Small Cap Value Report (17 Nov 2015) - CDOG, IDOX, INTQ, LVD, MOS, BLNX

Hi Paul

thanks for another great report. Re. Lavendon I don't think its as much of a bargain as it appears, having had a look at the historical performance of the business.

Last 6 years owner returns are as follows:

- Increase in book value/share: 23.5 (the accounts look pretty clean, as you've said, so I'll assume that the book value is "real" value for now)
- dividends per share: 20.15p
Total return = 43.65p/107.1=40.8% over 6 years = 6.8%, which by curious coincidence matches their operating margin exactly.

Is this an attractive investment if one considers paying out a notional £1 now for a prospective 6.8% earnings yield in future? Given an equivalent owner earnings yield (dividend plus increase in book value) is available from a low cost stock market index, it doesn't look like great compensation for the risk involved in a smaller company.

So... I think that its cheap for a reason - and the reason is that the business inherently earns a pretty low return on capital, and always will.

Of course, the market is a fickly thing, and the share price may go up and down like the proverbial, but I think not for me.

Good post Kelvin. I think we're in the minority looking at the ROCE of a business as a main filter. Many seem to be enticed by the 'SP was up there, now it's down here' style of investing. Nothing wrong with that of courses you are good at timing purchases and jumping off before the fan is visited by the smelly stuff. Over time, companies do better if they have a higher return from the capital they employ.

NI

In reply to post #112137

As regards ROCE, I've had a discussion about this with a colleague this morning. Personally I place less reliance on ROCE than many people do. It's never going to be that high at an equipment hire company anyway, as outsized returns will simply stimulate competitors to join that space and erode prices.

A far more useful measure, in my view, is operating profit. On this basis, Lavendon (LON:LVD) does fine, with an operating margin of 11.6%.

Moreover, my manual calculation of ROCE (excluding intangible assets, which I always write off) comes out at a reasonable 15.1% (based on last year's figures, with Fix Ass (less intangibles) + current assets, less current liabilities of £259.9m, and pre-exceptional EBIT of £39.3m.
To my mind, that's a perfectly acceptable ROCE, especially given that debt funding is so cheap at the moment, and likely to remain so for some time.

Moreover, there's an attractive divi yield of 3.6%, which is covered by earnings 3.4 times. The last divi rose 30%, so a very pleasing trajectory there.

We have a bang up-to-date positive trading statement, and a strong balance sheet, to reassure.

So, either the price now is wrong (too low), or the price over the last few years has been wrong (too high). I think it's the former - this is a stand out valuation anomaly in the sector, in my view.

It's nothing to do with anchoring to a previous share price, and saying, ooh it must be cheap. It looks extremely good value on solid metrics like PER, divi yield, operating margin is good, balance sheet is good, ROCE is not that bad when you take out intangibles, etc.

It's not a share I would want to hold forever, but to my mind risk:reward is clearly attractive at c.140p per share. In my view, there's a probably 20-40% fairly easy gain on this, if we're patient, just for it to re-rate back to a more appropriate valuation, of a PER of say 10-12.

I see very little downside from this price, and quite good upside. But as always, I'm grateful for opposing views - always important to consider all angles on it.

Regards, Paul.

In reply to post #112140

Paul,

I hold LVD and I'm thinking of buying a few more although that will take me to a larger holding than I'd normally be comfortable with for such a cyclical small cap business. I believe there are two institutions (Old Mutual and Kames Capital) who have been offloading shares for most of this year and suppressing the price. Given yesterday's trading update, there's clearly no fundamental reason for their selling and I always find buying under such circumstances is profitable if you're prepared to sit out and wait for the selling to be cleared, the fundamentals of the business will out. 

All the best, Si 

In reply to post #112137

A big problem with ROCE is that the number for capital is pretty noisy and open to interpretation, so the raw numbers are not that useful and adjusting them is tricky.

ROCE is relevant as a limit factor - i.e. in those businesses which are capitally constrained. Many profitable businesses have other more dominant constraints, and end up returning surplus cash as dividends, or spending on non-core ventures. So beware of using it outside of the situations in which it's critical. Think for example of a financially attractive business like Bioventix (LON:BVXP). They could retain more of their dividends or raise more capital, but it would be irrelevant - it wouldn't improve your returns per share. I believe the key is understanding the constraints to growth and the risks.

Thanks for the update on Lavendon, I am a holder and it was my first purchase for my son's ISA, so I was getting a bit worried. I am now re assured. Also thanks to all on the discussion and data, as a 'student' of investing all in depth discussion helps my learning.
Paul, it's good to go out on the lash occasionally. Although I look forward to your post daily its no problem to wait; good on you.
KR Charles

It seems a boring business that at least I can understand and I like boring businesses. Also it is based in the UK and not in a country with "stan" its name, or Russia or India or anywhere where the market authorities are easily corrupted (this rules out at least 70% of investments.).

its a buy!

Hi Paul.
I'm back; can you help the 'learning'. Just looked at the valuation models on stockopedia for Lavendon. DCF puts it at 26.78p; Ben Graham rule of thumb at 45.23; Earnings power at 16.6p and Tngible Book value at 87.92p. Relative to sector is at 224.16p which is obviously good. Some say DCF is a very valid measure- what are your thoughts and what can I learn from this. Totally confused - Charles

Although LVD appears to be reasonable value at present, I'm a little more cautious than most. I would certainly attribute a lower than average PE multiple to a business like this based on quality factors.

Firstly, it is correct to be concerned about ROCE, not least because the company itself is. The second paragraph of the 2014 Chairman's Statement says:

"The growth in our revenue has delivered improved profitability which, alongside self-funded
investment, has driven the Group’s return on capital employed (ROCE) ahead of our weighted average cost of capital (WACC) for the first time since the economic downturn in 2008 – an important strategic milestone for the Group."

Where cyclical businesses such as LVD are concerned, it is more instructive from a valuation perspective to examine ROCE across the cycle. Taking a single year ROCE is meaningless, and will likely lead to an overvaluation of the business if you happen to take that measurement at a favourable time in the cycle. Clearly, the minimum acceptable ROCE is cost of capital and based upon the Chairman's comments above, this has been an issue for the group in the past.

To help see this over a 10 year period, there is a very interesting chart in LVD's 2014 results presentation:

A more optimistic view of LVD may be that the uptrend in ROCE isn't wholly cyclical, but at least partially due to business improvements and efficiencies. I'll leave that view to the optimists however!

The common problem with these sorts of cyclical, low ROCE businesses is that when ROCE is at the top of the cycle the company takes on more debt for expansion (and low ROCE companies of course require more capital per unit of growth) and when the cycle eventually turns they are left over-leveraged. Indeed, that happened with LVD in 2009 when it carried out a placing and open offer in order to repair its balance sheet (albeit one of many back then!). As we can see from the LVD interims, the company is now expanding its fleet in these more profitable times with the resultant leap in net debt, now standing at approximately 4.6 times underlying 2014 earnings. (I don't like EBITDA - that's for bankers!).

So those with a long term view may well be more cautious on LVD's valuation for the above reasons. In the short term, traders will, as usual, focus on PE and growth with the usual result of bidding the share price above intrinsic value in the good times. So perhaps there's a short term profitable trade to be had here, but beware: you'd better be vigilant for any signs of a turn in the tide!

Best,

MI

Sorry, if that chart's impossible to see, I've uploaded it here:
http://imgur.com/8EZlAhu

In reply to post #112140

Hi Paul,

Maybe I missed something, but it looks like Lavendon's FCF is steadily decreasing towards 0. That would be a big no-no to me, unless there are large capex justified by reasonable opportunities to increase sales or reduce costs...

Cheers

value101,

FCF is after capex, and Lavendon (LON:LVD) are building up their rental fleet - clearly a policy decision, so it doesn't really make any sense to use free cashflow as a performance measure, and be concerned about it, when they are deliberately expanding as their chosen strategy.

The best explanation I've heard today for the share price weakness at LVD came in an email from a friend earlier today. He believes that the market is worried about declining revs/profits from the M.East, which is apparently decently profitable for Lavendon, in light of the low oil price, and likelihood of countries like S.Arabia scaling back their infrastructure spending.

That, to my mind, is a far more credible explanation for the soft share price. All the stuff about ROCE is background noise, because it's already known about. We need to look for something that's changing, and I think worries over M.East exposure is the most sensible explanation for the soft share price.

Regards, Paul.

In reply to post #112356

There is an excellent article on the calculation of FCF and its significance where companies are investing to grow (which LVD is doing) here: http://www.sharescope.co.uk/philoakley_article54.jsp

Note the point that where there is investment CAPEX (as distinct from maintenance CAPEX) it's the ROCE on that CAPEX that counts (as discussed in post #14 above)

Cheers,

Mark

Hi Paul

Novice investor here

After reading about internetq I was surprised to read about the accounts with this one being dodgy. On the face of it I wouldn't buy it's stock because1. It's not an industry I know well 2 doesn't give me confidence coming from Greece.

However first look at the numbers look quite good, but I don't understand why there is "payments for intangible assets"? As I thought this was like brand names and intellectual property etc. Which I thought just adds value over time ?

Appologies for sounding simple, I'm a bit lost with this one.

Thanks
Sean

Morning Paul.

Not sure if you are still holding Mobile Streams (LON:MOS) as your "seasonal fizz stock", but if so I wondered if you had any views on the removal of currency controls in Argentina, one of their principal historic markets, and the impact this might have. On the one hand it might allow them to repatriate earnings more easily. On the other, a 30%+ devaluation in the Peso will presumably hit the value of revenues assuming the FX isn't hedged, and many of their costs are £ or US$ based. I recall you saw this very much as a punt on possible growth in other markets such as India so it may be that the Argentine situation is of secondary import.

Thanks,

Gus.

In reply to post #115266

Hi gus,

I sold half my Mobile Streams (LON:MOS) on one of the big spikes up, so more than doubled my money, and am running the balance for free. So to be brutally honest, I'm not really monitoring events, but have just tucked away my remaining "free" shares for the long haul, on the basis that the company has been highly successful in the past, doesn't need cash, and is now trying out similar activities in other countries.

So who knows, it might work? A total punt, not my normal thing at all, but everyone needs to have a little fun!

Regards, Paul.

In reply to post #112509

Hi smatthews1,

What Globo (LON:GBO) did to create fake profits, was to capitalise a huge amount of costs onto the Bal Sheet. So instead of the debit entries going through the P&L as costs, they instead go onto the Bal Sheet into intangible assets, thus inflating reported profits.

InternetQ (LON:INTQ) is doing exactly the same thing. The easiest place to find this, is on the cashflow statement, within the investing activities section, where you will see an item called "Payments for intangible assets", which is costs that they are capitalising. Although in this case, it's not much higher than the depreciation/amortisation charge, so you could argue that it's not flattering profits that much.

INTQ's Bal Sht looks weird, in that it displays a lot of the same traits that Globo's did - extremely high intangibles and receivables, running cash balances simultaneously with a similar amount of debt, etc.

I was right in thinking that INTQ might bounce after the bear raid, which it has, but it's certainly not a stock I would want to hold for any length of time, indeed I've sold out now.

I'm not saying that INTQ is definitely a fraud, but I think it displays a remarkable similarity in its accounts to Globo, and that should be enough of a warning to keep any sensible person away from it!

Regards, Paul.

In reply to post #115326

Thanks Paul.

Mobile Streams (LON:MOS) is a strange company. Not sure if I was writing a business plan I would choose Argentina, India and Nigeria as my target markets but then at least they have about a quarter of the world's population in their sights, have a reasonable balance sheet and have been profitable in the past.

A bit of a yo-yo to be honest - hopefully some more "up-yo" although I suspect the Argentine situation will adversely effect their share price in the near term. Some comfort in the fact that the founder/CEO still holds c.30% of the company stock.

Thanks again.

Gus.

In reply to post #115335

Hi Gus,

Fair comments, but bear in mind that the mkt cap (£3.4m) & EV (£1.3m) of Mobile Streams (LON:MOS) are already so low, that the merest sniff of upside, and the shares can easily multi-bag - as we saw very recently. OK, the big rise didn't hold fully, by any means, but it's still over double what it was a few weeks ago.

The stampeding herd of bulletin board gamblers tend to surge in & out of this stock occasionally - so right now there will be a lot of people watching this stock, and it could easily double (or more) on a strong RNS. The company has been commercially successful before.

Overall, I think it's a very interesting little speculation, to add some potential fizz to an otherwise quite boring portfolio!

Regards, Paul.