Small Cap Value Report (Fri 23 Feb 2018) - DRV, SGI, RMV | Graham Neary

23rd Feb '18 by Graham Neary

42 comments 15148 reads

Good morning!

Stocks I've noticed so far are:

Driver (LON:DRV) - trading update, "comfortably ahead of Board's expectations".
Stanley Gibbons (LON:SGI) - proposed refinancing.
Rightmove (LON:RMV) - final results.

If you have any further suggestions, please let me know.

Also, Paul updated yesterday's article in response to many reader requests, so there are many stocks covered in that article now. You can read it here if you like.

Thanks,

Graham

Driver (LON:DRV)

Share price: 75p (+15%)
No. of shares: 54 million
Market cap: £40 million

Trading Update

This is a "global construction consultancy". It helps clients manage large building projects by providing a range of consultants from a wide variety of disciplines.

It was unprofitable during 2015 and 2016, then was refinanced in early 2017 and recovered to make a small profit last year. Paul described it as a "nice turnaround situation" when those results were announced.

The StockRank has recovered from a very weak score a year ago, to the current fantastic score:

Today's update informs us that performance continues to improve:

Trading results in the first four months of the financial year ending 30 September 2018 are significantly ahead of both internal forecasts and the equivalent period last year. Current activity levels are also high and the Group has a healthy pipeline of potential assignments for conversion in the months ahead. Taken together these factors indicate that the outcome for the year as a whole is likely to be comfortably ahead of the Board's previous expectations.

So we are "significantly" ahead for the first four months of the financial year, and therefore the full-year results are likely to be "comfortably" ahead of expectations.

Why the discrepancy in language used between these time-frames? There is no guarantee that business will continue to be lively, of course.

At the annual results statement, the Chairman reiterated that it is "notoriously difficult to predict activity levels", and that "fluctuations in activity" are a feature of the business.

I was badly stung investing in a firm providing professional services to the construction industry, which has soured me from returning to the sector. No matter how cheap a company in the sector looks,…

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nicobos

23rd Feb '18

Graham - good write up on Stanley Gibbons (LON:SGI) .

You seem surprised that existing shareholders still retain such as significant stake in the business. My view is that the shareholders have been wiped out but via the back door. Existing shareholders may own 42% but of what?

In order to inject the capital they have, I'm sure Phoenix would have structured the £10m shareholder loan as a preferred debt instrument but with equity type returns (>c.16% interest at a guess).

This will be compounding for 5 years (Payment In Kind not cash paid) against shareholders equity and you'll end up with shareholder debt >£20m. This is how Phoenix will get their return. There will be no dividends in the meantime for ordinary shareholders. My guess is they could probably sell their equity in 5 years for 2p and still make a good return if the get their loan repaid!

Shareholders are left with a deep out of the money option which is probably close to worthless (unless the business sees some miraculous recovery with very strong outperformance!).

The bounce today is a temporary relief rally IMHO. Once people realise the exact terms of the deal and that the shares are worthless, they'll drift down towards what Phoenix paid (a great short if the stock was borrowable!).

Do shareholders honestly think that a vulture fund would be handing out free cash !? Deep value investors - beware of swimming with sharks.

You have been warned !

Graham Neary

re: Stanley Gibbons (LON:SGI)

Great points there!

I did intend to put a remark in the article saying that it will be fun to see what the interest rate is on this loan. The devil is in the details, etc.

Thanks for your feedback.

Graham

re: Driver (LON:DRV)

Hi Ian,

Yes, they have a wide range of expertise, including in dispute resolution etc. It's all construction-related, as far as I know.

If the economic conditions keep improving, yes I would expect more upgrades!

Graham

Thanks andrea. The cheque is in the post :)

G

Hi there, I have no opinion on that I'm afraid. Fortunately, it appears that you have been answered intelligently by others!

G

timarr

Hi Graham

Re: Driver (LON:DRV)

It's "construction", but only in the broadest sense. Basically their main business is providing technical based legal expertise into engineering project disputes where something has gone wrong. As most infrastructure projects end up overrunning they end up with a lot of business in these areas. So "construction" can be anything from oil rigs to airports. About 40% of the business is based in the Middle East and they're particularly favoured when there's a dispute under common law involving a party from a different legal jurisdiction.

The Buffetology Fund holds, I think. Keith Ashworth-Lord obviously thinks they have a moat but they look a bit different from most of the other holdings as far as I can see.

I like the company, it's a bit different but I just can't get beyond the thin margins and the idea that most of the value walks out at the end of the day to have a pint and a pie somewhere ...

Funderstruck

So pleasing to see that so many agree that it is still OK to pay compliments; long may it continue.

ken mitchell

Graham. Great updates. Thanks.

Not convinced though by your comment that “when a company buys back its own shares it results in extraordinarily good things for shareholders.”

NEXT have bought back more than half their shares. Despite wisely only buying back when they think the share
price is cheap, nearly all their buybacks were well ABOVE the current share price.

Also a 1.5% or whatever buyback should not be included in the dividend yield.Investors get real money with a dividend or special dividend. There is no cash pay out with a buyback. And if the share price goes down after buybacks, no obvious reward to shareholders at all.

There was an excellent LEX article in the FT onbuybacks recently, covering their many faults and a few plus points.

I also hold NEXT and much prefer it when they cancel their buybacks and opt for special dividends instead. Last year their dividends and special dividends gave a superb yield of nearly 10%. That’s real money.

24th Feb '18

NEXT have bought back more than half their shares. Despite wisely only buying back when they think the share price is cheap, nearly all their buybacks were well ABOVE the current share price.

That's wrong.

Since 1999 NEXT have repurchased 227 million shares at an average price of £15.98 out of an original stock of 375 million shares. Of those only 8 million were in excess of the current share price, and half of those only marginally.

The net effect of the repurchases has been to lift EPS today from £1.63 per share (i.e. the EPS if shares hadn't been retired) to £4.14 per share and increase dividends from 62.3p per share to £1.58 per share. Shareholders who held their shares for the whole period have seen over twice the level of dividends they would have seen if shares hadn't been bought back.

It's true that many share repurchase schemes are value destroying, especially where they're directly related to share option schemes, where management aim to boost the share price to hit the option price to benefit themselves. However, where the buyback is at levels below a company's intrinsic value they're inherently value enhancing for the shareholders that hang on, as the NEXT figures show, and they have the secondary effect of getting rid of more fickle holders.

However you don't have to take my word for it, here's Warren Buffett from the Berkshire Hathaway 2016 shareholder letter:

In the investment world, discussions about share repurchases often become heated. But I’d suggest that participants in this debate take a deep breath: Assessing the desirability of repurchases isn’t that complicated.

From the standpoint of exiting shareholders, repurchases are always a plus. Though the day-to-day impact of these purchases is usually minuscule, it’s always better for a seller to have an additional buyer in the market.

For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.

NEXT's rationale for repurchases over special dividends has been set out several times - here, for instance:

https://www.theguardian.com/bu...

In summary, with NEXT, share buybacks have enhanced EPS and dividends for the remaining shares because the company has been disciplined in exercising them. That's rewarded long-term shareholders to the advantage of short-term investors. Which is exactly how shareholder capitalism ought to work, in my view.

iwright7

timarr,

Yes Buffetology hold Driver (LON:DRV) and I think Keith views it as a recovery stock, (as do I).

Keith commented in 18 moths ago. "It briefly lost its way – not for the first time – in 2014/5 but is coming back strongly under new management".

timarr

Thanks for your very interesting reply.

Unfortunately I missed out one key word - RECENT.

It should have read:-

“Next have bought back more than half their shares. Despite wisely only buying back when they think their shares are cheap, nearly all their RECENT buybacks were ABOVE the current share price.”

And for the last few years, and since the share price fell from £80 to £36, with some of their buybacks at over £60, the investors who have been rewarded are NOT those who stayed, but those who took advantage of a willing buyer (Next) to get out.. I bought after the big falls at £38 and so far have gained both from the share price recovery AND the now large dividend, unlike those who bought much higher.

Next DO operate a sensible buy back policy, and only buy back when confident the share price is cheap. Many Companies buyback regardless of price. There are many examples of catastrophic buybacks.

E.g Banks buying back heavily ahead of the banking crash and following those buybacks with rescue rights issues! And In the US huge sums are spent on buybacks (see LEX article for many examples) including one Company
alone spending more than the entire one year NHS budget!

I.e even if sometimes long term shareholders eventually benefit, it does seem an incredibly expensive way of going about it! So many other ways the $1 TRIILLON spent on them in US could have been invested?

Yep, I had a look back and the most recently comment seems to be from March last year when Ashworth-Lord commented:

Driver Group announced a major reorganisation with the aim of retrenching to its core dispute resolution and expert witness consultancy business. In tandem, the group has raised £8m via a Placing at 40p to recapitalise its balance sheet. There is a very good business in there that is screaming to get out and we are working closely with management to ensure that it sees the light of day.

Having had a look back at the Buffettology Fund's investing principles the key quality metrics look like FCF and ROCE. Neither of those look pretty right now, but historically they were quite good. Maybe I'll take another look here.

Hi Ken

The research on buybacks is pretty damning, they generally destroy value in favour of managements. Buybacks only really took off after share options schemes were popularised by management consultants in the 1980s and 1990s as a way of aligning management and shareholder interests. They don't, of course, they incentivise managements to do short term things to prop up the share price at the expense of long-term investors. It's always worth spending a bit of time looking at any holding that does this, to try to work out for whose benefit it's being done.

It's true that Next (LON:NXT) have bought back some shares at above the current level - basically about £290 million over 2015 and 2016. But this has happened in the past - they bought back a billion pounds worth of shares between 2007 and 2008 only see the share price drop well below the buying price in 2009. People complained at the time but in retrospect those shares were purchased at an average price of £17.43 and shareholders have since seen over £30 worth of capital appreciation and over £10 of dividends.

People get hung up on income, but in a perfect world the last thing a company should do is pay out dividends. The average, risk adjusted return on equities is somewhere between 4% and 8% (yeah, that's economics for you, accurate as ever) and any company that can invest its earnings to get a better rate of return than that should do so. Dividends should only be paid out when they can't beat that level of return, which then gives us shareholders the problem of finding something else to generate those returns.

In truth, of course, companies often do incredibly stupid things with our capital which is why we usually prefer they give it back to us so that we can do our own incredibly stupid things with it. But those few companies - like Next (LON:NXT) - that have long term records as good as this should be given the benefit of the doubt, in my view.

Hi timarr

Brilliant reply! Agree with most of it.

Not so sure about “in a perfect world the last thing a company should do is pay out dividends.”

Take Next again. I remember almost buying at 30p many years ago, but decided against because share had quickly 5 bagged from 6p when it looked as though they were going bust. Had I bought then and still hold the dividend yield alone last year would have been 10 times that 30p buy price!

Reinvesting dividends is often THE way to maximise returns. Another reason why I much prefer them to buybacks.
And surely it is wrong to include buyback yield in the dividend yield?

Finally I’m still bemused about “buybacks...result in extraordinarily good things for shareholders.” What are these extraordinarily good things?

Hi Ken

I think the full quote is correct:

When a good company buys back its own shares, it results in extraordinarily good things for shareholders

When Next (LON:NXT) or Rightmove (LON:RMV) or Burberry (LON:BRBY) buyback shares at a discount to their underlying value there's a compounding effect on the valuation. Essentially the remaining shareholders are being given a larger fraction of the future earnings of the company. And future dividends, if they're paid.

The important thing is that the company is able to continue to generate those earnings in perpetuity. A "good company" is one that has exactly those characteristics. If you like, the company is reinvesting your dividends for you, but with the benefit of avoiding any tax. Assuming those earnings are maintained this ends up supercharging your returns through compounding effects.

To take a counter-example, many years ago I was a shareholder in Character (LON:CCT). The directors engaged in an aggressive buyback scheme right up to the point where they suffered a significant profit warning and had to issue more shares to fix the problem. Character (LON:CCT) is exactly the wrong type of company to engage in buybacks - it's operating without much a moat and is exposed to the fickle nature of producers and buyers.

I fully appreciate that the idea that dividends aren't optimal is hard to stomach, but in a rational world that would be true for the reasons given above. Unfortunately, as we well know, company managements are often irrational and profligate with shareholder value, which is why taking a dividend is a sensible option. It's also sensible if you like investing in companies with less certain earnings streams or competitive advantages than the ones mentioned above.

In short: I think Graham is absolutely correct. But it's critical to apply this only to good companies and not to all companies.

xcity

26th Feb '18

Thanks for the discussion on Next buybacks.

I'd make one cautionary comment about the psychology. It leads to a series of EPS increases which investors may think of as growth in the business when it is really financial engineering. This becomes a problem if it creates the impression of the business being higher quality than it really is. Though never a problem for anyone who does their sums.

I also wonder whether the Next strategy means that the shares are a sell if the company aren't buying back, even if they have money to spare? They presumably have the best view of underlying value.

xcity

Next are buying back again, and this is instead of another special dividend. Their post Christmas update was positive enough for Next to feel confident enough to go for buybacks again.

It leads to a series of EPS increases which investors may think of as growth in the business when it is really financial engineering. This becomes a problem if it creates the impression of the business being higher quality than it really is.

Obviously that's not a Next (LON:NXT) specific issue - in fact it's the increase in EPS that's the incentive for many managements to make share buybacks. It artificially inflates profitability and the share price, helping hit share option price targets. I actually wrote about the research around this ages ago:

http://www.psyfitec.com/2009/1...

It's one reason you have to look hard at any company performing buybacks - if the buybacks don't have any obvious rationale other than boosting the share price then that's dubious. If the reason is related to the shares being undervalued then that's more credible, as it's benefiting long term shareholders.

With Next, all things being equal, I'd say that if they're performing buybacks then they're probably a buy, otherwise you have to take a view on future growth. Whether you equate that to a sale is another matter - share price is a combination of net current value (aka intrinsic value) plus future growth prospects (plus or minus irrational investor optimism / pessimism, but let's ignore that). Buybacks should never take account of the latter, but it's a definite factor in a purchasing decision.

At the moment the market doesn't have much confidence in Next's ability to grow earnings, I'd guess.

apjacko

28th Feb '18

Hi Graham, didn't Paul Scott have this as a good short in August last year, when the share price was at £40.70

drvodkaquickstep

6th Mar '18

There is a detailed report on Driver Group's recent AGM which can be found in the ShareSoc members area here: https://www.sharesoc.org/members-area/

To access the report, you'll need to be a full member of ShareSoc, which is a not-for-profit organisation that supports individual shareholders and campaigns for shareholder rights. If you're not already a member you can join here: https://www.sharesoc.org/membership/

Once you've joined, you'll receive an invitation to register for our "members network" private social network, from where you'll be able to access the report (and reports on 100s of other meetings). If you're already a member and have any difficulty accessing the report, please do not hesitate to contact us here: https://www.sharesoc.org/contact-us/

Small Cap Value Report (Fri 23 Feb 2018) - DRV, SGI, RMV

Driver (LON:DRV)

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Graham Neary

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