Small Cap Value Report (Mon 14 Aug 2017) - TCM, TRCS

Good morning!

Thank you for the feedback last week, re timing of these reports. The consensus (of those who responded) seems to be that readers prefer us to take our time, and get it right, rather than rush for a deadline. I think the existing 1pm email deadline is a good compromise, so I've resolved to have early nights on school days, and get at least the bulk of my reports out by 1pm.

You've probably already realised that a conventional 9-5 work schedule never suited me. That's why I bowed to the inevitable, leaving full-time employment for the last time in 2002, to become self-employed.

Anyway, on to today's results & trading updates.

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Telit Communications (LON:TCM)

Share price: 145p (up 17% at time of writing, but is volatile)
No. shares: 129.8m
Market cap: £188.2m

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

Resignation of CEO, and Board to be reinforced - I'm not really meant to write about companies where I hold a short position. However, that rule was only introduced because Stockopedia lost some (idiot) subscribers, who objected to me ringing the alarm bells about Globo some time ago. So every now & then, I do flout this rule, because it's so important to discuss such a topical & controversial stock.

As I predicted, the allegations against the CEO (of having committed fraud in the USA, years ago, and fleeing the country) have been admitted to be true;

Oozi Cats, has resigned from the Board and his employment with immediate effect. The independent review has found that the evidence shows that an indictment was issued against Oozi Cats in the US and that this fact was knowingly withheld from advisers...

The Board's indignation that a fraudster failed to tell them that he was a fraudster, strikes me as quite comical;

...It is a source of considerable anger to the Board that the historical indictment against Oozi Cats was never disclosed to them or previous members of the Board and that they have only been made aware of its existence through third parties...

Surely the company, and its advisers should have checked the background of the former CEO, years ago? Isn't that their job, rather than Tom Winnifrith's (who was the whistleblower in this case, hat tip to him)?

This opens up a wider question of why it is that we expect people to be scrupulously honest, through society's obsession with filling in forms, which are then taken at face value, with usually no additional checks. This is true in many walks of life. The trouble is, if people have something to hide, then they tend to lie.

There's an article in today's Guardian, saying that in one London borough, only half of landlords disclose their rental income to the taxman. I've always thought self-assessment an absurd system. There must be enormous amounts slipping through the net, in uncollected tax.

The same is true of job applications & CVs. Many CVs are largely works of fiction. Or they at least have sufficient distortions, half-truths, exaggerations, and omissions, to make them very unreliable. I always enjoy that part of The Apprentice, when Claude Littner reveals in his interviews, that he has discovered some massive lie on a candidate's CV, by making some simple background checks himself. Hence too why canny potential employers often use Facebook & other social media to find out more reliable details.

An acquaintance of mine decided that her degree (a Third) was holding back her career, so she unilaterally upped her grade disclosed on her CV, to a 2:1. One canny potential employer double-checked with the University, and revealed the truth in her interview. She feigned a coughing fit, and asked to use the bathroom, never to return to the interview. Shortly afterwards she got a job at another organisation, on a 6-figure salary, who hadn't bothered to check any of her credentials. It's depressing how this type of thing is now so widespread - largely because there's no serious downside risk - often nothing happens when people are caught lying. Even if people lose their jobs, as Mr Cats has found at Telit, he's trousered so much money already through years of high salary, and share sales, that crime has paid very well for him.

This also applies to investing. Looking back, a lot of my biggest investing mistakes have occurred because my sole source of information about a company was from that company itself. So rather stupidly, I based my investing decisions on an often highly distorted, overly optimistic view of things.

For that reason, I now try to find out additional information on companies from third parties - e.g. customers, suppliers, (former) employees, Google, etc. That's often a lot more insightful than what the CEO, or the paid advisers (broker, PR, etc) tells you.

I can't remember who it was (some renowned investor anyway) who said that investors shouldn't employ analysts, they should employ private investigators - to dig up the dirt. What's astonishing about Telit, is that a fraudster could be the CEO for so long, without anybody apparently noticing.

New NEDs - the company says it will be appointing 3 new, UK-based NEDs;

The Board intends to appoint three additional independent non-executive directors as soon as practicable to reinforce it, one of whom will become Chairman. It is expected that the non-executive appointments will be UK based and have previous PLC Board experience. The Nominations Committee has appointed Korn Ferry to conduct this search.

To my mind, that doesn't seem a very satisfactory response. NEDs are generally pretty useless, in my experience. Often they're used to give a cloak of respectability to unsatisfactory businesses. Although in this case, I suspect the Institutional shareholders are likely to be leaning on the company to appoint some heavyweight NEDs, with a bit of gumption.

There are additional comments, which presumably must refer to a series of articles published on Shareprophets in recent days;

The Board is also aware of additional speculation from third parties relating to Telit's financial condition, trading performance and business relationships and has considered that speculation in detail.

The Board confirms that there is no substance to the speculative and accusatory articles that have been published and that it stands behind the Group's audited accounts to 31 December 2016 and the most recently published interim statement.

It's hardly surprising that the company stands by its 2016 accounts, given that the CFO has become the interim CEO. He's not likely to admit that any of the figures are wrong, is he?

More detail is given about distributors, and a company called BAMES which went bust in 2013, having had some kind of relationship with Telit.

EDIT: I forgot to mention, this paragraph is also interesting;

The Board is now moving on from this difficult situation and will continue to deliver on its stated strategy under the interim leadership of Yosi Fait. He will be conducting a preliminary review of the Group's activities and cost base. 

I see this as a tacit admission that the company is under financial pressure, and needs to cut costs.

My opinion - my view is that when a CEO is exposed as having been a fraudster, then there's no way I would invest in that share. Corporate culture usually tends to flow down from the CEO, in my experience. Therefore, my feeling is that a company which had a crook as its long-standing CEO, is unlikely to be squeaky clean in other respects. So I think there could well be more dirt to emerge here.

Certainly that's what the accounts are telling me, with some obvious red flags. Primarily, excessive capitalisation of costs into intangible assets, poor cashflow, and excessive debtors. Those are the 3 key signs I look for, of aggressive (or worse) accounting.

So, in my opinion, I think it's probably only a matter of time before this share experiences another leg down, due to accounting issues. That's why I've opened a smallish short position.

As regards the bank situation - Shareprophets flagged up that the recent interim results, note 5.2 revealed that a banking covenant had been breached. However, that the bank had waived this breach. It's not clear whether the bank has waived the covenant completely, or just for the 30 Jun 2017. If it's the latter, then presumably the same covenant breach could occur on 30 Sep 2017?

 My hunch is that the bank borrowings don't look anywhere near enough to cause the company to fail. So I'm fairly sanguine about that. So possibly this risk is somewhat exaggerated? The company could always raise a bit of additional cash from Institutions, once it's convinced them that everything is fine now the bent CEO has gone.

Once again, the outstanding tech analyst from Cantors, Kevin Ashton, has hit the mail on the head. He points out that Telit has never made an economic return. He's absolutely right. This company creates artificial profits from excessive capitalisation of costs into intangibles, something I've long been flagging up in these reports.

My industry source tells me that Telit actually has very good products, and decent customer support. So there could be some merit in the company. However, what's the point, if it doesn't actually (to date) generate any genuine profit?

The company's recent outlook comments suggest a much better H2, but there is also doubt over the timing of new business, as it admits. So I wonder how reliable those outlook comments are - especially given who was CEO at the time?

Overall, it looks a can of worms to me, and I suspect the accounts are likely to come under much closer scrutiny. Although possibly that might be deferred until the company has shored up its balance sheet, maybe with another equity raise?

In the past, I've mentioned the possibility of a short squeeze. This share is very heavily shorted, and ultimately shorts have to buy back. So if there's good news, that can cause an explosive move upwards. That could still happen. So I'm not terribly comfortable with my own short position here.

However, on balance, I think the risk is probably to the downside, due to all the accounting red flags. It would make sense for the company to kitchen-sink the accounts (which would surely require the departure of the new interim CEO, due to him being former CFO). The company would then need a complete new broom as CEO, to adopt much more conservative accounting policies.

Overall then, a fascinating situation, which could go either way. I think the risk is leaning towards further downside. It's worth noting that, once again, the bears called it right. Bears are not always right, but it does seem true to me that they often dig deeper than bulls. Where there are obvious red flags in the accounts, as there are with Telit, then I think people need to be terribly careful.

What fascinates me is how many investors (Institutions, just as much as PIs) will believe what they want to believe. So, you often see bulls strongly defend a stock, and buy more, even when presented with irrefutable evidence that something is badly wrong. 

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Tracsis (LON:TRCS)

Share price: 450p (up 2.3% today)
No. shares: 28.0m
Market cap: £126.0m

Trading update - for the year ended 31 Jul 2017.

Tracsis is an acquisitive group of companies, with a focus mainly on technology & software for the rail industry.

You might recall that the company put out a warning in Feb 2017, which I reported on here. It said that trading was expected to be H2 weighted. The reason wasn't anything the company could control - it was due to the timing of rail franchises being granted.

This is what the company says today;

Group trading for the year has been in line with market expectations.  Revenues for the year were in excess of £34m (2016: £32.6m) with good trading experienced throughout all parts of the business.

EBITDA and Adjusted Profit are expected to be in line with market expectations and also ahead of the previous year (2016: EBITDA £7.6m, Adjusted Profit £6.9m)...

I like - the company has given both the EBITDA and the adjusted profit comparatives from last year. This is much better than just giving the (often meaningless) EBITDA figure on its own.

I dislike - the company confirms market expectations, but doesn't give a footnote stating what those expectations actually are. This creates more work for investors, since we have to now try to find out what expectations are. With small caps, that information can be difficult or impossible to get hold of, or inaccurate. So I strongly urge smaller companies to put in a helpful note, stating what they believe market expectations are, at the same time as confirming that trading is in line. This is already done by some companies, and I'm keen to help make RNSs more user-friendly, by urging all companies to clearly state both the adjusted profit, and the adjusted EPS which they believe to be the consensus market expectations.

EDIT: please see comment no.8 below this article, where the CEO of Tracsis has responded to my comments. Isn't that great! Let's hope more company management, and maybe even some City advisers, might care to comment in future too, which I very much welcome.

Valuation - Stockopedia shows market consensus of 22.p adj EPS for y/e 31 Jul 2017. That results in a PER of 20.3

It's good when a company delivers on revised guidance, as in this case;

As anticipated and communicated at the interim results, the second half of the financial year was considerably stronger than the first half.  H2 revenues were c. £19m (H1 2017: £15.6m), and profitability was also stronger in the second half (H1 2017: EBITDA £3.5m, Adjusted Profit £3.1m).

This announcement jumps about a bit, so you have to read it carefully to make sure that you've read it correctly!

Cash - Tracsis has a history of being risk-averse, and it likes to keep a decent cash pile on the balance sheet. This also gives it the firepower to make more acquisitions of course;

At 31 July 2017, Group cash balances remained strong at c. £15m (2016: £11.4m), which reflects excellent cash generation in the year and after paying contingent consideration of £1.1m in respect of acquisitions made in 2015 (SEP and On-Trac).  The Group continues to be debt free and highly cash generative.

There are some earnouts to consider, which I believe are in the region of about £4m. The earn outs are structured well, and designed to be self-funding in cashflow terms.

Outlook comments sound fairly good;

..The combination of these initiatives, our continued diversification, a good pipeline of M&A prospects, and anticipated industry momentum leaves the Group well positioned as we enter the new financial year.

Specific points noted include;

Significant multi-million pound contract win for our TRACS Enterprise Software - maybe this is what might have pushed the H2 results over the line, I wonder?

Successful delivery of a North American contract for our RCM technology - this is interesting, as North America could be an exciting area of future growth.

Strong trading for our recently-acquired business On-Trac and SEP - the group really hasn't put a foot wrong, and is a (rare!) example of a successful acquisitive group. Hence I feel the shares do deserve a premium for good management, based on the excellent track record.

Restructuring in traffic & data services division - which should improve future profit margins.

Vivacity Labs investment is flagged as having considerable potential.

I think there's probably enough red meat in the above points to keep shareholders happy.

Although the existing forecasts only show modest EPS growth, so I would want to see the company exceeding those forecasts to continue to justify a fairly warm PER.

My opinion - this is a good collection of (mostly) high margin, niche businesses.

Management have an excellent track record of making good acquisitions, and not over-paying.

The balance sheet is excellent, with plenty of cash.

There could be decent upside, if the USA market really takes off for the RCM division.

For me, I probably don't see enough upside to make me want to buy the shares. I generally look for things where I can foresee a fairly easy 50%+ upside, in a reasonable timescale (say a year, or less). I'm not convinced there's enough upside with Tracsis to get me interested.

It has been a good share to buy on the dips though, as you can see from the 2-year chart below. I think the market has done a fairly good job, in pricing this share in accordance with the newsflow. It's tricky to trade though - I've found it very illiquid, and haven't been able to buy in any decent size, on those dips, despite trying!

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I can't see anything else of interest within my remit today, so will sign off for the day.

Regards, Paul.