Small Cap Report (5 Mar) - CUP, FOUR, BREE, MACF, JSG, ISG, ZTF

Pre 8 a.m. comments

Regular readers will know that I don't like Cupid (LON:CUP) at all, based on evidence online (try Googling for customer reviews of some of their biggest brand names) of their operations apparently being less than ethical. This was reinforced by a recent BBC Radio Five Live expose of Cupid's modus operandi, which can be listened to here, and specifically names Cupid plc.

I cannot see anything in their results narrative which addresses these concerns, other than rather vague statements that, "...it is important for the Company to have a medium term goal of improved quality in the eyes of the consumer ... we believe this will cost an additional £2m in brand building marketing across several of our key profit generating markets ...". Hmmmm.

The figures themselves (for the year ended 31 Dec 2012) look very good, with revenues up 51%, adjusted EBITDA up 45%, cash having almost doubled to £14.1m, and the final dividend raised to 3p. All good stuff, but if this is being achieved by misleading customers, as the BBC allege, then it cannot have a very long shelf life. Therefore a very low PER is fully justified.

 

I believe that Director share transactions often give you the best indication of what management really think about a business, and the Director share sales at Cupid from the Stockopedia table (last item on the menu under "Accounts" on the StockReport) says it all - over £30m banked in Director sales in the last two years!

Follow the money is my view, and the most knowledgeable money has been getting out.

 

 

Post 8 a.m. comments

Impressive results have been issued today by 4imprint (LON:FOUR), with underlying EPS up 29% to 28.3p, which seems way ahead of broker consensus of the 22.4p and 22.9p that are shown on Stockopedia and a competitor website for year ended 31 Dec 2012. The difficulty is knowing whether the EPS forecasts have been calculated on the same basis as the adjusted reported EPS figure, which I simply don't know.

Another way of checking whether actual is better than forecast, is to look at the actual EPS growth, which in this case is +29% against +21% shown on Stockopedia forecasts, so it would appear to be a comfortable beat against forecast.

At 385p it seems to me that the price is probably about right, on a PER of about 14 times 2012 earnings.

FOUR also pays a fairly decent dividend, which has been raised to 15.45p for the year. It had net cash of £10.7m at the year end, so all seems to be going well. It looks as if their main area of activity is North America.

 

I'm getting increasingly perplexed at the very stretched valuations being paid for high growth companies at the moment. The old Jim Slater PEG system is quite a useful rule of thumb, i.e. that the annual rate of earnings growth as a percentage can be substituted for the PER to decide if you're paying a sensible price or not. So a company that is growing its earnings by 20% p.a. could be considered fairly price if it was rated on a PER of 20.

What I've noticed in recent weeks is that shares which would have been on a PER of 15-20 are now soaring up to ratings in the twenties, or even thirties. A good example is Delcam (LON:DLC). Great company, which I've followed for years, but it looked fully valued at around 1000p/share. It's since shot up to 1400p/share, putting it on a pretty warm PER.

It's the same with LOQ, which friends of mine hold, and have been proven very right about, but a PER of over 30 is looking extremely generous now. I'm told that it's being driven by very strong Institutional demand, who are now prepared to pay aggressive valuations for growth businesses. So maybe I need to recalibrate my idea of what fair value is? On the other hand, I'd rather play it safe, and stick to more pedestrian valuations where good companies are available cheap because of temporary negative sentiment (e.g. Vianet, where you can now lock in a 6% dividend yield, because of a recent disappointment on timing of contract wins, etc).

To my mind it's a percentages game - so why buy (or hold) something which is already fully valued (or over-valued), when there is so little upside percentage gain potential to be had? That only makes sense if you keep your finger permanently hovering over the sell button, and exit on a hair trigger. But I suspect lots of people are thinking along the same lines, just running with the momentum and hoping to sell at the top when it turns. Some of these stretched valuations could fall a considerable amount, very quickly, once sentiment turns. So it's always important not to be the one holding the parcel when the music stops.

Top-slicing is a great strategy I think - i.e. selling 10-20% of a position after it's had a big run upwards in price, as you thereby lock in some gains, but still have exposure to further upside.

It's not as if we're in a buoyant economy either, so companies which are growing earnings by 20% this year may struggle to follow that with another 20% next year or the year after. Hence stretched valuations make even less sense, unless you are highly optimistic about the macro economic picture? Or the company has some niche which you think they can continue exploiting with no worries about competition appearing.

These are all warning signs to me, that markets might be over-heating somewhat, and I've been cutting back on positions lately which have gone up a lot, just to lock in some gains. It's always dangerous to become over-exuberant in bull phases, so I hope readers are being careful.

 

Breedon Aggregates (LON:BREE) reports a strong set of results, despite market conditions in construction in 2012 being, "the worst trading conditions I can remember in my 50 years in this industry", as Peter Tom, their Executive Chairman reports today.

Revenue is up 3% to £174m, and underlying operating profit rose 55% to £8.8m.

However, it doesn't pay a dividend, and looks to have net debt which is far higher than I would be comfortable with as an investor, which rules it out for me.

 

The market doesn't seem to like 2012 results from Macfarlane (LON:MACF), as the shares have dropped 8% to 25p this morning. The problems here have always been net debt (reduced to £6.8m) and a whacking great pension deficit (reduced slightly to £18.9m). These are material figures compared with a market cap of about £30m.

My problem with pension deficits is that the deficit shown on the balance sheet can often be seriously understated compared with the much larger deficit used to calculate overpayments. So it's a real minefield for investors, and each pension deficit needs to be considered carefully on the specific facts for that case.

The dividend is attractive however, with 1.55p total for the year, giving an excellent yield that must be around 6%. Management state their intention to maintain the dividend, but that looks a tight squeeze to me considering they also have to reduce debt, and pay £2.5m into the pension fund in 2013.

On the more positive side, I like that they are seeing some growth by targeting growth markets, such as protective packaging for internet retailers. On balance, I always come to the same conclusion with Macfarlane - too messy to be considered as an investment, although this is probably the closest I've ever come to seriously considering it - on the basis that rising interest rates on Gilts should trigger a partial reversal of the increased pension deficit.

 

Results from Johnson Service (LON:JSG) do not appeal to me, because they still have a weak balance sheet with far too much debt, seem to be endlessly restructuring, and there's the added complication of a pension deficit too. It just doesn't look good value to me, once you adjust for debt. Adjusted, fully diluted EPS for 2012 came out at 5p. So at 43p the shares are on a PER just under 9. That's fine, until you factor in that net debt works out at around 23p/share. Also they are having to make payments of £1.9m p.a. to reduce the pension deficit. So if anything it looks fully, or even over-priced to me.

 

It's difficult to say anything meaningful about the accounts from Interior Services (LON:ISG), since their profit margin is so tiny as to make analysis of the figures pretty meaningless. Underlying profit before tax was £3.8m on turnover of £659m! So a margin of not much more than half a percent. So what happens if something goes wrong with a contract, and cost over-runs? As we saw with Severfield-Rowen (LON:SFR), once you lose control of big contracts, the very existence of the company hangs in the balance.

For me the cut-off point where it simply becomes too risky to invest in any company is where they make a profit margin of less than about 3% of turnover. Below that, and the swings in profitability from one year to another can become too extreme, and the risk of something going wrong becomes too great.

 

I've had a quick look at results from Zotefoams (LON:ZTF), which look OK. EPS is up slightly to 12.1p, so at 197p the shares don't look good value to me. The balance sheet is sound, and there is a 2.7% dividend however, so if you like the company's long-term prospects, then great. I don't know enough about the company to judge its prospects.

 

As a further aside, I'm struck by how it's the larger groups reporting 31 Dec results first. Yet these are the largest & most complicated groups. Surely it should be smaller companies rushing to get their much simpler accounts out promptly? These days a good Finance Director should run the accounts close to being on a real-time basis. I managed to get the 31 Jan year end results audited & published within 6 weeks of the year-end back in the 1990s, when I ran the finances of a ladies wear  group with about 150 branches, and about a dozen limited companies. So with advances in technology, it's very difficult to justify why it takes smaller Listed companies so long to issue their accounts. There's no problem with booking auditors either - if you're organised, they welcome the chance to get them done & dusted nice and early.

So here's a plea to smaller Listed companies - how about demonstrating your grip over your finances by issuing more timely financial information to shareholders. Having to wait until mid-March 2013 to see accounts for 2012 strikes me as pretty shoddy. They should be available in early Feb for relatively small companies.

See you same time tomorrow. I publish the first section just before 8 a.m., then updates are published for each company mentioned over the next couple of hours. So it's always worth checking back if you're an early bird. The finished report is usually done by about 10:15 a.m., once I've irioned out the typos & formatting.

Regards, Paul.

(of the companies mentioned today, Paul holds a long position in Vianet, and no short positions)