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Six seductive small caps

Simon Thompson uncovers six alluring investment opportunities
September 11, 2017

The September results season is in full flow and in today's column I cover six small caps on my watchlist. Expect another double dose later in the week as around 10 of the companies on my radar are scheduled to report in the coming days.

Aircraft leasing company Avation (AVAP:243p) has delivered the bumper set of full-year results I was anticipating when I rated the shares a strong buy at 220p a couple of months ago (A trio of small-cap buys’, 10 Jul 2017). Moreover, there is every reason to believe the share price will continue to gain altitude towards my 275p target price.

In the 12 months to the end of June 2017, the company’s aircraft leasing revenue increased by almost a third to $94m (£73m), a performance that drove up pre-tax profit by 18 per cent to $21.5m and produced EPS of 36.3¢, or 28.6p using the average exchange rate over the period. Avation also completed the sale of six of its leased ATR 72 aircraft to a single commercial lessor, Chorus Aviation Inc. (TSX: CHR), a deal that released $31m in net cash proceeds and has boosted cash on Avation’s balance sheet to $88m. The disposal also reduced the company’s loan-to-value ratio to 72 per cent after taking into account of gross borrowings of $648m, most of which is secured on its remaining portfolio of 35 aircraft. Book value per share is now around 321¢, a sum worth 246p a share at the current sterling-US dollar exchange rate.

And there's hidden value in the balance sheet as Avation has 27 options on new aircraft for delivery, which excludes six further ATR72-600 planes currently on order. Bearing this in mind, John Cummins, analyst at house broker WH Ireland, points out that the company is well positioned to benefit from “the firming of the ATR turboprop market with significant orders coming from Iran, India and China”. I covered this very subject in some detail when I discussed the dynamics of the turboprop market in my last article (‘A trio of small-cap buys’, 10 Jul 2017).

The point is that only 85 new ATR turboprop aircraft are being manufactured each year, so a firmer market for new ATR aircraft is clearly supportive of the opportunity for Avation, the lessor that has the largest number of ATR options and orders. Furthermore, if demand in China takes off, as seems highly likely – aircraft manufacturer ATR has signed a Letter of Intent with Shaanxi Tianju Investment Group for the purchase of 10 ATR 42-600s to develop a commuter service in Xinjiang, China – then Avation's portfolio of planes and options will become even more valuable still.

Importantly, the quality of the existing fleet is improving: the average age of the 35 planes is just over three years, the average lease terms 7.5 years, and 95 per cent of the debt secured on the aircraft is either fixed or hedged. This makes the planes even more attractive for commercial buyers, and is supportive of sale prices on disposal at a premium to the net carrying value of the aircraft. Indeed, although one of Aviation’s three Airbus A320 aircraft was out on lease to AirBerlin, an airline that became insolvent in mid-August, the company holds security deposits and substantial maintenance reserves as security, and the directors expects a “prompt transition of the aircraft to another airline”, a reflection of the interest it has received. I also understand that they are assessing a number of aircraft, and are looking at the possibility of adding twin aisle planes to the fleet for the first time.

The good news gets even better because Avation’s board has just paid out a dividend per share of 6¢, up 85 per cent year on year, highlighting their willingness to hand back some of this year’s record profit to shareholders. This means that the shares trade slightly below a conservative book value, are rated on a modest 8.5 times earnings for the year just ended, and offer a 1.9 per cent dividend yield. That's great value and certainly justifies my 275p target price.

Please note that I first advised buying the shares at 159p ('Get on board for blue-sky gains', 11 Sep 2014), since when the company has paid out total dividends of 13.25¢ (10p) a share. Buy.

 

A slick investment

Shares in Faroe Petroleum (FPM:95.5p), an independent oil and gas company primarily focused on exploration, appraisal and production opportunities in Norway and the UK, have proved volatile since I last rated them a medium-term buy at 91.75p ('Eight small-cap plays', 27 Mar 2017), as has been the case since I first advised buying at 75p just over two-and-a-half years ago ('A slick operator', 5 Feb 2015).

A key reason for buying the shares in the first place is the strong correlation between the oil price and Faroe’s share price, a relationship that’s completely understandable given that the oil price is a critical factor in determining the commercial viability of the company’s projects. It’s therefore worth noting that Brent Crude has rallied back strongly from its summer lows of around $45 a barrel, and is now within a few dollars of the $57 a barrel highs that acted as a glass ceiling earlier this year. The rally in black gold is warranted for a number of reasons.

Firstly, global oil inventories have been falling, down by 500,000 barrels a day to just over 3bn barrels in the second quarter this year, according to Paris-based International Energy Agency (IEA), reflecting supply cuts from big producer countries. At the same time, the IEA upgraded their global oil demand growth numbers, which suggest total consumption will hit 97.6m barrels per day this year, a rise of 1.5m barrels. Opec, a body that represents nations that control a third of global oil output, has also raised its global demand forecasts, too, for both 2017 and 2018, while at the same time lowering estimates for production outside of the cartel. Of course, supply is also being pushed up, led by Libya which is exempt from the Opec cut agreement, but oil watchers are more interested in the drawdown of inventories for short-term moves in the oil price.

Bearing this in mind, the impact of Hurricane Harvey is having an effect as around a third of US oil refineries have been impacted by the storm and refineries that are still operating in Texas are struggling to import crude because of outages at port facilities. Some oil analysts suggest that 3m barrels a day of US crude oil refining capacity has been grounded, representing a sixth of the country’s total, because of the disruptions at Gulf coast refineries including the country’s largest refinery, The Saudi-owned Motiva refinery in Port Arthur, Texas. That refinery alone has capacity to process around 600,000 barrels a day of crude. Shale oil producers have also been impacted as pipelines from the largest US shale field, the Permian Basin, to refineries in Texas were shut down. And this is not just a US-centric problem, as the country is the world’s largest exporter of petroleum products, exporting the equivalent of 3m barrels each day.

 

Strong newsflow

Importantly, the ongoing rally in the oil price comes at a time when Faroe has been announcing some positive news. For example, at the end of last month, the company commenced the spudding of the Goanna exploration well located in the northern part of the Norwegian North Sea, near the border with the UK and adjacent to the giant producing Statfjord and Snorre fields, which offer potential for alternative export routes. The Goanna prospect is targeting a structural and stratigraphic prospect of Upper Jurassic Munin Formation sandstones. Faroe has a 30 per cent interest in the prospect and its associated costs of drilling this well are being fully carried by its joint venture partner, Wellesley Petroleum, up to the budgeted dry hole cost.

Expect more newsflow from other parts of Faroe’s exploration portfolio, too. Graham Stewart, chief executive of Faroe, says that: "Our rolling exploration programme continues with the Iris/Hades (Aerosmith) exploration well, and Fogelberg appraisal well scheduled for the end of the year and the beginning of 2018, taking advantage of low drilling costs and Norwegian tax incentives."

The company has also been making some smart acquisitions, having just acquired a further 14 per cent interest in the producing Blane field, located on the Central Graben of the UK continental shelf, extending into the Norwegian sector, taking the company’s interest to 44.5 per cent. The purchase price of $5.25m equates to just $5 per barrel based on reserves of 1.1m barrels of oil equivalent (boe), although analyst Daniel Slater at broker Arden Partners “believes that there could be a further 2m to 4m boe gross upside from an infill well, which may be drilled going forward”. Strategically, the acquisition makes a lot of sense as Mr Slater points out that “Blane is a tieback to the Ula platform on the Norwegian side of the maritime border, an asset which forms one of Faroe’s North Sea hubs”, adding that “operating expenditure is $15 per boe, comfortably below Faroe’s average of $25 per boe in 2016.”

Mr Slater has edged up his risked net asset value (NAV) forecast to 105.1p a share risked, and his unrisked net asset valuation to 125.9p a share factoring in an oil price of $60 per barrel and a gas price of 40p a therm. He also notes that: “Faroe is a relatively low-risk way of playing the E&P [exploration and production] sector, but with upside provided by the production growth profile and results from the ongoing drilling campaign.” I completely agree and with the price of black gold heading higher, then I can see potential for Faroe’s share price to make headway again towards my 115p medium-term target price. Trading buy.

 

Molins packing a punch

The share price of small-cap packaging company Molins (MLIN:163p) have risen by 15 per cent on an offer-to-bid basis after I highlighted the valuation anomaly a couple of months ago, prompted by some fine equity research from analysts Paul Hill and Hannah Crowe at Equity Development (‘Four small-cap plays’, 4 Jul 2017).

The move is justified on many counts, not least of which is the disposal of its underperforming tobacco business, which has left the company with pro-forma net funds of £22m, a healthy sum in relation to Molins' market value of £32.6m. Furthermore, the sale of a packaging facility in Ontario, Canada, for a net £5.9m – a sum well in excess of the £1.5m book value of the assets – will bolster that cash pile by a further £4.9m when the deal completes in two months' time. Molins is leasing out a newly built plant nearby that facility at an annual cost of £350,000 and will spend £1m on fit-out costs.

Analyst Sanjay Jha at house broker Panmure Gordon forecasts a year-end net funds position of £28m, or 139p a share, slightly higher than Equity Development’s forecast of £27m. That’s solid asset backing and there’s still an outside chance that the company could yet reap a windfall from a slimmed-down residential planning application on a 10-acre site it owns in Buckinghamshire that's now surplus to requirements. An application for a mixed 131-unit scheme on the green belt land was turned down by the Secretary of State at the end of July, but Molins’ board still believes there may be scope to resubmit a slimmed-down version of the application for fewer housing. A decision will be made before the year-end.

Importantly, prospects are robust for the company’s remaining businesses, which supply high-speed packaging equipment and machinery. In the six months to the end of June 2017, Molins’ revenue shot up 40 per cent to £25.4m, buoyed by a trebling of sales in Asia Pacific to £5.6m, and 58 per cent top-line growth to £9.5m in the EMEA [Europe, the Middle East and Africa] regions. Turnover was flat in North America, the largest market segment, but the company was facing pretty tough comparatives there. More important is news that current order intake is supportive of full-year expectations that point towards underlying pre-tax profit rising from £0.9m to £1.1m on revenue of almost £48m, as analysts at Panmure Gordon predict to deliver a 39 per cent hike in EPS to 5p.

 

Drivers of growth

Critical to this growth, and predictions that Molins can grow revenue by 8 per cent in both 2018 and 2019, is demand from the pharmaceutical, healthcare, nutrition and beverage end-markets that the company services. These markets are expanding at around 5 per cent a year and have attractive underlying long-term growth drivers such as urbanisation, convenience and health awareness. During our results call, chief executive Tony Steels, who has led the company’s restructuring since his appointment in May last year, highlighted an ambitious medium-term target to grow revenue annually at an organic rate of 10 per cent, and generate a 10 per cent return on sales. It will take some doing as analysts at Equity Development predict an operating margin of 2.1 per cent this year, doubling to 4.6 per cent in 2018, rising to 5.7 per cent in 2019, but if it can be achieved the shares will clearly warrant a price well in excess of NAV of 203p a share.

That’s because as sales rise, and operational gearing of the business kicks in, then profit will rise sharply too. This explains why Panmure expects Molins underlying pre-tax profit to ratchet up to £2.6m in 2018 and to £3.6m in 2019, an outcome that should drive up EPS to 10.4p and 14.7p, respectively. Equity Development has similar forecasts. In other words, even without deploying its war chest on bolt-on acquisitions, there is a potentially a strong organic growth story here, and one that should support the reinstatement of the dividend in due course when profit hits a meaningful level.

So, with earnings-accretive acquisitions in the packaging sector on the cards, a new senior management team in charge, and the shares trading on 15.5 times next year's earnings estimates, falling to 11 times 2019 forecasts, I feel that Equity Development’s sum-of-the-parts valuations of 180p a share could yet prove conservative, and Panmure Gordon’s raised target price of 194p (up from 176p) is probably now more realistic.

Trading on a bid-offer spread of 160p to 163p, I continue to rate Molins’ shares a buy.

 

Alpha tender offer

A few weeks ago, I highlighted how a number of companies on my watchlist are playing the growing institutional appetite for private rental sector (PRS) housing ('A trio of small-cap buys', 22 Aug 2017). One of the companies is Alpha Real Trust (ARTL:135p), an investor in high-yielding property and asset-backed debt and equity investments in western Europe. I know the business rather well, having initiated coverage on the shares at 80p ('High-yield property play', 10 Feb 2016), and banked six quarterly dividends of 0.6p a share since then. The holding is currently showing a 67 per cent total return on an offer-to-bid basis.

In my article last month, I noted how Alpha has made £50m of disposals in the year to date, including £37m realised last month from the sale of a 70 per cent stake in its wholly-owned H2O shopping centre in Madrid to CBRE European Co-Investment Fund. As a result, Alpha has £38.5m of free cash on its balance sheet, a chunky sum in relation to the company’s £113m investment portfolio, and supportive of its investment in two large PRS schemes in Leeds and Birmingham that have a gross development value of £88m. The directors feel the company can afford to return around a third of this cash to shareholders, so they have announced a tender offer pitched at 123.1p a share to buy back 10m of the 69.2m shares in issue. This will enable some larger shareholders to book some profit which otherwise they would have been unable to do so.

Clearly, with Alpha’s shares being offered in the market on a bid-offer spread of 130p to 135p, it doesn’t make any sense for smaller shareholders to participate in the tender offer, especially as I upgraded my target price to 145p when I covered the investment case a few weeks ago ('A trio of small-cap buys', 22 Aug 2017). Also, the tender offer will be accretive to the company’s NAV, which stood at 162.4p at the end of June 2017. Assuming shareholders tender 10m of their shares at 123.1p each, this reduces the company’s NAV from £112.6m to £100.3m, but reduces the issued share capital from 69.3m to 59.3m to boost NAV per share to 169p.

In other words, at the current offer price of 135p, Alpha’s shares are being priced on a 20 per cent discount to the end of June 2017 pro-forma NAV post the tender offer. That’s still value in my book, and I continue to see share price upside. Buy.

 

Car dealers: value buy, or value trap?

In the aftermath of the EU referendum I highlighted a number of investment opportunities, some of which were likely beneficiaries of a positive currency tailwind on their earnings, and some offered potential for M&A activity (‘Brexit: Reality check’, 28 Jun 2016). On the whole, the calls I made have worked out well and spectacularly so in a few cases: chip designer Arm (ARM) was taken over within weeks later at a price point 61 per cent higher than in my article; and the share prices of specialty chemicals groups Victrex (VCT) and Croda (CRDA) have risen by 53 per cent and 33 per cent, respectively.

However, not all the companies I highlighted have enjoyed a strong recovery. The heavily asset-backed and lowly-rated UK car dealers are a case in point: the share prices of Cambria Automobiles (CAMB:65p) and Vertu Motors (VTU:45p) are only slightly above the levels at which I subsequently published an update last autumn ('Value plays', 18 Oct 2016), having reversed 20 per cent from their April and May highs this year.

Admittedly, newsflow hasn’t helped sentiment as new car volumes and used car margins have been softer since April, partly due to sales being pulled forward into a bumper March as buyers avoided the increased vehicle exercise duty that came into effect on 1 April, but also due to more cautious car buying activity generally. The net result is that new car sales declined by 16 per cent in the second quarter across the industry, and by over 9 per cent in July, and by more than 6 per cent in August. That said, we are still on course for one of the best years ever with trade body The Society of Motor Manufacturers and Traders (SMMT) forecasting 2.59m of sales over the course of 2017, just 100,000 below the record sales of last year, an outcome higher than in any year between 2000 and 2014. This is why earnings forecasts haven’t actually gone into reverse. It’s also worth noting that volumes and margins remain robust in dealers’ high-margin aftersales, in part a reflection of the significant increase in the new car parc in recent years.

For example, analysts at broker Zeus Capital still expect Vertu Motors to deliver revenue of £2.85bn in the 12 months to the end of February 2018, a result that should lift pre-tax profit by 15 per cent to £31.5m and produce fully diluted EPS of 6.1p to support a 7 per cent rise in the payout to 1.4p a share. Zeus anticipates two-thirds of their profit estimate was earned in the first half to the end of August 2017, so a large chunk of forecasts are in the bag even if car buyers are more cautious in the new registration plate month of September.

On this basis, Vertu’s shares are rated on seven times forward earnings, and offer a 3.2 per cent prospective dividend yield. They are also priced on a deep discount to NAV of 62p a share, even though £182m-worth of freehold and leasehold property exceeds its market capitalisation, and the company started the financial year with net funds of £21m, or 5p a share. Furthermore, there is hidden value in its estate of 124 outlets, as highlighted by the recent sale-and-leaseback of Vertu’s freehold Jaguar Landrover dealership in Leeds at a 40 per cent premium to its £10m book value. Cambria is priced on a similar earnings multiple for the financial year to August 2017, even though three-quarters of its market capitalisation is backed by leasehold and freehold property. The company has an ungeared balance sheet, too, according to analysts at N+1 Singer.

 

Recessionary valuations imply collapse in sales

Clearly, the valuations suggest that a savage downturn is on the cards, and one that will decimate car dealers’ profits. However, that is unlikely to happen unless credit conditions deteriorate and impact funding lines for new car sales, consumers become overly cautious, and manufacturers fail to take the initiative. However, they are already reacting to the sales slowdown. The launch of scrappage schemes may persuade some owners of an estimated 19m old standard polluting cars to trade them in, and feel better for their green credentials, but ultimately these schemes are a mechanism to boost car makers’ sales. It’s also telling that Cambria’s management confirms that orders for the all important month of September are building in line with their cautious budgets, so although it’s early days the catastrophic downturn in trading being factored into valuations appears to be overcooked.

Admittedly, the Bank of England is keeping a close eye on the rapid growth in Personal Contract Plans (PCP), the means by which the majority of new cars are funded by consumers, and where there are concerns in some quarters over the credit quality of many borrowers. Ultimately, though, this method of funding of new car purchases only becomes a problem if borrowers default on their credit commitments, either because they become overstretched or because their income dries up due to unemployment. The latter is clearly not an issue right now with the UK’s employment rate of 4.4 per cent at the lowest level since the 1970s. Furthermore, while some car owners may regret their purchases, the vast majority are clearly happy to fund them this way, hence the growth in the PCP market.

In the circumstances, and having taken all the issues affecting the car dealers into consideration, I feel the risk factors embedded into the current valuations appear to me overdone and rate the shares in both companies speculative buys at the current level.

Please note that I first advised buying shares in Cambria at 57.5p (‘Drive a rerating, 13 Jul 2015), so the holding is still in the black even after reversing all of this year’s gains. My call to buy shares in Vertu did well initially, with the share price rising from my 66p entry point (Poised for a strong rally’, 9 Sep 2015) to a nine-year high of 79.25p in January last year, but it has since reversed those gains and, at 45p, is well in the red even after factoring in dividends.

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com for £14.99, plus £2.95 postage and packaging, or by telephoning YPDBooks on 01904 431 213 to place an order. It is being sold through no other source. Simon has published an article outlining the content: Secrets to successful stock picking