Small Cap Value Report (Fri 31 Mar 2017) - PEB, SEPU, DX., HAYT, AVG

Good morning, it's Paul here.

Just a brief report today, as I have to prepare for tomorrow's UK Investor Show.

Graham is travelling over to the UK today, as he's appearing in the bears panel discussion tomorrow at UKIS. Should be an interesting, and quite fun day! I usually run into lots of SCVR readers on the day too, so am looking forward to putting some names to faces, and catching up with long-standing friends.

Ed & the team are having a well-deserved break this year, so there won't be a Stockopedia stand at the show. So I'll be flying the Stockopedia flag, and hopefully won't say anything inappropriate! (that comes later, at the Westminster Arms!)

Pebble Beach Systems (LON:PEB)

Share price: 4.77p (down 6.9% today)
No. shares: 124.6m
Market cap: £5.9m

Final results - for the year ended 31 Dec 2016.

These are pretty shocking numbers. The original core business (which has now been sold) is split out as discontinued operations. Business there just seems to have fallen off a cliff;

• Revenues down from £46.9m in 2015, to £31.7m in 2016
• Despite cost-cutting, the adjusted profit fell from £3.3m in 2015, to a loss of £7.8m in 2016

NB. the figures above are just for the discontinued part of the business. I'm highlighting them because it's a reminder that demand for products at any company can just dry up. It's not clear what exactly went wrong here, but for whatever reason, some customers clearly just stopped buying its products. Maybe competition overtook Vislink, with better & cheaper products?

Technology generally seems to be moving ahead so quickly, that this is an ever-present risk with any company making technology-driven products. The product life cycle seems to be getting shorter, and cheaper competition from e.g. China seems to often move in, and destroy existing businesses such as Vislink.

Therefore, as investors, we have to be very careful not to buy companies which are subject to such forces, and can move from being highly profitable one year, to being dead in the water just a couple of years later. I'm increasingly wary of investing in any companies like this, with technology products which quickly become obsolete. They have to run to stand still very often.

This point is also important for broker notes. They usually just assume a continuation of business, with x% uplift each year for revenues. Yet in some cases, that might be wildly over-optimistic, if competitive pressures are building up.

All that's left is the Pebble Beach software company. The group head office is to be closed in 2017, which should reduce central overheads considerably - since these are now wildly out of kilter with the size of the company.

PB made a £2.3m profit in 2016, but this was largely wiped out by central overheads of £2.1m, giving £0.2m profit for continuing operations in 2016, and that's at the adjusted level - i.e. the best possible presentation of the numbers.

Net debt was £14.5m, which is the company's biggest problem. For the time being the bank is being co-operative, but there's no guarantee that will necessarily continue.

Strategic review - mentioned today, basically means the company is now up for sale, and is likely to de-list I would imagine.

My opinion - a total disaster for shareholders. The situation looks highly precarious, certainly far too risky to even consider an investment, in my view.

The shares are now just a punt on whether the remaining business can be sold for more than the bank debt. Shareholders would get any excess (less costs). If there's a shortfall from selling the remaining business (i.e. for less than the bank debt), then of course shareholders would get nothing. Why take the risk of a 100% wipe-out?

From one disaster, to another. The common theme with PEB and SEPU is that reckless, incompetent management destroyed shareholder value by gearing up too much for acquisitions.

Sepura (LON:SEPU)

Share price: 13.5p (up 8.0% today)
No. shares: 370.1m
Market cap: £50.0m

Discussion with lenders - just the title of this RNS makes me shudder.

This company is supposedly being taken over at 20p per share, by a Chinese firm. Personally, I question the wisdom of allowing the Chinese to buy any companies in the West. It's a semi-hostile, one-party state, with a very peculiar economic system, riddled with unrecognised bad debts, which is certainly not capitalism.

The fact that Sepura's share price is currently 13.5p is indicating to us that the market is sceptical about the Chinese takeover actually completing. There have also been regulatory issues. Put on top of that the precarious state of the bank situation, and it all looks fraught with risk to me.

We already knew that the bank covenants would probably be in breach at end Mar 2017, as it was pre-announced late last year. The RNS today says;

Sepura plc ("Sepura") announced on 22 November 2016 that it would in all likelihood require a waiver of some of its covenants from March 2017. Further to that announcement, Sepura has entered into an agreement with its lenders to defer the 31 March 2017 covenant tests to 15 May 2017 (with an option to further defer to 31 May 2017 in certain circumstances).

So the news today is just confirming what we heard before, and has given the company up to 2 months breathing space.

My opinion - I had a successful dabble in this share last year, buying near the bottom, then selling out at about 19.3p. My feeling at that point was that it wasn't worth holding out for the last 0.7p takeover premium, because the risks involved were too high - i.e. the buyer being Chinese makes it inherently risky, plus with a dangerous bank position as a backdrop, risk:reward looked poor at that time.

I suppose upside could come from a higher, competing bid appearing, although if that was likely to happen, I imagine it would have happened by now, as the company has been in play for months.

If the Chinese deal completes, then there's a near 50% gain to be had on the current price. So it looks finely balanced, but personally I see potential for a possible 100% loss here. Therefore 50% upside, and 100% downside risk, with unknown probabilities on the outcome, doesn't strike me as a risk worth taking (in terms of buying or holding now).

While we're here, let's make it a hat-trick of dismal, shareholder-value-destroying companies.

DX (Group) (LON:DX.)

Share price: 9.5p (down 8.4% today)
No. shares: 200.5m
Market cap: £19.0m

Interim results - for the six months to 31 Dec 2016.

I won't spend much time on this, since we already know what the situation is here. It's a declining business (in terms of profitability) because the core DX Exchange operation is gradually being replaced by email substitution by its (former) clients, typically firms of solicitors & accountants. So the fixed costs of maintaining a large network of collection points is having an operationally geared impact on profits - which have basically collapsed in the last few years.

In the figures announced today, the company was just above breakeven - a £0.6m adjusted profit before tax. Once again, large exceptional costs were booked, mainly goodwill impairment.

Dividends - the company says there won't be any for the foreseeable future.

Net debt - too high, at £18.4m

Current trading - in line with management expectations. Stockopedia shows a broker consensus of £1.6m profit for the full year. But it's borderline stuff, as that represents a profit margin only just above 0.5%. So it wouldn't take much to tip the company over into losses, in future periods.

Balance sheet - looks precarious to me. The company relies on both bank financing, and getting cash up-front from its clients (represented by the deferred income line within creditors) to finance itself.  As DX Exchange contracts, so will the cashflow from customers paying up-front. So a negative working capital effect from declining business. That's not good.

Possible takeover - clearly management need to do something decisive here, as it seems to me the existing business model is just broken, and in probably terminal decline.

There's a separate announcement today about a possible purchase by DX of John Menzies distribution division. This would generate estimated cost savings of £8-12m p.a., so looks sensible.

If this deal goes ahead, it would constitute a reverse takeover, since John Menzies shareholders would own 75% of the enlarged company, plus its pension scheme would own 5%. DX shareholders would thus be diluted down to just 20% of the enlarged group.

My opinion - the IPO of this company was a terrible deal, that stitched up the institutions who participated in it, with a structurally declining business. Still, that's their look out, they should have done proper due diligence before writing the cheques.

A high, but unsustainable dividend yield was the hook to get institutions interested in the stock originally. So I'm now very wary of any IPO which promises a big dividend yield. They often go wrong, and can be disguising a poor underlying outlook. After all, if a business is capable of paying great divis in the future, why would the existing owners want to sell?

Shareholders just have to decide whether to ditch their DX shares in the market now, write off the loss, and move on - wiser from the experience. Or, whether to take a punt on the enlarged group doing better than DX did on its own.

Personally I feel that, when the original investment idea has gone completely wrong, and there's not much likelihood of it recovering, then it's best to just cut the cord, ditch them & move on. That's what I try to do anyway (although often long after I should have cut the position, unfortunately - this is a specific area where I'm trying to improve my own performance).

Breaking news!

Hayward Tyler (LON:HAYT) - has just announced that it's in "very early stage" bid talks with potential acquirer Avingtrans (LON:AVG) .

The share price of HAYT is up 45% at the time of writing. So the quandary in this type of situation is whether to grab an instant profit, in case the deal falls through. Or to wait for potentially bigger upside - which may or may not be forthcoming. This is a quality problem to have to worry about. Sometimes in situations like this, I sell half, and keep the balance. That way you can claim victory whatever happens.

AVG has an excellent track record of buying and selling companies at the right time & price. So I doubt they would overpay for HAYT. Although I don't have any particular view on what HAYT should be worth.

EDIT: Avingtrans has just issued its own RNS, confirming the bid approach, but giving no other details.

Right, all done for today. I look forward to seeing some of you tomorrow at UKIS.

Best wishes, Paul.