Small Cap Value Report (12 Jul 2016) - ASC, GFRD, NRR, BEG, SOM, WJG, AVN, ABDP

Good morning!

Yesterday's report didn't really get off the ground I'm afraid, my apologies for that. So I'm building up more thrust as we speak, and looking forward to achieving escape velocity imminently!

The big news of course is the "coronation" of Theresa May as our new PM, with removal men apparently scheduled for Downing Street tomorrow. As usual, I'm not interested in discussing the politics of it here, that's a discussion for elsewhere. All that matters for our purposes here is the impact on markets. Perhaps readers could consider that before posting comments below, as it gets very boring when people start ranting on about politics here.

There was a very strong rally yesterday, with the Mid Caps Index (MCX) up about 3.5%. Amazingly it has now recouped nearly all of the Brexit falls. So those of us who held our nerves through the last few weeks, are not looking quite so daft now.

Note also that sterling has recovered a little from recent lows, currently at $1.315.

Markets hate uncertainty, so I think it's clearly a good thing that we actually have a new PM, rather than a lame duck situation until the autumn (what were they thinking?). Also, there seems a general feeling that the grown ups are back in charge now. May seems professional, calm, and experienced. So hopefully she'll make a success of Brexit negotiations, and bring the country together.

Also, I was delighted to hear May talk yesterday about detailed measures to improve corporate governance, such as making remuneration votes binding, and reining in widespread Director greed, which is proving so corrosive for social cohesion. She also favours adopting something like the German model, of bringing in e.g. an employee representative onto Boards, etc.

The nice thing about small caps, is that there are always laggards when the market generally rallies. So even if you've missed the rally, there are (selectively) still some good buying opportunities out there, in my view.

Mind you, if you're gloomy about the outlook for the economy, and hence earnings, then strong bounces such as we've seen this week are the ideal time to be selling into strength. That approach is much more profitable that panic selling during the big plunges.

As mentioned before, I'm scrutinising the trading updates of larger caps too, at the moment, to get a better sense of what the economy is doing. Obviously Brexit has caused a shock to the system, but we don't yet know whether this is likely to be a blip, or whether it's the start of a new & protracted economic downturn. For what it's worth, my opinion, based on trading updates released so far by companies, is that things are probably going to be OK - i.e. more of a blip, than a protracted downturn. However if the facts change, then so will my opinion.

ASOS (LON:ASC)

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

Trading update - I'm not really meant to mention shares where I hold a short position, so will keep this brief.

Sales growth in the 4 months to 30 Jun 2016 is impressive, at +30%. This is faster than the sales growth for the 10 months to 30 Jun 2016, of 25%. Although note that in constant currency, the acceleration is only marginal (26% for 4m, and 25% for 10m). So what was previously a currency headwind, is now a helpful tailwind.

Margins - what's not so good, is that the gross margin has fallen 180bps. The company says that 70bps of this movement is due to the phasing of its summer sale (happening earlier this year). The balance is what they hilariously call "price investment". This ludicrous terminology actually just means cutting selling prices.

My opinion - my main issue with Asos, apart from the bonkers valuation (forward PER of over 60!), is that its margins are relentlessly declining. Overall profit has been flat, or falling, since 2013. So why are the shares on a PER of 60, given that profit isn't increasing? That doesn't make sense to me. The net profit margin is now wafer thin - raising the question whether Asos are just busy fools - shifting a huge amount of product, for very little profit?

Liberum reckon that the EBIT margin is likely to improve from 4% to 6% in the coming years, but personally I'd be amazed if that actually happens. I think Asos is having to constantly erode its own margins in order to maintain sales growth.

I remain of the view that Boohoo.Com (LON:BOO) (in which I hold a long position) is a much better growth stock - it has considerably higher gross margins than Asos, much better net profit margin too, and altogether seems to have better growth potential, being a smaller business. Also its rating (fwd PER of 38) is considerably cheaper than ASC, although admittedly not cheap in any conventional sense.

Galliford Try (LON:GFRD)

Trading update - this is of interest to gauge the outlook for the construction sector, post Brexit.

It sounds fairly reassuring, echoing similarly reassuring updates recently from Persimmon, Bovis and Inland.

Results for y/e 30 Jun 2016 are in line with expectations, with a record level of profit.

Net debt is negligible,at £2m. Note that housebuilders' balance sheets are vastly stronger now, than they were in 2008. So even in a downturn, we're not likely to see the same sort of carnage, and rescue fundraisings, that we saw back then. Clearly lessons have been learned.

Outlook - a bit of a cop out, using the too early to assess type of standard comment that everyone is using at the moment. Although the company points out strong fundamentals;

Recent political events create a backdrop of uncertainty for the new financial year.  It is too early to predict specific effects on our markets, but the strength of underlying demand for new homes and the continuing availability of mortgage finance and Help-to-Buy give grounds for confidence in both Linden Homes and Galliford Try Partnerships.

The late-cycle nature and public sector focus of Construction are key advantages for the Group, with the order book already 82% secured for FY17.  The balance of our businesses and the strength of our order books mean that we are well-placed to manage the impact of this uncertainty.  We are keeping the position under review and will update in more detail when we report our annual results on 14 September.

My opinion - evidence is building that Brexit does not seem to have killed the sector stone-dead, which would have been the worst case scenario. It stands to reason though really, if you think it through. There is huge demand for new housing, and mortgages are so cheap that monthly payments are very affordable in most areas outside the S.East. Help To Buy is propping up the market too.

To my mind, these are simply not the dynamics of a market that's about to crash. So I'm remaining long of recently-purchased housebuilders Persimmon (LON:PSN) and Inland Homes (LON:INL) .

Newriver Retail (LON:NRR)

My thanks go to a reader called "tads" who pointed out in the comments below, that this retail property REIT has today commented favourably on its markets since the Referendum.

Today it says;

...We believe that consumers are ultimately price-driven and with our convenience-led specialism, strong operational metrics, rigorous cost-control and conservative balance sheet we feel well-positioned to withstand market uncertainties following the EU referendum result.

Importantly, since the referendum the business has remained active, progressing a number of leasing deals with major national retailers who are continuing to take space as planned. Finally, and significantly, yesterday we signed a new improved debt and refinancing facility for £85.3 million with a US based institutional lender, further endorsing our business model and reducing our interest costs."

I think the phrase "... major national retailers who are continuing to take space as planned", is very important. The fear was that company investment plans would widely be put on hold. So any reassurance that this is not actually happening, in any particular sector, is valuable intelligence.

So, well spotted tads, and thanks for flagging this useful info. I don't think we're out of the woods yet, by any means, but a picture is beginning to build that business is carrying on without too much disruption.

Begbies Traynor (LON:BEG)

Share price: 47.5p (down 12% today)
No. shares: 111.0m
Market cap: £52.7m

Results y/e 30 Apr 2016 - the core insolvency practitioner business is being supplemented with acquisitions in property services (e.g. valuations, auctioneers). This seems a sensible strategy, given the continuing low interest rate environment, which is greatly depressing the level of corporate insolvencies.

Key points;

Adj. EPS a whisker ahead of broker consensus, at 3.2p (2.9p last year) - PER of 14.8 - hardly a bargain

Divi of 2.2p maintained

Net debt reduced to £10.4m

Outlook comments don't sound great (which of course is good news for the economy, as insolvency practitioners flourish in the bad times);

The financial performance of the group's counter-cyclical activities in both business recovery and property services, which generate the majority of the group's revenue, are directly related to the national insolvency market. The market as a whole remains difficult to predict and, although activity levels have stabilised over the last year, market volumes are at the lowest level since 2004.  We therefore remain cautious about activity levels in the near term.

However, the acquisition of the Pugh & Co auction business subsequent to the year-end, together with the Taylors valuation business, gives the opportunity for growth in earnings in the new financial year.  We will continue to look for further opportunities to develop and enhance the business, both organically and through selective acquisitions.

I've just had a Q&A phone call with management, so here is the gist of my call. I don't think any of this is commercially sensitive, so hopefully it's OK to publish it here;

Q1. What's the situation with zombie companies?

A1. Some have recovered, after c.8 years of low interest rates. Some smaller ones have just disappeared, being struck off from Companies House. There's no longer the mass of zombie companies which existed immediately after the financial crisis.

Q2. Any signs of Brexit-related slowdown?

A2. Logic says that there's bound to be some slowdown. Usual sectors to be hit in downturns are construction, retail (especially if forex remains unfavourable for imported goods). Business investment may also reduce. Key issue is the attitude of banks - if they tighten lending criteria considerably, then that makes things worse for the economy. Also keeping an eye on the buy-to-let area, where recent changes mean it's much less attractive - could be a deluge of properties up for sale, possibly?

Q3. Why are banks prepared to instruct much more expensive, big name insolvency practices?

A3. A variety of reasons - close relationships, and that if something goes wrong on a big case, the bank manager can't be criticised for having hired a top name firm. A constant frustration for BEG.

Q4. Are you pleased with acquisitions?

A4. Yes, going well, and particularly excited about potential for auction business.

Q5. Is there not a conflict of interest, using their own in-house property services companies on insolvency jobs?

A5. Potentially yes, but checks and balances are in place to deal with this. So contract terms have to be agreed by creditors. Pleased with synergies - e.g. sharing overheads, and also operationally - i.e. if you own the property services company, then you get their undivided attention on jobs, and very good interaction between staff.

Q6. Trade debtors very high - nature of the business I know, but could this not be managed down, with e.g. stage payments?

A6. They do use stage payments where possible, but it's a competitive market.

Q7. Are you seeing cost pressures, especially for staff?

A7. Not really, as insolvency is a tough market at the moment. Although there will always be a need to reward/retain key people. There is more upward wage pressure in the property division than insolvency division.

My opinion - the low interest rate environment has meant that insolvency practitioners have experienced lean pickings in recent years, and that looks set to continue. BEG has managed the situation well, I feel, down-sizing its cost base, to remain decently profitable. Note that the good divis have been maintained also.

The balance sheet isn't ideally structured, with huge debtors, funded by bank debt, which is expensive. However, that's just how this sector works. A very large debtor book does however increase the risk that there might need to be an unexpected write-off. I'm not saying that's the case here, just that it's a risk.

I like the strategy to buy complementary businesses, and it sounds like BEG has chosen its acquisitions well.

Overall, as a counter-cyclical business, this share is probably best seen as an insurance policy that will probably pay out handsomely if the economy really goes sour. The PER drops quite a bit, to about 11, based on the new year forecasts, which include a full year of recent acquisitions.

Somero Enterprises Inc (LON:SOM)

Share price: 165p (up 4.1% today)
No. shares: 56.2m
Market cap: £92.9m

Trading update - a pleasing update from this US-based global supplier of laser-guided concrete laying machinery;

...trading in June was significantly stronger than both the previous month and when compared to a year ago. This was led by particularly strong activity in North America; with China, the Middle East, and Europe each contributing satisfactorily to overall growth.

The strong performance in June and the continuation of the positive trading environment together with margin improvement and solid operating cash flow generation mean the Company now expects to report results slightly ahead of current market expectations for the full year ending 31 December 2016.

Good stuff.

Finncap has edged up its forecasts for 2016 from $18.9m to $20.3m at the adjusted PBT level. This translates into forecast adj. EPS rising from 21.3c to 22.5c. There's obviously a translation benefit into sterling too.

So at a rate of £1 = $1.315, I make that 2016 forecast EPS of 17.1p, so the PER is only 9.6.

Net cash was last reported at $12.6m, which is likely to have risen since then. There's also a translation benefit into sterling, so this is £9.6m, or 17.0p per share - quite useful. Strip that cash out, and the ex-cash PER drops to only 8.7.

My opinion - we have to remind ourselves that this is a highly cyclical business. So at some point, we don't know when, earnings are likely to fall. I doubt we'll see such a dramatic fall as happened in 2008-9 though. Also the company's balance sheet is now very much stronger than it was then.

It's good to see Somero making positive noises about other markets too, not just its core US market. I think there's considerable scope for Somero to grow its overseas markets, and it's that potential upside which is my main interest in the company, as the peak of the cycle this time could be a lot higher than the last peak, if they conquer new markets where they currently only have a toe hold.

Mello Beckenham

David Stredder has asked me to invite everyone to tomorrow's (Weds 13 July) meeting, 6:30pm usual start time, at Sea Salt restaurant in Beckenham (over the road from Beckenham Junction station). Here are the booking details.

The company presenting is larger than usual, a £260m market cap developer of student accommodation, Watkin Jones (LON:WJG) .

With holidays, and recent market volatility, David is struggling a bit with numbers, so if people could attend that would be very helpful. These events are very friendly, and sociable, so well worth coming along to.

Leeds ShareSoc event

Investors often complain that events are always in London. So well done to ShareSoc in their efforts to hold events in other cities also.

Here are the details of their Leeds event - today next week - so 19 July.

I'm a big fan of investor events such as this, and have met numerous terrific people at them, who become great contacts, and friends. Also, if people don't support these events, they will stop happening.

There are 4 companies presenting, so should be something of interest to everyone there.

Avanti Communications (LON:AVN)

I see that the company has effectively put itself up for sale. Shareholders need to be mindful that debt ranks ahead of equity. Therefore, there is only likely to be a return for shareholders if a bidder can be found that is prepared to bid more than the value of the bonds.

It seems to me that any acquirer would be best off just buying the bonds at a discount to face value, then wait for the company to default on the interest payments. Then shareholders are wiped out, and bondholders own the business.

It will be very surprising if this ends with even a de minimis payout for shareholders. Total bargepole.

Ab Dynamics (LON:ABDP)

Share option scheme & trading update - I'm very impressed that all group employees are eligible for its new share option scheme. To me, that indicates a management team with good ethics, who want everyone to benefit from share options, not just lining their own pockets like so many listed company Directors do, in an apparently shameless fashion.

It's also great to see that the strike price of the new share option scheme is the current share price, of 395p. So options will reward on the share price rise, not just lobbing out free (or deeply discounted) shares like confetti as you sometimes see elsewhere.

Things seem to be going well;

The Company continues to increase capacity, with the new factory facility expected to be completed in 2017. Additionally, the Company is committed to its new product development programme, which includes the recently announced partnership with Williams F1 to supply advanced dynamic vehicle simulators to the automotive industry.

The Directors believe the Company is on course to achieve the market expectations for the financial year ending 31 August 2016 and the continued global demand for its products and services gives excellent visibility on revenues well into the next financial year.

Outlook comments, are positive - as a big UK exporter, this company should benefit from the lower pound;

 "Although the United Kingdom has voted to leave the EU, for AB Dynamics it remains business as usual.  We believe there will be a period of uncertainty until the implications of the result become clear but we are a Global business with 96%  of our sales going to export and we will continue to focus on delivering the service and excellence our customers are accustomed to."

My opinion - the share price is up 7.7% today, to 428p, which looks justified.

Am kicking myself for not having bought some of these on the recent dips, it looks a really good business, that seems to be on a roll, and should benefit from the weaker pound. So a thumbs up from me.

Regards, Paul.

(usual disclaimers apply)