Small Cap Value Report (Fri 28 June 2019) - AIEA, SDI, COST, CRW, CVSG, PVG

Good morning, it's Paul here.

Let's get started today with a look at the profit warning yesterday from floor-coverings business, Airea.

Airea (LON:AIEA)

Share price: 56.5p (down 26% yesterday, at market close)
No. shares: 41.4m
Market cap: £23.4m

Trading update (profit warning)

Airea plc (LSE: AIEA), the manufacturer, marketer and distributor of floor coverings, announces the following trading update for the six months ending 30 June 2019.

This is what the company said, in a brief update;

Despite a very strong order book and first quarter and with continued growth from our export markets we will announce revenue slightly down and a lower operating profit for the half year compared with the corresponding period in 2018. This is due to significantly tougher conditions during the second quarter.

Like many UK businesses the economic headwinds are against us and we are experiencing a high level of market uncertainty; however, the business is well positioned to continue to prosper despite this continued economic uncertainty.

How on earth do we interpret that?!

If H1 revenue is only "slightly down" on 2018, then I presume profit should also be down a relatively small amount, providing overheads have not grown.

Looking back at H1 2018, the company reported revenues of £9.1m, and operating profit of £1.5m.

rhomboid1 contacted the company to query things, and posted his thoughts in comment no.50 to yesterday's report here. I don't think the company should have disclosed that information, but it's in the public domain now.

There don't seem to be any broker forecasts on the company, so I'm struggling to quantify things, or to value the company.

Valuation - stripping out one-offs, and normalising the tax charge, I calculate that last year EPS was about 5.8p. If we assume that this year might be a bit less, say 5p, then the current year PER might be around 11 - which looks about right to me.

My opinion - this is a nice little company, which has restructured and is now decently profitable. Yesterday's profit warning was a setback, but not a disaster.

The balance sheet is strong, although note there is a pension deficit. But it also has freehold property, and a very strong working capital position, including net cash of £2.7m.

I think the share price has correctly adjusted, to about the right level, given the likelihood that it might now struggle to beat last year's profit, and to reflect macro uncertainties.

It's not a stock I hold any more, and I don't see any compelling reason to buy back in. Overall, it looks priced about right to me.

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Scientific Digital Imaging (LON:SDI) - from yesterday, this company put out an encouraging trading update.

The uplift seems to have come from accounting adjustments, rather than underlying trading;

This uplift in FY19 guidance reflects the accumulation of positive outcomes in relation to items subject to prudent estimate or judgement at the time of the 15 May 2019 trading update.

So not massively exciting, but it does at least reinforce that management's accounting estimates are prudent, which I like.

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On to today's news, and let's start with 2 profit warnings. These seem to be coming thick & fast at the moment, which makes me nervous - how long will it be before my portfolio is hit with another profit warning? Should I be selling, and moving into cash, for safety's sake? Since a profit warning usually hits the share price by about 30%, if there isn't the likelihood of a 30%+ rise, then risk:reward doesn't look good.

Or, are profit warnings a good opportunity, to buy companies I like, at a more favourable price? These are the questions that small caps investors wrestle with on a daily basis. In truth, there's no one-size-fits-all rule, each case is unique.

Although Stockopedia's excellent profit warnings guide, did conclude (from a large data sample) that it's usually best to sell immediately when problems emerge.

Costain (LON:COST)

Share price: 186p (down c.39% today, at 12:12)
No. shares: 107.9m
Market cap: £200.7m

Trading update (profit warning)

Costain, the smart infrastructure solutions company, today issues a trading update ahead of announcing results for the six months ended 30 June 2019 on 21 August 2019. 

We're off to a bad start, with a pretentious-sounding description, which tells me nothing about what the company actually does. When will management and advisers learn that not being able to describe their activities simply & clearly, just wastes other peoples' time in trying to find out?

It seems to be one of these large, low margin, contracting groups, most of which have gone disastrously wrong, so I'll keep this brief - it's a horrible sector, best avoided altogether.

Trading on current contracts during the first half has overall been in line with expectations.  

New contract wins in the water market are noted.

This is the problem -

However, the Group has recently seen a number of delays to the timing of contract start dates and new awards.  Projects affected include the M6 Smart Motorway, Preston distributor road and HS2 Southern Section main works.  Additionally, the M4 Corridor around Newport project was cancelled by the Welsh Government earlier this month. 

Consequently, revenue for FY2019 will be lower than previously anticipated and underlying operating profit for the full year is expected to be in the range of £38.0 million to £42.0 million. 

It's excellent that the company has given clear guidance, numerically, on the likely outcome. All companies should do this.

Order book -

Revenue secured to date for FY2019 is £1.1 billion with the Group's operating divisions expected to trade within the target margin range for the year. Revenue secured for FY2020 is c£900 million (compared to c£850 million for FY2019 at the same stage last year) and is also higher margin business overall.  

Bear in mind that forecast revenue for FY2019 was £1,464m, and FY2020 was £1.474m, so the above figures are well short of that - i.e. the group needs to secure considerably more work to hit broker forecasts.  A positive point on higher margins for FY2020.

Arbitration award - a one-off £9.8m charge has been incurred, relating to remedial works from a contract back in 2006. The relevant sub-contractor has gone bust. The fact that such a large liability, from 13 years ago, could bounce back onto Costain, is very worrying. What other potential contract liabilities could there be lurking in the undergrowth? This really puts me off.

Broker update - I'm not going to waste time crunching the numbers, as I can't think of any circumstances, or any price, that would tempt me to buy this share. I had a narrow escape with Kier (LON:KIE) recently - where on paper it looked amazingly cheap, then the price crashed on a negative update. Following on from numerous other failures of contracting groups, I think you'd have to be  stark-staring mad, to even look at this sector for possible investments.

Thankfully Liberum have crunched the numbers for us, and reduce EPS by 33% and 29% for FY2019 and FY2020 respectively. That makes today's c.40% share price fall look sensible. The broker also suggests dividends are likely to fall correspondingly.

Revised EPS forecast for FY2019 is 27.4p, giving a PER of 6.8 - probably about right for, what is a low margin, risky, contracting business.

Balance sheet - Costain's saving grace is that it had the good sense to strengthen its balance sheet a while back. As a result, it's one of the few in this sector with sound finances. Hence I don't see any insolvency risk here.

As last reported at 31 Dec 2018, the key stats are;

NAV:  £182.3m,  less intangible assets of £58.5m, gives NTAV of £123.8m - a positive figure, which is quite unusual in this sector!

Working capital looks sound to me, with a current ratio of 1.43 - solid enough, in my view. Current liabilities only contains £10.0 in interest-bearing borrowings, comfortably exceeded by cash of a whopping £189.3m - so this looks a very solid cash position.

There is £60.5m in interest-bearing debt in non-current liabilities, but this still leaves Costain with an overall net cash position of £118.8m. This looks a window-dressed year end figure though, because the narrative discloses the more meaningful average;

Throughout the year the Group had a positive net cash position with an average month-end net cash balance of £77.1 million (2017: £96.7 million). The period-end and month-end balances have reduced due to a lower level of revenue and therefore cashflow receipts and payments during the year.  Going forward average month-end and period-end net cash balances are anticipated to trend closer to each other.

Bank facilities available are substantial.

In December 2017, the Group successfully increased and extended its total banking debt facilities to £191.0 million, which now have a maturity date of June 2022.

The Group maintains a regular, constructive dialogue with its banking syndicate who remain highly supportive of the business and its significant opportunities. In addition, the Group has in place committed and uncommitted bonding facilities of £320.0 million. 

 Although if I were a shareholder, I would prefer the group to avoid gearing up using these bank facilities - because we've so often seen how this sows the seeds of collapse when something later goes wrong. A recent example of that in another sector, was Staffline (LON:STAF) (where I hold a long position) - where a reckless acquisition spree, and hollowing out the balance sheet with goodwill & debt, brought it to the brink of collapse - staved off by yesterday's fundraising being successful.

Also, I think Costain could & probably is, using its relative financial strength, to win contracts. Government is no doubt very wary of yet another infrastructure, out-sourced private sector group going bust (e.g. Carillion & others), so should be placing more business with a financially strong group like Costain.

My opinion - I was starting to warm to Costain, after checking out its strong balance sheet. However, the arbitration award mentioned above worries me the most. That a liability from 13 years ago could re-surface, and lead to a material liability of £9.8m, is most irksome. My worry is that Costain is taking on large, complex, low margin work, which could have a long tail of potential problems & liabilities in the future. That seems a really unattractive business model.

Overall then, it's not of any interest to me. Although if you like the business, then today's fall could be seen as a more attractive entry point. Although be careful not to succumb to "anchoring" - the share price has fallen because earnings estimates have fallen considerably. So it may be cheaper, but isn't actually better value.

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Craneware (LON:CRW)

Share price: 1935p (down 34% today, at 14:42)
No. shares: 26.68m
Market cap: £516.3m

Trading update (profit warning)

This UK company, perhaps surprisingly, supplies healthcare billing software for US hospitals. It calls itself the "market leader in Value Cycle solutions", whatever that means. Today's update is for the year ended 30 June 2019.

What's gone wrong? - the timing & quantity of sales in H2 lower than expected. So just a straightforward case of the company not selling enough to meet targets. That's never good, especially not for a company like this, whose shares are on a very aggressive forward PER of about 46, as of last night.

Slower revenue growth - is now said to be c.6% up on LY. This compares rather badly with the +18.5% revenue growth shown on the StockReport from broker consensus. I can't find any specific broker research to verify this. Bear in mind that this shortfall has arisen in H2.

Checking the last interim results, H1 revenues were up 15% on LY, to $35.8m.

Last full year's (06/2018) revenues were $67.1m, so this year being up c.6% means that 06/2019 revenues will be c.$71.1m - that's a significant miss of $8.4m revenues, against broker consensus of $79.5m.

If we deduct the $35.8m reported for H1, that implies H2 revenues were slightly below H1, at $35.3m 

Adjusted EBITDA growth is said to be up 10% against LY - not bad considering, because this sector is very highly operationally geared (high gross margins).

Capitalised development spend - has shot up from $4.7m LY, to $9m this year (previously flagged by the company).  Obviously, R&D spend is a good thing, if it results in improved products & competitive position. However, capitalising this much makes EBITDA a nonsense number. So I would certainly not entertain valuing this company using EBITDA as a basis.

Outlook comments - management remains confident, with a significant & growing pipeline.

My opinion - this has always struck me as a high quality company. It's really something special, for a UK software company, to be supplying software to many healthcare facilities in the USA. No doubt that's why this share has always been so expensive.

Software companies often rely on large, lumpy contract wins, and sometimes a profit warning due to a poor short term performance in winning contracts, can provide an attractive entry price.

I'll put this share on my watchlist, with a view to possibly buying a few, if the share price continues falling.

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CVS (LON:CVSG)

Share price: 724p (up 17% today, at market close)
No. shares: 70.6m
Market cap: £511.1m

Trading update

 As a result of these actions, the encouraging progress noted earlier in the second half has continued.  Consequently, the Group now expects adjusted EBITDA1performance for the full year to be comfortably above current consensus market expectations.CVS calls itself the UK's leading provider of integrated veterinary services. Today's trading update is for the year ending 30 June 2019.

I read this TU before 8am, and thought to myself, gosh that's rather good, this share is likely to go up today. Unfortunately, I got so bogged down in writing about profit warnings on 2 other shares, and a bit of sunbathing on my terrace (well, it is a heatwave!), that I missed a profitable opportunity here. Never mind.

Summarising today's update - 

• Strong LFL revenue growth, of +5.4% in the 11 months to 31 May 2019 - very good, but it's in line with market expectations, so shouldn't be share price sensitive particularly
• Costs were running high (which seems to be above-inflation pay rises, and expensive locums), and action has been taken to reduce this, resulting in;

 ... As a result of these actions, the encouraging progress noted earlier in the second half has continued.  Consequently, the Group now expects adjusted EBITDA1 performance for the full year to be comfortably above current consensus market expectations.

Why on earth do companies follow the fashion of reporting EBITDA? It's so silly, and counter-productive in my view. Why replace a credible measure of profit, with a less credible measure (EBITDA)?

What they should do, in my opinion, is to report the far more credible figure of adjusted profit before tax, with the main adjustment allowed being the removal of amortisation of acquired intangibles.

I've challenged this with a couple of broker & financial PR friends, who replied that institutions seem to like the fashion of reporting EBITDA, so that's what they do. Give me strength! Although, to be fair, banks rely on EBITDA for a key covenant test, so there is some logic around reporting EBITDA for highly indebted companies (such as this one)

Previous profit warnings - I remembered that CVS seemed to have disappointed the market earlier this year, as you can see from the chart;

Candlestick charts are great, as the big red blocks down are profit warnings. There seem to be quite a few above, in the last 2 years.

I checked back, and this is the pattern of events in 2019 -

Jan 2019: Shortage of vets, resulting in above inflation pay rises, and having to use expensive locums. Expecting full year performance "materially below" expectations. Cost savings will be implemented.

Mar 2019: Interim results - adjusted EPS down 14%. Weak balance sheet - NTAV negative at £-96m. Too much debt

Jun 2019 (today): comfortably ahead of market expectations for full year (at EBITDA).

This is a very unusual pattern of events!

My opinion - I wonder if the rapid pace of acquisitions had stretched management, and weakened financial controls, resulting in the profit warning in Jan 2019? That often happens at acquisitive groups.

In this case, kudos to management for apparently getting back on top of things very quickly.

I very much like this sector - having to pay occasional & large vet bills myself, for 2 little dogs, I can see what a licence to print money it really has become in recent years. I completely understand that vets are highly trained professionals, and usually lovely people too with good intentions, but boy do they charge high fees these days.

Back in the 1980s, taking my dog to the vet didn't cost very much at all, it was an incidental expense. These days, it's quite routine to have to pay £250, £500, or even £1,000 to have my little fellas sorted out for whatever relatively minor troubles they're having, e.g. a couple of teeth removed, ear ticks, worming tablets, etc.

There's no doubt that it's lucrative work. Also, I think if the vet has a good manner with our dogs, we want to see him again. So they have a real hold over people.

On that basis, I can see that CVS is a very nice business model for staff, and shareholders. On our last visit to the vets, one of my little tinkers showed his disdain for the establishment by urinating on their point of sale display of dog accessories. I thought he went a little far, making his point, but did agree with his sentiment that the vets gross margin was far too high. 

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Premier Veterinary (LON:PVG) - continuing the vets theme, this micro cap seems to offer care plans for peoples' pets. It's very small, and still loss-making. So doesn't interest me.

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I shall leave it there for today, and the week!

It's been a pleasure really getting stuck into SCVR writing this week, I've enjoyed it. Thank you to subscribers for your excellent contributions in the comments sections. More of this please, it's a team sport! :-)

Best wishes, Paul.