Small Cap Value Report (Fri 7 June 2019) - SOM, SUN, GAW

Good morning, it's Paul here!

EDIT at 15:19: thanks for all the interesting reader comments today on Somero Enterprises Inc (LON:SOM) - some outstanding contributions, bravo! End of edit.

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Somero Enterprises Inc (LON:SOM)

Share price: 280p (down c.20% today, at 09:08)
No. shares: 56.3m
Market cap: £157.6m

Trading update (profit warning)

This company is based in the USA (its largest market), and sells laser-guided concrete screeding machines, to lay perfectly flat concrete floors for warehouses, etc.

I'll spend some time, properly looking into this, because I've always liked this company and am thinking in terms of buying the dip, possibly.

What's gone wrong? 

Trading during the five month period to the end of May 2019 has fallen below management's expectations, primarily due to adverse weather conditions in the US, the Company's largest market. Broad sections of the US experienced the highest levels of rainfall on record.*

[Paul Scott: The asterisk relates to some rainfall data, given at the end of the announcement.]

The record rainfall seen in the US has delayed project starts which in turn has slowed the pace of equipment purchased by our customers, the impact of which was seen through historically strong trading months of March and April.

If this is true, then it fits my definition of a good profit warning - i.e. something that's a one-off negative, and should be easy to recover from. Therefore I'm starting to get interested - re a possible purchase on the dip.

The downside risk is that the adverse weather explanation might be masking a more negative cyclical trend, or a deterioration in Somero's competitive position, possibly?

Things have started to improve - which is positive, and adds weight to the adverse weather argument being true;

Whilst there was an improvement in trading to end the month of May, and although the Company expects weather conditions and therefore trading in the US will improve throughout the rest of 2019, the Board now does not expect the Company to fully recapture the shortfall caused by this extended period of poor weather in the current financial year...

Revised guidance is provided - extremely useful - all companies should do this when putting out a profit warning. If they're not sure, then a range of possible values is better than no figures at all;

As such, the Company now expects to deliver 2019 revenues of approximately US $87m, EBITDA of approximately US $28m

As always, the two key questions for lowered guidance are;

1) How does this compare with last year's figures?

Looking back at 2018 results, and doing CTRL+F for "EBITDA", I quickly identify that adjusted EBITDA was $30.8m in 2018, and $28.0m in 2017. Therefore today's RNS is taking EBITDA back to the same as 2017, and 9% below 2018 - hardly a disaster.

2) How does this compare with previous profit guidance?

The quickest way to find out, is to look on Research Tree for updated broker notes. FinnCap has updated its forecasts, and reduces its 2019 EBITDA estimate down 10.8% to $28.0m. This works out at a previous forecast of $31.4m EBITDA.

Rather perplexingly, FinnCap has also reduced its 2020 forecast EPS by 10.9%. If the weather is a one-off impact in 2019, then surely that should have no effect on 2020? There might even be a benefit to 2020 performance, from pent-up demand left over from 2019?

Cash position - Somero today gives guidance on this too;

The company expects to have net cash at 31 December 2019 of approximately US $18m, after one-off investments of $4.0 million related to building expansions for the Skyscreed ® 25 and the Fort Myers Training Facility as well as the $2.0 million acquisition of Line Dragon.

Plenty of cash then. I don't have any concerns about Somero's balance sheet, it's fantastic. When last reported on 31 Dec 2018, the current ratio was 4.40, and there were no significant long-term liabilities. So bulletproof basically.

The company reported net cash of $28.2m at 31 Dec 2018, so it's forecast to drop considerably to $18m by end 2019. Mainly for the capex mentioned in the excerpt above.

Dividends - note that the final divi of 13.5 US cents, and a special divi of 11.7 US cents were both paid on 26 April 2019, which I make a whopping $14.2m cash outflow. So very generous divis are also a contributor to lower cash.

Somero has a policy of paying out divis based on surplus cash above a certain amount. Therefore today's lower cash forecast is likely to have a knock-on impact on divis, at least in the short term.

Updated forecast today is for 19.6 US cents, or 15.4p, for 2019 divis - yielding 5.5% on today's sharply reduced 280p share price. That's very respectable, especially as there should be increased divis in future, if this does turn out to be a one-off disappointing year in 2018.

Valuation - revised EPS forecast of 35.7 US cents for 2019, is 28.1p.

The current share price of 280p makes that a 2019 PER of 10.0 - very good value, if this turns out to be a blip downwards in profitability. Not such good value, if it turns out that earnings have peaked and are now in decline! That's the crux of the matter here.

My opinion - I'm leaning towards seeing this as a buying opportunity.

I have found management & their announcements, to be trustworthy and accurate in the past. That's a vital consideration when looking at any profit warning. It's not infallible, but I find this approach tends to work well:

• Sceptical & avoid buying, when unreliable (based on past performance) management give excuses for something going wrong, and are optimistic about the future, and
• Give the benefit of the doubt to management which have a good track record of meeting/beating forecasts, especially if the share price has recovered well from any previous setbacks

Somero management has an excellent track record, and I've found them straightforward in telling it how it is. For that reason, I'm looking favourably upon today's news as a possible buying opportunity.

It usually pays to wait a week or two after a profit warning, for the sellers to finish. The trouble with that, is we don't know who is selling, or how much more they have to sell. Buying immediately after a profit warning is usually the wrong thing to do. Sometimes it can be a good thing to do. Every situation is different, so there aren't any hard & fast rules which always work!

Remember also that if a severe recession were to arrive in the USA, then this share would probably be smashed to pieces. That's exactly what happened in 2008, although its balance sheet was much weaker back then. That extreme cyclicality is probably why this share tends to look cheap most of the time.

Buying this share now, therefore relies on buyers having a sanguine view of the economic outlook, especially in America. If you think we're in a late stage economic growth phase, with a recession likely, then something as cyclical as Somero really isn't a good place to be.

If however, you think the economy is likely to do OK, then this share could be a bargain.

Investing is really all about predicting the future.

EDIT at 16:01 - I thought this section was getting too long, so originally stopped there. However, looking at the reader comments, tomps (Tamzin from PIworld) has flagged the outlook comments, which are important. This read positively;

Somero continues to see growth opportunities across all its markets, particularly in the US, where customer optimism for 2019 and beyond is reinforced by extended backlogs and healthy new project starts, albeit much delayed.

[Paul Scott: this gives me more confidence that the weather explanation of current poor trading, is true]

The positive US market conditions described in the Company's 14 March 2019 trading update have not changed and whilst we anticipate it will take some time for momentum to rebuild, the level of work in front of our customers remains significant.

The Company's strong balance sheet, flexible operating model and diversity across territories gives the Board confidence for the medium to long term.

This does lend weight to the idea that this might be a temporary setback today, rather than something more serious.

Export markets - comments sound lacklustre here;

In the Company's other main markets, Europe and China, as well as in the Rest of World territories, trading in 2019 is at comparable levels to 2018, and the Company continues to see opportunities for growth in H2.

Growth in India has been steady, as the Company continues to gain traction in the region. The Middle East and Latin America are trading below 2018 levels, however the Company expects improvement in H2 2019, notwithstanding the political uncertainly and economic challenges seen in these regions.

New products - says strong interest in them.

End of edit.

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Surgical Innovations (LON:SUN)

Share price: 2.9p (down 29% today, at 13:38)
No. shares: 790.6m
Market cap: £22.9m

Trading update  (profit warning)

Surgical Innovations Group plc (AIM: SUN), the designer, manufacturer and distributor of innovative technology for minimally invasive surgery, provides an update on current trading.

Trading slowed down in Q2;

Following the strong final quarter of 2018, trading in the first quarter ended 31 March 2019 was in line with the Board's expectations and showed modest growth in revenues compared with the equivalent period last year. This momentum has not carried into the second quarter, with orders in the UK and EU markets lower than expected. 

It blames Brexit uncertainties. I'm not sure about that. Surely Brexit uncertainties were at their peak in Q1, when trading was fine?

I've converted most of the remaining text into summary bullet points;

• Export markets are fine, with strong growth in the US
• Volatile demand & lack of visibility
• UK demand muted, due to NHS under-funding (it says there are 4.3m people waiting for treatment - which is appalling, if true)
• New product (Cellis) not selling as quickly as hoped, but current trend improving
• Regulatory audit recently will improve access to international markets in future - regulatory approvals getting tougher, a barrier to new entrants
• Extra costs will be needed to meet regulatory demands

Overall this is the result;

Taking these factors into account, the Board considers that growth in revenues in the second half of the year is unlikely to fully counter the relatively weaker second quarter to date. Full year expectations for revenue will exceed those of the prior year by a more modest rate of growth than previously anticipated.  Whilst margins are expected to remain in line, overheads will reflect the investment in additional resources devoted to operational and regulatory matters.

Accordingly, adjusted profit before tax is expected to be below the level achieved in 2018. The Group currently holds net cash and continues to be cash generative.

That's a bit too vague for my purposes. Thankfully there's a broker update on Research Tree.

2019 EPS forecast has reduced from 0.22p to 0.14p, quite a big drop of 36%. 2020 & 2021 have also been reduced by 25% and 15% respectively.

At 2.9p per share, the forward PERs are -  2019: 20.7, and 2020: 12.6

If it hits the 2020 forecast, then the price looks reasonable. How likely is that though, given that it's warned on 2019 profits today?

My opinion - it doesn't interest me. The growth rate has slowed, and I'm not keen on companies selling into highly regulated markets.

If you understand the company, its products & markets, then it could be worth looking into. Especially if you feel that performance could improve. The Brexit excuses don't really cut the mustard for me. If customers want the product badly enough, they won't give a monkey's about possible future disruption.

On the upside, it has a solid balance sheet and is genuinely cash generative (I've checked the last 2 years' cashflow statements).

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Not a small cap but... 

Games Workshop (LON:GAW)

The astonishing march of this niche retailer of figurines for games, continues unabated!

Remarkable numbers are reported today;

We expect the Group's sales for the year to 2 June 2019 to be approximately £254 million and the Group's profit before tax to be not less than £80 million.  Royalties receivable from licensing are approximately £11 million.

It just goes to show, that stunning profits can come from unexpected niches.

The annoying thing is, MrContarian (who posts his excellent morning small cap tweets here first thing, and gets cross with me when I forget to put up the placeholder!) flagged this share to me when it was £8, as performance was improving strongly. I bought some, then got bored at nothing much happening, and sold them. Only to see them soar about 5-fold since!

Lessons learned (this is memo to self!);

Preconceptions - Don't write off a share just because its activities seem unglamorous, or out-dated, or even peculiar, as many people (including me!) wrongly thought about GAW. If I'd done proper research on its products & sector, instead of relying on lazy preconceptions, then a fabulous profit could have been made. This reminds me a little of a friend, who keeps threatening to short Card Factory (LON:CARD) because he thinks greetings cards are old fashioned, and in terminal decline. Whereas CARD is actually one of the relatively few physical retailers reporting positive LFL sales this year, and that it says young people are buying more cards.

Patience is needed, to give time for a story to develop. Just because a company is overlooked, and the share price is stagnant, doesn't make it a bad investment. My example here, is that David Stredder and I jointly researched Dart (LON:DTG) a few years ago. We both bought stock below 100p. It went nowhere for ages, and of course I sold out, but has since 10-bagged!

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I'm winding down for the weekend now, so will leave it there.

Best wishes, Paul.