Small Cap Value Report (14 Dec 2015) - NXR, WTM, TRB, WGB, CHRT, BOOM

Good morning!

Firstly, a couple of announcements from Friday which I omitted to comment on last week:

Norcros (LON:NXR)

Share price: 194p (up 1.2% today)
No. shares: 61.0m
Market cap: £118.3m

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

S.Africa politics/economics - the share price of this bathroom fittings group is volatile at the moment, reacting to events in S.Africa, and the consequent volatility of their currency. Most of the profits come from its UK operations, so personally I'm not going to react at all to these events - which have a habit of sorting themselves out over time anyway.

The problems seem to have been caused by the country's Finance Minister being fired last week. This BBC article updates with the appointment of the third Finance Minister in a week! Interestingly, Norcros shares have not recovered much of the dip last week (yet).

Waterman (LON:WTM)

Share price: 91.6p (up 0.1% today)
No. shares: 30.8m
Market cap: £28.2m

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

AGM statement - an upbeat statement from this group of engineering & environmental consultants was issued on Friday last week. It details work on particular large projects, and concludes by saying;

"We have experienced continued growth in our markets during the first five months of the current financial year.  The Board looks forward to announcing further progress when our half year results are issued in February 2016." 

"I would like to take this opportunity to thank all our staff and shareholders for their continued support and valued contribution during the last financial year.  We are continuing to recruit and I welcome all the engineers and environmental consultants who have joined Waterman in 2015, during which period we have increased our Group headcount by 11% to 1,339."

The "further progress" comment is a bit of a cop out, as it side-steps making any reference to market or management expectations, which is the information that is needed. However, the overall tone is clearly positive, so I think it's safe to assume that the company is probably trading in line with expectations, although it's always better when a company specifically says so.

My opinion - I like this sector, as it is clear that the UK is experiencing something of a multi-year boom in property and infrastructure spending. The CEO of Waterman sounded very upbeat when I interviewed him recently.

Therefore, I see the opportunity with this share being that the company could potentially not only meet, but beat expectations. I see scope for this share to rise to perhaps 150p over time, and it's paying progressive divis along the way too.

Although the downside risk is of course that investors will all rush for the exit at the same time when the inevitable next downturn comes along.

Tribal (LON:TRB)

Share price: 29p (down 47% today)
No. shares: 94.8m
Market cap: £27.5m

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

Profit warning, Rights Issue, move to AIM - this education software & services group is having a really bad year, with a series of profit warnings, culminating today in the announcement of a Rights Issue planned for early 2016.

Thankfully, I avoided trying to catch the falling knife earlier this year, mainly because of the company's weak balance sheet (which I've repeatedly warned about here). However, the planned Rights Issue will fix that issue. The beauty of Rights Issues, is that existing shareholders can buy the cheap shares, thus protecting the value of existing shares. Whereas if funds are raised in a discounted Placing, it is seriously detrimental for existing shareholders.

For that reason, I picked up a few shares this morning in Tribal, at about 29p. It's not a big position, as I want to leave enough room to take up my Rights shares in 2016. This fundraising will however remove the uncertainty caused by the weak balance sheet, and problematic bank debt - since it seems clear that banking covenants are likely to be breached when tested on 31 Dec 2015 - although with an equity fundraising in the pipeline, the bank is very likely to remain supportive.

The key points from today's statement are worth repeating in full;

·    Since our update issued on 19 October 2015, and despite the Company having been appointed preferred bidder with a number of important new customers, sales momentum has continued to be slow and a number of key customer contract milestones have moved into 2016

 ·    As a result of this adjusted operating profit for the year ending 31 December 2015 ("FY15") is likely to be significantly lower than anticipated 

·    Connected to the above trading position and the movement of customer contract milestones, certain significant cash receipts may not be received until early 2016, and if this happens net debt at 31 December 2015 will be higher than our previous expectations 

·    Discussions are being held with our debt providers to negotiate amendments to the operation of covenants and the waiver of any event of default that may result from our current trading performance 

·    The Board is proposing an equity rights issue (the "Rights Issue") of up to £35 million in the first quarter of 2016, in respect of which £30 million is fully underwritten on a standby basis by Investec pursuant to a standby underwriting agreement entered into today. The proceeds of the Rights Issue will be used primarily to reduce debt, and for general working capital purposes 

·    The Board is proposing, following completion of the Rights Issue, to cancel the listing of the Company's ordinary shares on the Official List and their admission to trading on the Main Market and to apply for admission to AIM

A lot more detail is given in today's announcement. It sounds as if the company will still be profitable for 2015.

It's clearly a lousy situation, but one that is now being fixed, with a (crucially) underwritten Rights Issue, which is expected to happen at the same time as publication of the 2015 results - so it's anybody's guess what will happen to the share price between now and then.

My opinion - this share has looked a can of worms for a while now, so am very glad that I avoided it. However, with the market cap now down to only £27.5m, and a refinancing in the pipeline, I think it's starting to look potentially interesting as a special situation. Although of course the market cap would be £62.5m once the £35m of new shares are taken into account, and Rights Issues are expensive - looks like the costs might be c.£5m, principally for underwriting, but also for the costs of producing a Prospectus.

The issue has always been the weak balance sheet. This situation shows the folly of running a company with an inadequate capital base (negative NTAV), plugging the gap with bank debt. Such companies are an accident waiting to happen, as we have seen in this case. If trading deteriorates, then management have no option but to raise fresh equity at a greatly reduced share price.

This foolhardy strategy has destroyed a considerable amount of shareholder value - these shares peaked at over 200p in early 2014, but have now lost over 85% of that value, a shocking turn of events, that is simply down to bad management. A new CEO is being sought.

Once things have been straightened out in Q1 of 2016, with the Rights Issue, then the group's finances should be a lot more stable. I am hopeful therefore of a recovery in 2016, although the outlook comments today don't exactly inspire confidence;

Whilst the deferral of revenues from 2015 into 2016 should benefit trading in the first half of 2016, our overall results are expected to remain weighted towards the second half of FY16.

That sounds contradictory to me - how can H1 of 2016 benefit from deferred sales, but the whole of 2016 still be H2-weighted? That doesn't make sense to me, and suggests there could be deeper problems. Still, cost-cutting is being done, and I would expect the 2015 figures to be kitchen-sinked, thus opening up the chance of improved figures for 2016.

It looks high risk, but a potentially interesting one now. Everything has a price, and in my view, the current price probably safely allows for the various problems, leaving potential recovery upside, if nothing else goes wrong.

Just look at this chart! Down from 160p to 29p since August!

So the big takeaway from this situation is the folly of a weak balance sheet.

Bank covenants - another issue to consider, is that banks currently use the Net debt to EBITDA ratio as a key covenant - i.e. to determine if a loan is performing or not. A breach of a banking covenant is extremely serious, as it constitutes effectively a default, and can trigger repayment on demand clauses. This is why bank debt is so dangerous normally, although at the moment banks are being extremely accommodative, due to ultra-low interest rates.

The problem is that, for software companies, EBITDA is a nonsense number, since it ignores development spending, which can be considerable. Therefore, at some point in the future, the penny is likely to drop with banks that relying on EBITDA for software companies is very high risk, and basically wrong.

So I can foresee a time when banks might pull the plug on lending to software companies, or at least force them to recalculate EBITDA after development spending, which would dramatically alter the figures for some highly indebted software companies. This is a ticking timebomb in my view, and a very real risk that people need to think about.

Walker Greenbank (LON:WGB)

Share price: 201p (down 5.0% today)
No. shares: 60.2m
Market cap: £121.0m

Flooding - this interior furnishings group announced a week ago that it had experienced flooding at its "Standfast & Barracks" factory in Lancashire, but was fully insured, for business interruption as well as actual damage.

Today a further update quantifies the problem, as follows;

Disruption to the factory is expected to have an adverse effect on the Company's trading performance in the current financial year ending 31 January 2016, with pre-tax profits expected to be approximately 15 per cent lower than current market forecasts before exceptional items.  Trading in the following financial year will also be impacted until full printing capacity is restored.

So clearly this is bad news. However, the company is fully insured, and expects to recover these losses in full from its insurer;

The Company is fully covered for these losses by its insurance policy, which includes flood damage and business interruption, and expects to recover in full the profits shortfall incurred in both financial years.

My opinion - given that losses will be fully recovered, there's really no logical reason why the share price should have dropped at all today, it's a completely spurious move in my view.

As a wider point, selling shares after a fire or flood can often be a big mistake. I remember selling my ASOS (LON:ASC) shares after their first warehouse fire, 10 years ago, and in doing so I threw away about £34m in potential upside on the 0.5m shares I owned at the time (when they were only a few pence each)!

A similar situation occurred recently with Pure Wafer (LON:PUR) where their factory burning down resulted in a highly positive outcome for shareholders, since the company pocketed the insurance monies, and didn't bother rebuilding the factory. Not such a good outcome for employees though, who lost their jobs sadly.

If a company is fully insured, including business interruption, then there's really no need to sell the shares at all. In fact, insurance claims can often be padded out, to over-recover costs, and result in a favourable overall outcome - with brand new equipment replacing potentially worn out equipment. Although it depends who the insurance company is, and what stance they take.

As a holder of shares in WGB, I'm not at all concerned about this flooding issue, as the insurance will take care of it.

Cohort (LON:CHRT)

Interim results to 31 Oct 2015 - I'm impressed with these numbers, showing excellent growth. The outlook comments also sound strong. The balance sheet is sound, with net cash. 

My main concern is that the shares have already re-rated to take into account the company's good performance, with the shares having almost doubled in the last year. So the big question is whether there's more to go for? Companies like this do tend to have profit warnings every few years, when gaps appear in the order book, so for that reason I wouldn't be happy paying the current price of c.400p for this one.

Audioboom (LON:BOOM)

Profit warning - this share is down 25% today to 3.13p, and I could see it going lower.

The company has burned through a lot of cash, and reports only £3.1m left in the kitty at end Nov 2015. That will mean that the begging bowl will definitely be coming out again next year. I can't imagine investors being impressed at financial performance to date - it's really not clear that there is a viable business model here at all.

It's a good App, but a poor business, in my opinion.

All done for today.

Regards, Paul.

(usual disclaimers apply)