Small Cap Value Report (29 Jun 2016) - IGR, BRAM, ZZZ

Good morning!

Thanks for all the positive feedback about yesterday's report - it's good to know that people find these reports useful.

Brexit

There has been far too much partisan nonsense about this issue, which I largely ignore, because it's at best a waste of time, or worse still, misleading. So for me, it's now all about listening to experts, and trying to work out what is most likely to happen next.

There was a fantastic programme on Radio 4 yesterday, where 3 professors in law discussed how Brexit might work out in practice. It also clarifies some of the complex issues, which I found extremely helpful. Highly recommended - the iplayer link is here.

A consensus seems to be developing that the most likely outcome is for the UK to go down the Norway route - i.e. full access to the single market, for a fee. I'm not interested in discussing the rights or wrongs of this. The only issue for our purposes here, is how it might affect our shares.

Going down that route would undoubtedly be positive for shares, and I think this is what's driving the current rally - i.e. a realisation that the world is not going to end, and business will probably continue pretty much as normal.

Set against that, as I mentioned yesterday, the economy is likely to slow down in H2 of this year. So plenty of profit warnings to come, for UK-focused companies I think. If the market thinks that a prolonged recession is likely, then the price drops will be brutal. However, if the market thinks a slowdown might be short-lived, then it will start to look through poor current performance, and factor in a recovery next year. We'll have to keep monitoring events closely to determine which is happening.

IG Design (LON:IGR)

Share price: 163.5p
No. shares: 59.3m
Market cap: £97.0m

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

Results, y/e 31 Mar 2016 - I read these numbers on my iPad in bed earlier, and was impressed - a good solid set of figures, and reasonable outlook comments too.

Adjusted fully diluted EPS is up 15% to 13.2p.

The PER is 12.4 which seems reasonable to me.

We have to be very careful with PERs at the moment. Since there is considerable economic uncertainty, we cannot just assume that earnings will continue rising in a nice progression, or even hold level. If companies see a slowdown in demand, this has a leveraged effect on profits (as overheads are usually fixed, in the short term, at most companies).

Therefore the absolutely key question to ask, for every company, is this: "are profits sustainable?"

I think it's also vital to look at the geographic spread of where companies generate their profits. A spread of geographies can smooth out results, and reduce vulnerability to forex movements such as we are seeing at the moment.

The adjustments to earnings here relate to exceptional items, and LTIP charges. I think that's OK. As a friend pointed out recently, if you're using fully diluted EPS then you're already taking into account dilution from share options. So it's logical to strip out the cost of options from earnings, otherwise you would be double-counting the cost of options. That sounded persuasive to me, although I've not crunched the numbers to fully satisfy myself on this point. Do any number-savvy readers have any view on this?

Turning to the balance sheet, net debt has come down considerably - down 40% to £17.5m. This is 1.0 times EBITDA - a comfortable level.

Overall I would describe the balance sheet as satisfactory.

Referendum comments sounds OK;

Whilst it is too early to know the full long-term impacts of the UK's exit from the EU, the Board feels that Design Group's diversified global portfolio of activity, together with our new global funding arrangements, means we are well positioned to manage the effects, and this outcome of itself results in no material change in outlook for the Group's near term financial results or future growth prospects. 

There are also some very interesting comments about forex, which I think has wider relevance. Note that companies are not passive when it comes to forex. As well as hedging, they can re-engineer products to mitigate forex headwinds;

Additionally, the relative strength of the US dollar against other currencies can materially impact purchase prices out of China. This is most noticeable in the weakness of the euro and Australian dollar and our European and Australian businesses are finding their margins are squeezed through substantial foreign exchange headwinds on products bought in from the Far East.

Balanced against this, we have seen the renminbi weaken against the US dollar and thus it has been possible to negotiate lower prices to mitigate at least in part. It is also a feature of our business that we innovate, invest and commercially redesign product to combat this effect but this can take more than one season.

Of course, as I write, the risk of Britain's exit from the European Union is particularly high profile. Our business would undoubtedly be impacted by this but our global presence and diversity is again our protection in this regard. The principal impact would manifest itself through movements in foreign exchange rates as our European businesses largely sell in the European markets with limited export from the UK to the European Union or vice versa other than one major customer where existing hedging for the 2016/17 season would provide protection.

Weaker sterling against the dollar would make those goods we import from China more expensive but again, we are well hedged into 2016/17 allowing us the benefit of time to see macroeconomic considerations settle and for us to re?engineer our product to hit required price points.

Meanwhile our earnings from our US and European businesses would be translated at more favourable rates.

Conversely a substantially stronger sterling would result in weaker translated overseas earnings but provide us with a platform for cost efficient imports into the UK, still our largest business segment.

As we fund the working capital needs of our overseas businesses in local currency, the translation impact is in any event less pronounced than otherwise would be the case.

Overall then, this group seems to have a good setup, with some natural hedges, whereby adverse forex movements one way are partly offset by an opposite effect elsewhere within their business. That's reassuring.

Outlook - unless I've missed it (which is possible, as the narrative in this RNS is very long-winded, and the very small font makes it difficult to read) I can't find anything specific about current trading or outlook. Just lots of positive-sounding waffle.

This is the closest I can find to an outlook statement;

The Group delivered another very strong year, with all metrics well beyond our initial expectations. We are still building further foundations for success, investing carefully and creating new competencies that will power our continued growth in profitability for many years ahead.

Net debt and earnings per share performance were especially pleasing and continued outperformance in the arena of cash management is providing the Group with additional flexibility and options to create value for shareholders in the future.

My opinion - I like it, and hold some personally. I don't see any particular reason to rush out and buy more, but am happy to continue holding for the foreseeable future.

Brammer (LON:BRAM)

Share price: 69p (down 52% today)
No. shares: 129.4m
Market cap: £89.3m

Trading update (profit warning) - if a share price is down c.50%, then you know there's something badly wrong. A normal profit warning hits a share by about 30% typically. Although in these jittery markets, there can be more extreme reactions.

I've just re-read my previous reports on Brammer, to refresh my memory. I was underwhelmed by the share when I reported on its profit warning here on 15 May 2015, and another profit warning which I reported on here on 11 Nov 2015. 

The company has made it a hat-trick today with another, more serious profit warning.

Weak sales, and various other factors mean the group is now trading not much above breakeven - bearing in mind that this is quite a big group (turnover of £717m last year);

...As such, we now anticipate Group adjusted profit before tax in the first half to be below expectations at approximately £5m.  As a result of this reduced level of profitability, the Group will be close to its net debt/EBITDA bank covenant¹ at the period end.

It's the bank covenant issue which is the big deal. I mentioned in yesterday's report how the key banking covenant is net debt:EBITDA, and when profits fall sharply, this can then put highly indebted companies into a whole world of trouble - fighting for survival basically.

Remember that debt ranks ahead of equity. So if an indebted company cannot service its debts, then the equity is wiped out, and holders of the debt end up owning the company. The only way to prevent this happening, is to do an equity fundraising, or negotiate relaxed terms with the debt provider.

We saw recently the same problem at Sepura (LON:SEPU) - management borrowed too much from the bank, and then got into serious difficulties once trading deteriorated. They had to do a deeply discounted fundraising at about one sixth of the share price before problems began.

I think we're likely to see wave after wave of highly indebted companies getting into trouble in H2 of this year. When time permits, I'll compile a list of potential shares to short, to take advantage of this opportunity. At the very least, I think this is a time to throw out any shares we have in highly indebted companies. They're an accident waiting to happen now, with an economic slowdown on the cards, in my view. Why expose yourself to that risk?

Going back to Brammer, they are taking sensible action;

In the light of current market conditions, we are reviewing the Group's trading outlook for the year as a whole, and the UK in particular (where recovery plans are still at an early stage).

We are taking measures to improve profitability and strengthen the Group's balance sheet. Our stock reduction programme continues to make progress and is still expected to deliver a £30m reduction by the end of September 2016. 

 That's actually quite encouraging.

Net debt was £104.3m at 31 Dec 2015, so if inventories are run down by £30m, then that should reduce net debt to a more manageable £74.3m. Also I imagine the group is probably trying to extend supplier payment terms too, to squeeze out more cashflow, and reduce bank debt.

The Board is now reviewing whether it is appropriate to declare an interim dividend in respect of the half year and will provide a detailed update on its revised expectations for the full year at the time of the interim results announcement on 4 August 2016.

I think it's a given that divis are now likely to be stopped altogether. So treat this like a non-dividend paying share for the time being. That's the only sensible thing to do, to reduce debt.

I mentioned in my previous reports how the balance sheet was too weak, and debt too high, and it's coming home to roost now.

My opinion - In my view, an equity fundraising is now quite likely. Although I think they could probably get away with a relatively small equity fundraise (say c.£30m) to pacify the bank. Therefore this share is not a basket case, in my view. It might even be an opportunity, possibly?

I'm tempted to have a dabble, as this looks a salvageable situation. If a turnaround is executed without dilution, then there could be decent upside here. However, on balance, with the company close to breaching bank covenants, I'm wary of getting involved. Probably safest to leave it alone for now.

Snoozebox Holdings (LON:ZZZ) - I've a quick look at the numbers, but am afraid I think it's toast. Nice idea, but it hasn't worked. Management seem to be giving it one last go, cutting costs, and focusing on semi-permanent installations. The equity is clearly worth nothing now, with NAV down to only £1.9m, and huge losses still being incurred. As a listed entity, it's game over fairly soon, I think.