Small Cap Value Report (17 May 2016) - LAKE, ZYT - new version (old one corrupted)

This is the new version of this report, created from a backup.

My apologies, but I had technical problems & the earlier report corrupted, so had to ditch it.

Regards, Paul.

Good morning!
A horrible start to the day for me, with another profit warning from LAKE.

Lakehouse (LON:LAKE)

Share price: 32p (down 33% today
No. shares: 157.5m
Market cap: £50.4m

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

Interim results, 6m to 31 Mar 2016 (profit warning) - the FD has done a good job issuing the interims reasonably promptly, given the distractions of board room upheaval. Slater Investments, and the founder Steve Rawlings were successful in taking control of the Board. So there might be an element of "kitchen-sinking" in these numbers possibly? (although I don't see any obvious signs of that in the numbers).

I've spent all morning so far, ploughing through the numbers, and the extensive narrative. It seems to me that the downturn in performance has, as its root cause, Government policy. Forcing councils & housing associations to lower rent by 1% p.a. means that inevitably, they have deferred planned maintenance spending, which impacts LAKE. Also, reductions to subsidies for property insulation have also hurt LAKE.

Given the changes to the Board, mismanagement seems to have also been an issue. Furthermore, LAKE concentrated arguably too much on making acquisitions, which maybe caused management to neglect the core businesses?

So this share is very much a special situation, not for people who are easily upset.

H1 profitability has fallen sharply:

• Underlying EBITA down 42% to £5.1m for the 6 months. However, this is flattered by contribution of profits from acquisitions.
• Excluding acquisitions, underlying EBITA was down 80% to £1.7m

My view - we were expecting a poor H1 anyway, and whilst these figures are clearly poor, the group has remained profitable. Remember that the context here is a share price down about 70% from this time last year, so a lot of bad news is already in the price. 

EBITA is a reasonable performance measure here, as it's basically operating profit (i,e, EBIT) with acquisition-related amortisation charges stripped out. That's fine. There are no significant exceptional items, so the figures above look clean to me.

Expectations have been revised down for the full year again, but the company doesn't say by how much! They could & should have given much clearer guidance, which is probably why the market has sold off the shares so heavily again today.

Whilst our operations remain on track to deliver a good core performance in the second half of the financial year, the challenges in the Group, mainly surrounding Regeneration, have caused the Board to revise its current expectations of underlying profits (before exceptional items) for the year ending 30 September 2016.

Notwithstanding the current challenges, the Board believes that the Group's business fundamentals remain strong and actions are in place to drive operational improvement, particularly in Regeneration.

Whilst very disappointed to be reporting a further revision to its expectations, the restructured Board is fully focused on improving performance and remains confident in the strength and resilience of the Group, together with the opportunities to restore shareholder value over time.

So once again, I'll have to just wait for revised broker notes, to determine how much expectations are being reduced by. My guesstimate is that we're probably looking at perhaps 7-8p adj. EPS this year, instead of the previous broker consensus of c.10p. Not good, but not a disaster either.

What's interesting though, is that the market clearly didn't believe the previous forecast of 10p, because that would have put the shares on a PER of just 4.5 - far too low. So the share price already factored in another drop in forecast earnings, and has arguably double-counted by dropping the shares by another 33% today. So I see an opportunity here for a recovery in the share price later this year.

Will there be more bad news? That's the big question, and I suspect that there might be. This phrase in particular, seems somewhat concerning:

...In particular the Board remains focussed on the outcome of a number of contract settlements on which there is a range of outcomes for the Group in terms of both cash flow and impact on the Income Statement.

Exceptionals - there's a likelihood of some exceptionals in the full year results:

At 31 March 2016, the costs associated with the Extraordinary General Meeting were immaterial and were not considered for separate disclosure. The Board however expects a sum to be reported in Exceptional Items in the full year. The Board was also in discussions with former directors of the Group over the terms of their exit, which had not been agreed at 31 March 2016; again any costs would be expected to be recorded as an exceptional item in the full year. The Board is currently evaluating deferred consideration calculations in line with contractual terms, along with the knock-on impact of the claim raised against the client in respect of previously recognised contract losses; at present, there is a possibility either or both of these items might give rise to further exceptional items (both income and expense) in the second half of the year.

Balance sheet - as is very often the case when management state that the balance sheet is strong, it isn't. It's quite weak, and LAKE is dependent on continued support from its bank. Although there's nothing to suggest the bank would withdraw support.

 NAV of £80.9m turns negative once you eliminate £93.1m goodwill & intangibles. This is the trouble with highly acquisitive groups - you tend to see the balance sheet piling up with goodwill and debt. So NTAV is negative, at -£12.2m. Not great, but not horrendous either. There are plenty of other companies with far worse balance sheets.

 Dividends - this is interesting. Despite all the problems, a 1p interim divi is announced today. That is very encouraging, as it suggests to me that things aren't too bad, and that management genuinely believe that H2 will improve.

 Outlook - today's statement contains a fair bit of upbeat commentary about the prospects for H2 and beyond. Note also that seasonality favours the spring/summer period of H2. A number of LAKE's subsidiaries naturally benefit from improved activity in the summer (e.g. putting in some types of insulation which can't be done in cold temperatures).

 Also its gas/heating business recognises revenue in equal instalments throughout the year, but its costs are much higher in winter, due to call outs. So the summer is much more profitable.

 The comments & figures on order book & contract wins also read positively.

 My opinion - I think this is a buying opportunity. It's a fundamentally sound group of businesses, that has remained profitable, despite all manner of problems being encountered in H1.

 I feel there could be one more profit warning in the pipeline, but the market cap has now already fallen so much, that personally I'm looking through that possibility.

 Is it going bust? Very unlikely in my view. The bank debt is not a serious problem, and it was used to buy what appear to be good acquisitions, thereby offsetting some of the deterioration in profit from the core businesses.

 Cashflow is a concern - there was a nasty negative capital movement in H1, which the company says is related to payments to subcontractors. So this is something to scrutinise carefully when the full year figures come out.

 I'm also worried about the contract settlement comments, which sounds as if another provision for contact losses could be on the cards.

 All that said, everything has its price. In my view this is a sound business, which after a period of time to sort out the issues, could be a decent recovery share. The 1p divi is significant in my view - this tells me that management are reasonably confident they can fix the problems. So taking a risk now, could lock in a c.10% full year dividend, if it pays out 2p for the final divi, which is possible. Then there could be upside scope on the divis in the future, as performance improves (hopefully).

 If the business does recover, then the share price could be double or triple the current level, looking outwards say 12-24 months. I like situations like this - buying when market sentiment is on its knees, but the company is fundamentally sound, with fixable problems. Remember also that it's reporting a good order book, and contract wins today too, which I didn't get round to mentioning above.

 There's so much detail in the announcement today, that I've only scratched the surface of it, but decided to focus on overview here, rather than detail.

 It will be interesting to see how long it takes sentiment to recover here. That depends on how many existing shareholders are throwing in the towel, and how cheaply new shareholders want shares before they press the buy button. Anything could happen, I've got no idea what the short term share price will do. Although I would expect Slater to be buying at this level, to signal confidence in the new Board.

 Bottom line, at this level of c.32p, I think risk:reward is looking favourable, if you're prepared to accept the potential risk of another hit from more bad news. I see 100-200% upside here, with patience (1-2 years), so am therefore prepared to risk further potential short term losses.

 The new Board will want to demonstrate that they're getting on top of the issues, so that is a good catalyst for things potentially improving later this year, combined with a tailwind from better H2 seasonality.

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Zytronic (LON:ZYT)

 Share price: 386p (down 7.3% today)

 No. shares: 15.4m

 Market cap: £59.4m

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

 Interim results, 6m to 31 Mar 2016 - I've just come off the phone to the CEO, Mark Cambridge, to have a catch up. The audio recording is on my website here. We kept it fairly brief this time, at 21 minutes. The CEO is refreshingly straight-talking, so always a pleasure to talk to.

 Key points:

 • Profit up 8% to £1.8m for H1

 • EPS up 10% to 9.6p for H1

 • Net cash has risen again to £99.5m, or 62p/share

 • Turnover down 1%, as lower margin non-touch products continue to decline

 • Gaming sector has shown particularly strong growth

 • Vending has shown a fall in sales

 Overall, the results look OK to me - neither good nor bad.

 Valuation - the cash pile is material at 62p per share, so personally I deduct that from the share price, to arrive at a cash-neutral share price of 324p.

 Broker consensus is for EPS of 25.2p this year, so I make that an ex-cash PER of 12.9, which looks good value to me.

 If you include the cash in the valuation, then the PER is 15.3.

 Will the company meet forecasts this year? With solid interims in the bag, I would hope so, but a fundamental problem with this company is the relatively limited visibility it has on sales. Therefore investors need to understand that there is always the risk of a gap opening up in the order book. That's just the nature of the business.

 My opinion - In my view the shares are fairly priced right now. I view this as a core long-term holding, because I really like the future potential for the company's large, and multi-touch screens.

 It's not without risk though, due to limited visibility of orders. However, in the past the falls in share price have turned out to be good buying opportunities.

 I like the company, and its straightforward management. Hopefully at some point the surplus cash pile will be put to good use, either as a special divi, or for a sensibly-priced, complementary acquisition. I nagged the CEO about this again today, as I do every time we speak! My typist is preparing a transcript of the audio, which I'll publish in a few days' time.