James Faulkner on Watshot in the Small Cap markets: ASOS, Amino Technologies and Diamondcorp

Yesterday’s shocking profit warning from ASOS (ASC) is a reminder to those who put their faith in super-premium rated stocks: you are running a very high level of valuation risk. In the previous 2-month trading update to 28th February ASOS reported a slow-down from 38% growth in Q1 to 26% in Q2. Although still a decent rate of expansion by any means, this slow-down should have been a shot across the bow for investors, especially in light of the firm’s stratospheric earnings multiple.

Sales in Q3 ended May were up 25% year-on-year, which marks a further slowdown on Q2, with strengthening UK growth having been more than offset by a weaker performance internationally. The irony of this is that ASOS undertook its international rollout in order to maintain the growth trajectory in the face of a UK market that was looking pretty saturated. This looks like a familiar case of corporate overstretch.

The profit per order is higher overseas versus the UK (helped by lower sales taxes, higher basket sizes and lower returns), so the impact on profitability from a slowdown in this part of the business is significant. Management indicate gross margins were down 370 basis points (versus expectations of c.+50 basis points for H2 overall), which translates into an EBIT margin of c.4.5% – 200 basis points worse than previous guidance of 6.5%. This really is a bloodbath!

Profit warnings come in threes, as the saying goes, and I wouldn’t be surprised to see ASOS continue to be bogged down in its international markets for the remainder of the year. Consumer confidence in Australia has fallen off the edge of a cliff, and Russia is also in a mess for obvious reasons. ASOS may be forced to ‘invest’ in (i.e. cut) prices in some of its weaker markets if it wants to see the top-line progression it is hoping for, which would put further pressure on margins and profitability. The shares have been hammered in recent months, but I still wonder whether the outlook for ASOS is positive enough to support a still-toppy earnings multiple in excess of 50 times.

Amino Technologies

And from one end of the valuation spectrum to the other… Amino Technologies (AMO) could be worth a look for any value investors out there. This Cambridge-based leader in digital entertainment solutions is sitting on net cash of £19.7 million, which equates to well over a third of the market cap (c.36p per share) and has just committed to extend its progressive dividend policy – which sees the divi grow by not less than 15% per year – by a further two years. The shares are currently yielding a very respectable 4.5%.

Amino is a market-leading operator in the rapidly growing internet TV market, providing complete hardware and software solutions which enable the delivery of television content to viewers via a broadband internet connection. The core ‘set-top box’ business caters to IPTV (internet protocol TV) service providers, while there is also a nascent product line aimed at the OTT “over the top” market, which enables the delivery of video content from the open internet by both IPTV providers and satellite or cable service providers.

The latter is a huge growth market estimated to be worth $20 billion by the end of 2014, according to research from MRG. Importantly, the ‘heavy lifting’ of the product investment stage appears to be complete, enabling older IPTV products to be phased out while existing customers are encouraged to migrate to the new boxes. Furthermore, the initial discounts on the OTT products will be phased out, thus pointing to margin progression going forward.

The trouble with Amino is that although profitability has been very strong, revenue growth has been patchy. This is partially due to the product transition period described above, but is also down to lumpy and somewhat unpredictable ordering from customers. There is also the issue of the cash pile, which has been a feature of the stock for some time. It is no good just sitting on cash and promising investors 15% dividend growth when that cash pile is holding back capital growth.

If the company cannot find suitable investments to put cash to work, it should return the cash to shareholders, either through special dividends or buybacks. Until management provides some clarity on this issue, I can’t see the shares making much headway. That said, the value case looks pretty compelling, and the firm is branching out into new markets such as home automation. The potential is there waiting to be unlocked…

Diamondcorp

My pick of the small cap miners this week is Diamondcorp (DCP), which stated in its results that it does not anticipate further fund raisings before its Lace diamond mine is in full production, now expected ahead of schedule, “by this time next year”. The Lace Diamond Mine, located 200 kilometres southwest of Johannesburg near the town of Kroonstad in the Free State Province of South Africa, is on track for first production from 2015 and expected to reach full production from 2017.

The mine is fully-funded to production with a 220 million Rand facility from South Africa’s Industrial Development Corporation (IDC). Furthermore, there is potential for resource upside at the “Bulge” section of the kimberlite pipe that could add material value to Lace. Results from the on-going drilling programme will form the basis for a resource upgrade and feasibility study that may see the Bulge included into the Lace mine plan.

The Lace Diamond Mine

It is worth noting that Lace has produced diamonds in the past, having first been brought into production during the 1890s until being put on care & maintenance in the 1930s following the collapse in diamond prices due to the Great Depression. But here comes the interesting part… De Beers bought the mine in 1939 and the first thing they did was to turn the water pumps off to flood the mine. Concerned about rising production having a negative effect on diamond prices, the company often bought up assets they deemed to have high potential and put them out of action to thwart the efforts of competitors.

Broker Panmure Gordon forecasts peak production for Diamondcorp’s Lace mine of over 400k carats per annum, generating revenue of over $70 million per annum, with EBITDA margins over 50%. At this point Lace becomes a globally significant operation, able to rapidly pay down the liabilities incurred to finance its development. It would also raise its profile with the major diamond producers. Based on a DCF (discounted cash flow) valuation Panmure values the Lace mine at $316 million with an IRR (internal rate of return) of 40%, providing its target price of 19p – suggesting potential upside of almost 150% from here.