Small Cap Value Report (Tue 6 November 2018) - VCP, FDP, CNCT

Good morning! 

Today we are looking at:

• Victoria (LON:VCP)
• First Derivatives (LON:FDP)
• Connect (LON:CNCT)

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This section by Paul Scott:

Victoria (LON:VCP)

• Share price: 410p (-5%)
• No. of shares: 125 million
• Market cap: £514 million

Update on bond

We had an interesting debate here (Mon) and here (Weds) last week about Victoria (LON:VCP) - issuing a profit warning, and simultaneously announcing that it was seeking to issue a junk bond to repay all its bank borrowings. This spooked me, and after various accounting shenanigans lately (such as CAKE, and YU.), my approach is this - if in doubt, run for cover. We can always buy back later. When writing last week, neither Graham not myself held any position in VCP shares - so as always, we were just giving our honest opinions, based on the facts available.

Graham took a more relaxed view, and gave an interesting alternative assessment of the situation, thinking that a bond issue seemed a good idea, and giving his view that the BB credit rating was not a worry.

The latest announcement today, says that the bond issue is being abandoned, as indicative pricing was too high. That's not at all surprising to me. After all, VCP has a stretched balance sheet, with too much debt. Plus it's just issued a profit warning. So why would anyone want to lend it money cheaply?

Management today says;

It is very disappointing that despite the positive, stable credit ratings, the indicative pricing for the Bond moved unfavourably over the course of last week, particularly when there have been no fundamental changes to the Group or its business.

Possibly the pricing moved because the company issued a profit warning here? The wording of that statement seemed to try to gloss over the negatives, but it was clearly a profit warning, and the market was not fooled. The share price plunged 25%, closing at 455p on the day of the main announcements (29 Oct 2018).

NB. my negative commentary on the situation was not published until the evening of Monday 29 Oct, after the market had shut, by which time the main damage to the share price had already happened.

Weak balance sheet - the pro forma 30 Sep 2018 financial information shows NTAV negative at -£169m, if you just write off goodwill and other intangible assets. That improves to -£99.6m if you also write off the deferred tax liability, which often relates to intangible assets. So still a significant negative balance sheet NTAV, whichever way you look at it. I don't normally invest in companies with negative NTAV, particularly if there is a large element of bank debt (relatively short term funding).

So I completely stand by my previous comments that the balance sheet is quite obviously weak, and over-reliant on bank debt.

Banking relationship - the group reassures today on its banking relationship;

Therefore, as we continue to have a close and positive relationships with our lending banks and operate with significant headroom with respect to covenants under our existing 2-year facilities put in place in August 2018, we will continue with these facilities. The banks have been, and continue to be, very supportive of our strategy and performance. Any suggestion to the contrary is untrue.

I think it would be helpful if the group publishes what its banking covenants are, and quantifies the headroom. Nothing reassures better than hard facts. A 2-year facility will clearly need to be refinanced in the not-too-distant future. That may not necessarily be a problem, if the company performs well. It would make sense for the company to pay down some of the debt from cashflows in the meantime. Maybe it needs to take a break from the frantic pace of acquisitions?

Directorspeak - how refreshing to hear a management team admit to their mistakes. This is impressive;

Nevertheless, last week was not the Board's finest hour in terms of the clarity of our communication. For the last six years, the Board has endeavoured to maintain an open dialogue, fully appreciating that it is the shareholders who own the company.

Unfortunately, we placed too much emphasis on technical guidance and market convention and not enough common sense was applied in terms of communication with shareholders.

By failing to communicate clearly last week and in the run-up to the Bond launch, the Company needlessly left shareholders feeling uncertain about the future.

Good for them, it takes courage to admit to mistakes made, and I think people will respect these comments, I certainly do.

However, it probably would have been better to have edited out this bit from the announcement, which is less impressive;

Critically, this also left an open goal for those with less than pure motives to spread outrageous untruths. This has damaged the value of the shares, although, of course, there has been no impact on the underlying business, which is high quality and continues to successfully design, manufacture, and distribute flooring products around the world as it always has done.

I've no idea who they are referring to, as I've not seen any other commentary about the profit warning or bond issue. Maybe the company was targeted by short-sellers on bulletin boards, or elsewhere, I have no idea?

The point is surely that, if management create an information vacuum, then this is likely to spook investors. For example, the last time I can remember a company suddenly announcing, out of the blue, that it intended to issue a junk bond, was Globo - which of course soon afterwards went bust. Many investors are also perplexed, and smarting, from the recent near-collapse of Patisserie Holdings(LON:CAKE) . Therefore, Victoria dropping a bombshell, with absolutely no explanation (initially) of why it had decided to issue a bond to repay all its bank debt, is very likely to trigger panic amongst investors, which is precisely what happened.

I'm sorry if my posts alarmed anyone, but if something unexpected, and potentially dangerous happens, then I'll try to protect my readers by airing my concerns straight away. The company has since clarified things, so hopefully they can get back on track. So it's not right for Victoria to both admit they are at fault, but in the next sentence to shoot the messenger.

Anyway, I wish the company well, and hope it recovers from this debacle. Whilst accepting that I probably won't be on their Christmas card list (although Graham might be). 

My hunch is that it's probably over the worst now, and that the shares might bottom out fairly soon. So it could be an interesting situation, for more risk-tolerant punters, maybe?

Graham's' View

In the same way that I didn't think Victoria's attempt to secure bond financing was any reason for shareholders to panic, I don't think today's news is any reason to panic, either. Cancelled bond sales happen all the time. There is never a guarantee that a mutually agreeable price can be reached.

That said, it would clearly have been better news for shareholders and for the company if more attractive financing could have been secured. I wonder if the sharp plunge in the share price (in addition to the profit warning) may have spooked some bond investors who were on the margin of discussions. Or maybe there was never much chance of them securing the interest rate they were hoping for.

At the end of the day, the attempt to issue a bond hasn't changed anything. Victoria carries on with bank financing as before. Some fees may have been incurred but for the sake of potentially €450 million in issuance, that was probably worth taking the chance.

When the company says:

Unfortunately, we placed too much emphasis on technical guidance and market convention and not enough common sense was applied in terms of communication with shareholders.

I think that what they are saying here is that they acted as if they were a big-cap announcing an additional bond issue to institutions, simply following market conventions. When that happens, nobody bats an eyelid. It's just another day in the office.

For an AIM company announcing its first ever bond issue, maybe they didn't think hard enough about how their initial announcement could be misinterpreted by investors and commentators who might mistakenly conclude that it was an action taken from a position of financial distress, rather than for the simple reason that bond financing is more attractive than bank financing.

Ultimately, it doesn't matter. The company hasn't been damaged, only the share price (though the share price may have continued to fall on Oct 30 anyway, even without this confusion). Investors who believe in Victoria can take advantage of the weakness to pick up more shares.

For what it's worth, VCP equity remains outside my investible universe, as I take no interest in companies growing via debt and acquisitions.

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First Derivatives (LON:FDP)

• Share price: £34.95 (+7.5%)
• No. of shares: 26 million
• Market cap: £909 million

Interim Results

This was the subject of a bear attack last month that now appears to be in danger of fizzling out.

Results published today are quite good, though very heavily adjusted. Adjusted profit after tax is presented with the following disclaimer:

Adjusted for amortisation of acquired intangibles, share-based payments, acquisition costs, foreign currency translation effect, share of loss on associate and exceptional taxation

It's a lot to take in. While some of the adjustments are reasonable and others are debatable, I much prefer companies with organic growth and simple accounts, rather than acquisitive growth and heavily adjusted numbers.

I also agree with the bears that FDP's activities don't look particularly attractive from an investment point of view. It has been described as a "low-margin consultancy business" by Matt Earl, who is short the stock. It describes itself as "a leading provider of products and services to some of the world's largest finance, technology and energy institutions".

Regular readers will be aware that IT managed services is an area I avoid (as it is too labour-intensive, and is better off owned by the employees and directors rather than by external shareholders). About 40% of FDP revenues are from managed services and consulting.

On the software side, the description of its technology platform makes very little sense to me. In simple language, it's a tool to analyse large quantities of data, either streaming or historical.

There are several references to artificial intelligence and machine learning, words which are undoubtedly very fashionable at the moment.

As far as the rest of the FDP revenue breakdown is concerned, about 31% of total revenue is from services related to software. The last c. 29% is from software sales.

Capitalised costs: the company has been capitalising R&D costs slightly faster than it has been amortising them, boosting pre-tax profits by £0.5 million during the period. 

PBT is £7.6 million, or £12.6 million if you allow for all of the adjustments.

Operating cash flow is quite good at £13.5 million, but the company has lots of ways to use it up, so the debt load has increased.

My view: It looks to me like an impressively large managed services provider, with some software and venture capital-type activities thrown in. Not an attractive investment, but an impressively large company all the same.

As far as shorting it goes, the bears make some excellent points, but the problem for them is that FDP doesn't look likely to go bust or run out of money very soon, and there is no smoking gun in terms of fraud or anything like that either. So the bear case amounts to saying that it is not a very good investment and is overvalued.

That might very well be true (I think that it is), but aren't there lots of overvalued shares at the moment? I think the bears are missing a catalyst for it to really fall apart. They could be waiting a while for the valuation to shrink.

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Connect (LON:CNCT)

• Share price: 35p (-6%)
• No. of shares: 248 million
• Market cap: £87 million

Audited Preliminary Results Year Ended 31 Aug 2018

I covered this logistics business in detail in September, and previously in June. It has been performing badly under the weight of debt and failed acquisitions (there seems to be a theme to today's report).

I've wondered if this one might be a value opportunity, as it does have a decent core business (Smiths News) and another business that seems to be doing ok (Dawson Media Direct, or DMD).

It mostly needs to do something about Tuffnells, the irregular dimension and weight business that has been a failure under its ownership. The failed Pass My Parcel unit is now closed.

Results:

• Revenue down 3.8% to £1,534 million.
• Pre-tax loss of £35.5 milllion, adjusted pre-tax profit of £28 million if you exclude goodwill impairment and various other things.
• Net debt stable at £83 million.
• Annual dividend cut by 68%, with no final dividend.

Free cash flow is £20.2 million, i.e. we have a trailing free cash flow yield of >20%.

Smiths News makes adjusted operating profit of £35.9 million, down by only c. 10% compared to the year before. This operating profit figure includes the losses at Pass My Parcel.

DMD makes a small but improved adjusted operating profit. This unit delivers to airlines.

Tuffnells makes a £5 million loss. Competition is blamed, e.g. DX (Group) (LON:DX.)

My view: I would be more excited about Connect if it was going to sell or shut down Tuffnells. In that case, I think I could make an argument that this offered better-than-average chances at the current share price.

Instead it is going to attempt what looks like a very difficult and distracting recovery. Therefore, after taking the debt load into account, this look priced about right to me.

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That's all for now. I'm taking a break for a few weeks, see you in a while!

Graham