Small Cap Report (30 Apr) - GOAL, DEMG, PUR, AVCT, HVN, PURI

Pre 8 a.m. comments

5-a-side football centre operator, Goals Soccer Centres (LON:GOAL) issues an in line trading statement this morning, in advance of its AGM at 10:30 a.m.. Bank debt has been reduced marginally from £50.2m to £48.75m between 31 Dec 2012 and 29 Apr 2013. I've always rather liked the underlying business here, which generates tremendous cashflow, but the level of debt is still too high for comfort, in my opinion.

The problem with highly indebted companies is that as an equity investor you're very much playing second fiddle. It only takes the whim of the Bank to suddenly shift from feeling comfortable to feeling nervous, and all of a sudden you have a crisis, where the Bank can impose all manner of demands, and ultimately even force the business into an emergency Rights Issue, or even into Administration.

Just because the Banks are under political pressure to preserve jobs in the short term by allowing zombie companies to continue trading, doesn't mean that the risk has gone, it's just hidden. I feel that many investors are therefore becoming too complacent about companies with excessive debt, and may get a nasty shock if & when the attitude of the banks change.

I might look again at GOAL once the debt has reduced by a material amount. To my mind an acceptable level of debt is around 1.5 times EBITDA. That's not set in stone, it's just a finger in the air type of number that feels about right to me. At the moment EBITDA at GOAL looks to be about £13m p.a., so their net debt is way above that, although in fairness they do have substantial fixed assets to support the balance sheet.

The problem is also that you cannot refinance easily at the moment either. So if the existing Bank stop playing ball (geddit?!!) then where do you go?

Goal's Chairman is stepping down after 10 years, but this appears to have been pre-announced, so does not seem cause for alarm.

 

Deltex Medical (LON:DEMG) issues its pre-AGM statement too, and it all reads pretty well. I hold a few shares in this one personally, which I bought recently after a positive announcement concerning the USA Govt approving the Deltex product for fast-track electronic payments to reimburse physicians who use it. Although I'm no expert on medical matters, that seemed to me an important step, and hence seemed a good trigger to buy the shares.

What is interesting here is the potential upside if they are able to generate a significant increase in sales. Margins are high, and the product is a probe which cannot be re-used, hence once hospitals begin using it, that should generate a recurring revenue stream. The largest single hospital user generates around $500k or £500k (cannot remember the currency, but it's probably dollars) p.a. in revenue alone. Hence one can see the roll-out potential if they are able to convince more hospitals to use this product.

On the downside, revenues have stalled around £6m p.a. for about four years now, and although the company goes to great lengths to explain all the bureaucratic problems when introducing new technology into hospitals, my view is that if surgeons were totally convinced that the product was vital, they would demand, and get it. So perhaps the upside case for the product is not as clear-cut as the company suggests? That's my hunch anyway. But as a bit of a punt, the shares have an attraction - cash burn is modest, and the product is already out there being sold, so it's not blue sky as such. Anyway, the AGM statement today all sounds pretty positive. There does seem to be a selling overhang with this share, as a seller fed the market with all the stock it needed on the last positive announcement, with the shares not going up despite heavy retail (i.e. you & me!) buying all morning.

 

I see that Pure Wafer (LON:PUR) are proposing to create distributable reserves by eliminating the share premium account. This is a purely administrative/legal requirement which is necessary for historically loss-making companies, to enable them to start paying dividends. It is therefore usually a positive step for investors, as it means the company is moving towards paying dividends.

PUR looks potentially interesting, on a cashflow basis (i.e. if you add back depreciation, it's actually generating a fair bit of cash).

 

Post 8 a.m. comments

There seems a lot of hope built into the market cap of Avacta (LON:AVCT). It''s valued at £37m, but half year figures to 31 Jan 2013 look lamentable - only £1.15m turnover, and an operating loss of just under £1m. Total cash burn (including capitalised R&D) seems to be running at almost £2m per half year, so they've only got enough cash left to last another six months by the looks of it. Let's hope shareholders like the story enough to cough up when the next fund-raising is necessary.

Personally I don't touch anything loss-making usually, unless it has at least two years' worth of cash burn already in the bank, as otherwise the risk of a dilutive fund-raising is too high. You can then end up nursing a loss on your existing holding, and effectively forced into supporting a discounted fund-raising (if you get the chance, as many are presented as a fait accompli via a Placing that by-passes existing smaller shareholders).

It really is high time that the authorities make it cheaper & easier to do fund raisings open to all shareholders. The costs & restrictions at present are ridiculous, and totally unnecessary. After all, anyone can buy shares in the after-market, so why place numerous restrictions on who can buy shares when they are issued?

All too often it just means a fee-generating opportunity for an army of expensive, and largely superfluous advisers, and an opportunity to get cheap stock for a favoured minority, whilst private investors are usually shut out, and nursing the cost from dilution.

In so many ways our small caps market is decades behind where it should be, given the technology we have available, all of which hinders the economy - as growth companies find it expensive & difficult to get funding.

 

Next I've been having a quick look at results for the year ended 31 Jan 2013 from Harvey Nash (LON:HVN). This has been on my watch list for a while, as a good value recruitment company.

As you can see from the three year chart below, the shares have re-rated strongly in the last six months (as have most smaller caps). The time to buy would have been last summer, but in my opinion the price now looks pretty much up with events, at least in the short term. There could be more upside in a cyclical economic recovery of course.

Adjusted basic EPS rose 5% to 8.33p. So the shares at just under 80p are on a PER of about 9.5. So not expensive, but there are a lot of similar businesses out there at similar valuations.

The final dividend has been increased 10%, to give 2.92p total dividends for the year, which looks a useful yield of about 3.6%. There's not a lot of growth happening, and it's low margin work on very big turnover, with little to differentiate one company from another, hence I can't get excited about this sector now it has re-rated in recent months.

Also worth noting that despite reporting £5m net cash at the year-end, HVN has finance costs of £767k (almost 10% of operating profit) for the year, so looks like a bit of year-end window-dressing might have happened? That suggests they are probably running an average debt figure of around £15m throughout the year (if we assume say 5% interest charged), although with cash balances attracting virtually nil in interest received, it's difficult to work out what the net debt position is likely to be throughout the year.

With £594m turnover, and £109m in debtors, you're going to get some pretty big swings in working capital, which is one of the problems with this type of high turnover, low margin business. The crucial thing is control over the sales ledger, i.e. making sure customers are properly credit-checked to eliminate bad debts, and are chased hard to pay overdue invoices. Otherwise you just end up becoming a bank for your customers.

Anyway, it looks fully priced to me for now at 77p. I should also add that the all-important outlook statement is less than inspiring. They say indirectly that H1 is likely to be weak, but that a stronger H2 should bring them in line for the full year. That's another way of saying that there is an increased risk of a profits warning, if H2 doesn't recover as anticipated. So another reason to be cautious on valuation.

 

Generally I try to avoid story stocks, as I've fallen for so many hyped-up stories in the past, and lost money in the long run on practically all of them. Although if you have good traders instincts (which I occasionally have, but generally don't!) then there's no doubt money can be made in a bull market. As long as you bank the profits and move on before the story goes wrong.

We're in a bull market for the time being, and I've noticed there seem to be many new entrants to investing in shares recently. New entrants tend to go for story stocks first, hence why I think there will be increasing activity in that area in the coming years and could be good money to be made if we manage to find some of the better ones.

Accordingly, I've made a bit of room in my portfolio for the odd story stock on a reasonable price, and generally I prefer things that are already growing sales, rather than pure blue sky stuff.

One of the things that has been twitching away on my more speculative watch list is PuriCore (LON:PURI). They have announced today a move into positive EBITDA for the year ended 31 Dec 2012. So that should mean cash burn no longer a problem.

The balance sheet looks a bit of a mess, but from what I can gather there is dilution of about a third of the existing equity likely at 40p from convertible loan notes. So if you factor that into the valuation, then the Enterprise Value looks to be roughly a bit over £30m. That doesn't sound outrageous to me for a company that generated sales of $47.4m last year, and is showing reasonable growth.

Just look at the share price collapse as the hype evaporated. New technologies often take years longer than expected to commercialise, hence why it rarely pays off to buy into the hype early on, and pay up-front for growth that doesn't happen as planned. I'd much rather buy into something that has a few bumps & bruises,  and hence is cheap, after disappointing many investors in the past.

That was how I originally made a lot of money, on Indigovision (LON:IND) - I bought into it when the share price had collapsed and it was below its own net cash, but the first signs of commercial success were beginning to appear - one or two big orders in high profile sites (such as the Athens Olympics). The shares more than 20-bagged in the next few years, until poor management and the credit crunch combined to put a dampener on things.

I mention it not just for the fleeting pleasure of reliving past glories, but to point out that the maximum money is made from picking up something fundamentally good, after it has massively disappointed early investors, but before a big turnaround has become too obvious. I'm always looking for opportunities like that. PuriCore looks to me like it might have some potential of that kind, but who knows? It's to a large extent a punt. A lot of investing is really educated guesswork, as there are always so many unknown factors about how the future will pan out for any company.

I don't really understand what they do, but it appears to be some form of water-based disinfection equipment for food, and medical equipment. Both areas look like they could have major growth potential, and several big existing deals have been done. That's the stage I like investing at - i.e. when the product is field-proven, and one or two big orders have been won. If strong growth is going to happen, it's usually at this stage in my opinion.

I bought a few this morning at 48.45p, and whilst the share price might be held back by the 40p price for the Convertibles, it could also be the kind of share that might multi-bag if some serious growth occurs.

It's just a lighly researched punt to me, so more than ever please do be sure to do your own research.

 

 OK, that's me done for today. See you same time tomorrow!

Regards, Paul.

(of the companies mentioned today, Paul has long positions in DEMG and PURI. He has no short positions)