Small Cap Value Report (9 Aug 2016) - BOO, QRT, STM, SCS, HSP

Firstly thanks for BOO - you persuaded me to drop a no retail/no airline rule and I am very impressed with this company.
As for the BoE rate cut I am hearing of a motor industry investment that was due to be in the UK but was immediately reversed on Brexit since the company cannot afford to wait and see how things might turnout. They are now moving ahead with an Eastern Europe base. Only one anecdote but I suspect that Carney is getting several of these sorts of messages and cannot wait until the figures prove the problem

Also thanks Paul for bringing Boo to my attention. I have doubled my money and just sold half as the metrics make me worry a little, probably unnecessarily. Anyway I am now in for free so let's hope they keep on trucking. Keywords seems to be another star in the making. All the best, Charles

Yes - well done on BOO. You got that one right. I didn't think there was much room between Amazon and ASOS for another online clothes retailer. But looks like they are making it a success.

There have been three broker forecasts today for BOO raising their targets to 80, 90, and 100p; that may help the share price too.

My "no airline" rule remains firmly in place...

Re. Quarto Inc (LON:QRT)
I had a good look at the HY accounts this morning and unless I am mistaken, the picture is a little worse than depicted by Paul. I am happy to be proven wrong.
1 Net debt of 72.5m$ is costing the company some 3m$ p.a. in finance charges. Since the adjusted operating profit was only 0.4m$ at this HY stage, this will put them in danger of being in the bad books of their lenders (breaching covenants), unless they recover substantially in HY2. A big red flag.
2 Perhaps more serious is the position on intangible assets and balance sheet strength. The balance sheet shows goodwill + other intangible assets = £41.5m$. Then there are some more intangibles described as pre-publication costs amounting to a substantial 58.1m$.
Looking at the Cash Flow accounts, there is a line under Investing Activities: Investment in pre-publication costs = 17.3m$
Not fully understanding what these costs really refer to, I googled to find out:
"Pre-publication costs represent direct costs incurred in the development of educational programmes and titles prior to their publication."
So to me this is akin to software companies capitalising their software development costs. It looks to me as straight forward people & materials costs which should be expensed in the p&l.
If you accept this argument then, 

-  loss before tax becomes   -18.4m$
- the company’s Net Tangible Assets come down to -48.6m$
- Operating Cash Flow is -10.8m$ and Free Cash Flow of the same negative order

All IMO and please DYOR.   Declaration : neither long nor short

In reply to post #146154

Hi Ramridge

Its different from software. Pre-publication costs are really the need to pay upfront for all the materials and IP that goes into a book. This is a short horizon for the types of specialist books they publish. Then they publish and tend to earn quite quick from them. TBH most of what they publish is what I would call rubbish (its not great literature!) except perhaps in children but there is a market for this stuff. Often it can be faddish - they were the biggest early sellers of adult colouring books for example. So the earn back can be quite quick and a sharp deterioration in future revenue from many titles. However, they do have a portfolio of options and some titles will go on to earn for longer duration and earn them very nice excess FCF.

IMO the key issue for them is that they need to show more ability to grow organically from their existing stable rather than through roll-up...that said I do like their focus on children stuff recently and what they have built through acquisition there.

With acquisition they need to show shareholders stronger cost control and synergy evidence.

I would like debt to come down quicker and be done ahead of acquisitions but the debt is likely very sustainable due to a non-cyclical and diversified revenue stream that shouldn't be prone to large negative shocks. But paying down debt quicker would give great earnings and FCF boost. They need to show that the new acquisition becker&meyer is really bottom line additive at c.USD10m acquisition costs, otherwise they are a perpetual LBO-like situation that never crosses the divide that transfers earnings from debt holders to equity holders.

I own shares and view them as long term very good value (partly coming off of the lack of good financial management that was made before the previous management team)...however, I feel that the management team is showing itself to be a bit fluffy. They really need to show that they can either get costs down or earnings up and identify for themselves (and us) the key long term growth engines. The longer they take to do this the more chance of downward volatility and corporate disruption.

Best wishes
Paul

In reply to post #146157

Hi Paul -
Thanks for this comprehensive reply. So just to be clear, it is possible that they capitalise development costs for faddish titles whose shelf life may be just a few years, perhaps leading to early write-downs ?

I'm particularity enjoying the commentary and subsequent reader comments at the moment. I'm still astounded at how quickly my portfolio (with a few bargains thrown in) has rebounded after the dreaded 'B' word.

Firm holder of Boohoo.Com (LON:BOO) at the moment, no airline rule firmly in place, but cant help thinking that Gama Aviation (LON:GMAA) look tempting.

In reply to post #146154

Hi Ramridge,

If you do a search for my previous comments on Quarto Inc (LON:QRT) I've covered all those issues about pre-publication costs, etc.

As stated in the main article, I'm not yet comfortable with QRT's balance sheet, but it's at least going in the right direction.

If you look at full year results, it's a nicely profitable business. So the interims are of only passing interest - all the profit is made in H2, and the outlook comments today were positive for the full year.

Regards, Paul.

Hi Paul -
Thanks for pointing me to your previous comments, in March 2016.
I am glad to note your view that it would be best to see pre-production costs written off as incurred.
In the case of Quarto they are substantial.
Regards, Ram

In reply to post #146172

If you're going to expense the pre-publication costs, you should probably add back in the amortisation of those pre-publication costs, otherwise you're double counting.

Alternatively, if you don't like fiddling with the P&L, one might just note that they've generated ~$32.8MM in free cash flow (almost half of their current market cap) in the last three years while growing and without share issuance. That would suggest they are creating some value.

In reply to post #146163

I don't think GMAA look like they are doing so well at the moment IMHO - see recent trading statement, as follows:

Gama Aviation, one of the world's largest business aviation service providers, says consolidated revenues, reported on a constant currency basis, for the half year ended 30 June will be no less than $205m (2015: $191m) and adjusted EBITDA will be no less than $7.5m (2015: $8.2m).

Gama says these revenues have been achieved despite the continuation of the challenging trading environment in Europe, as previously highlighted at the time of the final full year results to 31 December 2015, announced on 21 April.

The Board does not believe that this is likely to change in the short term........

So, in summary, they are forecasting revenue growth of "at least" only 7% and an actual drop of EBITDA of nearly 10%. Aren't AIR potentially better value?

Re SCS (LON:SCS) I'd not over estimate the currency impact;

All purchases are in £ and 60% are uk sourced , plus they are normally no 1 customer so have a degree of heft that'll help smooth any currency impacts

There's an informative presentation here:

http://www.scsplc.co.uk/~/media/Files/S/ScS/pdf/interim-results-for-the-26-weeks-ended-24-january-2016.pdf?pdfdata=1

Looking back at when they went bust in the credit crunch it was primarily driven by 2 factors , the implosion in non status and lower quartile credit availability (which is still an issue hence the revised customer demographics for ScS2) and the withdrawal of credit insurance (no longer a requirement from suppliers). The same CEO , and major shareholder, David Knight is unlikely to have learnt nothing from the experience, and he frequently references back to 2007/8.

Eg http://www.investegate.co.uk/scs-upholstery-plc--suy-/rns/agm---interim-mgmt-statement/200712030700409503I/.

My guess is they'll steer a profitable path through whatever issues they face and meantime I'll enjoy a 10% yield.

Net margin is low but there are many more positives than negatives in my view.

PS I hold a few, most bought yesterday .

Paul, your blogs are always much appreciated.

Re SCS (LON:SCS) (I am a holder) I note your comments about how the company previously went bust in 2008 and that this is potentially a risk in another recession or credit crunch. Looking over the company's announcements from 2008 it strikes me that the main cause of the company's demise then was the withdrawal of credit insurance at short notice thus leaving the company with no working capital. It's only fair to say that this was an extreme situation because of the credit crunch aspect which was hopefully a one-off and is not typical for a "normal" recession. The recession then was also extreme.

I would argue that in a normal recession even thought there would be a significant profit reduction and maybe some losses for a year or two, this would be unlikely to cause insolvency. If true this surely makes the company much more investable than you imply. I would much appreciate your comments. Thanks again.

Hi all,

With management's credibility at stake, a policy of 'underpromise and over-deliver' seems pretty essential...and I thought the SCS (LON:SCS) update was admirably restrained.

ATB

SCS management have indeed learnt a lot from the previous downturn which was exceptional in 2008. I have had conference calls with the team and others have met with them and these were key questions. The company are doing well and I think they will continue to be the stand out performer in the sector and the yield is tremendous due to the very low rating. I think this will change over time but not because the dividend will reduce....I am a long term holder here.

Paul....SCS may be a good management for you to interview as clearly there is a big divide between those investors who think like you that they will suffer badly just like 2008 in any downturn whereas others see that this time it will be very different and that SCS are built to survive and prosper. The dividend should be of great interest to readers if the latter scenario plays out so maybe if you hear the management explain how they see things from here that will help the listeners.

I am also a holder of ScS. As an Fd of several Retai businesses down the years, the one thing I was expecting here was a big operational gearing effect from such a stellar sales growth. The EBITDA has not really stormed through as I expected this year...and the first half Interims and subsequent discussions with management gave strong clues as to why. Firstly, they did invest heavily in marketing..and it seems to good effect, so would expect that to continue. Also, such strong sales numbers would have driven max commissions for the sales team, and I suspect max bonus for all the central teams. I understand that in furniture, in particular, a high proportion of seliing staff remuneration is "incentive based" rather than base salary.
If next year produces a more modest sales growth than the +14.8% for last year, then we should expect lower bonus/commissions than a year of +14.8% would have attracted.
A second point is that they have quoted "order Intake" being +14.8%. In furniture there is an average gap of around 8 weeks between order intake, and when you actually deliver the sofa and book the sales. The first two months sales for next year are therefore already baked in at a very good level.
Retail appears quite polarised in recent times...where it is better to be low end & cheap (Aldi, primark etc) or high end Waitrose etc. .Rather than in the middle. Scs do have their niche at the lower end...certainly cheaper and more "in your face" aggressive promotionally than their contemporaries

In reply to post #146160

Hi Ramridge

I just found your question now. Just looking at Quarto again given trading update a few weeks ago and results due in March. So here's my response...and I am interested in feedback.

I think you and Paul Scott are a bit wrongheaded to worry about the accounting treatment for development costs. They would be better to drop it for the simplification it provides but it is not obscuring the economic earnings. Its EBITDA impact is modest and if cash-flow is looked at the impact is very slight too and approx 10% reduction for 2015 FY. Sometimes this sort of accounting treatment gets in the way of economic assessment but I don't see why that is the case here...please explain why. (I think both of you are having a rather automatic knee jerk response)

Quarto is an annoying company. I think management whilst "honest" are fluffy and too cautious for their own good. Leaver appears not to like the balance sheet position of the company and its debt pile but is not brave enough in seeking a solution so leaves himself hostage to fortune. By not dealing with it more aggressively he leaves himself hostage to fortune should earnings be seen to take a dip. A rights issues aimed at getting net debt down to target level would be better than trying to walk the tightrope more. Of course, there would be a wobbly response short term but, if the business is a good one, it would be short lived and closed out by value investors who no longer needed to worry about a messy balance sheet.

They are also annoying as they insist on having analyst meetings that regular shareholders can't attend. I suspect this is just stupidity and bad advice to them rather than they have something to hide. I think it is remarkable that this is permitted by FCA as obviously an element of non public information is generated (perception is information when dealing with fundamental uncertainties as all company and market has a considerable element of).

I read that the company is going to seek to define it long term IP a bit better. This could be interesting. I wonder if they are cautious about this though as its unstable and based on their luck in hitting the hot spot. Maybe recent acquisitions give them more room to do this though (children's books).

Overall, they need to improve their disclosure a great deal to give investors reason to believe. Otherwise they need some short term earning and/or debt reduction surprises.

My hunch is that this is a good investment and cheap. However, I repeatedly feel like selling it as I have nagging doubt that they are hiding something big. But, I end up looking and thinking they are just being stupid! Leaver's in danger of playing it so cautious and cute that he gets himself punted. Stupid management is not a great worry if the underlying business is good and cheap enough.

Best wishes