Small Cap Value Report (29 Feb 2016) - WTM, RTC, DX.

I'm posting this article 2 days late, as I was unwell on Monday, so apologies again for the delay. Let's catch up!

The main company I want to report on is this engineering & environmental consultancy;

Waterman (LON:WTM)

Share price: 95p
No. shares: 30.8m
Market cap: £29.3m

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

Background - regular readers here will know that I've been positive about this consultancy group for a while now. It's not a madly exciting company, but the economic cycle has been working in the company's favour, and it had turnaround potential due to having one division making heavy losses, thus diluting overall group profitability, which management were focused on sorting out.

For further background info, see my archive of articles on this company (as with any company, just find the company's StockReport, then click on the "Discuss" tab, to see a list of all mine, and other peoples' articles which relate to that company). Incidentally, I was really pleased to see one reader comment that when researching a company, he first looks at the StockReport, and if he likes that, then his second step is to click "Discuss", and read my views on the company. He reckons that saves a lot of time when researching companies, to decide whether or not to then continue to do his own in-depth research.

To give investors a chance to ask questions, and to get a flavour for the person running a business, I also try to interview CEOs of my favourite companies - so this link (audio and transcript) is my interview with Waterman's CEO, Nick Taylor, on 15 Oct 2015. He seemed fairly upbeat about the outlook for the next couple of years, and strikes me as a grounded, sensible CEO - the best type, in my view. With small caps, I don't want visionaries, I want hands-on, motivated, honest, and competent manager/entrepreneurs.

Results for y/e 30 Jun 2015 were good, and the shares moved up from around 70p to c.90p after the results were published in Oct 2015. The share price had been held back somewhat by a selling overhang, although the seller (Ruffer) seems to have stopped selling now, and Hargreave Hale took a decent chunk from them (c.6% of the company) - see Holding in Company RNSs in Nov 2015.

Interim results, 6m to 31 Dec 2015 - to save me re-typing the detail, here is the highlights section reproduced;

(problem graphic removed, as corrupted article)

I've highlighted the items which matter most to me.

Note that, refreshingly, the adjusted profit figure actually shows a lower growth rate than the headline figure. Usually companies just use adjustments to present a more flattering view of profits, so it's a sign of management with integrity when they highlight a less favourable adjustment. The reason is that last year had some exceptional costs, whereas this year doesn't.

Adjusted EPS seems to have done comparatively well (up 54%) because of a greater proportion of profits being attributable to owners of the parent company, and less to non-controlling interests.

Interim divi up 50% is a strong statement.

Balance sheet - overall this looks fairly sound to me. Note that Receivables is rather high, at £29.9m. That represents 32.9% of annual turnover (which I have annualised simply by doubling H1 turnover of £45.4m, to arrive at a full year turnover of £90.8m). Normally I like to see receivables under 25% of annual turnover. So it's an amber flag.

I have investigated this issue before, and the reason that receivables is high, is essentially the nature of the business - doing long term contract work, it is unavoidable that work done, but unbilled, does build up, and is then invoiced periodically.

There's a balance sheet entry going the other way in trade payables, with £14.2m shown as "amounts due to customers on long term contracts".

There's no denying that this business model does carry some risk, so it's worth bearing in mind.

Although it's pleasing to see that the trend for receivables is positive - the figure has reduced by £2m vs a year ago, despite turnover having risen 10%. This is reflected in a more healthy cash position - with net funds up £3m to £6.6m. 

So whilst acknowledging the inherent risk in the business model (big debtors & big creditors creates scope for things to go wrong), the position looks under control, and improving.

Outlook - this all sounds very positive to me;

Waterman is on target to exceed its previously declared financial objectives to triple adjusted annual profits before tax to £3.3m over the three year period to 30 June 2016, with a return on capital employed (ROCE) of 20%.

In October 2015, the Board announced a new aspiration to increase the Group adjusted operating profit margin to 6.0% by June 2019.  As noted above, the Group's progress against this objective is positive with adjusted operating margins increasing from 3.3% to 4.1% over the last twelve months. The Board expects further progress to be made during the second half of the current financial year and beyond.

The results have benefitted from the Board's strategy of focusing primarily on the UK, where 90% of Waterman's revenue is now generated and this focus is anticipated to continue for the foreseeable future. Waterman's long-standing relationships with blue chip companies continue to generate repeat business year on year and the Board expects this to continue whilst the UK economy is strong.

Valuation - there's still plenty of green on the StockReport in the valuation & growth section. Note that the StockRank is a perfect 100.

Furthermore, the EPS forecast for this year, at 7.8p, looks as if it might end up being on the low side. 10p EPS forecast for 2016/17 could I think end up being more like 11-12p, so that could give useful further upside, if I'm right about this.

My opinion - I'm pleased with the figures & outlook from Waterman. Obviously we know this is a cyclical business, so it's bound to suffer when the next proper recession comes along. However, from talking to the CEO it's clear that there's abundant infrastructure & commercial building work going on in the UK, for several years to come, which is likely to keep Waterman busy.

With artificially low interest rates likely to continue for a long time, that provides a favourable backdrop for infrastructure spending, which benefits Waterman. So I think it's far too early to think about getting off the rollercoaster, as it could well have a lot higher to go. I call it a rollercoaster because we know that, sooner or later, there will be another plunge! But you could say that about lots of sectors, this is not the only cyclical area of the economy by any means.

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RTC (LON:RTC) - good results for y/e 31 Dec 2015 from this minnow staffing group. Pre-tax profit rose from £1,018k in 2014 to £1,282k in 2015.

Basic EPS rose 33% to 7.85p, so at 80p the shares are on a PER of 10.2. There's a fair bit of debt on the balance sheet, net debt of £3.9m is about 34% of the market cap, so the shares are not looking cheap any more. A company this small should be on a discount to the sector, as it is heavily dependent on a handful of major contracts, thus making it higher risk.

Having said that, the future looks good for the time being, with a 5-year contract for providing labour to Network Rail.

If I had to pick a small recruiter, I'd prefer Empresaria (LON:EMR) to RTC, as it has a better spread of business, is on a lower PER, and is larger & hence more liquid & financially stable (not dependent on any one or two big customers, as RTC is).

It's difficult to see much more upside from RTC, I think the big re-rating has probably now happened. Although it has surprised on the upside in the past, with more Network Rail work than originally planned, so who knows?

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Quartix Holdings (LON:QTX) - strong results for 2015 published. Group revenues up 28% to £19.7m, and a very high profit margin was achieved, with profit before tax up 19% to £6.0m.

The valuation is much too toppy for me now, at 31 times forecast 2016 earnings.

At 352p, I suspect the shares might have run ahead of events somewhat now, so it doesn't interest me. 

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DX (Group) (LON:DX.)

Share price: 19.5p
No. shares: 200.5m
Market cap: £39.1m

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

Interim results, 6m to 31 Dec 2015 - this is certainly an interesting one! I won't go over all the history again, as most people will already be aware I'm sure. Here is my archive of articles.

I suspected that something wasn't quite right with this share, and the fundamental flaw was that its big profit earner, the DX Exchange service, has seen a sharp downturn in demand. For a largely fixed cost, subscription revenue business, that's a disaster.

Clearly the former owner must have seen this coming, and one imagines that's why they wanted to sell it on to fund managers who were stuffed in the IPO at 100p per share. The generous divi yield was the hook to get the IPO away, but as with some similar offerings in recent years, the divi may not be sustainable.

The share price collapsed, in one of the biggest falls I've ever seen on a profit warning, dropping from 85p on 12 Nov 2015, to 23p the next day. Unusually, there was little noticeable bounce in the aftermath, with DX shares bottoming out on 20 Jan 2016, at 14.5p. A one-month bounce to about 25p followed, but the interim results have knocked us back to 19.5p.

A few comments;

DX is still profitable, but only just - it made £1.4m operating profit (pre-exceptional) for H1 this time, versus £10.1m last time - a catastrophic decrease in profitability.

There seems to be an H2 weighting to profits, which the company alludes to in the commentary, but that is dependent on the level of DX Exchange renewals in H2, from the key legal, and Government sectors.

Dividends - a 1p interim divi is proposed, payable in May 2016, subject to a capital reduction to create a distributable reserve. Management "remain committed" to a 1.5p final divi. Is that wise, in the circumstances?

Balance sheet - this buys the company more time, as it has only modest net debt of £12.3m. Although note that as DX Exchange contracts, it has an adverse working capital effect - since up-front payments from customers dry up.

Exceptional charge of £88.4m - doesn't matter, as it's non-cash - just a goodwill write-off.

Major planned capex - planned for a new central hub in the W. Midlands. This is now to be funded by a developer, rather than DX taking on the debt. Probably a good thing in the circumstances, but that depends on what the costs will be.

Directorspeak - obviously they're going to put a favourable spin on things, they have to;

Although market conditions remain difficult, we have completed the managed exit of a number of unattractive contracts and have seen our sales team start to secure attractive new contracts.  In addition, we continue to make steady progress with our strategic OneDX programme including our plans to develop our new central hub.

Despite the current headwinds to the business, and with much to do still in the seasonally important second half, the Board anticipates that the Company will trade over the full year broadly in line with its expectations.  We continue to position the Group for longer term sustainable growth and the Board remains confident in the medium term outlook for the Group." 

My opinion - luckily I anticipated problems ahead at DX, and dodged a bullet, by selling out in early 2015 due to concerns over the sustainability of profits, and particularly because DX's profit margins simply looked too good to be true, in a low margin, ultra-competitive sector. The reason of course was that DX Exchange was highly profitable still, but very much a cigar butt. That's why the key numbers were not disclosed in results - i.e. a proper breakdown of where the profit actually came from. That also made me suspicious.

However, before getting too smug, I caught the falling knife at around 33-36p, mistakenly thinking that the falls were overdone. So that's been a losing trade to date.

None of that matters, as the market doesn't know, or care, what price any of us paid for our shares. All that matters now, is whether it is correct to buy, or sell? I was leaning towards selling, but on studying the accounts a bit more, I'm now leaning towards holding, as a seasonally stronger H2 could trigger a nice rally in the shares in late 2016, possibly. That would then be the time to exit I think.

To my mind, the business is down, but not out. I think management has some time to stabilise things, and build higher margin new business. If they manage that, and downsize the fixed costs of the DX Exchange (it should be possible to exit leases of multiple small sites by assigning them), then there could be a reasonable business remaining. We don't really know. It all depends on how management execute over the next couple of years.

If it was £100m+ market cap, I would sell without a qualm. However, at £39.1m market cap, for quite a sizeable business, maybe there is upside potential?

As always, this is a snapshot view of my opinion at this point in time, and I reserve the right to change my mind at any point.

What do readers think on this one? I would be very interested to hear your opinions, as I always say, investing is a team sport.