Small Cap Value Report (Mon 10 Sep 2018) - DEB, RBG

Hello!

Graham's back from holiday, but I've volunteered to write Monday & Tuesday's reports, so he can ease himself back into things gently, with a 3-day week!

My public portfolio - BMUS

My first job of the day is to re-balance BMUS ("Beam Me Up, Scotty!") - my Stockopedia fantasy portfolio. A reader recently commented that it doesn't seem to fully reflect my current thinking on a number of shares, and that there seemed to be gaps - i.e. companies I've mentioned on Twitter as being big holdings, are not yet in BMUS. He's quite right, so I'm fixing this issue today - not that it's of earth-shattering importance, but the issue should be ironed out.

I haven't regularly reconciled BMUS to my real life portfolio. It was only ever meant to be an approximation to my real holdings, as it would be a nuisance & a waste of time to be constantly updating it, but I appreciate the point that it probably should match my real life portfolio more accurately.

I didn't particularly want to run a fantasy portfolio, but the boss here, Ed,  challenged me to prove statistically that I'm a good stock picker, back at the start of 2015. Who could resist a challenge like that!

I feel that, in any field, people who set themselves up as commentators should be open to factual scrutiny, to prove that they out-perform the market at least most of the time. If that's not the case, why would anyone listen to their views?

Performance should be measured in a way which is completely open, cannot be edited, and is published in real-time. Otherwise it's open to manipulation, and hence cannot be trusted.

Anyway, just to clarify, the trades that I shall be putting through BMUS today are simply to re-balance the holdings to reflect my real world positions, for my top 8 holdings.  There's also a tail of another 20 or so smaller positions in real life, but I need to keep BMUS manageable to update, so it's my top 8 holdings only.

It should be up-to-date by the end of today.  EDIT: I messed up the calculations, and need to adjust it on Tuesday, so please bear with me on this.

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Debenhams (LON:DEB)

Share price: 10.6p (down 17% today, at 08:32)
No. shares: 1,227.8m
Market cap: £130.1m

Press comments

There's no RNS as yet, but this is worth a comment, because it's major news. The BBC reported over the weekend that DEB has called in KPMG to assess future restructuring options, likely to include a possible CVA. Interestingly, this article also claims that "very few" of Debenhams stores are currently loss-making. Although with LFL sales on a downward trend, costs rising, and longish leases, it seems to me only a matter of time until more stores do move into losses.

This article on a website called DevonLive suggests that major trade credit insurer, Euler Hermes, is reducing its exposure to Debenhams further. This could be very serious. Withdrawal of trade credit insurance can often push a company into insolvency, because supplies of inbound goods dry up.

My opinion - I feel that there's a risk that DEB might tip into administration. Why take the risk of exposing our portfolios to that, when you don't have to?

It's trying to sell a subsidiary in Denmark, which could prop things up for a while, with a potential disposal at around £200m being mooted.

The problem with department stores is that they are supertankers - huge, costly to run, and slow to turnaround. A large & costly central infrastructure is needed to manage so many product categories & many thousands of individual product lines. As we all know, shopping habits are changing, and a bit more business leaks away to online competition every year. DEB has its own online offering, but that doesn't seem to be fully offsetting lost profit from physical stores.

I covered the figures in detail here on 19 Apr 2018. My conclusion then was that this share is uninvestable. I reiterate that view today, with increased emphasis. A CVA could work, in the way that it did for Carpetright (LON:CPR) . However, we have seen from history that CVAs usually just defer the inevitable collapse - prolonging the life of weak & outdated retailers.

House of Fraser is in the process of restructuring, with Mike Ashley in a position to aggressively renegotiate rents down to nil in some cases. By doing a pre-pack administration, Ashley can pick & choose which shops he wants to keep, and dictate terms to landlords. This could well end up giving HoF a considerable competitive cost advantage, after the restructuring is complete.

I don't see how Debenhams could possibly compete with a revitalised HoF paying very little in rents. Therefore Debenhams needs to go through a similar pre-pack administration process, in order to survive and prosper, long term, in my view. That route would wipe out existing shareholders.

This share is really now only for gamblers. It might spike up (e.g. on short squeezes), but my analysis of the numbers suggests that the end game is almost inevitable - either a CVA, or a pre-pack administration, with the Debenhams business being sold (maybe to Ashley) in order to raise cash to repay the debt holders. Shareholders get nothing usually.

In the meantime, suppliers are not likely to want to send in stock, suspecting that they may not be paid for it.

I would ignore any future assurances from Debenhams in update RNSs, saying that everything is OK, because their previous statements have lacked credibility. In particular, management claiming to have a strong balance sheet is demonstrably untrue - it has negative NTAV, and net debt, at a time when profits are disappearing fast. It's likely to tip into losses next year, in my view, and borrowing facilities may then be withdrawn.

This is not likely to end well, in my view, for current shareholders. Although the business should survive in a restructured form. Anyone buying the shares now should understand that this could easily be a 100% loss. Why take the risk?

** STOP PRESS! **  Debenhams has issued an intended-to-reassure type of update at 13:08 today. It doesn't say anything that changes my view of the company, but here is the link if you're interested.

Sir Philip Green

I've recently read 2 biographies of Philip Green - "Top Man" was written at the height of his career, in 2005, when his empire was flourishing, and profits at BHS had soared under his ownership. 

The second book, is an interesting, but far from impartial biography (it's a hatchet job), called "Damaged Goods" - written recently by a journalist with an undisguised grudge against Green. This book reflects the appalling & idiotic decision of Green to sell BHS for £1 to the conman Dominic Chappell (nicknamed "Con-Dom"!)

The reason I mention this, is because both books are very interesting & highly entertaining, so I recommend them to you. Also, I mention them because historically SPG shied away from buying both Debenhams and House of Fraser, because he regards department stores as too difficult & complex to turn around.

Mike Ashley

Mike Ashley of Sports Direct has historically been in Green's shadow, but for years there has been a clear rivalry between these two megalomaniacs. I wonder if that is part of the motivation behind Ashley's current aim to restructure (and maybe revitalise?) the department store sector? i.e. to prove his ability to do better deals than SPG? They way I see it, they're two peas in a pod in some ways - controversial, vulgar, arrogant & domineering, pushing boundaries, and never happy unless they're doing deals. Although both have of course been enormously commercially successful.

Ashley has a c.30% stake in Debenhams, so is apparently taking a keen interest in developments. It seems to me that the best outcome might be for Ashley to repeat what happened to HoF - i.e. allow it to go bust, having prepared for a pre-pack administration. Then merge HoF and Debenhams, and stuff the landlords with brutal deals on rents, or hand back any shops that can't be retained on a much reduced rent. This approach would also preserve more jobs than a CVA. In the long run this could revitalise the UK's struggling department store sector.

Results from John Lewis partnership are due out imminently too, with it expected (says the Telegraph) to report profits close to zero.

Retail property & rents

I certainly wouldn't want to own any retail property right now, as the values are likely to plummet, pretty much across the board. As I've been saying here for a long time, retail rents need to come down drastically. That can only happen if weaker tenants go bust, and landlords are left with empty units that they cannot re-let. Then & only then do rents come down, as landlords become increasingly desperate to find a new tenant.

In my view, the solution to the UK's high street woes is not Government intervention - that usually just causes unintended consequences. Capitalism's process of creative destruction needs to be allowed to work. Brutal though it is, just like in nature, it's the survival of the fittest.

So much business is leaking away online, that there's significant over-capacity now on the High Street. Therefore, the weaker players have to disappear. That leaves enough business for the remaining, stronger businesses, who should flourish if they can manage down their rental costs.

In this recent article the boss of John Lewis says that online retailers should not be punished for having more efficient business models. Although he does make some good points on exploitative employment practices needing to be tackled. How long before the staff in warehouses are replaced by robots? So the employment issue may be short-lived.

All in all, we seem to be entering a phase of drastic change in the retailing sector. There are going to be winners & losers. I am fairly sure that, based on the figures, DEB shareholders are likely to be facing a 100% loss in the long run. The business as currently structured, is just not sustainable in my view - it's financially weak, and has lease commitments which need to be jettisoned - which requires some form of insolvency procedure.

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Revolution Bars (LON:RBG)

Share price: 124.4p (down 2% today, at 11:25)
No. shares: 50.0m
Market cap: £62.2m

(at the time of writing, I hold a long position in this share)

Possible acquisition/merger with Deltic

There was some excitement around this share on Friday when a website called Betaville put out an article (free registration required to access article) claiming that RBG was in "amicable discussions" with nightclub operator Deltic, about a possible merger.

This is reviving discussions from last year. To recap, it went something like this;

• Profit warning due to forecasting cock-ups by (since departed) CFO - May 2017
• Stonegate (a large, acquisitive pubs group) tabled an agreed 203p cash takeover bid for RBG - July-Aug 2017
• Deltic then tried to crash the party, by proposing an alternative - a merger of RBG and Deltic, creating an enlarged, listed group
• The share price rose above the bid price, and settled at about 210p, as many shareholders (including me) thought that Stonegate might improve its offer (which was not particularly generous in terms of valuation on fundamentals)
• Deltic seems to have persuaded Institutions in RBG to reject the 203p cash bid, as under-valuing the company, which is what happened
• Stonegate refused to pay more than 203p, and walked away - Oct 2017
• RBG told Deltic to get lost, and so nothing happened re the merger proposals
• The share price has painfully fallen from 210p to the current level of about 124p (less than that last week)
• Lacklustre, but not disastrous trading was announced in the most recent trading update on 14 Jun 2018, with adjusted EBITDA expected to be flat against last year, at c.£15m
• RBG has carried on with its self-funded roll-out of new sites, despite not having had a CEO for the first half of 2018. A new CEO joined a couple of months ago.

RBG response - this was issued on Friday last week (7 Sep 2018). The Betaville article forced RBG to issue this announcement, after the market had closed. Here it is, in full;

Statement regarding media speculation

 Revolution Bars Group plc (the "Company") notes today's press speculation regarding a potential transaction with The Deltic Group Limited ("Deltic"), and the movement in the Company's share price.   

The Board confirms that it is in the very preliminary stages of considering a transaction involving a possible acquisition of Deltic.  The Board also clarifies that it is only in very preliminary dialogue with Deltic regarding such a potential transaction.

Furthermore, no agreement (in principle or otherwise) has been reached with Deltic regarding such a transaction, so there can be no certainty as to the terms, timing or structure of any such transaction, nor as to whether any such transaction will occur at all.

It's interesting that, as well as playing down the discussions, RBG describes it as a "possible acquisition" of Deltic, by RBG, and not a merger. Although this is splitting hairs, because the deal would always have been done via RBG (listed) buying Deltic (private) through the issue of new RBG shares. Therefore merger/acquisition can be used interchangeably here.

Deltic wanted to manage the combined group, in its proposals last year. That was a strange, and arguably impertinent proposal - i.e. please buy us, and make yourselves redundant, as we want to run the enlarged group! This clearly introduces a huge conflict of interest for RBG's management. Did they dislike Deltic's proposals because of commercial reasons, or for the RBG Directors' self-interest? I don't know the answer to that, but it's an important question to be asked.

My opinion - things are interesting, as arguably RBG is back "in play". This could perhaps rekindle renewed bid interest from others, possibly including Stonegate, which is a consolidator in the sector. Stonegate's recent acquisition of a rival cocktail bar chain Be At One, doesn't necessarily mean it wouldn't also be interested in RBG, but I suppose it probably reduces the odds.

Looking back, rejecting the 203p cash bid from Stonegate last year was a big mistake. I'm sure many RBG shareholders, myself included, regret not selling at the time. I did top-slice a bit, but should have ditched the lot, with hindsight. However, it's usually best to sit tight in bid situations, as agreed bids very rarely fail. Sod's Law intervened, and this one did.

Personally this is still a big position of mine (2nd biggest actually, after Sosandar). This is because, I remain of the view that the market value of RBG is completely wrong. Its EV/adjusted EBITDA is about 4.5 times, and lower still at site contribution level. Sooner or later, someone will come along and buy it, because that valuation is well below the norm, of about 7 times. That Stonegate tried to buy it at 203p confirms my view on valuation.

That the bid fell through, for rather bizarre reasons, in retrospect, does not alter the valuation point. You could argue that the underlying value of RBG has gone down since then, as it's been rudderless, without a CEO, and there are clearly some operational issues that need sorting out (e.g. lousy food offering - although new food offering is being launched imminently), staff rotas, and I think there are some maintenance issues in some sites.

On the plus side, the longer things go on, then the more branches RBG is opening - expanding by about 6 new large sites p.a., which are being procured on very competitively low rents. So although the short term losses are painful, I'm very confident of a good outcome here, with patience.

In the meantime, I reckon it's possibly got one more profit warning in it - a continuation of the soft trading mentioned in June seems likely. So maybe a dip in share price on that, although I think it's already largely in the price, and paradoxically makes a bid approach more likely - because a bid premium would look generous, but actually wouldn't be!

Anyway, let's see what happens. It's not one to trade in & out of, in my view, because then you run the risk of missing a premium-priced takeover bid - which is one of the main reasons to invest here.

The current situation appeals to me a lot - a bombed out valuation, for a highly cash-generative (and dividend paying) business. Plus the company is back in play now - with upside potential from a deal either with Deltic, or a bid approach from someone else.

It would take years to replicate what RBG already has. Plus RBG is unusual in having very little debt. Therefore an acquirer could easily gear up to part-fund its acquisition.

Market sentiment is irrationally gloomy on this share, and has been for a long time, in my view. At some point that should produce a nice payday.

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I'm about to add some more comments on today's results & trading updates, but seeing as it's now the evening, I'll add them to tomorrow's report, so that everyone sees them.

Regards, Paul.