Small Cap Value Report (8 August 2016) - UTW, QRT, TCM, YOU

Good morning!

In case you missed it, I belatedly wrote a report on Saturday, for Thursday last week, which was a duvet day. Here is the link - it covers results from Portmeirion, Brammer, Johnston Press, and Zamano.

I'm having a quiet week in Hove (rather than charging round London to meetings, lunches & socials), so there shouldn't be any duvet days this week. Boring companies reporting today, so let's have a longer preamble.

Consumer spending data

There's an interesting article here showing data which suggests UK consumer spending is holding up better than might have been expected in July, thanks perhaps to warmer weather. Of particular note is that spending in hotels, restaurants & bars was up 9% against last year - a huge rise.

It does feel as if people want to have more experiences, rather than buy more stuff. Have we reached peak stuff? I certainly have - my flat in Hove certainly needs a massive de-clutter - car boot sale at the weekend maybe?! In the 1980s I had my own market stall at weekends, selling secondhand books & bric-a-brac when a teenager, so it's a trip down memory lane doing a boot sale every now & then!

With disposable income data looking positive, and interest rates at a record low, this just doesn't feel to me like the right set of circumstances for a recession - despite all the doom & gloom from forecasters & commentators. Also, the worrying data from manufacturers could improve once the benefit of weaker sterling feeds through.

Brexit uncertainty

An interesting comment last week came from the CEO of Vertu Motors (LON:VTU) (in which I hold a long position). He made the point that business leaders & managers will generally have been Remain supporters. So they have a preconceived belief that Brexit will cause a recession. Therefore, they are now acting on that preconception, by being more cautious. Yet evidence is mounting that Brexit (so far) has caused very little economic impact. So there is scope perhaps for the negativity to unwind, as businesses realise that life is continuing as normal. An interesting idea.

So my overall view remains that we're probably in for a bit of a soft patch, but not a deep or prolonged recession. The market seems to be signalling the same view, given the recent strong recovery from the Brexit plunge in many shares. You've got to have a view on the macro picture, otherwise you can't invest/trade with any clarity or logic - other than if you have a buy & hold forever type of strategy.

Liquidity

Personally though, I'm not touching tiny, illiquid things right now. I want to be able to exit from positions quickly & easily if the economy really does go wrong. Remember that with micro caps, liquidity is only there when you don't need it! (i.e. when things are going well). Try selling when the market is plunging, and you get a rude awakening - you're high & dry. That means you can only sell your liquid stuff - usually the good stuff - and you're left with the dregs that you couldn't sell.

So my key message today is that when things are uncertain, it's best to stick to more liquid stocks, and avoid the smallest stuff - unless it's absolutely compelling value, with great upside potential.

Remember also that market cap is not necessarily a good guide to liquidity. If the shares are tightly held, then even a share with a market cap of say £200m can be difficult to trade. So it's always worth checking the investor relations section of a company's website, to see what the >3% list looks like. Quite often you'll find that maybe 75% or more of the shares are tied up with Institutions & management, which can leave a very thin market for retail investors.

That type of situation also can cause pricing anomalies if one or more institutions decide they want to try and sell in the open market. They drive the price down, and that then puts off retail investors from buying - because most of us like to buy shares that are rising, not falling - the trend being your friend, and all that.

Still, I love pricing anomalies! That's what I make my living from - finding under-priced gems every now and then. So inefficient markets are our friend.

Utilitywise (LON:UTW)

Share price: 134.4p (down 5.7% today)
No. shares: 78.1m
Market cap: £105.0m

Trading update - I'm surprised the shares haven't fallen more than 5.7% today on this rather wobbly update, covering the year to 31 Jul 2016.

Here are the figures reported today;

The Group expects to report significant revenue growth in the period with revenues of at least £82m (£69.1m 2015).

Adjusted* Group EBITDA is expected to be greater than £18m (£17.8m 2015).

Net debt at year end was £0.2m (2015: £6.7m) as progress with improved commercial terms in our Enterprise division yielded some improvement in cash flow. As previously reported this is expected to continue into FY17.

That's an 18.7% increase in revenue, but only a 1.1% increase in EBITDA - so the profit margin has fallen considerably - I wonder why?

Net debt - a big improvement, essentially wiping out net debt. Poor cashflow has been a nagging doubt about this share - so it's good to see progress being made, with debt being paid down now.

Staff attrition - this sounds rather worrying;

As announced at the half year, staff attrition has continued to be a challenge. Although the actions taken to address the staff attrition are well underway, it has had an impact on the performance of this division in the period.

However, we are already seeing the benefits of the actions that we have taken and we therefore expect energy consultant headcount to increase in the new financial period, as previously indicated.

This got me thinking, so I had a look at the staff reviews for Utilitywise on Glassdoor (requires registration to view them all). Not great is probably the kindest way to describe them. Although I do stress that Glassdoor has to be treated with considerable caution - it's a small sample of people, and often it's ex-employees with a grudge who leave unfavourable comments.

In this case however, what emerges is that it's a call centre. cold calling type of business. So I'm not surprised that staff attrition is a problem - who would actually want to do a job like that? Doing a sales job in a call centre is nightmarish for most people, although marginally better than working in an abattoir perhaps? Bearable if the commissions are good though.

There clearly seem to be issues with management. Also, they need to sort out their staff canteen, with several reviewers criticising it, including one who called it "an expensive carbuncle!". This is starting to sound like a company which has grown too fast, and possibly has inadequately skilled middle management?

European business - will achieve breakeven on target. So when will it generate proper profits?

This initiative sounds potentially interesting;

The partnership with Dell to introduce Internet of Things (IoT) Building Automation solutions to customers is progressing well with trials underway and we see a significant opportunity to roll this out to both new and existing customers. 

Possibly a future growth driver there?

Valuation - FinnCap has issued a revised note this morning, showing that the numbers being reported today by UTW for FY16 are well short of its previous forecasts.

Previously EPS forecast was 19.8p, which has been reduced today to 17.7p.

The PER is 7.6 - based on 17.7p reduced forecast for FY2016. So that's a very modest valuation, considering there's now no net debt either.

FY2017 forecasts are reduced even more - EPS has been slashed by 17.5% to 19.8p.

Dividends - there's a generous yield, and the argument that this was being paid out of increasing debt no longer holds water, since debt has been eliminated.

So expect 6.5p this year, and 7.3 next year - giving yields of 4.8% and 5.4% respectively - pretty good stuff, when you consider how low interest rates are. I can certainly see more investor interest in higher yielding shares, now that we seem to be locked into permanently low interest rates.

My opinion - as mentioned before, there are several things I don't like about this company;

• Its business model - carries regulatory risk. Also, I don't like investing in any arguably unnecessary intermediaries that are paid on commission, such as price comparison sites, insurance outsourcing, legal claims, anything like that - the goalposts can suddenly move, unexpectedly, clobbering profits.
• Massive net Director selling from 2012-14. Although also some big buys from a NED more recently (who's probably regretting those, as he's almost 50% underwater on the last lot)
• Aggressive accounting treatment, which we've discussed to death here before - so profits recognised early, then huge debtors sit on balance sheet - although this should be improving, with better terms being negotiated with energy companies.
• Increasing evidence that the company doesn't seem to be managed very well - e.g. staff attrition reported today - has it grown faster than management ability to control it properly? It looks like that to me.
• Seems to have to run to stand still - ramming through lots of new business, to cover overheads.
• Question marks over ethics - is the customer really sold what's best for them, or what makes UTW the most commission??

However, on the plus side;

• Shares look cheap on a PER basis, and carry a nice dividend yield.
• Interesting growth opportunities around new technology.
• Management says it has taken actions to improve staffing problems.
• Cashflow & balance sheet should be improving from improved energyco terms.
• If customers are saved money, then they're probably happy.

Overall - I find the company a little too accident-prone. So it's not for me. Also, I feel that Woodford has supported the price by repeated buying, and now holds 27.1%. What would the share price have fallen to, without him mopping up a lot of the shares? What happens if he changes his mind? (Answer - he can't as that would trash the share price).

It's a bit of a can of worms this one, in my view.

Quarto Inc (LON:QRT)

Share price: 261.5p
No. shares: 19.7m
Market cap: £51.5m

Audio interview tomorrow - I am interviewing Marcus Leaver, the CEO of this illustrated book publishers, tomorrow morning. Therefore please could you think up some questions - as I like to source my questions from private investors, to make it interactive.

Here is the link to submit your questions.

Thank you in advance. The company is issuing its results tomorrow morning, so I'll chat those through with the CEO too.

Acquisition - Quarto has today announced the acquisition of the publishing assets of becker&mayer (sic). The $9.8m purchase price is mostly deferred, through the issue of $7.5m in zero interest promissory loan notes. That's a neat solution.

Anyway, more on this company tomorrow (I don't currently hold, due to balance sheet concerns, but I am considering a possible purchase).

Telit Communications (LON:TCM)

Share price: 277.5p (up 6.7% today)
No. shares: 114.9m
Market cap: £318.8m

For background, I reviewed this company's 2015 results here on 7 Mar 2016. The points in that report are still relevant - that there are a number of red flags with this share, and that its aggressive accounting treatment of R&D means that reported profits are basically fictitious, the way I look at things. Also its cashflow is very poor.

Interim results, 6m to 30 Jun 2016 - I'm really surprised this share has risen today, as the figures are not good. Key points;

Revenue up 6.3% to $166.1m (note that it reports in US dollars)

Profit before tax down 46.0% to $4.7m - note the low profit margin of only 2.8%

The company tries to obscure this fairly lacklustre performance by instead focusing readers on more aggressive profit measures. So in the "financial highlights" section at the start of today's statement, it doesn't even mention actual profit of $4.7m. Instead it mentions the totally meaningless measure of $21.4m adjusted EBITDA, and adjusted profit before tax of $11.4m. Note that they are much larger figures than the actual profit on the P&L itself.

In some circumstances, adjusted profit is fine, if it's just removing the amortisation of goodwill, and any genuine one-offs. Less acceptable is to adjust out share based payments - since that's actually variable remuneration mainly for management usually. Note 4 to today's results is helpful, in giving a reconciliation of profit to adjusted profit.

The elephant in the room though, is development spend. In my view, technology companies like this have to keep spending like crazy on R&D, just to stand still, in such a competitive & fast-moving area. Therefore the most prudent of them write off all such spending as they go along.

Telit spends heavily on R&D, and it capitalised $15.3m onto the balance sheet in H1 2016. This compares with an amortisation charge (for previous development spend) through the P&L of $4.4m. Therefore the net gain to the P&L was $10.9m - which wipes out almost all of the $11.4m adjusted PBT, and actually makes the company loss-making to the tune of $6.2m if we base the adjustments on statutory PBT of $4.7m.

So if you adopt prudent accounting policies, this company doesn't make any money at all - it's loss-making! In the interests of balance though, as a reader points out below in the comments, the company is completely open about its accounting, and provides notes to reconcile the figures. Also, its accounting policies are perfectly permissable, they're not breaking any rules. 

Opinions differ on how to treat development spend, but for me, I'm only interested in genuine positive cashflow. Profits that don't turn into cash are not of any interest to me, which is what this company is reporting.

In fact, the cashflow statement is the best place to go, for companies which aggressively capitalise costs onto the balance sheet. Sure enough, the cashflow statement here is awful. 

Operating cashflow of $21.2m is decimated by negative working capital movements, to arrive only $8.5m net cashflow from operating activities. However, as noted above, the company spent $15.3m on capitalised development spend, so it's now $6.8m negative cashflow.

Then there was $13.7m spent on an acquisition, $2.4m on capex, $6.9m spend on divis (was that wise? In a word, no), leaving a yawning cash outflow which had to be plugged with drawing down fresh loans of $21.0m.

Overall then, a rather worrying cashflow statement - a supposedly highly profitable business that actually burns cash. Also, paying divis out of borrowings is a bonkers thing to do.

Guidance - helpfully, the company gives full year guidance, but unfortunately only with its fantasy definitions of profit. This leads investors to dramatically over-value the shares, in my view.

Outlook - lots of positive-sounding narrative, about stronger H2 performance.

This bit sounds very interesting;

"Although R&D, S&M and G&A growth were ahead of revenue growth, as a result of our continued investment in infrastructure, our target remains to reduce operational expenses as percentage of revenues by some 8-9% by 2018."

If they are indeed able to do that, then it would be transformational for the (genuine) profitability, and for cashflow. The trouble is, they're up against a headwind of increasing development spend amortisation charges in future years. Although there's an easy way around that - adjust it out!

A confident outlook for H2;

"Overall, we are confident of a strong second half performance, which will lead to double digit revenue growth and profitability growth for the year."

Balance sheet - not good.

NAV is $112.6m, but once the $104.9m intangibles are removed, that drops to a NTAV of $7.7m - a thin capital base for something valued at about £319m.

Current ratio is 1.1 - a tad on the weak side.

Receivables (debtors) looks a bit high to me, at $76.7m - that almost 3 months' turnover. Why do customers pay so slowly?

Other current assets of $15.9m - I don't like stray debits on the balance sheet, which can indicate inflated profits. That's another red flag.

My opinion - companies which adopt aggressive accounting treatments are often rewarded with a temporarily racy market cap. However, reality eventually comes home to roost, often catastrophically.

In this case, it looks like a proper company, operating in a sexy space (internet of things). However, so far, it's not really making any proper, cash profits. Therefore I think the mkt cap of over £300m is extremely optimistic. Investors are placing a lot of faith in jam tomorrow.

Maybe its products & prospects justify such optimism, I don't know. My job is just to look at the here & now, and dissect the figures, and to me these are poor figures, so it's a bargepole job for me.

The chart looks encouraging - could be a nice trading share, given the uptrend it's in? So maybe one for traders, rather than investors?

YouGov (LON:YOU) - continuing the theme of companies which adopt an "if it moves, capitalise it" strategy! 

A positive-sounding update for y/e 31 Jul 2016;

YouGov's trading for the year ended 31 July 2016 is now expected to be slightly ahead of the Board's previous expectations.

 The Company has achieved another year of double-digit revenue growth well ahead of the global market research sector with the proportion of revenue derived from data products and data services continuing to increase in line with YouGov's stated strategy.

Revenue from the US and Middle East markets has grown strongly with the Company also benefitting from the appreciation of their currencies against £ sterling over the past year.

The Company's balance sheet remains strong, with net cash balances at 31 July 2016 of £15 million.

My opinion - very much like Telit, I urge readers to look a the cashflow statements from YouGov, rather than the P&L. It's also capitalising internal costs aggressively. So if you value either share on adjusted EPS, you're potentially going to end up seriously over-paying. Caveat emptor!

That's me done for today, see you tomorrow!

Regards, Paul.

(usual disclaimers apply)