Small Cap Value Report (12 Oct 2016) - VTU, PHD

Good morning!

Let's have a day when I don't mention sterling. EDIT: sorry, I didn't manage this. See below.

Vertu Motors (LON:VTU)

Share price: 46.88p (up 1.9% today)
No. shares: 397.3m
Market cap: £186.3m

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

Interim results, 6m to 31 Aug 2016 - it looks as if investors are beginning to realise that new car sales are not the be all & end all for car dealerships. Most of the money is made from used car sales and aftersales (i.e. warranty & repair/servicing) - both of which look buoyant for Vertu in today's numbers. Those items combined generate 71.8% of gross profit.

There's a short results presentation video here from BRR Media, very helpful.

Some key points;

New car sales to private buyers, down by 4.2% on a LFL basis.

Profit before tax rose 14% to £18.7m.

Diluted adjusted EPS rose a smaller amount, up by 1.8% to 3.98p. This is because the company issued more shares during the period, to finance growth.

Net cash is reported at £12.9m, but bear in mind there are huge liabilities from manufacturers to finance Vertu's stocks of cars, so I'm sure this figure would move around a lot in the normal course of business. Remember that a balance sheet is only ever a snapshot on one particular day, so may not be typical.

Net assets are £238.4m, less intangibles of £96.4m, results in NTAV of £142m. The shares therefore trade at what seems a fairly modest premium of 31% to NTAV.

The bulk of fixed assets are valuable property assets - freeholds & long leases, which amounted to a net book value of £124.8m at end 2015 (note 18 to the last Annual Report here), so this is a soundly financed group in my view.

The all-important outlook comments are reassuring;

The Board anticipates that the Group's full year results will be in line with market expectations.

Current trading sounds fine;

September is a key month for the Group's profitability in the second half of the financial year, being a registration plate change month.

 Profit in the month was ahead of prior year levels on a like-for-like basis and recent acquisitions further bolstered the Group result.

The Group's service and used car performance continued to demonstrate strong underlying growth trends in September.

Like-for-like new car private volumes for the Group were down 1.7% year on year, in line with the SMMT registration data. 

Note that the decline in new private sales of -1.7% for Sept 2016 has moderated from the -4.2% figure noted for H1.

Forex - for me, this is the key issue with car dealers, and many other importers. With sterling having dropped so much, then it's inevitable that European manufacturers will have to raise prices in 2017.

The key questions then are, how much will sterling prices of imported cars rise by? What impact will that have on demand? What level of margin reduction will European manufacturers be prepared to absorb in order to maintain healthy UK sales? (they have to keep those factories operating, even if it means less profit per unit).

Domestically produced cars will probably also have to rise in price, due to the higher cost of imported components, but UK producers like Jaguar/LandRover and Nissan will certainly be under less pressure than the European manufacturers to raise prices.

I've noticed in the past, during periods of inflation, that car manufacturers can be quite clever at adjusting product specifications, model denominations, discounts & financing deals, to disguise the fact that customers are having to pay more than before. Have you noticed how many manufacturers are replacing 6-cylinder models with cheaper 4-cylinder engines that are tweaked to produce almost as much power as the old models?

Anyway, this is what Vertu says today;

The latest SMMT forecast for 2016 UK new vehicle registrations stands at 2.64 million (2015 : 2.63 million) and the Board sees no reason to disagree with the underlying market stability implied by this forecast.

The market is starting to see vehicle price increases reflecting the manufacturers' reaction to declining Sterling exchange rates against all major currencies.

Lower margin channels for manufacturers and retailers alike, such as Fleet car supply and Motability, are likely to see more impact than higher margin retail channels.

There are diverging economic forecasts with regards to Sterling's currency outlook and this leads to uncertainty over future manufacturer volume strategies and pricing.

The Board shares the outlook on the new car market given by the SMMT which anticipates a fall in 2017 registrations of around 6%.  This would equate to a historically robust new car market of around 2.5 million units.

Valuation - the PER here is really low. Stockopedia shows a broker consensus of 6.17p for FY2017 (ending 28 Feb 2017). This puts the share on a PER of 7.6 - hardly demanding, especially when you consider that it has little bank debt, and owns a lot of freeholds outright.

Dividends - the yield is currently reasonable at about 3.2%.

My opinion - these are good results, and a sound outlook.

I was concerned about the impact of weaker sterling, but am comforted from Vertu's remarks today.

The other risk is if the UK economy moves into a general recession next year. It may do, we don't know. That would reduce consumer & business confidence, and lead to reduced purchases of vehicles, both new & secondhand. So it is a risk.

I think it's safest to assume that there probably won't be any earnings growth next year. Interest rates are very low, which is making vehicle purchases so much more affordable than they used to be. Young people are often buying new or nearly new cars, because a monthly payment of say £100-200 for a personal finance lease probably works out better value than buying some old banger that constantly requires costly repairs. Cheaper insurance, tax, and fuel economy too. So the market has changed.

Therefore, my belief is that the next downturn in the car market may not be as bad as people fear. The wild card is interest rates of course. If sterling really collapses, and the Govt has to take emergency measures to boost it, by jacking up interest rates considerably, then all bets are off.

Overall, I reckon the low PER and good asset backing factor in a lot of bad news already, so I'm happy to hold at this level. We're in one of those patches where there's a lot of scaremongering going on. Last time that happened in June, those of us who held the line and remained optimistic, cleaned up. So I'm taking a similar view of things at the moment. As always that is subject to change, if events change.

Proactis Holdings (LON:PHD)

Share price: 141p (up 1.1% today)
No. shares: 39.8m
Market cap: £56.1m

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

Results, y/e 31 Jul 2016 - the financial highlights here look positive. I won't repeat them all here, as you can just read the RNS for that.

Things I like:

• High recurring revenues - a much sought-after feature by investors, as this should protect the downside risk (i.e. little chance of a serious profit warning in future)
• Strong growth in order book, up 32% to £26.1m
• Adjusted EPS up 20% to 7.3p - good growth, but PER maybe now up with events at 19.3
• Exciting future potential for its new service to automate client supplier interactions, and accelerated payment service (a bit like Tungsten, but done sensibly & profitably)
• Development spend - £2.1m was capitalised in the year, but the amortisation charge of £2.5m was higher, so that's fine - capitalisation isn't flattering the operating profit.
• Adjusted earnings figures look reasonable - and don't differ too much from basic earnings.

Things I don't like:

• Balance sheet looks weak to me - current ratio of 0.63 is well below where I would normally be comfortable. Although extent of recurring revenues here does give some comfort. Similarly, NTAV is negative, at -8.6m.
• Operating profit after all costs is £1.9m - not a huge amount for a £56.1m market cap company - so valuation is clearly anticipating further profit growth.

Things to note:

• Negative tax charges have boosted EPS in last 2 years.
• Restructuring costs pushed into exceptionals in both years, but not excessive at c.£0.3m p.a.

My opinion - I don't see much immediate upside here, as the shares have done very well over the last 3 years. Today's results look good, but not spectacular. Once you normalise the tax charge, the rating looks fairly punchy, but not excessive in a market that is rating growth companies highly.

Overall, I'm happy to hold for another year, but am keeping this as a fairly small position in my personal portfolio. If there's subsequently evidence of faster growth, and the new services really taking off (they are currently being trialled with 3 customers), then I'd look at it again, and would be prepared to pay more for faster growth if that scenario plays out.

Sorry, I ran out of time today, so many things going on, so didn't get round to looking at Walker Greenbank (LON:WGB) or Telecom Plus (LON:TEP) - my apologies.

Regards, Paul.

(usual disclaimers apply)