Small Cap Value Report (16 Feb 2016) - SFR, TRI, HSP, TRCS, FTC

16th Feb '16 by Paul Scott

22 comments 20520 reads

Good morning!

Here's an interesting snippet for you - in the US, between a survey of CFOs found that they believe 20-30% of listed companies "intentionally misrepresent" earnings.

That range sounds very much in the right ballpark to me, based on my work interpreting financial results. Also bear in mind that CFOs are the guys who prepare the numbers, so they know what to look for.

So we all need to be very careful when valuing companies on a multiple of adjusted, pre-exceptional EBITDA! (not that any readers here would be so daft!) Chances are the figures have been manipulated in some way, and hence we will be led towards over-valuing the shares. Therefore it's very much worth checking all those footnotes, and valuing companies on traditional, un-manipulated figures perhaps?

Possible changes to corporation tax - interest deductions

I tend to be so busy scrutinising company results, that sometimes I miss forthcoming important changes to laws, taxes, etc. So I'm particularly grateful when people flag up important issues to ponder. Roger Lawson recently posted an excellent blog on ShareSoc's website, asking "What's spooking the commercial property market?".

In this article he outlined how changes are afoot to possibly restrict the amount of interest charges which companies can deduct against profits when calculating their corporation tax liabilities. Roger says;

According to the FT article, it is possible the Chancellor will not allow interest costs in excess of 30% of EBITDA to be allowed against corporation tax. Potentially this could affect any companies that are highly geared or have large assets which are financed via debt.

I have therefore done a quick review of my portfolio, to make sure there are not any companies that might be affected by it - by comparing the P&L interest charge with 30% of EBITDA. The only share that came close for me, is Enterprise Inns (LON:ETI).

In this case, the highly-geared pubs group last reported EBITDA at £296m (before exceptionals - it will be important to see whether or not the tax proposals allow adjustment for exceptionals?), and the P&L interest charge (before exceptionals again) was £158m. So I make that a 53% proportion - well over the likely 30% maximum - suggesting that ETI is likely to see its corporation tax bill increase significantly. This could well explain why its shares are down 30% YTD.

Overall, this proposal is an excellent idea…

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Tortoise investor

16th Feb '16

I assume the corporation tax changes will not affect REITs as they are exempt from corporation tax on the profits and gains arising from their property investment business?

Cisk

I've never heard of this proposal - can anyone advise how to calculate EBITDA from the stockopedia income figures? Enterprise's £296m is in their accounts but I can't reconcile to the stocko figures...

underscored

Or that they stop coming here and muscling out firms that pay their tax?

alihaouas

Hi Paul
i hope you will have time to comment on tracsis as it is down today

Paul Scott

ken,

The problem with PE companies is that they buy existing UK companies, but then re-engineer their balance sheets so that they no longer pay tax. So the PE guys don't generally bring any new jobs to the UK, they just hijack existing companies, and squeeze out their corporation tax liability - so a major net loss to the UK economy.

Then there's the slightly different issue of large US corporates setting up operations in the UK, in such a way that they don't pay any UK Corp Tax.

As the UK already has pretty much the lowest Corp Tax rate in Europe (apart from Ireland?) then the UK should remain an attractive destination for inward investment. We can then argue about whether possible Brexit might be a short term problem, but a long term gain, who knows? Let's not get onto that issue, as it's too political for this site.

Regards, Paul.

grym02

Thoughts on Hargreaves - $HSP? thoughts on blindwells valuation

Graham Neary

I am no PE fanboy (generally avoid their IPOs like the plague) but it must be said that they *do* provide value when they buy up companies and successfully leverage them. Basically they provide value to company vendors by outbidding everybody else for the company, and they provide additional value by using only a small amount of equity capital to turn around and then "flip" a company. Since the equity slice is small, then a marginal improvement in the value of the business (and thus their stake in it) can generate a huge IRR for them. Using a small equity slice each time means they can work on improving the value of multiple businesses at the same time, which is actually a good thing for society.

Obviously there is a big risk to jobs and to the company itself by increased leverage, but the PE playbook is well known, it's hard for outsiders to judge how much leverage is truly appropriate, and in the end being a company owner means being able to capitalise it as you see fit.

One way of looking at it would be to say that if the PE owner chose not to get involved, then the original owner would be equally capable of decapitalising it themselves by taking out special dividends, by breaking it up, etc. It's either that or just sell the whole thing off completely. If the original owner doesn't want to continue capitalising it themselves, then ultimately nothing can force them to.

I think what contributes to most of the annoyance about PE is the feeling that their IPOs are generally overpriced, so that their financial success is far greater than the value they generate. This is almost certainly true but who's to blame? Surely the buyer who keeps falling for it bears just as much responsibility as the seller - aren't the institutional investors and the individuals who overpay supposed to be "sophisticated"!

These are likely to be unpopular views which will result in getting thumbs down! Oh well.

bobo

Trifast management is deluding itself if it thinks it has a strategy. It follows where the world's winds blow.

Filtronic has been a basket case for last few years. recent announcements of small orders are just crazy. Time to kill the horse.

Sorry to be negative, but let us be realistic.

FREng

Digital Globe Services (LON:DGS) reported "The Board is pleased to report that the strong trading in the second half of last year has continued into the first half of the current financial year, with the Company delivering year-over-year, double-digit revenue growth, gross margin in excess of 30%, and an Adjusted EBITDA* margin in the double digits. Group revenue is expected to be in the range of US$22M - US$24M, an increase of at least 13% over the same period last year (H1 2015: US$19.5M). EBITDA is expected to be between US$2.2M - US$2.4M, an increase of at least 400% (H1 2015: US$0.5M). The revenue and EBITDA achievement represents the Company's strongest H1 performance to date as the Company heads into its typically stronger second half. "

It's the dreaded "adjusted EBITDA", of course. But maybe the fall after the profit warning was overdone, and some bottom fishing might be profitable?

Wol

Paul
Thanks for bringing the potential tax changes to our attention. And yes, good luck to George Osborne in getting the private equity boys to pay their fair share of tax, though I wouldn't put it past them to have their next wheeze ready to cheat the Revenue.
But there are some industries that need higher levels of debt. You mentioned property companies. Financial companies - banks, companies providing car purchase loans, etc. also tend to run with very high levels of gearing, making their money on the turn between the cost of borrowing and the cost of lending. Are these expected to be exempt? If not, this could kill some of them. Barclays e.g. has a net gearing of 231%
For the record I don't hold any of the banks but do hold (very successfully so far) S&U whose net gearing is a more modest 45%
Julian

ganthorpe

I know Severfield Rowan well but not a holder currently.
I would not put too much reliance on the property aspect as two major units are in rural North Yorkshire (Dalton and Sherburn) with very large specialised buildings and probably difficult to easily be used for other activities or to get planning permission for housing on any volume..

jonesj

The whole debate about people & companies paying their taxes only looks at one side of the equation.

On the other side we have:
1 Governments who are notoriously poor allocators of capital. Whatever they buy or interfere with will cost much more than it should & provide less benefit that it should. e.g. HS2, the NHS, Nuclear Power stations.

2 The finance director (Mr Osborne) think's it's just OK to borrow over 5% of his budget every year. His predecessor, Mr Brown borrowed up to 11%. These idiots will bankrupt the country eventually.

The presumption always seems to be more money going to the government is good, whilst ignoring the question of whether or not they are competent to handle it.

I would argue that they are not competent to handle the money & we would be better off with lower taxes and lower spending.

Ken Lowes

Thanks Paul,
I would like to see it all come to an end but unfortunately most government interference causes untold problems down the line, when I say most government I mean all parties, If Nissan Toyota Jaguar (Tata ) and BMW along with many other household names weren't here we would be in a mess. Most of these companies were given incentives to rescue the plant, or start it up, as in the case of Nissan's phenomenal success in Sunderland. If companies are rescued and jobs are saved we should be willing to forgo the CT (if any) for a period of years as compensation for the risk taken by the investors. Tax avoidance comes from sloppy poorly thought through legislation, and lazy tax officials who always attack the low lying fruit, you and me. That's it I shall stop now as I can feel another Polish invasion coming on. Well not Poland particularly but it is time for my medication.

Richard Goodwin

Ultimately though it's not an attack on private equity. It is an attack on the use of extreme levels of debt to avoid taxation.

The debt is needed to capitalise the company in the absence of equity.

cig

17th Feb '16

Tweaking the tax treatment of various financial instruments available changes neither the total stock of capital nor the underlying investments. If interest repayments were taxed the same as dividends, and capital gains, as they should be, you'd probably just see more equity structures, plus a net gain due to some people moving from tax structuring to more productive jobs. Main issue here is it's hard to change without international coordination.

ridavies

Re your starting comments on taxation liabilities, I find your general comments almost as interesting as your comments on individual companies. I would like to add to this particular one wiht the following comment, in my local newspaper The Isle of Man Examiner dated 9.2.16 re Cafe Nero. CN asked for a letter to be printed under the heading We Dont Have An Entity On The Island. 'CN itself has never used any overseas (nonUK) entity in the Isle of Man or anywhere else to reduce UK taxable profits, whether that be throguh any tax reduction on interest or another mechanism. All reports in the press stating otherwise are categorically inaccurate and a complete misstatement of the facts.' It does say that it has 'shareholders from many parts of the world including some of whom are based on the Isle of Man' and so presumably cannot speak for them or their actions, but it confirms that ' it does not have a corporate entity on the Isle of Man. Contrary to reports on the press, CN neither now nor in the past has any of its corpoarte structure in the Isle of Man', How you sqaure that with your comments, I leave up to you.
I pay some attention to the regular comments about the Isle of Man - I cannot speak for other offshore jurisdictions - in the UK especially. I rarely hear about the no doubt thousands of schemes operating in the City of London and elsewhere in the UK, nor about the lack of transparency in the UK in direct contrast to the recent direct actions of the Isle of Man to come up to speed with world leaders in transparency. The UK recent (and to me disgustingly inadequate) agreements with major international organisations on tax liability eg some little time ago with Goldman Sachs, more recently with Starbucks and Google, make the pursuance of smaller organisations and individuals seem trifling by comparison - but of course they are the soft underbelly and relatively easy pickings for HMRC and make good press.
However, methinks he doth protest too much. I would be interested to see how you square off your comments on your analysis on Cafe Nero and links with the Isle of Man and Luxembourg with the letter I have sent to you above.
One final point if I may. Having just been through the Isle of Man budget statement 16.2.16, the Island (and its 84k population the vast majority of whom are pretty ordinary lime anywhere else in the British Isles) the Island is still suffering from the actions of the UK Exchequer immediately post the crash in 2008/9. The first and most important was the unilateral reduction by the UK of the Manx share of the shared VAT agreement with the UK of £200m in 2 tranches - equivalent to almost 1/3 of IOM government revenue. Yes, £200m, and yes 1/3 of the annual budget! The second was much shadier. Kaupthing (Icelandic) Singer and Friedlander (British) - a bank bought by the Icelandic spending spree some years before - was stopped from sending all its assets to Iceland by the UK, using the Terrorism Act! However, the funds of the bank were protected only for UK investors, with some deal arranged with a Dutch Bank. The £600m lent by the IOM branch to the London HQ for investment purposes was deemed by Mr Darling and team to be foreign funds for which the British government was not responsibie. It took many years and a huge amount of IOM Government time for a scheme to be set up to repay all the deposit holders.
Just a few thoughts! Thanks again for all your useful contributions which I use regularly in my investment plans.

muckshifter

I found your take on Hargreaves, a company that has been on my personal “bargepole list” for probably the last four years, interesting Paul.

The main justification for its “bargepole” status in my view is that I see no future for coal. Everyone knows that coal burning produces more global warming emmissions than other fossil fuels, as well as other pollutants, but its excavation and processing also releases methane which is twenty five times more damaging in this respect than carbon dioxide, a fact which you rarely see mentioned by enthusiasts of Carbon Capture projects. Nearly twenty years ago I talked to the coal handling managers of every coal fired power station in the UK about stockpile handling, and almost to a man they predicted closure of their coal fired power stations before, or around, now. Haven’t read Hargreaves recent reports, but I expect that they have a large element of coal stockpile value which may not be realiseable. But the cost of coalsite reinstatement ie. a serious liability, which was originally anticipated to be recovered in advance through profitable coal production which has now been cancelled, will still be required if the company is to survive. So I’m far from convinced that the wind down of working capital would produce a large benefit.

Also, recently HSL bought C A Blackwell, which didn’t impress me at all, as I’ve dealt with both in the past and fail to see any synergies, or much chance of the staff of the two companies integrating painlessly. It reminded me of one or two companies I’ve known in the past desperately trying to change the nature of their business, unsuccessfully.

And finally, I noticed the bit in your report about the land holdings. I’m sceptical about their potential, just as I was perhaps ten years ago when shareholders in UKCoal were enthusing about the huge (half a billion £ IIRC) potential from their vast landbank. HSP own, IIRC, loads of opencast coal sites, many of which closed perhaps fifteen to twenty years ago, which probably represents most of their landholdings. The ones I particularly remember are Dalquandy, which was the Crouch operated biggest opencast mine in Scotland, Blindwells, a Fairclough Parkinson site near Edinburgh, and Westfield which was originally a Costain site and the deepest opencast in Europe I believe. On opencast sites there are usually quite large areas reserved for offices, overburden heaps, soils heaps, coal handling etc. – perhaps as much as 30% of the overall site area. This portion of the land is clearly ideal for any type of development. But the remaining 70% or more has huge variations in the depth of backfill it contains as well as the type of backfill, method of replacement, settlement time since it was reinstated (not forgetting that many of these coal sites ran for twenty years or more), and whether or not any attempt was made to compact the backfill as it was placed ( not usual) which will have a huge bearing on the value of the land to a developer. So, have HSL actually sold any of that sort of land to developers, or are they just getting planning permissions etc. and ”hoping”.
Regards.

18th Feb '16

PS to the post above, many of the coal fired stations where I talked to the coal handling managers have indeed closed as they predicted, and a few more are now winding down.
Regards.

hayashi22

Bizarrely the Hargreaves management spent loads of dosh on buying up coal assets at a time when many were suggesting fossil fuel would be phased out. Seems like a bonkers approach to running a business.The ceo owns loads of shares as well. Very odd.

Small Cap Value Report (16 Feb 2016) - SFR, TRI, HSP, TRCS, FTC

Possible changes to corporation tax - interest deductions

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Paul Scott

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