Small Cap Report (12 Mar) - SDM, KBT, SIV, FCCN, KBC

Pre 8 a.m. comments

As usual, I'll check out one or two company results that interest me the most, and publish comments just before 8 a.m., then I'll review a few more company results at a more leisurely pace, and update the article in stages until it's finished around 10 a.m., when the last typos have (hopefully!) been eliminated.

Stadium (LON:SDM) has caught my eye as a special situation before, although it's not a share that is currently in my portfolio. It does sub-contract electronic manufacturing, and makes power supplies. A poor year was expected for calendar 2012, and turnover fell from £45m to £41m. Adjusted profit before tax fell from £2.6m to £1.4m.

The accounts are a bit fiddly, as there was a £2.4m one-off profit on the disposal of its Hong Kong property, delivering £3.3m in cash proceeds, which has brought the group to effectively a net cash neutral position of £0.1m.

Reported EPS dropped from 9p to 4.2p, although one of the main attractions is the dividend, which has been held at 1.75p for the final, giving a total payout of 2.8p (after the 1.05p interim dividend paid in Oct 2012). This equates to a dividend yield of a stonking 6.2%, with the shares currently at 45p.

There were also some reorganisation provisions, so a fair few things to untangle in order to ascertain the underlying performance of the business.

The key question is how EPS compares with broker consensus, and the reported 4.2p seems to have come in a little ahead of consensus, which is for 3.1p EPS in 2012, rising strongly to 7.25p in 2013.

It looks potentially interesting, if you think management can turn around performance in 2013, and deliver the increased forecast EPS. The outlook statement is mixed, with reference to "difficult market conditions", but that they have "self-help programmes" to make them more efficient. Their strategy includes making acquisitions where they can leverage their manufacturing know-how, and exploit cross-selling opportunities.

I've just found the pension deficit, which is a £7.1m liability shown on the balance sheet, and given that the amount disclosed on the balance sheet can often be just the tip of the iceberg, I think that rules out SDM as a potential investment for me. So I like the dividend yield, and the potential earnings recovery, but it's operating in a competitive & low margin sector, and the pension deficit makes it messy.

Just as an aside, this would be an interesting company to see at a meet the management evening, e.g. Mello Central or Equity Development's next investor evening, to get a better handle on the various issues affecting the company, and to discuss its strategy & prospects with management.

Post 8 a.m. comments

I've been sceptical about K3 Business Technology (LON:KBT) for some time, mainly because of its rather aggressive accounting treatment (capitalising development spend), and its very weak balance sheet, which has a large deficit on net assets, once intangibles are written off (as they almost always should be, in my opinion).

KBT is one of the largest fallers today, with the publication of poor interim results, which show revenue down 5% to £31.6m for the six months, although the fall would have been far worse had it not been for the benefit of acquisitions.

Profits have also fallen sharply, they say due to contract delays and investment in new products. Adjusted EPS fell from 18.1p to 6.5p, and basic EPS is only just above breakeven at 0.8p. That's not a great position to be in with £12.3m of net debt, and there is no interim dividend (although they say that a final dividend is expected).

It's the balance sheet which puts me off. Current assets are £27.1m, but current liabilities are £42.7m, so that's a yawning £15.6m deficit in the middle of the balance sheet on working capital (I usually like the middle part of the balance sheet to show a surplus).

Plus there are £5.3m in long term liabilities. Fixed assets can effectively be ignored, as it's pretty much all intangibles, which have no resale value, but are just a mixture of acquired goodwill, and capitalised development spend.

I might look at KBT if & when they sort out their balance sheet with a decent slug of fresh equity (they need £10-15m more equity in my view), but for the time being it's too wobbly a proposition to be investable for me. Investors who are prepared to take on higher risk might disagree with me, but I cannot see the point in taking risks you don't need to, unless there is multi-bagger upside potential.

Half year results from ST Ives (LON:SIV) are actually for 27 weeks to 1 Feb 2013, so it's worth bearing in mind that an extra week's revenue has probably been compared with six months costs, perhaps flattering the figures somewhat (but it won't be a huge distorting factor).

Basic underlying EPS is up 8.8% to 7.67p, so assuming no seasonal difference between H1 and H2, that means consensus forecast of 16.4p EPS looks achievable for the current year (ending 27 Jul 2013). Their shares have risen 7p to 138p this morning, so the market clearly likes their interim results. That's a PER of 8.4 times current year forecast earnings, which looks reasonably good value.

Although they are trying to develop it into a marketing group, the overwhelming bulk of turnover still comes from printing, so it's not likely to ever command a premium rating.

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Net debt has fallen nicely to £7m, which is pretty immaterial for the size of the group and its level of profitability. The interim dividend has been increased 14% to 2.0p per share, and there was a 4p final divdend paid in Dec 2012, so the full year forecast dividend of 6.3p looks realistic. That equates to a healthy 4.6% dividend yield.

Remember that dividends like this should also contain in-built inflation protection, in that they should rise (say) 5-10% p.a. over the long term, providing the underlying business trades reasonably well. This makes higher yielding equities still pretty good value, in my opinion, when you compare them with the lower, fixed interest rate on Gilts. Or comparable yields on corporate bonds, but a fixed rate, with no inflation protection.

We inevtiably seem to be facing higher inflation in the coming years, due to money printing and sterling devaluation. Equities are probably the only asset class which provide decent inflation protection at the moment, as it's difficult to see how residential property prices can go any higher, in fact are surely still over-valued on salary multiples. How can squeezed tenants afford higher rents? Plus capital values could easily drop 20-30% once interest rates rise to levels where zombie households are forced to sell, instead of treading water on low monthly interest payments on mortgages whose capital that they will never be able to repay.

I think there are many accidental landlords who will get a nasty shock once interest rates normalise, and there could well be a rush to sell residential property, something which needs to happen so that prices correct to a level where first-time buyers can come back into the market on sensible salary multiples.

How did I get onto this? Oh yes, dividends. The only downside I can see with SIV is that they have shown a strangely large swing from a £20m deficit into a £4m surplus for their pension fund in just the last 6 months. That is a big red flag to me, saying more investigation is required, as things are rarely what they seem with pension fund accounting. So the pension fund must be colossal to have seen such an apparently positive swing in one year, and I would want to see chapter & verse from the last Annual Report, on what over-payments are contractually agreed. It could be a large, hidden liability, so needs further research.

Ignoring the pension fund though, SIV shares could have 20-30% upside based on today's figures.

It's just a question whether the pension fund is a sufficiently large enough problem to offset an apparently good value underlying business.

So the big question on everyone's lips is whether this market rally can continue, or whether we are overdue a correction (at least in the short term). Some argue that buyers are being forced in, as they cannot stay out of a market rally which is leaving their relative performance behind (this applies more to fund managers rather than private investors, who can do what we like).

Another view is that equities are still reasonable value, especially compared with other assets classes, and I urge you to click here to see a chart from the Wall Street Journal, which shows that despite having reached previous Index highs, equities are on significantly cheaper valuations than at the same highs in 2000 and 2007, especially when compared with Treasury Bonds.

I'm playing it safe, and am selling or top-slicing anything that has risen a lot & looks fairly valued. However things that still look good value to me, and have good prospects, I'm running for the long term. Also I'm being highly selective about opening new positions, unless they are compelling value (which hardly anything  new that I look at is right now).

OK, that's pretty much it. It's French Connection (LON:FCCN) results tomorrow, a position I've eased back on recently, as the last trading statement worried me a bit. I'm looking for current trading not being much worse. If it's showing further significant deteriorations in current trading, then I'm likely to sell up & move on. They've got enough cash to keep going for a couple more years, but if they don't turn it around in that time, then it's history. Or at least would need a restructuring to ditch the problem retail business, and I'm not sure whether outside shareholders would be protected in such a situation. All too often management snatch the assets on the cheap from a friendly Administrator, leaving external shareholders with nothing.

I don't think FCCN are anywhere near that type of scenario yet, but if things get a lot worse on current trading, then it might be heading that way in the longer term?

Also I am looking forward to results from KBC Advanced Technologies (LON:KBC), which I have high hopes for, given their upbeat recent series of trading statements, and modest forward PER.

See you at the same time tomorrow.

Regards, Paul.

(of the shares mentioned today, Paul has long positions in FCCN and KBC, and no short positions)