Small Cap Value Report (24 Feb 2016) - GRA, TSTL, MCB

Good morning!

Grafenia (LON:GRA)

Share price: 8.5p (down 16.1% today)
No. shares: 46.1m
Market cap: £3.9m

Profit warning - I hadn't realised that the market cap had dropped this low, so will stop reporting on this trade printing company from now on.

Today's update explains the structural problems operating in this sector, and what makes it such an unattractive place to invest;

Our markets have never been more competitive, with established players, aggressive pricing from new European entrants and domestic commercial printers diversifying into the trade print sector.  We are continuing to experience downward price pressure, which has intensified in the second half of the financial year. To combat this, we have increased our promotional activity, incentives and selective discounting.

Note how competitor Tangent Communications (LON:TNG) recently said it is leaving the stock market - with a takeover bid from management, although I note there was a higher competing offer subsequently announced. Both these companies are now too small, and struggling, to justify being listed. So I suspect Grafenia may not remain listed for much longer - the threat of de-listing can itself be a time-bomb under the shares, so personally I would be tempted to ditch them if I held, just to be on the safe side.

Due to the above factors, there's a nasty impact on profitability;

As a result of this and the challenging trading conditions, it is the Board's view that our full year results will be significantly below current market expectations.

Profits have been on a steadily downward course for the last 6 years, so continuing the trend, it looks as if y/e 31 Mar 2016 won't be much above breakeven in all probability.

Outlook - there is some more upbeat-sounding commentary on initiatives to improve performance, under the new CEO (who incidentally has been buying shares, and now holds just over 2% of the company).

Balance sheet - I've checked back to the last interim report, and the balance sheet looks alright to me. So this is not a financially distressed company, in my opinion.

My opinion - the company operates in a horrible, low margin, highly competitive sector. With profits trending down to zero, there's little to attract investors.

My main worry is that the company could well de-list, now that it is really too small to justify the costs & hassle of a listing. That would be an instant 50% off the share price if it happens. Why take that risk?

Historically Grafenia has paid very generous dividends, but those are also falling - the interim divi was halved from 0.5p to 0.25p. So it's probably best not to place any reliance on receiving more divis.

The shares are now just a punt on the new CEO turning the company around, and there are some interesting comments in the narrative today about new products & services. So who knows? There might be life left in this company, but it's really one for special situations investors only at this stage, due to the high risk of a de-listing.

Tristel (LON:TSTL)

Share price: 125p (down 14.0% today)
No. shares: 42.2m
Market cap: £52.8m

Interim results to 31 Dec 2015 - this is quite a crowded trade - shares in this manufacturer of infection control products are popular with private investors, and rightly so because the company has demonstrated a good track record of profitability, and growth. However, the trouble with crowded trades, is that the shares can end up being priced to perfection - leading to disappointment on results day, as we've seen today.

Revenue is only up 8% to £8.0m. That's not enough growth, for a share on a growth company rating. Growth in the UK market seems to have stalled. Overseas growth was better, at 20%. The company's 10 year growth trend is 18% p.a.

Gross margin was excellent, rising from 69% to 71%

"Very tight control on costs" led to profit before tax and share-based payments rising 36% to £1.5m.

Overall then, this trading performance doesn't inspire. Growth slipping from 18% to 8% is clearly disappointing, even if short term profitability has been maintained through cost control.

Share-based payments - this has clearly spooked some investors, and I don't blame them. A £1,015k share based payments charge is booked in H1, which consumes two thirds of adjusted operating profit, taking actual operating profit down to only £455k, down 55% on H1 LY. This just doesn't look good, whatever the reasons.

Balance sheet - excellent, no issues here at all. The company has £4.3m in net cash, or 10.2p per share, which is worth bearing in mind when valuing the shares.

Outlook - this is another fly in the ointment, in terms of short term sentiment (if not long term value);

Whilst revenue growth in the period was solid at 8%, it was below our ten year long trend of 18% per annum.  However, we have many irons in the fire - both in terms of geographical expansion and new products - which will generate further revenue growth in the years ahead.

Margins, costs and cash are all being managed with strict discipline, and growth in profits and earnings per share are satisfyingly on target. Whilst the second half of the year is typically more profitable than the first, with the increased investment in new products and the 510(K) submission we expect a more equal split this year.

The outlook for the Company continues to be very promising and we remain confident for the full year.

It's good that the company is managing investor expectations down for a more equal split of profits between H1:H2 this year. Those short term costs could of course generate stronger future growth - the US market in particular is the big prize the company is hoping to break into.

Broker forecasts - The current year sees a forecast of 5.2p adj. EPS (revised down 2% today). No particular problem there. However, the 2016/17 forecast has today been revised down a whopping 20%, to 5.6p. (broker figures quoted are from FinnCap. Note that Equity Development has also issued revised figures today, available on their website).

Personally I wouldn't be comfortable with a PER over 20, so that equates to a share price of 112p, or about 10% below today's already reduced price.

My opinion - the increased costs of gaining US approvals doesn't concern me that much, because that could turn out to be a very good investment for future years.

However, the fairly pedestrian 8% revenue growth (suggesting that maybe the main UK market might already be saturated?) is more of a concern. Growth companies have to grow reasonably fast, to justify a rich PER. The growth here isn't enough at the moment.

Add in excessive share-based costs (which we can't just ignore - it's another form of employee remuneration - so that is a very real cost), and I can understand why some investors took fright this morning.

For me, the price is a bit too high now, given fairly uninspiring results - OK adjusted profit was up nicely by cost control, but it will need stronger top line growth to get much further. I appreciate though that long term holders of the stock might be perfectly happy to sit and wait for (hopefully) US approvals to come through - later in 2016 possibly (EDIT: likely to be mid-2017, according to a note today from Equity Development) - which could propel the shares upwards again.

So overall, I would say a bit disappointing short term, but the longer term upside still looks good. Also note that the dividend yield of over 2% isn't bad for a growth company - so investors are at least being paid to wait. Note that a 3p special dividend was paid in Aug 2015 too, a healthy sign.

Webinar details - here is registration link for a webinar with Tristel management tomorrow, starting at 1:15pm, so best to sign in shortly beforehand.

Also, please see the comments section below, where Tristel's PR - Paul McManus - has helpfully posted details of a meet the management event (also tomorrow) in London. It's great to see a company reaching out to engage with private investors both in person, and through a webinar, especially after results that have clearly disappointed somewhat. Let's hope more companies follow this lead - I'm very keen to encourage this kind of engagement by companies and private investors.

McBride (LON:MCB)

Share price: 167.4p (up 8.3% today)
No. shares: 182.2m
Market cap: £305.0m

Interim results to 31 Dec 2015 - there's been a decent move up in share price today, so the market must like these half year results from this manufacturer of household & personal care products.

I last reported on the company here on 8 Sep 2015, noting that its results for y/e 30 Jun 2015 were good, and that a convincing turnaround was underway. Although the balance sheet displeased me, with too much debt, and a pension deficit.

Today's results look really good. Bear in mind that the company is radically reducing the number of product lines it makes (by about 30%), in order to concentrate on efficiency, and higher margin products. That strategy is clearly working (remember these are just 6 month figures);

Revenue - down 5.6% to £344.1m, but up 0.4% in constant currency. That's fine, as you would expect revenue to be flat or falling during this kind of restructuring.

Adjusted operating profit - up 40.8% to £17.6m (up 57.1% in constant currency) - a very convincing result.

Adjusted operating margin - up 3.4% to 5.1%, again an excellent improvement, really impressive for this type of business. It's unusual to see such a big leap in this sector. Perhaps there are favourable raw material price falls in play also? Note that the company is targeting further improvements, to reach 7.5% margin eventually.

Broker forecast - a key broker has upgraded this year's EPS from 10.1p to 10.9p, and 2016/17 also upgraded from 12.8p to 13.6p.

Net debt - has reduced by 6.6% in the last year, but is still substantial at £86.3m. As usual, management say that their level of debt is conservative relative to earnings. No it isn't!!

Gross bank borrowings of £114m seems a lot to me, compared with forecast £28m profit before tax this year. Although given the improving trading, I'd say net debt of £86.3m overall doesn't look a particular problem. Bear in mind though that the bank might take a very different view when the next credit crunch happens - and bank share prices are telling us that maybe it's already happening, or in the pipeline? So I'm wary of getting into shares of any highly indebted companies right now.

I like that McBride states what it's bank covenants are, and confirms that it is "comfortably within" these. So on balance the situation looks alright, but it's definitely not conservative, as management repeatedly, and wrongly (in my view) state.

The Group's funding arrangements are subject to covenants, representations and warranties that are customary for unsecured borrowing facilities, including two financial covenants: Debt Cover (the ratio of net debt to EBITDA) may not exceed 3:1 and Interest Cover (the ratio of EBITDA to net interest) may not be less than 4:1. For the purpose of these calculations, net debt excludes amounts drawn under the invoice discounting facilities.  The Group still remains comfortably within these covenants.

Pension deficit - the accounting deficit is £30.7m. However, the triennial actuarial deficit (which are usually higher) is £44.2m. A revised deficit reduction plan has been agreed, and this has resulted in a big increase in contributions by the company, from £0.4m p.a. to £3.0m p.a. with effect from 31 Mar 2015 (so already in place).

Whilst not necessarily a deal-breaker, in terms of whether or not to buy the shares, an annual cash outflow of £3m p.a. is actually quite material, as it's money that could otherwise have been paid to shareholders in dividends. So investors definitely need to adjust their valuation of the shares to reflect pension deficit payments.

Expectations were that pension deficits would sort themselves out when interest rates rose. Yet here we are, 8 years on from the GFC, and if anything, expectations of rate rises in future seem to be disappearing off the horizon. So pension deficits are likely to remain a problem, or get worse, as in this case.

Outlook - very pleasing;

For the second half year, current expectations are for constant currency underlying revenues to be slightly lower year-on-year, in line with market conditions.

The start of the impact from the customer choices project, planned during our first half year, is expected to reduce second half revenues by an additional £6.0 million.

The ongoing actions of our "Repair" phase are expected to provide further progress in profitability, despite the backdrop of lower revenues.  As a consequence, the Board is now expecting full year results to be modestly ahead of its previous expectations. 

So modestly ahead - hence the broker upgrades today. Excellent stuff, really impressive, this all smacks of very good management, and gives confidence in the company.

My opinion - it's not something I would buy shares in, as the balance sheet is too weak, and being a supplier to supermarkets means that profits are always going to be squeezed. Sure, the company has done a terrific job in turning itself around, but whether the 5%+ operating margin can be defended, against relentless customer attacks (remember that supermarkets generally are making hardly any money at all right now, so they are desperate), is the big question mark.

Overall though, hats off to management for executing a very impressive turnaround, that has been been reflected in a buoyant share price. Is there more upside? Possibly. Investors who don't concern themselves with balance sheets might decide to chase the shares up to the 200p level in due course? I could see that happening. I'm usually too cautious with this type of share, so there may well be more upside to come.

Note that the Stockopedia black boxes like it, with a StockRank of 93.