Exploit LMS’s ‘margin of safety’

Under the management of top rated fund manager, Gresham House Asset Management (GHAM), LMS is selling off its legacy portfolio in order to recycle the cash proceeds into new investments with potential to generate double-digit annual gains. Interim results to end June 2019 revealed net cash accounted for £16.4m of the company’s net asset value (NAV) of £59.1m (73.3p), a sum that is set to increase sharply after LMS announced the disposal of its 67 per cent equity stake in Entuity, a UK technology company that provides all-in-one network management software to large and medium sized businesses in 45 countries. The holding was revalued from £3.2m to £4.9m in LMS’s 2018 annual accounts, and revalued again to £8.67m in the 2019 interim accounts. I can reveal that LMS has just completed the sale of the holding at a price of £10.5m which means that proforma net cash is now £26.9m (33p a share).

There have been some significant gains on LMS’s listed investment portfolio, too. The holding in Nasdaq-quoted SolarEdge Technologies (SEDG), a company which offers an inverter solution for a solar photovoltaic system, was worth £1.18m at 30 June 2019, since when its share price has soared from $62.46 to $88. Moreover, the sterling-US dollar exchange rate has tumbled from £1:US$1.27 to £1:US$1.207 in the same 11-week period, so the holding is now worth £1.75m.

LMS’s listed holding in Aim-traded software company IDE (IDE:3.15p) was worth £127,000 at the end of June 2019. IDE is a turnaround situation, and a recent update from management revealed that the company has moved into cash profitability this year. This sent IDE’s share price surging to such an extent that LMS’s stake is now worth £516,000. LMS also holds 984,000 shares worth £5.8m in Gresham House (GHE:590p), a company I included in my market beating 2016 Bargain Shares Portfolio and one that I maintain a positive stance, too. So, by my reckoning, LMS’s listed investment portfolio has risen by £810,000 in value to £8.14m (10.1p a share) since 30 June 2019.

There have been other notable gains in LMS’s unlisted overseas portfolio, too. That’s because LMS held £10m of unquoted US investments and a further £9.2m in US funds at the end of June 2019. These holdings are now worth £20.25m at current exchange rates, representing a £1m valuation uplift. Excluding the holding in Entuity, LMS also holds unquoted UK investments worth £2.5m, and £7.5m in UK funds.

Taking all these portfolio movements into account, I estimate that LMS’s proforma NAV has increased by six per cent from £59.1m to £62.7m (77.7p) since 30 June 2019, of which the quoted investments and proforma net cash accounts for £35m (43.4p). To put LMS’s valuation anomaly into perspective, the company only has a market capitalisation of £42m at the current offer price of 52p, implying that the shares are trading 33 per cent below my spot NAV estimate. Effectively, the company’s UK and US quoted and fund investments, which have a combined value of £30m excluding the Equity investment, are in the price for a miserly £9m after making a few small balance sheet adjustments. That’s plainly an absurd valuation once you consider the portfolio breakdown.

Prospects for further realisations

LMS has an interest through the Brockton Capital Fund in a super prime residential development under construction in London’s Mayfair which is scheduled to deliver 18 principal and 14 pied-a-terre apartments by mid-2020. In addition, four flats in the adjoining building are being refurbished. LMS is carrying the investment in its accounts at £4.92m, up from £4.6m at the end of 2017, based on the look through interest in the preferred debt position in the development vehicle attributable to the company.

The valuation methodology used is a discounted cash flow model which means that as the development nears completion the discount embedded in the carrying value of the asset unwinds. Importantly, the investment climate at the top-end of the London property market is showing signs of life, hardly surprising once you consider that European and North American international buyers have around 65 per cent more buying power now than when the London property market peaked out in 2015 after taking into account the subsequent 25 per cent devaluation of sterling and the 20 per cent plus falls in London residential property prices.

Of course, not all of LMS’s legacy investments will produce exits above carrying value like Entuity, and there could be write-downs on some holdings before LMS exits. But when the balance of the legacy private equity portfolio is being valued at only 30 per cent of its book value then they don’t all need to be winners. Moreover, there is clearly value in some of LMS's legacy investments to justify a slimmer share price discount to NAV.

For instance, LMS owns an 8 per cent equity stake worth £7.7m in US-based Medhost, a provider of technology services to the US medical sector including helping companies streamline accounting processes, improve cash flow and patient access, and documentation management. It is a co-investment with funds of Primus Capital, in which LMS has previously had investments. LMS made an original investment of $5m in 2007 and subsequently received a return of $10.1m in 2013.

LMS is also a majority investor in a US-based fund, San Francisco Equity Partners (SFEP) which has two remaining investments to sell, one of which is YesTo, a California-based company that develops and sells innovative natural beauty products. Including LMS’s directly held investment in YesTo, the company’s 9 per cent equity stake has a carrying value of £5.8m, implying an equity value of £64m, a valuation based on comparable transaction multiples for trade buyers.

Other large investments in the portfolio include a $2m (£1.65m) stake in ICU Eyewear, a global leader in reading eyewear and sunglasses. ICU’s designs have revolutionised the reading glass industry with fun styles, bright colours and unique patterns at affordable prices. It was the first company to develop and implement a manufacturing process for eco-friendly reading glasses made from reclaimed plastic, recycled metal and sustainable bamboo.

GHAM’s plan is to continue divesting LMS’s legacy portfolio and target new investments in smaller private companies that are worth £50m or less given that valuations are more attractive in this space and there is less competition, too. This segment of the private equity market is also off radar for venture and early stage funding providers and sub-threshold for mid-market private equity investors, thus creating an opportunity to generate superior long-term returns.

Bearing this in mind, Gresham House has bolstered GHAM’s investment team this year following the addition of the Livingbridge and Baronsmead Venture Capital Trust teams. Livingbridge brought its own network and has created additional investment opportunities in the pipeline of unquoted stocks for GHAM to select from. Gresham House had previously been keeping its powder dry in order to take advantage of the investment opportunities in Livingbridge VC’s own pipeline.

Decent upside to realistic target price

Admittedly, one reason why LMS’s shares are trading on a discount to book value is due to the fact that over three quarters of the shares in issue are held by the top 10 shareholders, including the family of Robert Rayne who established LMS’s investment activities in the early 1980s as investment director and later managing director and chief executive of London Merchant Securities. He is non-executive chairman of Derwent London (DLN), a £3.3bn market capitalisation REIT, and a member of LMS’s investment committee. That said, the shares are readily tradable, albeit it’s likely to be more cost effective to split orders into smaller lots to build a position rather than trying to buy in a single order.

Also, ahead of the third anniversary of the appointment of the incumbent manager, GHAM, the board of LMS has commenced a process to review its investment management arrangements to ensure that the ongoing interests of shareholders are actively considered. A number of written proposals have been received from a select number of parties, including GHAM. However, given the progress GHAM has made to date, and the fact that 83 per cent of LMS’s market capitalisation will shortly be backed by cash and quoted investments, it’s reasonable to expect the fund manager to retain its mandate and start putting the bumper cash pile to good use.

So, taking all these factors into account, I feel that a fair value price of 65p a share is a reasonable target on a 12 month time-frame, representing a 15 per cent discount to my spot NAV estimate of 77.3p. Offering potentially 25 per cent share price upside, the shares rate an asset backed buy.

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