Small Cap Value Report (3 Nov 2016) - VCP, IGR, GBG
Good morning!
Exchange rates
I've been pondering this issue a lot lately. On balance, I'm beginning to wonder whether myself & other commentators might be over-reacting a little? Certainly prices of most things will rise, due to weaker sterling. However, I was reading an article yesterday saying that a lot of larger retailers have hedged their currency forward by a considerable amount - e.g. Debenhams is 1-2 years hedged apparently. So maybe inflation could be more gentle & gradual than I previously thought?
Also, if you look at the long term chart of sterling against the dollar, we saw a huge devaluation from mid 2008. Sterling dropped from about $2.00 to a low of around $1.40. That caused a surge in inflation for a while, before it came back down again. It's no wonder that the British manufacturing sector was hollowed out, with sterling having been overvalued for so long.
A burst of inflation could be seen as a good thing, as it will scrub off some of the national debt, and private sector debt.
I think smaller retailers will feel the pain most, as their larger competitors will be cushioned from the impact of higher prices through their currency hedging. Also the bigger companies have more leverage to resist price rises from suppliers.
Breaking news! The Government has apparently just lost a court case over invoking Article 50. This apparently could delay Brexit, which has given sterling a boost - it's bounced a little in recent days to about $1.24.
Victoria (LON:VCP)
I had a fascinating meeting yesterday with Geoff Wilding, the former investment banker who has been instrumental in Victoria Carpet's remarkable renaissance over the last 4 years. He gave me a masterclass in how to do a successful buy & build (he's done 6 of them, in various sectors, including Victoria, so is worth listening to).
His 4 key points were;
1) Don't buy turnaround situations. Target companies must already be well run, and profitable.
2) Retain existing management - lock them in with earn outs over 3-4 years, to keep them motivated & involved.
3) Buy companies which have modern factories & equipment - this minimises capex requirements in future.
4) Management have to be honest & trustworthy. If in any doubt, walk away.
He pointed out that many private companies have very inefficient balance sheets, as owners often focus on profitability, but not ROCE. So there can often be surplus assets on the balance sheet, which is great for an acquirer - cashflow can be freed up from squeezing inventories & debtors, selling freeholds, etc.
Carpet-making is quite simple, and should generate good cashflow, if company is well managed. So quality of management is the critical success factor - "any idiot can run a tufting machine, but not everyone will make money from it!" The machines are big, but only cost about £400k each. So you can generate a lot of revenue & profit from relatively modest capex. The good cashflow is one of the reasons why Warren Buffett bought a large carpet manufacturer.
I really like this company, but aired my concern about its debt, and relatively weak balance sheet, and what impact this might have in an economic downturn. He showed me a graph which depicted the cost structure, and most costs are variable, or semi-variable. Therefore, carpet-making has little operational gearing - so profits should be fairly safe, even in a recession, as most costs would reduce (perhaps after a delay) in line with reduced revenues.
He doesn't sound at all worried about debt - saying the business has scope to increase its borrowings if the right deal came along. If debt ever did become a problem, he would just switch off acquisitions for a while, and the strong cashflows would repay debt fairly quickly.
By the end of the meeting I was regretting having recently sold my VCP shares! I only sold them as part of a general portfolio pruning, due to margin calls after a few other things had gone wrong. It's certainly back on my buying list, but I'll bide my time until after the US Presidential Election is out of the way - as that seems to be causing some general market turbulence at the moment.
I wish there were more hours in the day, as I'd like to meet more management - you learn so much from discussing the business with its CEO. Good news also - as I was impressed with the company, I invited Geoff Wilding to do an audio interview with me for Quality Small Caps after the next set of results, due out later this month. He said yes, so I'm looking forward to doing that, and will soon be soliciting your questions for me to ask him.
Geoff Wilding is an engaging, and interesting New Zealander - and pretty direct - so you get straight answers to questions. It amused me that a couple of times he paused mid-sentence, frowned, then said, "No, I can't say what I was about to say, I'll get myself into trouble!"
IG Design (LON:IGR)
I see this share has fallen a lot recently. A month ago the share peaked at 309p, but has since dropped to 240p, on no news. So I've been looking again at the share, to see if it's worth buying back into - I sold mine at 280p after it shot up after being tipped in a magazine, as it looked fully, or even over-valued to me.
On revisiting the numbers at 240p per share, I can't say that it looks cheap. Given that there's a fair bit of debt, the forward PER is over 15, and the dividend yield is only about 1.5%. Hardly a bargain, even after the big recent fall.
This is the problem with a lot of small caps right now - many things have risen unrealistically high on momentum, leaving the fundamentals looking stretched.
GB (LON:GBG)
This is another share which has looked very expensive for a while.
The share peaked at c.350p in September, but has fallen sharply to 239p now, despite an in line trading update on 20 October. The downside could be explained by the change in CEO, although that was announced a week earlier, and didn't move the price much.
The only downside I can see is that a UK Government contract is proceeding more slowly than anticipated.
So having scrubbed off all of this year's share price gains in just a few days, is this share now good value? Not really, no. It's still rated at 22 times forward earnings, and a paltry 1% dividend yield (although people don't buy growth companies for the yield).
So this is perhaps another example of an overvalued company correcting somewhat in price? It's nowhere near bargain territory though, despite the big sell-off. That's the problem with growth companies at the moment - they're far too expensive in many cases, leaving no room for any disappointments.
There are loads more trading updates out today, but I didn't get round to reporting on them. See tomorrow's report for a catch up on the backlog.
Regards, Paul.
(usual disclaimers apply)
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28 comments
re GBG, 287k share options at an exercise price of 2.5p, with a fair value of 300.5p. To me, this is like giving founders' profits to hired execs. Maybe I mis-understood?
Also, share option costs are excluded from the operating profit headline figures. What usefulness then are the headline figures.
It's a shame - otherwise I would consider buying this company's shares.
I have just bought some IGR - a first half position - so clearly do not agree with the comments on this one. I have the company on about x14 for the year to march 2018 with around 15% growth in reported eps for this year and next. My main concern is the exposure of its UK sales (around 30% of the total) to the feeble sterling price. It imports a fair share from its own operation in China, I believe on a dollar pricing basis, but against this sales in the US (approx 40%) will be boosted by the purchase of Lang this year. Net debt fell from £25mn to £15m in the year to March 2016, operating cash flow was better by 8% and reported 'real' eps grew by 23% to 12p. The current boss took over an ailing company in 2008 and has it set, ,I hope and believe, to do great things.
I am amazed anyone listens to forecasters because they get everything hopelessly wrong. Who would have forecasted Trump or Corbyn or that the euro would cause massive unemployment and we would prosper out of the Eurozone? Or that Brexit would win or that Cameron would be toast? No one has a clue.
Why listen to any of these asses other than Paul who is often right
On the subject of big companies hedging, which includes Next, Sports Direct etc so the prices rises would be gentle and over the next couple of years, I can't believe that UNILEVER would not have done similar. Yet it was the first big one to very quickly raising prices within a few months of currency depreciation. Unilever's competitor like Proctor & Gamble, and lots of others (including holiday companies) don't seem to have jacked up prices across the board. I can't help wondering whether we are taken for a ride by Unilever!
"Also, if you look at the long term chart of sterling against the dollar, we saw a huge devaluation from mid 2008. Sterling dropped from about $2.00 to a low of around $1.40. That caused a surge in inflation for a while, before it came back down again. It's no wonder that the British manufacturing sector was hollowed out, with sterling having been overvalued for so long.
A burst of inflation could be seen as a good thing, as it will scrub off some of the national debt, and private sector debt."
Spot on Paul. So many Remoaners failed to acknowledge that Sterling was massively overvaslued in the first instance over last few years.
Inflation is indeed going to be used to erode our stratospheric National debt around £1.7trillion on balance sheet. It continues to grow because we're apparently rich so can afford reckless spending/generosity.
All the while the "Illusion of wealth" gets stronger & stronger. Just like the China credit bubble,and at some point they will burst..and Govt bond markets will spiral downwards.
Re your comments on IG Design (LON:IGR) Paul, the surge at the end of summer may have been down to some extent to Small Company Sharewatch's comments on promises to come for the SP. I guess when they said:
'IG Design looks like it will surprise on the upside as it spreads from giftwrap into new areas of, as the CEO put it to me, “everything but the cake”. Sticking my neck out I wouldn’t be surprised if the shares are closer to 300p than 200p in 18 months time'
that it would come so quickly, though only lasted for a little while before the fall you have identified. After the songs of praise in August, they duly added the share to their portfolio for Sept issue (ie bought in August for 220p). The US acquisition does seem to be a good deal, and of course their sales will be in $US there. However, the PE and PEG are pretty demanding, and consumers can always cut back on discretionary purchases like this, especially downtrading to a less expensive alternative.
All Apple prices have gone up around the world. It has nothing to do with Brexit or currency devaluation. Check the prices in the Apple stores online in the US, Australia and NZ - all have gone up.
tabhair,
iii and lse are fairly active, I post on both but there are many more, never managed to log in to some of others, wrong inside leg measurement?
www.iii.co.uk and head to community
www.lse.co.uk and share chat
To post you need to be registered for a day or so but I could read from day 1.
Regards,
Seadoc
Paul, Re Gattaca (LON:GATC) please try to throw light on where the company's revenues come from? The CFO's review says 32% of NFI is from abroad, yet in the segmental breakdown it syas that UK revenue is £587m out of £618m. How does this tally? In your last write-up in August you mentioned that 90% of turnover was from the UK. Maybe the answer lie in the note which says "Revenue and non-current assets are allocated to the geographic market based on the domicile of the respective subsidiary." BTW there doesn't seem to be a break-down of the geographical breakdown of profits, only revenue. Not sure if that matters. Thanks very much.
Hi Paul,
The axe has finally fallen on the Motley Fool discussion boards, where your Paulypilots Pub was a real powerhouse of investment discussion.
Just wondering what your thoughts and feelings were at the UK Motley Fool's demise?
That is a real shame. Seems to me like there would be a gap in the market for an online shareholder discussion forum. I am surprised that the likes of ShareSoc don't have this. Has anyone got any suggestions on where people can discuss UK shares? stockopedia comments section is useful, but not really suited for a discussion forum.
Re Victoria one of my investment memes is never to invest in companies which are managed by ex investment bankers, particularly if they grow by acquisition!! Perhaps VCP is the exception which proves the rule.
Fanmail
How does the exception prove the rule? Wouldn’t it do just the opposite? Doesn’t it prove that the rule does not hold for all cases and is therefore not a rule at all?!
It's "prove" in the sense of "test". So this is an exception that is testing whether the rule is valid or not.
It's complicated
https://en.wikipedia.org/wiki/Exception_that_proves_the_rule
Debenhams is 1-2 years hedged apparently. So maybe inflation could be more gentle & gradual than I previously thought
It is true that Debenhams are hedged for dollars at $1.50 for at least another year and possibly a little further, but if exchange rates do stay at these or similar levels, there is an increase to their "cost of goods sold" of c20% looming at some point (even if delayed by hedging) on the 35% of stock they source in dollars...a cost increase to them of c£80m. Can they pass all of that on to customers and preserve their margin and profit....or will that prove extremely difficult in an area like clothing where Demand appears weak and any LFL growth anywhere appears hard to come by, and promotion and discounting is rife. A business with c£100m PBT and c£280m of Debt, and a potential £80m cost increase looming.
If that were not bad enough, the next question is "where is the other 65% of goods sourced from, which is not paid in dollars?". I am sure some will be in Euro's, and other foreign currencies where we have also seen a sizeable depreciation of sterling.
If businesses can pass the exchange rate hits on to customers, then we will see significant inflation. To the extent they cannot, then we could see a very nasty squeeze on profits and share values, which could be fatal for some of the weaker players.
A week or so after Brexit, some currency traders I knew predicted that Sterling would slide against the dollar as the year went on, reaching a December low of $1.10/$1.15. They then predicted that it would recover post January over the next 18 months back up to $1.50 as the UK became cheap and assets became too attractive to foreign investors.
Notwithstanding today's minor bounce, the first part is coming true.
I don't buy the inflation argument accordingly.
The BoE MPC today said:
"Largely as a result of the depreciation of sterling, CPI inflation is expected to be higher throughout the three-year forecast period than in the Committee’s August projections. In the central projection, inflation rises from its current level of 1% to around 2¾% in 2018, before falling back gradually over 2019 to reach 2½% in three years’ time. Inflation isjudged likely to return to close to the target over the following year."
VCP Fully agree, in my ongoing review looking for new investment opportunities I was reviewing the carpet sellers and noted your comments about the new entrant into the market, Tapi, plus the comments if I recall from Carpetright that implied that they were feeling the competition.
As part of my review this led me to VCP, a manufactuer rather than reseller, and looking to benefit from the £ (vs importer carpers), adding nicely under-lay acquisitions, with a very grounded owner / manager in Geoff Winding. As has been written buying into companies where the management own a very considerable equity stake (c33%) in the business gives investors a level of comfort.
And who knows by then Apple et al may even pay their fair share of taxes
Sorry - this post should have been held until April 1st
Re Inflation, there's a split I think between the multinationals like Apple and the UK based companies.
Apple report in and price their products in $US. If the local currency falls in value then their local prices go up pro-rata and that's that. We need to pay more pounds to buy the products. Unfortunately we can't opt out of the higher prices and say only those who voted Leave should pay them.
For UK based importers and retailers like Next that report in sterling then they can and need to do more to mitigate the impact.
John
I don't think that is true for Apple products. The price of an Apple Watch with White Sport Band is $269 in the US and £269 here. The price hasn't changed here recently due to the falling GBP/USD rate. Not saying that they will not hike the price of course.
Never mind when we sign a trade deal with the US we will be able to import Apple products from the US without import tariffs :).
DYOR and all that ;P
Apple's new MacBook Pros are ridiculously expensive in the UK after Brexit
http://uk.businessinsider.com/apple-increases-macbook-pro-mac-prices-uk-due-brexit-usd-gbp-exchange-rate-2016-10
Apple's new laptops are extremely pretty — but they don't come cheap for Brits.
On Thursday, the Californian technology announced an overhaul of its MacBook Pro line, giving the devices a redesign and adding a touch-sensitive screen that sits above the keyboard.
But it also bumped up the prices for the laptops very significantly in the UK — far more than it did in its home market, the US — in what seems to be a response to the weakness of the pound following the Brexit vote.
Even existing Mac lines — ones that haven't been updated — have had their prices raised in the UK.
Some kind of price increase is often inevitable when doing a big product overhaul. And that's what you see in the States. The cheapest 13-inch MacBook Pro before the upgrade was $1,299; now, it's $1,499.
But in Britain, this price bump is far larger. The cheapest 13-inch MacBook Pro, pre-upgrade? £999. Now? £1,449.
That's an increase of £450 in the UK, compared to $200 in the US. (And remember: The dollar is worth less than the pound!)
This is even more pronounced on the more expensive 15-inch MacBook Pros. The cheapest model, pre-upgrade, was $1,999 in the US and £1,599 in the UK. Post-upgrade, it's $2,399 and £2,349.
That's a price increase of £750 in the UK, compared to an increase of $400 in the US.
These articles usually quote US prices without sales taxes which vary by state but are much lower than our VAT rate whereas the UK prices quoted include VAT. So to compare the underlying Apple pricing like for like you need to convert the pre-VAT UK price to $US.
VAT doesn't cover the price differential , logically if our currency is worth 20% less then for dollar value to remain constant then GBP price must compensate (or Apple lose margin) - in terms of LFL The 6-core Mac Pro now costs £3,899, £600 more than its previous price of £3,299, while its US price hasn't budged.
Of course Hammond could drop VAT. in the Autumn statement....
Well done, you found the one product that didn't go up. Macs are up, MacBooks are up, iPhones are up, and iPads are up.
Watches aren't selling very well so I expect there is some stock in the UK for them to sell through before they go up as well.
I didn't single out the watch because it hadn't gone up. It just happens to be the one apple product I can remember the price of. My point really isn't whether they will go up or not. More that they charge different prices in different countries - and as you point out it depends on what they can sell things for. For example :
iPad Pro $549 or £549
iPhone 6S $549 or £499
in terms of sterling. look at the GBP response to the Article 50 court ruling today..and then the relative response of FTSE100 (-0.6%) 100 and FTSE250 (+1.4%) since 10.00 am.
That is a small indication of the aggregation of the views of a broad variety of market participants on the impact of currency drag on UK plc