City Insider: Small cap, big risk – the stock market isn’t for everyone

City Insider - A City perspective on the travel industry from FT journalist David Stevenson

High-turnover giants can stand exposure to the whims of the market, but smaller players should think long and hard, says David Stevenson

A few Mondays back, a bouncy venture capitalist (one of those irrepressibly optimistic American types who talk at a 1000mph) sat opposite me, singing the praises of one of his tech companies looking to list on AIM.

Instead of congratulating him I found myself spluttering, “Good God man, why would you want to list a successful technology company on the London stockmarket – are you mad?”

The poor man muttered something about needing stock to fund more acquisitions, and then dived into an exceedingly frothy cappuccino and switched subject to the weather.

Later in the week I said almost exactly the same thing when I met up with David Howell, chairman of small-cap luxury travel company Western and Oriental PLC.

W&O already has an AIM listing, and it would appear to be working little magic at the moment. When asked whether he’d recommend a market listing for a similar private business in the travel sector, Howell said that AIM is simply “too volatile” and that any company thinking of listing probably needs a much larger potential market cap.

“I would suggest rather that they become part of a bigger company,” was his sensible advice.

To be fair, the market isn’t picking on W&O – at the moment investors see little value in the travel sector as a whole. Just loook at the lowly ratings of Thomas Cook (one notch off being dirt cheap) and rival Tui (just good value).

These giants can largely afford to ignore such short-term pessimism, but it is a real problem for small-cap companies with turnover of less than £100m.

Outfits such as W&O need market confidence so that they can issue more shares, which in turn can be used to buy new companies, bulking up the share price and increasing the operating margin.

Take away that market confidence and the company is forced to hunker down and focus on increasing the EBITDA margin and prioritising organic growth.

Of course there’s nothing wrong with that, except that the market doesn’t really tend to take much notice of organic growth either.

Up until the beginning of April, W&O was firing on all cylinders – as Travel Weeklys’ Edward Robertson noted, the group had posted a “52% growth in sales through travel agents in the first half of its financial year”. But the market took almost no notice of these results, and the shares kept on falling.

In fact, since peaking at 4.25p in August 2009 W&O’s share price has steadily declined to the current 1.5p, implying a £6m market cap. So far the company has raised close to £20m through various placings, yet the City is suggesting that 70% of this money has been destroyed by the management, the dreadful market conditions, or both.

To be fair not every company in the travel sector has been quite so badly savaged in the last few months. Travelzest, W&O’s nearest peer, has seen its shares rise from a disastrous 8p at the back end of 2009 to 18p, but even this £25m market cap is a fraction of its likely intrinsic value.

Clearly there is something wrong with the perception of the small cap travel sector here in the UK. W&O may have had its problems over the last few months (think ash clouds, Iceland generally, riots in Bangkok and Jamaica, and sterling) and business may currently be a bit quiet, but there’s every reason to think that its core luxury segment business will come back later in the year.

Look at the medium term and you can see a business whose management seem confident of eventually hitting group sales of around £100m on an EBITDA margin of 5% – “No doubt about that” is Howell’s confident prediction.

But all this confidence in the future glosses over one essential statistic: the total cost of keeping W&O private is close to £1 million a year. That’s a lot of nomad advisers, consultants and PR spend, and a huge liability for a small, growing firm.

So what next for companies like W&O? Some form of exit was always planned for the group and given its lowly rating, a bid from a larger company must be a fair bet.

According to Howell both Carrier and Elegant (close peers in their market segment) were taken for over £30m apiece, and although both were probably more profitable at exit (no PLC costs), I suspect that he’d be a very happy man if he got north of £20m.

In the absence of a bid the focus will probably remain on organic growth, although Howell is careful not to rule out smaller companies coming in with the right offer. A ‘perfect fit’ company probably has £10 to £20m in sales, a healthy gross margin of 15-20% and top-line sales growth, with existing shareholders looking to spend more time on their gardens.

If you fit that bill I suggest you contact W&O – just don’t expect to get rich from holding shares in a publicly traded company.

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