Small Cap Value Report (Thu 28 July 2022) - HOTC, APTD, RST, HEAD, SRT, TWD, INCE, EPWN, VINO, FORT, FNTL, DSCV | Paul Scott

28th Jul '22 by Paul Scott

64 comments 8865 reads

Good morning. Paul & Graham are here today.

Agenda -

Paul's Section:

Hotel Chocolat (LON:HOTC) 134p (unch.) (£184m) - confirms today that its Japanese JV has entered court protection to restructure. Hence a c.£30m hit to HOTC - as indicated 9 days ago in a bombshell announcement, so today is really just confirmation. I question how management allocated capital so badly - spending about £1m per shop in Japan, for just 20% ownership of the JV? Despite crashing by about 80% this year, HOTC shares still don't look cheap yet, given it's now really just a UK business, and faces plunging profits in 2023 from cost headwinds.

Headlam (LON:HEAD) 307p (down 1%) (£257m) - a surprisingly good trading update, with self-help measures absorbing costs & reduced volumes, to still report increased profit in H1, and in line with expectations for FY 12/2022. Very good balance sheet, although cash is down a lot, partly due to generous shareholder distributions. A very nice value share, thumbs up from me.

Ince (LON:INCE) 5.6p (down 53%) (£5m) [No section below] - this one continues to be a disaster, we’ve been warning against it here for years, due to a diabolical balance sheet, with all sorts of nasties in it - e.g. large deferred consideration, excessive debtors, bank debt, and deeply negative NTAV.

INCE did a deeply discounted fundraise once before, and it’s now announced another one! 5p placing, a 58% discount. I wouldn’t pay anything for INCE equity personally. Although occasionally things like this can be speculative multibaggers, but a more likely outcome seems to me that it gets taken private for tuppence, or goes bust. It’s amazing to think these are lawyers & financial experts, yet are utterly incompetent at managing their own finances (although to be fair, the same accusation could be levelled at me! LOL!). INCE equity is therefore uninvestable at any price, in my view. For gamblers only - you never know, occasionally these things do pay out, although not often in bear markets. At least the risk of insolvency might have reduced somewhat, given this latest emergency fundraising.

Epwin (LON:EPWN) 76p (down 1%) (£110m) [No section below] - A solid H1 trading update. Trading has “moderated slightly” in June & July, but it “remains confident of achieving expectations in 2022”. H1 revenues up 13%, mainly due to price…

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yiannos1

28th Jul '22

Hi Paul ,

A brief comment on your comments regarding Reach plc. This was one of my biggest investments and having exited between £2.80 and £3.20 , I have decided to reinvest again under 90p.

The actuarial valuation of the pensions assets is nothing else than an appraisal of extreme economic conditions. It’s exactly the same thing as the BOE tests carried on the banking sector and based on violent and unfavourable economic conditions , in Reach’s pension deficit case a stock market collapse and 0% interest rates. I believe that this deficit will disappear with another 1.5% increase in interest rates. Then the board will have the option of buying an annuity.

On your comment regarding the declining newspaper and printing sector I have to agree with you , but also emphasise that the expected revenues are just the same as the 2014 revenues and there was a £100 debt also at that time!

In addition there seems to be an 8p yearly dividend based on my calculations , that is about 9% and plenty of cash and future cash flows for acquisitions and perhaps buybacks.

andrewdb

unbound.com or unbound.co.uk takes you to a crowdfunded book publisher.

I know it is a little off topic but the crowdfunded book publisher is (disclaimer I hold and am a customer) rather good.

Give them ~£25 and some time later you get a hardback with your name in the back with all the other book's crowdfunders.
Good for presents if you are willing to wait (lead times are long). Got my dad "empire of booze" - a history of the british empire through the lens of drink with his name in it,
(recommend the book too)

Trident

Whilst sometimes Directors purchase shares and it doesn't prove to their advantage, I would have to say this is positive, but mainly for those Directors that have participated. They are getting circa 9% for their risk, and they can convert to equity later (within the five year term) if the prospects are good.

I guess the note will allow either for the 9% coupon to be paid by the Company annually (which is 9% of the rough historic operating profit that seemed to be in evidence) or accumulated if the Company doesn't want to pay out the cash in a financial year?

This is less risk to the Company, arguably, than a Bank loan. But their cash balances didn't seem to warrant a cash raise, though they seem to state that the extra £1m raised will help them improve /meet regulatory requirements, though of course those regulatory costs will be generally deductible from profits anyway.

I think we have to accept there is a fine balance here, but my amateur view is that participating Directors have done quite well out of this, as the Company seems to say it takes a positive view of prospects.

I imagine if they had the normal annual resolution to disapply the rights of shareholders to participate in share issues up to a certain %, this was an easy raise with the City boys, and mostly ordinary shareholders would not have had much of a sniff (unless someone corrects me).

I don't hold

shipoffrogs

Buying an annuity is also based on an actuarial valuation which is appraised on even more extreme conditions.

Bouden54

I don't think that's the case for a pension buyout with an insurance company - they would base it on more realistic assumptions, not the ultra cautious assumptions used in the actuarial model. If interest rates rise a bit more, they should be able to easily offload the pension to an insurer.

Exactly this is what I was trying to say in a nice way.

illiswilgig

Airea (LON:AIEA)

Inventory - Shipoffrogs

"The consolidated income statement includes £6,384,000 (2020: £5,937,000) as an expense for inventories".

Ah thank you. I found that statement to be less than clear.

Going back to your original question 'So they have nearly a year's worth of stock on the balance sheet.'

No I don't think that they do.

Making carpet tiles, even for the premium market is not high margin. Admittedly I am not an expert but it seems very unlikely that £6,150m of stock at cost would generate anything like revenue of £15m? If that's what you mean?

Or looking at it another way - in 2021 they spent £6.849m on raw materials, adding on a high proportion of the labour and overheads for the cost of a years product gives something like £11m to £12m quite possibly higher.

So the £5m in note 14 as finished goods probably represents less than 6 months of output. Does seem high as I said, but then margins might be lower and there could be good reasons for holding stock - which makes my guesstimate less than accurate and holding less than 3months stock would probably be too risky?

Which means I am not clear what the reference in Note 14 means. But based upon my limited industrial experience I'd think it was the value of goods held in inventory that was taken out for sale during the year?

Hoping I've not managed to further confuse things, and apologises for all the waffle,

cheers

Mark

peterg

Who on earth chose unboundgroup.co.uk as the website address?

Most likely because unbound.co* was/were taken?

Absolutely not. The liabilities on a buyout valuation will be much higher than on an actuarial valuation.

Berksbee

Thanks Trident. Reassuring and a very useful second perspective.

Hi Paul, Graham,

Excellent short/summary commentaries today. I am a definite fan of them and just loved the "are utterly incompetent at managing their own finances (although to be fair, the same accusation could be levelled at me! LOL!)" comment!

12barblues

This is not right. The insurance company base their calculations on far more conservative investment assumptions than the average actuarial valuation, and then add their profit margin on top. A pension scheme might typically need to be something like 120% funded compared with the 'technical provisions' used in their actuarial valuation, never mind the IAS19 fantasy numbers in the accounts.

A buyout is a very lengthy process - a couple of years, not weeks or months - and needs clean member data including wonderful things like GMP equalisation which most schemes have not yet completed. There is nothing easy about a pension scheme buyout!

I'll stop there, because any commentary on the farce that is company pension accounting and comparison with other valuation bases runs the risk of ending up longer than War & Peace...

My comment was in response to Bouden, not shopoffrogs, who is absolutely spot on.

jonno

I agree that Headlam (LON:HEAD) is a 'good' company. I hold and have added a few today. They have a suite of self help measures in place and the balance sheet is sound. I especially like the value of its freehold property, cited at £109m in the trading update. I assume that Paul arrived at his figure of £120m by including the book cost of the new Ipswich distribution centre that was completed in July 2020.

My best expectation in the short term is that the company will tread water. I am conscious of the potential for a profit warning, but if one can be avoided that would be a great result in my view. On a medium term view I think that the shares are great value. In a 'normal' market with a reasonable economic outlook they have historically traded on a PE of 14 or thereabouts. Hopefully I am laying the groundwork for good future returns, but accept that I have to be patient.

All the best

That’s why the market fluctuates on a daily basis. You and 12barblues say this , Paul says another thing , and Bouden54 and I offer a completely different opinion based on how we understand things and probably how we have experienced similar situations in the past.

The question is simple , since I started this conversation:

Is Reach plc a good investment under 90p in the foreseeable future? I strongly believe based on the figures that I have in front of me , and the guidance from the company , that it is a good investment.

Well , at the end of the day Mr Market is going to decide and prove who is wrong and who is right.

abtan

Foxtons (LON:FOXT) (I hold)

Hi Jonno

I thought the results today were excellent.

Some thoughts, with a focus on Lettings + Sales (though I remain a fan of the financial services business too - it's small, but it is profitable.)

LETTINGS

Lettings revenue of £39.4m (+20% YOY) was excellent and if pre-2020 is anything to go by, then there will be a H2 weighting.

The increase was driven by a 32% year-on-year increase in Revenue/Let (£3,284 --> £4,330.)

I'm not entirely sure why there has been such a drastic increase, even in the current climate, as average weekly London rents have only increased 23% year-on-year (£412 --> £506.)

Foxton mentioned longer contracts, so maybe this is pulling forward future revenues?

On a similar note I just discovered this Foxton Lettings Reports today, in case anyone fancies a read:
https://www.foxtons.co.uk/pres...

SALES

Sales revenue looked "okay" though of note was the long backlog of transactions waiting to be completed. £19m of commission is apparently in the queue with a c.3months wait time.

For context H1 revenues were £20.8m.

Given the above backlog I am assuming the normal drop in revenues in Q4 won't happen this year.

PROFITABILITY

I prefer to look at Adjusted Operating Profit of Sales + Lettings combined given that central costs are allocated based on headcount.

Total Sales + Lettings Adj OP in H1 = £6.6m

This is nothing special by itself, but for H2 if one assumes:

# lettings increases in H2 as per historical norms;
revenue/let remains relatively stable vs H1;
# sales drops, but with rev/sale stable;
contribution % margins remain stable vs the last 12 months;
fixed costs remain relatively stable vs the last 12 months;

then Adjusted Operating Profits in H2 alone could be as high as £20m.

That might seem farfetched, but I keep going over my numbers and I can't see what I'm missing. For clarity, all the H2 growth is coming from Lettings.

To add weight to the above projection, there appears to be real operational leverage here too as fixed costs have remained relatively stable for a while now.

The £0.9m increase in costs from NI, business rates, etc... was offset by £0.9m of savings. Annualised cost savings are £3.0m, so any further operating cost rises in H2 will hopefully be mitigated.

---

NEXT YEAR

Of course next year I am expecting operating profit to drop, but not by much.

The full year affect of acquisition will feed through and I imagine there will be more acquisitions on the way.

The company has been on a sales recruitment drive in H1 - which is how they explain the Sales Operating loss in the period (-£0.6m)- and they expect the benefits of this will come through over the following 12 months.

I'm also wondering whether there will be surprise interest income. There is £113m of client monies lying around and the Foxton T&C's confirm that all interest income is due to the company.

In conclusion the company is:

cash positive (EV = £123m);
cash generative (I predict underlying cash generation for the year of £15m-£18m);
has a highly recurring lettings business, which should ride the inflation wave.

At the current valuation, the downside seems limited with a lot of upside if things progress as the company seems to imply they will.

Fingers crossed I haven't missed anything.

GN100

M&C Saatchi (LON:SAA)

Artisan Partners increasing their position and the SP drifted up a bit yesterday - possibly as a result of a trading update. I wonder if somebody knows something?

https://www.londonstockexchang...

Unbound (LON:UBG)

Anyone buying their bargain basement offer of shares?? I nearly had a fit when it appeared on my broker account website - until I saw it was Zero amount!

MiserableJacktPotato

Right, but unbound group? has all the charisma of a mouldy banana.

I'm no marketeer but surely liveunbound or anunboundlife or something would be more memorable / tell a story.

Paul Scott

29th Jul '22

Hi yiannos1,

To be fair, I did say in the main article that valuation of Reach (LON:RCH) shares rests very considerably on how the pension deficit actually pans out. The existing agreed cash payments are just over £300m to 2027. It has not been able to agree updated deficit recovery payments with 3 of the 6 pension schemes trustees, which doesn't suggest to me the problems are going away any time soon.

I don't have a strong view either way, because I don't know how the pension scheme will end up getting resolved. As said in the main article, if you think (as you seem to) that the pension scheme liabilities will disappear quite soon, then RCH shares could indeed be very cheap. That's a perfectly rational view, if you turn out to be right re pension scheme liabilities.

I wouldn't bank on interest rates continuing to rise though (thus reducing scheme liabilities). As we saw last time the Fed (which indirectly drives (or at least influences) the UK & Europe) tried to tighten, it stalled the stock market, and they were worried about the economy going into recession, so the US reversed back to near-zero interest rates, causing pension deficits to shoot back up again.

This week we've had news that the US has entered a technical recession, so why would the Fed keep raising rates, and crash the economy? I just don't see that as likely at all. Particularly where the causes of inflation are already peaking, or sowing the seeds for lower inflation (e.g. falling commodity prices, supply chains beginning to ease), all combined with a squeeze on consumers, meaning that sales volumes are already falling at many companies (e.g. Headlam (LON:HEAD) yesterday).

Some of my more knowledgeable City friends think we could even go into a glut for many products next year, bringing inflation down very rapidly, and with it interest rates, as the Fed/BoE decide the economy needs boosting to get it out of recession, rather than more tightening.

On the question of buyouts of pension schemes, I don't know a lot about this, but do recall a question I asked mgt of Norcros (LON:NXR) a few years ago. Why don't you just hive off the pension scheme to an insurance company, or similar? He sighed, and said it's a 30-year liability. If we sell it on to someone else, they'll want belt & braces calculations, and add their profit margin on top. Why would we give away all that money to someone else, when we can manage it ourselves?

Another thing he pointed out, is that a lot of the pensioners might be elderly, but when they die, there's a continuing liability to pay a widow's pension. In some cases, the widow can live another c.20 years.

Hence I remain of the view that we shouldn't just dismiss the RCH pension scheme liabilities & cash contributions, which are currently consuming about half profits. As profits (inevitably) fall in the coming years, then that could end up at three quarters, or even all of the profits. Who knows?

As I say, no firm view from me either way, because I don't know what will happen. But I think it's right to flag the issues, which the company tends to gloss over I think.

Regards, Paul.

Small Cap Value Report (Thu 28 July 2022) - HOTC, APTD, RST, HEAD, SRT, TWD, INCE, EPWN, VINO, FORT, FNTL, DSCV

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Paul Scott

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