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Value’s hiding place

Value does not respond well to attention. It has to be coaxed out
Value’s hiding place

Value is often where you least expect it and it is often in the dullest vehicles. Or – to put it the other way around – it’s least likely to be found in racy, exciting vehicles that everyone’s ogling and chasing. That’s probably to be expected. After all, the exciting situations are the ones that grab the attention. They are likely to stimulate lots of dealing activity, which should – or at least could – mean that prices get driven out of the musty corners where value hides and into the spotlight where it evaporates in the heat.

Take Plus500 (PLUS), which provides a spread-betting market place and which is one of the four companies whose shares are traded on the Alternative Investment Market (Aim) to which I want to give attention as I seek new holdings for the Bearbull income portfolio. Plus500 reports a surge in activity as punters get their fix trading contracts for difference (CFDs) in Bitcoin, Litecoin, Ripple and similarly exotic products that offer a novel way to lose money. Earlier this month, it reported that revenue and profit for 2017 will be ahead of market expectations, boosted by strong trading volumes in crypto-currencies.

As it turned out, Plus500’s timing was a bit out. Just days later, the City’s watchdog-in-chief, the Financial Conduct Authority (FCA), sent a warning letter to bosses of spread-betting firms where it made clear its concerns about punters betting on the price of heaven knows what via CFDs, which, in effect, are synthetic ways to trade the price movements of underlying assets such as shares, currencies and – just lately – crypto-currencies. The watchdog believes these credulous folk are not sufficiently protected against their own naivety – maybe even stupidity – by spread-betting providers. In particular, the CFA wants the product providers to explain to customers how particular CFDs might be “aligned to their needs”.

This only prompts the thought, how can it be in anyone’s needs to take a tiny morsel of the feeding frenzy in Bitcoin via a CFD? It’s not about needs. It’s about joining in the mad, crazy, intoxicating delirium that goes with all financial mania. It’s about getting high on the greed that rolls into ecstasy or fear, depending on which way the trade turns out. And, ultimately, it will be about the blind panic that runs amok when the bubble does what all bubbles eventually do. In that case, warn the punters by all means – and, for instance, there is no shortage of warnings on Plus500’s website. But there is a limit to which their urge to trade can – and should – be coolly and calmly rationalised into a phoney tick list that pretends to align products with needs.

True, such thoughts don’t go down well with the FCA. Besides, it has a point when it says that, in the year to end-June 2016 when it investigated spread-betting providers, 76 per cent of the retail customers who bought CFDs from the 19 firms on which it focused lost money. Like taking candy from a baby, or what?

Plus500 was quick to distance itself by pointing out that it was not one of the firms in the FCA’s review and that it distributes its CFDs via a different route. Yet that’s a bit disingenuous since it is benefiting marvellously from current conditions – a bull market perhaps spilling into mania and not just in crypto-currencies. Proof that these are ideal for spread-betting firms is that in 2017 Plus500 added 246,000 new customers to its trading platform, a figure that dwarfs the 104,000 it added the year before, which was itself a record.

Most of those will go the way of all day traders. They will quit having lost money. The average punter at Plus500 is active for 15 months. This means a prodigious churn in customers. In 2016, those 104,000 new punters led to a year-on-year increase in active punters of just 19,000 (see Table 1). Come the next bear market – and come it will – the number of active customers may fall dramatically, even though – at least in theory – CFDs are a great way to trade falling markets.


Table 1: Plus500 – punters' beware
December year-end2013201420152016
Operating profit145.3132.6150.5205.9
Profit margin (%)63.548.145.958.2
Operating cash flow118.985.5108.9156.7
Capital spending-1.4-0.8-1.9-1.1
Free cash flow117.584.7107.0155.6
Dividends paid-60.0-65.0-123.2-125.0
No. active customers     85,795   105,976   137,000   156,000
Revenue per customer ($)1,3252,1602,0192,103
Source: Co accounts; data in $m except where stated  


Sure, the longevity of other spread-betting firms such as IG Group (IGG) and CMC Markets (CMCX) tells us that there is life after a bear market. So Plus500 is unlikely to face existential moments when it all turns nasty. Even so, a bear market may be enough to threaten its dividend. As the table shows, Plus500 distributes most of its free cash. So falling trading volumes, which would deal a disproportionate blow to profits and cash flow given the high fixed costs in the company’s business model, could lead to a dividend cut. Fun though it might be to add the raciness of Plus500, with – currently – a 6 per cent-plus dividend yield, to the Bearbull income portfolio, it’s actually quite easy to err on the side of caution.

Shares in Elegant Hotels (EHG) also have attractions that come with reservations. They offer a level of asset backing that’s usually reserved for the best hidden-value situations. Against a share price of 92p, the book value of net assets is 93p per share, comprising mostly the value of the seven freehold hotels that the company operates in Barbados. That’s about equal to the share price, but management believes that underlying net asset value (NAV), which reflects the current market value of the hotels, is 163p per share. It is only rarely that the London market offers shares in a fully functional and decently profitable company at such a discount to NAV – 44 per cent.

Yet, Elegant’s profitability (see Table 2) may be illusory. Its profit margins are fine, but it has to employ so much capital to generate its revenues that return on capital – arguably the ultimate arbiter of value – is quite ordinary. Depending on how it is calculated, return on equity averages around 8 per cent, which is lower than most shareholders would find acceptable. The alternative explanation is that Elegant’s assets are overvalued, thus depressing returns to capital.


Table 2: Heritage - becalmed in the Caribbean
year end Sept201420152016  2017
Operating profit16.619.116.213.6
Profit margin (%)28.731.828.422.7
Operating cash flow16.711.417.012.5
Capital spending-7.9-3.5-9.7-5.4
Free cash flow8.
Dividends paidnana-9.5-7.9
Occupancy rate (%)68.968.462.963.9
Daily rev per room ($)243255238227
Source: Co accounts; data in $m except where stated  


Granted, Elegant’s upscale hotels produce room rates to die for (Table 3), but those come with high fixed costs, static occupancy rates and gently falling revenues per room. It does not help that Elegant depends heavily on cash-strapped UK holiday-makers for custom. Worse, the company is currently incapable of generating enough cash to sustain the dividend. Table 2 also shows that, barring a surge in free cash generation, Elegant’s dividend was unsustainable and its bosses acknowledged as much when they cut the payout by 25 per cent for the year to last September and warned of a further 24 per cent cut this year.


Table 3: How Elegant compares
 Elegant HotelsMeliá Hotels InternationalMillennium & Copthorne
No. rooms58879,76437,022
Occupancy rate (%)63.971.771.8
Ave daily rate (£)26299107
RevPAR (£)1687277
Source: Co accounts; £1=$1.35=€1.13  


There remains the hope that Elegant, a minnow among quoted hotel operators, may become a mouthful for a predator; it was in talks – now abandoned – with Spanish resort hotels operator Meliá Hotels International (BMAD:MEL) late last year. Others may sniff around. That, however, is not sufficient reason to hold the shares. Nor is the case much enhanced by the ostensible discount to NAV, since that asset value – whatever management may say – looks open to question. Certainly, I struggle to find value much above 70p per share when I crunch valuation numbers; this despite the substantial capital spending that management has been doing. I will have to find my value elsewhere.

That could be in Randall & Quilter (RQIH), which used to occupy multiple niches in the non-life insurance industry, but is turning itself into a more focused player. On the back of raising £70m in new equity via two share placings last year, R&Q is concentrating on buying closed books of non-life insurance policies and on providing management services to insurers, especially to underwriters in North America seeking to exit their legacy liabilities.

The change in the group’s shape is substantial. Annualised revenues for the 12 months to end-June, at £168m, were twice the figure generated for all of 2016, net profits rose from £8.4m to a notional £12.4m and earnings per share were over 50 per cent higher at 18p. True, lively growth will be needed even to sustain the dividend since the extra shares in issue mean that the cost of just a repeat of 2016’s 8.6p payout would rise from £6.2m to £10.8m (see Table 4). At 151p, almost twice their level of two years ago and up 16 per cent so far this year, the shares clearly have momentum and it may be tempting to ride with that. The shortcoming is that erratic cash flows, even at the best of times, mean it is difficult to value insurance industry players, even one such as Randall & Quilter, which will generate increasing amounts of revenue from assured fee income.


Table 4: Randall & Quilter – it's getting better
Year end December2013 2014     2015    2016
Operating profit3.7-15.7-16.0-5.4
Cash from Op's-35.9-21.614.714.1
Capital Spending-0.6-0.7-0.2-3.1
Free cash flow-36.5-22.314.511.0
Cost of dividends-2.2-3.0-6.0-6.2
Source: Co accounts; all data £m   


Meanwhile, shares in IT services supplier Maintel Holdings (MAI) offer a simpler value proposition, even if it is compromised by a profit warning in early December that whacked 20 per cent off the share price to its current value of 650p. Maintel’s immediate problems are that two especially profitable contracts that came with a major acquisition made in 2016 were worked through more quickly than expected, cutting both revenues and profits in the second half of 2017; simultaneously, drawn-out bankruptcy proceedings at a US subsidiary deterred customers.

Despite this, the value proposition is easily stated: so long as Maintel produces profits and cash flows that equal the average of the past five years, the shares look good value for all who expect sensible returns. Yet the hope among City analysts is that earnings will grow rapidly from a depressed base.

I can work through my usual short-hand valuation exercise and find value per share of about 790p. The method is to capitalise average free cash from the past five years by the cost of capital, weighted between expensive equity and cheap debt. From that, deduct net debt and what remains is an approximation of what an investor would pay in order to get a given investment return (in my case, 8.5 per cent). As I say, the figure comes out at 790p, an amount that is clean of any messing around with possible value created by capital spending in excess of depreciation – Maintel does not do enough cap-ex.

That lack of capital spending may restrain growth in the future. Alternatively, Maintel’s bosses may rely on acquisitions for growth – always risky. However, they are confident enough to promise that dividends will grow by 10 per cent a year in the foreseeable future. Given that, on average, dividend costs have been well covered by free cash (see Table 5), then that growth rate looks feasible for a while; coupled with a starting yield of 4.9 per cent, that only adds to the value proposition.


Table 5: Maintel - simple value proposition
Year end December2013  2014  2015      2016
Operating profit4.
Cash from Op's1.06.16.810.6
Capital Spending-0.1-0.1-0.6-0.5
Free cash flow0.
Cost of dividends-1.5-2.0-2.6-3.7
Source: Co accounts; all data £m   


There is more work to be done before I make a decision on Maintel – ditto Randall & Quilter – and there is the little matter of what should be axed from my income portfolio to make room. That’s a cue that next week I should look critically at what is probably the weakest holding, GlaxoSmithKline (GSK).