Small Cap Value Report (15 Dec 2016 - Part 1) - JE., PURP, IPEL, PTY, CMS

Good morning!

We have 2 reports for your delectation again today. I shall be covering trading updates from Impellam (LON:IPEL), Communisis (LON:CMS), and Parity (LON:PTY) . Plus any other bits & bobs that look interesting - e.g. big price movers, takeover bids, etc.

Graham will be writing his own report, click here today - covering Xaar (LON:XAR), Sutton Harbour Holding (LON:SUH), and Haynes Publishing.

Tomorrow it will be 1 report only, from Graham, as I'm having the day off.

All our reports appear on the SCVR landing page here. The most recent is highlighted in the large box, but others appear below. So it's worth scrolling down to see if there are 2 reports for the day, although we'll always mention this at the start of each report too.

Internet shares - winner takes all?

Just Eat (LON:JE.) has announced this morning the acquisition of two competitors. In the UK, it has bought its main competitor, Hungry House, for £200-240m. I'm surprised this has not triggered competition regulatory issues. Certainly, from what I've seen, JustEat and Hungry House have been the 2 big takeaway delivery companies in terms of TV advertising. It seems that JustEat has won the war, and is now gobbling up its competitor. This now gives it a very dominant position in the UK - although Deliveroo and UberEats seem to be up & coming.

(UPDATE: a friend has pointed out to me that Deliveroo & UberEats serve a different market - delivering food from restaurants which don't have their own delivery staff. Whereas JustEat is an interface between takeaways & their customers.)

We've seen similar things in many other sectors, where once in a lifetime changes to business models are taking place, driven by the internet and ubiquitous smartphones.

Where sector disruption occurs, with new technology, It seems to me that, all other things being equal, after a while there tends to be one big winner. This might be the first mover. And/or the big winner might be the company which simply out-spends the competition on marketing. It's often the case that the big winner becomes self-reinforcing after a while, as it sucks in liquidity of users - so think Ebay, PokerStars, Rightmove, etc. - they're dominant because they have the most users, which attracts more users. Ultimately creating an unassailable lead.

So you really can't apply conventional valuation metrics in these scenarios. I missed out on Just Eat (LON:JE.) because I thought it always looked far too expensive. That was a mistake, as I hadn't grasped that it was becoming the dominant player, and would crush the competition, as we're seeing today with Hungry House selling up.

JustEat also announced today that it's buying a Canadian business for £66.1m, to add to its other international operations. That's another aspect of why valuations on internet shares can be so expensive - e.g. Asos & BooHoo - because they're not only succeeding in the domestic market, but are delivering strong growth internationally too. So the growth could continue almost indefinitely.

All the while, conventional companies such as High Street retailers, are being squeezed from all directions. They're losing business to rapidly growing internet competition, plus their costs are rising quite rapidly.

Having done very well on Boohoo.Com (LON:BOO) this is an area that I'm focusing on much more closely. As mentioned before, one of my favourite stocks for 2017 (and beyond) is Gear4Music (G4M), in which I hold a long position. This is one of several companies disrupting the European musical instruments/equipment sector. A niche area, but the margins improve with scale, and triple-digit % sales growth in Europe augurs well for G4M I reckon.

My latest stock pick in this area of internet disrupters, is Purplebricks (LON:PURP) (in which I hold a long position). Again, the valuation looks nuts on a conventional basis. However if you look at the opportunity the company has, it's potentially enormous. Sure there are competitors, lots of them, but I doubt many will achieve critical mass where they can afford the marketing spend required to prosper.

So again, I see the online estate agency area as a dash for market dominance - where the winner is likely to take all. If PURP is that big winner (no guarantees it will be, of course), then the valuation would be into the billions, not hundreds of millions. This is clearly what Neil Woodford spotted, when backing it heavily pre-IPO.

Also, if PURP became really dominant in online estate agency, then why would it need Rightmove? It could cut out Rightmove altogether (or offer it as an optional extra), and create its own property portal.

Also, I think conventional estate agents are pretty much doomed, long term. How can they possibly compete, with all those big fixed costs, and pricing which is now completely uncompetitive? What's going to happen to all those empty shops too?

For this reason, I've decided to look through the high valuation, and am considering whether to increase my position in PURP. There's a really good video of management presenting recent results here. 

I welcome reader input on this issue. Have I gone bonkers in a bull market, losing sight of my value investor credentials? Or am I on to something? Let me know what you think in the comments below!

US interest rates

Have started moving up, ever so slightly, from 0.5% to 0.75%, with 3 more increases planned for 2017 apparently.

ITV news showed a chart last night of how, historically, UK interest rates have followed the trend set by the US. So I suppose we ought to think about the impact of higher interest rates in the UK too, at some point.

My feeling is that the amounts are so trivial - even after several increases, our interest rates are still likely to be extraordinarily low by historical standards, that I can't see it having much impact at all on my investing strategy.

Although rising bond yields do of course mean rapidly shrinking pension deficits. I saw a very interesting broker note on Norcros (LON:NXR) (in which I hold a long position) yesterday, which pointed out that the share price is tracking bond yields very closely. So I'm pondering whether or not to buy some more Norcros.

We should probably be getting a lot less worried about companies with pension deficits now, anyway. There could be some nice opportunities there.

If our interest rates rise to say 1-2%, will that really suck money out of equities into savings accounts, which will still be paying a pathetic amount? Equally, bonds look hideous, as their capital value falls as interest rates rise. Property comes under pressure when interest rates rise. So it seems to me, decent quality, reasonably priced equities are really the only place I would want to put my money for the foreseeable future.

Impellam (LON:IPEL)

Share price: 695p (down 2.5% today)
No. shares: 50.3m
Market cap: £349.6m

Trading update - this is a pre-close update for the year ending 30 Dec 2016, for this staffing group. It sounds OK, in the circumstances (several staffing groups have reported tougher conditions in H2 of this year);

Notwithstanding the well-publicised disruption in the UK healthcare market and the increased uncertainty following the UK referendum, the Board expects to deliver 2016 EBITDA broadly in line with market expectations.

I don't know why they quote EBITDA. I prefer adjusted profit before tax as the key profit measure, providing the adjustments are reasonable. When companies refer to EBITDA, it raises my suspicion that they're trying to hide something (e.g. capitalised costs).

I had a good dig through the interims from IPEL here on 28 Jul 2016, so have just re-read my notes there, to refresh my memory. Debt is too high, and the balance sheet too weak, for my personal taste.

Comments today on UK performance are interesting - note how Govt is squeezing their profit margins on NHS doctors (good!);

Trading performance in the UK has been mixed.

Some of our UK specialist businesses have seen weaker performance compared to the same period last year and we continue to be impacted by disruption in the healthcare markets as a result of Government announcements regarding caps on locum pay rates and agency margins. This has impacted performance within our UK doctors business.

Our market leading managed services businesses have continued to perform well, benefiting from 10 new client wins including Willis Tower Watson, Veolia, Johnson Matthey and Kings College Hospital and have a strong pipeline.

Overseas businesses seem to be doing well, and there is a favourable forex translation effect too;

Since the announcement of the interim results on 30^th July 2016, the Company has continued to see strong performance across its US businesses.

The integration of the Bartech business continues to proceed as planned and the business has performed well in 2016 with some notable new client wins and extensions of services.

Delivery of the synergy cost benefits following the combination of the legacy Impellam and Bartech businesses are in line with management's expectations.  In addition, the weakening of sterling has provided a currency translation benefit.

Net debt - some positive noises are made on this, although no figures given.

On a group level, cash generation continues to be strong and we expect net debt to be materially lower than at the end of 2015 and in line with market expectations.

I'll check out the 2016 results in the spring of 2016, and see if I can get comfortable with the debt, and balance sheet generally.

(UPDATE: looking at a broker note, net debt is forecast at £94.3m at end 2016 (1.3x EBITDA doesn't sound bad at all), dropping to £56.4m at end 2017.

Note the very strong forecast free cashflow generation which is set to reduce net debt quite rapidly, providing nothing goes wrong of course.)

Outlook - sounds a bit hesitant;

Whilst the Board is pleased with  the positive results from Impellam's UK Managed Services, US and  Australian businesses and the progress made in 2016  with the Group's strategic plan, it recognises the prevailing uncertainty in the UK and will therefore continue to manage the business prudently, whilst investing in opportunities to drive profitable growth.

Valuation - growth has come mainly from acquisitions, and that's been fuelled mainly by debt, which is important to bear in mind before getting excited about growth rates, and the low PER.

Also bear in mind that this whole sector (staffing companies) is cheap at the moment. This may be partly due to worries about the UK economy, but also down to repeated media reports of temporary warehouse staff being (apparently) treated badly. Also, will cheap & malleable E.Europeans tire of being exploited by big companies in the UK? Brexit seems a receding risk though, in terms of workers actually being forced to leave the UK.

So here are the Stockopedia valuation & growth graphics;

That PER does look attractively low. Especially as the company says it is generating cash & paying down debt. Think I might put this share back on my watch list.

There's a dividend yield of 3.1% too. It's always nice to be paid whilst you wait for a share to go up.

My opinion - I'm warming to this share, on valuation grounds. Not one I currently hold, but it's going back on the watch list.

A couple of quickies, as I have to get ready for a seminar this afternoon.

Parity (LON:PTY) - this sounds a positive trading update:

The Board is pleased to report that the Group's momentum, detailed in the interim results announced on 8 September 2016, has continued and that it now expects EBITDA* for the year ending 31 December 2016 to be slightly ahead of its original expectations.

The Group has benefitted from increased internal collaboration to support growth in the higher margin Consultancy Services division, which has driven profit improvement and cash generation.

The Board looks forward to 2017 and continues to be focused upon improving shareholder value.

I draw your attention to the last paragraph about shareholder value. Sometimes that can be a coded message that some sort of deal is being considered - maybe a sale of the company?

Skimming over the StockReport, several factors jump out at me;

• Looks like there's a fair bit of debt
• Weak balance sheet
• Rather poor track record
• Doesn't pay divis

So probably not for me.

Communisis (LON:CMS) - I don't usually comment on contract wins unless they look significant. This one looks good, although no financial details are given;

Significant contract win with Her Majesty's Revenue and Customs (HMRC) for all outbound customer communication....

The Term of the contract is 5 years, consisting of an initial 3 years with the option of a further 2 year extension. Preparatory work has already started as Communisis progresses toward a go-live date in mid-2017.

HMRC currently issues in the region of 185 million letters each year, and the contract also includes the deployment of document composition technology...

...We are excited to be starting this new relationship, in support of HMRC's "digital by default" agenda."

I'm not quite sure how sending out 185m letters every year fits a "digital by default" agenda though?

My opinion - the poor balance sheet puts me off this company. However, this is reflected in a low PER. It would be interesting to find out how much profit this new contract is likely to add to future performance. Might be worth a closer look.

Right, got to dash.

I'll see you next week, as Graham is holding the fort tomorrow.

Best wishes, Paul.

(usual disclaimers apply)