Gooch & Housego and Sectors to Avoid

Today Gooch & Housego (GHH), a photonic components manufacturer, held its Annual General Meeting in Ilminster, Somerset. I would have attended as a shareholder except the time of 11.00 am would have meant a very early start. As it was, the trading update issued in the morning prompted me to sell my holding anyway.

The key negative in the announcement was this: “Looking forward, we believe timing and mix will result in a FY 2019 group trading performance showing low single digit growth compared to last year”. That compares to analyst’s prior forecasts of revenue growth of 14% and adjusted earnings growth of 48%. The share price promptly fell by 20% to about 1100p in the morning and it had already been falling in the last few weeks from a peak of over 1800p in October 2018.

Apart from the well-known problems in China of the manufacturing sector, the cause of the problem is assigned in the announcement to the cyclical nature of the microelectronics sector and the recent impact of the US/China tariff wars. It also comments on the “excess inventory” in the Chinese market taking longer than expected to normalise. However, the company does expect a “multi-year growth phase” in the hi-reliability fibre couplers market which may become apparent in the second half of the year.

But my experience tells me that electronic component manufacturers are notoriously vulnerable to wide swings in volumes and profits. If they are not selling in cyclical markets, or are vulnerable to stock holding changes, they are vulnerable to rapid product obsolescence and leapfrogging by competitors. This is normally a sector I avoid for those reasons. GHH seemed to be operating in a very specialised part of the market which I thought might make them less prone to these problems, but it seems not.

This is a case where my prejudices against a certain market sector are reinforced. Such companies need to be very cheap but Gooch & Housego has not been recently, being perceived as a high-growth tech stock with big ambitions.

The other concern is that the share price decline from October last year was not based on any published news from the company, although the fact that the CFO was declared as leaving in November might have been perceived as such. But in October 2018 the company said: “Overall G&H has a robust order book combined with greater diversification. The Board remains confident that the Group is well positioned to continue to deliver further progress in FY2019 and beyond”.

It would seem that some folks knew about possible problems at the company before me which always makes for tricky investment. With a relatively small shareholding which I had only held for a short time, it’s an example of when it’s best to sell and take a loss. The business might recover but such an experience tells me that it’s always likely to be vulnerable to such shocks.

The electronic hardware sector will therefore continue to be on my blacklist of sectors to avoid which includes oil/gas exploration and production companies, mining exploration, banks and other financial sector companies, insurers, gaming companies, fashion retailers, drug developers, etc, etc. You might call me opinionated but experience tells me that some sectors are just too tricky to invest in unless you have very specialised knowledge. I’ll probably be giving my reasons in detail for avoiding some sectors in a book I am working on as it will take longer to explain than can be covered in a short blog article.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Plus500 Share Price Dive and Betting Against Your Customers

My last blog post mentioned my brief holding in Petrofac. Another company I held briefly was Plus500 (PLUS). Yesterday its share price dropped over 30% following a profit warning in a preliminary results announcement. The cause is simply that tightening regulations are impacting revenue.

Plus500 is big CFD provider. That fact that most “investors” in CFDs lose money is widely acknowledged and the Financial Conduct Authority (FCA) and EU regulators have been tightening up on the rules that apply to Contracts for Difference. The reality is that most such “investors” are ill-informed speculators.

The FT said today that the announcement was most revealing as it showed “for the first time how much its earnings relied on betting against its customers”. Columnist Lex also described it as a “risky business” and that is one reason I sold the shares and have not considered reinvesting since. There are some companies that are simply too dubious to hold – rather like Petrofac, particularly if you also have ethical qualms about how they operate.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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£400 Million Legal Claim to be Launched Against Petrofac

Keystone Law have announced that they are about to launch a legal claim against Petrofac (PFC). This is what the announcement says: “Keystone Law is getting ready to launch a claim on behalf of institutional investors who have suffered significant losses on their Petrofac investments since at least 2010. The team, led by senior litigators George Lambrou, Matthew Reach and Robert Lawrie, has joined forces with litigation funder, Innsworth, to mount legal action against the oil services company. The claim is centered on allegations that Petrofac was involved in bribery, corruption and money laundering, which first emerged in press articles in early 2016. Petrofac saw billions wiped off its value in 2017 when the SFO confirmed its investigation. The value of the shareholder claim is expected to be in excess of £400,000,000.”

Petrofac share price peaked at 1750p in 2012 but is now only 390p. The company admitted in an RNS announcement on the 7th February that a former employee had admitted bribery under the UK Bribery Act 2010 after a Serious Fraud Office (SFO) investigation.

At a prospective p/e of 5 and dividend yield of over 7%, is this a bargain one wonders? But one would need to be convinced that the company has changed its culture. Revenue and normalised earnings are also forecast to fall. It’s also a tricky sector as developing oil/gas production projects depends on the market prices of those commodities so can result in feast or famine for new business. The threat of a major law suit won’t help the share price either.

I did hold some shares in this company from 2009 to 2012 and attended at least one of their AGMs in 2012. It’s interesting to look back at what I said in a report on the meeting that I wrote at the time and which is available to ShareSoc members on their web site. Basically I complained about evasive answers and waffle from the directors. There were also negative press comments subsequently about £1 million spent on a private jet for the CEO, and lack of disclosure of that to investors. I concluded that I did not trust the directors of the company and sold my shares.

As I have said many times before, it’s always worth attending AGMs to get an impression of the directors – you can always learn a lot by doing so.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Accesso and Executive Chairmen

Yesterday the share price of Accesso Technology Group (ASCO) dropped over 35% after the company issued a trading update and also announced that Executive Chairman Tom Burnet was moving to become a non-executive director. This company has been one of the great growth stories on AIM after Tom took charge as CEO in 2010. Revenue has grown more than 6 times since then but profits and cash flow have been more variable. But Tom is a very persuasive speaker and the share price multiplied by more than 25 times to reach a peak of 2800p in September 2018 – it’s now 930p.

I first purchased the shares in 2012 when the business was selling a solution for theme park queuing and most of their revenue came from one customer. They have now developed the technology to have wider applications and have a wider customers base of “visitor attractions”. Acquisitions have also been made to broaden the product offering and the strategic plan of the business was to become a “consolidator” in the ticketing and other IT solutions to this sector.

Tom Burnet was made Executive Chairman in May 2016. That concerned me somewhat because he is clearly a very forceful person and I generally do not like Executive Chairmen unless there is a very good reason to have that kind of sole dictatorship such as the company being in dire difficulties – there did not seem to be such a justification here, and it is of course contrary to Corporate Governance guidelines for good reasons.

I sold most of my shares over 2016, 2017 and 2018 after the share price continued to ramp up driven by momentum and some investors apparently feeling that Tom could do no wrong. He seemed to think likewise when I prefer more humble personalities as CEOs. Institutional investors also piled in. But the financial numbers were not all that impressive – indeed I queried the poor return on capital and large increase in administrative expenses at last year’s AGM. Other commentators queried the revenue recognition, poor cash flow and high levels of software development capitalisation. Director share sales by Tom and others in 2018 were also a negative.

That’s the history, so what about the current valuation? The last published financial results were the interims for the 6 months to end June 2018 when I made a note that the prospective normalised p/e was 47! But Accesso’s interim results are usually very untypical of the full year figures as it’s a very seasonal business – not many people visit theme parks in the winter. But they did mention the impact of IFRS15 on revenue recognition where they had previously been recognizing the full value of tickets, not just their commission income. This is probably why current analysts’ forecasts show a fall in revenue for the 2018 year versus 2017, with a resumption of growth thereafter.

The latest announcement suggested the full year results will be “broadly” in line with market expectations – which is a bit tendentious bearing in mind we are now well past the financial year end already. It also mentions a one-off cost exceptional cost of $1.7 million on an acquisition which was aborted in October 2018. Why was there no announcement of this at the time as surely it was price-sensitive information?

Actually figuring out what the likely earnings will be for 2018, particularly as the new board might wish to take a bath and clean out any questionable capitalisations is almost impossible without more information.

My fall-back valuation method in such circumstances is to look at the market cap revenue multiple. Revenue forecast for 2019 is $138m which equates to £106m when the current market capitalisation is £254m. So the multiple is 2.4 which is relatively low for a high growth business, with good IP (protected by patents), high recurring revenue figures from existing customers and some profits rather than losses. The business might look very attractive to trade buyers who could strip out a lot of the overhead costs (which is why revenue multiples are important in valuing such companies).

There may be more bad news to come of course, but at least they now have a conventional board structure with a new non-executive Chairman (Bill Russell) who seems to have a very relevant background.

The dangers or having a dominant and forceful Executive Chairman have of course been reinforced by events at Patisserie (CAKE) where Luke Johnson had that role. Having a more conventional board structure might not have prevented the fraud there altogether, but it might have enabled the non-executive directors to more easily question the way the company operated, the internal controls and the information being provided to them. Indeed it might have ensured more questioning non-executive directors were appointed to the board in the first place. A separate Chairman might also have questioned whether Luke Johnson was spreading himself too thinly across his numerous business interests.

The corporate governance principle of having a non-executive Chairman is not something investors should ignore.

Postscript: I corrected the revenue growth figure and the market cap sales multiple figure a few hours after the above was first published after I identified some sloppy research, but the conclusions were unchanged.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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AssetCo Case and the Grant Thornton Defense

I mentioned in a previous blog post yesterday the judgement in the case of the alleged breach of duty by Grant Thornton (GT) when acting as auditors of AssetCo Plc (ASTO) in 2009/10. See https://www.bailii.org/ew/cases/EWHC/Comm/2019/150.html for the full judgement. For those who have not had the opportunity to read all 300 pages of the judgement, here are some interesting points from it:

It was conceded that the audit was negligent in a number of respects, but GT’s defense against the damages claim was based on what it asserted were six “insuperable obstacles”. Some of the key points they made are below:

  1. They deny that if the true accounting position had been known they could have avoided an insolvent liquidation. Indeed they claim that AssetCo was better off not knowing, in 2009 and 2010, the truth of its own position.
  2. They claim that the steps that AssetCo took (a scheme of arrangement) mitigated all their losses and otherwise avoided all harm.
  3. That none of the damage claimed by AssetCo was caused by Grant Thornton but by the directors of the company.
  4. That the Letter of Representation supplied by AssetCo as part of the audits contained falsehoods and hence GT should be relieved of all liability.

They also disputed the quantum of losses suffered by the company and their entitlement to interest thereon.

The judge concluded that GT’s conduct was “not reasonable”, and upheld the claim. The defense that AssetCo were better off not knowing their true financial position is a very remarkable one indeed! How are companies expected to avoid losses if they do not know their true financial position?

But this case is a good example of how civil claims arising from company fraud are simply too expensive to pursue in most circumstances and take much too long to get into court. Expecting civil claims to discourage bad auditing and somehow police audit work is simply not a realistic proposition.

If GT’s defences had been upheld, it would effectively make it impossible to challenge any incompetent audit work however bad it was and however damaging the consequences. If the case does go to appeal, let us hope the judgement is upheld.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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AssetCo, Patisserie, Stockpiling, Warehouses, Sheds, Brexit and Venezuala

A week ago, an award of damages of £21 million plus interest and costs was made against Grant Thornton for their breach of duty when acting as auditors of AssetCo Plc (ASTO) in 2009/10. See https://www.bailii.org/ew/cases/EWHC/Comm/2019/150.html for the full judgement. I understand Grant Thornton may appeal. These are the key sentences in the judgement: “It is common ground that in those years the senior management team at AssetCo behaved in a way that was fundamentally dishonest. During the audit process management made dishonest statements to GT, provided GT with fabricated and massaged evidence and dishonestly misstated reported profits, and provided GT with flawed and dishonest forecasts and cash flow projections. Outside of the audit process, management were engaged in dishonestly ‘overfunding’ assets (i.e. misleading banks as to the costs of new purchases etc so as to borrow more than was permitted), misappropriating monies, dishonestly under-reporting tax liabilities to HMRC, concluding fraudulent related party transactions and forging and backdating documents. GT accepts that it was negligent in a number of respects as the company’s auditor in failing to detect these matters…”

In 2012, AssetCo (ASTO) was forced to make prior period adjustments for 2010 that wiped more than £235m off its balance sheet. AssetCo was, and still is, an AIM listed company now operating in the fire and emergency services sector.

This is undoubtedly a similar case to Patisserie (CAKE). According to a report by Investors Champion, former Chairman Luke Johnson suggests it “has possible relevance for a claim against Grant Thornton” and he will be pushing the administrators to instigate similar action. Let us hope it does not take as long at ten years and millions of pounds in legal costs which administrators may be reluctant to stand.

According to a report in the FT, manufacturers are stockpiling goods at a record rate in anticipation of supply chain disruption from Brexit. Importers are also stockpiling goods – for example Unilever is storing ice-creams and deodorant such as its Magnum ice-cream bars which are made in Germany and Italy. There is also the increasing demand for warehousing by internet retailers, even for smaller “sheds” to enable them to provide next day or even same day delivery.

Big warehouses are one of the few commercial property sectors that has shown a good return of late and I am already stacked up with two of the leaders in that sector – Segro (SCRO) and Tritax Big Box (BBOX). On the 31st January the Daily Telegraph tipped smaller company Urban Logistics REIT (SHED) for similar reasons and the share price promptly jumped by 7% the next day wiping out the discount to NAV.

There has been much misinformation spread about Nissan’s decision to cancel manufacture of a new car model in the UK. They denied it was anything to do with Brexit. This was to be a diesel-powered model and as they pointed out, sales of diesel vehicles are rapidly declining in the UK. The same problem has also hit JLR (Jaguar-LandRover). One aspect not taken into account in many media stories was that Japan has just concluded a free trade deal with the EU. Japanese car manufacturers no long need to build cars in Europe to avoid punitive tariffs. Where will the new vehicle now be made? Japan of course!

There has been lots of media coverage of the politics of Venezuela and its rampant inflation. A good example of how damaging extreme socialism can be to an economy. Over twenty-five years ago it had a sound economy and I had a business trip scheduled to visit our local distributor there. But at the last minute the trip was cancelled after a number of people were killed in riots over bus fares. I never did make it and I doubt I will ever get there now.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Staffline Issues, Audit Purpose and News on Patisserie

Yesterday Staffline Group (STAF) issued a statement first thing in the morning saying that the publication of results scheduled for that day would be delayed. The shares promptly dropped by about a third. Later in the day it stated that “the company can confirm that this morning concerns were brought to the attention of the board relating to invoicing and payroll practices within the Recruitment Division”. A full investigation was promised and the shares were then suspended. Is this yet another accounting scandal in an AIM company one wonders? Generally after such announcements, only bad news comes out.

Staffline is a recruitment/staffing and training business. It’s one of the largest AIM companies with revenue of nearly a billion pounds and reported profits of £71 million last year. It has been growing rapidly in recent years.

I have never held the stock although I did see a presentation by the company a couple of years ago. In general I don’t like employment businesses as they tend to follow economic cycles and the sector has few barriers to entry. I also considered the company to be at risk from regulatory and tax problems. The company also has considerable debt which is odd for this kind of business which generally have a “capital light” structure. Investors might have been concerned by the announcement on the 8th January that net debt had risen to £63 million at the 2018 year-end.

Investors will have to keep their fingers crossed for further news.

I covered in some previous blog posts the issue that audit quality is generally poor and that false accounts and outright fraud are regularly missed by audits – and it’s not just one or two firms – the whole audit industry seems to be incompetent in that regard. The Commons BEIS Committee held a meeting yesterday and one of the witnesses was David Dunckley, head of Grant Thornton, who audited the accounts of Patisserie (CAKE). He admitted that auditors did not look for fraud when auditing accounts and that there was an “expectation gap”. Committee members were not impressed.

Meanwhile Investor’s Champion revealed that Luke Johnson and Paul May, directors of Patisserie, owned a property that was leased back to a subsidiary of the company. As a related party transaction this should have been disclosed in the Patisserie accounts but was not.

The FT also disclosed that at least 30 shareholders had signed up to support a legal case with law firm Teacher Stern. But other investors are talking to other solicitors. In such cases it can be many months before the basis of a claim is clear and solicitors tend to jostle for the business of pursuing a claim in the meantime – one might call some of them “ambulance chasers”. Investors are advised not to spend money on such actions until the basis of a claim, and the ability to both finance an action and identify asset rich defendants is clear.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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