Interactive Investor

A bargain share or certain sell?

10th February 2017 16:34

Richard Beddard from interactive investor

It's decision time for troublesome ITE. I've read the annual report. I've attended the AGM. Now it's time to decide whether the share ranked lowest by the Decision Engine deserves its place in the Share Sleuth portfolio*.

Since I'm taking the Decision Engine apart and reassembling it share by share, the list this month doesn't rank all the companies I follow, just those I have processed so far.

The shares at the top of the list have qualities that, in my opinion, will make them good investments over the next decade. They are straightforward businesses generating excess returns that are both resilient and adaptable to competition and changing circumstances. They're managed equitably for the long-term. They are probably undervalued at current market prices.

As a rough guide, I consider shares scoring seven or more out of ten to be good value, shares scoring five and six to be more questionable, and shares scoring less than five too speculative for long-term buy and hold investment.

That doesn't mean trading ITE, which scores a lowly four, will lose you money. For a start, my judgement may be wrong. But even if I'm right, the shares could still turn out to be a bargain. To understand why, you have to imagine alternative future scenarios.

Substantial debt

This much we know: ITE has built up a substantial amount of debt, £74 million at the year-end in September 2016, and it may breach bank covenants if trading deteriorates markedly again. ITE puts on trade shows in emerging markets and, despite multiple acquisitions in countries like India, China, and South Africa, it depends still on Russia, Central Asia, Ukraine and Turkey for the majority of its revenue.

That revenue has diminished is due to economic and political difficulties in the second group of countries. The Russian and Central Asian economies depend on oil revenues, which have fallen due to low prices; there has been war in the Ukraine; and Turkey, which experienced a failed coup last year, is a less attractive destination for tourists due to political instability.

The glossiest scenario is that we are experiencing a nadir

Not only are these export markets more off-putting for international exhibitors because they are less buoyant, the exhibitors' products are more expensive when priced in their depreciating currencies.

Acquisitions, particularly in India, are not performing as well as ITE hoped either. There it is being held back by lack of venue space, which means the exhibitions are not growing as the company expected.

Despite all these problems, ITE still earns healthy returns on capital. Exhibitors pay in advance for space, and ITE can often scale down its exhibitions to reduce costs. The company's finance director has a number of tricks up his sleeve to husband working capital, and he may choose to refinance ITE's debt before its current arrangements expire in 2018.

One avenue that could give the company more wriggle-room is to negotiate new covenants, perhaps with a new bank, so they are based on borrowings net of cash rather than gross as they are now. ITE had £15 million cash at the end of its financial year end in September 2016.

Although it's common practice to limit net borrowings to a multiple of profit, banks may have been reluctant in the past to agree to such a covenant because they were unsure that, in extremis, the company would be able to get its cash out of its foreign subsidiaries.

Glossiest nadir

The glossiest scenario is that we are experiencing a nadir. A tepid recovery is already spreading through Russia. That could gather apace (although a full recovery seems unlikely unless the oil price rebounds further).

Ukraine recovered somewhat in 2016 too. Following the coup attempt, bookings are down in Turkey so ITE will experience contraction there in 2017, but perhaps it too will recover later. Venues will be built in India, eventually. The covenants may never be tested and now, when there is metaphorically and, unfortunately sometimes, literally, blood on the streets, could be a great time to buy.

The Decision Engine is telling me to remove ITE, but I shan't until I have another to replace it

The gloomiest scenario is the opposite, nascent recoveries peter out, gathering storms deepen. Venue construction projects are delayed again. ITE's profits fall below the levels specified in the covenants, and the company has to put its acquisition policy into reverse and sell good businesses, or raise more capital, to survive.

As an armchair geopolitician at best, I have no idea which scenario is more likely, and that uncertainty is informing the Decision Engine's ranking. The business has been complicated by debt. The debt makes the company less resilient and in the worst case could render impressive historical returns irrelevant.

The company has a new chief executive and a new finance director, who I met at the Annual General Meeting at the end of January. As is nearly always the case, they created a good impression, but because they are new I know little about them.

ITE has a score of four. The Decision Engine is telling me to remove the shares from the Share Sleuth portfolio, but I shan't, not at least until I have another share to replace it. Since I'm not confident about the future of ITE either way, I prefer not to act at all until I have found a compelling reason to.

To find a reason, I look to the top of the table. Dewhurst, XP Power, Solid State, Treatt and Science are well represented in the portfolio already. Next is a relatively recent addition and I want to read about how management are dealing with the challenges it faces on the high street and on the Internet in April's annual report before I consider adding more shares to the portfolio.

That leaves Portmeirion and Howden Joinery as the most likely candidates.

Lower down the table RWS, Porvair and Wynnstay have announced results in the last month. Patent and technical translator RWS and filter manufacturer Porvair can, it seems, do no wrong and are denied a better ranking by their high valuations.

Wynnstay is more of a mixed bag. The shares are rated on a lower multiple of earnings, but manufacturing and selling animal feed is a less profitable business.

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*A model portfolio I manage. For the latest update see this article published by our sister magazine, Money Observer.

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Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

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.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. 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.

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Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

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