Small Cap Value Report (19 Nov) - RNO, SPGH, MBH, PEG

Good morning! Shares in Manchester-based industrial chains business Renold (LON:RNO) have doubled in the last six months to about 41p, driven by a turnaround in performance from cost-cutting. I last reported on this company here on 22 Oct 2013, when they issued a very positive trading update, indicating that full year results (to 31 Mar 2014) would be "substantially ahead of current market expectations". So their interim results to 30 Sep 2013 announced this morning should show a good improvement on last year's H1, which they do.

Turnover is down 1.1% to £95.6m for the six months, but adjusted operating profit is up 42% to £5.1m. That equates to adjusted EPS of 1.1p. The outlook statement indicates that H2 is expected to deliver a similar result to H1, so that means 2.2p for the full year is looking likely. So at 41p that puts these shares on a PER of 18.6, hardly a bargain.

It's even less of a bargain when you consider that this £90m market cap company also has net debt of £22.0m, a whacking great pension deficit of £65.3m, and doesn't pay a dividend. Net tangible asset value is only £0.8m, and this can only be seen as a stretched Balance Sheet, weighed down as it is with high net debt and a large pension deficit.

Opinions are divided on how to treat pension deficits. They are likely to continue shrinking as corporate bond yields rise (which reduces the present value of scheme liabilities), but in this case a rate of 4.5% is being used, which probably doesn't leave huge scope for further improvement? It is not clear from today's results what the overpayment arrangements are with the pension fund Trustees, so I would need to investigate that from their last Annual Report before investing here.

The buoyant share price seems to be driven by expectations of further improvement in trading from additional costs being stripped out, and I suppose perhaps an expectation that recovering economies might generate more demand for industrial chains? It must be an internationally competitive sector though, so this just doesn't strike me as an exciting investment, especially where trading improvement is only being driven by stripping out costs. Not to mention the enormous debt & pension overhangs. It's difficult to see them being able to pay meaningful dividends any time soon.

So my conclusion, as with so many shares at the moment, is that the big rise in share price looks to have got well ahead of itself overall, hence I cannot see anything approaching attractive risk/reward at the current price. Investors just seem to be ignoring debt and pension deficits at the moment, which strikes me as madness - and just leads to people over-paying.

On the plus side, the PER here are Renold drops to 11.3, based on 2014/15 forecast of 3.58p EPS. Although even that isn't cheap when you consider the debt & pension deficits. A PER of nearer 6 would be about the right price here, in my opinion.

The company mentions a need for further capex, so an equity fundraising looks like a sensible option to get the debt down first.

I've had a quick look at the last Annual Report from Renold, and note 18 covers the pension scheme arrangements. A small excerpt is copied below, which intrigues me - there seems to be some sort of loan arrangement whereby the group pays interest to the pension fund, which is used to reduce the deficit, if I've understood this correctly? I've not come across such an arrangement as this before, and wonder if any readers know the chronology of events here and could clarify what the arrangements are?

Note that there also appears to be a higher level of profitability (not disclosed) from 2017 which would trigger higher pension payments by the company:

(extract below from note 18, Renold 2012/13 Annual Report):

 

The merged scheme will be underpinned by a 25 year asset backed partnership structure. The partnership holds an intercompany loan from Renold International Holdings Limited, the holding company for most of the Group’s overseas trading companies and the associated interest income, which will provide annual cash contributions of £2.5m to the pension fund, with annual increases linked to RPI and capped at 5%. This income stream will be used to fund deficit repair payments and the first £0.5m of annual administrative expenses (with the company bearing any excess). The interest in the SLP held by the Schemes is not reported as
a plan asset in the consolidated financial statements as it is a non-transferable interest issued by the Group. The IAS 19 deficit will be reduced as the cash contributions under the new structure are made.

Total cash costs for UK deficit repair payments and UK administrative expenses in the period was £3.8m (2012: £3.4m). The Group has also agreed that if operating profits reach an absolute pre-determined level in the year ended 31 March 2017, additional contributions will become payable while profits remain above this level. The pre-determined profit level is significantly higher than the operating results disclosed in the current year.

The new arrangement replaces all other existing funding arrangements for the UK defined benefit schemes and there is no separate schedule of contributions as at 31 March 2013.

 

 

 

 

 

Overall, I'm perplexed & quite disturbed by the unrelenting bullishness of this market. The mood has changed by such an extreme extent, from say 18 months ago when markets were really negative, to a euphoric mood today. So I'm becoming more convinced that a sharp correction is overdue. That doesn't worry me at all with my emphasis on Value & GARP, as that type of stock shouldn't be affected much at all, and pullbacks would just be a buying opportunity.

However, I do think that a lot of people are going to get a nasty shock when they suddenly realise that stocks they hold which have risen well above a reasonable valuation, come back down to earth with a bump. There are a lot of margined players in the market too, who will be forced sellers once their favourite stocks drop sharply, exacerbating the falls. So I'm steering well clear of trendy stocks that everyone thinks will never fall - it's only a matter of time before they do fall, and hard.

 

 

 

 

Next I've been looking at a potential turnaround at manufacturer of fibreglass insulation material, Superglass Holdings (LON:SPGH). I've not reported on this one since May 2013, when their rescue refinancing took place - which involved massive dilution, although at that time the existing equity was worthless on any rational calculations.

Clydesdale Bank also showed flexibility, and took a partial debt for equity conversion. Or maybe it was changing their debt into convertible debt, I can't remember exactly, but something along those lines. The shares were then consolidated from 2p to 50p.

I commented here on being tempted to nibble a few at 50p, but didn't have enough information to ascertain whether the refinanced company would be adequately profitable or not. In this type of situation broker notes tend to be non-existent, so you can't really form a view on what is likely to transpire in future.

My caution was wise here, as the shares have since slipped to 33p, including a 2p fall this morning on publication of their results for the year ended 31 Aug 2013. Again, it's very difficult to form a sensible view on the company from these figures. Turnover fell sharply from £32.4m to £24.4m, against which deep cost cutting measures have been taken, which only partially fed through in these published figures.

The operating loss of £11.0m is obviously horrendous, but includes exceptionals of £5.9m.

The refinancing left them in a sound financial position (for now) with net cash of £4.3m at 31 Aug 2013. So it's really all down to the outlook statement. This bit doesn't exactly sound optimistic:

 

It is difficult to envisage that activity levels in Green Deal and ECO can fall any further and with recent evidence of strong growth in housing activity, it is likely that demand will begin to recover, albeit from a very low base. However, we had previously anticipated better, albeit slow recovery in demand under ECO/Green Deal. Revenues in this area in 2014 will therefore be lower than management had originally expected.

 

They also refer to further cost savings, and their "introduction of best in class technology", and possible improving margins. I suppose a case might be built for recovery in the housing market driving demand, but in the absence of any broker research, buying these shares would just be a wild punt in the dark. It's not clear to me that they have a viable business, and the only forecast I can find is for an increase in turnover to £28m next year, with a loss of £1m.

So overall, I might have had a punt if the market cap had been say £1-2m, but at just under £ 10m market cap, it doesn't look a sensible proposition to me at all, based on the information currently available.

 

 

 

 

The Chairman of ShareSoc has often written articles complaining about the way private investors are increasingly shut out of fundraisings, since most now seem to be done by Placings, to invited Institutions and occasionally HNW individuals only. Personally I don't object to small Placings, providing the issue price is close to the existing share price, and the dilution is fairly small (up to about 10% of the existing shares in issue seems fine to me). So a Placing can be a relatively cheap & quick way to raise money when needed.

However, this method seems to be increasing abused. Another example today is a £10 m Placing by Michelmersh Brick Holdings (LON:MBH). The company has 58.2m shares in issue already, and has today announced an oversubscribed Placing (i.e. it's a done deal at the moment most investors are aware of it) for another 22.2m new shares at 45p (which is a discount of almost 16% to yesterday's share price).

If you think it through, that's a pretty raw deal for existing investors, especially private investors who have not been given access to this Placing. That's a 38% enlargement of the company's share capital, and existing investors have been shut out, so get diluted, at a discount, with no comeback. Pretty bad really, isn't it?

Now you could argue that the company has done well to get its share price to more than double this year, and so it's better to dilute shareholders at a 12-month high for the share price, rather than at a low. But it must stick in investors throats to know that people who participated in this Placing can now "flip" the stock in the market, for an instant profit of about 7p per share, or 15% profit on the Placing price. Usually the share price will trend down to the Placing price, as people do exactly that, and bank some instant, zero risk profit, at the expense of private shareholders whose holdings are now worth less.

I see this deal was done by Cenkos, the company's NOMAD, so if I were a shareholder in Michelmersh, I would be on the phone to Cenkos reading them the riot act.

How can private shareholders stop this kind of thing? I think the best way is to vote against the disapplication of pre-emption rights at the AGM, and vote against any resolutions to issue more shares, unless there is a clear need to do so, and an explanation given as to why.

The other thing to consider is that debt was too high at Michelmersh, so overall perhaps it's not a bad thing that they raised some fresh equity, even though they've harmed the interests of private shareholders in the process, relative to the Institutions who were given cheap stock.

We need reform to the system. We already have the technology to enable us all to communicate electronically, so it's ridiculous that we still use such archaic processes. When a company needs to raise money, the shares should be immediately suspended for (say) seven days, and an online book built, open to all existing shareholders. All resolutions needed should be done instantly, online again, with the minimum of paperwork required. We really do need to start lobbying Government hard to radically reform the whole system of corporate governance, fundraisings, etc. It needs to be made quicker, cheaper, fairer, and all-electronic. That would create a far more attractive market that would genuinely make it easier for growth companies to raise money, by cutting out all the unnecessary intermediaries & their hefty fees.

You can't help feeling that a mood still pervades in parts of the City whereby private investors are regarded as cannon fodder to drive up the share price, and then get diluted through discounted Placings given to favoured Institutions, perhaps? It's not good enough.

 

 

 

 

I'm sure many readers have noticed that newspaper & magazine share tips are triggering some extraordinary price movements at the moment - perhaps a sign of frothy markets again, or perhaps a sign of new entrants into the markets - because we all probably started with newspaper tips when we first started investing.

What I've noticed of late is that you can spot a newspaper tip in a small cap by a spike up, then a plateau, then a rapid fall back down to where it started. I don't know what the correct technical charting term for this is, but it looks like a table, so let's go with "table" as the term for a tip-driven chart formation.

Northern Petroleum (LON:NOP) is a good example of this. See the 3-month chart below, where a 25% price rise was triggered in late October by a tip in a sunday paper (I think it was the Mail on Sunday?). That lasted all of 7-days, and then the price came right back down again. Actually, maybe the "Grand old Duke of York" might be a better name for this chart formation?!

Why am I mentioning this? Well probably because I think it needs to be taken into account when deciding what to do with our own shares. So from now on, if one of my shares is tipped somewhere & shoots up, then I'll probably be selling some (or even all) into the Table.

Although that approach can go wrong - e.g. I sold my shares in Staffline fair too early because I was worried that a newspaper tip had pushed the price up too quickly, but the shares then proceeded to double again. So I suppose it all boils down to valuation - i.e. if a share is tipped, and rises to an over-valuation then that's a time to sell. If it rises, but is still cheap, then it's maybe just time to top slice a little, and buy back later if they dip back down again? What do readers think? Is this sensible, or just all background noise? Comments in the comments please!

Recent Northern Petroleum share price chart, note spike up on newspaper tip, and spike in volume too:

 

 

 

Life has been a rollercoaster for shareholders in Petards (LON:PEG) recently. The shares recently doubled to almost 20p, but have come most of the way back down again since to 13.2p at the time of writing. It's a tiny £3m market cap security equipment company, ruggedised for public transport. Their historic performance has been lukewarm, with turnover falling from around £18m in 2008 to only £9m in 2012, so profits have ebbed away to around breakeven.

However, recently they announced some big contract wins, and have today issued another statement saying that the order book is up to £20m, of which about half is to be delivered in 2014.

The fly in the ointment in today's announcement is that they say they need more working capital to fulfill these orders, and are reviewing their options. The market hates uncertainty, especially when it concerns fundraisings, so whilst I might have been tempted to pick up a few of these on a pullback, on balance it would probably be best to wait until their fundraising is complete. Could it be another of the dreaded discounted Placings referred to above? Another example of why it's essential that the system is reformed, as now private investors won't want to buy shares, knowing that they might just end up diluted by a deal done with Institutions which they are blocked out of.

 

 

 

Right, I've run out of time for today.

See you back here tomorrow, for more doom & gloom! It does seem that way at the moment, but I just speak as I find, and if valuations look toppy to me, then I'll say so. Sorry if that offends people who are long of the stocks mentioned, but this column is all about speaking the unvarnished truth as I see it. It's only ever one person's opinion of course, sometimes right, sometimes wrong, so above all DYOR!

Regards, Paul.

(of the companies mentioned today, Paul has no long or short positions)