Small Cap Value Report (Fri 18 Oct 2019) - EHG, ESL, EZH, Brexit

Good morning, it’s Paul here.

Estimated time of completion is 3pm. Update at 13:30 – today’s article is now finished.

As usual on Fridays, it’s very quiet for company news. So once I’ve covered the few interesting small caps announcements, I’ll write a section on the potential Brexit deal. I read through both the Protocol for Northern Ireland, and the revised Political Declaration last night. Also I’ve dug out my notes on the original withdrawal agreement, so have a few comments to make.

Aside from its effect on companies, the economy, and the stock market, this stuff also interests me on a personal level. In the 1980s I did a degree at Keele University in International Relations  (a hybrid course covering politics, history, economics, international law, international confllict amp; cooperation, etc.). Therefore, these days, in my time out from the markets, I can usually be found with my nose in a book on one of these topics. It’s very important to switch off from the markets sometimes. Especially when your portfolio is going through a bad patch (as mine has been for about the last 18 months, unfortunately).

Can I just ask that in the comments, people try to avoid the whole political side of Brexit, which is (a) incredibly boring, (b) pointless, as nobody is likely to change their mind anyway, and (c) inflammatory.  Instead, let’s stick tightly to the economic amp; stock market issues surrounding Brexit.

We have 2 takeover bids announced today, encouragingly in the small caps space. This reinforces my view that there’s currently a lot of value out there, selectively, in UK small caps. Takeover bids confirm that. I think we could see a lot more, particularly if Brexit uncertainty is removed.

The stock market feels like a giant game of snakes amp; ladders. We’re seeing lots of profit warnings, and the associated 30%+ instant plunges in price. Yet at the same time, plenty of premium-priced takeover bids are happening. It’s a reminder that there’s actually quite a lot of luck involved, in this game – due to future events often being unforeseeable.

Share price: 109p (up 56% today, at 10:25)
No. shares: 88.8m
Market cap: £96.8m

Recommended cash offer

Elegant Hotels Group plc, the owner and operator of seven upscale freehold hotels and a beachfront restaurant on the island of Barbados, would like to draw shareholders’ attention to the announcement made by Marriott International Inc. in relation to a recommended cash offer by its wholly-owned indirect subsidiary, International Hotel Licensing Company S.à r.l, for Elegant …

Marriott is offering 110p in cash, which is hearty 57% premium to last night’s closing price of 70p.

That’s a good price, and shareholders should be delighted.

It’s really striking to see the mismatch between the undervaluation given to the company by the UK stock market, and the price that a larger competitor is prepared to pay;

We’ve generally reported favourably on EHG here in the SCVRs. Indeed, I flagged it up here on 4 Oct 2018 at 68p as: this could be an interesting entry point, perhaps – based on a positive trading update, and freehold asset backing. Although the discount to NTAV always worried me – as it seemed to suggest the market didn’t believe the freehold valuations. Turns out the market was wrong.

That’s quite an interesting general point. We often tend to assume that share prices are carefully calculated evaluations of value. But they’re not. Share prices are just what the most recent trades happened to be at. In illiquid shares, where big holders are locked in, then it’s just the smallest, often insignificantly small, trades which actually set the share price. Thus creating many anomalies in small cap share prices.

Whereas more liquid mid amp; large caps, where anyone who wants to transact in the shares can do, the prices are more rational. Pricing anomalies there tend to occur more due to group-think (irrationally fashionable or unfashionable sectors/companies), than due to liquidity issues.

Anyway, congratulations to EHG shareholders!

Share price: Suspended at 71p since 21 Aug 2019
No. shares: 379.3m
Market cap: £269.3m

Possible offer by Wincanton

These two logistics companies are looking at a possible combination. They’re similar sized, in terms of revenue amp; profit.

ESL ran into trouble with accounting problems, and the shares have been suspended since 21 Aug 2019. Therefore, I imagine the share price would have been significantly lower, if the shares had been trading in the market, than the frozen 71p level. Hence (am guessing here) the probability seems to me that any bid from Wincanton could be below the previous share price of 71p, but who knows?

This is what ESL said today in its announcement;

Statement re. possible offer

The Board of Eddie Stobart Logistics plc (“Eddie Stobart” or the “Company”) notes this morning’s statement from Wincanton PLC (“Wincanton”) and confirms it has granted due diligence access to Wincanton to assess the potential merits of a combination. 

No proposal has been made by Wincanton to Eddie Stobart as to the terms of any potential offer, and there can be no certainty that any offer will be made to Eddie Stobart shareholders.

Sensibly, Wincanton has not mentioned price, until they’ve looked through the books.

This is what Wincanton said today, which is basically the same;

The Board of Wincanton, the largest British third-party logistics company, announces that it is currently undertaking a diligence exercise on Eddie Stobart and its assets, in order to enable it to assess the potential merits of a combination. No proposal has been made by Wincanton to Eddie Stobart as to the terms of any potential offer, and there can be no certainty that any offer will be made to Eddie Stobart shareholders.

There’s nothing shareholders can do, other than watch amp; wait.

Graham’s article here on 16 Sep 2019 is interesting, and worth a read to get up to speed. There was already potential bid interest from a company called DBAY.

My opinion – this is a financially distressed situation, so any bidder is likely, I imagine, to be far from generous. The problem with Wincanton is that, whilst a seemingly good business, it also has a weak balance sheet. Therefore, combining two businesses, both with weak balance sheets, would really need to be supported with a significant equity raise. There might also be competition-related regulatory hurdles to overcome.

With its shares still suspended, there’s not a lot ESL shareholders can do, other than wait, and pray.

Share price: 110p (up 11% today, at 11:44)
No. shares: 146.0m
Market cap: £160.6m

Trading update

The Board of easyHotel plc, the owner, developer and operator of “super budget” hotels, today issues the following trading update for the financial year ended 30 September 2019…

I’m quite surprised that the share price is up 11% today, because this statement doesn’t read well to me. Perhaps the price rise is due to market makers marking up the price, due to read-across from the 57% premium bid for Elegant Hotels (LON:EHG) ?

The other point is lack of liquidity. Only 4,650 shares have changed hands today in EZH. There might be some delayed prints later, but there isn’t really a market for this share, it’s almost completely illiquid.

The quoted spread is 94p Bid, 110p Offer – a hideous spread that makes it pointless buying the shares. You would need a roughly 17% rise in share price, just to get back to breakeven!

Out of curiosity, I asked my broker for the real prices (which are hidden from private investors). There’s a 98p Bid, a 4p improvement, but only for 845 shares!

On the Offer side of the book, the best price is 110p, and even that is only in 1,000 shares!

Therefore, the only way to transact in this share would be to get my broker to “work an order” for me – i.e. I name the price amp; quantity, then my broker rings round the market makers (or rather uses Bloomberg messaging) to see if any of them bite. They might have an order in the background from someone else, and hence sometimes you get filled. Although often it can take a few days, or even weeks.

All of this makes me wonder why this, and other illiquid small caps, have a listing at all? It’s pointless, unless companies amp; their brokers make some effort to create a more liquid market in the shares.

Bid approach – ah OK, I’ve just realised that EZH was in a bid situation! That explains why it’s so illiquid. Reading back through the announcements, ICAMAP Investments bid 95p for the company, and acquired a 68.77% shareholding. The offer closed for acceptances on 1 Oct 2019.

Therefore, it looks as if the bidder didn’t get enough to reach the threshold to de-list the shares.

Are minority shareholders holding out for a higher price, perhaps?

Owned hotels are trading much better than franchised ones;

Profitability – this strikes me as poor, for a company with a market cap of £161m. Hotels need to generate a ton of EBITDA, in order to fund the continuous amp; large maintenance capex. Although in this case, the franchisees presumably look after their own capex;

Delivering continued market outperformance in challenging trading conditions has required an investment in both price and an increased use of online travel agents (OTAs). 

The Group has maintained a tight control of central costs, in support of delivering its year end targets, but against this more challenging trading environment the Board anticipates that Group adjusted EBITDA will closer to £4.6m for the year ended 30 September 2019.

Dividends – reviewing its dividend policy, but doesn’t really matter because divis were minimal anyway.

My opinion – I don’t know enough about the detail here, but hopefully my reading of the situation, as described above, is correct. Let me know if I’ve missed anything.

It looks like a special situation, where maybe the minority shareholders are holding out for a better price?

In terms of valuation, I can’t fathom it at all. This seems to be a very asset-intensive company, that’s earning a poor return on those assets. Maybe there’s some other attraction to this share, that I’ve missed?

Given that you can hardly trade it in the market anyway, I’ve probably just wasted an hour or more of my life, writing this section! Still, it’s strangely enjoyable rummaging around, trying to work out what’s happening with shares. It’s a bit like doing a puzzle, and trying to figure out what’s likely to happen in future.

In this case, I imagine the major shareholder might want to de-list the company. If so, it could put pressure on minority shareholders to sell out – that looks the most likely outcome eventually.

We’ll have to wait until tomorrow, to see if the revised deal for Brexit, which has apparently been agreed between the UK Govt amp; the EU, gets through Parliament.

Firstly though, what actually is this deal?

Political Declaration – this is only 26 pages, and is written in fairly plain English, so worth a look. It’s not a deal at all, but just a series of statements about what both parties agree they want to achieve, in principle, in future negotiations.

It seems as if contentious areas have been fudged with ambiguous wording, possibly? It seems like an agreement where each side might interpret the wording very differently.

From investors’ point of view, probably the most important points in this declaration, are that free trade is prioritised. Therefore, if passed by Parliament, the prospect of impediments to trade, including tariffs, disruption at ports, etc, has probably disappeared.

I don’t think there was ever much prospect of that happening anyway, because;

• The EU offered the UK free trade right at the start, and
• The UK is a large net importer (about 30% of lorries travelling from Dover to Calais are empty, due to the imbalance), so it never made sense for the EU to want to restrict its own exports by imposing reciprocal tariffs. 
• As both sides want free trade, what’s the most likely outcome? I’d say it’s probably free trade!

From what I can make out, this new deal seems to be a resuscitation of Mrs May’s Withdrawal Agreement, with a few tweaks. Looking back at Mrs May’s deal, it was almost indistinguishable from the UK actually still being a member of the EU! So Brexit in name only.

The new Political Declaration strikes the same tone, although it does acknowledge the end of freedom of movement, and that the UK would become an independent coastal state, amongst other things – both contentious areas. In other areas though, the latest Political Declaration sounds as if the UK will continue being very closely aligned with the EU in numerous areas – which maybe is a good compromise?

The major tweak is of course Northern Ireland.

Revised Protocol to the Withdrawal Agreement – this is a very heavy read, and to be honest, I didn’t understand a lot of it, as it’s written in a very legal type of way. Looking at it again today, it’s only the first 15 pages that need to be read, as the subsequent annexes are just a long list of EU Directives.

These arrangements replace the previous non-starter of the Irish backstop – which potentially left the whole of the UK permanently tied to EU law. I’ll re-read this section again over the weekend, but it’s basically an agreement on putting a customers border in the Irish Sea, with N.Ireland effectively being both in the UK, and in the EU. It’s difficult to see how else this issue could have been dealt with.

Although seeing as the UK amp; EU actually want free trade, then maybe this Irish issue might become redundant once a full free trade deal is done?

My opinion – being a betting man, I reckon Parliament might pass this new deal tomorrow, but apparently the arithmetic in parliament is very tight.

It looks like a compromise that’s very similar to being in the EU anyway – with most economic areas continuing as they are now. So it probably won’t please anyone, but maybe it’s a compromise that most people could live with? The alternatives are probably worse.

From a shares point of view, if this passes, then it removes a massive uncertainty, and as such, I see that as being very positive for bombed-out shares. Also, it means that companies can plan ahead with greater certainty, and are hence more likely to invest. Management time would be freed up for running businesses, rather than planning for worst case scenarios.

Although, the big issues have not yet been properly negotiated. It’s all very well setting out a broad overview of what both sides want, but achieving detailed agreements (to be done by end of 2020 – yeah right!!!) is quite another thing. So we’re probably looking at years of negotiations to thrash out the detail.

The above is only my initial take on things, and of course I’m an interested observer, not an expert.

This BBC article is short, and interesting

Let’s see what happens over the weekend!

I’ll leave it there for today. Thanks for your contributions this week in the comments section.

Best wishes, Paul.

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