Small Cap Value Report (Mon 2 Dec 2019) - TED, BMY, SIXH, PTRO, LSL, SDI

Good morning! Today we have:

• Ted Baker (LON:TED) - inventory was overstated
• Bloomsbury Publishing (LON:BMY) - enters domestic Chinese market
• 600 (LON:SIXH) - half year report
• LSL Property Services (LON:LSL) - trading update
• Pelatro (LON:PTRO)
• SDI (LON:SDI) - acquisition

Today's report is now finished.

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Ted Baker (LON:TED)

• Share price: 397.6p (pre-open). 
• No. of shares: 44.6 million
• Market cap: £177 million

Independent review of inventory

I'm surprised the shares are down by less than 10% in early trading.

Ted Baker has identified that the value of inventory held on its balance sheet has been overstated.  Based on preliminary analysis, the Board estimates an impact on value of £20m to £25m.

To give the estimated impact some context: TED's inventory was previously valued at £210 million (August 2019), which was also the company's net asset value.

With inventory and net assets both being written off by around 10%, I'm surprised that the market cap is down by less than 10%.

We've had our fair share of accounting problems over the last few years, and I think investors need to be wary of:

• Early estimates being too optimistic.
• Other accounting problems being discovered, after a more thorough investigation ("there's never just one cockroach in the kitchen").
• Accounting problems being indicative of wider ethical problems in a company.
• The company being unable to generate the expected level of profitability, when it starts telling the truth about its finances.

For all of these reasons, I think investors should be extremely cautious when a company makes an announcement like this.

On the third of the above four points, it should be pointed out that ethical problems at TED aren't a big surprise. Its founder Ray Kelvin left the company about a year ago, in the midst of a "forced hugging" scandal. Company culture was evidently not what it should be. Bad corporate culture has a funny habit of creeping into the financials.

And on the fourth point: overstated inventory means that historic profits were overstated by that amount, too.

While this doesn't automatically rule out a recovery, it means we need to bring extra scepticism when it comes to the turnaround plan.

For example, if £5 million of the overstatement related to H1 this year, then the H1 pre-tax loss was really £28 million, rather than the £23 million which was reported. That's an even bigger loss to reverse the next time around.

Analysis

It's a strange feeling to watch a share that I coveted for so long, get cheaper and cheaper. And yet, the cheaper it gets, the less that I want to own it!

I've been reading through the archives, to see if I've been making any sensible comments on the stock this year.

Actually, I thought that it might be undervalued at the start of the year, and was lucky that I resisted the temptation to have a nibble at it. At the time, it did look very cheap relative to earnings forecasts.

The old me, who was always looking for a bargain share, might have opened a position in it. But I stayed away, primarily because of my caution when it comes to the retail sector. "Probably undervalued" was no longer a good enough reason to invest.

In October, a reader pointed out to Paul that TED's inventories looked too big. Paul agreed, saying:

I cannot fathom why the business has such large stock-holdings? The bought in margin is high, so TED may still be able to sell this stock for more than cost, hence no write-down required by the auditors, but it might still need to be heavily discounted to shift it.

For my part, I've gone back and done a calculation for inventory turnover (COGS/average inventory) for FY January 2019.

This comes out at 1.24x, implying that it took nearly 10 months to move stock. Wow!

Stockopedia calculates the same metric (calling it "stock turnover") on a trailing twelve month basis as 1.19x, i.e. about the same as I get.

In H1 this year, I calculate that stock turnover was .66x on a half-year basis . Annualising that would give us 1.33x, which implies that it took just over 9 months to move stock. An improvement  which the company was proud of:

...we have seen the benefits of reducing our investment in inventories through tighter, more flexible buying and a proactive approach to current season sell through in response to market conditions, and improved supplier terms.

For context, stock turnover at Next (LON:NXT) (in which I have a long position) is 4.87x, according to Stocko. This implies that it takes Next 2.5 months, on average, to move stock. That is clearly far superior.

Apart from the very slow stock turnover, there were other clues that TED might have been having inventory problems. I'm talking about margins.

After all, it doesn't matter too much if inventory is growing, if it can still be sold at a tasty profit. 

For FY January 2019, TED's gross margin declined from 61% to 58.3%.

In H1 this year, it declined again to 54.3%.

Those are some sharp movements, and their effects on profitability are of course compounded by the negative operational gearing which retailers face.

Summary

In summary, I have zero desire to invest in this share.

It had net debt of £141 million as of August 2019, and its total debt facility as of September was £180 million. So the headroom for further losses might be limited.

If the new managers can handle inventory more efficiently, that could free up some additional cash, but I would be concerned that those gains could be wiped out by further trading losses rather quickly.

It's a stunning fall from grace for a stock which was in the FTSE-250 Index as recently as September!

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Bloomsbury Publishing (LON:BMY)

• Share price: 274.2p (+1.6%)
• No. of shares: 75 million
• Market cap: £206 million

Bloombury enters domestic Chinese market

This sounds promising. Bloomsbury is stepping up its Chinese activity with the creation of Chinese JV. That's the standard way for foreign companies to enter China.

In this case, the JV partner is the Chinese government, via something called the "China Youth Publishing Group" (Chinese-language website here). This is managed by the Communist Youth League of China.

At present, Bloomsbury merely publishes English-language books in China, and gets royalties for its its titles which are translated to Chinese.

The new JV will publish original Chinese-language books and Chinese translations of other titles, including from Bloomsbury's own portfolio.

Rationale:

This new joint venture is a unique opportunity for Bloomsbury as it becomes one of a very small number of Western publishers with joint ventures in the Chinese mainland domestic market. China is an important and growing market for books and in particular is a key market for trade and academic publishing. It is expected to continue to grow, with China projected to surpass the USA as the world's largest economy by 2030.

My view

What's not to like about this? If it works, it could be great news for BMY, its Chinese customers and its shareholders. 

Getting in bed with the government is part and parcel of doing business in China, if you want to have a strong physical presence there. There's basically no other way of doing it.

BMY says "the investment is de minimis", which I will interpret to mean that upfront costs are close to zero. 

Good luck to BMY on its new venture. This share has a StockRank of 83 and could be worth researching in greater detail. It is well-liked by one or two investors I respect, and is firmly on my radar now.

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600 (LON:SIXH)

• Share price: 18.3p (+2%)
• No. of shares: 117 million
• Market cap: £21.5 million

Half-year Report

The 600 Group PLC ("the Group"), the diversified industrial engineering company (AIM: SIXH), today announces its unaudited interim results for the six months ended 28 September 2019.

I last covered this one in July.

It continues to offer tremendous "Value", with a Value Rank of >90.  Note that the forward P/E ratio is 5x, according to Stocko.

What's holding the share back, I suspect is the 44 million warrants at 20p. If the share price exceeds 20p, this could create an avalanche of shares.

The benefit of this dilution, if I've read the accounts correctly in the past, is that the company would no longer be on the hook for around £9 million in convertible loan notes, which are due in 2022. 

Coming up with that loan repayment in cash would be a significant burden for the company. Cash in hand is less than $1 million (accounts are reported in USD) and it has a net debt position of over $4 milllion even if you exclude the 2022 convertible loan notes.

On the plus side, underlying pre-tax profitability has improved to $1.7 million for the half-year period, and H2 is forecast to be even better. The story is much simpler to understand, following the sale of the company's pension surplus.

Management are optimistic:

This period has seen further progress in our strategy to build a global industrial business. The de-risking of the Group, both operationally and financially, has created a platform from which we are now beginning to leverage the strength of the Group's brands and grow the business into increasingly diversified niche markets worldwide both organically and by acquisition.

My view - it's not going to pass my sector filters, because it's too "heavy" and industrial. It makes machine tools and precision engineered components. It has not earned a double-digit Return on Capital for about 20 years.

As a value play, it might be of interest to some of you. From Stocko's perspective, it's a Super Stock. It ticks all the boxes from a quantitative point of view, so it might fit into some people's strategies. But I would definitely watch out for those warrants.

It might be prudent to imagine that the market cap was already inflated by another 44 million shares (i.e. by 38%), in exchange for the loan note conversion. If the company still looked too cheap after making this adjustment, that could be a reasonable basis for making a purchase of these shares.

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Pelatro (LON:PTRO)

• Share price: 51.6p (+29%)
• No. of shares: 32.5 million
• Market cap: £17 million

Contract win and trading update

This was on a PER last night of 3x, according to Stocko.

And there is good news today:

The Group has been selected by one of the largest global telcos in the world, with significant operations in Asia (the "Telco"), to implement its Contextual Marketing Platform as well as its Unified Communication Manager software (the "Contract").

Expected total revenue from the contract, including variable payments, adds up to $10 million - $12 million over a 5-year period.

Profit from the contract is unclear to me - the company says that "incremental costs" will be incurred to deliver it. Hopefully the margin on it will be attractive.

Either way, for a small company, this is highly material. Pelatro says that the contract will bring "better quality and higher visibility to future revenues", along with reputational benefits and cross-selling opportunities.

Pelatro is a precision marketing business, headquartered in London. Its track record in recent years is encouraging: profitable growth, which is frankly not all that common in the micro-cap world!

This update includes a description of company strategy: it's determined to focus on recurring revenues, rather than one-off contract wins. Sounds great. I try my best to avoid companies which need lumpy contract wins to succeed. If Pelatro succeeds in becoming a recurring-revenue type of business, it would become highly investable to me.

Trading update: the company says that the value of contracts won this year is an all-time high, but the recognised revenue will be minimal, since the value won't be recognised until later in the contract (no doubt there has been some impact from IFRS 15 here).

Additionally, the effort to win the major contract described above has taken management focus off other opportunities. So we will have a revenue miss this year. Revenue this year will only be a little higher than last year. But it looks forward to starting FY 2020 with a lot of recurring revenue already locked in ($4 million locked in, versus $1.5 million locked in at the start of this year).

My view - I wholeheartedly approve of the strategy. Missing revenue this year doesn't matter, if the long-term revenues are growing and are underpinned by long-term contracts and repeat business.

I'm not familiar/confident enough in terms of my understanding of its products to take a punt on Pelatro, and that would be my main hurdle to investing in it (see my comments in September). But it does sound like the management team are switched on and have the right attitude about building a business that can grow and generate cash over the long-term. Worth looking into in greater detail.

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LSL Property Services (LON:LSL)

• Share price: 238.4p (-0.7%)
• No. of shares: 102.7 million
• Market cap: £245 million

Trading update - 2019 Expectations unchanged

This company provides a range of property-related services.

LSL has delivered a creditable performance in the 10 months to 31^st October 2019. This performance has been delivered during a period when market activity levels have remained subdued given the continued uncertainty over the UK and global political and economic environment. 

I don't find this company's activities particularly interesting, so I'll move on.

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SDI (LON:SDI)

• Share price: 72p (+7.5%)
• No. of shares: 97 million
• Market cap: £70 million

Acquisition

The market loves this update, showing that SDI still has some interesting acquisition ideas.

The price tag for this deal is £4.3 million, plus up to £1.7 million for the acquired company's net assets. This is probably good value versus PBT last year of £0.78 million.

Description of the acquired company:

 Chell specialises in the design, manufacture and calibration of pressure, vacuum and gas flow measurement instruments for a variety of sectors including aerospace, vehicle aerodynamics, gas and steam turbine testing and power generation industrie.

Here's its website.

I like the sound of this.

Also, I see that the shares of Judges Scientific (LON:JDG), with a similar business model, continue to reach fresh highs. Doubtless this is helping to provide a bit of a tailwind to SDI, since many investors will be choosing one or the other share.

With a market cap in excess of £300 million, and the recent announcement of a special dividend, there is a risk that the JDG business model is reaching the upper limits of what it is capable of doing. That's unlikely to be the case for SDI, with a market still sub-£100 million and net asset value only half that of Judges.

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Hanging up my pen for today, thanks everyone.

Graham