Small Cap Value Report (Mon 18 Nov 2019) - HAT, IQE, CMH, MIRA, LWRF

Good morning!

Today, I'm provisionally looking at:

• H & T (LON:HAT) - FCA review of unsecured lending business
• IQE (LON:IQE) - trading update
• Chamberlin (LON:CMH) - interim results
• Mirada (LON:MIRA) - interim results
• Lightwaverf (LON:LWRF) - strategic review

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H & T (LON:HAT)

• Share price: 275p (-26%)
• No. of shares: 40 million
• Market cap: £109 million

FCA Review

(Please note that I have a long position in HAT.)

What an unpleasant way to start the week! H&T has been one of my largest positions for a long time. It reached 25% of my portfolio before I finally reduced the size of the position in August 2017, selling coincidentally at around the current share price.

Thankfully, I had no plans to sell any more H&T shares, so this news doesn't bother me all that much - I can continue holding it until the costs of this FCA review have been digested.

The FCA has singled out H&T for a review of its unsecured loans business:

This review is focussing on H&T's creditworthiness assessments and lending processes for HCSTC loans, in light of changes to the Consumer Credit Sourcebook (CONC) rules regarding affordability assessments implemented in November 2018 and the Dear CEO letter issued to all HCSTC firms by the FCA in October 2018.

Background

Some investors avoid this sector entirely, for ethical reasons. Personally I don't think that bank overdraft charges or credit card fees are any better from an ethical point of view - but perhaps that's a debate for elsewhere!

From a practical point of view, and considering the sector as a whole, it has been wise to avoid the short-term lending space. The regulatory environment is making it almost untenable.

Normally, if a borrower defaults on a loan, this is considered to be an unfortunate situation for both the borrower and the lender, who have both miscalculated what the borrower was able to achieve.

But when this happens in the world of short-term unsecured lending, borrowers are considered to be the victims of predacious lenders. This is reflected in huge legal liabilities on lenders, who can be chased for compensation for seemingly trivial and subjective reasons such as not speaking "sympathetically and positively" with a defaulter.

Wonga is long gone. The Money Shop collapsed this year, under a pile of compensation claims. Albemarle Bond has shut down. And QuickQuid is gone, too, under the weight of compensation claims and with its owners citing "regulatory uncertainty". The compensation payouts will have been welcomed by many customers, but the firms which paid them out are now finished, and won't be back.

H&T's position

I've been aware of the risk in this sector, and was consciously happy with H & T (LON:HAT) because it did not have a major exposure to HCSTC (high cost short-term credit), informally known as payday lending. I was hoping to avoid a day like this, but even worse - with the share price dropping 50%+, say.

If you scroll back to this year's interim results, H&T's average monthly net loan book had increased by over 20% to £20 million. But the proportion of its loans that fell under the definition of HCSTC were just 36% of this book, down from 50% in the prior year.

I was also encouraged by this statement in the interim results:

Our historic approach to affordability and creditworthiness ensured we were in a positive position to be able to meet all new requirements with minimal changes to our policies or procedures.  In November 2018 the FCA's new rules and guidance on assessing affordability and creditworthiness in consumer credit came into force....

Unfortunately, this doesn't match up with what the company says today:

The review is ongoing and will result in changes to these policies and procedures surrounding H&T's provision of unsecured HCSTC loans.  The Group has ceased all HCSTC unsecured lending, at least temporarily...

What on earth?

Let's be clear: in August, the company said that it was able to meet all new requirements with minimal changes. But now, it says that its policies and procedures need to change.

I don't wish to be too dramatic about this, but it's a shocking difference in just three months.

Therefore, I'm not surprised to see the share price fall by more than it seemingly should for purely quantitative reasons. There is a question mark over the company's ability to predict regulatory action - other companies in the space have been unable to predict what the regulator would do, so maybe it's inevitable that H&T would have difficulty, too?

And there will be concerns about how long this issue could drag on, and how the costs could mount up. And as I wrote on Twitter this morning, it's an unfortunate distraction when management should be focusing on the successful integration of the 65 acquired Money Shop stores.

Conclusions

At the time of writing, the fall in market cap is worth almost £40 million.

This reflects both the immediate costs (compensation claims/fines/review costs) and reduced profitability in future periods, without any short-term unsecured credit product.

But I must applaud H&T for the clarity they provide in helping us to quantify the problem:

In the year to December 2019 H&T expects that the proportion of revenues in the HCSTC unsecured lending segment is less than 4%...

H&T is looking at the HCSTC unsecured lending practices over the past 6 years as part of this review. The average HCSTC unsecured portfolio over the period has been £3m with a peak in December 2016 of £4m and has now reduced to £3m. There were total customer interest payments of £24m over this period. Revenue less impairment over this period totalled £11m.

You might not agree with me, but I think that these numbers are all very small in the context of H&T's overall business. Revenue less impairment from short-term lending has averaged less than £2 million per annum, and has not been rising since 2016.

Therefore, while this is a blow, I doubt that it is a terminal problem. Let's consider the company's financial situation:

• June 2019: net debt of £11.6 million
• July 2019: used £8.6 million of banking facilities (and a strongly supported equity raise) to buy and fund Money Shop stores.
• September 2019: used £8 million of existing cash and banking facilities to buy pledge books from Albemarle Bond.

In the absence of free cash flow from trading, these developments could have pushed net debt to £28 million, and that's before the company gets slapped with customer redress payments.

Fortunately, the rest of the business continues to trade in line with expectations (according to today's RNS), and these expectations were upgraded in September.

Therefore, I would hope and expect that the company's ongoing profitability will enable it to handle this issue, without coming back to the market for fresh equity. It says in today's RNS that existing financial resources should indeed be sufficient for any customer redress payments.

For the record, EBIT of £19 million is forecast for the current financial year, rising to £22.8 million next year (before taking into account the withdrawal from short-term credit).

I'm a little tempted to increase my position size, but am most likely to neither buy or sell any shares in this business. It is now just 8% of the portfolio.

Just goes to show that you can never get too comfortable, when owning shares in a highly regulated business. Perhaps I have under-estimated this risk in the past - but I'm still a big fan of H&T.

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IQE (LON:IQE)

• Share price: 53p (-19.5%)
• No. of shares: 793 million
• Market cap: £420 million

Trading update

Cardiff, UK 18 November 2019: IQE plc (AIM: IQE) the leading supplier of advanced wafer products and material solutions to the semiconductor industry, announces the following trading update for the full year ended 31 December 2019.

There have been high hopes about this one for a long time, but anyone who bought into it since mid-2017 is unlikely to have done well (so far). This year, it has been an unlucky victim of the events surrounding Huawei's relationship with the US.

In June, the company announced a sales miss for 2019. Revenue would fall somewhere within the wide range of £140 - £160 million (versus previous consensus forecast of £175 million).

Today, we learn that it is struggling to meet even these reduced expectations. Revenue will fall somewhere between £136 - £142 million.

Visibility sounds poor. There are only six weeks left in FY 2019 (slightly over 10% of the year), and yet the company still needs a >4% margin on its full-year revenue forecast. Could we not expect a tighter forecast than that, at this very late stage? Does it not already know what orders it will be working on in December?

The company says there is a forex tailwind of £3 million, and this is included in the new guidance.

So without that tailwind, I presume it's fair to say that revenue guidance would be £133 million - £139 million? And that would fall fully outside of the previous range.

So revenue is down compared to 2017 and 2018, despite all the heavy investment that has taken place. Today's RNS refers to "general diseconomies of scale associated with operating at low volume in some sites", and forecasts an operating loss for the current year.

My view on IQE has been consistent, I think: while I would never claim to be an expert in its technology, I've always thought that its financial performance looked very ordinary.

I said in May: "why would you want to buy a capital-intensive manufacturer from Apple's supply chain at a multiple of 26x, when you can buy Apple itself at 14.5x?". In June, when the share price dropped as low as 44p, I said that it made a more interesting candidate for a short sale, rather than a long idea.

Operations

Photonics - "consistently strong" volumes with the Company's largest customer, "underlining IQE's lead position for epi-wafers in this supply chain".

Wireless - "continued low volumes of orders and reductions in inventory by our major RF chip customers in the US".

Capex - I've noted previously that the company was headed for a net debt position. Fortunately, its debt facility has been increased to £57 million. Net debt is forecast to end the year at up to £20 million, as capex plans are reduced.

Outlook

The outlook for 2020 includes a seasonally weak Q1 and continued supply chain transitions in the wireless market. Beyond Q1 2020, IQE is cautiously optimistic about a return to growth... the Company expects total revenue will return to moderate growth in 2020.

My view

It won't surprise anyone that I remain sceptical when it comes to this share's valuation. As far as I can discern (bearing in mind that I'm not an expert in this technology), it's a heavy manufacturer that plays an important role in a few supply chains, but doesn't appear to have much pricing power.  And there is no sign of much/any revenue growth in the short-term.

On that basis, I would value it around book value, or more realistically at a discount to book value, to reflect its poor track record when it comes to profitability.

For the record, book value at June 2019 was £298 million. Excluding intangible assets. this reduces to £175 million. I would guess that a reasonable valuation is somewhere below this.

Stockopedia agrees that there is little to say in its favour, and calls it a Sucker Stock.

Hopefully I've got this completely wrong, and it works out well for shareholders despite all of the above!

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Chamberlin (LON:CMH)

• Share price: 23p (-10%)
• No. of shares: 8 million
• Market cap: £2 million

Half-year Report

This small engineering company reports revenues down 26%, an operating loss before restructuring costs of £1 million, and a "major downsizing of operations".

Net debt at £6.1 million, as I'm sure you can tell, is multiples of the market cap.

Outlook - "the combination of higher revenues and a significantly lower cost base is expected to give rise to second half operating margins of approximately 3%, with a consequent reduction in net debt."

My view - it has been listed for a long time, and has very admirably refrained from diluting shareholders during that period. But if it's not going to grow from this very small size, can a listing really be justified?

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Mirada (LON:MIRA)

• Share price: 140p (-12.5%)
• No. of shares: 9 million
• Market cap: £12.5 million

Interim results: replacement and clarification

Mirada had a bit of trouble reporting its IFRS 16 numbers this morning. Hopefully all sorted now.

This company makes software for digital TV operators. It has been around for 20 years, and has well over 100 employees (163 according to Stocko), but it has very rarely produced a profit for its investors. This is not forecast to change until 2021.

The interims show an EBITDA profit of $1.96 million, but this includes a $1.7 million gain from a disposal.

Trading is in line with expectations, but the share price is down, anyway. 

Sales pipeline is described as "very healthy". The company has "considerable confidence" in the future.

My view - it is extremely difficult to analyse Mirada's prospects. The shares are only for the brave.

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Lightwaverf (LON:LWRF)

• Share price: 3.7p (-7.5%)
• No. of shares: 121 million
• Market cap: £4.5 million

Strategic Review including formal sale process

This "connected homes" business reported a nasty profit warning earlier this month.

While today's RNS puts a brave face on things, it sounds to me like it is basically throwing in the towel.

Here's part of the explanation given:

"..the Company would benefit from additional finance from a financial or larger corporate partner in order to support the Board's growth plan. Whilst the Company has been able to raise equity finance to support its development, the Board believes that the recent fundraisings have taken up more of management's time than desired, relative to the amounts raised and this has adversely impacted growth.  

My view - no change to my view that widows and orphans (and probably lots of other people, too) will feel a lot safer not owning any shares in this. It gets the mandatory Sucker Stock warning from Stockopedia.

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All done for today. Thanks everyone!

Graham