Small Cap Value Report (19 Feb 2016) - PLUS, AVAP

Good afternoon!

It's extremely quiet today for results & trading updates, so looks like I'll be able to down tools a bit earlier than usual today.

There's an interesting article today here about strong UK consumer spending. This reinforces my conviction that probably the safest place to invest right now is reasonably-priced UK consumer-focussed shares. That's where the bulk of my portfolio is anyway, and so far so good - I'm having a very good year so far (helped very much by the HOME takeover approach, so a bit of luck involved too).

Plus500 (LON:PLUS) - this share has been a fascinating roller-coaster ride, and whilst I looked at its results published a few days ago, decided against reporting on them here, partly because it's too big now (market cap is £615m, well above my usual cut-off c.£300m). Also, it's such a difficult company to assess, because there have been a lot of red flags, but on the positive side the company has paid out bountiful dividends, suggesting that the profit & cash are real.

My view currently, is that the big question mark remains how they manage to make such out-sized profits, when nobody else in the sector does, and whether that is sustainable?

The reason I mention it now, is that a Conference Call with the company has been arranged specifically for private investors this coming Monday at 10am. Details are not available yet, but will be shortly. If you would like to be contacted when more info is available, then this is the contact email address for the organisers, the very helpful Reg Hoare at MHPC: plus500@mhpc.com

I'm always happy to support initiatives such as this, to improve communication with private investors. After all, it's private investors who create the liquidity in the market, and set the price. So it's crazy the way many companies and their advisers almost completely ignore us!

Avation (LON:AVAP)

Share price: 132p (down 5.4% today)
No. shares: 51.5m
Market cap: £68.0m

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

Interim results to 31 Dec 2015 - anyone who's been to an investor show in the last 2 or 3 years will have met the CFO of this airline leasing company, the affable Richard Wolanski.

The shares have dropped 5.4% today, so presumably a few people are not particularly impressed with today's results.

Operating profit is up 14.7% to $17.9m for the 6 months, reflecting the quite rapid growth in fleet size.

However, profit before tax has fallen 20.2% to $5.6m, because of a large rise in the finance charges going through the P&L. Obviously as a leasing company, Avation buys the planes (which sit in fixed assets), and has large borrowings to fund the fleet.

The jump in finance charges seems to be due to $100m loan notes which were issued in May 2015. The company has previously flagged that there would be a drag on profits in the short term, due to the time lag from drawing down the loan note funding, and putting it to work deploying new planes:

"Since the beginning of the financial year, Avation has added five aircraft into the fleet. Avation has preserved cash raised from the $100 million unsecured notes issued under a Global Medium Term Note programme ("GMTN") to support the funding of further aircraft acquisitions. As additional aircraft are delivered, monthly lease revenues will continue to grow resulting in a significant increase in revenue in the second half of the financial year.

Therefore I don't see the fall in H1 profit as being a surprise, or a concern, as it is neither.

Residual values - this is where leasing companies often go wrong - i.e. they book profits for a number of years, but when a recession hits & customers go bust, the fixed assets turn out to be worth nowhere near book value.

Reassurance on this point is given today, since Avation specialises in narrow body aircraft;

In comparison to larger widebody aircraft, narrowbody aircraft are operated by most of the world's airlines and make up the majority of the global fleet. These aircraft are relatively simple to transition between airline customers due to their more generic layout and popularity. There is a large and mature secondary market for narrowbody aircraft that provides confidence in the residual value and continued liquidity of these assets.

Cost of debt - the weighted average has fallen from 5.1% to 4.9%, which is helpful for profitability.

Outlook - there are just fairly general comments about continued growth, but I don't see any reference to the company's performance versus market expectations.

Forecasts & valuation - WH Ireland has put out an updated note this morning. It has cut back profit expectations for the current year quite a lot (19.6%), due mainly to 1-3 month delays with new aircraft deliveries, and what seems to be a problem with a 737 contract not completing.

However, this does not look a particular cause for concern, as forecast for 2016/17 is unchanged, and 2017/18 has been increased. What is most striking, is that there is very rapid growth in the pipeline - EPS for 2016/17 is forecast to almost double from 22.5c this year, to 43.5c next year. At £1 = $1.427, that translates to EPS of 30.5p, so the PER would only be 4.3 at that point! I am sure that would attract investor interest. Even if you raised the PER to 6, that implies a share price of 183p, or nearly 39% up on the current price. Looks interesting.

Net asset value - the question is, whether valuing a leasing company on a PER basis is correct or not? Since earnings may not be sustainable in the long run, it's probably not the best way to value this type of company.

I prefer to look at the market cap vs NTAV (assuming that the depreciation policy is correct, and not over-stating NTAV).

In this case, NAV is currently $122.3m (I've removed a $179k relating to minority interests), then deducting $2.4m of intangibles (goodwill), gives us NTAV of $119.7m. That's £83.9m in sterling. Compare that with the market cap, which is currently £68m, and there's a discount - implying that there could be upside on the share price, perhaps?

My opinion - I'm very wary of this sector, so only have a small position in this share (which is currently underwater). I'm tempted to add a little more to the position on any further weakness, which there might be in the short term due to the fairly sizeable cut in current year forecasts.

Also, I would need to get a better understanding of the financial implications of the 737 contract apparently falling through.

Management of Avation are experienced in this sector, and seem to have addressed every risk inherent in aircraft leasing - e.g. they have matched up borrowings with individual aircraft leases, they've got caps or fixes on the interest rates payable, they've thought carefully about what type of aircraft to finance so they don't get lumbered with white elephants that are only good for parking up in the desert, etc.

Overall I think it looks potentially interesting, but am also a bit scared by it, in case there is some other looming risk which I'm unaware of. That's what the 2 year chart is telling me too - that the market isn't yet convinced by Avation. That said, in my experience when the market does decide it's comfortable, then a re-rating can be very rapid. Hence why I'd rather be in it (in a small way only), and wait to see what happens.

Webcast - I've just noticed that there is a webcast starting at 2pm TODAY (19 Feb 2016), so I'll tune in to that now - here's the link.

Work-in-progress - please refresh this page later.