Small Cap Value Report (4 Sep 2015) - BVXP, ISL, SSY

Good morning!

I'm trying to type this standing up, as I read an article saying that it's unhealthy to work at a desk sitting down all day. Seeing as that is how I've spent most of my waking hours over the last 25 years, then maybe it's time for a change. So I've bought a VariDesk, and it's really very good - you can alternate between standing & sitting, by raising or lowering a platform that sits on your desk & carries your screen(s) and keyboard. Although after an hour standing up, I've already got aching feet & back!

CNBC noted this morning that "the market only seems to be able to focus on one issue at a time" - i.e. Greece/Euro, China, Fed tightening, etc. I think the reality is that commentators are only able to focus on one issue at a time! The market takes everything into account, which is why moves are so unpredictable.

It's non-farm payrolls day in the US apparently, so that might drive volatility this afternoon possibly, as a widely-followed economic indicator. Although I'm paying less attention to short term volatility now - it seems to be something we just have to live with - and instead concentrating my attention on forthcoming trading updates and interim results in Sept.

With small caps, it's too expensive to be dipping in and out, as the spreads are too wide. That's why I focus more on large caps, if I want to actively trade things, especially when gearing is involved. With small caps I think it's best to do your research properly, take a position, and then stick with it, providing the long-term fundamentals remain sound.

Even when things go wrong, which they frequently do with small caps, good companies with sound Balance Sheets tend to recover from profit warnings. Two of my best performing shares this year (SAL and FLYB) were my worst last year. By sitting tight, and ignoring all the doom & gloom, and instead focusing on the fundamentals, losses have been largely recouped. I am hopeful that ENTU might pan out in much the same way, as it looks like a similar baby & bathwater situation at the moment, but time will tell on that.

Bioventix (LON:BVXP)

Share price: 1090p (up 17% this morning)
No. shares: 5.05m
Market cap: £55.0m

Trading update - well done to holders here. It's a stock that ISA millionaire Leon Boros discussed when I interviewed him last year. The shares have risen 69% since then, so maybe it's one of those elusive "superstocks" which always look too expensive, but then keep reporting positive earnings surprises - so you realise after the event that actually they weren't expensive after all.

This is a theme that interests me, as I'm currently reading a book about it, which is challenging some of my ingrained value investor beliefs. I think there is definitely a case for paying up sometimes - i.e. paying more than you feel comfortable with - but only when you find something really exceptional. Plus, above all, running those winners, to capture the big long-term, multi-bagger move up. Although I think being too loose with that approach could be very costly, if you get into the habit of over-paying for unexceptional shares.

Today's update sounds very positive;

As highlighted in the interim results, the core business remains robust and the board is pleased to report that revenues for the year are expected to be in excess of £4.2m (2014:£3.5m).  Given the relatively modest and fixed cost base, profits before tax will be significantly ahead of market expectations.

Broker consensus (probably only one broker) is for £3.8m turnover, and 44.8p EPS.

Rather confusingly, the interim results announcement issued on 30 Mar 2015 (for H1 results to 31 Dec 2014) seems to have mistakenly been entitled "Final Results", which threw me off the scent for a few minutes!

The company did £1.93m turnover in H1, on which it made £1.26m profit before tax, so a staggeringly good profit margin of just over 65%. There is serious operational gearing here, as the gross margin is 89.5%.

I've crunched the numbers, and I arrive at 47.9 EPS for the full year to 30 Jun 2015. This is arrived at using the following assumptions;

• £4.25m turnover (since the company says "at least £4.2m")
• Gross margin of 89.5% (same as interim results)
• Overheads in H2 same as H1, at £467k = £934k for the full year
• This gives operating profit of £2,870k
• Using same tax rate as H1, gives PAT of £2,436k
• Using 5.08m shares in issue, gives estimate of 47.9p EPS for FY 2014/15.

Current broker forecast is 44.8p EPS, so I wouldn't say that my estimate is a dramatic uplift, it's only about 7% higher than the current market estimate, which doesn't really qualify for being called "significantly ahead".

Valuation - maybe there is some other factor I haven't allowed for? So perhaps 50-55p EPS is closer to the mark as a guesstimate? Therefore at 1090p the shares would be currently on a PER of about 20-22. That's obviously a punchy rating for such a tiny company, but it reflects the high profit margins, and consistent growth.

My opinion - so far this company hasn't put a foot wrong, and if you think the growth and margins are sustainable, then it could continue to be a very good investment.

The niche products take years to develop, and then become a cash cow (or cash sheep would be more appropriate here!). That, and the fact that it's only a small niche, means that there are no competitive pressures. So to hold these shares, you need to be very certain that competition will not appear, and that the expertise of the handful of key staff/Director(s) at the company can be retained.

Shares are also very illiquid, so if something does go wrong, it could be impossible to sell in any size. So there are latent risks here I think, but so far, so good!

IS Solutions (LON:ISL)

Share price: 69.1p (up 33% today)
No. shares: 35.3m
Market cap: £24.4m

Trading update - this IT company's shares are today's biggest riser, up 33%, so clearly this update contains positive info.

There's quite a bit of detail, but the conclusion states;

As a result of this excellent start, the Board is confident that the Company will deliver a strong performance for the year ending 31 March 2016. Revenue will be ahead of market expectations and profitability will significantly exceed current market expectations.

Both parts of the business appear to be doing well;

The traditional IS Solutions business is experiencing much stronger underlying demand for its Analytics offering with sales currently well ahead of management budget. With financial organisations being the largest investors in big data solutions, the Board is very pleased to announce that this divisions' business team has secured two major contracts with new customers from within the financial services sector. One of these contract wins will initially be for a three-year period, the second will be completed in this year but we expect additional work upon successful completion of the first phase. It is anticipated that they will add contracted revenue in excess of £4 million over the current financial year and in excess of £350,000 per annum of recurring revenue in subsequent years.

It is pleasing to report that sales within Celebrus are also ahead of plan as it benefits from being part of a larger organisation and thus able to capitalise on its increasing pipeline of opportunities. Recent wins in the retail and airlines sectors have been added to the continuing success in the financial sector putting it ahead by 64% of sales for the same time last year.

My opinion - I don't know anything about this company, having not looked at it for more than two years. It's been modestly profitable, and paid modest divis in the past, so it looks a sensible company, not some blue sky nonsense that we have so much of on AIM, unfortunately.

Whilst the news today sounds fantastic, the element of recurring revenue is only small. It's also not clear what the >£4m revenues are - are there associated costs (e.g. for contractors?) or are these licences, hence largely profit? Or a mixture of the two?

Therefore I think the main thrust of further research needed on this company, is to identify whether this is just a one-off good year, that will benefit from large, lumpy licence sales, or whether the company is starting a sustainable period of rapid growth. If it's the latter, then there could be a lot of upside. If it's the former, then maybe not so much.

It definitely looks an interesting situation though, and is worth us collectively doing some more research on it, I think. So please add your comments below, if you have looked at this company.

The StockRank is very poor, at 16, so that's telling me we need to approach it with a degree of caution. I'd also want to check out what development spending they are capitalising, as whilst it's a perfectly acceptable accounting treatment in moderation, you can end up wildly over-paying if you're not careful, if large chunks of the payroll are being capitalised instead of expensed. In reality software companies have to run to stand still, so I prefer to expense all development spending, unless it's for a specific, one-off project, which has an end date.

I note that this company is active in a "sexy" space of Big Data, which might also help its shares go to a toppy valuation in due course.

(good, that should be enough to guarantee me a thumbs down vote from the usual culprit lol! To whom I would simply say, if you don't like my stuff, don't read it!)

SCISYS (LON:SSY)

Share price: 66p (up 3% today)
No. shares: 29.0m
Market cap: £19.1m

Update re banking situation - there's a reassuring update today from this mainly public sector software company.

I reported here on 4 Jun 2015 in detail about the problem of the company warning it could breach its banking covenants, and why it was nothing to worry about - because the bank debt is modest, and comfortably covered by freehold property - this is why I love freehold property, as it gives an anchor which allows a company to survive in choppy waters. Banks generally don't mind lending to a company that is having difficulties, if they hold security over freehold property.

Anyway, it's announced today that the bank has been helpful, and amended/waived the covenant problem. There's also a backdoor trading update, where they say;

...subject to achievement of no less than £0.5m EBITDA in the year to 31 December 2015, it will issue a Letter of Waiver when its covenants are tested on the publication of the Consolidated Group audited accounts for the year then ending.  The Board remains comfortable with current market guidance for the year to 31 December 2015 and foresees no issue in meeting the minimum EBITDA threshold stipulated.

My opinion - I used to hold a few of these shares, and I do like the company, and think it has hidden potential. However, the serious profit warning in June suggests to me that management don't have proper control over contracts, with the potential for heavy cost over-runs. As they say on Dragon's Den, for that reason, I'm out!

All done! Have a smashing weekend, and see you back here on Monday morning, all bright-eyed and bushy-tailed!

Regards, Paul.

(of the companies mentioned today, Paul has long positions in FLYB, SAL, and ENTU, and no short positions.

A fund management company with which Paul is associated may also hold positions in companies mentioned.

NB. These reports are just Paul's personal opinions, not recommendations or advice, so please DYOR)