Join our community of smart investors

Exploiting buying opportunities

Simon Thompson highlights a quartet of small caps
November 22, 2017

I had an informative results call this week with the directors of Redditch-based Solid State (SOLI:395p), a supplier and design-led manufacturer of specialist industrial and rugged computers, battery power packs to the electronics market, microwave systems and advanced antenna products.

The company has delivered the robust sales growth I was expecting when I suggested buying the shares at 410p at the time of the full-year results (‘A trio of small-cap buys’, 10 Jul 2017), or for that matter when I advised running profits a month later at 530p after my 480p target price had been hit ('High-yielding opportunities', 8 Aug 2017). Revenue increased by 12 per cent to £22.5m in the six months to the end of September 2017, reflecting a 20 per cent surge in turnover in the distribution division which accounted for 42 per cent of the total, and 7 per cent growth in the higher-margin manufacturing business.

The downside is that the change in business mix, combined with longer lead times in its antenna business, which accounts for 10 per cent of total revenue, and planned higher investment in sales meant that gross margins declined by three percentage points to 28 per cent and proved a drag on profits. This had been flagged in a pre-close trading update a month ago when I rated the shares a hold at 435p (On the money’, 24 Oct 2017).

However, the 10 per cent markdown in the share price since then looks overdone to me given that the sales effort is clearly working: the end October order book is up 38 per cent year on year to £20.1m, and order intake hit an all-time high last month, suggesting that analysts' forecasts that point to a flat full-year pre-tax profit of £3.1m on revenue up 12.5 per cent to £45m are well supported.

Moreover, since the end of September, the company has won a second major contract for mesh radios for the UK Ministry of Defence, segmenting its position as a key supplier in this area. And its computing manufacturing business, accounting for a quarter of sales, continues to trade in line with the 9 per cent improvement in billings seen in the first half; and the directors note “firm evidence that the oil and gas sector is showing a sustained recovery beyond just a re-stocking spike, highlighting a new battery pack project for a new well development in Africa”. That’s good news for Solid State’s power business, accounting for a quarter of sales.

So, with the order book robust, and the latest news from the high-margin manufacturing segments equally positive, then it’s realistic to expect the recent uptick in order intake to continue, and with it a decent return to profit growth in the 2018-19 financial year. Trading on a price-earnings ratio of 12 and offering a 3 per cent historic dividend yield, the shares are being harshly valued. Buy.

 

Bilby firmly on the mend

Aim-traded Bilby (BILB:89p), a provider of gas heating appliance installation and maintenance services to residential and commercial properties, has posted a near-trebling of first-half pre-tax profit to £2.9m on revenue up 28 per cent to a record £38.5m, an outcome that more than doubled adjusted EPS from 2.7p to 6.2p and provided clear evidence that the problems that beset the company last year when I advised holding the shares for recovery at 49p are consigned to history ('On a roll', 20 Dec 2016). Other investors clearly share the same view, as the share price hit the upper end of my target range of 85p to 90p, which I outlined after the company delivered a hefty profit beat on the previously upgraded estimates of house broker Northland Capital  (‘A trio of small-cap buys’, 27 Jun 2017).

Importantly, contract momentum continues to build across the business, which in turn improves sales visibility and derisks profit estimates. Awards include an eight-year gas servicing contract with East Kent Housing that has been expanded to cover 16,700 properties and provide a range of building maintenance and electrical works, as well as the installation of 1,500 new boilers each year; a seven-year gas servicing contract with Walterton and Elgin Community Housing for work on more than 400 properties; and a three-year gas servicing contract, with a two-year extension option, with Sussex and Hampshire housing association Saxon Weald, for work on more than 4,000 properties.

Contributions from last year’s two acquisitions – DCB and Spokemead – are playing a significant part in winning new business, and I would also flag up that last summer’s tragic fire at Grenfell Tower has prompted a review by many local authorities of the safety practices at their properties. DCB is a provider of building, refurbishment and maintenance services to housing associations and local authorities throughout Kent, Sussex, Essex and London; and Spokemead is a specialist in electrical installation, repairs and maintenance services to local authority-owned housing stock. Bilby now services more than 300,000 properties and boasts visible future revenues in excess of £320m.

In light of the bumper trading performance, and the fact Bilby has delivered adjusted earnings per share (EPS) of 6.2p in the first half alone, analyst Mike Jeremy at Northland Capital upgraded his full-year EPS estimate from 9p to 10.5p, implying 37 per cent growth year on year, for the 12 months to the end of March 2018, rising to 12p the year after. Predictions of a hike in the dividend per share from 1.75p to 2.75p look well founded too. So, with the earnings risk skewed firmly to the upside, I continue to rate Bilby’s shares a buy and have raised my target to 120p. Buy.

 

GYG’s order book set to make waves

The hurricanes that ravaged the American east coast have led to a number of small delays in the start dates of refit contracts at GYG (GYG:123p), the global leader in new-build and refit superyacht painting. That’s because some owners decided to extend their Mediterranean sailing season before transferring their prized vessels to the Caribbean for the winter months.

Importantly, all the work has now commenced, but the net result will be that up to €4.9m (£4.4m) of revenue and €1m of cash profits will be pushed into the 2018 financial rather than booked in 2017. Guidance now points towards 2017 pre-tax profit increasing by 14 per cent to €5.8m on revenue of €61m to deliver EPS of 8.6¢, albeit that’s shy of the €7m profit forecast when the company listed its shares, at 100p, on Aim and I suggested buying them (‘Floating a profitable passage’, 4 Jul 2017).

Of far more significance is news that GYG’s current order book of €18.1m is up 37 per cent year on year, underpinning analysts’ maintained and conservative looking expectations that GYG can deliver revenue of €71m in 2018, pre-tax profit of €8.6m and EPS of 12.9¢. On this basis, the shares are priced on a modest 10.5 times forward earnings and offer a prospective dividend yield of 5.4 per cent based on a 6.6p payout in 2018. In my book that represents great value and I maintain my 170p target price (‘Plain sailing’, 27 Sep 2017). Buy.

 

Flushed out

It’s not often that a company announcement leaves me speechless, but that’s what Blackburn-based tissue maker Accrol (ACRL:40p) achieved this week.

I advised buying the shares around the 100p mark when they listed on Aim ('Clean up with Accrol', 6 Jun 2016), and subsequently recommended running profits at 144p when the company issued an in-line trading update in September and appointed a new chief executive, Gareth Jenkins, from DS Smith, one of Europe’s leading packaging companies, where he had been managing director of the UK and Ireland packaging division (‘A trio of small-cap plays’, 18 Sep 2017).

At the time, analyst Mike Allen at house broker Zeus Capital was predicting a rise in Accrol’s pre-tax profits from £13.5m to £14.6m on revenues up 15 per cent to £155m in the 12 months to the end of April 2018, after taking “more prudent gross margin assumptions” and noting that the challenging trading environment “has made passing on increased costs to customers more difficult”. EPS estimates of 12.5p covered last year’s payout of 6p a share more than two times, implying the shares were being priced on a modest 11.5 times earnings and offered a 4.2 per cent dividend yield. Debt was not an issue as net borrowings of £19m at the April 2017 year-end represented only 1.2 times historic cash profits of £16.1m.

Despite the reassuring trading update in September, a month later the company issued a profit warning, noting that profits were being hit by input cost pressures resulting from a rise in parent reel prices; slower-than-anticipated product price increases; and a significant fine being imposed by the Health and Safety Executive (HSE) than was previously expected in relation to an incident that occurred prior to the IPO, and was not disclosed in the Admission document. To compound matters, the company’s cash position was being squeezed, prompting the suspension of the shares to enable its bankers, HSBC, and major shareholders to come to some arrangement. I covered the announcement at the time ('Trading plays’, 9 Oct 2017).

The full extent of the problems were disclosed this week when the company announced a proposed placing of 36m shares at 50p each to raise £18m, subject to shareholder approval at a general meeting on Friday 8 December, a fundraise that will increase the shares in issue by 38 per cent. However, what really shocked me was the update on the net debt position, which has ballooned to around £22m, even after factoring in the proceeds of the placing, a marked deterioration since April. Only a small part of the increase relates to the HSE fine which will be in the range of £550,000 to £2.9m, subject to a one-third discount for Accrol’s early guilty plea. Sentencing is expected on Wednesday 17 January 2018.

Furthermore, instead of delivering cash profits of £17.5m in the year to the end of April 2018 as Mr Allen had predicted in early September, the board now expects “break-even or a marginal loss”. The directors point to the 13.7 per cent rise in pulp prices between January and October, a cost pressure acerbated by foreign currency movements, and one that has increased parent reel input costs. The problem I have with this is that these factors are hardly new; the company highlighted them at the time of the full-year results in the summer, and again in the September in-line trading update. Also, sterling has actually appreciated against the US dollar since both those announcements were made, and has risen against the euro since the September trading update too.

The lack of visibility on Accrol’s earnings is another concern, as the directors go to pains to point out that the trading performance for both the 2018 and 2019 financial years is extremely sensitive to a number of key variables – parent reel pricing, the exchange rate between sterling and the US dollar, and the level of turnover – which could lead to a breach of the cash profit covenants on its credit facilities. That’s worrying given the cash profit covenant for the financial year to the end of April 2019 has only been set at £4.1m, or 75 per cent less than Accrol reported in the 2017 financial year.

Also, although the directors have “made tangible progress on agreeing price increases with its customers and are confident of a positive outcome to these negotiations”, they add that “price increases may result in a reduction of volumes from customers... and if there were to be greater volume loss than expected, then this would adversely impact financial performance and the working capital position.” Given this trading backdrop, the final dividend has been axed, albeit the we note that the board's intention is to return to the dividend list at the earliest appropriate opportunity.

The bottom line is that there are simply too many red flags to have any confidence in backing a turnaround at this stage, which is why Accrol’s shares plunged from 133p to 40p on relisting, turning a 33 per cent paper profit into a stomach-churning 60 per cent loss. Sell.

 

■ 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