Small Cap Value Report (31 Aug 2016) - HSS, TAP, CHH, GYM

Good morning!

We've had to wave a tearful goodbye to our villa in Paxos - we only booked it for 9 nights, as the cost became too high beyond that.

I've found a spot on a nearby beach, with intermittent WiFi, so hope I'll be able to file this report before the 1pm email deadline.

This evening I'm heading back to Corfu, and am staying there for 3 nights, to round off my holiday. I've booked a little townhouse through Air BnB, which worked out very good value - similar price to a budget hotel room, but for a whole house.

It's the first time I've used Air BnB, partly to see for myself how much it is likely to disrupt the hotels sector. There are so many areas where new internet competition is threatening old, established business models. As an investing theme, it's something we have to be very mindful of - there's money to be made both spotting early the big winners of the future, and avoiding the established businesses which are likely to die out.

I read somewhere that we need to change our mindset, from viewing large companies as unassailable behemoths. Instead they should perhaps be seen as vulnerable, slow-moving giants, that new internet-based competitors are gunning for, slowly chipping away at their market share.

HSS Hire (LON:HSS)

Share price: 78.5p
No. shares: 154.8m
Market cap: £121.5m

Interim results, 27 wks to 2 Jul 2016 - this tool hire company says that the unusual period end has affected cashflow, and worsened net debt. However, debt is still the elephant in the room with this company. It simply has way too much debt, and actually doesn't have any equity at all, once intangibles are written off.

Net debt is a staggering £238.7m. This compares with a hire fleet book value of £142.1m (see note 10 to today's accounts). Therefore the entire hire fleet is financed with bank debt, plus there's another £96.6m debt over & above the debt required to finance the hire fleet. That's a crazy state of affairs. It's the legacy of the former private equity owners, who avoid corporation  tax by loading up companies they own with insane amounts of debt. So PE floats are often sold back to the stock market with still far too much debt remaining, as in this case.

It's loss-making too. H1 is a loss before tax of £9.8m, although by calling some items exceptionals, and adding back amortisation of intangibles, a small adjusted profit of £205k is eked out - an improvement vs. prior year H1 adjusted loss of £3.9m.

With all that debt, the finance charges going through the P&L are hefty, at £7.1m for H1, so that annualises to £14.2m.

Outlook - comments sound reasonable;

Trading in Q3 2016 has started ahead of Q3 2015 and is in line with management expectations.

Our revenue mix continues to reflect particularly strong growth amongst our key accounts and in services, as our customers recognise the operational benefits of single-sourcing tools and equipment, including technical training for their staff. We expect this trend to remain a feature of the second half of the year, alongside continued growth of our specialist categories....

The simplification of operating structures within core, powered access and power within England and Wales will deliver cost reduction and sales efficiencies.

We will continue to focus on utilisation improvements which, together with increased refurbishment activity, will allow capital spend in 2016 to be lowered to between £40m and £45m.

The Board remains confident that the investments being made provide HSS with scalable operating capacity to support future growth and that the Group strategy remains appropriate to create shareholder value over the medium to long term.

Whenever companies talk about feeling positive about the medium to long term, it means that there are some short term problems.

Note the substantial capex requirement. This is a common feature of equipment hire companies - EBITDA is meaningless, as they have to constantly spend on replacing worn-out equipment, otherwise the business would rapidly decline.

My opinion - it has way too much debt, hence any profits it does make are really just swallowed up in debt interest payments.

There's a poor dividend yield of about 1.7%, although the balance sheet is so weak that it really shouldn't be paying any divis at all, in my view.

I see no attraction in this share whatsoever. Nor do Stockopedia's computers, which put it on a very low StockRank of only 18.

Taptica International (LON:TAP) - this share has risen 28% today, to 164p, valuing it at just under £100m.

The P&L figures look outstandingly good, although partly helped by acquisitions.

It has a sound balance sheet, with $9.5m in net cash.

The drawback is that it's an Israeli-based internet advertising company. There has been a flurry of this type of company floating on AIM in recent years, and I'm very wary of them. Often there seems to be something wrong - it's not always transparent how companies actually make their profit, or they're playing fast & loose, or ripping off customers in some way.

Then we had the debacle of ad-blockers killing the business models of some ad tech companies a while back. So the profits can be substantial for a while, but then collapse once the market changes in some way.

However, in this case, I've run through the figures, and I can't see any red flags. The profits & cashflow look real to me. A special dividend declared today reinforces that view. Also the client list sounds impressive - big companies.

Even after today's rise, the shares still look good value, on current year forecast earnings. So if you are prepared to buy into Israeli companies listed on AIM (generally I don't, but occasionally break my own rule), then this one seems worth of a closer look.

The crucial thing is to understand the business model, and determine whether profits are sustainable or not. IF they are, then the shares could be quite interesting maybe? However, be very careful, as AIM listed overseas companies often go badly wrong.

Churchill China (LON:CHH) - interim figures today look good. This is accompanied by a confident-sounding outlook statement, that the company is on track to meet full year expectations.

The share is looking a little expensive now I think, but it's a nice company, on a roll, and with a good balance sheet too.

I like it, but I wouldn't pay the current price, which is a PER of about 19, taking into account today's share price rise of about 7%. I think that's looking toppy.

GYM (LON:GYM) - this is a chain of budget gyms. I've used one in the past, and they're good - large, with lots of equipment, but no pool. This is reflected in a very good value subscription price.

I have to say though, looking at the figures, I think this share is very significantly over-priced. I think they've managed to convince investors to value it on EBITDA, which of course is meaningless - gym equipment wears out quickly, as it has such heavy use. So to ignore both capex & the depreciation charges (which is what EBITDA does) is a serious error, in my view.

It's a capex-heavy model, and in my view the returns generated from the capex don't look particularly attractive.

This company is certainly disrupting the gym market, by offering a much more affordable alternative to conventional gyms. However, it doesn't have any moat - there are competitors copying the same format, of offering cheap, no-frills gyms.

To my mind, it's not worth the current lofty valuation. The current year PER is 45.6, dropping to 28.5 next year. I think you can buy much better businesses, on lower ratings.

I have to sign off now, it's proving almost impossible to concentrate here, with so much noise & distractions from music, screamy/shouty kids, etc. Grrrrr, pesky people enjoying their holidays, how dare they!! lol  ;-)

See you tomorrow, when I should be more settled in my temporary little house in Corfu old town.

Regards, Paul.

(usual disclaimers apply)