Small Cap Value Report (17 Jan 2017) - BRY, DOTD, HOTC, JPR, GAW, MGR, DIS, CRW, GRG, EHG,

Good morning!

Today I'm going to cover 5 companies, as follows;

• Brady (LON:BRY) - in line trading update
• dotDigital (LON:DOTD) - in line trading update, plenty of cash, and good growth
• Hotel Chocolat (LON:HOTC) - in line trading update - is that good enough to justify such a high PE rating?
• Greggs (LON:GRG) - large cap bakery/fast food - Strong LFL proves that High Streets still viable.
• Elegant Hotels (LON:EHG)- profit down a bit, as expected.

Also, Graham is going to report on;

• Miton (LON:MGR)
• Distil (LON:DIS)
• Craneware (LON:CRW)

His sections will be added to the end of this report (as opposed to him publishing a separate report).

Please note that Graham added sections to yesterday's report, in the evening, covering Ashmore (LON:ASHM) and Orosur Mining Inc (LON:OMI) .

Inflation

Is starting to rear its head again. Figures out this morning apparently show the CPI measure of inflation rising to 1.6%. This is likely to be the thin end of the wedge, because sterling's depreciation is only starting to feed through.

Therefore investors need to think carefully about this issue. How will higher inflation affect companies that you've invested in? Will they be able to pass on cost increases to the end customers? Pricing power is very important at the moment. To have pricing power, companies need to sell differentiated products/services, that people want to buy. Not generic products.

At the moment, I expect we'll probably see a spike up in inflation during 2017 to somewhere between 3-5%, at a guesstimate. That view is based on what happened in 2008, when sterling also devalued sharply, and inflation spiked up to about 5%, before coming back down again.

Changing my mind

Just to clarify, from yesterday's report. If the facts change, then I change my mind - as the famous saying goes. This point is worth reinforcing. I'm not expressing sentiment in these reports. I'm trying to form a rational, facts/figures-based view on various shares at this specific moment in time.

New information is being published all the time. So views on stocks should be seen as fluid, because they should be facts-based, and the facts change (sometimes dramatically - e.g. when there's a profit warning, or an out-perform trading update). Therefore, if new information is published which greatly improves a company's outlook, then personally I don't have any problem at all changing my mind about the share, from negative to positive.

So, as with WANdisco (LON:WAND) yesterday, after assessing the trading update, I was perfectly happy to instantly revise my long-standing negative view of the share from a bargepole job, to being happy to put in a (speculative) buy order.

I find it bizarre that anyone would cling to their previous view on a share, despite the facts having changed. That's a completely illogical approach and would almost certainly lead to poor performance. Some of my biggest profits have come from spotting (early) a changing trend in a company's performance, and diving into its shares at a time when most other people still perceive the company negatively.

So a bargepole view from me is definitely not a permanent thing. It's just a facts-based view of risk:reward for that share, at that particular moment in time. I'll happily drop my bargepole view, if things suddenly improve.

Being able to quickly change your mind, when the facts materially change, is a vital skill which greatly improves performance (if you don't possess this skill already, which many readers do).

Brady (LON:BRY)

Share price: 70.5p
No. shares: 83.1m
Market cap: £58.6m

Trading update - this trading & risk management software company (serving the commodities & recycling sectors) has a 31 Dec 2016 year end, so this is a full year update.

This sounds reassuring;

...pleased to report that the Company is trading in line with market expectations.

That's good because, last year it failed to clinch the all-important Q4 contract wins required to meet market expectations. That led to a sharp sell-off, on a profit warning in late Nov 2016. That has thankfully not been repeated this year. Although the share price has recovered most of the lost ground, it's still slightly below where it was in Nov 2016, just before the profit warning.

Directorspeak/outlook - I don't know what to make of this (below). It sounds, by implication, critical of the previous strategy of former CEO Gavin Lavelle?

"The markets in which we operate remain challenging. However, there has been a sea-change in the mood and focus of this business, and as a team, we have entered 2017 with considerable optimism. I would like to thank all our staff who have embraced the changes we are making with vigour and dedication.

We are concentrating on providing a first-class service to our clients, and improving our earnings visibility through increased recurring revenues. We are making steady progress and I look forward to providing a further update in our preliminary results in March."

My opinion - I'm generally not keen on software companies any more. The reason being that there are so many profit warnings in this sector, amongst smaller companies anyway.

Brady is particularly difficult to value, as its profits have been erratic in recent years. So forecasting, and hence valuing the company on an earnings multiple, is little more than guesswork - more so than at most other companies.

Note how the broker consensus earnings forecast has been steadily declining in the last year

(had to remove picture, as corrupted text)

I look for the opposite of the graph above. You're more likely to get out-performance in the share price by investing in companies where the broker estimates are rising. Although it's important to remember that forecasts are only an opinion of the analyst that prepared them (usually guided by the company itself). Actual results at smaller companies can often differ considerably from forecasts. So we should not take forecasts as gospel.

To make a rational decision on whether to buy this share, I think it would need a proper analysis of the software products. How good are they, in comparison with the competition, etc? Arguably we should do that for all companies, but sometimes the figures do all the talking - e.g. if sales keep growing, and there is a very high profit margin. Neither of those factors is present with Brady, at the moment.

The profit margin at Brady is low, and erratic. Also, sales growth seems to have largely stagnated in recent years. Although that's understandable because its sector has been under a lot of pressure, with low commodity prices in recent years.

Now that commodity prices seem to be strengthening, perhaps Brady may enter a period of more buoyant trading? This share is not for me, as I don't really know how to value it. However, I can see why some investors might be feeling more optimistic about the sector that Brady serves, given the improving picture for commodities.

dotDigital (LON:DOTD)

Share price: 59.4p (down 2.6% today)
No. shares: 294.9m
Market cap: £175.2m

Trading update - for the interim period, 6 months to 31 Dec 2016 (the company has a 30 Jun 2017 year end).

Here are the main highlight points (I missed off the last point about divis, so that the picture would fit onto this page more easily);

(sorry, had to remove picture, as it corrupted the text)

Whilst organic revenue growth of 17% is good, we should bear in mind that this share is richly valued - on a forward PER of 24.6 using the Stockopedia blended forward PER.

Operational gearing should mean that earnings increase faster than the 17% revenue growth reported today. Sure enough, EPS Is forecast to rise by about 21.5% this year, and a similar amount next year. On that basis, the PER of 24.6 seems within the bounds of what's reasonable. On a PEG basis, a high PER is justified, if the earnings are growing at a similar % rate, which they are here.

One thing that troubles me, is that revenue is up 17%, but further down it says that average revenue per client is up by 24%. Does that not imply that the number of customers is actually shrinking? i.e. the company seems to be making more money, but from sweating its existing clients, rather than winning new clients. That sounds a bit worrying to me. I'd want to see the number of customers rising strongly, as well as average revenue per client rising. I'd need to understand this issue better before buying this share.

Cash pile - at £18.9m, the cash pile is meaningful, at 10.8% of the market cap. Or put another way, we could reduce the PER down to about 22 by stripping out the cash.

What is the company going to do with all this surplus dosh? That needs clarifying. I'd rather see the company do something with the cash which creates shareholder value - e.g. an exciting acquisition, or a big special divi.

My opinion - the key question is to find out what the customer churn rate is. If new customer wins are only replacing lost customers (if that), then the company could end up running to stand still, once the avg revenue per client stops increasing.

I do like this company, but am worried that organic growth may not be sustainable, as it seems to be relying on squeezing existing customers for more fees, rather than winning significant new customers (net of churn).

Hotel Chocolat (LON:HOTC)

Share price: 290p (down 1.7% today)
No. shares: 112.8m
Market cap: £327.1m

Trading update - covering the 13 weeks ended 25 Dec 2016.

Key points;

• Pro forma sales up 14.6% at constant currency.
• No disclosure of LFL store sales - why not? (bear in mind store numbers have increased from 80 to 90 during H2, so this will have boosted total sales somewhat)
• This comment below implies higher LFL sales - so why didn't they give us the actual number?

Retail growth was driven by increases in footfall and items per basket, with customers also choosing to buy more higher-priced gift items.

Online sales - positive comments, but again no figures;

The digital business showed similar momentum, and in January a new website launched; improvements include optimisation for smartphones and tablets, a bespoke 'gift creator' service for delivered gifts, and better integration of the tasting club subscription service.

Digital should be growing much, much faster than retail. So it only showing "similar momentum" doesn't excite me. There again, it sounds like early days. I could see potential for the company to team up with say florists, to deliver this upmarket chocolate together with a nice bouquet.

Current trading - in line;

Trading since December continues to be in line with management's expectations. 

Valuation - as we know, growth stocks are on aggressive valuations right now. HOTC certainly ticks that box, as you can clearly see below!

(see StockReport - had to remove this picture, as it corrupted the text)

The quality scores are good. Although note that the operating margin is nothing to write home about, at 7%. Maybe that is set to increase as the company expands, I don't know, having not seen any broker forecasts.

If the margin rose into the teens, and the number of shops doubled, then the company would grow into this valuation over a number of years. Trouble is, do you really want to pay up-front for it?

My opinion - I like roll-outs, and am happy to pay up for the best ones. However, in this case, I'm not convinced it is one of the best - the profit margins are not that good. Also growth isn't particularly exciting. The roll-out of Revolution Bars (LON:RBG) is similar, in terms of operating margin, and % expansion rate of the estate, yet that's on a PER of only about 13, a third of the rating of HOTC. That disparity doesn't make sense to me.

I think investors are possibly paying too much here for only moderate growth. The company would certainly need to step up a gear in terms of growth (organic, store numbers, and online) to justify such a toppy rating, in my view. So it's not for me.

Johnston Press (LON:JPR) - (at the time of writing I hold a long position in this company) - just a quick comment, to point out that well-known (and effective!) activist fund Crystal Amber has again increased its shareholding in this troubled newspaper group. They've gone over 20% today (up from 18% last week). Although with a market cap of only £17m, this is only valued at about £3.5m, so not a big bet in actual valuation terms.

A friend told me yesterday that the expensive bonds (which dominate JPR's balance sheet) are trading at a 30% discount to par. So clearly there is a deal to be done here, in terms of restructuring the debt, which I think is very much CA's intention.

Expect fireworks here, as a recent press article suggested CA also wants to shake up the board. Things are further complicated by disposals, and a pension deficit.

This is a very interesting situation, and I suspect there could be upside from a debt restructuring. So CA coming on board & hoovering up 20% certainly reinforces my view on that. It's high risk though, as without a debt restructuring, the equity could easily end up being worth nothing. So a special situation, for risk-takers only.

BREAKING NEWS! 

Games Workshop (LON:GAW) (in which I hold a long position) has just (at 14:10 today) put out a positive trading update:

Games Workshop is pleased to announce a significant increase in sales and profits for the period from 28 November 2016 to 15 January 2017, compared to the same period last year.

In light of the above, and having now finalised the product phasing for the year, profits for 2016/17 are likely to be above market expectations.

Forex seems to have played a part;

Sales and profits have further benefitted from the continuing favourable impact of the weaker pound.  However, the Board remains aware that there is some uncertainty in the trading periods ahead for the rest of the 2016/17 financial year.

The timing of this announcement is odd, because I reported favourably on the company's interim results here, just a week ago. No outlook statement was given at the time, yet here it is issued a week later, seemingly at a random time during trading hours! Not a good way of doing things.

Mind you, that doesn't really matter to shareholders, who I am sure will be delighted with this good news. I've joined the party (very late) today, as a friend kindly tipped me off that a positive trading update had been issued, so I grabbed some shares online.

Broker forecasts have already been raised from c.40p to almost 60p EPS this year. So it's remarkable that another upgrade has been signalled today. So although the share price has almost doubled in the last year, the rating still looks reasonable value, because earnings forecasts have also shot up.

If it does say 65p EPS this year, then at 830p now, the share is on a PER of 12.8 - hardly demanding for a business that seems to be trading its socks off! It would be interesting to have more detail on how much of the improvement in profits is down to forex, and how much more is in the pipeline?

A 30p dividend is also declared today.

Overall then things seem to be going very well for this quirky company. If this great performance can be maintained, then the flow of divis is a very good reason to hold this share, in my view. The capital appreciation this year might be a bit of a one-off, but who knows? Companies that trade well, usually continue to trade well.

Balance sheet is good here too.

Finally, note that the StockRank is a superlative 99, so the Stockopedia computers spotted correctly that it is a high quality, good value, improving share.

Next we have 3 sections written by Graham:

Miton (LON:MGR)  (written by Graham)

Share price: 34.75p (+1.5%)
No. shares: 177.5m
Market cap: £62m

Year End Trading Update

Returning swiftly to the fund manager theme (see yesterday’s Ashmore update), today saw an update from Miton.

It includes the phrase at least in line with expectations, helping to nudge the shares slightly higher in trading.

If you recall that Ashmore managed to grow AuM by 5% over the past 12 months, Miton was not too far behind: up 4.4% during 2016.

See above that “average” AuM was impressively higher by 20%.

It’s a performance-based business, and performance is pretty good at Miton:

The Group's product range of fourteen funds and investment trusts has continued to deliver strong performance. Eight of the funds / investment trusts are in the first quartile and four are in the second quartile of their respective sectors since launch or manager tenure.

I wonder how the above stats would break down in terms of percentage of total AuM?

Outlook is confident:

Growth in our average Assets under Management and controlled operating costs are now delivering enhanced profitability and robust cash generation. The substantial net inflows in the fourth quarter mean the Group has real momentum as we move into 2017."

I like the company’s emphasis (see website) on “genuinely active investing”. The main challenge facing the fund management industry nowadays is that too many managers are just closet indexers charging high, active management fees.

It’s not good for business to admit this, but when my family and friends ask me for basic advice, I often tell them to look at index funds, where for less than 20 basis points in management charge (sometimes much less than this), they get fully diversified and liquid equity exposure. This, in my opinion, is far more attractive than an expensive, less diversified, less liquid mutual fund, which is doing a poor job of mimicking the index.

But, having said all of that, I still strong believe that there is a space for active management, for those who actually do it. And there are still a number of them about, who are worthy of consideration, in my view. Miton is one of them.

One interesting trend in today’s results is the flow of customer funds last year out of equity and into the multi-asset sector. Perhaps this reflects some equity fatigue among asset allocators, who feel that equities cannot go much higher than this?

Miton’s valuation seems to be offering a decent proposition at these levels. The Stockrank is happy with it, at least.

Distil (LON:DIS)  (written by Graham)

Share price: 1.475p (+28%)
No. shares: 500m
Market cap: £7m

Trading Update 

The market cap remains very small here despite a strong share price move today on the back of the following Q3 Christmas update, describing “significantly higher sales” and full-year results will be “ahead of current market expectations”:

Year-on-year third quarter (Oct-Dec 2016) revenues climbed by 71%, volumes grew by 56% and brand marketing investment increased by 88%. 

The only research coverage I can find on this company (which I believe to be commissioned) suggests that 2017 will be unprofitable but that revenues will climb to £1.5 million (from £1.2 million). Those forecasts look out of date now, however.

Have any readers tried RedLeg Spiced Rum or Blackwoods Gin?

Sales are still very low (£666k in the most recent H1 period) but of course drinks brands can be some of the best investments – this might be worth looking at.

Craneware (LON:CRW)  (written by Graham)

Share price: 13.5p (+5%)
No. shares: 27m
Market cap: £364m

Trading Update

Yet more positivity today:

The Group is pleased to announce continued growth and expects to report 15% increases in both revenue and adjusted EBITDA for the six month period ended 31 December 2016, building on the return to double digit growth reported in the year to 30 June 2016 and slightly ahead of expectations.

Healthcare automation is huge business these days (I have a friend who has helped to build apps for patient medical records), and it benefits from the fact that hospitals and doctors tend to be very resistant to change. They don’t like changing their systems, which makes it hard to break into them – but they generate fantastic recurring revenue for those who do.

Craneware is a US-focused business with a terrific track record in revenue growth, profitability, returns on capital, etc, so it is one of the winners in this space.

The PE ratio is high, as you’d expect, at just over 30x.

If what they are doing keeps working, however, I would expect them to eventually merge with a larger rival who doesn’t want to compete with them anymore. So it would not surprise me at all if the current share price was a fair entry price.

Thanks Graham, back to Paul now!

Finally, a couple of quickies;

Greggs (LON:GRG) - (written by Paul) - I'm impressed with the trading update from this High Street bakery & fast food chain. It ended 2016 with a flourish, with Q4 LFL sales up an impressive 6.4%. Full year LFL sales were up 4.2%, which (providing margins haven't fallen) should be enough to absorb cost increases.

Full year profits are said to be "slightly ahead of previous expectations". So it looks like c.60p EPS is on the cards. At 1013p per share, I make that a PER of about 16.9, which looks about right to me. Yes, the business is performing well, but with 1,764 shops, it must surely have more-or-less saturated the UK market? Although more modest expansion can still continue from up-sizing the best performing shops, and introducing new product lines.

The balance sheet looks fine, free of bank debt. There is a small pension deficit, but nothing to worry about.

Overall this looks a very nice business. The outlook statement sounds cautiously optimistic to me;

"In the year ahead, whilst we will undoubtedly see a number of well-documented industry headwinds, we are confident we will continue to make progress with the implementation of our strategic plan, including significant investment in our capability to supply a growing shop estate."

Elegant Hotels (LON:EHG) - (written by Paul) - results for the year-ended 30 Sep 2016 - don't look very good to me. Profit has dropped - down 14.5% for adjusted operating profit. Adjusted EPS came in at 0.131 US cents, down from 14.7 US cents in the prior year, but slightly above broker forecast.

A 3.5p final divi, on top of the 3.5p interim divi, means an overly-generous 7p total payout, for an 8.7% yield. A divi yield that high is itself a red flag - it's the market telling us that the divis are too high relative to earnings, and that it's likely to be cut. So I think it would be a mistake to buy this share just for the yield.

Net debt of $61.8m may look high, but bear in mind that the company owns the freeholds to its properties in Barbados. So debt is not unreasonable relative to assets, assuming that the assets are of good quality. TripAdvisor reviews put that into question somewhat, with a recurring theme from customers mentioning tired decor, and maintenance issues. So I feel the company should curtail the divis, and instead use its cashflow to upgrade its properties.

My opinion - an interesting share, but there are too many headwinds right now for it to interest me. Especially related to currency, as 70% of revenues come from British tourists, who are clearly now affected by the weakness of sterling vs the dollar.

It's a potentially interesting share though, and is on my watch list.

All done!

Regards, Paul & Graham.

(usual disclaimers apply)