Small Cap Value Report (Mon 5 Feb 2018) - IQE, MUR, BEG, GAW, GTC, VLTY

5th Feb '18 by Graham Neary

79 comments 24222 reads

Good morning!

So far, I've noticed the following bits of news:

Murgitroyd (LON:MUR) - interim results
Begbies Traynor (LON:BEG) - small acquisition
Getech (LON:GTC) - trading update
Veltyco (LON:VLTY) - trading update
IQE (LON:IQE) - response to negative publication by shorter

I'll try to unpack the situation at IQE (LON:IQE) first.

IQE (LON:IQE)

Share price: 103p (-1%)
No. of shares: 789 million
Market cap: £813 million

Response to ShadowFall Report

This opened lower but has recovered most of the losses by mid-morning.

IQE manufactures wafers for the semiconductor industry. It's widely-followed by private investors and has been discussed here on numerous occasions before.

When I last covered it in November, I noted the material amount of short interest outstanding (6.5% was disclosed at the time) and guessed that this was due to 1) its high valuation against conventional metrics, 2) the lack of free cash flow generation, and 3) its reliance on a small number of customers. The share price at the time was 162p.

Since then, reported short interest has risen to 11.7%, although the total short positions outstanding will be higher than this.

Whenever we see so much short interest, we need to sit up and take note - it usually means that a lot of sophisticated investors have noticed something terribly wrong with the company or its valuation.

Bear attack

On Friday night, an investment fund run by respected analyst Matt Earl published a letter detailing the rationale behind its short position in IQE.

Matt did not contact IQE prior to publication of this letter. If he had, perhaps they would have provided answers to many of the questions he raised? We'll never know.

His letter does raise worthwhile questions about IQE's joint venture operations, and provides a good overview of IQE's lack of cash generation over the years.

However, it's not a "smoking gun" publication - it provides searching analysis and raises questions, without going so far as proving any wrongdoing. Matt Earl himself is quoted today in ShareProphets as follows:

We see IQE’s statement as helping to confirm our view that while…

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crazycoops

5th Feb '18

sjalloq

I don’t recall seeing your posts previously but I have very much enjoyed your posts today on IQE (LON:IQE). You have very eloquently summed up the main reasons why I am invested here. Thanks for taking the time to do so.

Edward John Canham

Games Workshop (LON:GAW)

Might be just me but I don't think it's a "solid trading update".

".....profits for 2017/18 to date are therefore slightly above expectations." The only expectation I can find is the 161p EPS on Stockopedia which, given the 97p EPS made in the first half of the year, sounds like quite a slow-down in the second half.

Phil

Re: Games Workshop (LON:GAW) there will be currency headwinds in H2. Nonetheless, Peel Hunt upgraded forecasts again today to 170p+ but I wouldn’t pay much attention as they seem to be consistently behind the curve on this share (and I suspect that’s down to the company’s approach and culture). This company is not for everyone but I am enjoying being a shareholder. I quite like the nonchalant randomness, although I suspect I would feel differently if they were delivering poor performance. Fortunately, they are on a roll.

Gromley

Re : IQE (LON:IQE)

I have to say that I am a little disappointed with Graham's uncritical acceptance of Matthew Earl / ShadowFall’s analysis and his motivation for writing it.

Leaving aside the fact that Earl’s “research” was clearly inadequate (seemingly consisting of cherry-picking certain stats that support his case and ignoring other readily available evidence), I was particularly drawn to the view espoused that :

Forty-two times the JVs’ 2016 profit [£6.6m] would suggest that the market is attaching approximately £278 million in value relating to the profit generated by these JVs.

Is it really credible that Mr Earl believed that IQE was valued based on this licensing revenue (especially given that we knew H1 licencing revenue was £1m as opposed to £3.5m in 2016 and that licensing did not materially figure in the forward views for IQE)?

The article is alleged to have been originally distributed (to whom we are not told) on 8th December before the trading statement confirming licencing revenue of no more than £2m, so given his lack of research elsewhere it is unsurprising that he did not realise that £6.6m was not a representative number of licencing going forwards.

Is there not an alternative possibility, that Mr Earl was hoping that his reputation(*) would convince the gullible to accept his statement at face value, without engaging brain?

[*] Even the respected Graham Neary (and despite my criticism here the respect is genuine) described Earl as the “respected analyst Matt Earl”.

However, looking at this further, there is a glaring anomaly with Earl’s analysis that I find hard to reconcile.

Earl asserts that the JVs contributed [profits of] £8.0m & £6.6m in 2015 & 16. Representing 42% & 30% of adjusted EBIT.

This implies adjusted ebit (2015,16) of £19m & £22m – my figures are slightly lower however I’ll accept we may have used different adjustments.

He then arrives at the imputed £278m over-valuation against the £6.6m 2016 contribution, because “On an EV/EBIT basis, IQE trades on c. 42 x its 2016 EBIT.”

So given the £22m implied EBIT above that gives an EV of £924m.

I can think of 3 figures of net debt he may have used to for the EV number
:
£39.5m (YE 2016), 41.9m (H1 2017) or zero given that debt was cleared by the fund raising but the excess cash is reserved for capex.

This implies the share price used in this calculation of either 117- 122p.

Oh dear – that would date the paper at either late January or before October 2017.

Why does that matter?

Well firstly because he explicitly states that the paper was originally distributed on the 8th of December – and if that is not actually true, should we question everything else he has written?

And secondly because if the report were actually written after the recent trading statement, ignoring facts revealed therein (such as the lower 2017 licensing revenue) would be highly questionable indeed.

I am troubled by these inconsistencies in ShadowFall’s story and therefore I am personally not confident that they are being honest in their writing or presentation of facts or analysis.

However as ever I would advise you to DYOR.

Hot Socks

As a general principle I think investing in companies which are profitable, as opposed to those which hope one day to be profitable, works quite well :)

timarr

Hi Gromley

Graham's analysis seems fair enough to me. It's always better to address the comments of a poster rather than try to impute motivations. And, in respect of this comment:

[*] Even the respected Graham Neary (and despite my criticism here the respect is genuine) described Earl as the “respected analyst Matt Earl”.

Why are you suggesting Matt Earl isn't respected? He has a long history of calling companies out going back to Connaught and Xchanging and moving on through Avanti Communications, Dialight and Mitie. One of the reasons the report has teeth is that he has a history of getting things right.

I'm not saying he's called this correctly, I don't know. But suggesting that he's not respected is wrong. He is.

Timarr - you need to read the context of that quote. The point in fact was that he IS respected by many.

Graham Neary

Hi Gromley, you could just take "respected" to mean "respected by me", as I have met Mr. Earl a few times and always come away with the impression he is a very good analyst.

However, as I did say in the report above, I don't believe that the company is being valued on 2016 numbers. So I disagree with Matt that there is any relevance to the 42x multiple he mentioned, regardless of which share price he used or when the share price was at that level.

AnonymousUser252054

The RNS from LXB Retail Properties (LON:LXB) is nothing like the cash return plan being proposed just last month. Now the BoD hint at 6p in the short term if shareholders commit to the following binding arrangement:

'the transfer of certain assets and associated liabilities (actual and contingent) of the Company's group of companies (the "Group"), which will endure beyond 31 March 2019, to IW Midco Limited ("IW Midco"), a third party company owned and managed by Brendan O'Grady a current member of the Investment Adviser team, together with an appropriate amount of cash to collateralise those liabilities'.

'a payment to IW Midco to provide for its operating costs (including remuneration) for the period for which it is expected to manage the transferred liabilities'.

'the transfer to IW Midco of any assets and associated liabilities remaining in the Group which have not otherwise been disposed of or discharged by that time'.

'The Company has agreed to pay the running costs (including remuneration) of the IW Group for the period from the Effective Time until the fifth anniversary.'

And some people aren't happy with the third party arrangements at IQE!?

Thanks Graham - I took it as the wider "respected by many", which I think is true - and possibly part of the problem in this case.

I get that you disagree with Matt that there is any relevance to the 42x multiple he mentioned.

But if you respect him, surely you cannot think he believes it has any relevance either?

Bad smell here imho - but I'll leave it at that.

bestace

For me it is the glaring dichotomy between Mr Earl's reputation as a bear analyst and the quality of this particular report that I find striking. In short (excuse the pun), I expected better from him.

I generally try and seek out a well argued bear case as a means of avoiding confirmation bias (I hardly need to tell you that!), but I found this report had far too many inconsistencies, untruths, partial truths, dodgy maths, selective omissions and insinuations masquerading as evidence.

Many of the issues I have with the report stem from an apparent lack of knowledge of the technical accounting involved. If Mr Earl does not have an accounting background, why did he not run the report by an accountant before publishing?

Given all the above, it is precisely because of his reputation that I find it somewhat implausible that he could write such a report unless he had ulterior motives for doing so.

Catstycam

It's difficult to know quite what to do for the best and will be quite different for one investor to another depending on their individual circumstances. It's easy to say "if you are going to panic then panic early!", which isn't particularly helpful.

Being largely optimistic about our holdings we tend to hold for too long, fearing the moment we sell out then the market will change and catch us out. It was obvious today there was going to be a general fall back as indeed there is going to be again tomorrow. Much of the fall was early on, so it was not easy to get a great price. For me I decided to wait and see how things would go today, hoping that the DOW would perform better than Friday and possibly recover somewhat. At one point the DOW was near break even although by that time all my holdings were lower. Like Friday the main fall was late on, well after the London market was closed.

It now appears there is a correction taking place. It is probable the DOW will fall further but of course none of us know by how much. If there is a correction of 15% then there could be another 2000 points to come off.

I'm not sure now is the right time to be greedy when others are fearful but opportunities will arise.

Personally, I may reduce my holdings. Has this worked in the past?, briefly yes should this be a correction. Corrections don't usually last long before there is (some) recovery.

Good luck whatever one does.

CM

pka

6th Feb '18

bestace, you wrote: "I found this report had far too many inconsistencies, untruths, partial truths, dodgy maths, selective omissions and insinuations masquerading as evidence".

Absolutely!

In my opinion, Earl's report is a disgrace. It's one thing to assert that IQE shares are overvalued (which may or may not be the case, as it's very much a matter of opinion), but quite another to insinuate that what is (as far as I can tell) a reputable company has been committing financial fraud. If it was a genuine mistake on his part, which I doubt, he should now apologise in public.

Thanks very much again for your fantastic post yesterday which demolished Earl's report.

Hi bestace

As others have said, I thought your analysis was excellent. I was merely pointing out that debating Mr Earl's motivations wasn't really necessary or helpful. In fact, if anything, it weakens the argument by distracting attention away from the real issues you've identified.

timarr

Ramridge

Hi bestace - I have this theory that Matt Earl's reputation has been built on bear reports that did not have at that time someone like you to debunk them.
You took a knife to his IQE report and exposed the weaknesses with surgical precision.

Many on this bulletin board including me do not believe anyone else could have done a better and more professional job than you.

Of course, to prove my theory you will have to take one of his previous "success" stories, and apply your art.

But that would be an academic exercise and poor use of your time.

cig

You can check the archive of his blog (from 2012) to see his hit rate. He doesn't get 100% right but he's right a lot of the time, especially on his conviction shorts. And some cases may have not played out yet (e.g. I agree with his thesis on Wirecard).

hayashi22

If anyone has a compliance background I would be interested in whether the following is permissible:
A hedge fund identifies a highly valued stock with a large retail following
the hedge fund commissions a piece of research (bearish) from an analyst. It pays the analyst
The fund takes a short position as does the analyst-once these positions are maxed out
the fund then publishes the research for maximum publicity
Clearly if nothing is amiss then expect more of the same!

Thanks for sharing.

I liked his logic and his hair.

Phil

Howard Marx

Market manipulation is a civil/criminal offence in most developed financial markets

https://www.fca.org.uk/markets/market-abuse

sjalloq

Ha, nearly as funny as the CMOS or dragging comments. Did you see Lumentum's results? ;-)

Small Cap Value Report (Mon 5 Feb 2018) - IQE, MUR, BEG, GAW, GTC, VLTY

IQE (LON:IQE)

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Graham Neary

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