Small Cap Value Report (Fri 21 Feb 2020) - SIXH, IQE, CKT, ADT, VLE

21st Feb by Graham Neary

32 comments 8886 reads

Good morning!

Small-cap news today from our universe of stocks is limited:

600 (LON:SIXH) (trading update)
IQE (LON:IQE) (grants share options to CEO/CFO)
Checkit (LON:CKT) (concert party increases stake)
AdEPT Technology (LON:ADT) (placing and subscription)

After I've covered these, I might say a few words on the recent deal by Volvere (LON:VLE).

Timings: finished at 2.30pm.

China Supply Chains & Coronavirus - Paul asked me to provide a link to the interview he published yesterday on his website, on a timely topic. Here's the link to the interview with the MD of UP Global Sourcing Holdings (LON:UPGS).

600 (LON:SIXH)

Share price: 11.25p (-20%)
No. of shares: 117.5 million
Market cap: £13 million

Trading update

This industrial group already issued a profit warning in December, triggered by "certain macro economic and political uncertainties" and "the global automotive slowdown".

Things have only got worse since then. The company cites the following factors:

the strike by a union at General Motors (but this has been over since October)
suspension of Boeing 737 MAX
two specific projects being pushed back
Coronavirus - revenue from sales into China is being delayed into the next financial year (after March).

It all means that the result for FY March 2020 will be significantly below the revised expectations, i.e. we have a follow-on profit warning.

Debt - the company has been trying to derisk, both operationally and financially. The failure to get a good result this year is clearly going to have an impact on those objectives.

Net debt as of September 2019 was $16.9 million (£13 million).

If the share price gets above 20p, the £8.5 million in outstanding loan notes would convert to equity. But as things stand, these loan notes are set to mature in February 2022 and will need to be paid for with cash

My view.

The P/E multiple has been cheap here for a while. Frustratingly for shareholders, it's starting to look like the market's scepticism was correct.

Despite getting rid of its pension scheme, the company still seems to be in a bit of a mess in terms of its balance sheet. And with trading so…

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hayashi22

21st Feb

Re IQE (LON:IQE) it does look as though these two Directors are rewarding themselves for failure. It needs institutions to object to these nil cost options at a time when the share price has plunged. I also think the company promoted the share price to a ridiculous level with wild ideas about the success of their business and its potential. Needless to say non of that materialised. The ceo of this company would be unemployable anywhere else.

davidjhill

Graham

Although I disagree with you around the investment case for Iqe (LON:IQE) in general, I do agree with you on culture and excessive management remuneration (which obviously in itself reduces the investment case).

The problem I have with nil cost LTIP type options in general (not Iqe (LON:IQE) specific, though this appears to apply) is on 2 things

1) They are designed to be long term incentives but actually act as short term incentives. The 2016 LTIP for example vested because the share price rocketed on Apple hype. Not because they had demonstrated the ability to make money consistently over time. Lots of holders, including myself, would have held on to the shares based on the long term potential for their wafers around the photonics business. BUT once LTIPs vest and directors sell shares there is no clawback when they suddenly have a period of mis-steps ( whether unlucky or incompetent). You don't get away with this in banking bonuses anymore for example. 2008 saw to that. Now bonuses under contract and ultimately SMCR are subject to clawback. Thus my view is that LTIPs mean shareholders interests are actually no way near aligned with management, who are just incentivised to be as greedy as possible.

2) The knock on problem is that once management are used to LTIPs vesting this tends to lead to disappointment when things are not going to plan and they are in danger of not receiving their gravy with their potatoes. Not getting any shares tends to lead to toys thrown from pram, rather than sleeves rolled up to do better (wrongly incentivising behaviour). This means boards are under pressure to discretionary vest some of them to soften the blow for the poor souls that have sometimes already milked their shareholders for a lot of remuneration and not enough long term value. This is a major problem with the LTIP scheme in my view as it is contrary to the intended purpose and consequent tax breaks. This issue appears, at least on the surface, to have been afflicting £IQE. In this case it appears as though senior managers may have been threatening to leave and take expertise (or worse) with them judging by the wording of the vesting rns.

So I agree with Mark Slater and yourself on the LTIP nil cost option issue. In my view Iqe (LON:IQE) should be an excellent business with good operational gearing from a fixed cost base and capable of being multiples of the current price. The problem is that this has not been borne out for shareholders, whilst management have been massively rewarded. No doubt they would claim that circumstance stepped in the way and that they should not be penalised for matters outside of their control. I would argue that if you want to own part of the business that you run then that is part of the risk you take. I would also argue from a purely personal perspective that management haven't done anywhere near enough of a good job to deserve such pay but that's just my opinion and I would/will vote my shares against such compensation.

Checkit (LON:CKT) is almost the opposite of this. They made shareholders a lot of money who got rewarded with a tender at 65p. They then injected a new business capable of delivering similar types of rewards again and re-invested their money from last time on a large scale.

As a case study in shareholder value which company do we think is likely to make shareholders more money? I know where my bet lies.................

Damian Cannon

Great commentary today Graham. I couldn't agree more with you regarding iniquitous nil-cost options and bonus schemes tied to adjusted EPS. Both of these elements are simply tools to transfer company ownership to board members with the vesting criteria at their discretion. Personally I think that nil-cost options should be legally banned.

WallerMa

LON:SIXH) was supposed to earn PBT of $2.5 million this year, from revenues of $70.8 million.

I can’t reconcile these figures in your report with the Stockopedia figures....can you help?

Trident

Re IQE (LON:IQE)

Hear!, Hear!, Graham.

Unfortunately, I think the CEO of this Company whilst breaking no rules, has milked the option awards, and I am glad someone has referenced it at last. People have also defended his complex pledging of shares, again properly disclosed, despite this being a rather odd arrangement.

I think all these signals send a distinct message about whose interests are being served in a cash hungry business which has paid no dividends, and has made at least one major dilution for a cash raising exercise when the market was favouring their share price.

It is a serial under performer, despite making advances in the manufacturer of various semi conductors. It has never truly delivered for shareholders, but has done pretty well for its CEO.

I was a holder having swallowed some of the wunderkind hype around its product offering. The CEO has been there a long time, and I think the remuneration committee are somewhat captive to his 'founder' status.

I will accept they have had some bad luck, but it is a poor investment from my perspective, and the image of an options hungry CEO does not help.

Exactly right..the ceo is seen as the founder and seems to think he can do what he wants. It needs a strong Chairman to stand up to this greed.

coinflipper

Thanks Paul for the Up Global Sourcing Holdings (LON:UPGS) interview.
While I have bought a few shares in UPGS and some china oriented ETFs recently, I'm also cognizant of many issues/risks that are articulated in this thread here https://twitter.com/supermugatu/status/1230562561201819650?s=21
"A single component missing in a 500+ part product means all levels of production are moot. Autos and consumer electronics are obvious examples."
It's reassuring to hear that UPGS is probably OK, but from what I hear professionally and personally (ie: friends/family in China and Asia) I'm worried about the risks that are being ignored or not articulated very well as per the twitter thread example.

simoan

"A single component missing in a 500+ part product means all levels of production are moot. Autos and consumer electronics are obvious examples."
It's reassuring to hear that UPGS is probably OK, but from what I hear professionally and personally (ie: friends/family in China and Asia) I'm worried about the risks that are being ignored or not articulated very well as per the twitter thread example.

I agree about the possible knock on effects. If you remember, there were huge repercussions from Japanese suppliers effected by the Tsunami in 2011. As an example, this is what Proctor & Gamble had to say yesterday:

"We face the demand and supply challenges associated with the coronavirus outbreak. China is our second largest market-sales and profit. Store traffic is down considerably, with many stores closed or operating with reduced hours. Some of the demand has shifted online but supply of delivery operators and labor is limited. There are also impacts outside of China: travel retail, a significant reduction in department store traffic in many Asian metro areas, and global supply. We access 387 suppliers in China that ship to us globally more than 9,000 different materials, impacting approximately 17,600 different finished product items. Each of these suppliers faces their own challenges in resuming operations. The operating challenges change with the hour, and of course the path of the virus is unknown, making it very difficult to provide precise estimates of impact."

"Results for the January to March quarter in China and for the total Company will be materially impacted on both the top and bottom line by these dynamics."

All the best, Si

mojomogoz

A current and good China convo here (live event so look in now) if people want to take part or just be voyeurs:

https://sinocism.com/p/open-discussion-on-sinocism-starts/comments?token=eyJ1c2VyX2lkIjoyNjQ0MiwicG9zdF9pZCI6Mjg2ODM4LCJfIjoieVpRTnAiLCJpYXQiOjE1ODIyOTgwOTMsImV4cCI6MTU4MjMwMTY5MywiaXNzIjoicHViLTIiLCJzdWIiOiJwb3N0LXJlYWN0aW9uIn0.W9Z4mEQ5rrIpRNH9faQ0llZSy0NqmWQh0eTrYSyrtVY

4351anf

many thanks for the notes on Volvere, Graham. Reassuring as it is also my largest holding

Graham Ford

Re IQE (LON:IQE)

A couple of year’s ago at the AGM I pointed out to them that their prediction of market growth rate was much higher than the increase in earnings (or whatever) needed to secure a LTIP bonus and the LTIP was thus going to be a reward for losing market share. The response of course was that they had employed remuneration consultants blah blah blah......

Nothing changed of course as a result of my comment other than the share price falling due to the mud slinging short attack, the trade war between US and China, then the Huawei ban, and now Covid-19 impacting Apple and by implication IQE.

What can we do? Well for one thing use our votes. It is pretty easy on II to vote on the resolutions at the AGM.

Also, perhaps we could start a thread for shareholder activism against excessive remuneration. I.e. each time someone sees a particularly bad example of this naked greed they post the details to encourage others to publicly condemn the management and vote against at the AGM. Just a thought.

(Still hold a small position. One day Rodney…!)

iainc

A key benefit to this report is that both authors think individually and present their honest opinion. Regarding Iqe (LON:IQE), a couple of years ago many subscribers wanted both Graham and Paul to confirm their own bias towards this company. Paul rode the sentiment and got out at the top and probably did very nicely, while Graham wrote about it, for what it was - a capital intensive, low margin manufacturer. Neither tried to please the crowd.

Today's report on Iqe (LON:IQE) does not show the directors in a good light, but they only have themselves to blame (while eating foie gras and supping champagne courtesy of their LTIPs)

The situation in China is that people have to go the police authority and acquire a licence to be able to shop in a supermarket or elsewhere. The theory is they will not be permitted access to the shop without the licence.

People returning to China have to serve a 14 days quarantine period, and so there is a practical difficulty if they do not have sufficient food, and have no licence. They have to rely on the local community in some way to supply them with food during this period.

People who turn up at shops without a licence may be arrested.

A good test of whether your neighbours like you or not!

bobsandy12

Great one as always Graham.....thank you

Could you let me know why the Stocko stock report for Volvere is so much red ink??

MassimoJack

Really good interview with Andrew Gossage of Up Global Sourcing Holdings (LON:UPGS) Paul, thank you for that!

However, I think a few people have taken from the interview that because Andrew was calm and measured in his response, that there will not be an impact on UPGS from the virus. My take, for what it's worth, was that there will definitely be an impact and that it may be material, but that over time (could be up to 12 months), things will return to a similar state to pre-virus.

I thought his point about the Chinese government being willing to step in and shore up situations where factories face short-term funding/solvency issues was also interesting. I think this is one of the big questions out there at the moment. These small factories run with fine margins and being idle for a month will have a major impact, as would any cancellations of work-in-progress.

As Andy said in the interview, we are still far too early in this process to be able to estimate what the final impact will be, but from my perspective, buying any company as exposed to China using pre-virus earnings estimates is a tricky game to play...

“... buying any company as exposed to China using pre-virus earnings estimates is a tricky game to play...”

Couldn’t agree more as:

1) Buying on sell side provided earnings estimates is nuts

2) Buying on isolated 6-12 month earnings result double nuts

And then what is exposed? Is it where you’re main production is located? Or is it the complexity of supply chain in interaction with industry chain margins and vulnerabilities. This is where the known and unknown unknowns will be coming from in your portfolio. It will be cos that don’t seem anything China connected. Take SDI (LON:SDI) as an example. Their CEO says categorically no China impact and everyone accepts at face value.....

But hard to believe all the rinky-dink pieces of kit they produce will not have loads of direct and indirect China links. SDI’s businesses are small. They probably don’t import direct from China...so CEO being truthful...but intermediaries they source from will. Some quite surprising shortages will appear if China’s satanic mills ain’t back to humming in next few weeks. SDI will do worse job resolving that and any knock on customer probs than UP Global Sourcing Holdings (LON:UPGS) by a long shot.

So, where’s the risk?

If you believe coronavirus is going to be bigger and this is just beginning then watch out for those bullets pounding in on “safe” bits of your portfolio.

UPGS has been infected already. Odds are it’s a better risk adjusted buy than something unimaginatively viewed as clean today.

And talking non obvious or second order effects...if UPGS can show better situation management than others (as Gossage claims) then maybe they will surprise to the upside on orders come year end in July as they’ve got all the relationships with retailers established and they need to fill shelves.

Simple negativity and cyclopic earnings perspective unlikely to be productive in current wu-flu angst

Effortless Cool

For those that are interested, Cenkos have joined finnCap in making their research available to private investors through their corporate website.

Gromley

RE 600 (LON:SIXH)

Graham's comments about the convertible loan notes being a major issue if they share price doesn't reach a level at which they would be converted (to shares) rather repaid, is interesting.

Today's profits warning significantly heightens this risk, but it was clear for sometime.

After their HY results at the beginning of December (incidentally 2 1/2 weeks before a profits warning trading statement I observed :

A more worrying option for the company, surely would be that the notes are not converted by 2022 and instead the company needs to pay off or refinance £9m.

I am not trying to be smart Aleck here by pointing that out - the truth is that most of us made enough good calls (amongst the bad) to be able to appear an investing genius if they are recalled selectively!

Rather the point is that the risk for 600 (LON:SIXH) of that debt has been visible for some time and when coupled with a very weak balance sheet and negative FCF over a sustained period it is a toxic mix.

I tend to be significantly more liberal than Paul or Graham when it comes to balance sheets, but that is generally only when there is strong and (seemingly) sustainable cash-flow ( Reach (LON:RCH) for example which has a negative TNAV and every reason to ignore the intangibles that are written down and down frequently but has such an impressive cash-flow that I consider it almost ironclad).

600 though was one that I steered well clear off because of the balance sheet coupled with poor cash-flow.

I have been invested in 600 (LON:SIXH) in the past, largely because of their (previously) massive pension fund surplus which I regarded as the equivalent of a very-long term bond with zero coupon, but trading at a pennies in the pound to ultimate redemption value. When they sold of the scheme at a small premium to the "pennies in the pound" back in 2018 as one of the last acts of selling off the family silver to keep paying the leccy bill, I was out.

They reinstated dividend payments at around the same as a statement of confidence that their new business model was leading them to a positive future.

I cannot now find the posts, but I am sure that at one stage I described that as "brave" and also somewhere noted something along the lines of them being only one economic slowdown away from needing significant refinancing.

Again - not trying to prove that I am smart - but to point out that the warning signs have been there for some time. I have taken several such bullets in the past, but have at least learnt some of the lessons of when to step away from a hazardous situation.

Possible Lessons

Back in December before the HY results and the first profits warning 600 (LON:SIXH) had a StockRank of 93 and was classed as a "superstock". (As Graham points out it is now 'contrarian' with a SR of 59 and I suspect at the next results it will probably be re-classified as a 'value trap')

Statistically I still believe that if you blindly buy a diversified portfolio of high SR stocks you will beat the market, but if you are relying on the SR to buy individual stocks, you need to be aware that much as 'value stocks' can be "cheap for a reason", some high SR stocks can be "high SR for a reason".

I have a working hypothesis that screening out high SR stocks that have significant risk factors (that are not measured in the SR) MAY be the recipe for low risk out-performance. (I'll update you all on that - once I've agreed terms with Dickie Branson for the purchase of Necker Island!!)

davidtianjin

22nd Feb

That is absolutely not the situation in the vast majority of China. I am living in China now in a major city near Beijing with my pregant wife and toddler. To enter the supermarket we just need to scan a qr code at the door, no police station trip necessary.

Furthermore, people flying to Beijing and staying in Beijing do not have to do a 14 day quarantine. Again that only applies to certain places.

RDHOWARTH

25th Feb

Its a good Q - largely accounting and unwind of transactions, releasing earn outs etc However there are also central costs involved with VLE which absorb operating profit from their investments. Shire has actually grown quickly and become profitable but the lack of profit at the point of sale of Impetus results in operating losses at the group level. Hence the focus on asset value which capitalises realisations. Now Shire has moved into profit the story should move on back to the P&L, which should be improved further by Indulgence as it comes through over the next year or two. You then have embedded value unrealised that will result on a stronger stock report and drives its stock rank back up - assuming all goes well of course.

Small Cap Value Report (Fri 21 Feb 2020) - SIXH, IQE, CKT, ADT, VLE

600 (LON:SIXH)

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Graham Neary

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