Affected by the Oil/Gas Price slump? Weir, Petrofac and IDOX

I don’t think any investor will be unaware that the price of oil has fallen off a cliff in the last few weeks. It was good to hear at the IDOX AGM this morning (26/2/2015) that the impact on their business was relatively minor – they supply engineering management information software plus public sector software and the former does have about 11% of sales in the oil/gas sector. The share price barely moved after a positive announcement in the morning that trading was in line with management’s expectations.

Incidentally this is one company that employs a serving Member of Parliament, Peter Lilley, as a non-executive director. After Sir Malcolm Rifkind M.P. suggested he needed other work to live on as his parliamentary salary was insufficient, it has become something of a political debating topic. Should M.P.s do consultancy work or take other jobs? Although Mr Lilley received a substantial number of votes against his re-election at IDOX this was probably more to do with the fact that he had been on the board since 2002. There is a full report on the IDOX AGM on the ShareSoc Members Network.

But yesterday was a different scenario with Weir and Petrofac reporting full year results. Petrofac reported an increase in profits and revenue over the previous year and said the results were “consistent with their previous guidance”. They also maintained their dividend. As they develop large engineering projects you would have expected that they would be severely affected by the slump in oil prices but they reported a record backlog of orders.

The share price had indeed slumped in recent months (as had Weir’s), but it started to bounce back in mid-January when it looked like the oil price had a least bottomed out. On the day of the results announcement it was up 72p (i.e. 9%).

Weir was a very different outcome even though they announced an increase in their dividend (which is usually a good indication of a board’s view of the future). They sell pumps mainly to the oil and mining sectors. Despite their results report being “in line with expectations” (in fact slightly better than analysts forecasts) the share price promptly dived ending up down 9% on the day. Perhaps the killer was that the announcement included the statement: “While visibility in oil and gas remains limited, it is clear that the Group’s strategic progress and cost initiatives will only partly offset the impact of a substantial reduction in demand and the associated pricing pressure.  As a result we are planning for a significant reduction in constant currency Group revenues and lower operating margins in 2015. However, we will continue to invest in extending the Group’s global leadership positions and increasing market share, supported by a strong balance sheet and the cash generative nature of the Group.”

But it’s worth pointing out that analysts had already forecast significant reductions in earnings for both companies, particularly in 2016 for Petrofac and 2015 for Weir. So surely this was old news at Weir? The company does have shorter lead times on orders of course as against the big projects of Petrofac.

You can also listen to the Weir results announcement, and the subsequent question/answer session on their web site but it does not really explain the larger share price impact a lot more. Perhaps it was simply that the Petrofac “outlook” statement in their announcement was a bit more bland.

It can be one of the mysteries of stock market investment as to what influences share prices. It can be simply confounded expectations  – perhaps expectations of better news than materialised or a more dour presentation style from the management.

Both companies operate in a sector that is cyclical in nature and driven by the price of the oil commodity, but Weir has traditionally had a higher rating than Petrofac perhaps because contracting businesses such as Petrofac are subject to large swings in orders and other factors around the company. But both now seem to be getting to low prospective price/earnings ratios presumably on the basis that there will be no quick recovery of the sector (as Weir specifically indicated).

Roger Lawson

DFS Furniture IPO – Should you invest?

DFS Furniture have announced an IPO which will be available to retail investors – as long as you are happy to “take” the price the institutions are willing to pay. Anyone considering investing in the shares might like to note the comments below, but you are of course advised to read the full prospectus and/or take professional advice on the matter if necessary.

This writer is well qualified to write on this subject because I used to hold DFS shares the last time it was listed, before it was taken private much to my consternation by founder Lord Kirkham. Back in the mists of time, I also spent some years working for a furniture retailer.

Let’s first consider the profile of the furniture market in which DFS operates. In theory there are few barriers to entry to sell sofas. All you need is a large shed, and suppliers willing to sell you furniture when you get a customer order (although DFS is unusual in that it does manufacture a proportion of its products). You need some stock as “display” items to furnish the showroom, but you don’t actually need to hold a lot of stock because many customers will wait for delivery. Customers do often require finance of some kind for these big ticket items but that can also be arranged via a third party. In reality you can often collect the cash from customers before you have to pay the suppliers for the goods so like many retailers there is good cash flow (the “Current Ratio” from the last DFS accounts is 0.25 for those accountants among our readers).

Gross margins (i.e. the difference between supplier purchasing prices and selling prices) should be very high in comparison with other retailers, and although DFS don’t give the gross figures their net EBITDA margin is given as 12.2%. With stock that does not age, and few returns,  the business should be a simple and highly profitable one.

But it’s not quite as simple as you think. Many national retail chains have dabbled in the furniture market without much success. Selling furniture is to some extent a seasonal business (boxing day used to be our best for sales), but is also weather based – not many people want to shop for sofas when the sun is out. So lots of promotions are required to get folks into the stores including expensive TV advertising – yes there is always a “sale” on at furniture retailers.

In addition sales are dependent on the economic climate, particularly consumers disposable income and their confidence that they will still have a job to pay off the credit that they will obtain. So when the economy hits a bump like the UK did in 2008/9, then sales can fall off a cliff. That is what happened at ScS which caused them to go into administration as was noted in their own recent IPO. People can postpone buying a sofa for a very long time as they are not “essentials”. Sales are also partly dependent on the number of new house purchases or house moves which tend to crystalise purchases.  And interest rates also affect sales as high credit charges deter purchases. So furniture retailers tend to go through large cycles of boom and bust, and in essence it’s a pretty mature business sector with few innovations – selling furniture over the internet has not yet taken off.

You can see why now is a good time to float a furniture retailing company. Disposable income is rising, there is confidence in the economy, house sales are rising and interest rates are low.

Let’s pick out a few points of interest from the DFS prospectus. Firstly it’s worth noting that DFS have a large market share of upholstered furniture at 26% and hence are the biggest by a long way. But there are lots of other players of course from ScS already mentioned, other chains,  department stores and local specialist retailers. As the prospectus says “The retail upholstered furniture industry in the UK….is highly competitive….”.

Is DFS differentiated in any way from its competitors? One nice thing about retailers for the investor is you can go and walk around their stores and take a view on that and their operations. Do not be surprised though to find few customers in such stores – that was always the case on most days of the week, but I do not think you will notice much differentiation. Vertical integration at DFS from having some sofa manufacturing facilities might be one differentiation however.

DFS have 105 stores in the UK, Ireland and Holland. The latter is a recent venture which may be suspect as few retailers are successful outside their home countries, and particularly furniture and carpet retailers. In total they have 110 properties but these are mainly leased. What properties they formerly owned were hived off via a sale and leaseback arrangement to  a company now called Delphi Properties Ltd and there is a particular warning in the prospectus on the lease terms (see page 27) with that company which is worth reading. Should retailers own their properties? Probably not but it does make then sensitive to a temporary downturn in business, and effectively such leases are off balance sheet liabilities.

Some 65% of DFS customers use credit to finance their purchases which is arranged through third parties. Indeed the company offers “interest free” credit terms. There is a warning in the prospectus (page 19) about the possible impact of changes to LIBOR on this.

How much profit does DFS Furniture make flogging sofas? Surprisingly nothing at all in recent years. There was a loss of £5 million in the last full financial year and £17m in the previous year. The reason for this is simple – they paid £57m in “finance expenses” (i.e. interest on debt) from their gross profits of £112m last year.

DFS was geared up with debt by their private equity owner Advent, who as part of the IPO are selling some of their shares and the other part of the money raised is being used to repay some of the debt. The current debt of £307m will be reduced by £78m but that will still leave a heavily indebted company.

In addition Advent will still hold a very major interest in the company after the IPO (the free float will be in the range 38% to 57% depending on various factors) – similar to the level of interest Lord Kirkham had when DFS was last privatised so this should tell you there are some risks here. Will it be taken private again if the market for sofas declines?

The company expects to pay a dividend of 40% to 50% of post tax profits but given the current financial structure of the group profits might not be high even after repayment of some of the debt. I have not attempted to work it out because the key question when looking at IPOs is whether it is a quality business with future profit growth prospects. With the current and near term future financial and ownership structure there are some doubts in that respect. DFS has certainly historically been a quality business which has survived the ups and downs of their particular retail market sector and kept their market leadership position, but it is unclear whether it is likely to be a sound investment for minority retail investors.

But as with all IPOs, a feeding frenzy might take place to acquire a stake in this high profile and reputable company, so you ultimately need to make your own decision as to whether to invest in the IPO and I suggest you try and work out the likely future profits and dividends.

Roger Lawson

Closet Index Trackers – Investigations in Progress

Since publishing a previous article on closet index trackers back in December 2014, the topic has received a lot more coverage in the financial press. Closet index trackers are those investment funds that claim to be “actively” managed and charge fees more commonly appropriate to that investment management process, while in reality their funds are so similar to those of index tracking funds that they match the index. The allegation is that they are obtaining higher fees on the pretence of doing more work such as investment research (as active styles require) while in reality they are just following the herd.

Funds that are alleged to be closet trackers by SCM Private are Halifax UK Growth C, Scottish Widows UK Growth A and Santander PF UK Equity A and it may be no co-incidence that these are all bank controlled funds (the first two by Lloyds).

The Danish regulator launched an investigation into the matter last September and now the Swedish authorities have apparently launched an investigation as part of a review of asset management. It follows alleged legal action by the Swedish Shareholder Association accusing one fund manager of “mis-selling” closet index trackers to retail investors. Note that proving any “losses” from such mis-selling might be somewhat difficult assuming that they did hug the index because some people claim that index funds generally beat actively managed funds – but that is after taking into account costs of course. The fact that someone promoted the likely merits of their fund by claiming that an active management style would generate higher returns might be one basis for a claim but only if in fact it was not undertaking the processes claimed. Otherwise they might simply claim it was co-incidence that their stock choices or performance matched the index.

ESMA, and Better Finance who represent European private investors, have also been looking at this issue and now the Financial Conduct Authority (FCA) have indicated that they might look into the matter later this year.

Is it important to private investors? Well it does if you invest in funds without thinking, without looking at what they are invested in, or simply taking advice from someone else (and particularly banks).  Chris Dillow highlighted that in the Investors Chronicle edition last week (dated 20/2/2015) where he reported that “financial advice was worse than useless” based on a report from the University of St. Gallen. Those retail investors who took their own advice performed better than those who received bank adviser input.

Would it help to have a measure of index tracking closeness in fund disclosures (e.g. in Key Information Documents (KIDs)? The key problem might be how to define such a measure in a useful and consistent manner. There would also need to be some evidence that investors could actually make good use of a report on the level of index hugging. As investors we are already deluged with so much information that adding more might simply confuse people, particularly if the consumers did not understand what it meant.

Of course if you invest directly rather than via a fund then you don’t have this problem at all because your portfolio can look totally different to an index . That of course might be a danger in itself if you pick the wrong stocks or sectors. But you will certainly be sure to avoid index tracking.

In the meantime there is surely a suspicion that all the hot air on this subject is being generated by those active managers keen to prove they have something special to offer in face of the recent onslaught of low cost index trackers.

Scottish Oriental Smaller Companies Trust AGM Report Summary

I attended the AGM of the Scottish Oriental Smaller Companies Trust (SST) yesterday (19/2/2015). This is an investment trust that is focussed on China, South-East Asia and India – yes there is not much Scottish about it apart from the fact that it is registered in Edinburgh and managed by First State Investment Management who are headquartered there (but whose parent is actually the Commonwealth Bank of Australia).

Normally they hold their AGMs in Edinburgh but this year it was in First State’s offices in the City of London, on which I congratulated the Chairman. It may alternate in future.  There were about 25 investors present, which is more than they get in Edinburgh.

When questions were invited I asked whether there were any plans to refresh the board bearing in mind that of the four directors two had been there since 2004 and Janet Morgan had actually been there since 1995. I considered this a breach of the UK Corporate Governance Code which suggests anyone who has served for more than 9 years is probably not independent and there should be proper justifications given on a “comply or explain” basis. Mr Ferguson said the board was being considered but they report against the AIC Code. I pointed out the same things as I have said at the Baronsmead VCTs and elsewhere (see article in our last Newsletter) – namely that the use of the AIC Code does not exempt them of responsibility under the main UK Code and in any case the AIC is a trade body that represents the interests of investment companies – it does not represent investors. I said there were good reasons for the 9 year rule in the main UK Code which was widely accepted and I opposed those who stayed longer in investment trusts.

The resolutions were then put in turn. After the first one had been voted upon I requested that the proxy counts were reported after each resolution as the intention apparently was only to give them out on a sheet at the end of the meeting. I asked for the votes against to be announced which they were. It is of course best practice to report all the proxy votes after the votes are taken on a show of hands and you can see below why the Chairman might not have wanted the numbers to come out until later. This is a common “sharp practice” when directors do not wish the proxy votes to be apparent to those present.

James Ferguson got 12,190 votes against his re-election as Chairman, but also 391,013 “Votes Withheld” (i.e. 4.2%) which is quite substantial. Janet Morgan got 30% of votes against and Alexandra Mackesy got 9% against . I voted against all three of these directors. I pointed out to the Chairman that he should take note of the large number of votes cast against the three directors.

There was then a useful presentation from Wee-Li Hee and Angus Tulloch representing the fund manager which I won’t cover here for reasons of brevity. But a full report is available to ShareSoc Members on the Members Network.

In summary this was a useful meeting, educational and generally positive. But I would prefer a new Chairman sooner rather than later although he did run the meeting competently. Incidentally James Ferguson was of course a former Chairman of fund manager Stewart Ivory where Angus Tulloch was also a director. They were acquired by the Commonwealth Bank of Australia. It’s a small world is it not in the fund management business!

Roger Lawson

Guide to Venture Capital Trusts and Foresight VCTs

The Association of Investment Companies (AIC) have just published a guide to Venture Capital Trusts entitled “Going for Growth”.  It provides a good overview of this specialist sector of the market. It can be found here: http://www.theaic.co.uk/sites/default/files/uploads/files/AICVCTConsumerguide.pdf

It includes a number of examples of successful investments made by VCT managers including that made by Foresight in Procam. However, the dangers of VCT investment were highlighted recently by the events at Foresight 2 VCT who recently held their Annual General Meeting. In their Annual Report it was noted that the ordinary shares had declined in net asset value from 75p to 59p during the year (i.e. down 21%). The largest reduction was caused by a substantial write-down in Closed Loop Recycling which was their largest single investment.

As a long-standing investor in Foresight 1 VCT, I recall a visit to the company that the VCT manager organised. Closed Loop Recycling process waste plastic bottles into food grade packaging material. It was clearly a business that was operationally geared (i.e. very dependent on volumes) and also very sensitive to the price obtainable in the market for the finished product.  It looked questionable to me at the time and has since required several fund raisings while they try to achieve profitability. Like many worthy “environmental” businesses, the financial return has been dubious in the extreme. It was surely doubtful whether this should have been allowed to become the largest investment in the Foresight 2 fund (and it was also held by some of the other Foresight VCTs).

The AIC publish financial data on all investment trusts and these are some of the figures for Foresight 2 VCT:

– Discount to net asset value:  -47%

– On-going management charge (including performance fee): 3.01%

– Net asset value total return over 10 years: 73.1 (i.e. a reduction of 30%)

– Share price total return over 10 years: 31.3 (i.e. a reduction of 69%)

– Distribution yield nil.

The company is also running out of cash and hence was unable to support the latest fund raising by Closed Loop Recycling apparently. The fact that they would consider doing so is surprising.

Needless to say some investors in Foresight 2 are not happy and a number of ShareSoc Members have approached us about this company and some of the other Foresight VCTs. In general they seem to be underperforming the sector while having high management charges. If you have an interest in Foresight 2, or any of the other Foresight VCTs, and have concerns about the performance of these companies perhaps you would like to contact ShareSoc.

It surely emphasises the point that one has to be selective about which VCTs you invest in and as with any investment trust you need to keep an eye on what they are investing in and how they are managed. Although they may have diversified portfolios of small companies, and some VCTs have performed very well after taking into account the tax reliefs they provide, it is not a sector for ill-informed investors to get involved in without some care. Reading the AIC Guide is a good starting point.

Roger Lawson

Postscript: the two directors who were up for re-election at the AGM, Peter Dicks and David Quysner, got more than  21% of shareholders voting against them. That’s no doubt symptomatic of the concerns of investor. The details are in an RNS announcement by the company.

Naibu and Majestic Wine – AIM companies losing directors.

The latest announcement (on the 18th February) from Chinese company Naibu (NBU) is that the non-executive directors have been unable to obtain any information about the company’s trading position from the two executive directors (Lin Huoyan or Lin Congdeng). The former finance director, Zhen Li, resigned at the end of last year and the shares were subsequently suspended at the request of the non-executive directors on the 9th January pending clarification of its financial position.

It seems the two executive directors have simply gone AWOL and are not responding to inquiries. The non-executive directors have appointed KPMG to report on the financial position of the company but whether they will get any co-operation from the executive directors remains to be seen.

What’s the legal position here? In theory, the non-executive directors have a majority of the board and therefore could pass resolutions to remove the executive management , appoint others and take direct control of the business.  At least that would be the case under normal UK company law. Whether that is enforceable in China may be another matter altogether.

But these events will certainly not enhance the reputation of AIM, and in particularly of Chinese companies listed thereon. Was adequate due diligence done on the background of the executive directors before the company listed would be one simple question to look into by AIM if they cared to do so.

Majestic Wine

This morning (19/2/2015) there was a surprise announcement that the Chief Executive of Majestic Wine, Steve Lewis, was stepping down and the suggestion is clearly that this is with immediate effect. Mr Lewis is praised for his work in the company in the last few years in the announcement, and the share price rose slightly on the morning of the announcement.

The company share price has been drifting down over the last few months – down from a high of 580p at the end of 2013 to about 330p now. Forecasts were revised down partly because of more investment in facilities while revenue and profits were flat.

Perhaps there will now be a change of strategy?

Roger Lawson

Rolls-Royce Results and a New Director

Rolls-Royce Plc published their full year results today (13/2/2015). How does this champion of British industry and one of the FTSE mega caps (market cap £17bn) now look?

Like all such large companies one could spend hours analysing the accounts because the initial “headline” data provided by the company in the announcement tends to err on the positive side. So the “highlights” are given as “Record order book of £73.7bn (that’s slightly up at 3% on the prior year), underlying revenue and profit in line with guidance (what that actually means is that they are just as bad as forecast with revenue down and profits non-existent), free cash flow of £254m (yes that’s 67% down on the prior year) and a reported profit before tax of £67m (that’s minus 96%).

But the CEO said that in challenging conditions the company has continued “to build strong foundations for future growth”. That’s the kind of phrase all defensive CEOs have in their kitbag.

They have sold the Energy business to Siemens for £1bn and are returning cash to shareholders by way of a share buy-back programme. Why not a tender offer or special dividend instead one might ask? The dividend yield is only 2.5% at present even after recent share price falls.

They are cutting costs to try and improve profitability, but this comment in the announcement is worth highlighting: “There are also a number of headwinds in our Civil aerospace business associated with our future growth. For example, we have invested in the capacity required to deliver our record order book, but delay in a number of our customers’ major programmes has meant some of this new capacity has come on stream before it is needed, leaving us with under-utilised production facilities. We have also constructed a number of new world-class facilities to replace older, less productive plants. For a period of transition we are carrying the cost of both the old and new facilities”. This does not suggest that matters are particularly well managed.

Cash flow  has “near term headwinds” and was impacted in 2014 by lower volume and lower deposits received.

One thing you can say about Rolls-Royce though is that their guidance on the future numbers is extensive. But the 2015 guidance is for flat revenue, lower profit before tax, flat or lower e.p.s. and even weaker cash flow than in 2014.  It looks to be a case of a record order book not turning into improved revenue and profits in the short term.

The share price fell initially, but then rose during the day of the announcement to finish 3% up at the time of writing. My view: it may be a great business with great products but they need to do a lot better than this. I have to admit to being a holder of the shares, but I sold some after reading this announcement.

Another announcement by Rolls-Royce today contained some changes in the directors. One of the NEDs has retired and been replaced by Irene Dorner who “brings a wealth of experience from international banking along with a passion for driving cultural change in large organisations” as the announcement says. She spent 29 years at HSBC and is “a passionate advocate of diversity and inclusion“. She left HSBC after having to apologise to the US Senate for HSBC’s money laundering activities.

Irrespective of the latter, personally I prefer non-executive directors to have a relevant business background. How much does she know of the engineering business or how to flog engines to airlines and plane manufacturers? Not a lot I suspect. Tesco was a good example of what happens when you fill the board with worthies who don’t know much about the trade the company is in.

Not a positive sign for Rolls-Royce I suggest.

Roger Lawson