Small Cap Value Report (Wed 12 Jul 2017) - FUL, CALL, EVE | Paul Scott

12th Jul '17 by Paul Scott

59 comments 19162 reads

Good afternoon, it's Paul here.

I'm running late again, sorry about that - I appreciate it must be annoying to find only a placeholder post, when you're expecting a full post. I'm on the case now properly, so will update this article this afternoon.

Falling knives

I see that the car crash at Carillion (LON:CLLN) shows no sign of abating. There's been an incredible destruction of shareholder value there, with the share price now down to only 70p (it was 300p in Sep 2016). Therefore it's come into my universe of small caps now.

I really don't know where to start, in terms of assessing Carillion. A quick look at its balance sheet shows that it's dominated by goodwill. Strip that out, and the NTAV is massively negative. So that rules it out for me (before or after the recent profit warning).

Falling knives generally can be a tempting, but easy way to incur losses. I've done a lot of these over the years, so have worked out which ones work, and which ones don't. Basically it's all down to the balance sheet. If a company reports bad news, but has a strong, cash-rich balance sheet, then over time it tends to recover. That stands to reason, because management are not distracted by a fundraising or disposals in order to stay solvent. Instead, they can just get on with fixing whatever issues have caused the profit warning to happen.

So for me, when assessing whether to buy a falling knife, the no.1 consideration is that it must have a strong and stable (!!) balance sheet, with no requirement for any fundraising. Carillion clearly fails that test.

The other key factor for me, is whether the problems which caused a share price to collapse are fixable. If it's just something that's a one-off, ring-fenced problem, then I would consider buying the shares after bad news. If it's a bigger, more serious problem, then I'd steer clear. That's a judgement call, so not something that could be computer modelled.

It would be interesting to revisit Stockopedia's awesome profit warning study, and introduce a balance sheet test. Would that improve the results, I wonder?

Contract companies

Carillion is yet another example of a company dealing with complex, large contracts, has gone disastrously wrong. This happens over & over again…

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tic_tac_toe

12th Jul '17

"There was another similar one, but I can't remember its name." Silverdell ?

dmjram

Maybe it was Connaught you we're thinking of?

"At the heart of the matter is a string of loss-making service contracts that the company entered into with local authorities and housing associations."

http://www.bbc.co.uk/news/business-11228059

Tortoise investor

I'm looking forward to your Fulham Shore (LON:FUL) comments Paul. I note they didn't publish any like-for-like sales figures and I also can't decide if the RNS is a bit of a warning about future profitability or whether they're just trying to reassure the investment community that although the restaurant sector itself faces headwinds, Fulham Shore (LON:FUL) is likely to ride those fairly well.

mw8156

connaught

PhilipHanson

You can add Balfour Beatty (LON:BBY) and Interserve (LON:IRV) to the list of construction/contract companies that have had large contract whoopsies. The support/services and construction sectors are a total bargepole for me now. Low margin, difficult customers constantly changing their minds on the requirements, highly competitive with little economic moat in the business, contracts are often won on price alone and then when one goes bad it can wipe out 3-4 years operation profit in a flash.

Wol

Other service companies with large contracts and major profit warnings / share price collapses - Serco, Capita...

And G4S
I've learned my lesson. I just give them a miss.

willhampson

Hi paraic84, I read it as both. To me they were signalling that they would not be as adversely effected as the wider market (they emphasize that operators with expensive leases and large debts will be particularly effected), but that the growth story may be more limited going forward. So not a profit warning, just a managing of expectations for future growth. I sold out a few months ago as I was concerned that the growth of the company, while impressive, was not explosive enough to support its very high valuation. Its a shame as I love the concept and they make great pizzas... Very interested to hear what Paul has to say.

Rusty2

But £G4S shares are up nearly 80% in the last year.

Costain (LON:COST) is another but that seems to be doing alright at the moment.

Mitie (LON:MTO) is another, has had a rather mixed year.

ricky65

"It would be interesting to revisit Stockopedia's awesome profit warning study, and introduce a balance sheet test. Would that improve the results, I wonder?"

I would also be interested to see if strong balance sheets had any impact. Also were there any other commonalities to the minority of shares that bounced back quickly from a profit warning?

Unless I see any quantitative evidence to the contrary, my blanket ban on buying after a profit warning will remain in place.

williamhargrove

I have a broad rule which says to avoid any company where the revenue stream is dependent on winning contracts. This rule of thumb came to me after costly experiences with the following companies: Carillion, Balfour Beatty, Firstgroup, Serco. These were all sold a few years ago now, but not before a significant loss was incurred.

gsbmba99

Perhaps bizarrely, I enjoy reading through things like the significant accounting policies in the annual report to see how much leeway management have to make the numbers be what they want them to be. Another reason to hate construction is the percentage of completion accounting methodology. It seems to give rather a lot of leeway such that issues can be buried for multiple years before surfacing. Conversely, my reaction when first reading through Bioventix (LON:BVXP) and Arcontech (LON:ARC) annual reports was how clean everything was. Not far off cash accounting.

"There is therefore a high degree of judgement in: assessing the level of the cost contingencies to recognise; appropriately recognising variations and claims; and estimating the revenue recognised by the Group based on the projected final out-turn on contracts." That's from the 2016 Carillion (LON:CLLN) auditor's report by KPMG who judged that there had been no movement (relative to 2015) in the "Risk of Material Misstatement" related to "Recognition of contract revenue, margin, receivables and liabilities." (page 86(88)).

Note 1 to the financial statements - Significant Accounting Policies - also contains this: "IFRS 15, which is effective for accounting periods beginning on or after 1 January 2018, prescribes the accounting treatment and disclosure requirements associated with revenue from contracts with customers.The Group is performing a detailed assessment of the impact of IFRS 15, with the assessment expected to be completed in the first half of 2017. The Group will be examining the potential impact on the timing of revenue recognition in relation to construction contracts. It is difficult at this stage to determine with any certainty the impact on revenue and profit from adopting this standard but further clarification will be provided in the second half of 2017 as it becomes available."

I wonder whether the Carillion (LON:CLLN) announcement was triggered by the in depth review they were doing to prepare for adoption of IFRS 15? If so, they certainly can't be the only ones going through such an exercise. There's a useful primer from EY on IFRS 15 with specific issues to think about by sector here (https://webforms.ey.com/Publication/vwLUAssets/IFRS_15_The_new_revenue_recognition_standard/$FILE/IFRS15_low.pdf)

JohnEustace

@gsbmba
That thought occurred to me also. Carillion (LON:CLLN) may be especially bad but it will be interesting to watch for any increase in short positions elsewhere in the construction sector. I imagine there are quite a few sharks sensing blood and looking for their next meals.
It will be a brave bidder that makes any move to take over Carillion.

alihaouas

are you not reporting on call- i thought iis one of your holdings paul?

I've been sitting on the fence on Fulham Shore (LON:FUL) but decided to make an initial small buy this morning. I see them as a smart operator that is well positioned despite the many headwinds in the sector.
Their new Franco Mancas in Ealing and Reading seem both to be trading very well and generating strong word-of-mouth recommendations based on recent family visits.

daveinthelakes

Purplebricks (LON:PURP) holders you may get Amazoned-

Just mentioned 9:45 eastern Time-

"Report: Amazon.com pushing Zillow in agent referral space
Jul. 12, 2017 9:45 AM ET|

In an otherwise sunny market so far following the release of some dovish remarks from Janet Yellen, Zillow (NASDAQ:Z) is 0.7% lower as Inman reports that Amazon.com (AMZN +0.9%) is set to throw one of its many hats into the real-estate referral ring as well.

A placeholder "hire a Realtor" page suggests that the retailer will be adding real estate agents to a burgeoning professional services marketplace. "

vik2001

@Paul - a good shout on shorting Dominos, a little while back they had lowered prices after Pizza Hut aggressively undercut it on bundle deals, which account for about four-fifths of its UK revenue.
they seem to have young uni students who know nothing about cooking a pizza properly. last time I ordered from them they pizza tasted wet. its put me of for ages.

MikeBrenner

The Amazon entrance into Real Estate agent referral, would be a good thing for Purplebricks as they focus on the transactions and having another source of qualified traffic that they can lean into with their technology and marketing spend to optimise against (generally they do this better than competitors) opens up a greater customer acquisition opportunity. Note that Amazon tries lots of these initiatives to leverage their traffic but very few go into deeper plumbing like Purpebricks are doing!

The Phoenix

Hi Paul,

Any chance you could do a short piece on basic balance sheet tests using Stocko highlighting how to check for to much goodwill etc for the 90% of us on here who aren't up to the speed of the pro traders. Great that the likes of you , Graham, Robbie Burns etc are about to make complex stuff reasonably simple.

Cheers

Small Cap Value Report (Wed 12 Jul 2017) - FUL, CALL, EVE

Falling knives

Contract companies

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Paul Scott

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