These letters are our way of informing you about the fund’s portfolio companies. Each time we write an investment letter, we incorporate all the elements we like to see present as if we were the investors. We frequently write about our framework for investing; always rational rather than emotional, but with a keen interest to learn and evolve from the investing experiences we encounter while managing our common capital, yours and ours. In practice, this translates into describing business models we still find attractive after we subjected it to rigorous analysis. There are many many more passes before we find one hit. We invest in companies that meet our quality criteria and offer an expected return of at least 15% p.a. using our own conservative assumptions. This core principal helps us to avoid overpaying for companies. When we do find an opportunity, we try to use the stock price volatility as a friend rather than a foe. While most investors see this volatility as a risk, we think it improves the probability that the share price reaches our target level. That is not to say that shares cannot get cheaper once we decided to commit our capital. And this brings us to the heart of this letter, by discussing an issue we encountered recently and why we will deviate from our usual narrative of writing about a new investment. In this letter we will return to Premier Technical Services Group PLC (PTSG), introduced in our previous letter (2018Q4). PTSG is the number one specialist facilities manager in the UK. We had learned of PTSG in 2015, a few months after it listed on the London Stock Exchange. We left it at that time, thinking it was potentially an interesting business, but one which we would first need to learn a lot more about. In any case, it was too expensive at the time. Fast forward to the end of 2018 and the stock price had dropped by a quarter when we decided to allocate time to do a proper analysis. We concluded that PTSG is a high-quality business and that paying below 10x current-year adjusted after-tax earnings for a business that has grown EPS at 28% p.a. over the last five years, in an industry full of growth and consolidation opportunities, is an attractive proposition. Initially we started building a 5% position for the fund. We followed on with further research and face-to-face meetings with the CEO, after which we were confident to move from our standard 5%, to a high-conviction 7% position towards the end of Q1 2019. Things were looking great and we were convinced we had added a gem to our portfolio, one that we would like to own for years to come. PTSG for their part, could execute their strategy and capture the growth opportunity in the UK specialty facilities management sector. Yet, weeks after we invested, the stock dropped by 50%. In a matter of one year the stock had lost 2/3rd of its value, while the results the company was reporting weren’t even bad, they were good! Professional investing is clearly no sinecure and it involves a lot of head scratching. We decided to press the reset button and do some additional deep dive forensic analysis. What did we miss? Could there be fraud involved? Are we using the correct process to analyse this company; is our valuation model the correct one to use?

In the beginning of this letter we said we accept share price volatility and we try to use it to our benefit. In our 2016Q4 letter we explained how we can benefit: “The occurrence of unexpected events creates volatility in share prices, and we aim to take advantage of this volatility to purchase high quality businesses or assets at attractive valuations”. In other words, we separate our own valuation (our calculation of intrinsic value) of the company, from the valuation it receives on any given day by the stock market. Looking back at our investment in PTSG, we need to convince ourselves that the company we invested in at double the current stock price still has the same characteristics and intrinsic value we attribute it today; does it still enjoy the same competitive advantage; does it still have the same earnings potential; is the business model still valid? If we can get comfortable with these answers, then the long-term outcome of our investment, irrelevant of the current price drop, will be intact.

From here on the reading will give you an in-depth, under the hood, analysis of our investment approach and going through the checks and balances of PTSG for a second time; if you prefer to avoid this (might be tedious) part, you are welcome to skip straight to the Conclusion on page ten of the letter.

In-depth analysis of PTSG – Take two

Between this and the previous letter when we described PTSG as a new addition to the portfolio, two new events resulted in the value dropping by half. First, there was the publication of the company’s 2018 annual report which made us question the management’s handling of certain accounting principles as well as their communication skills. This was followed by a report by an opportunistic short seller on the company. Both events happened at the end of March 2019. As a result, we double-checked our thesis and performed even more detailed analysis on these new developments.

Business overview & management

PTSG is a high-quality business growing at 30% p.a. trading at less than 6x this year’s after-tax earnings. The business is recession-proof, highly profitable, has a sustainable competitive advantage, a strong balance sheet and owner-managers with an excellent track record both as operators and capital allocators. This translates into attractive financial characteristics with high margins, low capex, high returns on capital and a progressive dividend policy. PTSG has a strong track record of growth and the outlook for continued growth is very promising, both organic and acquisitive. PTSG provides regulated and safety-related specialist building services in the UK and focuses on the most complex and lucrative services of facilities management. ​Regulatory bodies require property owners to arrange for safety-related inspections on a regular basis. Today, 72% of PTSG’s Gross Profit is derived from testing/inspection and repair/maintenance (T&I). These revenues are mandatory and recurring. The balance comes from more cyclical installation revenue. In the T&I business, scale and route density allow PTSG to be the most cost-effective solution. PTSG services 180,000 properties in the UK and has strong market positions in access and safety, lightning protection, mechanical fire and electrical testing. Margins are consistently high, reflecting the specialist nature of activities, the strong focus on cost control and the Group’s leading operating model, whilst remaining competitive on pricing.

PTSG’s founders, chairman John Foley and CEO Paul Teasdale have each founded other specialist service businesses, MacLellan Group and TASS Europe respectively, and worked together when TASS acquired MacLellan in 2004. COO Roger Teasdale and CFO Mark Watford worked in the same divisional team at Smith & Nephew prior to joining PTSG towards the end of 2014, but ahead of its IPO the following year. As well as obvious relevant experience in building companies in this space, the board has very strong finance oversight. We note that the directors mentioned above are significant PTSG shareholders, together they own just under 40% of the issued share capital. John and Paul’s combined annual compensation is below £250,000. Paul’s twin brother Roger was persuaded to leave a well- paid job to join PTSG in 2014 on the basis of a higher compensation package (£400,000) and an options package, subject to certain milestone targets being met. The last of four milestones was reached in 2018. Management confirmed to us that no new stock option plans are expected to be introduced.

The company estimates its market share at 5% to 12%, depending on the segment, in a very fragmented market that is growing 6-7% p.a. supported by increased regulation. A growing market combined with market share gains and a successful acquisition strategy resulted in EPS growth of 30% p.a. over the past 5 years. PTSG is a niche specialist service provider of the following services:

• Electrical Services (34% of revenue): lightning protection, fixed wire testing, portable appliance testing, fire alarm and extinguishers, dry risers, steeplejack services
• Access and Safety (15% of revenue): safety testing & installation, cradle maintenance and installation
• Fire Solutions (46% of revenue): dry riser installation and maintenance, sprinkler installation, test and maintenance, install and test fire alarm and emergency lighting, supply and test fire extinguishers
• Building Access Specialists (5% of revenue): steeplejack services, high-level installations, reparation and cleaning

PTSG’s services focus on providing safe building environments. Its operating model has the following characteristics:

• Customer Diversification: ​PTSG services 20,000 customers and 180,00 assets with no customer representing more than 5% of revenue. (e.g. PTSG services 400+ Marks& Spencer stores nationwide)
• National Coverage and Staff Utilisation​: PTSG is the only truly national player in its chosen markets. It has 31 office locations including the Castleford head office from which it deploys service engineers to client sites more or less nationally, within a regional structure. Relatively local engineer resources reduce travel time and cost, theoretically increases the number of jobs that can be serviced (and revenue earned) and facilitates high service levels and competitive pricing to customers. ​The keys to generating attractive profitability are client density and high engineer utilisation levels​. Trained engineers, specialized by service and workflows, are split into installation or scheduled service/maintenance streams. PTSG is growing fast and growth improves route density. Staff costs account for 40-45% of revenues.
• Use of Technology​: Clarity, a self-developed integrated ERP software system, is used to schedule, monitor, certify and invoice jobs and provide a workflow audit trail. The software includes workforce management, performance dashboards, real-time tracker and a secure client portal.
• Repeat Business: High annual client renewal rates (88%+ in T&I in 2017) provides a good recurring income revenue base, increasingly under 3-5-year agreements. ​The business is recession-proof because the testing and maintenance/repair work is non-discretionary and needed for compliance​. Taking into account the recent Guardian and Trinity acquisitions, which we will discuss later, compliance work represents ​72% of the Group’s gross profit. ​Installations, except for retrofitting, is driven by construction activity and is more cyclical. The widening of the service offering and a nationwide offering drive cross-selling opportunity.
• Accreditation and Training: PTSG has 133 accreditations including ISO 9001, OHSAS 18001 and ISO 14001.
  

Growth strategy

PTSG generates significant shareholder value through organic growth, including cross-selling, and through complementary acquisitions. Although the company believes that the Group is already a market leader in a number of its UK segments of operation, it has less than 12% share in each of its principal markets and they believe that there is significant scope for continued growth. Many of PTSG’s customers are streamlining their businesses through supplier rationalization, moving to single source supply, which is benefitting the group and is expected to continue.

Historically, PTSG has achieved strong levels of organic growth by improving processes and efficiencies in both existing businesses and those acquired. Central to the group’s strategy is leveraging its already significant and expanding customer base to create value in the acquired businesses. Furthermore, through the successful acquisition and integration of acquired businesses, the group has demonstrated its core competence in delivering value not only for its shareholders, but also for the vendors of acquired businesses through the agreement and achievement of financial targets relating to elements of deferred considerations. Management believes that the reputation of the group as an attractive acquirer positions the group favourably for completing acquisitions on attractive terms, where owner-managers are interested in playing a role in the enlarged businesses. Management is committed to pursuing acquisition opportunities in existing and adjacent markets with a view to cross-selling services and leveraging the existing client base. Only 5% of customers receive multiple lines of service, which leaves considerable scope for improvement and increase the profitability. A sales team looking at cross-selling opportunities is currently doing £8m of new business p.a. on total run-rate sales of almost £80ml (pro-forma £120ml incl. the Trinity acquisition).

The company has an in-house acquisitions team and a strong pipeline of opportunities comprising both bolt-on to the existing divisions and businesses with activities in new and adjacent sectors. Acquisitions will be considered that allow the group to:

• enter attractive new markets where the group can leverage its operational and managerial framework;
• expand existing operations geographically to increase its penetration of the UK market; or
• grow its operations in an existing market and geography where the business can leverage economies of scale to improve margins.

Market opportunity and competitive environment

The markets in which PTSG operates are highly fragmented, with many local players lacking the scale, breadth of service and geographic coverage to compete effectively. PTSG is now the market leader in a number of its specialist niches although its market share does not exceed 12% for any of its businesses. This strong market position, as further described below, is due to a number of factors, including:

• it is an established provider with a strong reputation;
• the group has invested considerable resources in Health & Safety, including obtaining a comprehensive portfolio of 133 H&S certifications which allow the group to provide services across multiple specialist segments, and is unique among its peer group in its operation of an in-house H&S team;
• the group’s online customer service point, which is offered to all divisions of the business, allows its customers to track and organize their ongoing compliance and other requirements in real-time; and
• bespoke operational and CRM software (leads to margin sustainability);
• it is competitive on price;
• its nationwide UK coverage across a broad range of services

Some other providers in access and safety do not provide ongoing testing and maintenance post the installation phase. The beauty of the PTSG business model is that, due to the small ticket size of the typical maintenance visit, competitors are largely focused on the ‘big ticket’ prestigious installation business; the complete opposite of the PTSG strategy. This allows PTSG to service not only its own installed base but to offer a differentiated after-market offering that can increase market-share by servicing the installed base of its competitors. Whilst PTSG primarily competes with many small, local players, there is a large competitor in each of Access and Safety’s and Electrical Services’ markets. In safety installation, the largest competitor and industry leader by sales is HCL, a division of Latchways Plc. Latchways is a global leader in the design and manufacture of fall protection systems and access solutions. As well as competing with Latchways through HCL, the group is a customer and accredited installer of Latchways’ products. Latchways was acquired by MSA Safety in October 2015. In electrical services, the main competitor and market leader in lightning protection is Omega Red, which is part of the SSI Services division of South Staffordshire plc. Omega Red claims to be more than three times the size of its largest competitor. An analysis of each of the group’s markets by estimated size, the group’s market share and the group’s ranking are shown in the table below from the 2015 IPO document:

Today the situation is as follows:

• Safety Testing​: £6ml in revenue versus HCL #2 with £2ml
• Cradle maintenance​: £3ml revenue versus #2 at £1.5ml
• Cradle Installation​: £4-6ml with CoxGomyl #2
• Lightning Protection​: installation, testing and maintenance and some specialist power services, PTSG is # 1 with £30ml revenue, #2 does £17ml and more competitors do about 5ml
• Electrical Services Testing​: PTSG is #5/6, but climbing rapidly
• Building Access​: cleaning, abseil works, a very competitive business and a small activity for PTSG
• Fire​: a business PTSG entered into 2,5 years ago (after IPO and therefore not in the above table). The market of extinguishers, smoke detectors and general fire systems is competitive with a few companies doing £100ml revenue at low single-digit margins. PTSG focuses on mechanical fire (dry risers, pipes and valves) and currently does £20ml revenue at 20-25% operating margins. In January 2019 PTSG announced the acquisition of Trinity Fire and Security Systems, a £40ml business with a 5% operating margin.

Acquisitions track record

PTSG’s acquisition model is clearly focused on applying its efficient practices (on scheduling and utilisation) to improve revenue and gross margin contribution while using central services to control operating expenses. We believe the company has clearly demonstrated an ability to both acquire complementary businesses on sensible initial multiples and deliver meaningful uplifts in profitability under PTSG’s ownership. Aggregating the pre-acquisition financials from the 23 acquisitions since 2007 results in revenue of £42ml and £5.1ml EBIT. Pro forma FY17 revenue (i.e. adjusting for full-year effects of acquisitions in that year) is £60ml with EBIT of £12ml.

In the first 10 years of the company’s existence, PTSG delivered organic growth in excess of 40% in revenue and more than doubled the profitability of the businesses acquired during this time. Based on a total consideration of £40ml overall this acquisition cost is equivalent to 0.67x revenue, 3.33x EBIT based on FY 2017 results. These figures confirm that the PTSG model is able to materially drive down initial acquisition multiples, which are low on an absolute basis and relative to its own multiple and generate good returns for shareholders. PTSG has made two further acquisitions in 2018; M&P Fire Protection and Guardian Electrical Compliance, and they announced the Trinity acquisition in January 2019.

M&P Fire​: PTSG initially paid £1ml cash for a business that generated £2.1ml revenue and £0.2ml profit before tax (PBT) in its last financial year. The deferred consideration of up to £2.5ml over the next 5 years is contingent on unspecified profit targets​. ​This looks like a typical PTSG deal structure and adds complementary installation and maintenance revenue streams (in sprinkler and wet and dry riser systems) in the South East of England. The strong increase in revenue and PBT since acquisition bring down the acquisition multiple from 17.5x PBT to 3.7x. This is driven by the growth rate of the business (>20% p.a.), sales growth initiatives from PTSG, the elimination of non-business expenses and other efficiency improvements.

Guardian: PTSG initially paid £12ml (for a business that generated £8.3ml in revenue and £1.8ml PBT in its financial year prior to acquisition, with 1ml cash on the balance sheet). Deferred consideration of up to £4ml is also payable over the next three years, in cash or shares at PTSG's discretion, subject to Guardian meeting stretching performance targets. (PTSG issued 12,7ml shares at £157p to fund the Guardian and Trinity acquisitions). Guardian contributed £3.14ml to sales and £1.12ml to operating profit for the 2.5 months since acquisition. This implies significant growth driven by the >20% growth rate of the business and some added value from PTSG. Efficiency improvements also included the elimination of expenses such as sponsoring of 2 local football clubs, a director’s club-box etc.. The strong increase in revenue and PBT since acquisition bring down the acquisition multiple from 8.3x PBT to 3.1 x.

Trinity: PTSG initially paid £10.8ml, £7.7m net of cash on the balance sheet, for a business with a run-rate revenue of £40ml and EBITDA of £2.2ml. Deferred consideration can be a max. of £5ml based on certain milestones. In FY2018 PTSG revenue was £69ml, so the Trinity acquisition is significant. As a national provider of fire and security services, concentrated on testing and compliance services, the acquisition is complementary with PTSG’s existing national presence. The CEO sees substantial cross-selling opportunities and applying PTSG’s efficient practices to Trinity should boost its margins from 5% to 15%. Based on their track record the odds are good that they will achieve their goals. With an acquisition multiple of 3.5x, our downside seems limited if they don’t.

PTSG has a big pipeline of potential targets they have approached directly, and they have been talking to for a while. The size of these businesses ranges from £1ml annual sales to £40ml and a purchase price from £1ml to £16-17ml, so there are substantial businesses amongst them as well. Momentarily they are looking at deals around 5x profit after tax. PTSG is the most effective solution as a buyer in the market; they created a repay model mostly a pound for a pound (an additional one pound of maintenance revenue for each pound of inspection revenue), they have a strong renewal model with renewal rates close to 90%, they have a very aggressive sales model where they can grow sales rapidly and in a very streamlined operational performance of the business where PTSG monitors KPI’s on a daily, weekly and monthly basis. So, PTSG does not only want to buy low, but they also want to do a lot with the acquired company.

What drives the sellers of the businesses PTSG acquires? Sometimes the seller wants to de-risk, take chips off the table but they are not ready to finish their working life. Then they come to PTSG and have access to 18,000 clients and PTSG know-how. Then effectively they take a view whether they can make more money with PTSG than without. Any deferred consideration has always been self-funded, so these attractive targets pay for themselves. So far, PTSG has never missed a milestone target in any the deals they have done, so that’s also a good reason to sell to PTSG.

Historically, PTSG has tapped the equity markets on regular occasions; an option that is currently unavailable because of the large drop in the stock price. Management are large shareholders and they have told us that they will not raise equity at the current valuation. Recently, the company’s credit facility with HSBC was increased to a £10ml term loan and a revolving credit facility of £30ml.

Operating margins & return on capital

Margins are consistently high, reflecting the specialist nature of activities, scale advantages, the strong focus on cost control and PTSG’s leading operating model, whilst remaining competitive on pricing. The operating margins are protected by barriers to entry described by PTSG as follows:

• PTSG is often the most competitive in the market, with significant scale and so smaller competitors will struggle to compete on price.
• Difficult to compete on service levels – excellent customer service as demonstrated by 88% retention rate.
• Multi-service contracts provide an advantage over single-line competitors.
• All services require highly skilled engineers. As market leaders, we have an unrivalled proposition to attract and retain engineers.
• Due to the density of work, engineers spend less time away from home.
• PTSG has 133 accreditations, many of which are required before they are allowed to tender for work.
• Many clients demand trade body membership such as ATLAS for lightning protection works, SAEMA for access and safety, NIC/EIC for electrical testing etc. These trade bodies have rigorous membership requirements that new entrants will find difficult to attain.

In addition to the above list, we believe that ​Clarity, PTSG’s proprietary IT-system, ​is a source of significant competitive differentiation vis-a-vis the smaller competitors, bringing both internal management and client interface advantages.

Three of PTSG’s four divisions generated EBIT margins over 20% in FY18 while Access & Safety’s FY18 EBIT margin was still a very respectable 16.7%. Over the last five years, the average adjusted group operating margins were 20.9%. These margins are expected to decline in FY2019 to approx. 16% when the 5% margin business of Trinity will be included. PTSG has a strategy to improve Trinity’s margins from 5% to 15% by exploiting cross-selling opportunities and by implementing its own operating model. Trinity represents 30% of PTSG’s revenue, therefore the upside is substantial.

PTSG’s business is an asset-light business that requires a lot of working capital (WC/Sales 37%; net capex/sales 1.1%). Large working capital requirements are typical for the UK construction industry. In the UK, the customer withholds 5% until the project is practically complete. When the project is delivered, 2.5% stays withheld for the defects period, which for PTSG’s businesses can take between 1-2 years from completion. PTSG generates 50% of the revenue from its Testing & Inspection business with third party facility management companies. These large customers get more favourable payment terms. The change in the business mix during the period 2015-2017, with an increase in installations and revenue from facility management companies, explains the increase in working capital/sales. With the recent acquisitions, sales from installations will drop to 42% (52% in 2017) and this, together with other initiatives, will help the company to lower working capital requirements. That being said, PTSG’s business is profitable enough to generate attractive ROIC despite the high working capital requirements.

Valuation

We adjust reported earnings for amortization of intangibles and non-recurring expenses such as restructuring costs, contingent payments for acquisitions and share options to determine the earnings power of the business. Share options expenses in 2018 and in earlier years are related to the service agreement with Roger Teasdale. The company confirmed that there will be no further share option expenses related to Roger’s compensation from 2019 onwards, as the final milestone target was reached in 2018. For our 2019 forecast we assumed 5% organic growth on PTSG 2018 revenue and adjusted operating profit excluding the 2018 acquisitions and consultancy fee from Trinity. To this we added the run-rate revenue from M&P and Guardian (contributed period in 2018, annualised) and the contribution from Trinity. This gets us to £ 124.3ml revenue and £20.2ml adjusted operating profit for 2019. We assume 5% revenue growth to be conservative vs ​the company’s reported 18% organic growth rate on average for the past 5 years. The adjusted operating margin of 16.3% assumes no improvement in operating margins despite the fact that management has identified opportunities to improve Trinity’s operating margins from 4.4% run-rate to 15%. On £40ml run-rate revenues from Trinity this potential impact is significant. On these forecasts PTSG trades at a PE multiple of 5.5x this year’s earnings. This is a very attractive valuation for a highly profitable recession-resistant business ​with the characteristics we described above, that has grown EPS at 30% over the last 5 years and with the potential to maintain high organic and inorganic growth over the medium term.

Concerns & Risk to our investment

The recent share price performance indicates that PTSG has, at the very least, a perception problem. This has been reinforced and exploited by short seller(s) who have been successful at highlighting the weaker aspects of the business and who have created doubt about the trustworthiness of management and the reported financials. At least part of the damage has been self-inflicted by a management team that underestimated the potential impact of certain decisions on investors’ perception of the company. The poor communication on related-party transactions (see below) and a large unannounced consultancy fee are good examples of this.

In our view, investor concerns are related to three main issues:

• reconciliation of the income statement with the cash flow statement
• related party transactions and
• the consultancy fee

PTSG has not generated operating cash flow in aggregate since 2015, despite strong earnings growth as a result of the increase in working capital as a percentage of sales. We explained above that this is the result of the change in their business mix with the increased weighting of installations revenues and business they do with facility management companies. Taking into account the three recent acquisitions, the current business mix should result in an improvement of working capital with a relative decline of installations and business with facility managers. Recent events have also convinced PTSG’s management that working capital, and in particular the receivables, should be a management priority. Several initiatives have been instigated to become more aggressive in collecting receivables, to deal faster with queries and variations to the initial agreement.

The Board did not see any harm in the Chairman and the CEO buying property from, and leasing back to, PTSG. A fast-growing company has better use for the cash than investing it in property is the main explanation offered by management. This had not been a major issue until a combination of events led to the current negative sentiment and the related party transactions were raised as a concern. The company has now instructed an independent valuation expert to review these rental payments. If they conclude that the rent is above market, the rent will be adjusted. Also, management has decided that there will be no further property transactions with related parties.

We summarise the risk to our investment as follows:

• Increased competition as competitors copy PTSG’s successful strategy. - Mitigating factor: today nobody is doing it. A new entrant would face tough competition from PTSG; a well-managed company with scale advantages.
  

• Operational problems related to integration, IT, accounting, ability to attract and retain employees etc. - Mitigating factor: strong track record.

• Poor performance from acquired businesses and management overpaying for acquisitions. - Mitigating factor: discipline for prices paid for acquisitions and strong operating performance of acquired companies’ post-acquisition

• Financial statements overestimate the company's true earnings power. The financials of an acquisitive company are harder to analyse.  - Mitigating factor: management are major shareholders, current valuation protects against inflated earnings
  

• Economic downturn in the UK.
  

- Mitigating factor: We believe this is more of an issue for the credit risk on the receivables than for sales. Credit risk is diversified with no single customer representing >5% of sales. 72% of gross profit comes from regulated compliance business and is recession-proof. Failure to manage a building environment in keeping with the legal requirements potentially exposes stakeholders to significant legal and financial liabilities and may invalidate commercial insurance cover.

• Dilutive capital raise
  

- Mitigating factor: management are major shareholders and understand the impact of a capital raise at an undervalued stock price. First Pacific Advisors, a large West Coast value asset manager, is the largest external shareholder.

• Increasing leverage (new HSBC banking facility) allows for 2.5x net debt ebitda
  leverage (3x if HSBC increases the facility to £40ml)

Conclusion

The recent share price performance indicates that PTSG has, at the very least, a perception problem. This has been reinforced and exploited by short seller(s) who have been successful at highlighting the weaker aspects of the business and who have created doubts around the trustworthiness of management and their reported financials. At least part of the damage has been self-inflicted by a management-team who underestimated the potential impact of certain decisions on investors’ perception of the company. The poor communication on related-party transactions and a large unannounced consultancy fee are good examples of this. Investor concerns are related to three main issues: a) reconciliation of the income statement with the cash flow statement b) related party transactions and c) the consultancy fee.

PTSG has not generated operating cash flow in aggregate since 2015 despite strong earnings growth as a result of the increase in working capital as a percentage of sales. We explained this is the result of the change in their business mix, with the increased weighting of the installations and the  business with facility management companies. Considering the three recent acquisitions, the current business mix should result in an improvement of working capital with a relative decline of installations and their business with facility managers. Recent events have also convinced PTSG’s management that working capital (and the receivables in particular) should be a management priority. Several initiatives have been instigated to become more aggressive in collecting receivables, to deal faster with queries and variations to the initial agreement etc. The Board did not see any harm in the Chairman and the CEO buying property from, and leasing back to, PTSG. A fast-growing company has better use for the cash than investing it in property is the main explanation offered by management. This has not been a major issue until a combination of events led to the current negative sentiment and the related party transactions were raised as a concern. The company has now instructed an independent valuation expert to review these rental payments. If they conclude that the rent paid is above market, then they committed to adjust it downwards. Also important, management decided that there will be no further property transactions with related parties.

While the 2 previous issues existed when the stock price was at 200p, a consultancy fee in the 2018 results might have been the catalyst for the loss of confidence. The 2018 operating profit was boosted by a £1.6ml fee for consultancy services provided to Trinity, a company that was only acquired in January 2019. This led to speculation that PTSG used this to artificially boost earnings. Management explained that they were in conversation with Trinity, a potential acquisition target, since the start of 2018. PTSG’s track record and profitability convinced Trinity to sign a consultancy agreement to help them improve profitability, with a payment dependent on realized results, but no explicit commitment for a sale of the company. During 2018, Trinity’s profit margins improved more than 2% and a consultancy fee of £1.6ml was paid to PTSG. We believe this explanation to be credible, but communication has been terrible. The fee was accounted for in “Other Operating Income” and it increased adjusted operating income, what management claims to represent the earnings power of the business. A very brief explanation of the consultancy fee was given in the notes of the annual report. The market concluded that PTSG’s management could not be trusted. Our view is that this was poor judgement by a management that still lacks experience in investor communication with public shareholders. If they were going to include this one-off consultancy fee in the operating income, then PTSG should have been communicated clearly and not hide it in the notes. Based on our conversations with management we were satisfied that they have learned some valuable lessons. It will likely take some time to restore credibility, but we have the impression that management is responding in the right way to all the concerns that have been raised.

Based on our conversations with management we were satisfied that they have learned some valuable lessons. It will likely take some time to restore credibility, but we have the impression that management is responding in the right way to all the concerns that have been raised.

***

Summary of the five largest positions of the fund:

Boustead Singapore Ltd (BP 6.23% and BS 4.06%):

We own both the holding company, Boustead Singapore, and its 51% owned real-estate entity, Boustead Projects (together Boustead). During the year we increased the position to make it the fund’s largest holding with a combined weighting of approx. 10%. The key value driver is a portfolio of industrial properties in Singapore and an asset-light design & build business in the construction industry. After a few years of price declines, the property market in Singapore has been stabilising and Boustead recently announced a record order book including design & build as well as design & build-to-lease projects. This bodes well for future profits for Boustead and ensures that the portfolio of investment properties will soon reach the critical size required for Boustead to launch its own REIT. Today, Singapore REITs trade close to Net Asset Value thereby valuing the underlying properties at the appraised market value. Based on our analysis the share prices of Boustead Projects and Boustead Singapore imply a discount of more than 50% on the appraised market value of their property portfolio thereby offering both downside protection and substantial upside if management can execute its strategy and launch a REIT. Recent developments and a tripling of the order book increased our confidence in a successful outcome.

Sporton International Inc. (7.70%):

Sporton holds the global market leader position for international certification and testing of smartphone and wireless communication devices. Testing and certification includes compulsory and compliant testing services for electronic devices. Sporton is one of the few companies that can provide both.  The main types of products tested are smartphones (44%), products such as keyboards, monitors and peripherals (34%) and Internet of Things (22%). Most sales are generated in Taiwan and China, which is also where most products are developed and manufactured for the global market. Sporton also has the largest market share of US FCC filings for personal communication systems and is the only firm focused on this type of testing and certification. Its main competitors are smaller subsidiaries of much larger established companies such as Bureau Veritas, SGS, UL and Intertek. These smaller competitors generally test the lower-end smartphone and Wi-Fi equipment. New entrants face substantial barriers to entry; the testing industry is a capital and technology intensive industry that heavily relies on its engineers and high-tech labs. No new meaningful competitors have entered this industry for over a decade. The smartphone industry is currently in a period of transition between maturing 4G technology and a nascent race to adopt 5G technology. The last waves of technological advances (3G & 4G) allowed Sporton to increase revenue and profit margins and the company expects the same to happen this time around. Other than the expected growth of 5G over the recent 4G, mostly due to the complexity in the new technology (and testing), Sporton expects to see a further driver of revenue growth with Internet of Things (IoT) devices and smart cars. Management expects revenue growth of 8-10% p.a. over the medium term. The capacity increase that came online in H2 2018 should further boost revenue growth to over 10% in 2019 and 2020. The current operating margin is 27% and Sporton believes it can increase this to 35% when 5G testing takes off. The company’s CEO & Chairman still owns 27.1% of the business and takes no salary. Additionally, the risk of bad capital allocation is reduced as the company makes no acquisitions and sets a policy of paying out most of the profits through dividends. The dividend pay-out ratio is 79%. Sporton’s share price has been suffering from poor market sentiment. We see this partly due to the still relatively small quantity of 5G smartphones being certified, combined with a concern of a slowing Chinese economy and an unfriendly trade tariffs environment. We purchased shares at 15.2x trailing earnings or at 12.8x net of the excess cash on the balance sheet. The dividend yield is also attractive at 5.3%. At this valuation, we do not need the company to reach management’s targets to achieve an attractive return. Over the last five- and ten-year periods, revenue grew at approx. 10% p.a. with average operating margins of 29% versus 27% today.

Premier Technical Services Group PLC (7.24%): see longform write-up above.

Hamilton Thorne Ltd (5.20%):

U.S.-based Hamilton Thorne Ltd (HTL) is a C$100ml company that supplies equipment, software and disposables to In Vitro Fertilisation Labs (IVF), a $1bn niche market segment inside the $15bn global fertility industry. The fertility market is interesting because it exhibits characteristics of a high-quality industry, combined with long-term demographic growth potential, as the maternal age has increased over the last decennia and couples are increasingly relying on assisted reproductive technology (ART) to fulfil their wish for children. HTL is facing more regulation and increased demands on the medical standards of their product offerings and the industry consolidation has led to rising barriers to entry. This has worked well as a deterrent to potential competitors from entering this niche market. In September 2016, HTL made the first of two transforming acquisitions by buying US-based Embryotech Labs, a provider of medical device toxicology testing services for less than 5x EBITDA. This business has low capital requirements and very sticky customers. In 2017, they made a second acquisition by purchasing Gynemed GmbH, a German company that manufactures and distributes consumables for IVF labs, most importantly the cell culture media. Gynemed is known in the industry for producing the best cell culture with a shelf life double that of the competition. Gynemed supplies 98,5% of all fertility labs in Germany, Switzerland and Austria. It is a low capex, high margin business (+75% gross) and has very loyal customers. IVF labs that use cell culture media in their certified processes rarely switch suppliers because this requires the whole process to be re-certified. HTL’s market is expected to grow at 5-10% annually. The introduction of new products, cross-selling opportunities from the acquired businesses and gaining market-share from smaller and less competitive companies, should allow HTL to grow organically at 10% or more for many years to come. We estimate that we bought into the new HTL at 12x forward EBITDA. HTL’s only listed peer is (the much larger) Vitrolife AB, trading for 32x EBITDA.

Volution (4.76%):

Volution Group PLC (Volution) is a leading supplier of ventilation products to the residential and commercial construction industries in the UK, the Nordics, Central Europe and Australasia. The ‘friendly middleman’ concept applies to this business as the end-customer is typically not choosing the brand of his ventilation products. These ‘friendly middlemen’ generally pass the cost through to the end customer and prioritize easy-to-install, reliable and familiar products that can be delivered quickly. Volution has a portfolio of long-established brands and guarantees fast delivery of thousands of different products through its distribution networks. The company benefits from scale advantages and can organise this at a low cost. The ventilation market in Europe is typically fragmented and consists of many companies of varying size and scope. The demand for their products is a function of activity in construction markets, both new-build and refurbishment. Regulation and consumer trends have been a tailwind for the demand of Volution’s products. Stricter building regulations have resulted in a shift towards air-tight buildings, resulting in increased use of Volution’s higher margin value-added systems and other more environmentally friendly solutions. CEO Ronnie George owns 2.8% of the company and approx. 50% of his compensation is performance linked. At 9x our estimate of current-year after-tax earnings, the valuation is attractive for a well-managed company with a strong market position in a niche with regulatory tailwind; a consistently strong cash flow generator with good prospects for both organic and inorganic growth. Management is focused on continuing its strategy of growth through acquisitions and it has the financial means to take advantage of the large opportunity-set in a fragmented ventilation market. Operating margins have the potential to improve as the company keeps growing and higher margin products become a larger part of the business mix. Cost overruns on establishing a new assembly facility in Reading (UK) also had a negative impact on profit margins for 2018. Management expects this to be completed by the summer of 2019, which should eliminate a major drag from the 2018 performance. We made Volution a 5% position for the fund.

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