Small Cap Value Report (29 Oct 2015) - EGS, OMG, MTEC, SOLI

Good morning!

(I'm running late today, so will keep updating this article this afternoon, after lunch)

I enjoyed the latest small caps broadcast from Share Radio, with my friend David Stredder giving his views on a number of stocks. Of particular note, as ever, is the topic of Director greed. This time, my attention has been brought to the ridiculous remuneration of the CEO at eg Solutions (LON:EGS) who has plundered this tiny, and usually loss-making company for extraordinary levels of remuneration over the years.

I've looked at the last few Annual Reports, and extracted the following key data;

Adding up those figures, in the last 4 years this company made a total loss of nearly £1.4m, and paid its CEO £1.65m! You have to ask, what planet is this CEO on?! No wonder the company had to do a £3.2m Placing last year, to replenish its bank account - as the CEO's emptied it basically!

I am told that at a recent ShareSoc meeting, where the questioning can be tough, this CEO retorted to a question about her remuneration by saying, "If you don't think I'm worth it, then I don't want you as a shareholder!". Unbelievable.

So this stock is going on my Bargepole List as a result. It's always worth comparing Director pay with profits. It can then become alarmingly clear whose benefit the company is run for - and it's not shareholders, that's for sure.

There's nothing worse than management who use a small, loss-making company as a personal piggy bank. As an aside, it's a pity that Director expense accounts are not disclosed in Annual Reports, as I'm certain there are some horror stories there too at some companies - I've been told about some small cap Directors who enjoy lavish entertaining, first class flights, posh hotels, etc., all on the expense account.

I do wish shareholders would step up, and exert better restraint/control on Directors. No wonder we have so many corporate scandals, excessive pay, bonus culture, etc. The managerial class is totally out of control! I don't think Directors understand how angry private investors are getting about executive greed.

OMG (LON:OMG)

Share price: 41.9p (up 1.6% today)
No. shares: 117.4m
Market cap: £49.2m

Trading update - a solid update from this software specialist;

Vicon and Yotta have traded well in the second half, therefore overall the Group's full year revenue and adjusted profit are expected to be in line with market forecasts.

The Group has ended the year with a strong cash balance at £11.7m (FY14: £7.6m).

Market forecast is for 1.4p EPS for y/e 30 Sep 2015, so that means a PER of 29.9. However, if you deduct the cash of 10.0p per share, then the cash-neutral PER drops to 22.8.

Whilst that may look high, the interesting thing about this group of companies, is that performance has historically been harmed by one heavily loss-making company within the group. The losses from that company are now being eliminated gradually, so a much more profitable group should emerge.

EPS is forecast to rise substantially, to 2.7p in the new financial year, which would give a cash-neutral PER of only 11.8 - not bad for an interesting technology company.

My opinion - I've held this share before, and have been meaning to look at it again. It's on my potentially interesting list, so it's worth a look I think.

Matchtech (LON:MTEC)

Share price: 505p
No. shares: 30.4m
Market cap: £153.5m

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

Results y/e 31 Jul 2015 - as usual, I'm reporting my initial impressions on the results statement. There isn't time for me to plough through all the detail & narrative.

The key things I look for, are positive here. It's reported 45.3p adjusted basic EPS, reduced to 43.3p at the diluted (for share options) level. I'm not sure which basis the broker forecasts are calculated on, but the consensus is 42.0p, so the actuals are a beat at both levels.

Note that MatchTech did a substantial acquisition in the period, almost a merger really, of Networkers. The figures today only include 4 months trading from Networkers, and since it's decently profitable, that means there will automatically be another jump in profits/EPS for the next year, ending 31 Jul 2016, since a full 12 months of Networkers will be in those future results.

Forecast EPS of 47.9p looks a bit light to me, I'd be disappointed if the result is under 50p for the new financial year. So that puts this share on a fwd PER of only 10. That looks excellent value to me, for a good quality recruitment company, with some scale, and a sound balance sheet.

Dividends - very nice, with a forward yield of 4.6%.

Net debt - has risen considerably, due to the Networkers acquisition (which was part-equity funded, part-debt) to £33.6m, but in my opinion this is a reasonable level of debt, which does not concern me at all.

Balance sheet - staffing companies tend to have rather weak balance sheets, but this is better than many others in the sector.

Debtors seems a tad high, at £98.9m, but I think that's probably because annualised turnover is higher than the £502.3m reported turnover, due to the Networkers part-year effect.

Working capital (net current assets) is strong at £55.4m, so having £28.6m of long term bank debt to part-finance this looks acceptable. The current ratio is very good at 2.16.

Outlook - the CEO certainly sounds upbeat! Still, in a sales-orientated business, I like enthusiastic & positive management;

The 2016 financial year has started well in-line with management's expectations, with many buoyant markets across the Group's core sectors. The Group is realising cost synergies from the combination and early signs of sales synergies are coming through.

Looking ahead, we regard all our international locations to be a huge opportunity to advance our activities in local and regional markets across the world and are planning for substantial growth over the next few years.

We believe the high engagement levels of our exceptional people will continue to underpin the lasting loyalty of clients and candidates alike, delivering enhanced shareholder value and improved returns.

I am optimistic about the future prospects for the Group and look forward to strong growth in all our markets based on the truly global scale and the greater brand awareness that comes with leadership status."

My opinion - I already hold, and am buying some more today, it just looks a good business, reasonably priced, with maybe 20-30% upside on the current price, based on things as they stand now.

With management also optimistic about the future, and planning for substantial growth, then this strikes me as an excellent GARP share.

Why is the price depressed? I have a theory that it's possibly due to an overhang of sellers from former Networkers shareholders, who might still be taking advantage of greater (but still poor) liquidity to exit, for whatever reasons. I see such overhangs as a buying opportunity - if people want to sell me their shares at an attractive price, that's absolutely fine.

Note the high StockRank of 91.

The share price seems out of kilter with the positive results & outlook, unless I've missed something?

Solid State (LON:SOLI)

Share price: 530p (down 27% today)
No. shares: 8.4m
Market cap: £44.5m

Profit warning - a bombshell dropped on shareholders today at 1:15pm, and the shares have been sinking ever since. My commiserations - it's an occupational hazard for small cap investors I'm afraid - we all get hit by profit warnings from time to time.

It's just a question of weighing up the pros and cons, and then deciding what the best course of action is. The smallest shareholders have the luxury of being able to ditch their position immediately, but medium to large holders can't do that, due to liquidity restraints.The nightmare scenario is if a large holder decides they want out, and slams the price down repeatedly until they are out, which can take months with some companies. Then it takes time for confidence to return. Buying immediately after a profit warning like this one is nearly always a mistake, but often existing holders do so, perhaps in a subconscious attempt to arrest the fall in share price?

So what's gone wrong? Two things - general market softness, and a specific large contract being delayed.

Firstly, the company comments on H1, which sounds as if it's gone alright;

"Despite some softening in Solid State's markets as widely reported by industry peers, the Company has made a satisfactory start to the year. Results for the six months to 30 September 2015 are expected to show turnover and profits before tax of approximately £21 million (2014: £17.13m) and approximately £1.50 million (2014: £1.55m) respectively.

But H2 looks as if it will now disappoint;

"Following a customer meeting on 27 October 2015, delivery expectations for a material contract have been varied which will impact the second half of the year.   The contract is high profile and a high priority for the customer and Solid State is confident that it is fulfilling its obligations to the customer.

"The Board continues to expect a second half weighting in the underlying business however, due to the contract variations and general market softening, it now anticipates that revenues and profits in the second half will be significantly lower than expected and, as a result, revenues and profits for the year as a whole will be below market expectations."

Revised forecasts - the house broker has put out revised forecast figures for the current year (ending 31 Mar 2015) as follows;

• Turnover down from £57m to £44m
• Profit before tax down from £5.3m to £3.2m
• EPS down from 56p to 36p
• Dividend from 20p to 12p (flat vs LY)
• 2016/17 forecasts withdrawn

Clearly then, this is a big miss, which would mean that EPS for this year would be little changed from last year's 34.3p.

Valuation - it's a matter of opinion how you value the company now. The prudent route would be to take revised forecast EPS for this year (of 36p), put it on a prudent PER (of say 8), and that arrives at a share price of 288p, which is about another 45% drop from where we already have fallen to.

Other investors might be prepared to pay a higher multiple, on the basis that this year had an unexpected wobble, and next year might be better. So perhaps put it on a PER of 10-12 times c.50p estimated EPS for next year. That would justify a share price of 500-600p. We're currently at the lower end of that range, at 530p at the time of writing.

My opinion - I'm trying to avoid contract manufacturing businesses, precisely because things can go wrong with contracts, and you suddenly lose 30-50% of your money when the company warns on profits. Companies with some degree (the more the merrier) of recurring revenues are much better bets, in my view.

I warned in my report here on 7 Jul 2015 that at 855p this share had become very expensive on the historic figures, so achieving forecast growth in earnings was vital.

More clarity is needed from the company, as to how this big contract is going to pan out now. It might be all systems go for next financial year, who knows? Investors do however need to think about what multiple is appropriate for a company with lumpy, unpredictable orders. I think a PER of about 10 is probably sensible, so a share price of say 300-500p perhaps?

It's worth noting that there was suspicious-looking selling for about 6 weeks prior to this profit warning. Were they insiders bailing out?