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Stockwatch: Recovery reveals 60% upside stockpicking turnaround
Should you buy into a turnaround as soon as the company's trading has stabilised, or wait for genuine evidence of recovery? The dilemma is pricing this anticipation into the stock, such that you pay full price once proof is out. It's frustrating, because you are gambling rather than investing early on, but it can still pay to weigh the odds.

A current example is AIM-listed Hornby (HRN), the hobby/toys group which at about 31p languishes around a five-year low, down from about 140p. The table implies a 25% discount to net tangible assets and, while Hornby is carrying high stocks after various disruptions, it's fair to say its equity is asset-backed at the current market price.

If the turnaround evolves as outlined when a 27p share issue raised £8.0 million last June, risk/reward weighs to the upside considering the key brands Hornby, Scalextric, Airfix, Humbrol and Corgi. The group is being downsized to focus on these, given that 40% of group revenue accounts for 90% of profit. Reducing group complexity should also help cut fixed costs by a third, with lower capital spending needs.

Recovery plan on track

The latest AGM statement cites "trading in line with expectations", which doesn't strictly add anything; those expectations could anyway be low. But in recent context it's not another disappointment and implies the situation is stabilising for now. A strategic review has determined a positive future and the means to achieving profits/cash flow.

More detail on progress is promised at the November interims and, while the actual results seem unlikely to appeal, if Hornby is considered on track then confidence may build in a turnaround. Its details are better considered from the 2015/16 prelims to end-March than my detailing here.

The issues appear mainly managerial, rather than a deterioration in Hornby's markets; the five-year revenue trend looks firm - if unexciting. There may be a parallel with Premier Foods (PFD), where efficiencies and capital-raisings honed a business that, despite its mainly traditional processed food brands, attracted a US takeover approach earlier this year.

One reason Hornby's stock languishes is that it has a credibility problem thanks to its directorsHornby's chairman since early 2013 also chairs Phoenix Asset Management Partners, which owns 39.2% of Hornby after injecting equity capital as part of a £15 million placing at 95p in June 2015, to avoid the group breaching bank covenants, and an £8 million placing at 27p last June to pursue a restructuring under a new chief executive.

So Phoenix is in pretty deep here, and in the longer-term may find it cleaner to sell out than retain a stake in the red. It looks the same with New Pistoria Income Settlement owning 14.3%, and then there are Ruffer LLP with 13.2% and Downing LLP with 6.6%, while the usual institutions look to have sold down or out.

It therefore puts pressure on the executive chairman to deliver, also after, unfortunately, he described the last chief executive as "the right man for the job" in the 2014 results, but who left earlier this year after his plan hit troubles.

So another reason Hornby's stock languishes is its credibility problem: that the directors haven't known what they are doing; that perhaps their failure to anticipate troubles implies the situation is complex and challenging.

They make a positive case for turnaround, but there do not seem any public disclosures of their buying stock - even in the June 27p placing. There have also been restructuring woes at Stanley Gibbons Group (SGI) as if "collectables" are a difficult sector, although in truth Hornby is more "hobbyist/toys".

Poor sentiment enhances recovery potential

More positively, such jaundice means that if the current turnaround evolves reasonably to plan, it would become possible to target 50p longer-term, despite the equity dilution from placings. The total number of shares issued is 84.6 million which explains the £1 million pre-tax profit forecast equating to about 1.0p earnings per share, and the context implies scope to target £4 million pre-tax profit once again - if the cost-savings are achieved.

Admittedly this assumes no further nasty surprises, while it looks wise to expect challenges. Also there doesn't appear to be strong consumer marketing skills among the executive directors, although the latest CEO has turnaround credentials at Energis.

Brexit is a new risk: 18.1% of revenues were continental European in the year to March 2016Barclays Bank may have insisted on a strong financial CEO as part of approving a £10 million loan facility to end-2019. Net debt was £8.1 million as of 12 June, so the £8 million (gross) placing later that month should have cut that and underpinned the £1.7 million cost of restructuring and also enabled investment.

It's possible to fret about Hornby's track record and what might next take them by surprise, but elements of a recovery base are coming together.

There are ongoing risks to consider, as cited in the 22 June prelims, such as the group's buying from Honk Kong in US dollars hence exposure to currency fluctuations (it attempts to hedge in the short term) and the group's high street distributors facing their own pressures. Direct sales are expanding via Hornby's website at a 39% compound annual rate between 2013 and 2015.

Brexit is a new risk: from note two of prelims to end-March 2016, a total 18.1% of group revenues were continental European, and while the plan is to centralise European business in the UK, it's not yet clear how Brexit will affect trading terms.

Takeover target

An "in-line" theme is probably the best that can be expected for now. Toys can be challenging yet genuine brands shine through difficult times: I recall Bluebird Toys falling from growth stock status in the mid-1990s, with twists-and-turns in trading updates, hence frustrating to catch any turn in its fortunes.

Yet by 1998 it became the target of hostile takeover attempts with America's Mattel ultimately successful and under whose ownership the Polly Pocket brand flourishes.

If Hornby can sort out its own operations then the story may evolve similarly, hence its stock a speculative 'buy' for those appreciating the risks.

For more information see the website.

Hornby - financial summary Consensus estimates
year ended 31 Mar 2012 2013 2014 2015 2016 2017 2018
Turnover (£ million) 64.4 57.4 51.6 58.1 55.8    
IFRS3 pre-tax profit (£m) 4.0 -3.4 -4.6 -0.2 -13.5    
Normalised pre-tax profit (£m) 4.1 -0.2 -1.6 0.6 -4.7 -6.3 1.0
Operating margin (%) 7.5 0.6 -1.9 2.0 -7.7    
IFRS3 earnings/share (p) 8.1 -6.4 -11.4 -0.3 -27.9    
Normalised earnings/share (p) 8.4 1.7 -3.8 1.8 -9.5 -5.9 1.0
Earnings per share growth (%) 11.6 -79.4          
Price/earnings multiple (x)         -3.2 -5.1 30.0
Cash flow/share (p) 11.5 21.6 -2.7 12.0 -20.0    
Capex/share (p) 9.8 8.6 10.4 12.9 8.6    
Dividends per share (p) 5.0 2.0          
Covered by earnings (x) 1.7 0.9          
Net tangible assets per share (p) 55.6 55.7 49.2 49.1 41.6    
Source: Company REFS

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.