Small looks just beautiful

IT IS possible that Horace Small Apparel is not going to be around as an independent company much longer. The group announced on 22 February that it was in merger talks with an unnamed third party. It further reported last Wednesday, with the 1994 results, that the discussions might or might not lead to an offer being made significantly above the market price. The shares jumped from 108p to 121p on the announcement and may fall sharply, though probably only temporarily, if the bid talks are abandoned. But the underlying fundamentals look so attractive as to make that risk well worth taking. Horace Small shares look an excellent investment, regardless of the takeover potential.

The company is one of a small group of companies quoted in London but has all its business in the United States. It was reversed into a failed oil UK exploration company with huge accumulated tax losses - $19m (£12m) as at the end of December - which under US tax law can be offset against profits in unrelated businesses. Horace Small has received tax credits with the last two years' results, and is unlikely to pay significant tax for several years.

Few UK investors will know much about Horace Small, which until recently has been a lacklustre performer. The group's main business is manufacturing and supplying uniforms, many of which go to the US. It has something in common with the British uniforms supplier, Wensum Company, which I wrote about recently, though Small is larger and more specialised. The shares are traded on the US stock market under an American Depository Receipts arrangement and attracted solid investor interest in the early 1990s. But the Americans turned sellers as they realised that the company was running into difficulties. Profits fell heavily in 1993, with a substantial loss reported after more than £4m of restructuring costs. The US selling left the shares particularly friendless. British investors were unwilling to invest in a struggling UK-quoted company with all its business interests far away in the US.

But this lack of interest is now creating an opportunity as the company begins what is shaping up as a meteoric recovery. Observers argue that the company has benefited from an input of British management, led by the chairman, Colin Keith. The group made a determined effort after 1993 to cut costs and improve productivity. It supplies many of its contracts (for instance, local police forces) on a regional basis through what are almost retail outlets. Acquisitions had left it with an excessive cost structure that needed trimming.

Even without the new contracts the group's trading performance is sharply improving. For 1994 the group reported a pre-tax profit of £3m against a loss of £2.4m on turnover up from £71.8m to £74.3m. Even if we exclude the impact of the restructuring charges, profits rose by 55 per cent, from £l.9m to £3m. There is no dividend because the group wants to build financial strength, but the historic p/e is 10.5. This would be more like 18 if the company were paying full tax.

The fascinating question is what is going to happen to profits over the next couple of years as the new contracts kick in and possible further contracts are won. The likelihood is that they will move up dramatically as the group benefits from a combination of higher turnover and higher gross and net margins.

Observers have also noted that the group is going through a culture change. In the past it could fairly be described as a textile company that happened to make uniforms. Now it is becoming a supplier of uniform services as companies outsource their requirements. A growing chunk of the manufacturing is moving to low-cost locations.

Over the next two years net profit margins could move up towards 10 per cent on sales of £80m to £90m. Operational gearing is reinforced by an interest bill running at around £1m a year. Pre-tax profits could hit £8m by 1996 for a p/e on an actual tax charge of around 5, rising to perhaps 7.5 on notionally taxed earnings. No wonder somebody wants to buy the company. The timing looks perfect and makes the shares an attractive investment regardless of the takeover interest. The directors have been heavy buyers at between 60p and 80p. Take note.