Small Cap Value Report (23 Jun 2016) - Referendum Day, LTHM, SDM, PRP

Good morning!

Thank goodness that Referendum Day has arrived. I don't know how much more of this we could take! It's certainly been causing me a lot of anxiety - constantly agonising over the best approach for mine & others' portfolios. I got very little sleep last night, worrying about this issue, and pondering what might happen if we get an out vote.

It's been neck & neck in the polls for some time now. Although my view has always been that a remain vote is very likely. The reason being that, on constitutional matters, the British public tend to be extremely conservative - at the last minute there tends to be a strong turn-out for the status quo. We saw that with the AV and Scottish referendums too (or is it referenda?).

On the other hand, out voters are extremely passionate, and a very high percentage are likely to turn out, so there's a chance of a big upset possibly.

Personally I found the out message very emotionally compelling. However, when you really think through what leaving the EU would entail - many years of disruption, even chaos, and certainly a recession in the short term, plummeting share prices, etc, is it really worth it? When very little would actually change in reality. UK politicians & civil servants simply don't have the capacity to re-write large sections of British law & regulations in a short space of time. So I think the status quo would probably be maintained in almost all areas. So what's the point then? To my mind, if you accept potentially dire consequences, then there has to be a massive prize at the end of it. I don't see that here at all. A leave vote strikes me as high risk, and low (possibly negative) reward. I wouldn't touch an investment like that.

I've also noted that the out campaign has attracted a lot of people one might describe as malcontents - generally unhappy with life, and so it's easiest to just blame immigrants. When in reality we have an army of hardworking, decent people from Eastern Europe here, doing jobs that often Brits won't do, for low wages. It's contributed to a housing crisis, sure. So let's build more houses!

Bottom line for me, I don't want to vote for something that is going to cost other people their jobs, as there will undoubtedly be job losses in some sectors - e.g. financial services. I wonder how many out voters really understand the consequences?

So I held my nose, and voted Remain. Far from my courage deserting me, as a reader commented here recently, I just thought things through, did more research, and decided to change my mind from out to remain. It actually takes courage to admit you're wrong, and change your mind. As opposed to doggedly sticking to a view that you've come to realise, after doing more research, is probably wrong. It's exactly the same with shares - getting out of failing companies is vital to preserve capital, once you realise the story is unravelling. Yet many investors refuse to ditch dying shares, and end up with perfectly avoidable 100% losses.

Chatting to my friends & family, there are quite a few people who have done the same as me - i.e. originally supporting out, but changed our minds to remain, after considering things more carefully. I don't know anyone who has moved the other way. This reinforces my belief that a remain vote is looking the most likely outcome.

Whatever the outcome, I think it's vital that we all respect the result, whatever it is, and come together. This has been an unpleasant & divisive campaign, not good for the country.

What happens next?

Nobody knows for sure, but this is my overview of the likely impact on financial markets:

Remain vote

Expect an immediate, and substantial rally, as investors scramble to get back into shares that they sold or top-sliced over recent months. I think this would be a blink & you miss it type of rally. Also there's been a buyers' strike for several weeks now - so expect good upward moves from companies which have issued positive trading news lately, to a subdued market reaction.

The impact on small caps would probably be some explosive upward moves, in the more illiquid stocks, as the market makers run for cover when there's a big wave of buying - marking up the shares price substantially. So some big opportunities to make money, I think.

Also expect sterling to strengthen significantly, as the risk of capital flight is eliminated.

Out vote

Expect a substantial fall in shares, and sterling. I've no idea how much, but I think a lot of traders will panic sell. Shorters will have a field day. Markets hate uncertainty, and a leave vote would introduce enormous uncertainty into almost every area of commerce, and would probably tip us into recession.

Long-term investors could ride this out, of course, and most businesses would cope alright, after a period of adjustment. At some point there would probably be some fantastic buying opportunities, but only if you hold spare cash, and have a strong stomach.

Here's an interesting thought - a friend suggested to me that the Establishment in the UK is so pro-EU, that they might well just find a way to ignore the referendum result, if it goes the wrong way. So an out vote does not necessarily mean we actually leave the EU. There's a history of this with EU-related votes in other countries.

Profit warnings

Quite a few companies are mentioning uncertainty, and weak current trading. If we get a remain vote, then I think some sectors could see a surge in business, as backed-up projects get the green light. E.g. the CEO of Porta Communications (LON:PTCM) said on a recent video that they had 11 client IPOs in the pipeline, all of which were on hold until after the referendum.

However, I'm also worried that some companies might be trading poorly now, but have not yet told the market - perhaps hoping that it's temporary, and due to the referendum.

James Latham (LON:LTHM)

Share price: 673p (up 3.1% today)
No. shares: 19.6m
Market cap: £131.9m

Results y/e 31 Mar 2016 - smashing figures are published today by this well-managed distributor of timber products. I last reported here on 30 Mar 2016, when the company issued a positive trading update. My conclusion then was that 44p EPS consensus forecast looked too low, and that 47-50p EPS seemed more likely, based on the good interims, and positive directorspeak.

Even I was being too cautious - the actual EPS has come out at 53.7p, thrashing last year's figure of 40.3p. So the PER is 12.5 - undemanding in my view.

It's even more undemanding when you consider that the balance sheet has £15.8m in net cash - just over 80p per share. Furthermore, the balance sheet overall is groaning with surplus capital. I think you could easily take £40m out of the company, by gearing it up a little, and still have a strong balance sheet. Being a family company, it probably won't do that though. So some people might argue that the company is inefficient with its capital. They won't be saying that when the next recession hits, mind you! Inefficient balance sheets can make all the difference between survival, or going bust, in a recession. So give me an inefficient balance sheet any day.

Outlook - the note of caution on current trading is probably the reason for a rather muted market reaction to these results (plus of course buyers sitting on hands until tomorrow's referendum result):

This year like for like revenues are 4% higher for April and May than the corresponding period last year, both in panels and timber. The gross margin is also higher. While this is a steady start to the year, there are some signs that this growth is slowing and the fluctuating value of sterling and the uncertain outlook for business activity caused by the EU referendum, make the immediate future difficult to predict.  

We continue to see encouraging growth in the newer decorative products we have introduced.

My opinion - I really like this company, and almost (but not quite) pushed the buy button this morning. That will probably look like a schoolboy error this time tomorrow.

Stadium (LON:SDM)

Share price: 79p (down 28% today)
No. shares: 37.2m
Market cap: £29.4m

Trading update (profit warning) - bad luck to holders here. This is today's biggest % faller. A 28% price fall suggests a vanilla profit warning - something bad, but not catastrophic. Let's have a look. The company is a "leading supplier of wireless solutions, power supplies and electronic assemblies".

As usual, my process on profit warnings is;

1) Assess the situation myself - are these temporary & fixable problems? (good), or more serious problems (bad).

2) Check the balance sheet - is the company adequately financed (good), or could this mean it may need to do a fundraising (bad)?

3) Get hold of latest broker notes, if possible - to have a more accurate grasp on the scale of the problem - since the company's FD will usually brief analysts with actual figures, whereas RNSs usually give words but little to no precise figures (which is an appalling state of affairs, and needs to change). Kudos to companies which do quantify the extent of the profit miss in their statements.

4) Wait. Usually buying straight after a profit warning is a mistake.

So here goes. They've lost a big customer (but this is not directly quantified):

...However, whilst the Board remains confident that Stadium's customer-focused design-led proposition is compelling, the Company has received notice from a significant Wireless customer in the telematics space that, following a period of reduced call-off, they will move product design in-house and manufacturing elsewhere.

The impact is as follows:

The loss of this customer will result in a delay to the Company's anticipated growth and full year results for 2016 are now expected to be below market expectations. Given the seasonality within the business, in line with previous years, the Board continues to expect that the Company will deliver materially higher profit in the second half of the financial year.

So an H2-weighting introduces more risk, although the company says this is normal seasonality.

Ah good, the company has quantified things:

...For the full year, higher margin Technology Products revenues are expected to contribute approximately 60% of total revenues. This, alongside the benefits of a reduced fixed cost base, following the integration and rationalisation of recent acquisitions, and ongoing efficiency savings will enable the Company to deliver high single digit percentage growth in normalised profit before tax* for the full year, albeit this is lower than previous expectation, and will be achieved on revenues slightly behind last year.

Excellent, that gives me a lot more to go on.

Normalised profit before tax last year (calendar 2015) was reported as £4.0m. So if we say up 8% this year (that's high single digit % growth), gives £4.3m profit for 2016. That sounds OK.

Adjusted EPS last year was 9.9p, so looks like the company is heading for perhaps 10-11p adj. EPS this year - hardly a disaster. So this share looks to be on a PER of about 8.

Balance sheet - not great. NTAV when last reported was only £556k. There's rather a lot of bank debt, and invoice securitisation. There was a decent cash pile too, but that's probably a year end spike. There's also a pension fund, and some deferred consideration creditors.

Overall, I don't think the company is in financial trouble, but I wouldn't rely on the divi being maintained, as finances are starting to look a bit stretched perhaps.

It'll probably be fine, providing trading doesn't deteriorate further. However, we know from experience that the first profit warning is often not the last.

Outlook - positive comments about the order book, and longer term outlook;

...In line with its previously announced strategy, the Company has developed a more robust and focused operating model by establishing strategically located design centres, manufacturing centres of excellence and regional fulfilment centres, to support further growth across the Company.  Given the visibility and rate of growth in Stadium's forward order book, the Board remains confident that in 2017 the Company will return to its higher growth trajectory.

Going back up the announcement, paragraph 2 also contains positive outlook comments:

...the Company continues to be encouraged by a strong order book which has already increased by 20% since the preliminary results announcement in March 2016. The Board can also confirm that the recently acquired business, Stontronics, continues to perform in line with expectations.

Broker notes - I'll see if there's anything in my Inbox relating to Stadium. We're in luck! N+1 Singer has put out a brief comment, saying they're reducing 2016 forecast profit from £5.5m to £4.3m. That's exactly the figure I deduced above too (I didn't go back an edit it, honestly!).

Singers also say the order book is £9m higher, and that the profit warning is down to a one-off event - a very good point.

My opinion - I think this constitutes a "good" profit warning, if there is such a thing - i.e. temporary, fixable problems. So going back to my profit warning checklist, this is how I score things here:

1) PASS - temporary, fixable problems (probably).

2) Caution - the company's finances don't look great, but it's not an outright fail either. Probably won't need a fundraising, providing things don't deteriorate further.

3) OK - broker note confirms my revised profit forecast - the company has given specific guidance on likely full year profit - very good, and well done. All companies should do this.

4) Wait? - well, that's a call each investor has to decide for themselves. I'm not tempted to buy immediately, but think it would start to look interesting if there's a further lurch down.

As profit warnings go, this one isn't too bad at all. If you like the company already, then it might be a buying opportunity possibly? The danger is that one departing customer might indicate deeper problems ahead? I don't know.

Prime People (LON:PRP)

Share price: 100p (up 4.1% today)
No. shares: 12.3m
Market cap: £12.3m

Results, y/e 31 Mar 2016 - these are final results, so include the blurb that you get in the Annual Report about Director remuneration, etc. (as opposed to more abbreviated preliminary results which most companies issue).

These are excellent results;

Profit before tax up 49% to £2.15m

Fully diluted EPS up 50% to 13.52p (giving a PER of 7.4)

Total divis for the year flat, at 8.84p (a divi yield of a remarkable 8.8%)

Moreover, this small recruitment business also has a strong balance sheet. Lots of smaller recruiters are on a low PER, but most have ropey balance sheets with a lot of debt. This doesn't.

It has no bank debt, and holds cash of £953k.

The current ratio is 2.39 - tons better than many small recruiters, which are usually somewhere around 1.0 to 1.5.

There are negligible long term creditors (only £9k!).

Why does this matter? Well a completely debt-free balance sheet means that the company is more secure, and can be more generous with divis.

Outlook comments below sound a bit wobbly to me. Also, is it just me, but the second paragrpah seems to contradict the first one? So I'm somewhat confused.

Following three years of buoyant trading in the recruitment sector, we anticipate that market conditions will be softer in the remainder of 2016.

Current activity is resilient across the group and, while we expect some slowing in our mature vertical markets, we are confident the business is well positioned to exploit available opportunities and to grow.

Surveying the business environment, we are conscious of several macro-economic headwinds, including the UK referendum on EU membership, turbulent emerging markets and other volatility that may affect our clients' hiring plans.

However, the Group continues to find opportunities for expansion and has successfully incubated new business lines over the past twelve months while increasing productivity per head and diversifying outside the UK. We will continue to invest in people and the technology that allows us to improve shareholder returns by offering our clients innovative approaches to recruitment and a globally connected service.

My opinion - what's not to like? These are terrific figures, and the share looks very cheap. It's financial sound, with no bank debt, and pays a stonking great dividend yield.

On the downside, the outlook comments seem a bit wobbly, and unclear. So maybe earnings have peaked for now?

Also, this stock is tiny, and controlled by management. So a very thin market. That means lack of liquidity, and a wide spread.

Bear in mind that a lot of smaller recruiters are cheap right now, and in fact I think this is a good sector to look at right now, as a likely beneficiary from a remain vote (if that happens).

It's not a share I currently hold, but I'm tempted to pick up a few on the back of these numbers.

Chart-wise, this looks a potentially good entry point, maybe?