Balancing risk and reward

For starters, investors are eagerly awaiting the European Central Bank’s next meeting on Thursday 7 September and, in particular, for any indication of a less accommodative stance on monetary stimulus given the strong recovery across the eurozone. If money talks, then the surge in the euro to its highest level against the US dollar since January 2015, rising by 14 per cent against the greenback since April this year, is a pretty strong signal that the smart money is betting the tone of the ECB’s meeting will be more hawkish.

Fast forward to Wednesday 19 September, and attention will be firmly focused on Federal Reserve chairman Janet Yellen, who now looks increasingly less likely to be given a second term in the job when it’s up for review in January after going head to head last week with President Donald Trump when she expressed strong views over the level of regulation needed in financial markets. Having indicated a month ago at the last Federal Open Market Committee (FOMC) to expect a normalisation of the US central bank’s US$4.5 trillion (£3.5 trillion) balance sheet ‘relatively soon’, then investors could be in for a double whammy: the potential for tighter short-term rates if expectations for a December rate high in the Fed Funds rate narrow; and the start of the unwinding of the Fed’s balance sheet. I feel both the ECB’s and FOMC’s announcements have the potential to raise equity market volatility even if the North Korean situation stabilises.

In a risk-off environment, investors have been penalising companies announcing any negative news: the savage markdowns last week in shares of global advertising giant WPP (WPP:1,422p); sub-prime lender Provident Financial (PFG:909p); and Dixons Carphone (DC.:180p) being a case in point. The small-cap sector has not been immune, either, as yesterday’s 18 per cent share price slump in Chariot Oil & Gas (CHAR:10.25p), a small-cap exploration company with activities in Morocco, Namibia and Brazil, clearly highlights.

Morocco holds the key

I have more than a passing interest here as I last advised running profits when the shares were 12.5p (‘Bargain shares second chance’, 18 Aug 2017), having earlier recommended to bank an 111 per cent profit on two-thirds of your holdings at 17.5p ('Bargain shares on a tear', 3 Apr 2017) after the share price raced ahead on my on my 8.29p buy-in price in this year’s portfolio.

The news that led to yesterday’s sell-off relates to Chariot’s exploration licences on Southern Blocks 2714A and 2741B in offshore Namibia where it is the operator with an 85 per cent economic interest. The directors were unable to attract a partner for these blocks, so they have elected not to enter into the first renewal exploration period, but have instead secured an option to back-in an interest in the licences for nil cost. The decision not to enter into the next exploration period was made in line with the board’s risk management strategy, its focus on portfolio management and capital discipline.

That’s not to say that these Namibian prospects are a lost cause as analysis of 2,128 kilometres of 2D seismic data, and the reprocessing of the historic 3D seismic data over the Southern Blocks, identified gas prospects in the Aptian clastic onlap play. However, the technical risk associated with these prospects deterred potential partners from committing to a programme of exploration drilling in the current environment. That could change over time, so in exchange for facilitating the partnering programme, Chariot has the option of taking a 10 per cent equity interest in the licence at no financial consideration following the drilling of the first exploration well in each of the licences. I would point out that analyst Dougie Youngson at broking house finnCap had not included the two prospects in his valuation which points to a maintained target price of 35p for Chariot’s equity.

Of far more interest to shareholders will be the outcome of the drilling programme by oil giant Eni at the Rabat Deep Offshore permits in Morocco. This is scheduled for the first quarter next year, the full details of which I covered in my last article (‘Bargain shares second chance’, 18 Aug 2017). Chariot has a 10 per cent equity interest and a capped carry for its share of an exploration well which will cost over $50m (£38.6m) to drill. The prospect could be worth 17p a share on a risked basis to Chariot's shareholders and as much as 87p a share on an unrisked basis if it hits pay dirt, according to some industry experts.

Clearly, with Chariot’s cash pile of US$25m (£20m) equating to more than two-thirds of its market capitalisation of £29m, then exploration upside from Rabat could be transformational for the company. That was my main bull point when I suggested buying the shares at 8.29p in early February this year, and that has not changed.

In the circumstances, I would still recommend running profits on the balance of your holdings and let weak sellers exit. The risk:reward ratio on a six-month basis, a period taking into account the Moroccan drilling programme, could still be very favourable. Run profits.

BATM on course for strong second half, and beyond

I had an interesting results call this morning with DR Zvi Maron, chief executive of BATM Communications (BVC:18p), a provider of medical laboratory systems and network solutions, and a constituent of my 2017 Bargain shares portfolio.

The company reported a small cash loss of US$303,000 (£235,000) on revenues up 10 per cent to US$49.8m in the six months to end June 2017, which in turn resulted in an IFRS operating loss of $2m after accounting for a non-cash depreciation charge of US$1.11m and amortisation costs of $0.64m. However, the board’s guidance points to a much stronger second half performance and Dr Marom says the company is trading in line with the market forecasts of analyst Robin Speakman at house broker Shore Capital which suggests break-even at the pre-tax level for the full year based on BATM delivering second half cash profits of $2.3m on revenues of $46.3m.

The order backlog across the business offers substance to these forecasts. For instance, the company’s Eco-med division currently has the highest ever number of orders with a backlog of $4.4m, most of which will be delivered in the second half. This unit has won three major contracts worth $6.75m since launching its biological waste solution at the end 2016. Developed for the biopharmaceutical industry by one of the largest manufacturers of vaccines for animal health, the solution automates the process of disposing of biohazardous waste safely and enables the treatment of the waste on-site.

Since launching a mobile version of the agri-waste product earlier this year, BATM has won its first order, worth $3.6m, and Dr Marom is very confident of getting another major orders before the year-end in a market that is largely untapped. He also notes that the division has commenced sales of a new unique patented Intergrated Shredder and Steriliser product, ISS 500, for the disposal of medical waste in hospitals and is “receiving a lot of interest because of its automated reloading system, which reduces human exposure to medical waste.” The ISS 500 machine is sold for around $100,000 and the first three units will be delivered to large US hospitals this autumn. If successful, then there is obvious scope for a roll-out as Dr Marom anticipates. I would also flag up that the bio-medical distribution business, accounting for 40 per cent of group revenues, increased sales at a 10 per cent underlying growth rate in the first half, and on higher margins too, and Dr Marom says that growth in the second half is even higher still.

Expect a better margin performance from BATM’s cyber and network solutions businesses as a previously delayed $5.2m contract in the cyber unit is delivered to a government defence department, most of which will flow through in the second half. BATM is also engaged in several ‘proof of concept’ trials with potential customers across multiple countries, highlighting the scope for future orders. In fact, Dr Marom expects another multi-million dollar contract win here in the second half. Maintaining a secure and safe telecoms network is becoming increasingly important, so it’s worth pointing out that BATM is “seeing increased demand for its SDN/NFV technology solutions” and has been conducting several “successful proof of concept trials.” Expect orders to materialise from some of these trails later this year too.

The other key take for me in the results was that the company only posted a net cash outflow of $400,000 in the six month trading period, highlighting the fact that $1.7m of the operating loss of $2m was down to non-cash depreciation and amortisation charges. In fact, shareholders funds actually edged up slightly to $81.2m, a sum worth 15.6p a share, so there was no erosion of the balance sheet strength. Indeed, it remains rock solid with net funds of $16.2m, a sum worth 3.1p a share, accounting for 20 per cent of BATM’s net asset value, and property assets worth $20m, or 3.9p a share. Current assets of $76m are more than double current liabilities, highlighting a strong liquidity ratio too.

The point being that if BATM can return to profitability in the second half, and ramp up profits in 2018 when Mr Speakman is forecasting  a 60 per cent rise in full-year cash profits to $4.2m on revenues of $101.5m, then the shares will warrant a rating much higher than the current price-to-book value of 1.15 times.

There is also hidden value in the balance sheet as Egens, a leading biotechnology company, acquired a near 5 per cent stake in BATM’S 95 per cent-owned subsidiary, Adaltis, an Italian manufacturer of medical diagnostics equipment, in a deal that placed a notional valuation of $58m on the business last year. That’s a significant sum in relation to BATM’s own market value of £72m especially as the company has net cash of £12m on its balance sheet and property assets worth around £15.6m. Moreover, there is a hidden gem in the company's joint venture, Ador, established at the end of 2015, which now has 40 patents for molecular diagnostic systems in the US. This portfolio of patented technology could be a very attractive investment for a large US company, and one offering considerable upside to BATM's shareholders.

So, although BATM’s shares are the laggard in this year’s portfolio, down 9 per cent on an offer-to-bid basis since early February, I am very comfortable maintaining my buy recommendation ahead of what is likely to be a robust second half performance, prospects of further multi-million dollar contract wins, and the momentum continuing into 2018 and well beyond. Buy.

Awaiting a judgement

As expected the half-year results from solar wafer maker PV Crystalox Solar (PVCS:22p) reflected the dire trading conditions in an industry with selling prices decoupled from production costs due to massive industry oversupply. A first half loss of €5.4m (£5m) led to a decline in net assets from €41.7m at the start of this year to €35.7m by the end of June, of which net funds of €27.9m and inventories of €7.4m are the two main assets on the company’s balance sheet. Based on the current exchange rate of £1:€1.075, the net asset value per share is about 20.75p, although this excludes the costs of exiting its UK production.

That’s because the board announced in mid-July, so post the half year end, that in light of adverse trading conditions it will cease all ingot production operations in the UK during the third quarter this year and will focus on the niche low carbon footprint wafer market where it has some competitive advantage. I covered that announcement when I rated the shares a hold at 22.5p (‘Value opportunities’, 19 Jul 2017), so the share price is little changed since then.

The reason for maintaining an interest is simple: the International Court of Arbitration of the International Chamber of Commerce will announce its ruling next month over a dispute between the solar wafer maker and one of its customers, a leading photovoltaic company. The unnamed photovoltaic company failed to purchase wafers in line with its obligations under a long-term sales contract with PV Crystalox, hence the decision of the board to take the matter to arbitration in March 2015.

The board subsequently stated that if the judgement is found in its favour then compensation could be a "multiple of its market capitalisation", albeit the share price then was half the current level. That said, the directors reiterated the same point again in the half-year results which suggests that a favourable judgement could be worth at least the company’s current market capitalisation of £35m, and perhaps substantially more.

Of course, even if successful, PV Crystalox still has the task of recovering the full amount of the award and there is no guarantee that the unnamed defendant will be able to pay. However, with net cash of 16.2p a share on its balance sheet, and stocks valued at 4.3p a share at their market value, then there is decent asset backing to support the share price. So, with PV Crystalox shares  being offered in the market at 22p, and the ICC ruling due in the coming weeks, I would definitely hold on, having included the shares, at 19p, in my 2014 Bargain Shares Portfolio. Hold.

Finally, I published an article yesterday highlighting four small-cap repeat buying opportunities and also updated the list of all the share recommendations I have made this year.