Small Cap Value Report (26 Nov 2014) - FCCN, HRG, CAKE, SRG

Good morning from Las Vegas! My body clock is all over the place at the moment (arrived here yesterday afternoon), so thought I might as well write a SCVR, seeing as I'm wide awake at 3:30am local time!

I'm staying at the Vdara Hotel, in a corner suite on the 53rd floor, so am literally looking down on the Bellagio, with a spectacular panoramic view as I'm typing this. What a tacky city! All good fun though.

French Connection (LON:FCCN)

Share price: 56.5p
No. shares: 95.9m
Market Cap: £54.2m

Trading update - covering the three months to 31 Oct 2014. The market likes it, as the shares have put on about a 10% spurt this morning.

As you would expect, the exceptionally mild autumn weather has impacted sales in the problem UK/Europe retail division (which racks up big losses). Sales are down 5.7% on a like-for-like basis vs last year (for the 17 weeks to 22 Nov 2014). However, gross margin is strongly up, being 240 basis points higher.

I've done some rough calculations to ascertain how a 5.7% sales drop combines with a 2.4% increase in gross margin percentage, and I reckon it translates into a 2% drop in gross profit. So in other words, the increased gross margin offsets almost two thirds of the drop in sales, so not a bad result considering everything.

The wholesale business has performed a lot better - with a 9% increase in sales against last year, and the spring 2015 order book is described as "strong". Global licensing revenue is also referred to positively.

Net cash, at a seasonal low, is £8.7m, so I imagine that will be back up to nearer £25m by the 31 Jan 2015 year end - almost half the company's entire market cap.

With tight cost control, the company reiterates that it should meet full year guidance, which is as near as dammit to breakeven.

My opinion - I remain of the view that this is an interesting risk:reward situation. The downside is protected by the bulletproof Balance Sheet. The upside could potentially be exciting, if the turnaround develops further. The business has been stabilised, and the heavy losses made in the retail division are likely to melt away in the coming few years, as leases expire on loss-making units. So even if underlying performance doesn't improve further, just closing loss-making shops will improve profitability.

So in my opinion, this share is likely to reward the patient investor over time, but as usual there are no guarantees - it's all subject to the vagaries of fashion. At some point I reckon a trade sale will be agreed - so if you're not in it, you won't see any benefit from that.

Hogg Robinson (LON:HRG)

Share price: 43.75p
No. shares: 324.3m
Market Cap: £141.9m

I reported on this company here on 22 Jul 2014, and considered it uninvestable due to a total car crash of a balance sheet. There's a massive pension deficit, too much debt, and a weak working capital position.

In my view the low PER and good dividend yield are not things I would rely on, because the company's finances are so unsound. Therefore the divis could be cancelled any time the bank manager gets the jitters, which could also trigger an equity fundraising, at who knows what price? Why take the risk of investing in a company with a dire balance sheet, when you don't have to?

Interim results - underlying operating profit was down 23%, but the company has previously warned that H1 would be weak, so no surprises there.

Outlook/Valuation - the company reiterates full year market expectations for the full year to 31 Mar 2014, which seems to be for about 6.5p EPS this year, so the PER would be about 6.7, which looks cheap until you factor in the balance sheet issues.

Development spending - note that the company capitalised £5.1m into Intangible assets, of which about 90% were internal costs, which helps boost adjusted profit.

My opinion - due to the extremely weak balance sheet, this stock has to stay on my bargepole list. The company might continue trading absolutely fine, and paying divis, if the bank continue supporting them, and if business doesn't deteriorate further. However, if there is another profit warning, and/or if the bank gets cold feet, then shareholders could rapidly end up in a sticky situation where an emergency fundraising might be required. I can't see any reason to take that risk. Meanwhile the upside is limited because the pension fund deficit will be a big drag on cashflow for many years to come. Why get involved at all?

I appreciate that I'm ultra-cautious on balance sheets, but that approach does eradicate 100% losses. Even when companies I like warn on profit, given time they tend to recover, because their financial position is sound - so you don't end up being diluted away when things go wrong.

Part 2 - am starting to get over the jet-lag here in Vegas, after enjoying the most amazing breakfast buffet that I've ever seen at the nearby Hotel Aria. I'm not into fixed odds gambling, as there's no point - the house has an edge, so you will always lose in the long run. So for me, that sort of gambling is just low stakes entertainment, very occasionally, with friends. So far today I've lost "broadly in line with" (!!) my roulette budget for today of $100.

A long nap has perked me up a bit. Along with housekeeping furnishing me with a kettle, so I can make a proper cup of Yorkshire Tea (brought my own teabags!). Feeling revived, I will therefore take a look at a few more company announcements today.

Patisserie Holdings (LON:CAKE)

Share price: 199p
No. shares: 100.0m
Market Cap: £199.0m

Checking the archive, I don't seem to have mentioned this company before. It operates the Patisserie Valerie chain of fancy teashops, with nice cakes. I like retail roll-outs, so looked carefully at the admission document when it floated in May 2014, and concluded that yes it's a very nice business, but the valuation was too high. There's no point (to my mind) of buying a share which is priced aggressively, such that I would have to wait 3 years just for the business to grow into the price I paid for it. My mission is to find bargains!

Preliminary results - for the 12 months ended 30 Sep 2014 look good. However, caution is needed because the strong headline growth in turnover & profit is flattered by an acquisition of a small cahin of sandwich shops, Philpotts, which added £6.2m of turnover and £0.7m of pre-tax profit.

Strip out Philpotts, and the organic growth drops from turnover up 27.5% to turnover up 17.1% - still good, but not madly exciting. Similarly profit growth moderates from +37.8% including the acquisiton, to +29.3% excluding it. Still very good, no doubt about that.

Margins are high, but probably as high as they are going to get, and I like that there was only one loss-making shop, which has now been closed.

Balance Sheet - this looks fine to me, no issues.

Outlook - is positive. I question the rationale for trading under five different brand names. Also, the store roll-out programme is not rapid, and given the up-market nature of Patisserie Valerie, I feel it is key to maintain its exclusivity. Therefore if you start to see them cropping up everywhere, it could kill off its own success. I particularly question the wisdom of them opening in a service station, and a factory outlet mall - to my mind those are exactly the type of locations that should be avoided if they want to safeguard the brand.

Valuation - it looks fully valued at 199p for the time being. That gives a PER of 17.9 times the 11.1p adjusted diluted EPS for the year being reported.

My opinion - in my view this is a nice business, but I question some aspects of strategy. The valuation looks up with events for the time being.

Security Research (LON:SRG)

This micro cap has decided to sell off its three subsidiaries, and return the cash to shareholders within 3 years. As such it no longer wants a Listing, so has announced its intention to de-List, which looks a done deal as they already have 69% shareholder agreement (75% is needed).

The shares are down 29% today, as many shareholders will now become forced sellers, given the inability to hold unlisted shares in many accounts, that's one of the big risk of micro caps, or any company where a small number of shareholders control the company.

That's me done for today. Off to the gym now, then some sight-seeing.

I've no idea what time tomorrow's report will be published. Assume it will be the evening UK time, and if it's any earlier that's a bonus! Must admit I'm finding the excitement of the UK markets a lot more interesting than Vegas! Although I might find a poker tournament to participate in tonight.

Regards, Paul.

(of the companies mentioned today, Paul has a long position in FCCN, and no short positions.

A fund management company with which Paul is associated my hold positions in companies mentioned)