Small Cap Value Report (19 Sep 2016) - WTG, SPRP, MTO, SPL, 7DIG, DPP, ADGO, STY, SPSY

Good morning!

Sorry I didn't get round to reporting on any more companies on Friday, I was too tired. Have decided it's time to focus on health, so spent the weekend charging around on my new bike. It seems to have blown away a few cobwebs!

Mello Beckenham

A lot of regulars read this column, so David Stredder has asked me to mention that there is NO meeting tonight. It has been pushed on to next Monday, 26 Sept.

Fairpoint Webinar

I like webinars, as they save me a trip into London, which isn't really worth it usually just to see one company. Fairpoint management are doing a webinar for investors today at 1:30pm. I've got the date right this time! Here is the registration link. 

Watchstone (LON:WTG)

Share price: 181p (down 16% today)
No. shares: 46.0m
Market cap: £83.3m

Correction to H1 2016 results - well this is embarrassing for the company. It looks as if they did their sums wrong in the most recent results, with the EPS figures being incorrect. Today's correction only seems to refer to EPS figures, so that suggests someone used the wrong denominator when calculating EPS, but that the numerator was correct. Sloppy. Mind you, this company has a long history of putting out nonsense figures, so I suppose it's par for the course.

Response to announcement by Slater & Gordon Ltd - of more importance is this second RNS today. Slater + Gordon are of course the muppets from Australia who massively overpaid for the core business of Quindell, when it was on its knees. S+G could have got away with paying a fraction of the ridiculous £637m initial cash consideration (plus further contingent payments). It's been described as one of the 5 worst acquisitions of all time.

This disastrous acquisition of Quindell's core business almost pulled down the whole of S+G. Indeed its share price collapsed from a peak of AUD 8 in early 2015, to just AUD 0.4 today - that's a fall of about 95%. S+G is now reliant on bank financing, and could yet go bust, as another article from the Sydney Morning Herald points out.

Conman Rob Terry, who created the tangled web of Quindell, laughably thinks that S+G "got a bargain". Clearly someone in complete denial, as is often the case with people of that ilk, who continue protesting their innocence forever, instead of doing the decent thing and owning up to their mistakes.

Unsurprisingly, S+G are now trying their luck, and attempting to claw back something from their £50m which is held in escrow. Watchstone (new name for Quindell, and under new management now, of course) denies that S+G has any valid claim. I suspect WTG may turn out to be correct. If you cast your mind back, S+G seemed so keen to buy Quindell's core business, and did their own detailed due diligence. I remember them even publishing details of the rationale for the purchase, with detailed numbers, and stating how confident they were about their due diligence. Utterly bizarre, you couldn't make it up. It was blindingly obvious to a simple blogger like myself that S+G was making a mistake of epic proportions.

It was Tom Winnifrith of course who exposed the reality that Quindell's profits were largely bogus - relying on unrealistic assumptions of future settlements for industrial deafness claims. Although its whiplash claims business did make some genuine profit.

My opinion - when you see one cockroach, you know that it's only a matter of time before you're going to meet the rest of his family too. That's how I think of Quindell - the whole thing is just toxic in my view. New management may be cleaning it up, but there are bound to be more nasty surprises, as we've seen today.

However, looking at the bull case, you could argue that the downside risks are priced-in. With £93.8m cash on its last balance sheet, plus the possibility of receiving the £50m escrow funds on top of that, then an £83.3m market cap does look interesting.

On top of that, you have the value of the remaining businesses, which are tough to value. They're loss-making on the face of the P&L, but supposedly profitable at the EBITDA level, even after capitalised development spend.

Tricky one this. Everything about Quindell repulses me, but if Watchstone does win the battle for the escrow account, then this share would be trading at a big discount to net cash, giving the chance for a re-rating. So it could be time to hold my nose and buy a few perhaps? Maybe not, I don't know. On balance I'm probably going to give it a miss.

WTG is of course still being investigated by the Serious Fraud Office (SFO) in the UK. I wonder what the outcome of that is likely to be? That could be another can of worms. Would WTG be required to compensate shareholders who lost money on QPP shares? What do readers think? It seems unfair that current shareholders might end up paying to compensate old shareholders? Surely it's former management that the SFO should be going after?

Isn't it bizarre how many legal or accountancy firms that list on the stock market seem to go disastrously wrong?! Aren't these people supposed to be experts??

Sprue Aegis (LON:SPRP)

Share price: 142.5p (down 9.5% today)
No. shares: 45.9m
Market cap: £65.4m

Acquisition - a small (up to £2.8m) acquisition of software rights and source code is announced, from Intamac Systems Ltd. Whilst not a material amount, it looks potentially interesting;

The Board believes that this is a major development for the Company as it significantly extends Sprue's technical capability and provides an opportunity to sell a wide range of internet-enabled products and services as part of its new Connected Home Strategy with the potential of recurring revenues.

In addition, based on expressions of customer interest received already, the Board is optimistic of commencing sales of internet-enabled products in Q4 2016.

Smoke alarms seem an obvious product to connect to the internet, and combine with other sensors perhaps, so I can see the potential here.

Interim results 6m to 30 Jun 2016 - the company trailed the key figures in a trading update on 22 Jul 2016, which I reported on here. So now it's time to compare the actual results with what was said then.

The numbers below are exactly the same in today's results, as in the trading update on 22 July;

• H1 revenue of £25.9m
• Operating loss of £0.9m
• Cash £14.7m

So that all looks fine, therefore I'm wondering why the share price has dropped nearly 10% today?

EDIT: Hedley05 has commented below (thanks very much), saying that this section of today's results from SPRP concerns him;

Cash declined by £7.7m since 31 December 2015 principally due to the circa £7.0m payment in H1 2016 for the buffer stock ordered to mitigate against potential supply chain disruption due to the relocation of the factory in China in Q4 2015; this stock remains largely unsold as at 30 June 2016 although the Board is confident it will be sold over the next 12 months

Looking at my Twitter feed, others seem to have also been spooked by the comment that this buffer stock remains unsold.

Other points to note;

Interim dividend maintained at 2.5p

H2 outlook seems encouraging;

...The Board has declared a maintained interim dividend of 2.5 pence per share and remains confident of a solid recovery and return to profitability in H2 2016

...the Board continues to expect Sprue's sales and operating profit before share-based payments charge for the year ending 31 December 2016 to be in line with market expectations at approximately £58.0m and £1.9m respectively. 

Isn't it wonderful when companies confirm expectations, and give the actual figures too?! All companies should do this - please note this, PR people & brokers who read this column! Clarity is what investors need, not the all-too-frequent game of trying to work out the nuances in a lot of carefully prepared weasel words! If in doubt, the market just slams the share price down further than it would have done if things were made crystal clear first time around (Crawshaw (LON:CRAW) being a good recent example of that).

Faulty batteries - product returns are "broadly tracking in line with management's expectations". So, that means things are a bit worse than expected then, on this issue.

The £5.7m warranty provision is expected to be adequate. However, the reputational damage is what bothers me. Personally, if I buy a product from a company whose brand I respect, and that product fails prematurely, then usually I will never buy anything made by that company again. So my fear is that there could be very real lasting damage to Sprue from this battery issue.

Mind you, the company reassured on this today, saying that it has not lost any major customers as a result of this issue.

Forex - a bit mixed here;

Since the EU Referendum and Sterling's devaluation against the US Dollar, the Group has seen significant on cost in all of its smoke and CO products and we are therefore taking steps to mitigate the cost impact to improve gross margins which will take effect towards the end of this year and early next year.

Offsetting the cost increase - which affects all importers of products in US Dollars - the Group benefits from a more favourable exchange rate on its sales denominated in Euros. 

I assume that "significant on cost" means that cost prices have gone up?

Balance sheet - still very strong, and has £14.7m in net cash. So despite all its problems, this remains a very strongly financed business, with no solvency issues whatsoever, in my opinion.

Cash could rise in future, as some was used to build up inventories for a change of factory, so that factor should unwind.

With a £65.4m market cap, the cash is quite a big chunk of the valuation, which could mean the business itself is cheap maybe?

My opinion - I thought this share looked too expensive when last running through the numbers 2 months ago, when it was 183p. With the price now down about a quarter, to 142.5p, it's starting to look a bit more interesting. Particularly when you subtract net cash of 32p per share, arriving at an enterprise value of 110.5p.

The trouble is, it's difficult to value on an earnings basis. Lots of things have gone wrong in the last year or two, and I'm not sure what the sustainable level of profitability is likely to be. Also, I don't like the royalty-based business model for some products. Reputational damage from the battery failure issue is a further worry.

Upside could come from internet-enabled new products. So I can see some upside potential here. On balance it's probably not for me, but with the valuation now more reasonable, it's going back on my watch list.

Mitie (LON:MTO)

Share price: 199p (down 26% today)
No. shares: 359.0m
Market cap: £714.4m

Trading update (profit warning) - yes, I know that it's too big to be considered a small cap. However, a 26% fall in price makes it worth a quick look. There might be some read-across to other companies in the facilities management space perhaps?

Mitie says that H1 results have been hit by a number of factors. An interesting factor is Local Authority budgets being squeezed. This was noted by Lakehouse (LON:LAKE) recently too;

Our Property Management business has been significantly impacted this year by local authority budget pressures and particularly by the statutory social housing rent reductions that came into effect in April. This has reduced the funding available to local authorities and housing associations for repairs, maintenance and project works.

Revenue and profits will be lower this year as a result, and start dates for some project programmes have been delayed this year.  The pipeline for this business continues to offer interesting growth opportunities for the group for the longer term.

This makes me wonder whether Govt policy to force 1% p.a. rent reductions is a wise thing? The law of unintended consequences seems to have kicked in. To recoup the 1% rent foregone, social landlords are clearly cutting back, and deferring maintenance & repairs. That in turn is triggering profit warnings from contractors like Lakehouse & Mitie, who then lay off staff in order to balance their own books.

The Govt then collects in less NI/income tax, and has to pay out dole money to the people laid off. Plus, properties become more dilapidated, and eventual repair bills might become higher, if preventative maintenance is delayed too long. It would be interesting to do a cost/benefit analysis here, which I suspect overall might show that the 1% rent cuts could be counter-productive?

Other factors noted by Mitie today;

However, in the short term we continue to experience the effects of significant economic pressures. These include;

- lower UK growth rates,
- changes to labour legislation,
- further public sector budget constraints,and
- uncertainty both pre and post the EU referendum.

We have taken strong action to counter the impact of these pressures by making changes now to the way we operate and initiating cost efficiency programmes across the group.  These positive changes will help to ensure the long term competitiveness of the group and its service offering.

In the meantime though, this year (ending Mar 2017) is likely to be disappointing;

Whilst we have seen some positive trends and contract awards in the year to date, it is our expectation that the pressures we are facing in our markets will impact our trading results during this financial year ending 31 March 2017, most significantly in the first half...

Operating profit for the full year is now expected to be materially below management's previous expectations as a result of a continuation of the pressures experienced in the first half and further one-off costs of organisational change associated with our cost efficiency programmes, which are expected to total up to £10m in the year. 

My opinion - disappointing, but companies like this can usually restructure reasonably quickly, and get back on track. So it might be one to put on my watch list?

The divis are good, 6.1% yield, if maintained at the prior year level. Although I'm not keen on its £178.3m net debt (at 31 Mar 2016).

Oh my goodness, I've just seen the balance sheet! Could have saved a lot of time by looking at that first. It's awful. Net assets of £415.1m includes £532.4m of intangibles. So NTAV is negative, at -£117.3m. That makes it too risky for me.

Here are some quick comments on a few more company updates;

SKIL Ports & Logistics (LON:SPL) - this is an Indian, AIM-listed (groans!!) developer of a new port facility. It's gone disastrously wrong I'm afraid. I broke my own rule of avoiding overseas AIM stocks, and bought some of this share a while ago, as it looked potentially promising. However, the wheels have completely come off.

By last Friday, SPL's share price had already dropped by about 75% from its recent peak, in Feb 2016. So it was fairly obvious that something must be going badly wrong. Sure enough, after the market closed on Friday, a disastrous update was issued.

This stated that further funding of £36m is needed. Today, the share price has plunged another 49%, to stand currently at only 10p. This is option value only, giving a market cap of only £4.4m now. So the existing equity is now more-or-less worthless really, since it's likely to be massively diluted by any fundraising.

I certainly wouldn't throw good money after bad. Management now has zero credibility.

Thankfully, with more speculative positions, I've come round to the idea of using a stop loss. Therefore once the share price was c.50% down from the peak, I ditched my shares as part of a general portfolio pruning around the time of the Brexit vote.

My commiserations to everyone who has lost money on this one. I know quite a lot of friends who were keen on the company, and believed in it. We need to redouble our efforts not to get sucked into any more overseas companies that list on AIM - especially Chinese & Indian ones, which seem to be the worst. They seem to nearly all end in disaster, in the long run. So why do we give them the benefit of the doubt?

£7DIG - another speculative share. I had a scrap of this stock in my SIPP (can't remember when, or why I bought them), but ditched it this morning, after reading the lousy results out today. The cash is running out, so a fundraising now looks inevitable - probably at a discount. Debtors look very high, which unsettles me. This is a sister company to Audioboom (LON:BOOM) . It doesn't look quite as bad as BOOM, but not far off.

DP Poland (LON:DPP) - interim results out today. It's still loss-making, and the increased gross profit has not translated into reduced losses. That's despite 28% LFL sales growth, which is indeed impressive. The market cap of c.£66m (at 50p per share) looks complete madness to me. This is in reality, one of slowest, and least convincing roll-outs I've ever seen.

Adgorithms (LON:ADGO) - awful interim results, as this was one of the ad tech companies that was hit by recent kerfuffle in that market. H1 gross profit almost halved to $2.2m, but operating costs tripled to $4.9m.

So it's moved from a $2.6m adjused operating profit in H1 2015, to a $2.7m adjusted operating loss in H1 2016. That's appalling. The board says it is confident about the medium term outlook, which of course means they're not confident about the short term!

The one decent thing about this company, is that it has $28.1m in net cash - which is about £21.6m.

After today's 17% fall in share price to 21.5p, the market cap is only £13.3m. So the shares trade at a discount of 38% to the company's own cash balance. Therefore the obvious way to unlock shareholder value is to shut down the business, and give the cash back to shareholders.

In my experience, UK shareholders don't usually ever see the cash again, at supposedly cash-rich AIM-listed overseas companies. Remember all those Chinese frauds on AIM, which managed to conjure away the supposed huge cash piles? So you can't always trust a discount to net cash for overseas companies on AIM.

ADG doesn't pay divis either. So I'd be careful with this one. It's an Israeli AIM-listed company. In  my experience, these tend to divide quite sharply into good, or bad. I'm not sure which this is.

Styles and Wood (LON:STY) - shares in this property services group have had a remarkable run since the summer of 2015, multi-bagging, after a clever financial restructuring was pulled off.

H1 results today don't seem very impressive to me. Only £0.5m adjusted profit before tax. Although it seems that the company has a heavy H2 weighting to its results, or at least it did last year anyway.

The balance sheet isn't great, but is much improved from what it used to look like, pre-restructuring. NAV is slightly negative at -£674k. Also I think debtors look high.

On outlook, the company seems confident about full year expectations;

The trading for the full year remains in line with market forecasts with deferral of work from live frameworks and larger longer term projects strengthening the projected carry through position for 2017.  

Consensus forecast seems to be 38.3p for 2016, and 44.0p for 2017.

At a share price of 432p today, that gives a PER of 11.3 (2016) and 9.8. That looks about right, maybe slightly warm to me, given that the balance sheet is threadbare, and there are no dividends.

My opinion - shareholders have had a bonanza here, in the last year. However, I think the share price has now caught up with, and maybe even overshot a bit on the upside. So if I held, I'd be banking the profits now. Although as with any share, if you think the forecasts are too low, then there could be upside from potential out-performance.

Spectra Systems (LON:SPSY) - this must be one of the most peculiar companies on AIM. It's based in America, and amongst a variety of high security type operations, cleans banknotes. It looks a bit of a lifestyle business, as it never pays dividends, and makes losses most years. There is however a decent net cash pile of $8.7m sitting on the balance sheet.

Performance in H1 of 2016 looks lacklustre. A loss before tax of $430k.

The outlook statement sounds interesting, with lots of potential opportunities. With a market cap of only about £7.5m (at 23.6p per share), and nicely cash-backed, this could be a potentially interesting punt, if some of their pipeline of opportunities actually turns into profits at some stage.

Mind you, looking at the share price chart over the last 5 years, this investment has been very poor, and traded sideways for the last 4 years. So the danger here would be that investors tie up money in something that could be very difficult to get out of. Meanwhile there's an opportunity cost, with money tied up here, which could otherwise be put to better use making money elsewhere.

All done for today, see you in the morning.

Regards, Paul.

(usual disclaimers apply)