A leisurely update

Now I'm not expecting to do frequent portfolio updates as I don't trade very often and most short-term market movements are just noise anyway but quite a lot has happened to my portfolio in the past month and a half so I thought I'd better get my thoughts together. Yesterday, my largest position - All Leisure Group (LON:ALLG) - announced their 2012 results. It's risen quite a lot this year, ~57% even after the pull back after the results, but I'm getting increasingly bullish on this share and don't see any need to trim it yet. It's actually my pick this year (and last year!) for the Motley Fool's share competition and I did a write up here as well as follow up comments so I recommend reading that first before reading this blog post.

The results at first seem very subdued. Revenue takes a large jump up but full year profits were tiny at £0.8m. What's there to be excited about? Well, 2012 is pretty much a transitional year for ALLG. Due to a weak cruising market (partly due to the Costa Concordia tragedy) and a fleet in need of a revamp the directors took the decision to pull three (out of four) of their ships out of service for a good part of the year for upgrades. Also, for one of their ships a third party charter pulled out and left the vessel out of service (during which they decided to do the upgrades). As a result, their cruising division showed a stonking loss for the year of -£6.9m - they say the loss of the charter 'contributed significantly' to this loss. However, this is in the past and we now have a fleet that's been recently upgraded and ready to operate at full capacity again. This appears to be paying dividends already:

"At the start of the winter 2012, mv Voyager was in the exceptional position of being 82% sold for that season prior to her inaugural sailing. Currently revenues per diem for mv Voyager are forecast to be 20% higher than achieved 2011/12 on mv Discovery. This is driven by the increased number of outside and balcony cabins and less capacity."

"Over the winter 2011/12, mv Minerva was out of service for just over three months, whilst a substantial technical upgrade was carried out. During this time the ship also underwent an extensive upgrade to both public areas and the 197 cabins. 73% of the cabins are outside cabins and clever use of space increased the number of balcony cabins from 12 to 44. A new observation lounge added to Promenade Deck increases the on board facilities. Passenger response to the upgraded vessel has been extremely positive."

So if cruising caused such a big loss, what made up the difference? Here we get on to what I see as being a very exciting development for ALLG - the acquisition of Page and Moy Travel group. They first announced the acquisition here where the headline figures got my attention. They paid £4.2m for a group doing £107.6m in revenues! How did they get it so cheap? The catch - it made an operating loss of £5.6m in 2011. Not great. The previous owners were two banks - HSBC & Credit Agricole - who ended up with it after the previous private equity owners, HgCapital, went bust with it in the 2008 downturn. It's probably worth noting at this point that HgCapital paid £180m for it. Whoa. Clearly they were far too optimistic but it's clear this business has done pretty well before in the past to have warranted such a price. Naturally the banks here just wanted this loss making business off their books so weren't price sensitive allowing ALLG to swoop in and nab it for a relative song.

At the time of the acquisition I was a bit worried as it seemed a big risk to be taking on such a loss making business given the current one wasn't firing on all cylinders either. However the heavy degree of insider ownership re-assured me that if anyone was going to lose big here through hubris it was going to be the directors so I trusted they'd thought this through (I very, very strongly prefer owner-operator shares. Never forget the power of incentives!). The annual results give more detail on the acquisition so we can learn more about what's going on here. Let's take a look at some figures for Page & Moy in 2012:

Full year results:

Revenue: £93.9m, Profit: £4.6m

Contribution to results:

Revenue: £60.9m, Profit: £8.9m

Balance Sheet Pre-Acquisition:

Tangible Assets: -£14.7m

So this tells us another reason why they got the business so cheap - it has negative tangible assets. This has pros and cons: pro, it means the business probably operates on negative working capital (like the cruising business) so expansion is an extra source of cash which can be used in the business. con, it means if things turn south the business is in trouble. That being said, the directors also state the business is a "low-risk model and has no forward financial commitment for hotel costs, transportation costs, or aviation capacity", which it probably needs to be to make negative working capital operation safe and viable.

It also says that the timing of the acquisition flatters the profits by £4.3m, so the combined entities made a loss in this FY. However, the major plus is that management have already turned the £5.6m loss in to a £4.6m profit. It hence means they acquired the business for less than last year's profits! What a wonderfully shrewd move by management. Revenue is down from 2011, yes, but this is due to cutting unprofitable lines of business. To quote the results again:

Following a detailed strategic review of the Page and Moy Travel Group brands and product portfolio prior to its acquisition, a number of underperforming products and business lines have been discontinued for 2013. Ceasing to operate the ex UK coaching holidays and components of the Christmas programme was part of this strategy, along with the decision to phase out the Page & Moy brand and incorporate the profitable components of the business into Travelsphere's portfolio of tours. The Group then re-launched the Travelsphere brand as a value for money, yet quality product. The end of year results show this has been very successful and going forwards the flexible business model of our Tour Operating Division allows us to align our capacity to fluctuating demand.

This means the 'pro forma' results of the business in 2012 were:

Revenue: £160.4m

Operating profit: -£3.5m

However we now have all ships upgraded and back in action. Given the non-acquired business did £66.5m this year but did £80.4m in 2011 implies at least a boost of £14m in revenues just from ships coming back in. Stockopedia reckons that the brokers are putting them on £202m of revenue for 2013 (although these same brokers reckoned they'd do £192m of revenue this year and make a 5.2p profit - no idea how they thought that was possible!!) which seems high but potentially achievable given the ship upgrades in capacity and quality. For fun, let's imagine a set of  'pro forma' results that take the 2011 ALLG numbers (with no ships out of capacity) and the 2012 Page & Moy numbers and combine them:

Revenue: £174.3m

Operating profit: £8.0m

So this puts this hypothetical year (which is probably closer to an average year) on a P/E of 3 at the current share price! Now in this hypothetical year the directors are still complaining about how poor the results are due to the economic climate (they were in 2011 and in 2012's results,) so clearly they still see the margins here as being poor at ~4.6%. ALLG was doing solid >11% margins pre-2009 so clearly there's scope for improvement there (although I've no idea what P&M's average margins are). So, we have a business on a pro-forma P/E of 3 despite the E being disappointing. This is why I'm so very bullish on these shares and think there's still plenty more upside available when the true earnings power is revealed here in the next few years of results and the business gets re-rated to a more sensible valuation.

What are the risks here? Well, besides all the ones I've mentioned before in my other posts I think the big new one is balance sheet risk. The weak balance sheet of P&M means that the combined business only has £9.3m of net tangible assets and the previous tangibles are now intangibles. I think the benefit of increased earnings power here outweights this though.

That's my updated thesis on ALLG. Since my last update I've also added CLIG & SIGG to my portfolio. I got the idea for CLIG through a Motley Fool write up here (and there's more here) and I especially liked their shareholder-orientated incentive structure (as well as the dirt cheap price and wonderful business economics). This quote from the annual report really got my attention:

As shareholders are aware, we run a business with a very simple business model. We collect fees from our clients for our services, we pay our bills which are both forecastable and to a great extent fixed. We don't use leverage, nor off-balance sheet instruments, nor do we trade derivatives as principal (other than occasional low level hedging). There are no associated companies or minority interests within the Group. We do not use tax havens. We do not handle client monies. We have a significant amount of cash in the bank relative to our size and we basically stick to what we know.

With regard to remuneration we continue to distribute 30% of our profits as profit-share. Our staff, clients and shareholders understand this formulaic approach. It's a pity that this approach has not been embraced by the financial service industry generally. As it is, in many parts of the financial services industry it seems as if losses are not the responsibility of mangers rather it's the shareholders who take the rap. Whilst our formulaic approach seems out of keeping with many in our industry, at least our shareholders have an idea that our returns go up and down together with theirs.

We have continued to manage our business very conservatively. We have continued to attempt to keep costs down. We do not spend shareholders' funds entertaining and we generally attempt to manage our business as if shareholders were present in our offices every day of the week. One reason I would suggest that expenses are kept down is because staff are either shareholders themselves or own shares via the CLIG ESOP. At present staff own (including ESOP ownership) 27.9% of CLIG shares, and 75 out of 82 of us are incentivised in this way (a handful of more recent recruits do not yet hold options).

As for SIGG I got the idea from @marben100 on Twitter and read some notes @BrianGeee1 kindly sent me. Essentially it's a wind-up play for 96.4p of assets compared to a market price of 57p. There's a lot of worry on ADVFN about the quality of the assets and how illiquid they appear to be. The new management however take a low management fee of 0.5% but are largely compensated as to how quickly and effectively they can realise the assets for shareholders so I'm glad our incentives are aligned here. Even at a big hair-cut and a relative slow asset realisation process my IRR should be decent here. I currently also have one other share on buy list but I'm waiting for cash to build up before I buy it - I'll reveal more when I actually pick it up!

In other news, my big write up on LCG came good when not one but three potential bidders appeared! I made some comments in my stockopedia post here as to what I think could happen. I'm still very bullish on the shares. MGNS also announced their results today and they were pretty disappointing - especially the big dividend cut. The outlook is still grim but the price is so low for a business that is clearly only suffering from a cyclical downturn that I'm happy to still sit tight and wait it out. It's another owner-operator share and John Morgan has stepped back in as CEO to take charge so our incentives are aligned here - I trust him to focus on long term shareholder value.

We're clearly in a full on bull market in UK small caps at the moment, with the FTSE Small cap index (ex. investment companies) up 8.25% YTD and the AIM index up 6.64%. I'm a bit torn between the worrying signs of increasing optimism from other investors however I still think I can find companies on cheap valuations so I'm not taking money off the table yet. I've had a good start to the year so far - I made only one short-term performance prediction in my 2012 performance review and that was that there was no chance I'd better my IRR of 97% (which I made entirely through lucky timing). Currently I'm being proved very wrong and my IRR for 2013 YTD is 166% as my portfolio is up 13.8%! As much as I'd love to put this down to skill I have to hold my hand up and admit I'm just the lucky beneficiary of a bull market - a lot of my out-performance has been driven by a handful of concentrated positions (especially ALLG) so it's statistically meaningless unless I can repeat this over many, many years.

Right, that's the end of this update. My current portfolio allocation can be seen below (Disclosure: I own all the shares shown):

London Capital Group - Worth a (spread) bet

OK, so the title isn't winning any awards for the terrible pun but hopefully the rest of the post will compensate. I'm a fan of London Capital Group (LON:LCG) as I believe it's a business that is fundamentally very attractive and is suffering from a number of headaches in the short term which don't really impair the long term value anywhere near as significantly as the market is pricing it to.

So, what's the story? LCG are a spread betting firm, a mix of their own brands and white label to other big names such as TD Waterhouse, Betfair, Bwin.Party and Saxo bank. They offer a number of products but by far the most significant is their UK Financial spread betting service (£26.6m revenues in 2011) followed by their Institutional FX business (£8m revenues in 2011). Whilst you might think this business is something similar to a stock exchange in characteristics I see it far differently; the economics share far more similarities to the gambling sector, an area I used to work in and know fairly well. The vast, vast majority of clients do not use spread betting like true 'investors' but instead they speculate heavily on margin - and they don't speculate very well. Nearly all the clients end up as net losers. A few people have asked me how such a model is sustainable, how does the business survive if the customers keep going bust? It's simple really - the same way William Hill & co survive, through a combination of recruiting new accounts and having old accounts redeposit. You'd be amazed at the gamblers who deposit year in, year out and somehow convince themselves that they are actually 'winners' and 'the sharp money'. Spread betting is, as the name suggests, gambling. The average revenue per user is much higher than traditional gambling too, at ~£1.4k per annum compared to more like £300 for a bookie.

At the end of 2008 LCG were riding high with their share price touching 400p. Now they are hanging just over 33p. What happened? The classic case of high profit multiple (20x in 2007) meets profit collapse in the 2009 recession. Since then the company has lurched from disaster to disaster; first the FSA forced them to pay a significant fine on grounds that seem very harsh, then the company had to write off millions of pounds worth of software assets after they proved unsatisfactory. To top if off, the most recent trading statement shows that profits for this year have collapsed to a loss after revenues took a big dive. How can this happen? Well, spread betting revenues are inherently more volatile than that of traditional betting as they depend on volatility in the markets. Big swings in the markets encourage clients to trade more and generates high revenues. Having a quiet year in the markets is the equivalent of William Hill having half the football matches they'd normally get in a season.  To get an idea of this volatility, here's a graph I lifted from the last annual report:

Looking at the graph, it's almost pure fluke that revenue growth has been so smooth for the past few years - good half years can be almost double bad ones. IG Group, LCG's much larger listed competitor (LCG are number 2) also reported significant drops in revenue for the past six months so this is clearly an industry issue rather than just an LCG issue. This is a big crux of my argument for this share - I believe this is not a structural decline but rather a cyclical one. It's folly to value a cyclical business on one year's results and a far better method is to look at average earnings over a decent period. Joel Greenblatt calls this kind of investing 'time-arbitrage', I'm able to 'arb' the difference between the price now, caused by investor's short time horizons, and the price sometime in the distant future due to my long time horizon.

Given everything is so terrible with LCG, why do I like it the share today? Essentially it all comes down to valuation. The market has looked at the most recent result and decided the company will never make a profit again, as the company now trades at a discount to the net cash on the balance sheet (£20.3m of cash against a £17.7m market cap) and about half of book value (which contains intangibles - it trades at 0.84 of tangible book). This is for a company which has, historically, earned an average of 20.7% ROE for the past five years even including all the disasters.

The business also has a number of qualities that are very attractive. For one, it's number 2 in it's main market (although the number 1 is 10x larger in revenues) which is still growing overall. LCG has achieved a huge CAGR of 35% in sales for the past five years and IGG has also done 27%. Whilst I don't think this level of growth can be achieved in the future I don't see why double digit revenue growth, on average, shouldn't be achieved. This is a growth company in a growth industry. Secondly, the company has a number of competitive advantages. Whilst regulation is a burden for this company it does massively increase the barriers to entry - if you want to be another FSA regulated spread better you'd have to comply. Whilst it's possible to relocate offshore (and a number of their competitors do) the FSA badge of approval is valuable in it's own right. It'd be especially tough to come in and try and win the white label contracts that LCG already have. Also the product is not a commodity - it has to be good to attract and win clients and a new competitor would need to reach their standard to compete. The competitive advantages LCG and IGG enjoy are reflected in the very good economics of their businesses: Both are non-capital intensive and generate high average ROEs despite the large cash regulation requirement and both have huge margins. So we have a growth company with good competitive advantages earning a huge return on capital and enjoying high margins (key phrase here - on average) - what's not to like? :)

Some more tasty facts and figures: Including the broker's expected profit for 2012 (-0.4p), the 4 year average profit of the business is 4.53p. Given the current share price, that's an average P/E of only 7.36. An average of 2.18p was paid in dividends over the period too (assuming no final dividend this year) giving an average yield of 6.53%. Now, I've chosen the 4 year time period to be as harsh as possible as it excludes the good 2008 & 2007 results. The same figures for a 6 year period are 8.94p of average earnings for an average P/E of 3.7 and an average dividend of 4.36p for an average yield of 13.11%. Even going on just the horrible 4 year numbers though, which includes two years where essentially no profit has been made, the share price still looks excessively cheap. It's worth pointing out that I don't include the net cash at all in my valuation. This is because almost all of it the company is required to hold under FSA regulations and so it's more like working capital than free capital - don't expect any IND style large special dividends any time soon.

The way I see it, even if things carry on being terrible the company is still going to earn a decent return, on average, for shareholders at the current price. The other thing to remember is that margins have come down from a high of an average of 44.7% for the four years 2005-2008 to an average of 18.1% (on adjusted profit figures) for the past three years. Profit growth hasn't come close to matching the revenue growth because of this margin contraction. IG Group have managed to hold their margins in the 40%s over this period so clearly LCG have under-performed in this regard. This is due to a number of factors: First, management have launched a number of smaller products that have more or less all made losses so far and so dilute the margin. Secondly, costs in the core business have also shot up without a corresponding rise in revenue. This is something management are now taking action about and are looking to trim back the cost base & try and get the smaller divisions to focus on achieving profitability. They believe they've found some 15% of the cost base that could be taken out and Simon Denham mentioned at the Mello meeting that IT costs should be dropping after a period of investment anyway. This is a source of further upside - if the company can execute on their cost cutting promises profits should recover.

Another factor to consider is the current interest rate environment. LCG benefit hugely from higher interest rates because they carry so much gross cash they can't do anything with (cash from customers and regulatory capital) other than invest at close to base-rate levels. At June 2012 they had £67.3m of this gross cash so each 1% rise in interest directly adds an extra £0.67m of profit to the bottom line - it's that simple. Not only that, but LCG also charge their customers financing charges to hold bets open based on LIBOR. Again, an interest rise plays nicely in to generating extra revenue here. This is yet another potential source of significant upside should interest rates begin to rise.

One last thing that stood out to me in the presentation Simon did. I knew from my time in the gaming industry that the customers tend to follow an extreme pareto distribution - 50% of your revenues come from the top few % of your customers. The big 'whales' as they are known are very important. However, when I asked Simon about his customer concentration he replied that his top ten customers account for no more than a handful of % of his revenues. This was pretty surprising to me, so I asked how this was the case. It turns out it's a deliberate risk management strategy, which makes sense, but it does mean LCG are turning away their biggest and most profitable customers! Again, I see further potential upside here should they decide to change this policy.

In the dream scenario here, revenues recover, margins go back to historical highs & interest rates rise. Any combination of these three would see PBT shoot back up and trigger significant multi-bagging from the current price. The downside is fairly well protected due to the very strong net asset position, of which a large chunk is held in cash. In my mind, this creates a really attractive risk/reward proposition. Simon mentioned at the Mello talk that a number of potential acquisition suitors had come knocking after the share price decline which I take as a good sign - people who know the industry well are coming around making opportunistic bids. I doubt a bid will take place around the current price any time soon though, LCG has big insider ownership from the three co-founders who will demand fair value for any purchase (which they believe, as I do, is significantly above the current market price). Personally, I'd much prefer a slow but big recovery than a quick 30% gain from a bid and am happy that my incentives are closely aligned with management.

So what are the big risks? Well, cash has fallen significantly over the past 6 months - down from £25.5m to £20.3m, far more than the actual profit loss. I remember Simon Denham saying something like only £4m of that £25.5m was 'excess cash' so it must mean they are close to eating in to regulatory capital (although in the 2011 annual report they say that, of the £25m of net cash, they had £10.7m of surplus regulatory cash requirements so maybe I'm misinterpreting him?). I'd expect that the company have anticipated such liquidity needs and are prepared accordingly. Another big red flag is the COO, who is also a major shareholder, has quit to 'pursue other interests'. This is a big worrying although the optimist could interpret it the other way, that after a number of years of poor margin performance we are seeing a replacement in a very significant senior position. There's also regulatory risk present, as we saw when LCG had to pay a large fine to the FSA. I see this kind of risk as an unpredictable cost of doing business, which decreases my valuation of the business but not in a significant way. A more serious regulatory risk would be if the government changed the rules to remove the tax advantages of spread betting, which would be very harmful to the industry.

The other really big risk is that I've completely mis-read the revenue decline and it's the start of a serious structural collapse. If that's the case, the assets could become significantly impaired by losses and the downside protection would be eroded. However, I personally believe the odds of this are pretty low given the obvious cyclical history of the company. There's also a bit of a stigma for these companies recently after the MF Global and Worldspreads frauds with the companies both dipping in to client funds. I think this risk is in reality very, very tiny due to the insiders owning such a large proportion of the company. Why ruin a great long-term business by engaging in short term fraud? I don't see the incentive here and as Charlie Munger says "Never, ever, think about something else when you should be thinking about the power of incentives".

With all that in mind, I've made LCG a 4.8% portfolio allocation (down from last time due to the price fall and appreciation of the rest of the portfolio) and I'm tempted to top up after even more recent falls. As for the rest of my portfolio, since my last post I've sold out completely of FCCN and redirected the proceeds in to KENZ and MGNS (which have both gone up since, nice to have a bit of good luck!). The losses at FCCN were worse than expected and due to the high operational gearing of the company the risk here is too high for me. Against weak comparables from last year the company still reported a revenue fall. The company has net cash of ~£25m, granted, but they burned £10m of cash last year. Even if things don't get worse, which there's no reason why they couldn't, they'd burn through that pile pretty quickly. Operational gearing could make the situation either very, very good or very, very bad here - it's kind of an all or nothing punt. Since I'm an investor who likes to be fairly concentrated and I can't protect the downside here it's one I'm going to pass on.

This could well turn out to mistake and a number of investors are still bullish here, including Paulypilot who knows the sector far, far better than I ever could given he's worked in it but I don't feel like I'm able to calculate the upside/downside scenario probabilities here. If the upside scenario materialises I won't kick myself, there's always plenty of other opportunities out there. I will, however, be paying close attention to this graph on Google trends as it's probably a useful indicator of any turnaround success. The current graph direction isn't all that pretty though...

For the record, here's my portfolio as it currently stands now:

Disclosure: I am long LCG, KENZ & MGNS