Small Cap Value Report (Wed 9 Aug 2017) - TCM, TAST, SCS, WATR

Good afternoon!

Let's start with a really shocking turn of events at Israeli, AIM-listed internet-of-things company, Telit:

Telit Communications (LON:TCM)

Share price: 127p (down 30.3% today)
No. shares: 129.8m
Market cap: £164.8m

Statement regarding Chief Executive Officer - Events have taken a shocking turn at Israeli internet of things group, Telit Communications (LON:TCM) . Hopefully readers listened to my repeated warnings over several years here, about this company's red-flag laden accounts. Also that its profits are essentially fictitious, the way I look at things.

Telit shares are down a further 30% today, to 127p. A bombshell announcement came out today. Here is the full text;

Telit Communications PLC (AIM: TCM, "Telit", the "Group"), a global enabler of the Internet of Things (IoT), notes speculation regarding historical indictments in the United States of America of Telit's Chief Executive Officer, Oozi Cats, in respect of matters which are unrelated to Telit and significantly pre-date its establishment.

The Board of Telit has appointed independent solicitors to conduct a thorough review of this matter. Pending the outcome of this review, the Board have agreed to Mr. Cats' request for a leave of absence from the company. Yosi Fait, Finance Director and President, will serve as interim Chief Executive Officer during this time.

Further updates will be made as soon as possible.

I think this must relate to explosive revelations on ShareProphets, which seemed to clearly link Telit's CEO & his wife to property frauds committed in USA many years ago.

To my mind, if innocent, then the CEO would have stayed on, and fought to clear his name. The fact that he's requested a leave of absence (jumping before he's pushed, perhaps?) makes this look almost certain that he's guilty. Indeed, the evidence presented by ShareProphets made it look like the people who skipped bail in the USA over fraud charges, are almost certainly the same people as the CEO and his wife. A wife who amusingly, seems to be on the payroll at Telit's "Art curator"!

So the big question is, what happens next? I expect the CEO is toast now. With him gone (probably permanently), then who knows what else could come out of the woodwork. Today's announcement makes this stock completely uninvestable now, in my view. So very much a bargepole share.

Given all the red flags with the accounts, this could really unravel now, maybe? So my guess is that sooner or later, accounting irregularities, or misstatements could come out, leading to another share price plunge.

There's also a big risk that the shares could be suspended, if the NOMAD resigns. FinnCap were only appointed a few days ago, so the logical thing for them to do, is run for the hills. Why on earth would they want to be associated with what looks like an emerging scandal at Telit?

I hope no readers were tempted to bottom fish here. It looks a complete can of worms - so a bargepole is the right way to treat this share. A big well done to Tom Winnifrith - yet again, he's dug up some dirt on a company, and exposed it. People may not like his style, but he's doing a very worthwhile job (mostly), shining a light on the murkier parts of AIM. How come the authorities aren't doing that?

There are a lot of similarities between this share, and Globo, in my view - a dodgy CEO, overseas+AIM, aggressive accounting with high levels of capitalisation, and high debtors. Cash hungry, despite high reported profits. It might even be worth a small short, which I am pondering. Although there can be powerful rallies with this type of share, which can make an ill-timed short an expensive mistake. Also, there does seem to be a proper business with Telit. Whereas Globo had very little of commercial substance - it was amazing how many people were completely fooled by Globo.

---

Tasty (LON:TAST)

Share price: 45p (down 10.0% today)
No. shares: 59.8m
Market cap: £26.9m

Trading statement - from this chain of restaurants, mainly under the "Wildwood" name.

This company fell from grace, following a profit warning in  Mar 2017, which I reported on here. Foolishly, I gave the company the benefit of the doubt, and caught the falling knife (buying some more shares). That was a costly mistake, and I've since ditched all my shares, deciding that the company has structural problems (i.e. that its format is weak, and dated, plus it's locked into expensive property leases).

We already knew that trading was soft, and today the company quantifies it for H1, as follows;

The Company expects to report unaudited revenue for the 26 weeks ended 2 July 2017 of approximately £24,375,000 (27 weeks 2016: £21,794,000) and adjusted profit after tax* of approximately £200,000 (27 week 2016: £1,283,000).

That's rather dismal - H1 profits have almost disappeared.

Outlook - reading this (below), I'm quite surprised the share price hasn't fallen more today;

In the Group's annual statements for the 53 week period ended 1 January 2017, released on 28 March 2017, the Directors communicated to shareholders that, as with other restaurant operators, the Directors expected the trading environment to be challenging. This has proved to be the case with trading across the estate below management's revised expectations, as indicated by the half year finance performance of the Company.

The Group has undertaken a full review of its estate, operational structure and cost base however the expected improvements from these initiatives are now unlikely to be significant in the current year. The Directors expect the first half / second half weighting of its financial performance of the Group to be similar to historic periods. 

Clearly things are not going well. However, it doesn't look a disaster either. It's difficult to determine exactly how the company is performing, as it hasn't disclosed the LFL sales performance. I suspect the LFLs are probably well into negative territory, for profits to have fallen so sharply.

Seasonality - note the company's comment above re H1/H2 seasonality. I've checked back, and this is how the seasonality panned out in 2015 & 2016;

(the figures below are adjusted profit, i.e. stripping out pre-opening costs for new sites)

H1 2015: £1,684k
H2 2015: £2,267k  (up £583k on H1)

H1 2016: £1,925k (NB. 27 weeks)
H2 2016: £2,867k (up £942k on H1)

I've calculated the H2 figures, by deducting H1 from the full year profit.

If we take the average uplift, then it's £762k. This implies that Tasty is likely to make an H2 profit this year of about £962k, giving my estimate of full year profit for 2017 of about £1.16m. That's a huge drop from last year's profit of £4.8m.

Often people forget the impact of operational gearing. Retailers/hospitality sectors are particularly bedevilled by this. A lot of the costs (rent, rates, etc) are fixed. Most variable costs, e.g. wages, and head office costs, can only be reduced a certain amount, before causing operational problems. Therefore, either good or bad performance at the top line, feeds through to a disproportionately larger impact on profitability. Great in the good times, awful in the bad times.

Balance sheet - this is what the company says today;

The Company remains profitable and has a strong balance sheet. The Company expects to dispose of certain fixed assets during the second half of the financial year to strengthen the cash resources available to the Group.

The Company also expects to close certain loss making sites which may lead to impairments but improved operational cash flow.

As I reported last time, the company's balance sheet is OK for now. However, if they keep opening new sites (with expensive fit-outs), then the position could deteriorate enough to become a concern.

The company only had modest net debt, and I would want to see it stop opening new sites altogether, and instead concentrate on eradicating the bank debt completely. Nothing is said about new site openings today, which is a concern.

Directorspeak - this bit (below) concerns me, as it sounds like the Directors are in denial;

The Directors believe the Group's core 'Wildwood' brand remains attractive to customers and that the Group has a property estate with desirable locations which will deliver significant financial performance. The Directors continue to refine and improve the 'Wildwood' brand offering in a difficult trading environment.

My opinion - It strikes me that this company's main problem is that its brand & menu proposition are weak, and dated. That's why financial performance is deteriorating.

There are macro headwinds at the moment, including big upward cost pressures (Living Wage, rates, food prices, etc). Plus there has been a huge amount of extra capacity added in the restaurant sector in recent years, with many very good expanding chains (e.g. Cote, Franco Manca, and numerous independent operators too).

In this environment, with consumers spoiled for choice, only the strongest propositions will continue to trade well. Many others, will be left floundering, as is happening with Tasty's dated, boring formats. I feel that the Directors should think in much bigger terms, about a complete re-branding of its restaurants, with a much more interesting, innovative menu.

The trouble is that the Kayes are a one-trick pony. Their insight was that pizza & pasta generate huge gross margins. The trouble is, everyone else has cottoned on to that. There are newer operators out there doing it much better, and at keener prices. Hence why Tasty is losing market share.

I imagine that they'll be able to stabilise, and turn around this company. However, that is likely to be a multi-year struggle. The big problem is getting out of leases on loss-making sites. Lease liabilities are fine, when all units are trading profitably. However, once a chain begins to struggle, and develops a longer tail of loss-making sites, then it can often be the lease liabilities that drag under the whole group. A CVA, or Administration is often the only way to get out of problem leases, although Tasty doesn't look near to that level of distress at the moment. If it keeps the bank debt down, to little to nothing, then it should be able to survive.

Overall, I'm trying to avoid problem companies like this at the moment, as things usually just get worse & worse. Why take the risk?

---

SCS (LON:SCS)

Share price: 158.1p (down 0.6% today)
No. shares: 40.0m
Market cap: £63.2m

Trading update - for the 52 weeks ended 29 Jul 2017.

This retailer describes itself as;

one of the UK's largest retailers of upholstered furniture and floorings

It operates mainly from retail parks, from big sheds. It does a lot of TV advertising, on minor channels.

Today's update seems to be in line with expectations;

The Board is pleased to report that the Group has traded in line with its expectations for the Year, with overall order growth of 1.4%. 

Valuation - one broker note today has an estimate of 22.5p EPS for the year that's just finished. This is in the same ballpark as Stockopedia's broker consensus EPS of 22.0p.

Taking the current share price of 158.1p, this translates to a PER of 7.0 - very cheap, if those earnings are sustainable.

The balance sheet is OK too. Although it's important to understand that the business model relies on cash received up-front from customers. So the cash pile isn't really the company's money.

Dividends - a stonkingly high divi yield of about 9.6% is on offer here. Clearly the market doesn't believe that such a high payout is sustainable then.

I think the company is paying out too much in divis, and should cut it by about half, and retain more cash in the business, to beef up the balance sheet.

LFL comparatives - the company explains softer recent sales figures by reference to the exceptionally strong prior year comparatives. That's fair enough.

Although as I mentioned when reporting on the interim figures, this just suggest that the company might now struggle to report any further growth for the time being.

Outlook comments from management sound fairly upbeat, considering the macro uncertainties & pressures:

"We are pleased that despite the challenging comparatives and wider market backdrop we have traded in-line with the Board's expectations for the Year.

Looking ahead, notwithstanding the current trading environment, the Board believes the business remains in a strong position to maximise opportunities as they arise and to grow market share."

My opinion - this share looks good value, superficially. It's a classic low PER, high yield share. There's a reason it's cheap - because it operates in a competitive, and very cyclical market, and only ekes out a small operating profit margin. It went bust in the last recession too, which highlights how big the downside risk is, in a recession. It's also dependent on availability of credit, which is an area of concern right now - with consumer borrowing reaching pre-crisis levels recently. If the banks switch off consumer credit again, then businesses like this would once again be facing oblivion.

I think SCS might find it very difficult to increase its profits any further, and might see profits go into reverse. There are some impressive new entrants in this sector, so competition is stiffening. Also remember that DFS Furniture (LON:DFS) warned on profits not long ago, although its share price seems to be recovering somewhat.

Overall, I think there are much better opportunities out there, than this. There's no denying how cheap it looks though. So if the business does perform well, then shareholders could see the shares re-rate, on top of receiving some huge divis along the way too. 

As you can see from the 2-year chart below, the returns have been rather lacklustre (although would look better if divis were included);

It's important to remember that all investments carry an opportunity cost. We've been in a roaring bull market for growth companies over the last 2 years, with numerous multibaggers. So having your money parked up in SCS has had a considerable opportunity cost - akin to being stuck on the hard shoulder of the motorway, whilst everything else goes roaring past, speeding to their destination. So SCS doesn't tempt me at all.

---

Water Intelligence (LON:WATR)

Share price: 123.5p (up 14.4% today)
No. shares: 12.0m
Market cap: £14.8m

Trading update & acquisition - this is an unusual little company, mainly based in the USA (but with small UK operations too). It detects & fixes water leaks, e.g. for swimming pools. The business model is partly franchised, partly company operated branches.

I quite like the update today. Overall it's just an in line update. However, growth has been strong, with the company reinvesting the proceeds into more marketing & other overheads. I'd rather see growth, and the proceeds reinvested, than no growth at all;

...Profits before tax remain in line with expectations, reflecting the Company's choice to fuel further growth through reinvestment in both additional staff and marketing efforts in order to capitalise on the market opportunity in its geographies:  United States, United Kingdom, Canada and Australia. 

A lot more detail is given. The company has reacquired a couple of franchisees, which should boost the reported profits.

My opinion - I vaguely recall trying to buy some shares in this micro cap company a while back, when my friend Edward Roskill mentioned it positively, in an interview I recorded with him. However, the share was so illiquid, that I couldn't get any stock at all, so gave up on it. Pity, as the share price has almost tripled since then.

Generally, I try to avoid the smallest & most illiquid stocks these days, as I can't buy or sell in the size I need to make it worthwhile. Also, if anything goes wrong, or if you need cash in a hurry, then this type of thing can be a nightmare (or impossible) to exit.

That said, the company seems to be trading well, and growing. So it could be worth a look, if you're prepared to swallow the risk of possibly being stuck high & dry in the share.

---

All done for today.

Regards, Paul.