Small Cap Value Report (Mon 18 Feb 2019) - Mello Trusts And Funds, MCLS, VCP, CLIG, ANG, CSSG

18th Feb by Graham Neary

39 comments 10652 reads

Good morning!

Mello Trusts & Funds

The first thing I wanted to do this morning was bring your attention to a new Mello event, to be held this year on the day before the main event in London. Mello Investment Trusts & Funds will be of interest not just to those of you who invest in funds, but also perhaps to those of you who invest in the fund management companies themselves. For example, I will be there to hear speakers from Polar Capital Holdings (LON:POLR) and Impax Asset Management (LON:IPX).

It's on Wednesday May 15th at the Clayton Hotel in Chiswick - convenient for Mello 2019 attendees, who only need to arrive one day early to attend.

PI World Interview

I was recently interviewed by Tamzin Freeman at PI World. We started out by discussing the initial steps that people take on the road to being experienced/professional investors, before moving on to discuss some of the things I've learned along the way and how my own strategy has evolved.

The video was published this morning - here's the link.

Right, let's take a look at today's news:

McColl's Retail (LON:MCLS) - final results
Victoria (LON:VCP) - trading update
City of London Investment (LON:CLIG) - final results
Angling Direct (LON:ANG) -trading update
Croma Security Solutions (LON:CSSG) - trading update

McColl's Retail (LON:MCLS)

Share price: 56.8p (+12%)
No. of shares: 115 million
Market cap: £65 million

Final Results

McColl's Retail Group plc, the UK convenience retailer, ("McColl's" or "the Group") today announces its preliminary results for the 52 week period ended 25 November 2018, and a trading update for the 11 week period to 10 February 2019.

Strong share price reaction at McColl's today but we must remember that it's from a very low base - in the good times, it almost reached 300p (see my view when the share price was 280p).

The 2014 IPO was at 191p, so IPO investors are sitting on a 70% loss over 5 years, before we account for dividends.

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Gromley

20th Feb

Some very good points there mrosbiston re McColl's Retail (LON:MCLS) – one of the benefits of posting here is to get some intelligent “kicking of the tyres”. So I’ll return the compliment and give you my view on each point you raise.

- I'm still concerned about profitability, there are a very large amount of adjustments.

Yes, although the net adjustment is quite modest (£0.8m), there some large negatives excluded that offset the £12m exceptional profit on sale and leasebacks.

Largely the adjustments look reasonable to me (relating to the supply disruption and transition and a couple of smaller historic issues) but there is one (actually two) that I would call out : £5.8m of cost for store closures and impairment. There will be an extent to which these costs (which amount to the lion’s share of adjusted profits in 2018) will be ongoing. This should be at a very much lower level but certainly something to keep an eye on in the next interims. In the short term there is also still some sale and leaseback to come in to offset these closure costs.

I'm keen to know how they expect a modest improvement in adjusted EBITDA when they acknowledge the expense headwinds (living wage, energy, new lease expenses) - with a smaller estate,

The first thing I think is that they will hopefully not see a primary supplier go belly up over a weekend again. You mention Brexit as a forward risk and I agree (although tend to be unconvinced by the most negative views) ; but even the worst possible Brexit outcome is surely a walk in the park compared to what they have just been through?

Nevertheless I’ll be happy to see the Brexit outcome before making any buy decision.

From a more helicopter view I would argue that the McColls business model is significantly less price elastic than the big supermarkets – so going back to my OP I would expect (unless management are useless) that Operating Margins above the 2-3% achieved by the supermarkets should be achievable rather than the recent impacted results that were below this level. Incidentally, you go on to talk about “the reduced estate” but actually my sense was that they are pruning unprofitable stores rather than downsizing, so I’m not sure I agree with the relevance of your further (otherwise valid) observations on the subject.

do you expect an undisrupted year? if brexit impacts the supply of fresh goods, alcohol and tobacco then this could be a major issue.

I don’t rule out an undisrupted year. However, I accept further disruption as a significant risk – one of the reasons that I am watching rather than buying at this time. Brexit is of course the great unknown for many businesses. But as I said above even a terrible Brexit outcome would imho be much less harmful than the events of 2018.

TNAV is c.(£100m) , does that concern you?

Not especially TBH. I differ from many (probably wiser heads) on the subject of balance sheets. Whilst I fully understand that ‘goodwill’ is entirely an accounting construct (based on the overpayment vs tangible assets on acquired companies) I don’t think it is entirely without meaning. There is a reason (good or bad) that acquisitions are made at above tangible book value – in the case of McColls acquisitions I would loosely characterise this as “location, location, location”. Those ‘intangibles’ have real value if they enable sustained ongoing earnings.

I would draw the comparison with PPE entries on balance sheets – which most balance sheet investors regard as more “real” – these assets most often can only justify their book value if they can be used to generated sustained earnings (their ‘scrap’ value is normally a small fraction of ‘book’).

I do however have a concern on the balance sheet and that would be the level of debt – they have had to relax the covenants in the short term to accommodate this which tells us they are walking a tightrope. As I indicated based on 2018 trading they are slightly cashflow negative which is highly risky for a highly indebted company, My two upsides against this are : 2018 was truly an exceptionally bad year (but I want to see that proved by better 2019 H1 numbers) and secondly that they have c. £10m of ‘discretionary’ capex that they can reign back on if debt coverage looks problematic.

there is a half decent business in there somewhere, but my opinion is it is one that will struggle to grow and i'm not sure how they plan on improving the operating margin (i can see they want to do it, i'm just not convinced how)

If and when I invest , I won’t initially be relying on growth it will purely be a value/recovery play – which by itself could easily give a 100% upside imho. I don’t think the margin improvement is as challenging as you suggest if they can spend some time on refocusing on the strategy rather than firefighting supplier problems, but I’ll be looking for signs of this bearing fruit.

In terms of growth I tend to agree that they don’t look likely to shoot the lights out, but once they have overcome the current challenges there is an interesting potential prospect : they point out how much of the convenience market remains in private hands and IF they can acquire businesses and add value (which looks credible to me) then there could be a credible multi-year growth story – it’s not my focus at the moment but if I invest and the ‘reversion’ part of the investment case plays out I might start to look at this further.

Interestingly the forecasts on the stock report have been updated now and give a consensus view of 7.9p for 2019. That’s an 18% uplift on the 6.7p adjusted figure (as per the company) for 2018, this strikes me as a little ahead of the ‘modest’ improvement cited by the company.

As far as the stock report goes this is shown as a significant downgrade (against the 11.8p previously) which contributes to the momentum rank of ZERO. However, I think there is an anomaly here; as I mentioned in my OP prior to the results 2018 forecast EPS was shown as 10.7p (2019 was for 10% growth to 11.8) I don’t know what the anomaly was (although I note that Stocko shows normalised 2018 EPS of 9.4p which is too high.) Potentially therefore the forecasts have actually been upgraded (although it could just be that one of the forecasts contributing to consensus has not yet been corrected). So just to be clear, whilst I see reasons to be optimistic here, it’s much too early to call imho, so for me this is a watch and wait.

Graham Neary

18th Feb

Thanks bonita! G

I agree an excellent review of the McColl's Retail (LON:MCLS) numbers, thanks Graham.

I take a slightly more optimistic view (although am not ready to be buying just yet).

Firstly, as I’ve mentioned before, I think there is a bit more of ‘moat’ than Graham recognises – in the form of the location of many of the stores and the extent to which they are embedded in their local community. (Although as has also been mentioned before this effectively mean that the landlords own the moat!)

Secondly, I think it’s important to understand just how disruptive the failure of P&H (their former wholesale supplier was) so I think there is a definite turnaround potential here.

However, the guidance that “we continue to expect adjusted EBITDA for FY19 to be a modest improvement on FY18.” Suggests to me that turnaround is a relatively long road.

Prior to this announcement the consensus view for 2019 (as per the stock report) was for a 15% improvement over 2018 – so ‘modest’ sounds like a downgrade on that expectation to me.

That said I am puzzled by the EPS forecasts shown :

Today’s results seem to me to be pretty much inline with what we were told at the last trading update. But based on the company’s numbers adjusted EPS came in at 6.7p however the forecast as per stock was 10.7p (and had been updated after the trading update in December).

Does anyone understand the mismatch in these numbers?

Profitability and Cashflow

Operating margins were a paltry 1.3%, but again recalling that this was a very disrupted year I would be looking for this to at least improve to nearer the 2.2% seen in 2017. I fully understand that such low operating margins, would immediately disqualify this as an investment for many people – however it is largely in the nature of the business (Op. margins for the big three supermarkets are in the range 2-3%)

It’s also certainly true that the impressive reduction in net debt is largely (in fact arguably more than all) down to one off factors.

The £46m improvement in working capital is all down to more generous payment terms from Morrisons compared with the previous supply deal with P&H and I would not expect any repeat of this.

There is also a c. £27m inflow from sale and leasebacks (with a smaller amount to come in 2019).

Cash flow from Ops before working capital movements was £21m (down on £41m the previous year)

The key “non-exceptional” items to come out of this were :

Tax : £5m

Interest : £8m

Dividends : £12m (but c. £4m pa going forwards at the revised payout rate)

Capex : £21m

With 59 store refreshes in 2018 and 20-30 expected for 2019 - capex will reduce somewhat. Guidance is for £15-18m pa with c. 45% of this being maintenance capex and c. 55% acquisitions, refreshes etc.

Overall therefore, they are cashflow negative (or at best close to breakeven) at this level of trading. However as per the view above that operating margins should improve in an un-disrupted year, I would also hope for the same from cashflow.

So at this stage I agree with the conclusion that it’s quite precarious financially and quite a high risk investment at this stage, but I will be watching for signs of improving underlying performance in a “clean” year.

I don’t believe that they routinely give a trading update before the half year results so I suspect the HY report in July will be the next material news (barring exceptionals)

EDIT : The results presentation is now online at https://www.mccollsplc.co.uk/media/1588/2018-preliminary-results-presentation.pdf

This does indeed give more guidance on the capex which I've added in above.

Roger Lawson

Note that City of London Investment Group (CLIG) has nothing to do with City of London Investment Trust (CTY).

Connor Davidson

I believe that City of London Investment Trust is managed by Janus Henderson. I looked into investing in City of London Investment briefly but was put off by this fact.

paraic84

I am a big fan of City of London Investment (LON:CLIG) so thanks for the writeup Graham. They are very transparent with their reporting and seem to be conservatively managed as a company. Anyone new to this share should take a look at this website page which highlights their monthly funds under management https://www.citlon.com/investor-relations/funds-under-management.php

This webpage indicates how their dividend is safe: https://www.citlon.com/investor-relations/dividend-cover.php They have so much cash in the bank that they can cover their dividend in any years where performance doesn't cover the dividend.

I don't hold at the moment as I would prefer to buy this share at a tiny bit lower than the current market price to factor in the risk of pound strengthening with a probable Brexit deal (I personally think MPs will back May's deal eventually so make my investment decisions on this basis) and nervousness about emerging markets.

mustwatch

Fantastic Video Graham.

I'm someone else who believes in Financials and insurance. Boring quality companies with no debt, grow slowly and pay good dividends. Never lose any sleep and when the price drops I just buy more.

GLA

City of London Investment (LON:CLIG)

Thanks for the corrections, I have fixed it to say there is no link with City of London Investment Trust (LON:CTY).

Chrisfarrell21

Hi Graham,

Off today's topics, but I wanted to thank you again for your consistent commentary on Plus500 (LON:PLUS) which has been proven to be very insightful.

I had been in and out of this in the past, doing reasonably well, and admit to being sort of permanently tempted to buy back in again. But each time I nearly pushed the buy button, I would re-read your analysis and not bother. There's just no need to buy shares in a business which has (and always had) this much suspicion around it.

So thanks again; just in money saved on this one share, I owe you a beverage or two of your choice.

Chris

stuartb58

Understand concerns over heavily indebted VCP, Graham - but there are good floor covering businesses, in particular in my view James Halstead. Lots of cash in the bank, excellent cash generation and straightforward accounting. Dividends increased every year for over 40 years!

pkr1988

Hi Graham, would love to hear your views on @LON:SLP

They put out their half year report today and it was very good

re: Sylvania Platinum (LON:SLP)

I'm sorry but I don't cover resources. Hopefully there will be others who can provide you with insights on that front. G

re: James Halstead (LON:JHD)

Point taken, thank you!

You're very welcome, Chris.

mrosbiston

thanks for the detailed post

- I'm still concerned about profitability, there are a very large amount of adjustments. I'm keen to know how they expect a modest improvement in adjusted EBITDA when they acknowledge the expense headwinds (living wage, energy, new lease expenses) - with a smaller estate, D+A would also reduce, i believe that would also have a reductive impact on EBITDA if they are currently adding back a larger amount for D+A, perhaps it would only have a minor impact (say £2-3m)
- do you expect an undisrupted year? if brexit impacts the supply of fresh goods, alcohol and tobacco then this could be a major issue.
TNAV is c.(£100m) , does that concern you?

there is a half decent business in there somewhere, but my opinion is it is one that will struggle to grow and i'm not sure how they plan on improving the operating margin (i can see they want to do it, i'm just not convinced how)

cmpeckham

Graham, I am interested in how your positive view of fund managers contrasts with your view of other services businesses e.g. legal. Are these not people businesses too, where key individuals can walk away (like Neil Woodford). You like the high ROCE but the reason for the high ROCE is that the business model is capital light. It's the people that are the real assets.

Why invest in these companies when you regard other people businesses as uninvestable? I'm not saying that you're wrong, I would just like to know the answer.

Hi, good question - exposure to key man risk can be a significant risk at fund managers, so I would avoid (or pay less for) those which suffer that risk.

But the difference between fund managers are other "people" businesses is that fund managers are immensely scalable. The same number of personnel can manage £5 billion as £1 billion, depending on how it is structured. Once the platform has been built, you get incredible operational leverage.

This doesn't typically hold true for solicitors, accountants, etc. If you want revenues to increase 5x, you probably have to hire five times as many solicitors or accountants.

Graham, thanks, that's a good answer.

I would add though that there is a fair amount of evidence that these businesses are not scalable in the way that, say, a software platform is. You will no doubt be aware of the reasons, including the difficulty of deploying larger amounts of money in the small cap (or EM?) sectors and the difficulty in moving it quickly. I have often heard and read successful fund managers discussing the difficulties that success has brought. If performance deteriorates with scale then ultimately the business isn't scalable.

thanks for the comprehensive reply. will definitely keep an eye on the situation. i actually regard the extension of the covenants as a vote of confidence from senior creditors, they must also have faith in the turn-around plan.

one thing i would be interested in would be if management significantly increase their holdings and/or institutions start buying.

Thanks mr o,

Yes a fair point that the covenant change is a vote of confidence, but the need to do it is indicative of the tightrope they are walking.

Good point also about management or institutional buying, I'd been thinking more about wanting to see earnings momentum, but any such buying could indicate early optimism on that front and that could be a useful flag as we may not get a formal update prior to the HY results.

Although I would imagine that if director buying was going to happen it would have been immediately after the results - any buying later in the half year without a public trading update would be questionable imho.

Small Cap Value Report (Mon 18 Feb 2019) - Mello Trusts and Funds, MCLS, VCP, CLIG, ANG, CSSG

Mello Trusts & Funds

PI World Interview

McColl's Retail (LON:MCLS)

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Graham Neary

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Profitability and Cashflow

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