Small Cap Value Report (23 May 2016) - LAKE, Falling Knives, RST, DODS

23rd May '16 by Paul Scott

18 comments 12538 reads

Good morning!

Lakehouse (LON:LAKE)

Share price: 35p
No. shares: 157.5m
Market cap: £55.1m

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

Meeting - A friend very kindly arranged for a small group of us to meet the new Chairman and existing FD at Lakehouse (LON:LAKE) last Friday afternoon. They were very generous with their time, and over 2 hours we delved into all aspects of the business.

My feeling is that the very public board room bust-up is now water under the bridge. So I was keen to move the meeting on to talking about the future. The new Chairman, Ric Piper seems an ideal choice for a business that has experienced considerable recent upheaval. His calm, avuncular manner, and methodical approach to the numbers (being a Chartered Accountant), is just what's needed in my view. He seems to have already established an excellent rapport with the FD. A new CEO is being sought, with the role currently vacant. I like the idea of a new CEO coming into a situation where there is a strong Chairman/FD partnership already in place. This should point the new CEO in the right direction from day 1.

I came away reassured that there is no issue with the bank funding. We ran through the bank covenants, and there seems to be plenty of headroom there. So it's not a crisis situation. It's a recovery situation. That was reflected in the 1p interim divi, and guidance of a 2p final divi in due course. So the yield is close to 10% - a very nice catalyst to push up the share price.

My one reservation is that I feel there is a possibility of one last profit warning, from the "contract settlements" issue. I spotted this in the interim results statement, and mentioned it here in my report of 17 May 2016. There is some uncertainty over negotiation of the final account on some big contracts. Management explained it could go either way - a favourable outcome would be great news. An unfavourable outcome could mean another profit warning, with a perhaps 10-25% impact (my estimate) on the share price, in the short term.

The negative cashflow in H1 seems to have been a one-off, due to the unwinding of a favourable working capital profile on a big contract in…

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Patrick L

23rd May '16

This is a great post Paul, especially informative for us Lakehouse (LON:LAKE) holders. Thanks v much.

vik2001

so there probably wont be much price movement up on this, until the next trading statement is released and until confidence is resumed back in the company... otherwise if there is a profit warning we could see another drop of around 15%

muckshifter

Haven’t looked seriously at Lakehouse, but they sound like a fairly typical contractor, to someone who has worked for contractors for decades. The cash outflow because of the unwinding of working capital is normally only a problem for contractors whose total workload is reducing drastically – it then is often a serious problem – as normally the “unwinding” of one contract is countered by the “winding” of the next one, leading to lots of cash in a growing contractor, and a shortage in a shrinking one.

The “contract settlement issue” could have done with a bit more probing if Lakehouse were being reasonably open as it often covers a multitude of sins. For example, on how many contracts were there substantial outstanding claims, and for how long have big ones been outstanding. Also, although I doubt they would give you the answer, what percentage of those claims have they included in WIP, ie. 50%?.

The best example of the use of WIP I ever saw was Birse, probably 20 years or more ago. They were at the time one of the most “contractual” contractors at a time when claims were rampant throughout the civils industry. They got into serious trouble whena number of major contracts turned sour at the same time, but to placate the banks they had £45m in WIP on the basis of claims, and also they pushed all new subcontract payment terms onto an extra months credit, ie. the best part of a months turnover kept in their pocket. This huge claims WIP mostly remained in their accounts for several years while they recovered from the disasters and then huge chunks of it were written off.
Regards.

Paul Scott

Hi Muckshifter,

A couple of us at the meeting did probe on the "contract settlements" issue, but management clammed up, saying it was too commercially sensitive to go into any more detail.

It wasn't clear whether they were talking about individual contracts, or all contracts. So it all got a bit muddled. From piecing together what they said, I got the impression that we're talking about something like a range of -£5m to +£5m potential overall outcome. I think the FD has made provisions according to what he & the auditors feel is required. But the final outcome could be different. Hence why they flagged this as a potential issue.

I agree that contracting businesses can indeed be problematic. Although in the case of LAKE, they've got quite a nice range of different businesses, which are now showing good cross-selling opportunities - something we talked about at the meeting. They sound quite excited about the potential in the energy sector, for example.

The share price would give you the impression this is a business on its knees, but that was not at all the impression I got from meeting management. They're quite upbeat about the future potential.

Hopefully David can get them along to a future Mello evening.

Regards, Paul.

simonty

Paul, did you ask about Ric Pipers history at Elektron ? A political can of worms, endless profit warnings, domineering Board. And Ric Piper just gave up the ghost and resigned ( I am sure it was not that simple). Anyhow, he did not have the influence or the backbone to look after shareholders in the face of quite a complex position. How will he fare at LAKE ?

StandardModel

Paul

Very interesting comment on an 'ideal turnaround' situation:

"Ideal situations are where there is perhaps one problem division within a group, but all other parts of the group are trading well. A good example of this is Avesco (LON:AVS)"

This also seems to describe OMG well; their OMGLife division being perennially loss making but now being worked on (a combination it seems to me of selling part of the business, downsizing another part and trying to finally drive some sales in what's left).

OMG (LON:OMG) have the added advantages of returning a lot of cash (with two special dividends paid in the last year or so) and what appears to be a stonking 2016 profit forecast of +95%.

I looked at both Avesco (LON:AVS) and OMG (LON:OMG) about a year ago and for the two reasons listed above I went for OMG (LON:OMG) - WRONG!! With OMG (LON:OMG) up 10% L12M (albeit the return of cash adds another 10%pts) and Avesco (LON:AVS) up 55%+. I still hold OMG (LON:OMG) but am wondering why it was the wrong choice.

I suspect that Avesco (LON:AVS) was more of a binary bet; if the managed to sell the loss making business at a profit the share would shoot up, if not it would probably decline. As it happened they sold their loss making division, got a load of cash and transformed into the company they had the potential to be.

OMG (LON:OMG) has turned out to be more of a boring, steady-as-she-goes stock. Albeit with still the potential of good gains if they deal with OMGLife successfully.

I continue to hold, mainly due to that +95% 2016 forecast. However, the share price action appears to indicate that the market isn't buying that forecast .... I wonder if this is, in fact, another binary bet driven by the doubling of profits in 2016? In that case who cares about OMGLife?

Mick

Hi Mick,

Yes you're right, OMG (LON:OMG) was another classic situation, where one problem division (OMG Life) generated heavy losses, which almost wiped out all the profit made on the other (very good) divisions.

I did quite well on that share, but sold out too soon. I think with all the special divis, shareholders have done well out of it.

Situations like that - with one problem division, causing a depressed overall valuation, for a group with some hidden gems in it, are nearly always profitable investments for me. Wish I could find more of them!! Do let me know if you come across anything similar ;-)

Regards, Paul.

TMFMayn

"Situations like that - with one problem division, causing a depressed overall valuation, for a group with some hidden gems in it, are nearly always profitable investments for me. Wish I could find more of them!! Do let me know if you come across anything similar ;-)"

French Connection.

Hi TMFMayn,

Indeed, I'm still in French Connection (LON:FCCN) for the long-standing reason - that the brand licensing & wholesale divisions are worth a multiple of the current market cap.

The problem retailing division will gradually disappear, as leases expire. Nothing has changed, that has always been the upside case for the shares.

I've mentioned before that FCCN could take 4-5 years to resolve the problem leases. However, it could quite easily all be resolved one morning with an agreed takeover bid.

Just because value hasn't YET been outed, doesn't mean the value isn't there!

Paul.

Tanglands

Don't want to be to technical but in pure accounting and therefore hopefully audit terms the recognising in WIP of "claims" has to pass avery high hurdle of certainty. Therefore in theory claims have to be virtually certain In terms of their recoverability so the example of 20 years ago should not be happening now. My challenge to the FD of lake would be why they would be holding in WIP assets that they did not believe were recoverable, so why now the possibility of a profit warning. The likely answer would be due to a contract dispute around performance where the counter party is claiming failure and therefore won't pay. If that is the case then those commercial issues will need to be addressed by the new management to ensure that no repetition occurs.

benjamin176

Minor point but the social landlord comment should say 4 years or 3 further years of rent reduction by 1%.

Interesting article in the Sunday Times about large investors frowning on new executives going through the normal kitchen sinking routine. They argue (rightly in my view) that existing non execs position should be untenable in these situations charged with sleeping at the wheel.

Just a point about deferred income. Whilst I see your logic Paul of stripping it out, isn't it a positive seeing an increase in deferred income as this will appear as revenue in the next reporting period?

Zipmanpeter

Re Lakehouse (LON:LAKE) - Clearly the blame for poor performance is being heaped on the Management/Board who were pushed out plus a 'perfect storm' scenario of changes to govt policy, timing and acquisition related issues. This may have be fair/not fair but it is the reason to believe that things will get better.

However, part of the attraction is the forward visibility of work and INCREASED value of frameworks and contract wins. However, if these were negotiated/approved by the guys who were seen to have 'screwed up' are we 2 years from discovering another bunch of sour contracts?

As a trader perhaps not an issue - hold for 12 months and hope with dust settled and the business back to being nicely boring,we find the price has risen and then get out for profit. However, as a buy and hold investor, are there reasons to worry?

Also the interim statement gave a nod to considation in energy metering. Was this seen as an opportunity and direction for acquisitions or a further risk to a part of the business with prospects.

Hi benjamin176,

You asked;

Just a point about deferred income. Whilst I see your logic Paul of stripping it out, isn't it a positive seeing an increase in deferred income as this will appear as revenue in the next reporting period?

Yes, that's a perfectly valid point. However, it's a different point to the one I was making in the main article.

I only strip out deferred income from net cash, to arrive at a true (in my eyes) surplus net cash position on the balance sheet.

That's completely different from considering that growing deferred income is a positive thing for the P&L, which is might well be.

Regards, Paul.

Beginner

Just for info Dods (Group) (LON:DODS) started off publishing parliamentary guides in London in the 1830s. They now do this across the devolved UK and in a small way in France. They have also expanded to provide parliamentary and snivel service training and instruction, as well as collecting parliamentary and political data for dissemination in-house and beyond. Essentially they are very posh paper shufflers by appoint to HMG, and they train further paper shufflers. Not dynamic, and to some extent a life-style business, I cannot see a compelling case for investment here. The increased margins seem to have come from reducing staff levels and greater automation. That should have happened twenty years ago.

Just to add to Beginner's comments, I've used Dods before for political monitoring and databases (used by a lot of agencies, companies, and campaign groups) and training. They offer a cheaper service than competitors for their monitoring because they use a lot of automation whereas competitors tend to use more staff to analyse data. The downside is that you get keywords and mentions but not much sophistication in terms of analysis so companies often move onto competitors unless they can't afford to. Their training is good quality and subject to much less competition, but quite expensive for a lot of organisations (and therefore more cyclical).

As Beginner says the company isn't particularly dynamic although neither is the sector it's operating in.

It is also worth flagging that if the UK did leave the EU I think this company could be significantly hit because a lot of its clients pay for bespoke EU monitoring and training services which they may no longer need! However, I don't know what % it accounts for so that might require some further investigation.

focusinvesting

I think you guys are too pessimistic about Dods. Dods is a company that is 44.15% owned by Ashcroft. Ashcroft has been a great investor in cash-generative turnaround situations. His approach is to have very competent people around him which mostly stay loyal to him for their entire careers. He subsequently buys a controlling stake in underperforming companies and he then places these people there. Examples are Impellam, OneSource and ADT.

Dods has been struggling with the decline in advertisement revenues in the print business and also because there has been a complete standstill in the event and training business because of the budget cuts at the Goverment since the financial crisis. Since Ashcroft's arrival the company has transformed to a digital company with an event and training business where activity is picking up again since last year. Note that Dods moat is the intellectual property that is very difficult to rebuild. They have a very vast amount of historical political data. Ashcroft appointed Cheryl Jones as Chairman in September 2014. Cheryl Jones also led the turnaround of Impellam in the past. Impellam has been a multibagger during her appointment and the company is still very cheap. Since Jones' arrival the fortunes of Dods have turned around in a very impressive way. A quick glance at the past 3 year financial performance tells that the momentum is very strong at the moment. The deferred income is no problem in my opinion since this is cash that is already generated, but that is not booked through earnings and revenues, since the subscriptions are still ongoing and need to be delivered. Therefore, the earnings and revenues are still lagging the true cash performance. This is actually a very conservative way of booking profits. Since these are digital subscriptions paid in advance, there won't be high additional costs like you wrote in the article. The digital infrastructure almost entirely contains fixed costs

Since this digital model is highly scalable, a very high ROIC can be attained in the future when the company is well led. In combination with the momentum of the earnings and the redundancy costs taken this year and the previous year I think this stock can turn in a multibagger. However, I admit a lot of the investment case lies on the competence of the management. Note that management (Cheryl Jones and William Wells) has been buying consistently over the last years. Purchase prices ranging from 4.75p to 13p last March. Apparrently, they see enough potential in the business.

Jaywing is also a very interesting Ashcroft company to watch. Note that tax optimization is used very smartly by Ashcroft. Jaywing, Dods and the USA business of Impellam have considerable deferred tax assets which allows them not to pay any significant taxes for the foreseeable future. This substantially improves the competitiveness and the incremental ROIC of the companies.

Disclosure: long in Impellam, Dods and Jaywing

Effortless Cool

24th May '16

"snivel service" - not sure if that's a typo or not?

25th May '16

Totally intentional! (I had dealings with Dods (Group) (LON:DODS) years ago, when I think the company was a very different entity to what it is today. The whole experience was extremely frustrating! The place was peopled by very many 'splendid chaps' all seemingly related to each other through their attendance at the right college! I had to arrange a meeting. It took twenty minutes to do this because the guy I was speaking to could not get his head around the concept that 'dinner' was a meal that some people took in the middle of the day and not in the evening! They say countries get the leaders they deserve! I wouldn't put someone else's money in here with the barge pole of my worst enemy. It strikes me as an engine for sustaining the lifestyles of the unworthy.)

Small Cap Value Report (23 May 2016) - LAKE, Falling Knives, RST, DODS

Lakehouse (LON:LAKE)

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Paul Scott

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