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10 cheap small-caps on steroids

The Small Cap Value on Steroids screen I introduced last year has shot the lights out
September 24, 2019

Over the past 12 months, the Small Cap Value on Steroids screen I introduced to this column last year has proved to be so wrong, it’s right. It’s time for me to hold my nose and plunge back in. The screen enjoyed a total return of 34 per cent compared with a negative 10 per cent from the market. It’s time to pile on the risk again with 10 more stocks selected by this gung-ho screen.

This screen is based on a fascinating research paper from 2015 titled 'Leverage Small Value Equities', which proposes a way to capture private-equity-style returns while investing in listed stocks. The premise of the paper is that historically the key reason private equity has made superior returns to the stock market is that it has bought lowly valued companies and loaded them with debt. The idea here is that a combination of high debt and a low rating can supercharge returns thanks to the 'steroid'-like effect on equity value of: debt paydown shifting value from lenders to shareholders; a share rerating as debt falls; and the sensitivity of post-tax profits to a reduced interest bill as well as any operational improvements.

The caveat is that when debt is very high, companies often find they don’t have the cash generation to pay debt down at all and end up sinking under their liabilities, which is the clear and present danger of this screen. Also, companies that have got their balance sheets into a mess in the first place can often have deep-rooted problems.

The approach flies in the face of the conventional wisdom espoused by value investors, which requires a so-called 'margin of safety' on any investment – high debt and margin of safety are not natural bedfellows. The results from last year’s screen, while very impressive on aggregate, demonstrate that safety is not high on the agenda. As well as alighting on one stock that more than trebled in value and two that more than doubled, some other shares cratered – Flybe shares were all but wiped out with a mercy takeover bid going through at a nominal price.

 

2018 performance

NameTIDMTotal return (2 Oct 2018 - 17 Sep 2019)
Trans Siberian GoldTSG240%
OPG Power VenturesOPG105%
Pets At HomePETS101%
Highland Gold MiningHGM54%
Communisis*CMS38%
MitieMTO12%
GattacaGATC3.4%
HSS HireHSS-9.2%
Central Asia MetalsCAML-17%
PendragonPDG-58%
Flybe*FLYB-97%
FTSE Small Cap--2.4%
FTSE Aim All-Share--18%
FTSE Small/Aim--10%
SmallCos on Steroids-

34%

*Taken over

It is worth noting that the wide spreads on troubled small-cap stocks means I think it's fair to factor in a hefty 3 per cent charge to represent real-world dealing costs. Also, as ever, the point of the screens in this column is to present ideas for further research rather than an off-the-shelf portfolio. A feature of last year’s performance is that many of the really amazing share price rises came from indebted miners that have profited from their sensitivity to highly unpredictable movements in metal prices. If I exclude miners, the average total return is still 12 per cent, though, which is well ahead of the negative 10 per cent from the market (taken as a 50:50 split between the FTSE Small Cap and FTSE Aim All-Share).

The authors of the academic paper this screen is based on – Brian Chingono and Daniel Rasmussen – have used their research to set up a quant firm called Verdad, putting the theory into actual practice. To make a workable screen I’ve had to slightly amend the criteria that was used in the paper to backtest the strategy, but I think the screen nevertheless is reasonably true in spirit. The criteria are:

  • Among the cheapest quarter of stocks based on enterprise value (EV)/ Earnings before interest, tax, depreciation and amortisation (Ebitda). EV is calculated using the basic method of adding net debt (including preference shares) to market capitalisation.
  • A market cap of less than £750m, but more than £25m
  • Net debt to EV higher than the median average of all companies with net debt*
  • Improving asset turnover (sales to total assets) over the past 12 months
  • Falling net debt over the past 12 months

One thing to note with the criteria is the focus on earnings before interest, tax, depreciation and amortisation (Ebitda). A key determinant of valuations based on Ebitda is that they tend to be lower for capital-intensive companies, which will have high levels of depreciation – an accounting charge used to spread the cost of capital investment across its useful life. That means this screen will tend to highlight companies that not only have high annual interest bills, but also have high investment needs.

This year the screen has highlighted 10 stocks. The table below has details of them, along with some fundamentals. I’ve taken a look at the most highly indebted company based on this screen’s net debt/EV measure, as well as one of the least indebted companies. As one may expect, both companies look like risky bets. This impression is not helped by the flattering choice of 'headline' numbers the companies have tried to focus investors’ attention on in recent results. 

 

2019 Small Cap Value on Steroids

CompanyTIDMEVMarket capPFwd NTM PEEV/EBITDADYFwd EPS grth FY+1Fwd EPS grth FY+23-month momentum3M Fwd EPS change12M Fwd EPS changeNet Debt/EV12M Net Debt reduction12M AssetTurn increaseNet Debt(-)
HSS HireLSE:HSS£229m£55m32p295.0--68%126%-7.9%56%-80%76%21%19%-£173m
Low & BonarLSE:LWB£149m£46m7p74.8--83%14%6.2%--66%23%10%-£99m
OPG PowerAIM:OPG£139m£60m16p43.9--12%2.5%-13%-45%-56%8.1%31%-£78m
ConnectLSE:CNCT£171m£94m38p54.7--11%2.9%1.0%-1.9%-15%45%6.8%2%-£78m
GattacaAIM:GATC£69m£41m128p54.4-3.3%8.4%-6.0%0.8%-40%32%23%-£28m
VpLSE:VP.£466m£298m752p84.64.0%7.7%4.2%-13%--2%36%11%3%-£168m
MaintelAIM:MAI£80m£56m389p66.38.9%3.6%7.5%-13%--30%4.8%0%-£24m
Shanta GoldAIM:SHG£91m£65m8p163.1---22%142%-74%28%14%11%-$33m
Finsbury FoodAIM:FIF£131m£93m74p85.34.8%8.3%2.3%14%-0.2%-15%27%1.2%5%-£35m
LekoilAIM:LEK£39m£34m6p143.9---98%-66%-87%21%37%35%-$10m

Source: S&P CapitalIQ

 

HSS Hire

HSS Hire (HSS) was the company I highlighted from the screen last year and, given its reappearance in the results, there’s merit to revisiting the equipment hire company to see what progress is being made. On the face of it, the headline numbers reported in recent first-half results suggest there’s plenty to be positive about. But dig a little deeper and there’s cause for serious reticence as well as a lesson in the importance of looking past headline numbers when trying to assess highly indebted companies.

Recent half-year results highlighted solid 3.9 per cent sales growth from continuing operations, an 11 per cent boost to underlying Ebitda, a £53m six-month drop in net debt to £183m, and a knock-out adjusted return on capital employed (ROCE) of 21.7 per cent. Sounds great, doesn’t it? But let’s have a closer look at each of these achievements.

 

Sales

True, first-half sales progress is welcome and the company appears to be benefiting from attempts to use improved customer insights to increase the amount of time equipment is out on hire. But pretty much all of the growth came from low-margin service work, which now accounts for almost a third of overall sales, based on interim numbers.

There is also reason to feel rather circumspect about the slow speed at which the company is collecting cash on sales. At the half-year stage, receivables (reported sales on which payment is yet to be received) represented 28 per cent of rolling 12-month revenue. Hire companies do tend to have relatively high receivables-to-sales ratios, but HSS’s ratio is still the highest among major listed peers, although it has been slowly moderating. 

 

Rising adjusted Ebitda

Given that there was an increase in the proportion of sales from lower-margin work, the outsized 11 per cent rise in adjusted Ebitda (earnings before interest, tax, depreciation and amortisation) to £27m comes down to reductions in central costs. Cost-cutting has been the cause of persistent exceptional costs in recent years, including £1m in the first half.

While the leaner cost base should be good news, the key drawback with focusing on Ebitda is that by definition it ignores certain cost items that are very significant for a highly indebted and capital-intensive company like HSS; namely, interest of £10.4m (excluding a £1.7m exceptional finance charge), and depreciation and amortisation of £21.3m.

The most noteworthy movement in these non-Ebitda items was HSS’s pre-exceptional interest charge, which jumped by £3.2m. This was above the £2.7m increase in adjusted Ebitda and came despite the sizeable reduction in net debt. The reason for the higher interest bill was a refinancing in June 2018 that saw HSS take on a new term loan facility priced at Libor plus a stonking 7 to 8 per cent. The lender, HPS Investment Partners, was also granted 8.5m warrants exercisable in five years at 1p should certain conditions be met. 

First-half pre-exceptional operating profits of £5.8m were in fact nowhere near enough to cover the group’s higher interest bill. This left the company with a £4.6m pre-exceptional pre-tax loss before accounting for a £14.6m profit made on the disposal of HSS's UK platforms business in January. The company did manage to eke out a free cash inflow of about £300,000, based on my calculations, by keeping capital expenditure below its adjusted depreciation and amortisation. 

The capital-intensive nature of the business (buying high-price-tag equipment to hire out) means management has a major balancing act in trying to maintain the rental fleet’s quality while also funnelling as much cash as possible into debt reduction. Indeed, even considering the heavy investment made by HSS during 2014 and 2015, the company may find it hard to stay competitive and keep a lid on capital expenditure given spending has been held well below depreciation for the past three years (see chart below). Indeed, first-half capital spending saw a noteworthy pick-up. 

Net debt

Given the minimal free cash flow, the £53m drop in net debt was accounted for by the UK platforms disposal: £47.5m net proceeds and the removal of £5.3m of finance-lease debt from the balance sheet. In 2018 the UK platforms business had accounted for 31 per cent of total adjusted operating profits of £16.3m. 

It is also worth noting that the company has delayed the adoption of new lease accounting rules until next year, but said in its 2018 results that adoption of the new standard would be likely to add £80m-£85m of debt-like lease liabilities.

 

ROCE

But what about the stunning 21.7 per cent ROCE figure? ROCE is often seen as an acid test of business quality, indicating the return a company makes on every pound invested. It is calculated by dividing operating profit by capital employed. HSS’s recently adopted method of calculating ROCE adds amortisation back to adjusted operating profits while ignoring intangibles when calculating capital employed. This methodology makes for a rather flattering take on operating performance. Indeed, based on a bog-standard calculation (using rolling 12-month pre-exceptional operating profit and the half-year balance sheet, which ignores lease liabilities), I make ROCE only 7 per cent. 

All in all, HSS is a company that looks as though it needs to improve performance further if it is to truly get its head above water. The challenge of paying down debt while keeping its hire fleet up to scratch is also not to be underestimated following three lean years for capital expenditure. As such, this represents a very risky play. Despite some signs of progress, I imagine few investors would want to touch the shares as things stand. There is also a very limited free float of 13.5 per cent. These ongoing travails help explain why the shares have given up 9 per cent over the past 12 months despite the company shouting about improvements to headline numbers. It is also a concern that HSS itself is cautious about the outlook, booking a £500,000 exceptional charge during the second quarter related to cost-cutting in response to “headwinds emerging in the market”. 

From the perspective of this gung-ho screen, though, there are undeniably some devil-may-care attractions. While HSS may not be there yet, should operational and trading improvements cause a credible debt-payback story to emerge, then there’s undoubtedly room for significant share price upside. What’s more, a bid may make sense for someone that is able to refinance the expensive term loan at a reasonable interest rate. 

 

Finsbury Food

Finsbury Food’s (FIF) recent full-year results provide a lesson on why investors should be a bit wary of a company’s headline numbers. The company, which has been built through a series of acquisitions since 2002, makes bread and cakes under its own brands, under licence from brand owners and for own-label supermarket ranges. Last year, when the company was swamped by a £13.1m exceptional charge related to bakery closures, management was keen to highlight lots of underlying numbers in the full-year summary that appear at the top of its preliminary results. This year, however, with the exceptional charge tumbling by over 90 per cent to £1.2m, the focus of the summary switched to statutory numbers, which due to the fall in exceptionals looked stunning. The table below shows how the profit-and-loss items in the headline summary changed from 2018 to 2019 and what was dropped this year. To make things easier to see, increases have been coloured green and falls coloured red – everything left out of the 2019 summary was red. 

Whatever the valid reasons are for this, I find it questionable what benefit is to be had from this kind of presentational flip-flopping. It only muddies the waters for investors trying to track a company’s progress on a consistent basis. It also looks a bit desperate.

But as illustrated by a recent run-up in the shares, there are reasons to feel positive about Finsbury as well as reasons to be sceptical. The key reason shareholders have to be sceptical is that Finsbury has powerful customers, such as the big supermarkets, and powerful licensees, such as Disney, and recently it has appeared to be struggling to pass on cost increases. Looking at the underlying numbers from the recent 2019 full-year results, a cost squeeze was evident on just about every line of the profit-and-loss statement. Cost of sales, operating costs and interest payments all rose ahead of sales growth. This meant that, despite the credible 4 per cent increase in like-for-like sales and 3.8 per cent rise in reported sales, underlying operating profit was down 5.7 per cent to £16.8m while EPS fell 8.8 per cent to 9.3p.  

On the plus side, after a four-year investment programme during which capital expenditure averaged about £12m a year, and during which the company also made some costly bakery closures, spending is now expected to fall. Broker Panmure Gordon forecasts that capital expenditure will come down to about £7m. This could herald a period of improving cash generation at the same time as the business benefits from the recent investment and restructuring. The deterioration in underlying profitability last year means it is fair to ask whether the main beneficiary will ultimately be the company or its customers, though. Still, there are definitely grounds to hope for improvement and the company’s focus on growth areas, such as free-from and food-to-go lines, looks sensible. 

The benefit of improved cash generation could be offset a bit by annual payments to June 2017 of up to £3m linked to the retention of key people at free-from baker Ultrapharm, which was bought a year ago for £17m upfront. It’s worth noting that Finsbury has not put a provision in place for a final June 2021 performance-related payment on the acquisition because criteria is “not currently expected to be met”. That looks disappointing, as at the time of the deal management expected performance to be strong enough to justify a final incentive of £1m, going to a maximum of £5m. 

On an aside, it is worth pointing out that the way the data used by this screen treats rolling 12-month periods, means Finsbury has qualified based on a fall in net debt from the half-year rather than over the last full year. Full-year net debt actually rose from £15.6m to £35.6m. Noteworthy contributors to this increase were £11m of capital expenditure, a £5.6m rise in working capital and the acquisition spend. 

*This article has been updated to correct Ultrapharm acquisition deal terms