Small Cap Value Report (15 Sep 2016) - NXT, CRAW, FRP, IND

Good morning!

There are some interesting announcements from large retailers today. It's worth checking these, to see how overall market conditions are faring.

Next (LON:NXT)

Share price: 5040p (down 3.3% today)
No. shares: 147.3m
Market cap: £7,423.9m

Every time I look at results from Next (LON:NXT) it reminds me just what a high quality business this is. The profit margin is spectacular. What this means, is that even when trading deteriorates, the business remains very strongly profitable. This is an important point to grasp, because at the opposite end of the spectrum people often buy poor quality retailers because they are on a low PER. However, profits can quickly turn into losses for low margin, poor quality retailers, in a downturn. Whereas a super-high margin business like Next can sail through a downturn with the bulk of its profits intact, because its operating margin is so high at around 20%. Even if it were to drop to 16%, you would still have a very profitable company.

Next describes current trading as "challenging and volatile". It is adding lots of new space, and with such good ROCE and short payback times, this makes a lot of sense. Continued share buybacks drive up EPS, even when profit is flat, or slightly down.

There are a number of headwinds though;

• Struggling to recruit new customers for its credit offering.
• As with all retailers, the cumulative impact of Living Wage is likely to hurt.
• Rapidly growing online competition is relentlessly chipping away at the market share of traditional retailers.
• Weaker sterling means cost prices rising next year.

For these reasons I'm reluctant to buy shares in Next, although on a PER of about 10-11, it's very tempting. The trouble is, it's difficult to see much future upside on profits. So as a mature business whose profits may have arguably peaked, perhaps the price is right?

Generally, I'm keeping away from opening any new positions in conventional retailers. I think online is gathering momentum at such a rate, that it's starting to seriously disrupt the sector. Companies like Boohoo.Com (LON:BOO) can dramatically undercut the High Street on pricing. A younger generation is increasingly happy buying frequently & cheaply online, which presents massive problems for conventional retailers.

Crawshaw (LON:CRAW)

Share price: 44.5p (down 39.5% today)
No. shares: 78.9m
Market cap: £35.1m

Trading update (profit warning) - bad luck to holders here. The update today is rather worrisome. This small chain of butchers & hot food last reported on 29 Jun 2016 at its AGM. It said that LFL sales were down 1.9%, but margin was up. So the market gave it the benefit of the doubt.

Today's update sounds worse. It says;

...These factors persisted through to the end of the half year period, resulting in a further reduction in like for like sales for the half year, although this was partly mitigated again by a further strengthening of gross margin. We expect to report on our half year results on 29 September 2016.

The company has declined to give a LFL sales figure this time. That's a mistake, as when key information which has customarily been given is omitted, then the market just assumes the worst, and slams the share price down.

Crawshaws seems eligible for an award for maximum number of excuses given for disappointing performance. So far, in the last 2 updates, it has blamed weaker sales on;

• Softer footfall in Mar 2016
• Structural timing of Easter
• Impact of start of the international football championships (June)
• Adverse persistent weather
• Build up to the EU Referendum
• Customers being even more price focussed post Brexit
• Supermarkets very recently launching some aggressive meat promotions

The only one that rings true to me, is the last one. I've always maintained that competition from supermarkets is the big risk with this share. They're not going to sit back and let a smaller competitor eat their lunch. It's inevitable that the supermarkets will put the squeeze on emerging competition, if it takes away too much of their market share, as they are now doing.

Margins - Crawshaws says today that its strategy to focus on higher margin products has been a success. That is clearly untrue. What's actually happening, I believe, is that customers are drifting away to competitors, because Crawshaws is no longer as cheap as it was, relatively.

This point is confirmed by the company itself today, when it contradicts itself by admitting that it now has to lower prices to become more competitive again;

We are confident our actions can restore sales momentum, and we will be prepared to invest in margin to drive sales and sharpen our value proposition.

We are disappointed with current trading and clearly the outlook for the full year will depend upon the result of our actions, upon trading during the important peak winter and festive season, and upon the timing of our store openings.

It ducks the key point of whether results will be in line with expectations or not. That's another error. It strikes me as a deferred profit warning, and the share price is saying that Mr Market thinks so too.

Store roll out strategy - these comments today are perhaps the most worrying. It sends a signal that the existing strategy of opening new shops isn't working very well. That contradicts the whole underpinning of this share - namely that it's a simple roll out of a successful format.

Today's update sings the praises of factory outlet shops - in out of town locations with ample parking, and it sounds as if the company is now going to focus more on this type of site;

We are particularly pleased with our new standalone factory outlet store format, which significantly outperforms the high street format on every measure, as do our more established three mature outlets.

Fit out costs are lower per square foot, property and running costs are very low, EBITDA margins are excellent, and without a food to go element the operation is even simpler to roll out.

Added to that, being out of town with parking, and therefore more of a destination, factory outlet stores are not so dependent upon local footfall.

We are therefore currently reviewing our store roll out strategy with a view to adding more of these types of openings in our overall new store opening pipeline. We have one further site at an advanced stage, and another in the pipeline.

My former employer operated mainly from the High Street, but we also opened about 50 stores in factory outlet centres (having multiple stores in some centres). They were remarkably profitable, so I completely understand why Crawshaws is attracted to them. However, the best outlet centres are mostly focussed on fashion. I'm not sure that the centre owners would want a butchers in the middle of a centre that is trying to be all about aspirational fashion brands. So I reckon Crawshaws may struggle to find enough sites in factory outlet centres. There aren't that many outlet centres to choose from anyway, compared with High Streets.

My opinion - today's statement has clearly badly unsettled the market. A highly rated roll out cannot cast any doubts on its roll out potential, otherwise the whole reason for investing in the company is undermined.

I think the company has handled this badly, by not giving any specific figures today.

It's all about competition in my view. I reckon Crawshaws is now getting noticed by the big supermarkets, and they're taking action to grab market share back again. It's a highly competitive sector after all.

The excuses given by Crawshaws are really annoying. The timing of football matches, or a referendum doesn't suddenly trigger a wave of vegetarianism. The reality is that people are still buying meat, but from somewhere else.

What happens next depends on whether management can reassure the big shareholders to sit tight, or even support the share price with purchases? Also, the key question is whether the store roll out still makes sense? My understanding was that each site made about £200k profit contribution, therefore adding on new ones made obvious sense. Is that still the case? What is the sustainable level of profit for new sites? Will the company be scaling back its ambitious store opening programme? I don't know.

If the company can regain sales growth through keener pricing, then this might turn out to be just a blip. Although lower prices mean lower profit margins of course.

I think the valuation here got well ahead of reality. Having said that, the price has now reset to a more sensible level, so personally if I held, I'd probably sit tight now.

Incidentally, I have to comment on the sharp fall in price yesterday, just before today's profit warning. Clearly some insider dealing going on, which is depressing to see, and reflects very badly on the company itself. Confidential information on trading must not be allowed to leak out, otherwise it creates a false market.

Rumours on advfn are that someone's mate at Crawshaw's HQ told him before today's RNS, that LFL sales are down 5%. So that would explain the selling yesterday. However, it also means that head(s) need to roll at Crawshaw, to make sure that staff do not leak confidential information to their mates in future, if that is indeed what has happened.

Also, I think the company clearly needs to issue a fresh update, stating clearly what the LFL sales figures really are. It's not good enough to withhold that information just because it's deteriorated. 

Fairpoint (LON:FRP)

Share price: 90.75p (down 12.3% today)
No. shares: 45.6m
Market cap: £41.4m

Interim results, 6m to 30 Jun 2016 - the key point with this group, is that its original business (debt management for consumers with financial problems) has been declining. To replace that lost business, it has been busy buying firms of solicitors. So it is now mainly a legal services group.

Figures today reflect that. The overall adjusted profit before tax is down slightly at £4.0m (H1 2015: £4.1m). However, this is now mainly generated by the legal services division, which made 78% of that profit, as opposed to only 34% of profit last time.

Adjusted basic EPS was down a little, at 7.03p (H1 2015: 7.38p).

The debt management business is being wound down now, blamed on regulatory changes announced on 20 Jul 2016, which have rendered it "unsustainable", which will incur £2.5m exceptional costs in H2, plus a £5.5m non-cash impairment charge. Perhaps this is not a bad thing - making the group easier to understand & value, with just one activity going forwards.

Webinar - 1:30pm on Monday - these are an excellent alternative to meeting management. The registration link is here.  (sorry, I got the date wrong earlier, the webinar is Monday, not today!)

Net debt of £15.6m seems reasonable, so no particular concerns there. Also, this net debt should disappear over time, as the IVA book gradually turns into cash.

Interim dividend maintained at 2.45p. So if the final divi is also maintained at 4.35p, then the total payout would be 6.8p, providing a very attractive yield of 7.5%.

Outlook - a bit mixed;

·      Majority of Legal Services trading in line with expectations

·      As noted in May, conveyancing volumes impacted by slowdown in housing market transactions; impact of Brexit has led to fall in mortgage approvals to 15 month low

·      As a result our expectations for conveyancing have been adjusted materially downwards

·      Overall, the Group's performance in H2 likely to be similar to H1

·      On track to deliver a simplified business model focused on legal services with a corresponding lower cost base, with DMP wind down as expected

Interesting comments above about conveyancing. It seems as if people are still keen to buy new houses (driven by Help To Buy), but sales of secondhand homes appear to be slowing. Note that conveyancing is only 8% of H1 revenues, so limited impact.

Valuation - the company says H2 should be similar to H1, therefore that implies about 14p adj. EPS for the full year.

Stockopedia currently shows 15.6p consensus forecast for the full year, so today's update implies a reduction of about 10% on that number. Not a disaster.

The PER is 6.5, based on a lower share price, and my lower estimate of 14p EPS this year. That looks good value to me.

My opinion - I've never been keen on the IVA activities, as it felt rather grubby - exploiting people who were in financial trouble, when there are debt management charities out there which do the same work for nothing.

I like the fixed fee approach which the legal services businesses are taking. So Fairpoint's expertise in streamlining processes through call centres, etc, should give it a competitive advantage over other firms of solicitors.

With a low PER, and a very good dividend yield, there is some attraction to this share in my view, so I'll probably pick up a few shares, if the webinar on Monday is reassuring.

Indigovision (LON:IND)

Share price: 150p (down 6.5% today)
No. shares: 7.6m
Market cap: £11.4m

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

Interim results, 6m to 30 Jun 2016 - today's figures are in line with the trading update of 8 Jul 2016, which I reported on here. A few key numbers;

• Revenue $21.8m, down 3.5% on H1 2015.
• Operating loss of $275k (H1 2015: $1.26m). Although note that a favourable change in forex gains/(losses) accounts for about half the improvement (a swing of $468k).
• Excellent balance sheet, with net cash of $4.6m. This has been achieved by squeezing debtors and inventories down. So good cash generation in the period, despite lack of profits.
• Camera volumes sold up by 20%, but eroded by price deflation.
• Gross margin of 52.1% is good, and up slightly on last full year.
• Interim dividend passed, which is surprising given the cash pile is there to pay one. Currently expects to pay a final divi.

Outlook comments sound reasonably upbeat, although bear in mind that the company has limited visibility, and has disappointed many times before;

After a quiet start to 2016, the Group experienced an improving trend in financial results as the first half progressed.

The pipeline of large projects for the second half is stronger than the first half and, although market conditions remain highly competitive and the timing of a number of customer projects remains uncertain, the Group currently anticipates a satisfactory operating result for the year as a whole.

My opinion - it's still in the game, is launching plenty of new products, and is very well financed. So at such a low market cap, I'm a holder rather than a seller.