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Small Cap Value Report (11 Oct 2016) – NXR, ENTU, BDI, CHRT, PHO

Tuesday, October 11, 2016 6:57
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Good morning!

I added a few more sections to yesterday’s report last night, so to recap on that, please follow this link. In particular, a very interesting turn of events has occurred at Richoux (RIC), which I reported on.

Sterling remains the pressing issue of the moment. At the time of writing it’s dropping further, and we’re down to £1 = $1.228, or £1 = E1.105 .

There’s a good article here, with Lord King welcoming the weaker pound. Economist Vicky Pryce emphasises the inflationary pressures that will be caused by weaker sterling. It’s certainly going to make UK industry much more competitive, which is surely exactly what we need when facing all the uncertainty from Brexit?

My main worry is for margins at importers (e.g. retailers). They have no choice but to substantially raise prices next year, but consumers are going to push back against that. We don’t know how it will all pan out, but I reckon margins are bound to be hit hard at retailers next year. That will really sort out the wheat from the chaff. Companies like Next (LON:NXT) are likely to sail through relatively unscathed, in my view. Whereas the poorer quality (in terms of operating profit margin) retailers on low margins already could be seriously harmed. I wouldn’t touch any low margin retailer at the moment, as performance could seriously deteriorate next year, maybe even into losses. Then the apparently low PER will go out of the window.

So broker forecasts should be treated with great caution right now, or even ignored completely. When circumstances change significantly, a formulaic approach to investing, relying on broker forecasts, can go disastrously wrong. It needs a human being to reasonableness-test things at times like this, to dodge the banana skins as much as possible.

Small caps feel strange to me at the moment – lots of sudden, erratic price movements. It feels as if the market is trying to work out which stocks deserve the big gains that we’ve seen since July, and which ones have been taken too high on speculative froth.

On the flipside, I’m also seeing signs of life in some really bombed-out small caps. Companies which disappointed have been slammed so hard of late, that I think people are out bargain hunting now perhaps, amongst the wreckage? There could be some nice trades to be done there, if one is very selective? The percentage gains from the lowest point of bombed out shares can be spectacularly good. Remember that, providing the balance sheet is sound, the downside is limited – companies with sound finances don’t go bust.

Right, on to today’s results amp; trading updates.

Norcros (LON:NXR)

Share price: 146p (down 0.5% today)
No. shares: 61.3m
Market cap: £89.5m

(at the time of writing, I hold a long position in this share)

Trading update – this covers the 6 months to 30 Sept 2016, being H1 of the y/e 31 Mar 2017. Given that the share price has been selling off relentlessly, I imagined that this would probably be a profit warning. The good news is that things sound fine overall;

Group underlying operating profit1 in the first half is expected to be in line with the Board’s expectations.

Previous trends have continued, with the UK market being soft (LFL sales down 5%), with South Africa taking up the slack, with 8% growth (10% in constant currency).

Thus the overall level of sales was only very slightly down at -0.2% on an LFL basis. 

Acquisitions boosted total group H1 sales by 8.5% to £128.8m.

Net debt isn’t a worry here for me, because the group is nicely cash generative, and has good freehold property backing. At this level I’m comfortable;

Closing net debt is expected to be around £28m (2015: £29.2m). Working capital and cash management remain a key focus for the Group.

Outlook – confirms full year expectations, which is pleasing;

With the continuing strong performance of our South African business and the contribution from the recently acquired businesses offsetting the challenging UK market experienced in the first half, the Board remains confident that the Group will continue to make progress in line with its expectations for the year to 31 March 2017.

Valuation – the forecast (reiterated this morning) I’ve got is for 27.0p EPS this year.

That puts Norcros shares on a PER of an astonishingly low 5.4.

Net debt is not a problem, but the issue which seems to concern investors and analysts is the pension scheme deficit. Let’s try to quantify this. If NXR did not have any pension schemes at all, then I reckon it would probably deserve a PER of about 12. Maybe a bit more, but that will do for now. That would equate to a share price of 324p, or a market cap of £198.6m, compared with the actual market cap of £89.5m.

Therefore, by my reckoning, the market is discounting the value of Norcros by c.£109m because of its pension deficit. Is that reasonable? In a word, no. The pension scheme is mature (average age 77), so will decline in size gradually, but considerably, over the next say 10 years. Also, the recently agreed deficit recovery payments are only £2.5m p.a. – easily affordable whilst paying a generous, well covered, and growing dividend yield of c.5%

It’s a given that, with interest rates so low, the pension deficit may grow in the short term, on an actuarial basis, but it’s actually a fairly modest drain on the group’s cashflow. I don’t see why the market is applying such an extreme discount for the pension scheme – whilst recognising that it is a large scheme overall, so it’s an issue that should be carefully considered, not brushed aside.

Given that the company is performing quite well, and executing well with its buy amp; build strategy (3 acquisitions have all panned out well in the last couple of years), then I think the valuation here looks much too cautious. Mind you, shareholders here certainly need patience. Despite the attractive valuation, and nice divis, the share price seems to be permanently depressed. I can live with that, whilst receiving a 5% dividend yield, which is growing each year.

Forex – not mentioned in today’s update, but the company is now seeing a helpful tailwind from the dramatic recovery in the Rand compared with sterling. That boosts the S.African earnings, when translated into sterling. I used to think its S.African operations were a dead loss, but have been proven wrong on that, with an excellent recovery underway.

As much of its UK products are made in the Far East, Norcros will undoubtedly have to raise prices, in common with other importers. I’m not sure what currency hedging arrangements are in place, but in any case hedging only defers the inevitable. So it will be interesting to see how Norcros manages its margins next year, and how customers react to higher prices. The way I look at it, higher prices are inevitable, and everyone else will also be raising prices, so we’ll just have to see what impact that has on demand.

My opinion – I think it looks great at this amazingly low valuation. Sure the pension scheme is unhelpful, but it doesn’t justify anything like the discount which the market is currently applying. Therefore, for me, this share looks highly attractive. It’s just a question of thinking rationally, and overcoming the emotional feeling of negativity which inevitably surrounds a depressed share price.

5% divis (and growing each year) whilst we wait for a recovery is fine by me. So I’ll continue to hold, and possibly buy more at this sort of level. But I’m not expecting fireworks any time soon, this one is a long haul, for the patient only!

As a fully listed small cap, Norcros will not attract IHT portfolio money, which is a pity. Maybe it should consider moving to AIM?

Entu (UK) (LON:ENTU)

Share price: 20p (down 18.6% today)
No. shares: 65.6m
Market cap: £13.1m

Trading update (profit warning) – the market cap of this home improvements (e.g. double glazing, etc) company has halved again in 3 months, since I turned bearish on it (not before time) here in my report of 19 July 2016, when the share plummeted 27% to 39.5p on very poor interim results. So with the market cap now down to only £13.1m, I wonder if there’s anything left for shareholders to salvage here?

Results for y/e 31 Oct 2016 don’t actually sound too bad, considering how much the share price has fallen;

EBITDA on the Group’s continuing activities before exceptional items for the year ending 31 October 2016 is expected to be between £3.6million and £4.0million, with an improved performance in the Energy Generation and Savings Division being offset by delays in realising the benefits of the May restructuring in the Home Improvements Division.

Although there will be exceptional costs, and losses from the discontinued activities. So that £3.6m to £4.0m figure could reduce down to very little, once everything is taken into account.

Indeed, checking back to the last interim accounts, headline EBITDA was £3.9m, but the overall post-tax, post-everything earnings figure was only £0.4m.

So it looks like H2 trading has only been around breakeven at the EBITDA level, which isn’t great.

More detail is given on how individual divisions are performing, which doesn’t particularly interest me – it’s the overall result that matters.

Debt – this concerns me a lot;

Borrowings at the year-end are also anticipated to be higher than expected at around £5 million mainly due to exceptional restructuring costs and issues identified within the Home Improvements Division.

A struggling business really shouldn’t have any debt, in an ideal world.

Dividends – this looks a mistake to me. Struggling businesses which are in debt, should not be paying divis at all;

The Board expects to be able to pay a final dividend of 1.0p per ordinary share, in line with expectations, resulting in a total dividend for the year of 1.5p per ordinary share, subject to the reserves and cash position at the time the Group announces its preliminary results.

It is the Board’s intention  to move towards a dividend policy of distributing one half of its post-tax profits as dividends each year split broadly one third as an interim dividend and two thirds as a final dividend each year.

Outlook – this is a profit warning for FY2017;

This reinvestment, coupled with the work still to be done in addressing the issues outlined above and management adopting a more cautious position, means that despite the expected improvement in profitability in FY17, the EBITDA outturn for the year ending 31 October 2017 is expected to be materially below current market expectations.

The thing is that the market clearly didn’t believe the existing forecasts, because the forward PER is 2.1 ! So it doesn’t really come as a shock to hear that the company is going to miss that forecast. I really do think forecasts should be withdrawn when it becomes obvious that they won’t be reached.

Broker forecasts have been repeatedly wrong here, by miles. So I think it’s safest just to completely ignore forecasts from now on, as they have zero credibility (along with management).

My opinion – it’s pretty obvious that the stock market was sold a pup when this thing was IPO’d. What concerns me most is that it floated together with a sister company, Epwin (LON:EPWN) which makes all the product for Entu to sell.

Epwin shares have done better, whilst Entu has languished from poor performance. That raises concerns about the whole structure, and what the split of margins is between the companies. Has Entu been hung out to dry, in order to create value at Epwin? I do wonder, because that’s what the figures clearly suggest might have happened.

Anyway, with performance having been so bad since floating, I’m not interested in getting involved with this one again. It may look cheap, but it’s always looked cheap, all the way down from 100p to 20p. So it’s a bargepole job for me, having suffered a loss on it before, I’m not going to compound the error by coming back for seconds.

Bond International Software (LON:BDI) – Constellation have indeed come back with a higher offer, at 121p now. I pondered whether that might be the outcome here last week.

As a general point, with sterling so weak I think we’ll see an upsurge in foreign takeover bids for UK listed companies.

Cohort (LON:CHRT) – it’s not one I follow closely, but news today of a “planned reorganisation” of its SCS subsidiary (nothing to do with sofas, this is a defence contractor) sounds a bit worrying. Could there be a profit warning on the way perhaps?

This follows increased challenges in SCS’s markets, further to those noted in the Group’s AGM statement in September.

Up-front exceptional costs will produce decent future cost savings;

The exceptional cost, which will be incurred in the current financial year, associated with the reorganisation is estimated at £2m and it is expected to result in a net annual cost saving of approximately £1.6m

Mind you cost savings come at a cost to future business - unless it’s getting rid of staff who are currently sitting at their desks twiddling their thumbs.

The Directorspeak reassures;

“After careful consideration, we believe integrating SCS’s operations with two of our other businesses is in the best interests of our long-term growth prospects.  As noted recently, our order book and near-term prospects provide a good base for future progress.”

Peel Hotels (LON:PHO) - interim results today from this small hotels group. As a beneficiary from inbound tourism after sterling depreciation, the hotels sector is one that I will be looking more closely at. Although it looks as if I’ve missed the boat, as the share price is already up about 25% since July.

Management confirm the benefit of weaker sterling for the UK tourism sector;

…It is difficult to be certain post Brexit but a low pound certainly should encourage incoming volume as well as serving as an incentive for British residents to spend more of their leisure time at home.

This really is a very small company. The market cap is only about £17.5m at 124p per share.

It makes about £0.5m profit before tax each half year. That has risen to £593k this time.

The return on capital seems quite poor. Total fixed assets are £35.7m, so to only be making a net profit of about £1m p.a. makes you wonder what the attraction is? Hotels need constant refurbishing too, so the capex is never-ending. Mind you, the £1m p.a. figure includes finance costs, which I should probably reverse out to make a more meaningful comparison.

The balance sheet contains about £10m in debt, which is fine in a low interest rate environment, when also capital values are high. Although note that debt is coming up for renewal inside 12 months:

The balance of the Company’s loan currently £8,557,422 becomes due on 31 August 2017 and we will begin the process of negotiating a suitable long term solution over the coming months.

Shareholder discount – this might be useful, and is a nice touch I think:

We are always delighted to welcome Shareholders to our Hotels where they can see for themselves the progress we have made, whilst enjoying a beneficial discount of 50% of our rack rate tariff, using a special reservations number 0207 266 1100 or e-mail  Shareholders can keep in touch with progress in the company and various promotional activities by visiting our website

My opinion – I don’t see the point in it being listed, as it’s too small. Maybe shareholders like the IHT relief from being AIM listed? There was a 1.5p divi paid in 2015, but nothing either side of that.

I’m really struggling to see any reason to buy or hold this share, other than hoping someone will come along and bid for it. Or if you think there could be upside on the property valuations, fuelled by artificially low interest rates?

Also remember that Living Wage will hurt profits here over the next few years. It’s not for me. There’s often a problem dealing in tiny things like this, and you can end up taking a nasty haircut if you try to sell in any size.



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