Small Cap Value Report (31 Oct 2014) - SGP, PURI

Good morning! I'm sitting here scratching my head, trying to work out what on earth is going on with the markets! Everyone (including myself) seemed to think that US equities had become overheated, and that the sharp sell-off a few weeks ago was a necessary & healthy correction. So what's happened since? The US market has gone straight back up again to record highs!! I don't understand it at all.

Since the market as a whole is strong, but many small caps are very weak (often for no good reason), then that looks to me like a buying opportunity at the moment, selectively (as always).

SuperGroup (LON:SGP)

Share price: 814p
No. shares: 81.0m
Market Cap: £659.3m

Not a small cap, but I'm mentioning it for two reasons. Firstly, I have a particular focus on non-food retailers, as I worked as an FD for 8 years for a ladieswear retail chain, so it's the sector I understand best. Secondly, there is a strong theme at the moment with exceptionally mild weather causing problems for clothing retailers especially.

Mild weather in September is very bad for clothing retailers, as it means that customers hold back on buying relatively high priced winter clothing like coats, jumpers, etc. However, a mild patch (it's still almost like summer here on the south coast, I have the windows open & am wearing shorts!) that lasts all the way through Sept & Oct too, is virtually unprecedented.

So I imagine that the whole sector must be having collective kittens, and worrying about being horribly over-stocked. That's bad for sales, but also margins, as the excess stock will have to be cleared, and the only way to do that is to reduce prices.

The market is anticipating this, and share prices are coming down, especially when the inevitable profit warnings come out. However, this is an opportunity! Weather is often trotted out as an excuse by badly performing retailers, but this is the real deal at the moment - there's no doubt all clothing retailers will be finding things very difficult. It may be too late to salvage a good autumn/winter season this year, but so what? The weather just fluctuates naturally, and it will probably go the other way next year, leading to bumper jumper sales!

I can't resist falling knives, but have learned (the hard way!) that the trick is to buy cheap shares when a good company has just run into temporary, or external factors, which don't in any way affect the long term performance or value of the business. That is precisely the situation we have at the moment with clothing retailers affected by this exceptionally mild spell.

Profit warning - the wholesale/retailer of the SuperDry brand is the latest to warn on profits. Today's statement is for Q2 and the half year to 25 Oct 2014 (since the company has an unusual 26 April 2015 year end).

On retail sales, the company says;

Total retail sales in the quarter were up 11.4% on the year, reflecting the ongoing investment in new space. Like for like sales were -4.2% although performance has been much more difficult in later weeks.

That's pretty much as I would have expected, given the mild weather. The end of October is particularly strong for clothing retailers, if the weather is cold. If it's still like summer, then those winter ranges really won't sell very well, and there's nothing you can do about it.

Does that mean the company is worth less though? No! It's just an unusually severe seasonal fluctuation in trading, and the stock market should take this in its stride. However, investors think so short term, that they wrongly slam the value of the company down, on short term fluctuations in trading. That creates opportunities for the more patient investor who is prepared to look through short term issues like this.

On the wholesale division the company says;

Wholesale sales for the period were £51.3m, a decrease of 3.7%. As a result of the difficult trading environment, partners have been staggering deliveries which has affected the timing of despatches across the half-year end and impacted on the quarterly sales performance. It is anticipated that the majority of the orders awaiting despatch will be made early in the third quarter.

Again, that is entirely predictable, and to be expected. It's not a concern at all, being a short term issue that will hit this year's figures somewhat, and will be forgotten by this time next year.

Overall on trading, the company says;

...the level of sector discounting and continuing weather related uncertainty, together with the planned strategic investment in the cost base, has led the board to revise its full year profit guidance to a range of £60m-65m.

Valuation - it's really helpful that the company has given a profit guidance range. All companies should do this - starting with a wide range of profit expectations at the beginning of the year, then narrowing, and adjusting the forecast profit range as the year goes on. All companies have this information internally, so why on earth should the owners of the business be kept in the dark?

There are conflicting forecasts out there on different websites, but the one which seems to best fit the revised guidance, is an old forecast of £71.0m profit. Dropping that to £60-65m sounds about right to me, so I think that works out at revised EPS of ballpark 58-60p EPS for this year.

Forecasts for next year shouldn't logically change at all, so something like 73-77p still looks valid as a forecast for 2015/16, accepting that this year's one-off bizarre weather probably won't repeat next year.

On valuation then, at 814p per share I make that a PER of about 14.0 times (based on 58p EPS forecast). That falls to a PER of only 10.9 based on estimated EPS of 75p for next year. So it's looking cheap for a high quality brand, with good operating profit margins.

However, note also that the company is cash rich. So it had £86.2m in net cash at 26 Apr 2014. That is equivalent to 106p per share, so taking that off the share price, arrives at an Enterprise Value of 708p. Stripping out the cash in that way, takes next year's PER down to only 9.4.

My opinion - you can never be sure where the bottom is with a falling knife, but in my view this share is clearly now getting into value territory - providing nothing else goes wrong. Note how much the shares had already fallen before today's announcement too - they have now more than halved since the peak in Mar 2014:

Shareholders should be pushing management hard to greatly increase the dividends too - the company has the capacity to pay much bigger divis than the forecast maiden divi of 5.0p this year, and it has already accumulated far more cash than it actually needs.

PuriCore (LON:PURI)

Share price: 27.5p
No. shares: 50.1m
Market Cap: £13.8m

Never mind sterilising cut flowers and lettuces, this company should be dispensing anti-depressants to its shareholders.

Interim Management Statement - we already knew that turnover would decline this year, as the company is changing its business model to generating recurring revenue streams, rather than one-off sales of equipment. So there's nothing particularly new in today's statement, but the trouble is that the shares are very illiquid, so it only takes a few small trades to really knock the share price.

I've never known such a small company take such a ridiculously long time to conduct a strategic review. It's been grinding on for months now. Makes you wonder if management have any clue what they are doing? A company this small should be able to thrash out a strategic plan over a weekend.

Unfortunately, the company only mentions turnover, which is down heavily as expected, but not profits. I can live with the change of business model to recurring, but smaller, revenues - that makes a lot of sense. However, it's a bit of an own goal to just report the lower turnover figures, without any mention of how the company is performing in terms of profit.

Cash - the main reason I've held these shares is because the company sold its endoscopy business for an excellent price in Jun 2014, so its Balance Sheet is now cash-rich. The company had $26.8m at 1 Jul 2014 once that disposal had completed, and it reports a fall in net cash to $22.7m at 30 Sep 2014. The trouble is, we don't know if that drop of $4.1m is due to losses, or working capital movements, or (more likely) a combination of the two.

Note that the cash of $22.7m translates to about £14.2m, which is slightly higher than the company's market cap.  The worry is that management will just burn the cash away with little to show for it, which based on their track record, has to be a significant worry.

My opinion - the CEO is stepping down in Jun 2015, which is a good thing in my view. Personally I would like to see the major shareholders step in and bring things to a conclusion here - i.e. a trade sale of the business. There is undoubted value in the technology, but to date management have not succeeded in commercialising it adequately, and personally I'd rather have the business sold, and cash returned to shareholders, which could provide nice upside on the current share price, rather than take the risk of management squandering the big cash windfall which was received four months ago.

For the moment though the cash pile = market cap means that this is not the time to sell, in my opinion. I like the comments from management about conserving cash, which is the critical issue from my point of view;

The Board remains confident in PuriCore's ability to deliver value to shareholders by leveraging its unique hypochlorous acid technology in markets and applications for which it delivers a competitive advantage.  As expected, 2014 revenues and earnings will be lower than in the prior year as the business model in Supermarket Retail transitions and investments are made across the Group to support longer-term growth.  The Company will remain vigilant in controlling costs and preserving cash while prudently investing for the future.  The Board has advanced the strategic and operational review of the business and plans to announce further details later this year.

Time is however running out rapidly, some decisive action is needed here in my opinion.