Small Cap Value Report (1 Sep 2015) - LTC, AGA, ENTU, ZZZ

Good morning!

Just when I thought it was safe to go back in the water...! Markets have taken another tumble this morning, with the FTSE 100 down 115 points at the time of writing at 6099, and the US futures off heavily. I'm not entirely sure what reasons are being given by commentators - probably the usual - China worries, when will interest rates rise, etc. Sometimes markets just get nervous about future earnings, and sell-off.

I've got my limit orders in with my broker, to automatically buy some US large caps, if there is another disorderly open with bizarre price aberrations. I'm not selling any of my UK small caps this time, because they held up so well last time (the prices were marked down, but on very little volume, and things very quickly bounced).

China

I've been thinking a bit more about China. A lot of us have disregarded the slowdown there as not affecting small caps we hold in the UK. I think that is true for consumer-facing UK small caps.

However, some comments in last week's results from Xaar (LON:XAR) made me ponder this more. Xaar manufactures print heads which are mainly sold to Chinese ceramic tile manufacturers. However, this is not necessarily reflected in their international sales statistics, because Xaar products might be sold to European manufacturers which incorporate them into products which are ultimately sold to China. This will be recorded as a European sale in Xaar's books, but ultimate demand for the end product actually comes from China predominantly.

I wonder how many other companies are in the same boat? What about Trifast (LON:TRI) ? They've done very well selling fastenings to European car manufacturers, but a lot of those products end up being bought in China. So Trifast is probably more dependent on Chinese demand than its accounts might suggest.

So I'll certainly be thinking much more about where the end products go to, rather than where a product is assembled. This might reveal more China-dependency in my portfolio than I realised was there perhaps?

Anyway, on to specific company news for today.

Latchways (LON:LTC)

Share price: 1068p (up 48% today)
No. shares: 11.2m
Market cap: £119.6m

1100p recommended cash bid - this looks a cracking deal for Latchways shareholders. As you can see from the chart below, Latchways (a maker of safety equipment, e.g. retractable safety lines for overhead workers) has struggled in the last couple of years, with disappointing results. So being offered a healthy 53% premium, all in cash, giving a clean exit for all shareholders, should be seen as a generous offer, and accepted.

The deal seems very likely to proceed, with irrevocable acceptances already received of 38.2%.

What is particularly interesting is that this is another example of a larger American competitor buying a British company. This now seems an established trend, and I think we're likely to see lots more such takeovers. With US companies generally looking expensive, and organic growth hard to come by, buying up cheaper overseas competitors is a logical strategy for the Americans.

The buyer of Latchways is MSA Safety Inc, which is listed in America, and is valued at about 10 times the size of Latchways, at £1.1bn.

I'd be delighted with this deal, if I were a holder of Latchways shares, as the price being offered looks generous.

AGA Rangemaster (LON:AGA)

Share price: 201p (up 9.7% today)
No. shares: 69.3m
Market cap: £139.3m

Possible bid by Whirlpool - a very interesting turn of events is unfolding at posh cooker maker, Aga. A takeover deal from the Middleby Corp is underway, but Whirlpool seems to be gatecrashing the party, and has made an initial approach regarding a possible cash offer for Aga, subject to due diligence.

For the moment Aga is continuing to recommend that Middleby deal, and is pressing ahead with that. The timescales look imminent, so Whirlpool are going to have to move very fast tabling an offer in days rather than weeks, in order to stop the Middleby deal going ahead.

This comment from Aga today is interesting, as it's leaving the door open to a higher competing offer;

Assuming AGA Shareholders approve the resolutions to be considered at the Court Meeting and AGA General Meeting, the Board of AGA will consider whether to proceed with the sanction of the Middleby Scheme on 16 September 2015 in light of the situation at that time. The Board of AGA retains the ability to adjourn the sanction hearing if it receives an offer from Whirlpool prior to this deadline which it would intend to recommend to AGA Shareholders or if it otherwise considers an adjournment necessary.

Checking their Stockopedia pages, Middleby has a mkt cap of £4.06bn, whilst Whirlpool is even bigger, with a mkt cap of £8.59bn. There's a striking difference in rating, with Whirlpool being on a relatively modest forward PER of 11.7, but Middleby much higher rated at a fwd PER of 24.6. Both companies have net debt.

What a great situation for Aga shareholders - having two large caps fighting to bid for the company. This could get very exciting if an increased competing bid from Whirlpool happens (and who knows, maybe then an even higher offer from Middleby?!)

So two situations where UK companies are being bid for by larger American companies. This could prove a rich seam of potential winners, if we can correctly predict the next companies to be bid for - let's see if we can as a group come up with some ideas!

Note also that AGA and Latchways are a similar size - just over £100m mkt cap, so I wonder if we could run a screen to identify companies of that size that might have takeover bid potential?

Entu (UK) (LON:ENTU)

Share price: 65.3p (down 29% today)
No. shares: 65.6m
Market cap: £42.8m

(at the time of writing I hold a long position in this share)

Profit warning - this company has only been listed since Oct 2014, and is doing a pretty remarkable job of destroying its own reputation amongst investors!

The share price started falling in June, on worries that a change in VAT might affect them. At the time I concluded that, since most of Entu's products are already charged at standard 20% VAT, then the impact would be limited. The company confirmed this limited impact, in comments with its results on 20 July.

The share price really began to tank in July, in what seemed unrelenting, and frankly rather suspicious selling - it was starting to look as if people in the know were selling in advance of bad news. They were. The bad news came out on 20 Jul 2015 - poor interim results, and a commentary which struck me as being odd - poor interims were brushed aside as being expected (something they hadn't told the market before!), and an emphatic statement that orders were strong & full year expectations would be met.

Being perhaps too trusting, I believed management assurances that the full year results would be in line with expectations. We have been told today that results will now be below expectations. However, the problems all seem concentrated in one division, solar.

Solar division - whilst the update today is infuriating, it's important to let your blood pressure subside as quickly as possible, and think it through rationally, in order to make the right decision.

Rather shockingly, the company has announced today that it is closing its solar division altogether. This seems rather drastic action, with the reasons given as follows;

...the Board expects the market environment for Solar to become increasingly difficult as a result of speculation about a possible increase in VAT for its solar products from 5% to 20% and uncertainties concerning the future level of feed-in tariffs, in particular a recent Government proposal for a substantial reduction in feed-in tariffs with effect from January 2016.

I don't see how speculation over a VAT rise would affect demand. Quite the opposite - if I were a potential customer, and I thought the VAT rate was going to rise, I would buy them now before the increase!

The comments on feed-in tariffs looks the more important factor. Even so, it's surprising that demand has dried up so suddenly, and that the division can't be down-sized. Shutting it down completely seems extreme. There again, the company knows its own figures best, so better to kill off a problem part of the business, than have continuing losses I suppose.

It does make you wonder about the sustainability of profits at the company generally though, if a division can just suddenly cease to be viable in this way. There again, artificial feed-in tariffs, a backdoor subsidy effectively by the Govt, don't affect Entu's main product lines such as double glazing, conservatories, etc. They're standard rated for VAT, and not subsidised.

The company does helpfully quantify the scale of the problem;

The Company now estimates that it will lose in excess of £2.0 million during the current year from its Solar activities against a budgeted contribution of £1.6 million. The Board does not believe that its Solar business is likely to make an acceptable return on investment in the medium term and therefore, after fulfilling all current obligations, Entu will discontinue its retail Solar activities in a controlled manner, and re-train and re-deploy as many staff as possible into its other activities.

My opinion - obviously I'm livid about the chain of events at this company, as set out above. However, it's important not to throw out the baby with the bathwater, and the share price has already more than halved, so these problems are already baked into the price, possibly excessively?

The problems are ring-fenced within the solar division, and the rest of the business is trading alright (if this assurance can be believed);

Following the developments in Solar, Entu now anticipates that its full year results will be below market expectations. The Company expects that its continuing activities will report an operating profit of approximately £8.0 million for the year ending 31^st October 2015. 

Difficulties in its Solar business notwithstanding, the Board remains confident of the future prospects of the Company's continuing activities, comprising home improvement products, insulation products, boilers and repairs and renewals cover plans, which continue to trade in line with management's expectations.  As previously announced these activities have the benefit of a substantial forward order book in excess of £30 million.

Given that the shares have dropped from a peak of about 145p to only 65p today, then this is a savage mark-down by the market, for problems that appear to be concentrated in one division only. The company has taken decisive action to close that division, so I suspect it won't be long before the stock market starts looking at this share more positively.

Basically, we can buy a company with net cash, which has core operations making £8m operating profit, for a £42.8m market cap. If we assume profit after tax of say £6m, then that gives a PER of only 7.1 at the current price.

Sure, there will be some exceptional costs this year for shutting down solar, but I think the market will look through that in due course, and value the share on the company's continuing activities.

Dividends - note that the company has reduced its dividend guidance today, saying the final divi will not be 5.33p (as they reassured it would be, in July), but instead will be "not less than 2.67p", giving 5.34p minimum for the full year total divis. That's a yield of 8.2% on the reduced guidance, and they are saying that's a minimum, so there could be upside on that potentially?

My opinion (cont.) - I think this is a buying opportunity. Sure the company has done serious damage to its reputation, and has handled the newsflow very badly this year. So I can fully understand why some shareholders will just want to ditch the shares and move on. That's a perfectly valid stance to take.

I've done the opposite, and bought more today, because I feel that the problems are ring-fenced at one division, and the rest of the business is doing fine, and now looks cheap on fundamentals. So providing there's no more bad news, I think this share could recover in time.

EBIT: New broker forecasts - I've got revised forecasts here (from the house broker), which exclude the Solar division, and show £100.9m turnover, and £8.1m PBT for the current year ending 31 Oct 2015. That equates to 9.7p EPS.

Therefore at 65.5p per share, the PER is just 6.8 for the current year (pre-exceptionals). I would say that is a very harsh rating, but given the sequence of events, I think the market is justified in being harsh towards the company. Management have screwed up, and need to rebuild market confidence.

Furthermore, this company joins the ever-lengthening Hall of Shame of companies which warn on profit in their first year on the market. Entu was floated by Zeus Capital, who also floated BooHoo, which also warned on profits fairly soon after floating. So this says to me they're probably being too aggressive in valuations for companies they float.

Snoozebox Holdings (LON:ZZZ)

Share price: 9.88p
No. shares: 211.8m
Market cap: £20.9m

Interim results to 30 Jun 2015 - I think it's clear from these figures that this portable hotels operator is still a million miles away from profitability. Turnover of £2.36m created only a £654k contribution to central overheads. The trouble is, the ignores the depreciation charge of £814k, which really I think should have been deducted, so really it's loss-making even before central costs of £2.2m for the six months.

It seems to me the central costs are just way too high. This business would be better suited to being a lean, privately-owned, owner/managed business, with very little in costs. It might work then, but I can't see it making enough headway to become profitable, based on these numbers. Admin expenses are £2.2m for the half year. So turnover would have to quadruple just to reach EBITDA breakeven.

Moreover, it's using a lot of capital, to generate a negative return. So to grow the business, they would have to keep adding on more units, at considerable cost.

Directorspeak sounds upbeat, but confirms that the company is still a long way from profitability;

With greater visibility, clear growth prospects and an executable event model, the focus in the second half of the year is to establish a robust platform on which to build the brand and scale the business. 

As a consequence, there will be further expenditure in operations, service delivery and on the blueprint forexecution of the brand experience. In the short term, while revenues continue to grow strongly, the Company does not expect to be EBITDA positive in the second half of the year.

I don't like the sound of this. It seems that, rather than cutting costs, they intend doing the opposite.

My opinion - it's a great concept, but I think it's becoming clearer that this company looks very unlikely to become a commercial success.

All done for today.

Regards, Paul.

(of the companies mentioned today, Paul has a long position in ENTU and no short positions.

A fund management company with which Paul is associated may also hold positions in companies mentioned.

NB. These reports are just Paul's personal opinions, not recommendations or advice, so please DYOR)