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Exploiting value plays

Simon Thompson highlights a quintet of small-cap value opportunities, including updates on two constituents of his 2017 Bargain shares portfolio.
July 25, 2017

Alternative Investment Market (Aim)-traded stockbroker and private wealth manager WH Ireland (WHI:152p) has produced the sharp profit recovery I was anticipating when I last recommended buying the shares at 135p a month ago on the back of a bullish pre-close interim trading update ('Top-slicing and running profits', 26 June 2017). Admittedly, comparatives were soft given the company was unable to undertake regulated activities for a 72-day period in the first half last year after being fined by the FCA ('WH Ireland hit by FCA fine', 23 February 2016).

However, this should not detract from what has been a dramatic improvement in trading. Excluding exceptional items, the company turned in an underlying operating profit of £374,000 in the six months to end-May 2017, significantly higher than the £155,000 profit made in the second half of the last financial year, and the £1.1m operating loss in the first half of 2016. The key to the turnaround has been the company’s corporate broking arm which delivered pre-tax profits before central overheads of close to £1m on revenues of £5.28m, compared with a £280,000 profit in the second half of the 2016 financial year. Fundraises for clients included a £48m capital raise for Aim-traded care home provider CareTech (CTH:400p), a business whose investment case I remain favourable on.

Annualised fee income from 81 corporate retained clients is now around £3m and means that 45 per cent of the company’s total revenues are recurring after factoring in the contribution from its growing private wealth management arm, giving the board confidence to set an objective of boosting recurring revenue to 65 per cent of the mix. More importantly, this robust activity on the corporate broking side has continued through June and July to such an extent that chief executive Richard Killingbeck informs me that “the corporate broking pipeline for the second half and early 2018 is stronger than it has been at any time since I have been here”. The appointment of Adam Pollock to head up this side of the business, having joined WH Ireland from rival Zeus Capital in March, has been a significant.

Progress is also being made in WH Ireland’s private wealth management division which increased assets under management (AUM) and administration by 8 per cent to £3.1bn in the latest six-month trading period, of which around a third are higher-margin discretionary accounts, including the Isle of Man office which now has £289m AUM and has turned profitable. WH Ireland has been restructuring this unit and has outsourced back office functions, a process that should deliver annual costs savings of around £750,000 largely in headcount reductions from the second half onwards, and a tad under £400,000 of savings from outsourcing the back office administration functions in the 2017-18 financial year. This unit made a pre-tax loss of £845,000 in the six-month period, but this includes almost £450,000 of exceptional costs and the double counting of overheads while the migration of the outsourcing functions was taking place. Mr Killingbeck expects a “material change” in the performance in the second half, further justifying his claims that “these numbers demonstrate we are shifting the dial”.

I would flag up that following the sale of its Manchester head office, and a placing at 123p a share at the end of last year, which raised £1.58m, the company has net funds close to £10m, a sum worth a fifth of the market capitalisation and accounting for a large chunk of net assets of £13.7m, so the company is well funded to grow both divisions organically and seek acquisition opportunities, too.

Breaking down the divisional performances, and taking into account cost savings, analysts John Borgars and Hannah Crowe at Equity Development believe WH Ireland should be capable of making between £2m and £3m operating profit in a ‘normal’ year, a reasonable assumption in my view. They also point out that even if you don’t attribute any value to the company’s corporate broking arm, “using a rule of thumb valuation for private clients assets under management plus excess cash on the balance sheet gives a value of £72m, or 259p a share”. That’s way in excess of my target price of 175p, thus leaving scope for additional upside if the positive momentum in the business is maintained.

So, having initiated coverage on the shares at 68p ('Broking for success', 1 August 2011), and last advised buying at 135p ('Top-slicing and running profits', 26 June 2017), I am comfortable maintaining the same advice at 150p. Buy.

 

Engineering a cheap entry point

As expected, Avingtrans (AVG:223p), a maker of critical components and services to energy, medical and industrial sectors, has launched a recommended takeover bid for specialist engineer Hayward Tyler (HAYT:44p). I highlighted this possibility a month ago when I rated shares in Avingtrans a buy at 218p (‘A trio of small-cap buys’, 27 June 2017).

At the time, I believed there was scope for Avingtrans' shrewd management team to replicate their success on previous turnaround situations and create significant value for shareholders by exploiting the recovery potential of the indebted bid target. Under the terms of the All-Share acquisition, Hayward Tyler’s shareholders receive one new Avingtrans share for every 4.755 shares held, which means that Avingtrans will issue 11.53m new shares to give Hayward Tyler’s shareholders 37.6 per cent of the enlarged share capital. On completion of the takeover, the company will have a market value of £68.5m. The terms being offered seem sensible to me and to the 45 per cent of Hayward Tyler’s shareholders who have already decided to back it. That’s understandable as there are justifiable reasons why this deal should be value-accretive to shareholders of both the companies.

Firstly, Hayward Tyler is heavily indebted with net borrowings of £22.1m, implying balance sheet gearing of 100 per cent of shareholders funds at the end of March 2017, a level of indebtedness that is also significant in relation to the £25.8m equity value of the All-Share bid. In stark contrast, Avingtrans’ finances are in a rude state of health as the company has net funds of £26.2m on its balance sheet. Therefore, the combined entity will have modest levels of gross borrowings in relation to pro forma combined net assets of £67.2m, and retain cash in the bank and ample headroom on existing banking facilities to pursue growth opportunities, both organically and through further acquisitions. Removing duplicated costs will result in a slimmer cost base, too.

Secondly, both businesses enjoy strong positions in their respective energy market niches, in particular the nuclear sector, so there is a healthy crossover of business activities. Moreover, in the power sector, Hayward Tyler’s core business should see the benefits from the increased scale resulting from being part of an enlarged entity, not to mention funding is on a better footing to enable its management to target investment. In addition, the enhanced scale of the business and greater access to the Chinese energy market should enable the enlarged group to make inroads into the Chinese nuclear energy market and achieve critical mass.

I also feel there is a great opportunity for Avingtrans’ management to work their magic and build up margins on Hayward Tyler’s record order book of just shy of £50m, and return that business to sustained profitability following mixed trading last financial year when it reported cash break-even on revenues of £62.7m following a difficult first half.

It’s the type of deal I was hoping Avingtrans’ shrewd directors would pull off when I recommended buying the shares at 200p in my 2017 Bargain share portfolio, and still believe that the share price should be trading at a decent premium to the combined group’s pro forma book value of 219p. In fact, I have a conservative-looking target price of 275p. Interestingly, it’s possible to buy Avingtrans shares on the cheap by purchasing Hayward Tyler’s around 44p in the market, and then accept the All-Share offer, to give an entry point of 209p, or 14p lower than Avingtrans current offer price. I would recommend doing just that given that earnings upgrades look firmly on the cards after the deal completes at the end of next month, after which the embargo on analysts publishing forecasts will be lifted. Buy.

 

Crossrider on track

Another constituent of my 2017 Bargain share portfolio, Crossrider (CRS:65p), a provider of security software and an online distribution platform, has issued an upbeat pre-close trading statement. I rated the shares a buy at 68p at the time of the full-year results in mid-March ('Going for growth', 20 March 2017), having included them in my 2017 portfolio at 47.9p in early February, on the basis of the potential for the board to deploy the company’s hefty cash pile on earnings-accretive acquisitions, combined with a likely return to growth in the existing business.

Bearing this in mind, in a pre-close trading update covering the six months to end-June 2017, the company revealed it’s set to post cash profits of US$3m on revenues of US$29.7m, a performance driven by its app distribution division which increased revenues by 13 per cent to US$20.6m to account for more than two-thirds of the total revenue. It’s a cash-generative business with cash conversion rates of around 90 per cent, which explains why net funds ended the six-month period down only US$4.2m to US$67.9m (£52.2m), even though Crossrider invested US$6.4m in acquisitions. Importantly, it’s spending that cash pile money wisely.

For instance, at the time of the full-year results in mid-March, the company announced the acquisition of CyberGhost, a leading cyber security SaaS provider, and a provider of secure virtual private networks (VPNs) for 1.5m active users, of which 145,000 pay for a premium version priced at $30.10 a year payable in advance, or US$6.99 per month. The product allows users to connect through a secure tunnel to pass data traffic over public networks, an area of the market that is set to boom at a compound annual growth rate of 20 per cent plus over the next five years, according to industry experts.

CyberGhost is profitable, too, having posted cash profits of US$1m in the year to 31 December 2016, and significant levels of recurring revenues from subscribers. The acquisition looked sensibly priced based on an initial cash consideration of €3.2m (£2.8m), the issue of 4m options over ordinary shares worth €3m and exercisable at nominal value, and a cash profit-based earn-out payment capped at €3m to incentivise management. I can reveal that Cyberghost is actually trading ahead of Crossrider’s expectations, so supporting analysts’ claims that the acquisition could add around US1.3m to cash profits in its first full year.

The point is that if Crossrider can invest its bumper cash pile as well in future acquisitions as it has done so with Cyberghost, while at the same time generating organic growth from its existing app distribution platform, there should be additional upside to the share price. That’s because net of cash on the balance sheet, Crossrider’s enterprise value (market value of £91m less net funds of £52m) is still only £39m, hardly a punchy valuation for a company that analysts expect to grow full-year pre-tax profits and EPS by 50 per cent to US$7.3m and 4.6 cents (3.5p), respectively. Effectively, the shares are rated on eight times cash-adjusted EPS estimates after stripping out a cash pile worth 37p a share, a rating that from my lens at least fails to take into account the likelihood of further earnings-accretive acquisitions being made. Buy.

 

Epwin’s share price slump overdone

Aim-traded shares in Epwin (EPWN:97p), a manufacturer of extrusions, mouldings and fabricated low-maintenance building products, have fallen since I last rated them a buy at 123p ('Hitting target prices', 2 May 2017), having previously rated them a buy at 106p earlier this year ('Exploiting undervalued special situations', 6 February 2017). A final dividend of 4.4p a share has softened the blow slightly, but even so this is a steep decline. In fact, the price is now slightly below the 103p level at which I initiated coverage when the company joined the junior market ('Moulded for gains', 29 July 2014), albeit the total return is still positive after taking into account dividends of 17.2p a share paid in the past three years.

True, trading conditions in the repair, maintenance and improvement (RMI) market remain challenging and it was the contribution from earnings-accretive acquisitions that enabled the company to deliver last year’s 25 per cent hike in adjusted pre-tax profit to £24.6m to support a payout of 6.6p a share. However, analysts have not changed their forecasts since the annual meeting statement at the end of May and still expect a flat pre-tax profit performance this year, implying that the shares now trade on a miserly seven times this year’s likely EPS of 14p and offer a historic dividend yield of 6.8 per cent. Moreover, after factoring in net debt of £20.6m on Epwin’s balance sheet, the company is only being valued on a multiple of 4.8 times cash profits of £33m to enterprise value of £159m.

Of course, the recent profit warning from uPVC windows maker Safestyle (SFE:230p) highlights that trading conditions in parts of the RMI market are very challenging. Epwin is a market leader in uPVC window profile systems for fabricators of windows, doors, cavity closers and curtain walling, and is the market leader in PVC-UE extruded 'cellular' roofline and cladding profile systems for the replacement and installation of soffits, barge boards, cladding and window trims. That said, new-build activity appears to be robust which should offset some of the weakness on the retail side. Admittedly, the ongoing slump in sterling – the currency is down almost 7 per cent against the euro since my last update in early May – is adding to cost pressures, hardly helpful in the current trading environment when building products suppliers are attempting to pass through higher input costs. There is also a second-half weighting to the numbers, providing investors with another reason to err on the side of caution.

Having said all that, I still feel they are being overly cautious. For starters, Epwin has invested £50m, including earnouts acquiring three companies between late 2015 and June 2016: Wrexham-based Ecodek, a leading manufacturer and supplier of wood plastic composite; Tamworth-based Stormking, a leading supplier of moulded GRP building components to the housebuilding and construction industry in the UK; and National Plastics, a national distributor of building plastics to the trade. All three acquisitions have performed at least in line with expectations, so much so that Epwin has just paid out on the earnout on the Stormking acquisition, highlighting that not all parts of its business are under pressure.

I also feel that the 25 per cent share price slump since end of April is factoring in a profit warning of far greater magnitude than is likely even in a worse-case scenario. Indeed, even without factoring in the operational improvements management have put in place in its fabrication business, and ignoring any upside from marketing initiatives, the fact remains that Epwin results this year will benefit from an extra five months' trading from National Plastics, acquired in June 2016.

So, ahead of a pre-close half-year trading update next month, I believe the de-rating has gone too far, and rate Epwin’s shares a high-yielding and lowly-rated recovery buy.

 

Quarto’s guidance debacle

Just as was leaving for holiday at the start of this month, small-cap book publisher Quarto (QRT:140p) issued a trading update, and one that indicated softer trading in the first half this year. Bizarrely, the company also announced that the guidance it had previously given to the market had been set to high!

The guidance had been using a publishing-only pre-tax profit baseline for the 2016 accounts that didn’t reflect the benefit of $2.1m relating to the reduction in the amortisation of capitalised pre-publication costs. Analyst Peter Ashworth at house broker Stockdale Securities says this had been used in the 2016 accounts as part of the review of the useful lives of the pre-publication costs which standardised the useful life to three years, adding that the revision effectively reduced the amortisation charge by US$2.1m (£1.6m at current exchange rates) in 2016. As a result, the baseline for 2017 had been set way too high which prompted Mr Ashworth to cut his current year pre-tax estimate by US$1.6m.

To compound matters, the company also warned that its first-half performance had been weaker than expected, reflecting the soft retail environment in its domestic markets, thus resulting in a lower-than expected trading performance in the year to date. Furthermore, and reflecting recent disposals, shareholders can now expect a more pronounced second-half weighting for what is now a pure-play publishing business. This news prompted Mr Ashworth to wipe another US$1.5m off its pre-tax profit forecasts to bring the total downgrade to US$3.1m, representing a 22 per cent profit shortfall on his previous profit estimate of US$14.1m. So, instead of generating modest growth year on year, profits are now expected to slump. Mr Ashworth also raised his year-end net debt forecast from US$54.4m to US$59.3m, so the likely reduction of borrowings from last year’s net debt levels of US$61.9m will be less than shareholders had anticipated. Based on these new forecasts, forecast net debt equates to four times this year’s new cash profit estimate of US$15.2m.

In the circumstances, it’s hardly surprising that shareholders bailed out causing the share price to fall in a matter of days from 239p on 4 July when the announcement was made to a three-year low of 140p. It also means that the share price is well below the 261p level at which I first advised buying ('Small-cap value buys, 9 August 2016), having repeated the same advice at 285p ('On the earnings beat', 7 November 2016), and suggested scope for further upside after my 300p target price had been achieved when I commented on Aim-traded investment company Gresham House Strategic (GHS:920p,) which holds a small stake in Quarto (‘How the 2016 Bargain share portfolio fared’, 2 Feb 2017).

The company also announced the appointment of Brian Porritt as interim chief financial officer. Finance director Michael Connele is leaving the business in September, as had been announced in March. Mr Porritt has extensive experience in such assignments across technology, media and marketing services sectors and most recently completed a two-year assignment as the same role at healthcare communications and public relations group Huntsworth (HNT:61p). Hopefully, he will be better in communicating guidance to analysts to avoid a repeat of this debacle.

When the company releases its half-year results on Tuesday, 8 August, I will be looking for the board to reiterate guidance given earlier this month for the business to perform “significantly better in the second half, driven by a strong publishing programme, and resilience of its publishing portfolio and enduring backlist”. Of course, there is a risk that soft retail conditions could get softer still, and with a second-half bias to the numbers, this increases the risk of another warning later this year. But if that can be avoided then there is value on offer here with Quarto’s shares trading on less than five times downgraded EPS estimates of 40 cents, or about 30p at current exchange rates; rated on an enterprise value to cash profit multiple of 6.4 times downgraded 2017 cash profit estimates after factoring in the debt pile; and offering a 8.2 per cent dividend yield based on last year’s full-year payout being held at 15 cents, or about 11.5p a share.

In the circumstances, and in light of the hefty share price fall already, I feel it’s sensible to hold on at least until the half-year results are released in a fortnight’s time, and await further clarity on the directors’ profit guidance for the rest of this year. Hold.