Small Cap Value Report (Mon 3 Dec 2018) - Macro, CRAW, MCLS, PLA

Good morning! It's Paul here.

I'm starting to feel a bit Christmasy, whatever that means. This has mainly manifested itself by my humming "Jingle Bells" under my breath, and asking when the Christmas tree will be going up.

Also, I'm thinking about starting a petition to raise 100k signatures, to get Parliament to ban the playing of Sir Cliff Richard's Mistletoe & Wine, not just over the festive period, but at all times.

MySale (LON: MYSL)

(in which I have a long position)

Several readers have asked if I met management as planned recently. Unfortunately not, I couldn't make the meeting in the end, and I've not spoken to them.

It remains a mystery why the share price is so weak - just more sellers than buyers. My broker tells me that, last week, a retail investor dumped his or her shares, trashing the price. Slamming the price down does seem to unearth some buyers, but then it goes to sleep again. Until the next time someone smashes the price down again.

The shares are tightly held, by management, and big investors Philip Green (through a company called Shelton), and Sports Direct. Therefore, there's a risk that they might decide to take it private. I don't mind if they pay a decent premium, but being notoriously tight, I don't think those characters would be minded to pay a generous price.

The key issue for MYSL will be whether the large receivables on the balance sheet do indeed start turning into cash, as promised in the last set of figures. Time will tell.

Macro musings

It's very quiet for company updates today, so I'll allocate some time to thinking out loud about current issues.

Balance sheets & debt - a friend sent me a very interesting email over the weekend. In it, he pointed out that banks seem to be tightening credit in difficult sectors (e.g. construction, outsourced services, traditional retailers, and others). This is forcing some companies to seek alternative funding, which of course usually means tapping shareholders for funds. We've seen several deeply discounted rights issues recently, and I think there could be many more to come.

My strategy of avoiding companies with weak balance sheets has arguably been too cautious over the last 10 years. I missed some good opportunities because of my strict rules on avoiding weak balance sheets. Although I've also dodged a lot of bullets, so overall it was the right approach. The one time that I broke my rules (Conviviality) turned out to be not at all convivial, with a £30k loss incurred in just days before it went bust.

Remember we have had artificially low interest rates for almost 10 years now. This has sown the seeds of the next recession, by causing misallocation of capital, and over-expansion in many sectors. We've seen how casual dining has hit the buffers, as too many chains expanded recklessly, often fuelled by private equity funding. Many signed leases on unrealistically high rents. There are now just far too many casual dining outlets, and we're in a war of attrition, where the fittest will survive, and the weaker formats, with weaker balance sheets, inevitably fall by the wayside.

Retailing generally is in the same boat. With so much business leaking away online, that leaves us with far too many physical shops, again on rents which are often unrealistically high. I think hotels are heading in the same direction - new ones seem to be popping up all over the place. Great for consumers of course, but again the weaker players are likely to end up going bust.

All of which makes me wonder whether we might be heading for a recession? Maybe, maybe not, we just don't know. Wages are rising, and we have full employment, relatively low inflation, and low interest rates. These are not the conditions for a recession to start. Although if the banks continue withdrawing credit, then that could start off a downturn.

Therefore, balance sheet strength is becoming far more important, and should be at the top of everyone's list of things to check, before investing in anything. Companies with strong balance sheets can sail through an economic downturn, and crucially, can afford to invest (e.g. buying distressed assets on the cheap) when others are falling by the wayside.

Companies with weak balance sheets, including too much debt, often end up being very bad investments when credit is tightening. They could go bust, or destroy shareholder value through heavy dilution, when emergency funds are needed from shareholders. So I'll be stepping up my warnings here, if I see a weak balance sheet, which I check for every company that is mentioned here.

Talking of which, I see that Crawshaw (CRAW) has today announced the disposal of its remaining 19 stores, and a distribution centre, to a company called Loughanure. The price paid was £1.4m. The buyer has therefore been able to cherry pick the profitable shops, and bought them for a song. These sorts of deals with administrators, are often very lucrative in the long run, for the buyer. Many successful businesses began with, or were greatly boosted by, a distressed purchase from insolvency practitioners, of the best bits from a failed business. I'd be surprised if there's anything left for shareholders, once administrators fees have been settled. Plus of course all the creditors have to be paid, before shareholders get a penny. The shares are still suspended, and after 1 month of having no NOMAD, will automatically de-list. The administrator says today that it won't be appointing a new NOMAD, so de-listing looks a near certainty now.

Accounting fraud - someone recently reminded me of (one of many) great quotes from Buffett or Munger - that you only see who's not wearing a bathing suit, when the tide goes out!

We've all been shocked by the revelations at Patisserie Holdings (LON:CAKE) . If a cash-rich, highly profitable company, run by (former) investment legend Luke Johnson, can suddenly announce that it's about to go bust because of undisclosed overdrafts being maxed out, then what other horrors could be out there?

A bull market can cover up all sorts of nasties, but when conditions become tougher, then it becomes a lot harder to conceal accounting fraud.

Last night, I was revisiting my 27 historic Globo articles here, pointing out that there were many things obviously wrong with the accounts from Globo (GBO). It was crammed with really very obvious red flags. Yet the fraud continued for several years, before the CEO eventually coming clean that the figures were fraudulently misstated. It's amazing that institutions poured money into the company, in several fundraisings, not noticing that the figures were clearly not credible.

Looking back at my articles warning people to beware of Globo, the main signs of accounting fraud tend to be;

• Costs that should go through the P&L being diverted (ie. capitalised) onto the balance sheet. This inflates reported profit.
• Consistent (over several years) inability to generate meaningful free cashflow, whilst reporting rising profits.
• Unusually high profit margins, with no obvious reason as to why that should be (with hindsight this was the "tell" at CAKE). Also, companies reporting high & growing profits, when competitors are seeing declines, is another tell (e.g. CAKE seemingly not being affected by lower footfall in High Streets, which struck me as odd, as I reported here in May 2018 (saying - "I'm perplexed as to how this can be, when so many other town centre operators are complaining of low footfall."). Overall though, I was almost completely fooled, like everyone else, by CAKE's misstated figures. It just never occurred to me that the figures could have been fiddled.

For this reason, I've decided to do some reading on the matter of uncovering dodgy accounts. I'm pretty good at it, but not good enough, as I didn't spot CAKE. Mind you, did anyone? I've downloaded a book called "Financial Sh$nanigan$" onto my kindle, and will start reading it on the train home today. I'll let you know if it's any good.

Takeover bids - an astute audience member asked me, during the Q&A from one of my talks at Mello London (last week), if Brexit uncertainty/chaos was likely to cause a halt to takeover bids. My gut feel is that it could well do - i.e. companies might put deals on hold, until it is clearer what the future holds.

Indeed, a second mooted takeover bid of shopping centre owner Intu Properties (LON:INTU) fell through last week. The reason given was supposedly to do with Brexit. Pull the other one! Brexit uncertainty was a known unknown well before the bid talks started. I think that it's a convenient excuse for why deals might fall through, as it saves face, and is a catch-all explanation. Whether that is the real reason, well I'm sceptical. If 2 bidders have looked at the books, then walked away, then I'm very nervous about wanting to catch that particular falling knife. I did some work on INTU's figures last week, and it does look potentially interesting though - there's a huge discount to book value - which in itself makes me wonder whether book values are realistic, or could be too high maybe?

Although last week we saw a cash takeover bid for Bioquell (LON:BQE) - the 40% premium being offered only takes the share price back to where it was in September, before the across-the-board stock market correction in October/November. Therefore, this seems a good example of shrewd buyer, taking advantage of stock market falls, to nip in and grab something on the cheap. Although a forward PER of 42 times seems a punchy price. Bidders often see hidden value in companies though, e.g. driving more sales through the acquired company, using the bidder's existing contacts. Synergies, e.g. removing duplicated costs, can also enhance the value of a target company.

I deliberately target shares which would make good takeover targets - e.g. French Connection (LON:FCCN) - already in bid talks with 4 parties, and Revolution Bars (LON:RBG) which rebuffed a 203p cash bid last year - now it's almost half that price. I hold long positions in both these shares. Of course, you have to be "in it to win it" with takeover bids. Selling up, into a falling share price, can save you losses in the short term, but you'll miss out on the instant, vertical move up in price when/if a bid is announced. 

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McColl's Retail (LON:MCLS)

Share price: 83.6p (down 29.6% today, at 11:33)
No. shares: 115.2m
Market cap: £96.3m

Q4 & full year trading update

McColl's Retail Group plc, the convenience retailer, ("McColl's" or "the Group") today announces its trading update for the 13 and 52 week periods ended 25 November 2018.

• LFL (like-for-like) sales showed an improvement:  Q4 was 0.0% LFL, better than Q3 of -0.9%
• Sale & leaseback of stores generated £25m cash
• Net debt - "materially lower than expected" at c.£100m

This sounds like a profit warning (which makes sense, given the share price is down nearly 30% today);

In light of transitional challenges and continued difficult trading conditions, adjusted EBITDA for FY18 now expected to be around £35m

I'm a bit confused over this. Q4 sales were OK, so why does that come with a profit warning? One analyst has pointed out that strong cigarette sales would be bad for the overall margin, as tobacco products are low gross margin.

Also, I note that the revamped stores are delivering over 5% LFL sales growth. This then implies that older stores must be delivering negative LFLs, since the combined total was flat in Q4.

Supply disruption - is ongoing, by the sound of it;

It (sic) the last 12 months, following the collapse of Palmer & Harvey, we have experienced significant supply chain disruption and have needed to accelerate the rollout of Morrisons supply to 1,300 of our stores. The speed of this transition has created significant challenges and severely disrupted our plans for the launch of Safeway. We are extremely grateful for Morrisons' support during this period, and whilst the transition is now complete, we are continuing to experience a number of challenges. We are working together to address these issues and to develop an optimal range and promotional offer for the future.

Bank facilities - this is far too vague, I'd want more detail, given that this business is still quite highly indebted;

We have also entered into revised banking arrangements. Whilst our existing financing is in place until mid-2021, a number of changes have been made to the terms to give us additional flexibility to execute our strategy.

Cost pressures - wages costs are hitting all retailers, we need to keep this in mind when looking at the whole sector, especially the low margin companies like MCLS;

In the short term, managing cost pressures will continue to be critical, the most significant being an increase in the National Living Wage. To improve efficiency we are investing in systems and processes, alongside our programme of estate optimisation.

We also expect continued uncertainty for consumers which will require us to demonstrate further competitive retail pricing.

As a result we now expect adjusted EBITDA for FY19 to be no more than a modest improvement on FY18.

In a nutshell then, the company is being squeezed from both sides - selling prices need to drop to be more competitive (thus reducing gross margin), and costs are rising. The result is that there probably won't be much, or any, improvement in profits for FY 11/2019. This is really not good, although it's hardly surprising either, is it? These factors are well known & ongoing.

Outlook - at least the new financial year should have some tailwind from soft comparatives during the period of supply disruption in FY 11/2018. The comments about WM Morrison Supermarkets (LON:MRW) makes me wonder whether it might bid for MCLS perhaps? Why would it want to, though, and take on all those lease liabilities? (which remember will be coming onto balance sheets soon, due to a change in accounting rules for leases). I suppose that bolting on £1.2bn revenues, and improving the margin by supplying through MRW's existing infrastructure, could make sense.

"Looking ahead, we expect competition in the grocery retail sector to remain intense and we face into significant cost pressures. Important to our future success will be continuing to develop our partnership with Morrisons, alongside our plans to enhance our neighbourhood convenience offer by improving the quality of our estate and our overall customer experience."

My opinion - the balance sheet is awful, with negative NTAV of -£102.6m. That automatically rules it out for me.

The profit margin is wafer thin. Downward pressure on selling prices, and upward pressure on costs, makes me worry that profits could disappear altogether, and turn into losses, if present trends continue.

** Dividend warning ** In my view it is very likely that dividends will be cut, or stopped altogether. The existing payout level looks unsustainable & imprudent, in my view. The yield is now over 10%, which is rarely a sustainable level.

The interim dividend of 3.4p was maintained at the same level as prior year. The commentary in the interim report cited strong cashflow as the justification for maintaining the divi. I've checked the cashflow statement, and it's noteworthy than nearly all the cashflow actually came from increased trade creditors. So you could argue that the suppliers are funding MCLS's divis!

Overall, I see nothing attractive about this share at all. I cannot imagine why anybody would want to hold this share on fundamentals, other than for takeover bid speculation - after all, its market cap is now loose change to one of the big supermarkets.

Why hold such an unattractive share, when there are so many other, better shares available on the market? The only reason I can think of, is for takeover speculation.

Given the factors noted above, I'd speculate that it's only a matter of time before another profit warning happens. Will this business still exist in a few years' time? 

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Plastics Capital (LON:PLA)

Share price: 106p (up 1.4% today, at 12:46)
No. shares: 39.0m
Market cap: £41.3m

Half year report

Plastics Capital (AIM: PLA) the niche plastics products manufacturer, announces the Company's unaudited interim results for the six months ended 30 September 2018 ("H1") or ("HY18-19"), which are in line with management's expectations.

It's really helpful when the start of the RNS tells us whether or not the company is trading in line with expectations, as this one does.

Revenue growth is all organic, and not bad at 11-12%

Outlook - sounds alright;

 Order books are healthy and we expect good sales growth to continue for the foreseeable future if economic conditions remain satisfactory.

The Board anticipates that profits for the full financial year will be ahead of FY17-18 and in line with consensus market expectations."

Name change - reflecting the fact that "plastic" is regarded in an extremely negative way these days, the company is changing its name to "Synnovia". I rather like that, it rolls off the tongue nicely.

Incidentally, I had lunch with a city friend recently, and we were discussing this issue. He said that his kids would not shop at M&S, as they use so much plastic packaging. They've had it drummed into them at school that plastic is clogging up the oceans, etc. Which is perfectly true.

However, as I pointed out to him, there are 2 conterveiling points;

1) Plastic is used to keep perishable product in good condition during transit, and for longer shelf like. So if we get rid of plastic packaging, then vast amounts of food will have to be destroyed - wasting resources & costing money.

2) Surely it's not the use of plastic that's the problem - it's the disposal of it which is poor. If we would properly recycle all the plastics we throw away, then they wouldn't end up in the oceans. Also, I believe it's other countries, particularly in Asia, which are the main culprits in throwing plastic into the rivers, and it ending up in the sea.

Balance sheet - this is the deal-breaker for me.

There's too much debt, and it's capex-hungry, thus generating negative free cashflow in the last 5 years.

My opinion - the P&L looks quite good, but lack of free cashflow, and the weak balance sheet, rule out this share for me.

Divis stopped in 2017, which makes sense, since they were effectively being paid from borrowings, not from operational cashflow.

The share price has gone nowhere in the last 5 years, and I can't really see anything to change that for the future either.

As a buy & build it hasn't worked, because there's no cashflow to pay down the debt. Buy & build only makes sense if you can get your own shares onto a high rating, and then use a mix of fresh equity & debt to buy highly cash generative businesses at dirt cheap valuations, and then make them more efficient by stripping  out costs & working capital. That's roughly what Judges Scientific (LON:JDG) , Norcros (LON:NXR) and Victoria (LON:VCP) , Ideagen (LON:IDEA) , and some others have successfully done (to date).

The big risk with buy & builds, is that debt can become excessive at the wrong point in the economic cycle, leading to collapse (e.g. Conviviality). Also, weak management doing a buy & build (also Conviviality) is a recipe for disaster, as they can't integrate or control the businesses they buy.

PLA is now stuck with too much debt, and a lowly rated share price. That means it doesn't have ammunition to make more acquisitions. With no dividends either, what's the point of the company existing, other than to provide Directors with well paid, and very cushy jobs? (since the subsidiary companies have their own management teams, the plc Directors are just an overhead, in my view, adding little value).

There's very little liquidity in the shares either. You could probably buy fairly easy, but then really struggle to sell in any meaningful size. That's a big risk with micro caps.

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That's me done for today, thanks for dropping by.

It's me on again tomorrow & Weds, so see you then!

Best wishes, Paul.