Small Cap Value Report (Tue 30 October 2018) - Market View, Mello London, TSLA, VLE, DUKE, IGG, PHD, AST

Tuesday, Oct 30 2018 by

Good morning!

It feels like news has been speeding up again in recent weeks, with so many interesting company-specific stories to accompany the sharp correction in equity markets.

Sentiment among the trend-chasing US retail investor community has been a casualty of events, with the celebrated FANG group of tech giants down between 14% and 24% so far this month and in aggregate down by over 20% since July. But the NASDAQ still has a long way to fall.

Closer to home, the AIM All-Share Index is down by 12% this month. Like the NASDAQ, it became top-heavy in highly-rated, popular shares such as ASOS (LON:ASC), Burford Capital (LON:BUR) and Fevertree Drinks (LON:FEVR). When sentiment turns, it's inevitably the highly-rated shares which bear the brunt of the correction.

We've also had accounting scandals at Patisserie Holdings (LON:CAKE) (still suspended) and Yu (LON:YU.), as if investor sentiment wasn't low enough. All in all, it has been a torrid time for investors.

The FTSE Index looks good value to me at c. 7000, though there are a lot of low-return businesses in this index (banks and resources, basically) which are unlikely to make for the most rewarding long-term investments.

If the US enters a bear market then FTSE sentiment is likely to remain weak in the medium-term, but personally I think the smart thing to do is accumulate shares during this period of market weakness (assuming that your time horizon is long enough).

If you're still a buyer of equities (and I know I am!), then consider coming along to Mello London in Chiswick on November 26th and 27th. The discount code "MLStocko25" gets you £25 off whichever ticket you choose (single day or both days). Paul and I and many other full-time investors and analysts will be there, along with a big selection of companies.

Right, time to talk about some individual shares.

Paul added an important section on Victoria (LON:VCP) to his report late last night. So I'd recommend checking that out, too. Here's the link.

Shares I am interested in today include Tesla,…

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All my own views. I am not regulated by the FSA. No advice.

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Tesla, Inc., formerly Tesla Motors, Inc., designs, develops, manufactures and sells fully electric vehicles, and energy storage systems, as well as installs, operates and maintains solar and energy storage products. The Company operates through two segments: Automotive, and Energy generation and storage. The Automotive segment includes the design, development, manufacturing, and sales of electric vehicles. The Energy generation and storage segment includes the design, manufacture, installation, and sale or lease of stationary energy storage products and solar energy systems to residential and commercial customers, or sale of electricity generated by its solar energy systems to customers. The Company produces and distributes two fully electric vehicles, the Model S sedan and the Model X sport utility vehicle (SUV). It also offers Model 3, a sedan designed for the mass market. It develops energy storage products for use in homes, commercial facilities and utility sites. more »

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Volvere plc is a holding company. The Company identifies and invests in undervalued and distressed businesses and securities, as well as businesses that are complementary to existing group companies. It operates through Food Manufacturing segment. Its food manufacturing segment consists of the Company's subsidiary, Shire Foods Limited (Shire), which is engaged in manufacturing frozen pies, pasties and other pastry products for retailers and food service customers. more »

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Duke Royalty Limited is a Guernsey-based diversified royalty investment company. The Company specializes in diversified royalty financing and provides alternative capital solutions to a diversified range of businesses in Europe and abroad. The Company’s investment policy is to invest in, without limitation and restrictions (including geographical restrictions), long-term, revenue-based royalties in private and/or public companies, and or other alternative asset classes and/or financing instruments from time to time that bear similar risk and return characteristics. The Company provides financing solutions to private companies that are in need of capital but whose owners wish to maintain equity control of their business. It provides capital to companies in exchange for rights to a small percentage of future revenues. more »

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  Is NSQ:TSLA fundamentally strong or weak? Find out More »

42 Comments on this Article show/hide all

BlueFrew 30th Oct '18 23 of 42

In reply to post #413539

£TSLA - Some of the other longer dated bonds (Aug 2025) have been trading at a yield over 8%. The yield has reduced a little recently, but it's still significant. They've also traded below par for the majority of the time since they were issued. To issue more bonds they'd have to offer a better yield than is on offer with the current bonds. Do you really want to be holding shares in a company who can only get a bond issue away at 8 or 9%?

Or they issue a load of equity. Which is good for the shorts. Can they actually issue bonds or shares though? There is some debate on that question.

Or they default and financial restructuring is necessary.

Or the accounts aren't a work of fantasy and the company does actually have the money to pay the bonds off, despite acting like a company in severe financial distress.

Or something else could happen which I don't expect. Baillie Gifford are supportive, however they are in quite a few stocks which have taken a bit of a beating recently.

If nothing else, it is an interesting situation which will be incredibly instructive for traders/investors.

(Short £TSLA )

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Graham Neary 30th Oct '18 24 of 42

In reply to post #413564

Hi - it's not a loan, and so I don't really think of it in those terms (though I know that the company itself thinks of it as a corporate mortgage). I would recommend that you think of it only as a stream of cash flows which grows or shrinks over the term of the agreement. There is no principal repayment so there isn't really any amortisation.

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mrosbiston 30th Oct '18 25 of 42

In reply to post #413529

how does a company increase revenue by 50%, increase receivables by 100% (how do you have such high receivables when cars are bought either cash or car loans?) - and does this by reducing capex and SG&A? its impressive alchemy.

It also managed to increase its gross margin despite selling less of the higher margin series X and more of the lower margin series 3.

when it comes to window dressing - this was a Christmas at Selfridges effort.

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sharmvr 30th Oct '18 26 of 42

In reply to post #413584

Indeed - I hold Duke Royalty (LON:DUKE) (on the back of cube podcast and at least in part my own analysis).
I would suggest their asset is more of a variable growth annuity. (Please rip me to shreds if I got this wrong because I really failed to understand the asset!)

Personally, I think they could add to disclosure about how they reach fair value (since that leaves a lot of room for expert judgement and opinions) but today's report and the interview from cube and the shareholder base gave me comfort that management are reliable.
Early days but think this has potential as a long term compounders. Dividend could be reduced to improve the diversification, but then again a high dividend probably does keep mgt focused on selecting the best opportunities.

Another thing that I am keen to understand more and why it is a small position is the related party disclosure (messiness and flags that I would rather not deal with) but then again this is not that different to any investment management business, so benefit of doubt pending more information.

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danielbird193 30th Oct '18 27 of 42

In reply to post #413504

It does sound like a huge increase when you put it like that, but those are nominal figures (so not adjusted for inflation over the period). If inflation is running at 2.5% then the real increase is only 3.5% per annum.

There also needs to be some compensation for the risk of the ratchet not applying in full. If the company doesn't meet it's revenue targets then the increase won't take effect (or will do so, but at a lower level).

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dscollard 30th Oct '18 28 of 42

@ Graham Neary. seems TSLA has car-jacked this small cap report. Nice cameo of how bulls and bears go at each other in a story stock with a lot of open interest Price action atm is probably more driven by short squeezes than bullish sentiment BUT the price action is bullish . May well be some enforced covering as well given overall market price action. Can't be comfortable in either camp but if I was forced I'd be a short from here. More fun to watch and take easier trades though

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Hot Socks 30th Oct '18 29 of 42

Graham - any thoughts on Restaurant Group and its proposed takeover of Wagamama? Does not look well received today! Maybe not quite small cap but I know you've commented on it before.

Thanks for the excellent reports and the work that goes into them.

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sharw 30th Oct '18 30 of 42

Graham - thanks for drawing attention to Ascent Resources (LON:AST) - not the type of company I would normally look at. The RNS at is well worth a read not only to appreciate the total frustration that can come from dealing with overseas bureaucracies but also learn how the Slovenian Environment Agency is abbreviated!

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rmillaree 30th Oct '18 31 of 42

In reply to post #413589

how does a company increase revenue by 50%, increase receivables by 100% (how do you have such high receivables when cars are bought either cash or car loans?)

If you look at their annual report they say the following - also note they  specifically mentioned they sold a wad of vehicles on the last weekend and funds for wont have flowed through to the bank so that had a measurable impact. say they sold 5k cars that final weekend at 60k (300 mill) a pop thats a seriously material value if the funds hadnt cleared the banking system - the funds coming via the customers finance partner of choice. 

per the company

Accounts receivable primarily include amounts related to sales of powertrain systems, sales of energy generation and storage products, receivables from
financial institutions and leasing companies offering various financing products to our customers, sales of regulatory credits to other automotive manufacturers and
maintenance services on vehicles owned by leasing companies. We provide an allowance against accounts receivable to the amount we reasonably believe will be
collected. We write-off accounts receivable when they are deemed uncollectible.
We typically do not carry significant accounts receivable related to our vehicle and related sales as customer payments are due prior to vehicle delivery,
except for amounts due from commercial financial institutions for approved financing arrangements between our customers and the financial institutions.

It also managed to increase its gross margin despite selling less of the higher margin series X and more of the lower margin series 3.

That will be fully explained by the material increase in model 3 margin from basically nothing the previous period when they were ramping up production  to 20% this period - that will more than outweigh any negative impact from the model S/X margin declines - pretty simples 

when it comes to window dressing - this was a Christmas at Selfridges effort.

Time will tell - the company have advised they expect q4 to be profitable too - there is only so much window dressing one can do on a q by q basis, without mucking up the next quarter - not long to wait in that regard.

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gsbmba99 30th Oct '18 32 of 42

In reply to post #413594

More on Duke Royalty (LON:DUKE) . The below is more or less direct from Charlie Cannon-Brooks starting from about 2:00 in the podcast (
"...we lend money to..."
"...typical duration of our loans are 30 years..."
"...the company repays back interest on those loans and prinicpal..."
" the end of the 30 years the loan is effectively extinguished and there is no bullet repayment..."
"... Yes we look at it as a loan ... but no it's not a flat repayment..."
"... our year 1 return would be about 13%, now that 13% would be part interest and part principal..."
That sounds to me like he's describing a loan instrument where amortisation is accelerated as the business performs to plan.

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millen 30th Oct '18 33 of 42

In reply to post #413639

That's I think what the actuaries would call an "annuity certain". Except that here there's a profit/ performance related element in the payment stream.

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sharmvr 30th Oct '18 34 of 42

In reply to post #413639

And on that basis amortized cost would be appropriate. Similar to a zero coupon bond issue but opposite ( part of the discount is effective interest). And accelerate repayment increases the effective interest rate.

Given the above (I was all over ias39, less clued on IFRS 9 - trust me it means something to old accountants), I would think the appropriate treatment would be amortised cost (not fair value p&l), especially since management don't intend to trade the royalty stream

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gbjbaanb 30th Oct '18 35 of 42

In reply to post #413514

"Tesla is maverick and disruptive, not just on technology or software but on the very definition of transport and how it is enabled from a systemic and infrastructure point of view"

absolutely, but that does not make it a company to invest in - its a research project, or a speculative startup. What it should be doing is developing the tech and innovative concepts and then licencing that tech to real companies like BMW or GM to make the cars for them.

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jonthetourist 30th Oct '18 36 of 42

PHD "if there are informed commentators with a bullish point of view I hope they will join us in the comment thread below."

I don't think I qualify as either informed or bullish, but since no-one else has stepped forward . . .

Proactis used to be a gloriously uncomplicated little software house in Yorkshire. They announced all their new contract wins on their web site, so you could be confident about trading, and never lost a client. When they switched to an SAAS model their profits went down for a couple of years. Entirely predictable though this was, it hurt the share price badly, and I bought quite a few (for me).

Then the strategy transformed to create scale via acquisition. That made it a much riskier investment proposition and I baled, but kept part of my investment because of the hefty potential CGT liability. So I have been watching the progress of the integration with interest. As have the institutions holding, a fairly serious list including Liontrust, Artemis and Fidelity.

My view is they are now a market consolidation play, in a sector which is definitely growing. Who wants to reconcile an invoice against a paper purchase order these days? So the debt to achieve scale is offset by the fact that they are not now losing big-name clients as they did after the merger. They claim to have achieved the cost-saving synergies they planned, which is often not the case. The growth is not very exciting, but I think the jury remains out. The share price shot up then fell back on today's news to remain neutral, which I thought was about right.

There are three potential triggers to make money from here. Serious sales growth would underpin a higher rating. They may finally monetise their supplier network, which they have been flagging as a plan for some time now. Or they may get taken out at a premium as part of market consolidation. An ideal world would see progress on at least two fronts, and no screw-ups.

A hold, without great conviction, for me. Other views welcome.


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gsbmba99 30th Oct '18 37 of 42

In reply to post #413649

Here's how I think it works based on what Charlie described (rough numbers):

Loan amount £100, term 30 years, interest rate 10% + repayment of 3% of original loan amount equals their "cash on cash" yield of 13%. Initial payment is £13
Year 1 - Interest £10, repayment £3, remaining balance £97, ratchet of 6% of payment amount = £13.8
Year 2 - Interest £9.7, repayment (£13.8-9.7=£4.1), remaining balance £92.9, ratchet of 6% of payment amount = £14.6
Year 3 - Interest £9.29, repayment (£14.6-9.29=£5.31), remaining balance £87.59, ratchet of 6% of payment amount = £15.48

If the business performs well and the ratchet is maxed out, the term of the loan becomes an irrelevance because it will be paid off much more rapidly than 30 years. Obviously, the ratchet can also reduce the monthly payments which would slow the amortisation.

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jonesj 30th Oct '18 38 of 42

In reply to post #413529

Volkswagen don't need to spend a single dollar to catch up with Tesla. They already have some electric models & watch out as they launch premium branded competitors to Tesla.
The 30 billion will be to put a large range of models out there in the market, not just 3.

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JohnEustace 30th Oct '18 39 of 42

In reply to post #413684

VW do have some catching up to do. Their EV's are internal combustion engine platforms retrofitted to take batteries and therefore compromised. They need to roll out fully electric platforms. Otherwise why are they spending $30bn?
The teardown exercise by Munro Associates clearly found that the battery, motors, and power control systems from Tesla are way ahead of the competition - defence standard electronics was what Munro said, at least a generation ahead of anything else he had seen. That's the hard value in the company for me. The likes of VW or Mercedes could pay a lot for that technology - although doubtless they are hoping for a fire sale.
It's the body-in-white that lets the Model 3 down, plus the Musk arrogance in ignoring the manufacturing lessons learnt by the rest of the motor industry and his well documented general behaviour.

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dscollard 30th Oct '18 40 of 42

In reply to post #413654

albeit Musk also rolled SolarCity into Tesla and has invested in the Gigafactory and a few other bits to make the ecosystem and a digital grid beyond just EVs .One could argue that the automotive industry isn't architected to disrupt itself, it's often the point of disruptors not to do things in conventional ways,

Totally agree that Tesla is univestable at the moment : it's one for the fanboys and the Musk worshippers on the long side and the sceptics/cynics on the short side.
Tesla is also a very strong brand and aspirational statement so there is value in that equity and positioning that is not just technology or capability.

In the same vein to your thrust, Toyota did just spend $500m on  Uber as they are clear on their competence and expertise and took a very efficient approach to complementing it.

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jonesj 30th Oct '18 41 of 42

The VW 30 million will be to put many different models in the market.

As for Munro, I saw some of his material on you tube and don't think this has sufficient credibility to influence investment decisions.

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JohnEustace 30th Oct '18 42 of 42

Don’t forget the Chinese. This CNN article today says they are too far ahead of the Europeans in EVs to be caught.

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About Graham Neary

Graham Neary

Full-time investor and independent analyst. Prior to this, I spent seven years in the financial markets as an analyst and institutional fund manager. I'm CFA-qualified, also holding the Investment Management Certificate and the STA Diploma in Technical Analysis.Away from finance, my main interests are recreational poker and everything to do with China, especially Mandarin Chinese. more »


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