Small Cap Value Report (2 Aug 2016) - STAF, FLO, LAKE

Good morning!

A deluge of 30 June interim results has appeared today, so I'll spend the whole afternoon working my way through them. Might have to switch into bullet points mode if it becomes too onerous.

It's particularly interesting that some beaten down stocks are only reacting gently to fresh profit warnings. This suggests to me that, in some sectors anyway, maybe the potential bad news from economic slowdown is already baked into the price? That could present opportunities perhaps, because if a share doesn't fall much on bad news, then after a while the most likely direction from that point on is probably upwards.

Once shares start going upwards, as we all know, that often sucks in more buyers. People love buying shares that are going up, and quite often with small caps the moves can be very rapid.

Even Indigovision (LON:IND) (in which I hold a long position) has been going up. I don't know why - but presumably the company should benefit from having its overheads in sterling, whilst buying & selling product mainly in dollars.

Staffline (LON:STAF)

Share price: 950p (up 1.6% today)
No. shares: 27.7m
Market cap: £263.2m

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

Meeting with management - I attended the private investor meeting yesterday laid on by this outsourced staffing group at Buchanan Communications, and it was a terrific success. About 30 investors came along, as well as a few city types (broker/analysts I think). Good quality sandwiches/wraps were provided, with crisps & cakes, etc, and soft drinks (so clear heads all round, which was probably a good thing!)

Management gave a detailed presentation, with slides, and there was also plenty of time for Q&A. So the session over-ran, ending up being not far off 2 hours. Despite having come down with a cold, the CEO was excellent I thought. I'm hoping to interview him over the phone for my interviews website at some point.

I last met management of STAF almost 4 years ago, and my article from that meeting is still on the internet, on my (no longer updated) old blog. It makes interesting reading, and a lot of it is still very relevant today. What is striking is that, in the last 4 years, management has done exactly what they said they would do. Plus the share price has more than quadrupled, even after taking into account the recent Brexit-related fall.

So a company & management with a very good track record - exactly what investors should be looking for.

I've got 6 pages of notes from yesterday's meeting, which could take me all day to write up. So instead I'll just cover what for me were the key points which I asterisked in my notes;

• Average wage paid to workers is £8.50 p/hr, and average hours worked is 33.
• Core business is supplying flexible staff into food industry (70%) and eCommerce (10%) - so largely recession-proof. At worst might see a 10% decline in business in a major recession. We did well in 2008 onwards - presented opportunities.
• Employability (getting unemployed into work) has been very successful - now UK's biggest player, with 25% market share.
• Very fragmented markets - scope to acquire.
• Probation service - interesting new area, sounded like it's going well & has scope to increase. Coming up with innovative ideas.
• 75% of workers are E.European. They're likely to stay in UK.
• Universal Credit - much better system, which allows UK people on benefits to take casual work without cashflow crisis of losing benefits - claims continue, and get to keep half of wages earned, under real time reporting to Govt. This will help STAF recruit more British workers, especially if E.Europeans do leave.
• Cause of share price fall? Probably due to worries over Work Programme - referrals stop in Mar 2017, then run-off for 2 years. However, mgt are very confident will either be extended, or replaced with something very similar, as works so well for Govt (£4+ benefits saved for every £1 cost).
• Ethics, compliance, etc discussed. Management adamant that they are totally ethical in everything they do. Indeed this is key selling point, and why big companies use Staffline, so no reputational risk.
• On-site model means virtually no capex, as STAF located on clients' premises.
• 8% market share with OnSite - could be increased to 15% "in a relatively straightforward way" - so good ongoing organic growth potential.
• Living wage - has not affected demand for flexible staff. Indeed, could be seen as positive - employers are more keen to use flexible workers.
• Apprenticeship Levy - a significant opportunity for STAF. Already operates in this space (Skillspoint), so scope for expansion.
• Online App for applicants is working well.
• Employability - STAF has been very successful in this area.
• Rules have changed so that past performance now included as one of criteria re winning new contracts. Positive for STAF, as they've performed so well (no. 1 in 8 out of 9 regions).
• Gross margin has gone down due to Living Wage, but cash profit is the same, since STAF charges x pence per hour, per worker. Higher wages are a pass-through on P&L.
• Broadening shareholder base to include European institutions.
• Dividends - key point - divi cover is 4.6 times. Will remain at this level until debt fully repaid. When net cash reached (end 2017) then intention to significantly increase dividends, by reducing cover to c.2 to 2.5 times.
• Working capital very tightly controlled - debtor days is 24.1, compared with sector average of 45 days.
• Discussion on acquisitions. CEO said only 1 out of 20 had not gone as planned. Good track record, but very careful - as 6% shareholder, CEO has his life savings in the company & isn't going to jeopardise that.
• Not looking to expand overseas - "UK is tough enough!"
• Prisons - big opportunity. We're in 9 already, there are 112 in total. Prisoners are positive about engaging with STAF's training programmes.
• Other opportunities for the future, outsourcing into completely new areas.

The above is nowhere near a comprehensive list of points covered, but for me it covers the key points.

Valuation - Stockopedia shows broker consensus as 114p for this year, so at 950p that is a PER of only 8.3 - which looks too low to me. Also, I reckon there's upside potential on that earnings figure.

Net debt should be cleared by end 2017, whereupon the dividend yield, currently about 2.7%, could rise considerably. Although I reckon management are more likely to find more bolt on acquisitions - which is fine by me, they've barely put a foot wrong in the past, and hence more acquisitions means faster earnings growth.

My opinion - as you've probably gathered, this is one of my favourite shares at the moment. The main potential risk is if the Govt decides to abandon welfare to work programmes altogether, but how likely is that? STAF reckon the chance of that happening is zero.

Looking at how the share is behaving, it looks to me as if there's an overhang - a seller in the market, holding back the share price. I would have expected the strong recent interims, and positive outlook, to have otherwise propelled this share back to where I think it should be - c. 1200-1400p.

Flowtech Fluidpower (LON:FLO)

Share price: 102p (down 7.7% today)
No. shares: 43.1m
Market cap: £44.0m

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

Acquisition & trading update - a small acquisition, costing £1.1m is announced.

Information is given on H1 performance, with the key points being;

Revenue up 27.8% to £27.4m, driven by acquisitions

Margins "remain resilient"

Net debt £14.1m - "in line with expectations", but quite significant. This looks manageable in the context of 2016 forecast EBITDA of £8.5m

Outlook comments today continue the cautious remarks at the last trading update on 1 Jun 2016, when the company referred to "more challenging market conditions"

Today the commentary is generally quite confident-sounding, but with a mild profit warning;

The outcome of the EU referendum has caused concern across various markets with additional currency weakening of sterling against dollar and euro.

Mid-year trading in distribution markets which the Flowtechnology division supplies has been more challenging and as a result the Board believes that the full year results will be marginally below market expectations.

That's fine - hardly a disaster, and the share price has already dropped considerably, so personally I don't see anything to worry about here. It might even be a buying opportunity?

Broker forecasts - FinnCap has this morning trimmed its 2016 adj.EPS to 14.2p, down about 5% on its previous forecast. Therefore the PER is 7.2 - looks good value to me, although bear in mind that net debt is equivalent to just under 33p per share.

Dividends - management sound fairly confident today, and reiterate the dividend policy;

The Board continue to view the future with a high degree of optimism that it can continue to deliver profitable growth while maintaining consistent high levels of service to our diverse customer base.

We remain committed to a progressive dividend policy and we expect to declare an increase in the dividend payable for 2016 in line with our previously stated intentions.

The forecast divi is 5.5p for this year, giving a yield of 5.4% - attractive.

My opinion - I think this is a very nice little company. It makes excellent margins, distributing a wide range of hydraulic parts. So for example, if a digger breaks down because a hydraulic part has failed, then the clock is ticking - the replacement part needs to be bought & fitted pronto, as downtime costs money.

FLO has a very wide range of parts, and excellent customer service, rapid delivery, etc. So it can afford to charge a decent mark-up on cost. Competition is fragmented too, giving it the opportunity to make bolt-on acquisitions at reasonable prices.

Today's mild profit warning was already in the price I think, so personally I'm toying with the idea of topping up my existing, entry level position. Mind you, as FinnCap notes today, continuing uncertainty may see the shares drift further down. Also, I think this company is little-known, so off the radar of most investors. Therefore it might be the case that the shares could be bought more cheaply, if one is patient. For that reason I might watch & wait for a cheaper top-up price.

With patience, I think there should be good upside here, once the economy has settled down post-Brexit. It's a good quality company in my view, with an attractive dividend yield. So one for the watch list perhaps, and of course doing your own research! Let me know what you think - as always reader views are encouraged in the comments section below - especially if you think I've missed something important, or you have a contrary opinion.

Lakehouse (LON:LAKE)

Share price: 31.75p (down 1.7% today)
No. shares: 157.5m
Market cap: £50.0m

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

Trading update & £37m contract win (profit warning) - well here it is! The eagerly anticipated profit warning that we all knew was only a matter of time. I've been saying for a while that this share had another profit warning in it. You could tell from the tone, and the hints given in previous updates. Really, management should be embarrassed about how they've drip-fed the bad news out to the market - this is a case study in how not to do it.

As Warren Buffett says, when something goes wrong, companies should get all the bad news out there quickly & comprehensively. LAKE has done the opposite, which is appalling really. I suppose we can perhaps put it down to all the board room kerfuffle.

Hopefully the new Executive Chairman, Bob Holt, has now kitchen-sinked it, with all the bad news now out. The share price has been volatile today, dipping to 25p earlier, but having already rebounded to 31.75p at the time of writing. This is very encouraging I think - we could be at or near a turning point, where all the bad news is in the price, and the shares could begin recovering from here, possibly.

Let's have a rummage through the detail in today's profit warning;

Order book almost flat at £633m (compared with when last reported on 17 May 2016)

Contract settlements - sounded ominous previously, they're now quantifying the likely cost at £4m this year;

Based on current discussions, this is expected to have an adverse impact of £4 million in the current financial year.  

Uncertainty over Govt policy on energy efficiency. Active dialogue with Govt;

The outcome of this consultation is crucial to determining the levels of funding and, as importantly, the types of works that will be funded

Compliance & construction divisions;

...underlying trading and order visibility remains generally strong ... subject mainly to the timing of project work

This bit sounds like more costs are being incurred, plus maybe some exceptionals?

The Group continues to invest in areas of growth and a programme has begun to reduce and re-assign headcount in certain operational and support functions to better align costs and staff levels with the Group's future plans. 

Net debt seems to be ballooning, as it was £22.6m when last reported as at 31 Mar 2016;

As at 30 June 2016, the Group's net debt was £30.6 million, comprising £28 million drawn from its £45 million revolving credit facility, together with an overdraft of £2.6 million drawn from its £5 million facility.

That's well within the limits of the facilities, but given all the other problems within the group, then increasing indebtedness is bound to be a concern.

Contract win - £37m over 5 years to instal smart meters for Scottish Power. Although setup costs of £1.5m to train engineers will be expensed up-front.

It sounds like there is an additional £1m in costs relating to other smart meter contracts.

The following sounds like code for poor financial performance in the metering business;

In light of such a rapid transformation exercise, the Group expects the year ending 30 September 2017 to be one of consolidation for its metering activities, as we seek to deliver top quartile performance for our clients on the above contracts. 

But with jam tomorrow promised;

The Group is encouraged by demand in the metering market, which is expected to contribute an important element to the Group's future growth agenda. 

The Board Room bust ups have cost £1.5m (including severance pay);

The Group anticipates that the cost of and events surrounding the two general meetings held in April and August 2016, together with the exit arrangements (in line with contractual obligations) of certain executive members of management, will cost £1.5 million.

Put it all together, and this is what you get - quite a nasty profit warning;

The Group is disappointed to report that the outlook for the current financial year [PS: ending 30 Sep 2016] is significantly below its previous expectations.

This reflects a number of one-off and non-recurring items, upon which the Board feels it is important to take immediate action.

The actions are expected to help restore shareholder value in the medium term and the Board remains confident in the opportunities and prospects for the Group,  notwithstanding a challenging and difficult year to 30 September 2016. 

My opinion - it sounds an absolute catalogue of woes, but most of the issues were already known. So this looks like a kitchen-sinking by the new Exec Chairman, after which hopefully there won't be any more significant bad news.

It seems remarkable to me that the share price has recovered to almost flat on the day. So the market really seems to be giving LAKE the benefit of the doubt now.

I was tempted to top up, on the basis that all the bad news might now be out. However, on looking at the last balance sheet, it's really rather ropey. NAV was £80.9m, but that included £93.5m of intangibles. So I make that negative NTAV of -£12.6m. OK that's not disastrous, but it isn't great either, especially when there have been so many problems.

Really, it beggars belief that a group which was in such a mess, was floated on the stock market at all. It wouldn't surprise me if the new management decide to repair the balance sheet with a placing of perhaps £10-15m.

Overall then I'm leaning towards holding my existing position, rather than adding to it. I'll give it some more thought. I think underneath all these problems, this is not a bad collection of businesses, with recovery potential. A few weeks ago I had a meeting with management and went through all the figures in a lot of detail, and came to the conclusion that once all the problems have washed through, there should be a decently profitable business underneath.