Small Cap Value Report (31 Jul) - MIN, MEC, SOG, VCP, FOUR

31st Jul '13 by Paul Scott

21 comments 18448 reads

Good morning. I'm running a little late today, apologies for any inconvenience.

Firstly, I've been looking at the interim results to 30 Apr 2013 from Minoan (LON:MIN 4.5p). This is a UK company which has been trying to develop a large holiday resort in Crete from what seems like the beginning of time. Obviously macro events have conspired against them in the last five years, so they bought a travel agency business to keep them busy whilst the Crete project was effectively on hold.

The market cap is only £7m at 4.5p per share, and it might be worth a further look, treating the shares as almost an option on possible long-term upside from the Crete project. Although they report a loss before tax of £900k for H1, on £19.8m turnover, the segmental analysis shows that the travel agency business is trading profitably (just), with a £117k profit on £19.8m turnover.

Costs of £604k were expensed on the Crete project, of which a third was paid in shares, and "corporate development" cost £416k. That last item sounds an awful lot for just six months, for such a small company, so the overheads might well be top heavy, that would need looking into.

I could see the share price being a high risk/ high reward type of situation, but it would need a lot more research to determine whether it's attractive or not. Just wanted to flag up the idea if any readers fancy doing some digging into it. I would also want to look carefully at the cash position, and solvency, as the Balance Sheet looks stretched to me.

Mecom (LON:MEC 39.75p) issues its interim results to 30 Jun 2013. This share is a similar situation to Trinity Mirror (LON:TNI 115.5p) which myself & many readers did extremely well on last year (we could do with another big winner this year, after disappointments from my largest two positions so far this year).

However, after going through the figures for Mecom again today, I think it's too high risk. Advertising revenues being down 20% year on year is just too steep a decline to be able to predict what the future holds, and they still have E95m of net debt.

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kenobi

31st Jul '13

Paul, Interesting to see that Minoan has traded at around 10p in the recent past, but over the last 5 years the trend has been down. Do they have the money to develop the resort ? I presume not otherwise they would have done it during the crisis, taking advantage of cheap local resources ?
If they don't have the money its a bet that they can raise the money, (and obviously get a return on it), I'm wondering if it's worth a punt on the basis that the shares will at some point trade on a higher value, perhaps based on news, but it sounds very risky.

K

Paul Scott

Morning Ian,

Thanks for the feedback, much appreciated!
I don't cover resources stocks. Here is the page from my Blog which outlines which areas of the small caps market I cover: http://paulypilot.blogspot.co.uk/p/what-sectors.html

Cheers, Paul.

DarwenLad

Paul,

Your daily letter is always a must read for me, and your hardwork much appreciated.

If you ever had time would love to your thoughts on 4imprint, a promotional products company, which reported interims this morning. It is the largest direct marketer of promotional products in both the US and Canadian promotional products markets - a $23bn market.

First half revenues are 14% up and underlying pre-tax profits are 41% ahead.It has net assets of £18.5m, no debt and net cash of £14.8m.(The only bit of bad news in the balance sheet is the £17.1m pension deficit but it is shrinking).

The share price roughly trebled between early 2010 and September 2012 (when I sold out). Since then it has risen by another two thirds and I am kicking myself for bailing out too early.

It is selling on around 28 times historic earnings so is not cheap.

Hi DarwenLad,

Haha, we crossed in the post! I mention 4imprint (LON:FOUR) as the last item in today's report, see above.

Smashing company, probably fully priced for the time being, is my current view.
Mind you, I thought it was fully priced in January at 370p, yet it's risen about 50% since then!
So with hindsight, I should have been prepared to pay up for growth stocks in the last year, but never mind.

Cheers, Paul.

bobdouglas

Paul,
Having looked at the results from Victoria this morning I enjoyed reading your quick but remarkably thorough analysis. I think the nitty gritty as you say is the issue of cash and a more prudent approach as regards dividends may have been just what was required. It would be nice to think the bank would be accommodating while the business turns itself round with the security of the freehold property and certainly at one time this would more than likely be the case. Speaking from personal experience they may keep supporting the business but can make it very restrictive in terms of allowing you the freedom required to implement the turnaround plan.

chriskp

I've been following your posts for a while but never actually had a crack at valuation myself. I had a look at the Minoan results and with my un-educated eye here are the major things i noticed.

• Assets – liabilities – intangibles / 150.83m shares = a net asset value of 21.4p per share. Almost all contained in the Crete project. In the notes it says the assets are held at historical cost minus depreciation so i'd assume it could be resold for a similar sum. If Greece leaves the Euro though this value could be hit very hard. I'd also guess that if project planing permission is denied the land value might fall.
• Increase in inventory and assets (525k$) much lower than increase in current liabilities (1684K$). I assume this means they are delaying payments to suppliers which allows them to show a positive cash flow. Their cash flow of +162 minus the above changes in assets/liabilities means they are using about 1m$ of cash during the period on a neutral asset basis?
• Cash held on balance sheet 819k$ so given ratio with above burn rate makes this a bit worrying.
• 8m$ of current (short term) liabilities vs total of current assets and cash (2.012m$) and 17m$ inventories. I’m not sure what inventories really represent for a travel agent? If they aren't easily converted to cash they debt looks pretty high given they are showing a loss and almost no cash generation.

Overall the travel agency is making a little bit of money 120k$ per 6 months but this isn’t covering the almost 1m$ per 6 months being spent on corporate development and the Crete project. Discount to net asset value looks pretty good though if the Crete project happens.

thekingsgambit

Hi Paul,

Your blog is now essential reading for any PI. Keep up the good work.

Not sure if it comes up on your radar but Spectra Systems (LON:SPSY) annouced a contract win for $10 million and will be delivered commencing August 13th :-
http://uk.advfn.com/news/UKREG/2013/article/58594043
£10 million market cap with £10 million cash on the balance sheet according to stockopedia figures. Looks too good to be true? I am doing some more digging as I speak and would be interested to hear your views.

All the best.

Stuart

Roger Lawson

Interesting comments on Statpro which I know quite well. Yes you are right to ignore EBITDA (adjusted or otherwise) but a lot of software companies with recurring revenue have very large deferred income as a liability on their balance sheet. This is simply an accounting oddity because they will never have to repay that debt so you should really remove it from liabilities when doing any calculations. But otherwise Statpro is clearly still a work in progress as they move from lumpy license fees to a hosted cloud solution.

As regards Victoria, the same applies in that obviously the figures reflect the costs of major restructuring. Trying to figure out what they might do this year is damn difficult (and there are no analysts forecasts), so you will have to trust Geoff Wilding, the Exec Chairman, to turn this company around. I was of course involved in the bun fight at Victoria, and was convinced he had a better chance of success than the previous management.

Hi Roger,

Thanks for your comments.
From time to time we have discussions here about deferred income, and I take a very conservative view of it. As I'm sure oyu know, Deferred Income arises when the customer is billed in advance for services that have not yet been provided. So once the customer has paid the invoice for next year's software support, the double entry is both on the Bal Sheet, with Dr cash, Cr Deferred Income.

So the software company has a pile of cash, which has been paid by customers for services that have not yet been provided. The Deferred Income ("DI") is then released to the P&L as Turnover the following year, and the software company will then have a load of costs for that year which marry up with that turnover, as they provide the service.

So whilst you are right that DI is not actualy a liability that has to be repaid, you can't just write it off & ignore the other side of the double entry. To my mind, the correct treatment is to write off DI (as it's not a real creditor), and write off the same amount from the software company's cash balance. That arrives at a true, prudent level of cash which the software company would have, if all their customers had support contracts that simultaneously expired on the year end date.

DI also fluctuates greatly throughout the year, and companies tend to choose year end dates which show a seasonal peak in cash balances, so will therefore often be timed just after they've had a lot of contract renewal monies in. Then that cash will deplete throughout the year as they burn up cash providing the service for which the customers have paid in advance.

I know some investors take a more relaxed view about DI, but personally I think it distorts Enterprise Value calculations, and together with capitalised Development spending, these 2 factors can easily lead one to considerly over-pay for software companies. I did that recently, and bought into a software company which I thought was attractively priced. But then when I did more work, I realised that the development spend was just an ongoing overhead, and the customers had paid up-front, so it actually didn't have any spare cash, and was only really making about £1m profit p.a., yet was valued at £30m. I sold the shares straight away!

Cheers, Paul.

Paul,
Regards deferred income are you saying a truer representation would be to take it out of cash and show it as a debtor ( prepayment) against the period to which it relates in the same way a bank loan is split into amounts falling due within one year,five years etc.

Hi bobdouglas,

Hmmm, not sure about that. You can't really take anything out of cash & put it in debtors, because cash is cash! I suppose I would prefer cash to be split into two, on the face of the Balance Sheet - so showing cash that has been paid up-front by customers, and then the balance (in the case of StatPro it would be negative) of the cash being shown as the company's own surplus cash.

Certainly when it comes to valuing the company, I would definitely reduce cash by the full amount of Deferred Income. Although some investors take a view on that, and will reduce cash by an arbitrary percentage of DI.

There's no right or wrong on this, it's open to interpretation. I'm just very wary of the two issues, of Deferred Income & capitalised development spending, as both can very easily lead you to considerably overpay for software companies.

Companies are always pushing the boundaries of accounting rules, in order to try to find more & more ways of flattering their performance. We've got to be very aware of this. Look at how many things are now stripped out of performance measures - depreciation & amortisation, interest costs, tax, restructuring costs, payments made in shares instead of cash, the list is endless! It all leads to investors over-paying for the supposed underlying performance of the business. A lot of companies I look at seem to have significant restructuring charges every year!

Cheers, Paul.

I don't see software companies keeping cash balances to offset their deferred liability (would be losing out on deploying it), and otherwise you end up with negative cash if it was deducted which would be a bit odd and confuse folks even more. As someone who has run software companies, I may be more aware of the realities. In practice most of the deferred income does not really represent services yet to be supplied - depending on exactly what it covers, it might simply represent a "license" allocated over the period of time for which no effort whatsoever is required by the supplying company. In other cases there may be a real service element (i.e. have to provide staff support), but often this is at a very high profit margin. The defered liability does not inhibit the company from paying dividends from the allegedly negative cash (unless retained profits are also insufficient), so for most purposes, it can be ignored.

Paul,
Thank-you for your reply. To be honest with you accounting is more the wife's bag, Anyway I have joined sharesoc and hopefully if I am allowed in - will meet you down south!

Kind Regards

Bob Douglas

cig

1st Aug '13

I doubt that the accounting book value (cost less depreciation) of such a speculative asset is of much help when trying to guess the resale value. The book value is not even a parameter in the valuation... It could be worth anything really.

Re euro-exit I'd expect tourist assets (as such) to be relatively resilient: if you run a hotel/resort with primarily international custom, revenue and prices should be relatively independent of the local economy/currency (short of civil war that turns people away) as the price of room etc is set relative to other destinations and in foreign currency. So a tourist-backed asset should not be that dependent of whatever the local currency and exchange rate are.

Still seems interesting as a purely speculative punt.

marben100

Hi Paul,

It is worth noting that software support contracts are usually highly profitable. In most cases margins exceed 50%. Hence, I really don't think that simply deducting the value of deferred income from cash on the balance is a reasonable treatment - especially when considering the net debt/cash position.

A more reasonable approach to assessing the soundness of the the balance sheet would be to consider the deferred income as a trade creditor, with a value of maybe 60% of the face amount on the balance sheet. Investors should do a little digging to determine whether the deferred income total is what one thinks it is (i.e. represents prepaid support contracts), and what the typical margin on the service that is paid in advance is.

Cheers,

Mark

Mark Simpson

The other thing to watch for is big drops in differed revenue as a proportion of sales. It can be a sign that management are using aggressive revenue recognition to meet short term forecasts.

2nd Aug '13

Hi Mark & Roger,

Interesting comments on Deferred Income (DI), which I take on board.

However, the problem is, if you ignore DI, then you are effectively anticipating future profits, since you are treating future turnover, which has been pre-paid by the customer, as part of the current cash balance. I accept that this might be very high margin turnover, especially if it's future licence payments, but there will still be a ton of overheads to offset against that turnover, just in ongoing running of the business, even if there are no costs which directly relate to the DI.

The other issue is, how much does the DI fluctuate during the year? If it remains fairly steady throughout the year, then fine, you can view the relevant cash as being pretty safe. But if the DI figure is unusually high at the year-end, because they've just collected in a load of 12 month support contracts & licences just before the year-end date (which is often the case), then the high year-end cash balance is really a mirage, and hence Enterprise Value will often be significantly under-stated, leading investors to overpay for the shares.

I think Roger hit the nail on the head, in that you have to carefully consider what type of DI it is, and how it fluctuates for each individual company throughout the year. I remain of the view that offsetting DI against cash is by far the most conservative treatment, and gives you a worst case view of the company's cash position, e.g. if the software were to become obsolete, and no customers renewed their licences/support contracts.

Cheers, Paul.

there will still be a ton of overheads to offset against that turnover

The 50% figure I quoted is a net one, i.e. net of all costs (usually mainly staff/admin) in providing the service that is prepaid. The gross figure is closer to 100% for software support/maintenance income (i.e. "cost of sales" is close ot zero). Rather than DI, the more important issue for concern is the relationship between capitalised software development expense and amortisation - that's where hidden costs are more likely to be found.

I agree with your points about timing and the nature of the DI figures which investors should research.

I remain of the view that offsetting DI against cash is by far the most conservative treatment

Well, yes, it is the most conservative - but excessively so IMO and I would not advise investors to use such an assumption when assessing the solvency of an investee company. The proof of the pudding is that I have sold a software sales/support business, with significant deferred income liabilities. In arriving at the price, the DI was NOT assessed as a future cash cost, but rather offset against the intangible value of customer relationships.

When I evaluate software companies, I generally view a larger DI figure as BETTER (subject to the points you make about timing and the nature of the deferred income), as it generally indicates a higher level of recurring revenues, as well as meaning that the firm has a lower working capital requirement. I'm more wary of software businesses with higher debtor days, where rather than customers paying up-front (which DI indicates) the firm is effectively using vendor finance to boost the sales figure (at best! ;0)).

Boros10

4th Aug '13

A fascinating discussion on deferred income. I agree with much that has been said but I feel we might be confusing apples with pears.

On valuation, I agree with Paul's view. Cash attributable to customer deposits or advanced payments should not reduce the enterprise value of a company thereby making it appear cheaper.

This cash has yet to be earned and in my view the offsetting deferred income creditor should be treated in the same way as debt when determining the enterprise value.

If we were buying the whole company and not just a part of it, would we be happy if the vendors stripped this cash out of the business just prior to the acquisition and we had to wait up to a year before we could bill the customer again despite having to provide services in the meantime? I doubt it, although I have on occasion seen an unsophisticated buyer, in a private company deal, get this wrong and pay for the cash which technically does not belong to the company.

As regards the merits of businesses which generate significant deferred income I agree with the points made by Mark and Roger, although I take Paul's point that if the deferred income peaks at the year end it may have the effect of flattering an otherwise poor cash position at other times of the year.

Whether its in the form licence revenues in the software sector or subscription revenues in the case of publishing businesses, cash paid in advance brings real benefits to a company and also shareholders. It has the potential to not only fund a company's working capital as Mark has pointed out but it might also help to fund Capex, debt repayments and even acquisitions. Strong free cash flow also means less risk of dilutive share issues. I've previously discussed the merits of Euromoney Institutional Investor plc, which generates more than 52% of its income from subscriptions for its specialist online financial content. It has been able to fund a series of small acquisitions without having to ask shareholders for more cash.

In large part Warren Buffett's success at Berkshire Hathaway has been his ability to use the premiums his insurance companies receives (the so called free float) to re-invest in quality businesses or stocks. Deferred income is another form of free float. It is free capital and in responsible hands it can greatly enhance shareholder returns.

So, although I would add deferred income to debt in determining a company's enterprise value I would generally be willing to pay a higher multiple of EBITDA for a business such as Euromoney, which benefits from subscription or licence revenues.

Hi Leon,

I think this point from you hits the nail on the head:

So, although I would add deferred income to debt in determining a company's enterprise value I would generally be willing to pay a higher multiple of EBITDA for a business such as Euromoney, which benefits from subscription or licence revenues.

I also agree with Mark & Roger that companies which can generate high levels of Deferred Income are showing the strength of their offering, in that customers are prepared to pay up-front for services not yet delivered. However, I would still want to see all, or at least most of the corresponding cash still in the Bank. It strikes me as inherently imprudent for any company to collect in customer cash up-front, and then spend it before the service has been provided to the customer. That approach doesn't leave any safety margin in case something goes wrong. We saw that with airlines at the time of the Icelandic ash cloud. Many airlines finance their operations heavily using the cash paid up-front by customers who book and pay in advance of their flight. That's fine when you have a predictable flow of up-front cash payments from customers. But if for any reason your aircraft are gounded for an extended period of time, it's potentially ruinous.

I recall asking the FD of Dart Group about this a few years ago, and I asked what would happen if the aircraft fleet were grounded for an extended period of time. He responded that they would just have to arrange an overdraft facility. But what Bank would grant an overdraft to an airline whose fleet is grounded, and has therefore run out of cash?!

The equivalent danger for a software company would be if customers stop renewing their contracts, if e.g. a competitor launches a superior product. The cash would then just disappear, as overheads eat into the cash pile, but no new cash is collected from customer renewals. People say that software revenues are very high margin, which is true, but most smaller software companies don't actually make much profit by the time you get to the bottom line. So they still have costs, even though they are not directly attributable to the individual customer contracts.

Im with Leon on this - when valuing software companies, I will always treat DI like debt, because the net cash figure used in calculating Enterprise Value should only be genuine surplus cash, not cash that has been paid up-front by customers. But I would be prepared to pay a higher multiple of EV for a business that has high levels of recurring DI.

Small Cap Value Report (31 Jul) - MIN, MEC, SOG, VCP, FOUR

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