Small Cap Value Report (7 Nov 2016) - RCN, SEPU

Good afternoon!

The US Presidential Election is now imminent - it's tomorrow, 8 Nov 2016. Who knows what the outcome will be? Mrs Clinton seems to have had a late boost from the FBI saying that it has found no evidence of criminal wrongdoing in her use of a private email server.

What worries me is that the public in America seem to be so thoroughly cheesed off with conventional politics, that we could see an upset. That's exactly what happened with Brexit here, with the polls being very wrong [EDIT: See comments section below, where it seems the Brexit polls were closer than I recalled!].

For that reason I'm keeping my hedges on (a put option on the S&P 500) just in case. It will probably expire worthless, but it does at least insure me against a plunge in the markets from a surprise outcome in the election.

Also, we're increasingly in a world of post-facts politics. I.e. the facts no longer seem to matter to voters. People seem to vote on a purely emotional level, and ignore facts which don't fit their preconceptions. Maybe this has always been the case? However I think the internet & social media are changing things for the worse - just reinforcing existing prejudices in people, and ignoring inconvenient truths. I fear for the future of democracy - with candidates that would have been laughed out of the room in the past, now being taken seriously.

The trouble with small caps, is that it's difficult & expensive to move in and out over short term worries. Hence why, occasionally, I think a bit of hedging can be useful. Although, not being an expert on that type of thing, I can end up hedging using the wrong instrument. E.g. with Brexit, I initially shorted the FTSE 100, only to subsequently realise that was a mistake. FTSE 100 stocks have earnings mostly in dollars, so those shares actually went up, after the initial plunge. The better hedging trade then would have been to short sterling.

I think there's been a bit of a buyers' strike in the UK market in recent days - as I mentioned last week, lots of shares have been selling off for no particular reason of late. I think it's partly because buyers are holding off because of the US election. Another reason is that the post-Brexit rally has just gone on too long, and taken some share prices up well above a sensible valuation. So a correction was inevitable.

On to today's company results & trading updates.

Redcentric (LON:RCN)

Share price: 60.9p (down 59% today)
No. shares: 147.2m
Market cap: £89.6m

Accounting misstatements - a dramatic title for an RNS, and a dramatic collapse in the share price today, so the news must be really bad.

It sounds like the CFO has been cooking the books;

The Company has served notice on its CFO, Tim Coleman, and placed him on garden leave with immediate effect. Mr. Coleman resigned with immediate effect as a Director of the Company on 6 November 2016. The Board anticipates making an external interim appointment of a replacement CFO.

This is because misstated balances have been uncovered on the balance sheet;

...an internal review by the Company's audit committee in relation to the interim results for the six months ended 30 September 2016 has discovered misstated accounting balances in the Group's balance sheet.

The accounting irregularities seem to have been going on for some time;

The Board has commenced a forensic review of the Group's current and historic balance sheets which will delay publication of its interim results (originally scheduled for 14 November).  The work to date has identified that audited accounts for previous years are likely to need to be restated, resulting in some write down in historic profits.

Current indications are that all issues relate to prior periods.

New business sales and recognition of those sales into revenue over the six months ended 30 September 2016 have been in line with management's expectations.

From this, it sounds as if the accounting irregularities possibly relate to revenue recognition - i.e. that revenues (and hence profits) may have been overstated?

The way double-entry bookkeeping works, is that if you overstate profit, then you've pushed through too many credit entries into the P&L. There has to therefore be a corresponding debit on the balance sheet - which is either overstated assets, or understated liabilities.

Understated net debt - worryingly, the balance sheet side of the problem has surfaced in net debt being higher than previously disclosed;

The net debt guidance announced in the pre-close trading update is now believed to be unreliable.  [PS: this announcement on 29 Sep 2016}

The Board now believes net debt at the half year was approximately £30 million.

The Board also believes that the underlying net debt position at 31 March 2016 was materially higher than as reported and thus the business has reduced its underlying net debt in the six months to 30 September 2016.

It isn't helping matters that today's announcement is as clear as mud. I now have to check back to the last accounts, to see that net debt was disclosed as at 31 Mar 2016 of £25.3m. By a process of deduction, the company is now saying that the real figure was over £30m.

I don't understand how this got past the auditors. If you look at the announcement on 16 June 2016, which was the audited accounts for y/e 31 Mar 2016. Audits are supposed to verify balance sheet items - and one of the easiest to verify is the net cash/debt position. They should just write to the bank to ask for confirmation of the balances in all bank & loan accounts. They should also review the bank statements either side of the year end, to check for large & unusual transactions. This is pretty basic stuff, so I think the auditors, PWC, have some explaining to do.

At the moment, the total impact of the corrections needed is to reduce NAV by c.£10m;

The Board believes from the information available to date that the impact of correcting these cumulative historic accounting misstatements would result in a need to reduce net assets by at least £10 million. 

How significant is that?

Looking back at the most recently reported (incorrect) accounts, NAV was £97.5m at 31 Mar 2016. However, that included £92.3m in intangibles, giving us only £5.2m NTAV. Given that we are now told this was overstated by c.£10m, then the real NTAV was about negative -£4.8m.

There's no freehold property on the balance sheet either, which would have acted as a cushion to this bad news. So overall, I think the balance sheet looks rather weak, and the attitude of the bank to this situation will of course be critical.

The last set of accounts do however show a strong underlying level of cash generation. We now know that some of that was falsified, but if the total scope of the falsification was £10m, over several years, then it doesn't sound too bad in the context of adjusted EBITDA of £25,8m last year.

If the real adj. EBITDA figure was say £20m, then that means this situation looks survivable. Net debt of £30m now would be 1.5x EBITDA, which normally a bank would be happy with.

My opinion - I think this looks survivable, and hence the 60% share price fall today might be overdone, perhaps? The 89p share price fall, multiplied by 147.2m shares in issue, means that the market has knocked off £131m from the company's valuation today. Yet the RNS says that the company currently believes the balance sheet is overstated by about £10m. So this could be a case of the market throwing out the baby with the bathwater?

On the other hand, this could be tip of the iceberg. What if more accounting irregularities are discovered? Also, was the CFO stealing money from the company, or was this an orchestrated over-statement of the accounts with no direct personal benefit gained by him? We don't know yet.

In my experience, if it's theft, then it's usually one or possibly two people working alone. However, if it's a deliberate overstatement of accounts, then that often involves several of the most senior people at the company colluding.

Therefore, I suspect maybe the market is taking a dim view of this situation, in the expectation that there could be more bad news to come?

It would have made a terrific trade this morning, if you managed to buy on the low point of 40p, as it's up almost 50% since then. On balance I think I'll steer clear of this particular falling knife. It is tempting however, as the core business looks good, and the extent of the accounting misstatement looks relatively modest, based on what we currently know. This sell-off could have been overdone, if things stabilise with the company & if its bankers are supportive.

I forgot to mention above, that no particular guidance is given on the bank covenants, other than this mention;

The accounting adjustments arising will result in a recalculation of the banking financial covenants, which will take some time to complete.

Again, I'm not really sure why this is a time-consuming thing to do. It should be fairly easy and quick to recalculate the correct net debt position. Then strip out the dodgy items from EBITDA, and publish the result. Mind you, the bank might well want third-party verification of the covenant calculations, from a big firm of accountants, to give them comfort. So maybe that's the cause of the delay?

Sepura (LON:SEPU)

Share price: 23.13p (up 25% today)
No. shares: 370.1m
Market cap: £85.6m

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

Possible offer - this announcement popped up on my phone, just as I was relaxing with a pint of Helles organic lager, in The Lord Clyde on Friday evening. It certainly put a broad smile on my face, and what a great way to start the weekend!

I picked up some shares in this maker of special radios for the emergency services, after an excellent broker note came through from Liberum a few weeks ago, making it very clear that the company was up for sale, and to expect a takeover bid.

Normally I wouldn't have touched it, as the company's finances look stretched, and it had already told the market that the bank covenants might be breached in Mar 2017. So not a good share for a safe portfolio, but an interesting one to have a bit of a punt on. Everyone likes an occasional punt, no matter what they say.

This is the main bit of the announcement after the market closed on Friday;

Further to the recent share price movement, the Board of Sepura (LON: SEPU) confirms that it is in preliminary talks with Hytera Communications Corporation Limited ("Hytera") regarding a possible offer for the entire issued and to be issued share capital of the Company.

Hytera has confirmed to the Board of Sepura that any offer, if made, is likely to be solely in cash. There can be no certainty that any offer will be made, nor as to the terms of any such offer. 

The usual disclaimers are made about it being preliminary talks, etc. However, it strikes me that by naming the potential bidder, and that any bid is likely to be solely in cash, then the approach sounds fairly serious.

Hytera seems to have been founded in 1993, and is a Chinese company. I'm not sure where to find information on Chinese companies, but it is listed on a US website as having a market cap of c.$3.2bn, so it looks a substantial company. I can't find any accounts for it. If anyone else can find the relevant info, please post it below in the comments. In particular, how much cash has the company got? Getting cash out of China is tricky I believe, so they would need official authorisation for a cash bid for Sepura.

An article in the Sunday Times apparently stated that a cash bid of at least 25p was likely. It could get interesting if other parties enter the fray. This is why I'm sitting tight, rather than cashing in today.

Sepura does have a lot of debt, but I did a spreadsheet to see what the post-fundraising net debt position looks like, and it wasn't too bad actually. However, there was still a considerable amount of debt. Unfortunately, I can't find that spreadsheet, which is a nuisance, it might be on my computer back in Hove?

My opinion - this is a punt of course, and the danger in takeover situations is that any announcement saying the talks are off would crash the share price. Therefore the dilemma is whether to run the position, or to bank the profits. Or a mixture of the two?

Personally I think Sepura looks a very worthwhile business, which has run into some temporary difficulties, which would make an attractive target for a larger company to acquire whilst its share price is depressed. Therefore I am minded to run with this one, and have decided not to bank any profit yet. It is high risk though, and not the usual type of thing that I'd go for.

(work in progress)