Small Cap Value Report (7 Aug 2015) - VLK, RGS, GTC, DIA, ESS

Good morning!

It's fairly quiet for company news today, although I'll cover several results/trading updates later. So I'll use this as an opportunity to touch on a topic which crops up from time to time, and where I think a concerted effort is needed by investors to curtail the wilder excesses of the managerial class.

Director Greed

Many of us are concerned that Directors of listed companies are increasingly taking advantage of their fragmented (and often disenfranchised) shareholder base, to line their own pockets. Salaries seem to constantly rise, on a permanent ratchet, helped by external consultants to supposedly benchmark against other companies - which is of course just a fig leaf to justify greed. After all, if you pay a consultant to deliver a particular, known verdict, they will do your bidding with great enthusiasm.

How many companies admit to having third or fourth quartile management in terms of quality & ability?! None! Instead, listed companies achieve the mathematically impossible feat of virtually all Directors being first quartile, or at a push maybe second quartile, in their ability - therefore justifying ever rising salaries.

Not being happy with big salaries, generous bonuses, and in many cases plenty of share options too (sometimes on ridiculously generous terms, e.g. nil cost), a few Directors are now also pushing for even more, namely ...

Value Creation Plans

I find the whole concept of these absolutely grotesque. The idea is that Directors are handed on a plate, a significant shareholding in the company, if performance criteria are met. So it's a bit like share options, but more convoluted.

The one that really stands out is at Vislink (LON:VLK) where the staggering greed of the Chairman seems to know no bounds. He's got form too, as uproar over excessive remuneration was one of the reasons he was sacked from Anite in 2003. This is surprising, since at an investor presentation, Mr Hawkins referred to his time at Anite as being highly successful in growing the company. Indeed Vislink's Annual Report describes his track record at Anite like this;

Specialist in turnaround and growth businesses (took the Anite Group from a £68 million loss to a £30 million profit)

The chap next to me at that presentation commented to me that he'd been an Anite shareholder, and that Hawkins "had made a dog's breakfast of the company", and presided over a collapse in share price, hence why he was kicked out. Well that, and greed over remuneration.

So this is a good example of why it pays to spend a little time googling Directors track records, rather than believing their sanitised/misleading version of their own career. After all, most CVs apparently contain misleading information, and so it seems do Annual Reports!

David Stredder, a Director of ShareSoc, has taken up the issue of the grotesque proposed reward scheme at Vislink, and reports back in this article, following a meeting he had with Vislink's Remuneration Committee (i.e. some Non-Execs).

What I find alarming, and staggering, is the following;

• That a scheme which could potentially hand a £multi-million stake in Vislink to its Directors, does not apparently require shareholder approval at all.
• The VCP scheme was announced just after the AGM, where surely such a financially significant scheme should have been discussed & approved by shareholders?
• Why do Directors who are already massively remunerated also need a further scheme to incentivise them? Are they not already incentivised by huge salaries? If not, kick them out I say!
• How can it be right for Directors to get upside only, with no personal risk, in a Private Equity style reward scheme?

In my view all incentive schemes for Directors introduce risk, because you often realise later that the bonus/options/VCP targets introduce perverse incentives for them to do things which would otherwise not be done - e.g.

• Aggressive share buybacks using debt (to exaggerate EPS growth), but leaving the balance sheet weak.
• Debt-financed acquisitions - resulting in a highly geared group which does well in an economic upturn, but is set up to potentially go bust in the next recession.
• Increasingly creative accounting, excluding share-based payments, exceptionals, amortisation, etc, so that management are incentivised to exaggerate profitability in order to achieve targets.
• Ramping of the share price by Directors & advisers in order to achieve short term targets, sucking in hapless investors who over-pay.
• The common theme is that so-called incentive schemes actually incentivise Directors to take irresponsible risks, which are not in the long-term interests of the company, and are potentially destructive.

In the short term, shareholders might well like these things, as it can revitalise a sleepy share price for a while, but at the expense of possibly wrecking the company longer term. Everyone assumes they will be able to sell out at the top, but how often does that actually happen? You can usually rely on the Directors cashing out at or near the top though, so it nearly always pays to follow them out pronto, whatever the reasons given for them wanting to sell (in response to Institutional demand - lol!)

Why do shareholders allow this?

As we've seen with Vislink, the shareholders have not even been asked to vote on it. Directors seem to have just put in place this ridiculous VCP scheme without seeking shareholder authority at all. How is that even legal? It seems like an elaborate form of theft to me, but that's just my personal opinion.

Plenty of small shareholders are up in arms too, and you can read their comments on this webpage set up by David & others to canvass shareholder opinion.

Here are the reasons that greedy Directors can get away with taking a disproportionate slice of the pie;

• Many shares are held in nominee accounts, where it is difficult or impossible to vote on AGM resolutions. So if you know that (say) 50% of your shareholder base is totally passive, you can start doing whatever you like!
• Spread bet and CFD punters can hold a lot of the company, but don't get any voting rights.
• Fragmented shareholding base - people with, say 5,000 shares are not usually going to bother voting at the AGM, since it won't make a difference. Collectively though, it would make a difference if they all voted.
• Shareholder apathy - many people in the market are really short term speculators, not investors. So they don't care about corporate governance, as they only hold for days/weeks/months, not years. Very few shareholders read the Annual Report in full.
• Passive Institutional shareholders - I'm often amazed at how little research Institutions have done, and how little monitoring (let alone exerting influence) some of them do. Fund managers are often not even aware about Director remuneration, and arguably don't want to rock the boat in case it backfires with questions about their own pay.

(I feel that we all benefit from strong Institutional shareholders who think & act like owners, since they keep management in check, but sadly there are not enough of that type around)

Improved shareholder rights

ShareSoc is running a campaign for improved shareholder rights, and already Government has been lobbied, and is sitting up and taking notice.

We need an improved system whereby all shareholders, including those whose shares are held in nominee accounts, have automatic, electronic voting rights at General Meetings. We've had the technology to do this for at least 15 years, so why hasn't it been done?

I believe that, if this change were made, there would be a dramatic improvement in corporate governance, since it would be easier to remove errant/greedy Directors by mobilising shareholders to vote against their re-election, and/or bad things like excessive remuneration. On that subject, I think the law needs to be changed so that Director remuneration is subject to a binding shareholder vote before being approved (whereas at the moment the AGM vote on the remuneration report is just advisory, as I understand it - how ridiculous!

EDIT: Please see comment no.11 below this article, from Mark Bentley of ShareSoc, who clarifies the current legal position on Directors pay. Thanks Mark for your clarification on this point, much appreciated.

Bottom line, if shareholders collectively allow Directors to push on an open door for excessive remuneration, then the greedy ones will do.

Related party fees

Also worth mentioning is £RGS where financial engineering has led to disproportionate rewards for Directors, one shareholder, and where other shareholders have ended up nursing potentially hefty losses once the wheels came off. Note that the major shareholder who ran the company banked a cool £17.5m by selling shares at 300p before the wheels fell off. Funny that.

One fund manager who is prepared to stick his head above the parapet and call out things like this, is Graham Neary, who wrote this revealing article about Regenersis on Investors Champion recently - well worth reading, and quite shocking in my view.

Overall

What happened to people just doing a job to the best of their ability, and being paid a reasonable salary for that? That's what the rest of humanity does, so why do Directors of listed companies need to be uniquely incentivised with all sorts of generous additional bonus/option/VCP schemes to persuade them to get out of bed in the morning?

It's appalling, and raises real moral questions about the people involved, to my mind. Especially because they are often achieving profit targets by stripping out costs by making  lower paid staff redundant, or limiting their comparatively tiny slice of the pie. Is this fair or reasonable? Do we want to live in a world where a small elite cynically line their own pockets, and stuff everyone else?  I don't, and nobody would call me a socialist, quite the opposite!

Getech (LON:GTC)

Share price: 53p (up 14% today)
No. shares: 32.5m
Market cap: £17.2m

Trading update - this is an interesting one. The shares opened down first thing this morning, probably due to the comment that the "this result would be slightly below current market expectations", referring to the current estimate of £2.0m (up from £1.0m last year) for profit before tax, y/e 31 Jul 2015.

However, probably like myself, other investors looked at it and thought that achieving a doubling of profit to £2.0m in the current carnage affecting the oil & gas sector, is a pretty darned good achievement! Indeed, as management say;

The Directors regard this as a strong performance given the current market conditions, which include the rapid fall and volatility in the oil price, and an extended period of retrenchment and redundancies throughout the oil and gas market globally.

So we're agreed it's a good performance, but the key question is, can it continue? I don't know, but the company comments today that it has had some success in signing longer term contracts, thus revenues should be more stable hopefully.

Outlook - it sounds as if 2016 is going to be alright;

However, we are increasingly confident about the prospects for 2016 as a number of significant discussions have already, at the request of our clients, been aimed at inclusion of Getech products in their 2016 budgets. This will supplement the income already committed to the Globe and Multi-satellite projects as well as the anticipated returns from the three NOC clients who signed contracts in the year to July 2015.

My opinion - this looks encouraging. I suppose the bull case is that the oil price might have recovered at some point in the next year, improving the longer term outlook. My main concern is that if the oil price doesn't recover quickly, then work could tail off again once this year is out of the way, possibly?

Getech has a strong balance sheet too, and pays nice divis, so it's worth considering, if you feel that a big recovery in the oil price is likely. Also, a company that can still trade well in a very hostile macro market, is surely worth looking at anyway?

I think this has to be regarded as quite high risk, but there is some appeal to it too, so it's worth a deeper look in my view.

Dialight (LON:DIA)

Share price: 550p (flat on the day)
No. shares: 32.5m
Market cap: £178.8m

Cost reduction actions - the company is making 12% of its workforce redundant, to save £3m pa costs from next year, with £1m being saved this year but offset by the same amount in costs.

The new CEO sounds bullish about the future;

I believe that we have a huge opportunity ahead and Dialight is well positioned to capture significant value in our rapidly growing markets. However, as sales continue to grow, the business has taken on excess costs which have resulted in our poor first half performance.

We firmly believe that our team can deliver continued growth with future resources being added in line with our strategy.  This action is a key part of our plans to transform our business in the short term whilst realigning to deliver profitable growth going forward.  As previously indicated, we will report back with the findings of our strategic review in October.

This explains why the share price bounced so strongly recently, after the profit warning which I reported on here on 27 Jul 2015. So clearly the market believes that the new CEO can turn around performance, and stripping out a load of excess costs is an effective way to do so, providing he only cuts out genuinely excess costs.

My opinion - overall, let's see what the future holds. It's difficult to value right now - expensive if no improvements are achieved, but possibly good value or cheap, if the CEO's bullish outlook turns into reality. So, it's a straightforward bet on the effectiveness of new management to implement a turnaround.

The StockRank is low, at 32, although it's fair to say turnaround situations are likely to have a low score, because they have disappointed. I feel this stock isn't cheap enough to make a good risk:reward on a turnaround. I like shares where the valuation is pricing in near-oblivion, not ones like this, where you're asked to pay up-front for a future improvement in trading.

(note the spike down in price on the day of the profit warning(s), as shown by the candlestick having a bar falling below it, which indicates the intra-day low - which is why candlestick charts are so useful, as they contain considerably more information than a standard line chart)

Essenden (LON:ESS)

Scheme of arrangement become effective - this sounds final, so they must have got 90% approval presumably from shareholders.

Sadly, we (former) Essenden small shareholders are being forcibly ejected from the building, with a lowball 80p takeover bid from the biggest shareholder, in cahoots with management.

The price being paid is obviously less than the business is worth, so I'm furious about this one. I would say the business is worth 100-120p as things stand now, with greater potential going forwards as the economy improves. No doubt the bidder agrees, otherwise they wouldn't be buying it.

I would put money on the company returning to the stock market, in a couple of years time, in a different form - probably larger & more polished, with other businesses attached, at a much higher valuation, with the new owners trousering many millions from improved performance. It's all sadly predictable.

It's so annoying when the upside is grabbed by someone else. I recall this happening with FDM (Holdings) (LON:FDM) a few years ago - the CEO put together a bid, forced out the rest of us, and sure enough in private hands the business did very well, and has since re-floated at many multiples of the price it was bought at.

It's worth noting the names of the people involved, as they tend to be serial offenders in my experience.

Right, I have to dash. Have a smashing weekend, and see you back here on Monday morning.

Regards, Paul.

(of the companies mentioned today, Paul has no long or short positions.

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

NB. These reports are just Paul's personal opinions, NEVER recommendations or advice)