Small Cap Value Report (Thur 20 Dec 2018) - YU, UCG, CNKS

Good morning!

The Fed did raise rates yesterday, provoking another 350 points to get shaved off the Dow Jones Index.

The FTSE isn't thrilled about the news either, and is down by another 0.5% this morning.

It's a horrible end to the year, at least for those who are nearing the end of their investment time horizon.

I most definitely have my buying boots on, and am working my way through the watchlist to see which other shares I should prioritise for a purchase early in the new year.

These conditions are painful for many investors, there is no doubt about that. It's unnerving to see so many shares collapsing in price - but you always to have to look at the specifics of each case. Has there been an underlying loss of value - and is it permanent or temporary? Or has there been no underlying loss of value, and the share price is merely reacting to the general mood of the market?

We have examples to look at today:

• Yu (LON:YU.)
• United Carpets (LON:UCG)
• Cenkos Securities (LON:CNKS)

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Yu (LON:YU.)

• Share price: 61p (-22%)
• No. of shares: 16 million
• Market cap: £10 million

Findings from the Accounting Review

I didn't expect to be back covering this again so soon, but here we are.

In summary, things are worse than expected: profitability is reduced by an additional £2.75 - £3.25 million, on top of the £10 million reduction previously announced.

The adjusted loss for the current year will therefore be in the region of £7.35 - £7.85 million.

The only thing the company has in its favour is a reported cash balance of £11 million as of 30 November 2018. So the market cap has fallen to just below this level.

I would note that the actual loss could wind up being much higher than the adjusted figure shown above.

The Adjusted Loss Before Tax excludes charges for Share Based Payments, gains or losses on derivatives contracts, and, for Financial Year 2018, exceptional restructuring costs, provisions made on first adoption of IFRS 9, and the costs of the Review.  It is also is based on a working assumption that the corrections will not result in a restatement of prior year accounts.

Underlying cause?

The underlying cause is described as "centred around material weaknesses in key internal controls across the customer to invoicing and cash cycle".

I'm waiting for a meatier explanation than this. While weaknesses in controls might be necessary to create this chain of events, they are hardly sufficient. Bad information must have been fed into the system. As an outsider, it is natural to assume that this was done deliberately, in order to flatter results.

I would therefore expect legal action from those who feel they have been robbed by the company. Such action could be directed at the company itself and/or connected individuals.

In March, Yu raised £12 million from shareholders at £10/share. This came on the back of results published on March 6th.

The FCA investigation into the company concerns its announcements from 6 March 2018 to 24 October 2018, so will include those results which preceeded the placing. An FCA finding of misrepresentation would surely help any potential legal case by those who took part in the placing?

Gross Margins

The Board has discovered that performance is much worse than they previously believed. Margins are "significantly below the level which was previously expected".

Things are so bad that there needs to be a complete reassessment of the growth strategy. I predict the company will be making a huge retreat and retrenchment.

My view

Bargepole and uninvestible, sadly.

Cash has fallen from £18.3 million in June to the currently-reported £11 million.

The company says this is primarily due to: "a scheduled annual industry payment, and an advanced payment against the next year's annual industry payments otherwise due in Q3 2019."

How big are these "industry payments"? Can they really account for a reduction of £7 million for a company of this size? I don't get it.

We can expect losses for the foreseeable future, and the cash position could be under more pressure. Instead of growth, the company is going to shrink. So I personally think that the current market cap is far too generous. It should be pricing in the potential for near-worthlessness, in my view.

The founder-CEO-majority shareholder remains in his post, for now. So it's a bit like the situation at Patisserie Holdings (LON:CAKE), if Luke Johnson also happened to be the CEO. Probably it's for the best that he stays on as CEO - but we have to ask how he missed this fundamental issue?

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United Carpets (LON:UCG)

• Share price: 6p (-4%)
• No. of shares: 81 million
• Market cap: £5 million

Half-year Report

This share has been a tricky one for me. It was the only deep value micro-cap I retained in my portfolio over the years, as I thought (and still think) that it had a few redeeming characteristics.

At the end of the day, however, I have to accept that the deep value micro-cap strategy no longer appeals to me - I don't like owning tiny illiquid companies of questionable quality, even if they are dirt cheap.

With United Carpets, I held back from selling it because it continued to achieve a level of profitability which made the shares superficially cheap. The momentum of trading turned negative, however, and I was expecting bad news from these half-year results.

They could have been worse.

Key points:

• Like-for-like sales are down 1.8%. This would have been worse except for a ramp-up in marketing spend (administrative costs up by £1 million)
• pre-tax profit reduces to just £121k
• like-for-like sales +0.1% for 11 weeks since period-end: stable

Outlook

The CEO expects a "reasonable outcome for the year", if the encouraging signs from recent trading can be sustained.

Selling the shares

I made the difficult decision to sell my remaining shares in UCG, so I no longer have a position in the stock.

Regular readers will know that I'm very reluctant to sell anything from my portfolio, preferring to sit back and let things take their course most of the time.

But in this case, I needed to accept that the company hasn't performed the way I hoped that it would, and its long-term future doesn't appear particularly exciting.

While it's true that it has generated excellent returns on capital and returns on equity, thanks to the franchise model, the carpet business is a very tricky one. Firms compete against each other on price and regularly run into difficulty.  Carpetright (LON:CPR), for example, looks to be in trouble.

It was only six years ago that many of UCG's franchisees ran into difficulty and the group's principal trading subsidiary had to be put into a pre-pack administration. The group managed to keep control of its principal trading subsidiary under this process, but it could have easily resulted in UCG shares becoming worthless.

While the situation is not yet as bleak as that, there are inklings of future financial distress in today's announcement:

...a small number of individual franchisees have struggled to meet their ongoing financial commitments and it was considered appropriate to increase the level of bad debt provision...

Learning a lesson

As a general principle, I think I will avoid shares which deal in floorings from now on (along with windows and PVC doors, which were already on my bargepole list).

It's always painful to take a loss, but it's not wasted if you can learn something from it. I won't invest in a company which sells these commoditised products again, regardless of price.

The bull case

It's certainly possible that profitability could recover at UCG. The company has blamed temporary factors, such as the weather and the world cup, for the tough trading in H1.

Reasons for optimism for existing shareholders:

• like-for-like sales have temporarily stabilised, as mentioned above,
• the dividend is unchanged, signalling management confidence
• cash of £2.1 million, with no borrowings
• balance sheet book value £5.1 million, nearly all of it tangible

These reasons aren't good enough for me, however. At the end of the day, the company has no moat. And it is so small that I would have to question the point of it being listed at all. Even before trading deteriorated, it had no real plans to grow.

If profits are going to be at current (lower) levels for the foreseeable future, then I think the company might be better off as a private entity rather than continuing to pay the fees of an AIM listing. That point alone is reason enough for me to want to get out.

I've just quickly checked my portfolio, and the only other really small company I hold is Distil (LON:DIS). But there is a world of difference between DIS and UCG: Distil is working hard to grow, while United Carpets is only able to stand still at best. This wouldn't be a problem if United Carpets was a private company, rather than a subscale public PLC!

I've already recycled some of my proceeds from the disposal into Britvic (LON:BVIC), and plan to deploy the rest soon. I'm already feeling more positive about my investment prospects!

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Cenkos Securities (LON:CNKS)

• Share price: 67.7p (+7.5%)
• No. of shares: 55 million
• Market cap: £37 million

Trading Update

Weird and unhelpful behaviour by this Nomad/Broker, putting out a trading update at 3:50pm yesterday.

The update itself could win an award for brevity:

The Board of Cenkos Securities plc is pleased to report that since the announcement of our interim results on 18 September 2018, revenues have improved. Accordingly, the profit before tax level for the year ended 31 December 2018 is expected to be in excess of the current market expectations. 

There are no forecasts available, so current market expectations are whatever you're having yourself.

This is an example of a cheap share which will never compound in value but should hopefully throw off nice income for shareholders, many of whom work for the company.

Cash was £22 million at June 2018, so there is that cushion.

As I've said many times, Cenkos has a super track record of never making a loss - instead of taking a loss, it slashes bonuses for its executives. They do get richly rewarded when the company is successful.

General weakness in equity markets and the company's own performance have probably both played a role in the share price slide here. While I wouldn't want to hold Cenkos shares long-term, I do think that the future cash return in dividends is likely to mean that shareholders will do fine.

Since 2012, for example, it has paid out 60p in dividends. I don't think it's competitive positioning has deteriorated. So if the culture remains the same and it carries on more or less as before, then investors should get their money back in dividends, if they hold for long enough.

The timing and threadbare content of yesterday's update says to me that the company perhaps doesn't treat shareholders with the absolute highest priority. But this is AIM, after all!

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I'm glad I wasn't travelling through Gatwick today, with all the cancellations. It is supposedly going to stay shut until 6pm - what a disaster!

Though in truth, I've virtually stopped using Gatwick at all, nowadays. I've found it's worth paying that bit extra for London City Airport, and it's now my airport of choice for London travel.

It is considerably more expensive, but the stress levels are lower than you get with an ordinary, full-size airport, and you save time and money by skipping a train journey. No doubt I'll be using it a lot more, in 2019.

Hopefully they sort out this Gatwick mess, and find out what was going on with the drones flying over it.

Paul will be with you tomorrow. Have a good evening!

Cheers,

Graham