Small Cap Value Report (28 Nov 2016) - LVD, TRAK, STR

Good morning!

Here is yesterday's report, apologies for it being late.

Lavendon (LON:LVD)

Share price: 218p (up 6.9% today)
No. shares: 170.0m
Market cap: £370.6m

Another potential bidder emerges - great excitement for Lavendon shareholders, as a second potential bidder emerges. This is the story so far;

22 Nov 2016 - a Belgian company called TVH Group N.V. (with branches worldwide, and turnover of E1.2bn in 2015) announces a final cash offer for Lavendon at 205p. This is the first thing the market knew that any takeover approach had been made, and Lavendon shares shot up from 139p to 197p.

TVH seems mainly interested in Lavendon's M.East business (where it is market leader), but also LVD's UK & French businesses are a good fit with TVH's operations in other European countries.

22 Nov 2016 - just 39 minutes after TVH's announcement Lavendon responded. It rejects TVH's offer, and declines to recommend it. The reasons given are concerns over execution risk, but more importantly that TVH had failed to gain enough support from LVD shareholders.

Lavendon reminds the market that it had recently issued a positive Q3 trading update.

25 Nov 2016 - in a very unusual move, it appears that TVH is taking a hostile takeover approach, by reporting that it has acquired 9% of Lavendon shares itself. Although some of these came from an institutional shareholder which had previously agreed to accept the TVH takeover bid. So TVH now either owns, of has irrevocable undertakings from just 16.9% of Lavendon shares - nowhere near enough to go ahead with its bid.

28 Nov 2016 - a second potential bidder enters the fray. Loxam SAS announces it has made a "preliminary approach" to LVD regarding a possible cash offer. It urges shareholders to take no action with regard to the existing TVH offer. So this looks like a blocking move, to dissuade more LVD shareholders selling out to TVH in the meantime.

Loxam is headquartered in France, and seems to operate in 11 European countries, plus Brazil and Morocco. It has turnover of E838m, so is a bit smaller than TVH, but more European-focused.

28 Nov 2016 - just 32 minutes later, LVD puts out its response statement to this latest bid approach. In it the company suggests that shareholders take no action. It points out that under the Takeover Code, Loxam has 53 days from TVH's original announcement (on 22 Nov 2016) to either announce a firm intention to bid, or to withdraw.

At 218p the market price of LVD shares is now 6.3% above the 205p level which TVH said is the maximum it is prepared to pay.

My opinion - what a fascinating situation! Obviously when 2 (or more) bidders emerge, then shareholders are more likely to get a full price in a takeover. It's striking how the 2 bidders are both apparently prepared to pay considerably more than the c.130p level where Lavendon shares seemed to have settled in the open market. What's going on then?

I've consistently pointed out in these reports that the stock market simply seemed to mis-price Lavendon shares, over the last 18 months. The price has drifted down from c.200p to c.130p, and seemed stuck at that level. This made little sense to me, as over that period Lavendon consistently issued positive trading updates, yet nobody seemed to care.

For reasons unknown, the stock market ignored Lavendon's good performance, strong balance sheet, and healthy dividend yield. So seeing the opportunity, bidders have entered the fray to take it private. I find this greatly heartening - it confirms my view that the stock market, for small caps certainly, can be wildly inefficient. Pricing anomalies often arise, which provides us with terrific opportunities to make money - by spotting these anomalies & taking advantage of them.

It's certainly required patience, and a willingness to disregard short term losses, charts, and market sentiment. However, a good business like Lavendon that is significantly under-priced, should eventually get a re-rating in some form. Either the shares will go up naturally as other investors spot the value, or bidder(s) come along and buy the company.

Personally I grabbed the profit on day 1, at c.190-195p. At the time I wondered if something else might be going on, because the price action was so strong - clearly someone was buying in the market, which you wouldn't normally expect when the market price is so close to the potential bid price (205p). So people who held back, and did nothing, are now quids in - well done to them.

I wonder what will happen next - it's going to be fascinating to watch. However my job here is done - the profit banked, it's time to move on. Mind you, even after the big recent moves up in share price, Lavendon is still not expensive. I could see an eventual takeover price of 250p+ being rational. Although for me, risk:reward is no longer favourable - as if all bids fall through, then the share price would take a big tumble. 

Trakm8 Holdings (LON:TRAK)

Share price: 126.5p (down 31.6% today)
No. shares: 32.5m
Market cap: £41.1m

Interim results, 6 months to 30 Sep 2016 - this share has really fallen out of bed - I'm not particularly surprised though. These interim figures are really poor, with adjusted operating profit down 61% to only £0.6m. That's not meant to happen at growth companies, so the share is losing its premium rating, understandably.

Checking back on my previous notes here, I was impressed with the company's full year results on 4 Jul 2016, although my conclusion was that the share price of 255p was high enough.

However, I reported here on 7 Sep 2016 that the latest announcement saying H1 profit would be below last year, and a heavy H2 weighting was expected, had spooked me. As I warned at the time, poor H1 results combined with an H2 weighting type of commentary, is often a precursor to a profit warning. For that reason, I've not been tempted to buy back into this share - I sold out in June because of general worries about Brexit.

It's quite surprising that the share price has taken such a battering today, given that the company had already told the market in Sep 2016 that H1 profit would be below last year's H1. Perhaps it's actually seeing the figures (which are ropey) that has moved some investors into sell first, ask questions later mode? Also, perhaps the H1 figures are so much worse than last year, that could also have worried some investors.

Let's have a look at the key figures then;

• Revenue up 12% to £13.2m for the 6 months
• Adjusted operating profit down 61% to £589k
• Net debt doubled to £4.4m
• H1 profit is flattered by almost £1m, due to development spending capitalised of £1,455k being greater than the amortisation charge of £481k

Overall then, it's not looking impressive at all.

What's gone wrong? - sterling weakness has hit profits by £0.5m, due to higher cost of components which are priced in US dollars.

Other factors mentioned include increased costs in sales & marketing, and engineering (related to new product development). I'm struggling with that explanation. Nobody sets out to deliver a 61% drop in profits. So to my mind, the poor result is probably more due to sales falling short of expectations. Also I suspect that maybe there's been some indigestion from the series of acquisitions made? That can cause management to take their eyes off the ball.

Ah, I've just spotted a section in the narrative which mentions delays in new product launches, which ties in my comment above about disappointing sales;

During the period we devoted much of our engineering resource on delivering three major new product lines: a next generation T10 Micro; the fully integrated 4G Camera/Telematics units; and our Connected Car solution. These products are using cutting edge technology and have had engineering challenges to overcome that have resulted in delays to our original time lines. We expect some of these new revenues to be earned in the second half with the rest now deferred into later periods.

We implemented a change in engineering leadership during the period and invested in additional engineers and the subsequent progress on project delivery has been excellent.

This is now beginning to sound a bit more encouraging. With profit warnings, I favour situations where some kind of fixable, short-term problem has caused the profit disappointment. Whereas I try to avoid profit warnings where something fundamental is going wrong with the business model. Mind you, it can often be difficult to distinguish between the two!

Outlook - the company makes lots of positive noises in the narrative. Trouble is, I'm not sure how much notice the market is going to take right now. I think it's all about actually delivering the full year numbers, not talking about it. When a share has crashed after disappointing updates, people don't tend to believe the commentary so much.

UK installed base - is still growing strongly - 177k units are now reporting to TrakM8 servers, up an impressive 18% since the last year end (31 Mar 2016).

The sales pipeline is healthy;

Largest ever pipeline of substantial new contracts in place as a result of increased sales  and marketing activity

However, this seems to be part of the problem - lumpy revenues. The company has, sensibly I think, referred to this in its full year outlook comments;

"The outcome for the full year remains subject to the timing and quantum of contract opportunities as well as the impact of exchange rate movements.

Strong delivery of our near term pipeline would deliver revenues and profits in line with current expectations, although there is a downside risk that if contracts drift into the next financial year profits would be broadly in line with last year on higher revenues.

"Subsequent years are expected to benefit from recent investments in growth initiatives and the growth of the telematics market."

That doesn't sound too bad to me. Last year the company made an adjusted operating profit of £3.9m, so it needs to do £3.3m in H2 this year to match that. That seems a considerable challenge, given that H1 was only £0.6m.

Therefore, I suspect the worst case scenario may be a good bit worse than matching last year's figures. The market is saying the same thing, with the savage share price markdown.

SaaS - note that the company says more clients are demanding a SaaS model - which involves TRAK having to absorb the cashflow impact of providing equipment. The cost is then recouped over the contract term. This is bound to put pressure on cashflow.

New products - this is where the upside could come from. People who've looked closely at TRAK have told me that it excels in innovation. So if new, blockbuster products are in the pipeline, then I'm wondering if we could be getting a buying opportunity at the moment? That's an area I need to look into. If any readers are up to speed on this, perhaps you could post a comment below?

Dividends - I think it was probably a mistake for the company to recently start paying dividends. Investors in growth companies are more interested in capital appreciation, than divis. Also, the balance sheet isn't strong enough to be paying divis, in my view.

For these reasons, I would treat the divis as being under threat. It wouldn't surprise me at all if the divi policy is changed. The board has reiterated its dividend policy, but note the subject to qualification!

Following the payment of a maiden dividend for our last financial year, which was paid in September 2016, the Board reiterates its commitment to dividend payments going forward subject to the Group's financial performance and prospects.

The Board therefore intends announcing a proposed dividend for the current financial year at the time of the announcement of the Group's final results in July 2017.  

Therefore, expect a divi if the current year works out alright, but don't be surprised if they pass the divi if the full year results disappoint.

Broker forecast - FinnCap has reduced its EPS forecast from 15.7p to 9.9p this year. This is based on taking the more prudent view on contract wins. I'd be amazed if the original 15.7p forecast is achieved, as that would rely on several big contracts being closed by year end, which is only 4 months away now.

Balance sheet - isn't great, but not alarming. NTAV is only £1m, once you write off intangibles, so a rather thin capital base. I think the company missed a trick by not raising more equity when the share price was riding high a year ago, peaking at almost 400p.

I'm not keen on rising debt here either, but £4.4m net debt is hardly a disaster.

My opinion - I have to eat my words of 4 Jul 2016 about the bear case on TRAK being flimsy. Since then the share price has halved, and to date bears have been proven right that the share was overvalued at the time.

However, what happens in future, who knows? Telematics is a great growth area to be in, and TRAK seems to be a genuinely innovative company in that area. I'm not convinced that the acquisitions have added value, but that remains to be seen - it's all about new products which will incorporate technology from some of the acquired companies.

I'm tempted to start buying a few shares in TRAK. However, given that experience has shown my falling knife catching approach usually fails, then maybe it's best to avoid it for now?

Ed's webinar clearly showed that buying after profit warnings is a poor strategy overall, and that is very much at the forefront of my mind. Watching from the sidelines may be the best approach, as I can't help wondering whether there's another profit warning coming in H2 - given that the target is now set so high, after a lousy H1.

Overall though, I remain of the view that, longer term this is a very interesting company. It's having a rough patch at the moment. My hunch is that the company will recover in due course, but possibly not in time to save the full year results? Who knows, we'll have to wait & see. On balance I'm probably going to remain on the sidelines for now.

Stride Gaming (LON:STR)

Share price: 242.5p (down 1.8% today)
No. shares: 67.4m
Market cap: £163.4m

Results y/e 31 Aug 2016 - a fellow guest at Mello mentioned this company to me last week, saying it looked interesting & was good value.

The company spent just over £70m on 3 acquisitions, and now claims to have 10% of the UK market share in online bingo. I always thought the whole point of bingo was that it's a social experience? So it's surprising to hear that it's now doing well online too.

Adjusted EPS has come in 8% up prior year pro forma figures, at 21.2p. That's above the 18.6p forecast shown on the StockReport. The PER is 11.4 based on the reported actual result. That seems a fairly modest valuation, although online gaming companies don't tend to command high valuations, because things change so rapidly, and there's so much competition.

Dividends - total 2.5p for the year. Not madly exciting, but at least it pays something.

Outlook - sounds OK. Mentions more acquisitions, which could be a problem in that it's likely to mean dilution for existing shareholders when more equity is raised.

My opinion - it looks alright, but online gaming isn't a sector that interests me.