shareholders if the company remains solvent.

So for my investment purposes, this company has no cash - because it's all spoken for.

EBITDA - this old chestnut again. It means nothing, and is absolutely not a substitute for profit, or cashflow at this type of company. The reason being that Monitise capitalises so much of its costs directly onto the balance sheet. Last year, it capitalised a staggering £40.8m onto the balance sheet, into intangible assets. This is all stuff that it had to pay for, in cash, but by-passes the P&L, ending up on the balance sheet instead.

EBITDA simply ignores those costs, as if the tooth fairy was picking up the bill. Sadly she doesn't, shareholders still pay the bill, whether costs go through the P&L or onto the balance sheet. It's all the same in terms of cash outflows.

Reducing costs - the headcount numbers are striking - average staff headcount has dropped from 1,059 last year, to 646 at 31 Dec 2015. The commentary says that further, deep cost-cutting is in the pipeline, such that it should reach EBITDA breakeven in the current H2.

Outlook - EBITDA breakeven in H2 sounds good, but bear in mind that the company capitalised £6.8m into intangible assets in H1, then EBITDA breakeven really translates into a loss of c.£13.6m p.a. - so the company would certainly go bust within a year or two, if it only managed to reach EBITDA breakeven and no better.

Having taken the tough decisions and defined a clear path to take the business forward, Monitise is not just a leaner business; it is stronger and healthier. We are proud of our market leading technology assets and digital expertise, our strong history and heritage of being trusted to deliver bank grade services to highly regulated organisations and our enviable list of clients who are supportive of our strategy.

We have faced many challenges during the last six months, and have further work to do to restore investor confidence in our business, but we are well funded and I am confident that we will be EBITDA positive in the second half of FY16. Investment in FINkit® will be proportionate to the timing and scale of contracts signed and we will continue to evaluate all assets in order to preserve and maximise value for all stakeholders. Our mission is to become the global toolkit that enables smarter and faster innovation for our clients where security, compliance and performance are mandatory.

My opinion - based on the historic numbers, clearly you wouldn't go near Monitise with a bargepole - because it has catastrophically, dismally, failed.

However, as a special situation, for high risk punters only, I think it might be worth a closer look. Suppose the company does manage to reach proper breakeven, without having to tap shareholders for more cash? The market cap might then be usefully higher than the current level of £38.4m. It's also got a ton of tax losses, which would mean that there would be no tax to pay on profit, if it is able to generate any (that's a big if!).

On the other hand, a business that has already got rid of about 40% of its workforce must be in turmoil - why would decent staff stay on? The danger in that type of situation is that the good staff leave of their own accord, leaving you only with the ones you didn't want to keep.

It remains to be seen if management can salvage anything from the wreckage here. On balance, I think it's too much of a punt for me, but I am tempted to look a little deeper, as an understanding of the products, and how they might become profitable, is key to everything.

It's easy to rant & rave about how awful things have been in the past, but investing is all about forecasting the future. Is there something salvageable here? I don't know.

Look at this for a chart! Can you believe that the market cap was over £1bn a few years ago, despite it never making a proper profit. So basically a 5-year delusional elevation in the share price, before reality finally dawned on people. Who said markets were efficient, and price-in all information? This share is a great example of how the market can actually become, and remain, completely delusional, for 5 years (2009-2013, inclusive).

Acal (LON:ACL)

Share price: 252p (up 1.0% today)
No. shares: 64.2m
Market cap: £161.8m

Trading update - this electronics group also announces a small (£2m) acquisition in N.America, which is not material, so hardly worth mentioning.

The trading update today covers the 4 month period to 31 Jan 2016, so that is 10 months of the year ending 31 Mar 2016 now in the bag.

During the 4 months ended 31 January 2016, the Group performed in line with our expectations.

Outlook - sounds alright, although note the caveat regarding macroeconomic conditions;

Whilst mindful of the current uncertain economic and market conditions, we maintain our earnings forecast for the full year.

Valuation - this is the tricky bit. Do we value the shares based on current year forecast, which looks in the bag now. Or do we factor in depressed conditions going forwards, to be on the safe side? I'm leaning towards the latter approach.

Broker forecast is for adj. EPS of 16.0p this year, so the PER is 15.8 based on that. With the benefit of acquisitions, EPS for next year is currently forecast at 19.3p, dropping the PER down to 13.1, which looks reasonable if forecasts are achieved.

My opinion - the company has some debt, to take into account in valuation, so overall I would say that with the earnings outlook now probably more uncertain than it has been for several years, I would be nervous about buying or holding this share.

The risk is that business slows down later in 2016, and the company would then put out a profit warning, and bang, you've lost 30% of your money instantly. Is it worth taking that risk? I don't think so. That's a comment which is not specific to this share by any means, but to lots of companies that are exposed to what seems to be a global manufacturing slowdown at the moment.

I think it's safest to keep away from this type of company at the moment, at least until the global economic situation becomes a bit clearer. The risk of profit warnings is not worth taking, in my opinion. I'd rather survey the damage, and pick up some bargains from the companies after they put out profit warnings, than pay more beforehand in the hope that they're not going to issue a profit warning.

We have to adapt our investing approach to market & economic conditions. So the risk with a lot of cyclical companies, is now to the downside, that they might miss forecasts. That needs to be reflected in lower share prices, through lower earnings multiples, in my view.

Acal's share price has been historically volatile, so this company is clearly very much affected by prevailing economic conditions, so this is exactly the type of share that I wouldn't want to be holding at the start of a new recession.