A share tip circled in a newspaper share listing

Why I’ve sold Fenner plc for a modest profit

A share tip circled in a newspaper share listingDisclosure: I own shares of Anglo American, BHP Billiton and BP.

My purchase of Fenner plc (LON:FENR) back in January 2015 was woefully mistimed. I was far, far too early to catch the bottom of the mining downturn.

I should probably have cut my losses and sold when this became clear to me, but instead, I did what I usually do in such circumstances — nothing.

As it turns out, this was a successful strategy.

I sold my shares in Fenner this week for a total return of 27% (including dividends, after costs).

That’s not outstanding in 22 months, but it’s far from a disaster.

Fenner plc share price chart 2015-16

Source: Stockopedia

If I’m honest, I’m not sure whether this year’s move back into profit is the result of good investing process or just dumb luck. (This is a topic that’s worth considering — Ben Hobson published an interesting article on this subject on Stockopedia recently).

But in this post, I’m going to focus on the three reasons why I’ve sold.

1. Uninspiring outlook

Fenner’s recent 2016 results were pretty solid. But the outlook statement was very measured, in my view. (All bold is my emphasis)

Coal: Operational gearing means that rocketing coal prices have provided an instant profit boost for miners. But Fenner is only expecting to see a gradual pickup in conveyor belt sales. It isn’t directly exposed to the upside from rising commodity prices. Here’s what the group said about the coal market:

This is a more positive situation which we believe will eventually lead to increased demand.

Oil & Gas: Fenner’s other big profit driver is the US onshore oil and gas market. The North American rig count has been rising slowly in recent months and yesterday’s OPEC production cut deal suggests this trend could continue. But Fenner believes a return to historical levels of profit may take some time:

The structural changes that have taken place in the industry will, we believe, act as a short-term constraint to growth but, in the longer term, will enable us to accelerate our market share gains and, over the next few years, return the business to the levels of profitability we enjoyed before the decline of the last 18 months.

Medical business: Promising, but several years will be needed to deliver meaningful growth:

Our medical businesses have created a technology platform incorporating some important patents which will provide significant new opportunities for growth, albeit the incubation period for such products is likely to be several years.

None of this is bad news. But Fenner’s valuation now looks reasonably demanding and there’s competition for cash in my portfolio. This outlook doesn’t seem a compelling reason to hold.

2. Would I buy now?

A good test of whether to hold onto an investment is to ask whether you’d buy it now. In Fenner’s case, the answer is  no.

The shares trade on 23 times 2016/17 forecast earnings, falling to a P/E of 20 for 2017/18. Forecast eps growth of 13% next year doesn’t seem that exciting at this valuation. Dividend cuts mean that the yield on offer is less than 1.5%.

Fenner’s balance sheet also remains under some pressure, thanks to net debt of £150m. At the end of August, this resulted in a net debt to EBITDA ratio of 2.4x, up from 1.7x a year earlier. Although it’s still below the group’s covenanted limit of 3.5x, this is quite high, given current low profit margins.

Fenner’s net debt also looks high using my favoured measure of net debt to net profit. Even if we take a generous view and compare the group’s debt to 2017/18 forecast profits of £25m, Fenner’s borrowings still amount to six times its post-tax profits. I normally look for a maxmium of 4-5 times.

These factors would be likely to put me off buying at current levels.

3. Historically cheap, or not?

Another measure I favour is the classic value investing ratio, the PE10. That’s the ratio of the current share price to ten-year average earnings per share.

Following Fenner’s latest results, I recalculated its PE10. I calculated two versions — one using reported earnings per share (eps), and the other using the group’s adjusted figures. Here are the results, based on a share price of 254p:

  • Reported eps PE10: 21.5
  • Adjusted eps PE10: 12.3

As you can see, Fenner looks quite affordable based on historic adjusted earnings, but much less so using the group’s reported eps.

I’m often unsure whether to use reported or adjusted earnings when calculating a PE10. In an ideal world, there wouldn’t be much difference between them. In reality, there often is, as companies seek to massage out genuine exceptional costs — and sometimes to simply disguise indifferent results.

Interestingly, Fenner’s reported and adjusted figures used to be pretty close. It’s only in the last few years that they’ve really diverged. To some extent this is understandable, but I’m still wary about relying totally on such a rose-tinted view of the firm’s profits.

Although the Adjusted PE10 is still pretty low, I’m no longer convinced Fenner is truly cheap by historical standards.

Final thoughts

I’m aware that I may have sold Fenner too soon. Earnings upgrade momentum is improving and future earnings could be better than expected.

On the other hand, I’m already heavily exposed to commodity prices through my holdings in BPAnglo American and BHP Billiton. I wanted to free up some cash in the portfolio in order to be able to focus on new opportunities, as they arise.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Glass skyscraper building

ShareSoc Leeds growth company seminar 3 Nov 2016 review (NIPT, EVG & PCA)

Glass skyscraper buildingDisclosure: I have no financial interest in any company mentioned.

ShareSoc’s northern expansion is continuing (!), and the society held another of its growth stock seminars in Leeds last week.

The companies presenting were Premaitha Health (LON:NIPT), Evgen Pharma (LON:EVG) and Palace Capital (LON:PCA).

As previously, the event was very well organised, with food and drink provided. The seminar was held in the Cosmopolitan Hotel in central Leeds, which is just five minutes’ walk from both Leeds station and a multi-story car park. It’s a very easy location to get to.

Further events are planned in Leeds and Manchester, as well as the usual locations ‘down South’. Full details are available here.

Here’s a quick summary of my notes and thoughts from the event.

DISCLAIMER: Please note that these comments are based on my impressions from the seminar. They are not advice or buying recommendations. I haven’t looked closely at these companies’ finances but would certainly do so before considering investing. Please do your own research if you’re considering buying (or selling) these stocks.

Premaitha Health

The story: AIM-listed Premaitha Health is focused on developing non-invasive pre-natal DNA tests (NIPT) for pregnant women. The firm’s main product is the IONA test, which was launched in February 2015. This test estimates the risk of a fetus being affected with Down’s syndrome, Edwards’ syndrome or Patau’s syndrome.

The IONA test is designed to provide more accurate results than the current ‘combined test’, while avoiding the risk and discomfort associated with more reliable but invasive tests such as amniocentesis.

Premaitha claims a reasonable share of the NHS market, and says that it is growing abroad. The firm says that the market for NIPT is growing fast globally, and believes IONA has some significant advantages over competitors.

Revenue rose to £2.5m last year, during the firm’s first year of commercial sales. Revenue is expected to be about £6.5m this year, but Premaitha expects to continue running at a loss as it expands its marketing operations and laboratory installations globally.

Possible problems? Unfortunately, a cancelled train meant that I arrived halfway through Premaitha’s presentation. As I sat down, Premaitha’s management was on the receiving end of some pointed questioning from the audience. There were two topics.

The first was the details of a £9m funding deal with Thermo Fisher, whose DNA sequencing platform is used by Premaitha. I’m not quite sure what the perceived concern was, but at least one audience member wanted to know more about the detail of this deal than management was prepared to divulge. I assume the investor’s ultimate concern was potential dilution.

The second concern was the ongoing patent infringement action against Premaitha by DNA sequencing platform Illumina (a rival to Thermo Fisher). Premaitha’s firm view is that the allegations are unfounded. However, defending them is likely to be costly. Premaitha provisioned an additional £5.8m against litigation in its results last year.

My view: Premaitha appears to have a good product and to be showing signs of successful commercial growth. But as a layman, I’ve no real way of knowing how likely it is that IONA will become a major commercial success. There’s also the overhanging risk of the legal action.

Evgen Pharma

The story: Evgen Pharma floated on AIM at the end of 2015. It’s essentially a ‘one-molecule company’, but its product, SFX-01, already has three or four potentially major applications. Two of these — for treating subarachnoid haemorrhage (a very dangerous type of stroke) and metastatic breast cancer — will enter Phase II trials later this year.

The gist of the story is that the molecule behind SFX-01, sulforaphane, is naturally derived from brassicas, most notably broccoli. The clever bit is that it’s only released by another molecule once the digestive process starts. You can’t extract it directly.

It’s science like this which lies behind Daily Mail stories about superfoods, but don’t think you can cure cancer by eating a lot of brocolli. According to CEO Dr Stephen Franklin, you’d have to eat 2.6kg per day of broccoli per day to get one dose of SFX-01. Most people, he advised seriously, are sick after about 300g.

What makes Evgen slightly different to some other small drug development companies is that the therapeutic properties of sulforaphane have been known about for many years. According to Evgen, more than 2,000 peer-reviewed articles have been published on sulforaphane since 1992. All have been positive. The problem has been finding a way of packaging the molecule stably for clinical use. Sulforaphane on its own must be stored at -20C!

Evgen has managed to find a way of packaging sulforaphane in a clinically stable format, known as SFX-01. If either of its Phase II trials are successful, then the shares could be worth multiples of the current price. These trials are expected to complete by H1 2018 and Evgen is now fully funded until the end of 2018. This means investors should have a clear picture of what to expect.

My view: One of Dr Franklin’s key goals was to convince us that Evgen is lower risk than many other small pharma stocks. His case is that the large volume of peer-reviewed literature backing the science behind sulforaphane reduces the risk of the drug trials failing.

As a layman, I was impressed with Dr Franklin’s presentation and clarity of his investment proposition. However, as with Premaitha, I can see no way for a non-expert investor to quantify the likelihood of success or failure, so I’d class this as a high-risk, high-return investment.

Palace Capital

The story:  Palace Capital was founded in 2010 by Neil Sinclair, a very experienced property man. He reversed into an AIM-listed shell company and then started making acquisitions in the regions, at a time when the view in London was that the rest of the UK was still in recession.

Mr Sinclair’s view is that there is still a supply shortage of decent commercial space outside London, especially in tier 2 cities like Milton Keynes. There has apparently been a lack of new development since the financial crisis. Management believe that rental rates are still rising strongly in these areas.

Palace Capital’s modus operandi is to use Sinclair’s experience and network of contacts to acquire distressed, partially-let and off-market properties, where the sellers are keen to sell and Palace is able to get a good price.

Once a property is acquired, Palace will actively manage and — if necessary — redevelop or re-purpose a property in order to increase rental rates and add capital value. There’s a strong focus on capital growth, rather than just rental yield. This could be one reason why Palace isn’t a REIT — I didn’t manage to ask the directors about this.

Evidence so far suggests that Palace is executing well on this strategy. Net asset value has risen to £106.8m, based on  £63.5m of equity raised to date. Rental income rose from £7.5m to £11.8m last year. Net gearing is acceptable — if not especially low — at 40%.

Palace has started paying a progressive dividend, which is expected to rise to 18p per share this year. At current prices, this gives a forecast yield of 5.1%.

My view: Palace shares currently trade at a 14% discount to their last-reported book value of 414p per share. This discount, plus a 5% dividend yield, should be an attractive package.

My concern is that while Palace’s business model clearly works well in a bull market, it might be more vulnerable than some of its peers in the event of a downturn.

The group’s focus on buying distressed and partially-let properties means that both the weighted average unexpired lease term (WAULT) and weighted average debt maturity seem relatively low to me.

Palace’s WAULT at the end of March was 6.3 years, up from 4.5 years in 2015. To be fair, this does seem to be improving, as the group finds new tenants and renews existing leases. However, occupancy fell from 90% to 89% last year. Alongside this, the group’s average debt maturity is just 5.1 years.

By way of comparison, Town Centre Securitiesan obvious peer — has a weighted average debt maturity of 10 years, and occupancy of 98%.

If interest rates remain low and the commercial property market remains healthy, then Palace should be able to sign new, longer leases with its tenants. This should secure a higher and more robust level of rental income, and enable the firm to refinance with long-term loans.

However, if the market slows before that process is complete, then I think there’s a risk that Palace could be more heavily exposed than some of its peers to a slowdown. This could have a significant impact on the value of the firm’s equity.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Jackup rig

I’ve bought more Lamprell after today’s results

Jackup rigDisclosure: I own shares of Lamprell.

After halving my holding in rig-builder Lamprell last December, I’ve hung on to the remainder — despite watching the shares fall by a further 40% or so.

My thinking has been fairly simple: Lamprell’s net cash and backlog of late-stage projects have meant that the firm should continue to generate cash next year, even without much new work coming in.

When the market does start to turn and new projects are awarded, Lamprell should be able to ramp up from a strong base — in terms of both financing and recently-upgraded facilities.

The risk, of course, is that the market slump will continue longer than expected, eroding the firm’s net cash and strong balance sheet.

I decided to wait until Lamprell’s interim results were published today before making a decision on whether buy more. I was also prepared to sell, if the figures were not what I expected.

Having read through the firm’s interim results this morning, I’ve added to my holding at 58.7p per share.

Deep value?

The biggest factor behind my purchase is Lamprell’s balance sheet. Here’s how things stand (as of 30 June 2016):

  • Current assets: $651.7m
  • Current liabilities: $240.0m
  • Net current asset value (NCAV): $411.7m / c.£314m or 92p per share
  • Market cap: £203m

Lamprell appears to be trading at a 35% discount to its NCAV. A substantial slice of this is net cash of $151m. However, a substantial part of the group’s appeal is its $412m of trade and receivables.

What this implies is that the market is valuing the firm’s ongoing business and fixed assets at zero. I think that’s overly pessimistic, given Lamprell’s strong net cash position and recently-upgraded dockyard facilities.

My thinking has been that while new work may be thin on the ground for a little longer, Lamprell’s yards are currently full of major projects due for completion over the next 6-12 months. As these complete, the firm’s receivables should gradually be converted to cash.

In Lamprell’s investor call this morning, CFO Tony Wright confirmed this view. As all major projects are at a fairly late stage, the group has no customer cash on its balance sheet (i.e. advance payments) and expects net cash to rise as receivables start to fall.

I’ve definied NCAV as current assets minus current liabilities. But even if we use the more demanding Ben Graham measure of current assets minus total liabilities, Lamprell still has a NCAV of $321m, or about £244m (71p per share).

The current £203m market cap equates to a 20% discount to Ben Graham’s fairly demanding measure of net current asset value.

…or cheap for a reason?

It’s worth repeating that one reason for the shares’ discounted value may be that the market expects Lamprell’s cash to be consumed by the business of surviving the current downturn.

The group certainly does have relatively high fixed costs. SG&A costs totalled about $26m during H1, so are likely to be more than $50m for the full year.

A second concern is that the recent problems with the Cameron jacking equipment on the Ensco 140 rig have reduced Lamprell’s full-year profit by $35m. I suspect that the company will recover this money and other incremental costs incurred on similar projects from Cameron. But it may be a long and slow process, and could involve costly legal action.

In the meantime, revenue forecasts for 2017 have been cut to $400-500m and the firm’s bid pipeline has shrunk from $5.3bn last year to just $3.9bn. Lamprell has very little work lined up when current projects complete, and may even end up losing money in 2017.

Oil market outlook

The final element in my decision is that I believe the oil market is reaching a low point, and that a material level of rebalancing is likely in 2017. I don’t expect oil to trade anywhere near $100, but I don’t think it will need to in order to trigger some increase in activity levels.

Oil at $55-60 will be enough — in my opinion — to start bringing the market back to life. Costs have fallen dramatically over the last two years and investment in new fields has all but dried up. This situation won’t remain static forever.

I’ve bought more

As things stand, I reckon Lamprell shares are worth about 80p — their NCAV minus a 10% discount. But if the firm can start refilling its order books, then significant further upside should be possible.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

CCTV security camera

IndigoVision Group H1 results: improved trading + good value?

CCTV security cameraDisclosure: I own shares of IndigoVision Group.

Yesterday’s interim results from video security system firm IndigoVision Group were encouraging, without being outstanding.

The main points were:

  • Revenue down 3.5% to $21.8m
  • Camera volumes up 20%
  • Gross margin maintained at 52%
  • Overheads reduced by 8% to $11.9m
  • Operating loss reduced by $1.0m to $0.3m
  • Net cash up to $4.6m from $2.76m at the end of 2015, thanks to lower inventories and longer payment terms

The group reported a number of new orders and said that trading is expected to be stronger during the second half. R&D spending is being maintained to ensure products are updated and renewed.

The group anticipates “satisfactory operating results” for the year. I took comment to mean that FY result are expected to be in line with forecasts from the firm’s house broker.

These forecasts suggest the shares may be going cheap at the moment: earnings of 22.6p per share and a dividend of 7.5p are expected this year, according to Stockopedia. This puts the stock on a forward P/E of 6.5 and a prospective yield of 5.1%.

Despite the stock’s recent gains, IndigoVision also continues to trade slightly below both its book value and its net current asset value:

  • Tangible net asset value: $22.5m
  • NCAV: $16.5m
  • Market cap: $15.5m

Although the discount to NCAV isn’t large, this should provide some downside protection. The tangible net asset value of $22.5m translates to roughly 224p per share.

That would give a 2016 forecast P/E of 10 and ought to be achievable, in my view.

I continue to hold.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Fifty pound note

Could rising debt undermine Fenner’s recovery?

Fifty pound noteDisclosure: I own shares of Fenner.

Shares in Fenner have been on a tear this week, climbing 13% on the back of an upgraded broker note and an upbeat trading statement. The shares are now worth 32% more than they were at the start of the year and my holding — which I bought too early in the mining downturn — is close to breakeven when dividends are included.

However, I can’t ignore the fact that Fenner’s net debt has risen to £150m. That’s the highest level since 2009 and looks quite demanding alongside 2017 forecast profits of just £17.4m.

An excellent Stockopedia interview with Nick Kirrage — who manages some of Schroder’s value funds — nudged me into researching this situation in more detail. (Incidentally, Nick and his colleagues blog at thevalueperspective.co.uk — worth reading for value investors.)

To get a fuller picture, I’ve gathered information about three key aspects of Fenner’s debt — borrowing levels and maturity, covenants and gearing/debt ratios.

Debt facts

At the time of its interim results (30 April) Fenner’s balance sheet looked like this:

  • Cash: £93.2m
  • Current debt (due < 1 year): £39.9m
  • Non-current debt (due > 1 year): £191.3m
  • Net debt: £138m
  • 8 Sept 2016 year-end trading update: Net debt c.£150m

According to last year’s annual report, £58.4m is due to mature in June 2017, with £38.7m due in July 2019. Beyond this, nothing is due for repayment until September 2021.

Interest costs were £14.7m last year, and were similar the previous year. That’s fairly material relative to forecast net profit of £13.6m in 2016 and £17.4m in 2017.

Currency effects: The devaluation of sterling after the EU referendum had an adverse impact on net debt, most of which is denominated in US dollars. Over the next year, this should be offset to some extent by the boost the weaker pound will give to Fenner’s US dollar earnings, which are considerable. Overall, I’m tempted to say that currency effects will be broadly neutral.

Liquidity: Current assets comfortably exceeded current liabilities, giving a current ratio of 1.64. That’s acceptable, if not outstanding.

Are the lenders happy?

Fenner’s debt level remained within its banking covenant levels at the time of its interim results. I’ve listed the two key covenant ratios below, with the covenant limits in brackets:

  • Net debt/EBITDA = 2.3x (< 3.5x)
  • EBITDA interest cover = 4.8x (> 3.0x)

There isn’t a massive margin for error here. But Fenner expects results for the year which ended on 31 August to be at the upper end of expectations. So EBITDA-related covenant problems seem unlikely for the time being. I imagine the firm’s lenders will be happy enough as long as interest payments are maintained.

Debt ratios

The standard measure of indebtedness used by most analysts and stock market data services is gearing. This measures debt relative to a company’s equity value.

Fenner’s net gearing (net debt/equity) was 50% at the end of February. However, I’m not convinced this is a very useful measure of a company’s ability to repay debt. After all, the only way Fenner could raise £150m to repay its debts today would be by flogging its best assets or issuing new shares.

Both measures would be a desperate last resort.  I’m more interested in a company’s ability to reduce debt by generating cash profits, without sacrificing planned capex or growth plans. After all, if a company cannot manage debt in this way, then its dividend will eventually be cut.

Inspired by John Kingham’s work at UK Value Investor, I’ve started to look at debt relative to companies’ profit and cash flow. On this basis, Fenner looks more heavily geared:

  • Net debt/10yr average free cash flow*: 5.2x
  • Net debt/10yr average net profit: 5.4x
  • Net debt/10yr average net profit (inc. 2016 forecast): 5.6x

These ratios look fairly high to me, but they’re not disastrous. As market conditions appear to be improving, I’m inclined to wait until the firm’s final results are published in November before making any further decisions about my holding in Fenner.

*I define FCF as operating cash flow – investing cash flow (exc. acquisitions) – interest payments

Is Fenner cheap or expensive?

However, I will leave you with two other statistics which suggests to me that the shares may be approaching fair value: The PE10 is a favoured metric of value investors, as it compares a company’s share price to its ten-year average earnings. This is enough to smooth out most cyclical peaks and troughs.

Deep value investors tend to look for a PE10 of 8-12. Fenner’s ten-year average net profit is about £26m, giving a PE10 of 14.

I’ve also calculated Fenner’s 10-year average free cash flow (see definition above), which is £29.1m. That puts the shares on a P/FCF10 of 12.6, which looks quite reasonable.

I continue to hold.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.