Is this AIM share too hot to handle?

While Next's half-year results confirm its investment credentials, Sprue Aegis may be too hot for the Decision Engine to handle.

Having simplified the Decision Engine algorithm last month I've applied it to the 50-odd companies it tracks closely. The process is more ponderous than you might imagine because it involves making judgements about businesses and their managers.

There is always a certain amount of to-ing and fro-ing in the table because moving share prices influence company valuations, one of the five criteria used by the algorithm. When companies publish their full-year results I plug them into the Decision Engine, which also shakes things up.

But, due to an excessive amount of thinking this month, there's been lots of movement in the table, and that's likely to continue for a while as I refine my judgements, some of them made quite hastily. For that reason, I won't be hastening to make changes to the portfolios I run.

Also, having seen the implications of the new algorithm, I've tweaked two of the criteria very slightly - there are five in total. The other three are unchanged and you can read about them in last month's article.

The revised criteria are that businesses should be:

#4 Managed equitably for the long-term

Having agonised about Goodwin's long-term incentive plan, which may award the directors a substantial amount of the company they already control, in return for, in my opinion, achieving a spurious performance target. I've added the word 'equitably'.

The test is: Judge management by their actions and their incentives. They should invest incrementally to grow and adapt the business. They should profit through their ownership of shares. They should not reward themselves unreasonably at the cost of shareholders, employees or society.

Goodwin has, incidentally, slipped out of the top 20 shares ranked by the Decision Engine, partly for this reason.

#5 Valued attractively

As I rolled out the revised algorithm, I realised that if I treated valuation like the other factors, scoring it from 0 to 2, companies like Quartix and James Halstead that score very highly on the other criteria would be ranked in the top 20 at any price. All value investors have their limits, so I've introduced a penalty that grows more onerous the further a share's average earnings yield falls below 5%, or, if you prefer to think in terms of PE ratios, as the debt-adjusted PE rises above 20.

The formula is: An earnings yield of 10% or more scores two. For earnings yields between 5% and 10%, the score rises with the yield from zero to two. Below 5% the score is punitive, losing a point with every percentage drop in the earnings yield.

James Halstead trades on an earnings yield of 4%, equivalent to a debt-adjusted PE of about 25. That means it scores -1 for valuation. Even so, the company still makes it into the top 20. Quartix, which trades on an earnings yield of 2%, equivalent to a debt-adjusted PE of 43, does not, a valuation score of -3 is enough to sink even the best looking business.

Although Next reported lower like-for-like retail sales for the first half of the financial year ending next January, a surefire way to give short-term investors the jitters, the company gave those looking further ahead cause for confidence.

The fashion and homeware retailer is opening more new stores than it planned to at the beginning of the year, replacing smaller less profitable stores with bigger ones. Store numbers will remain broadly the same at the year-end, but the larger stores mean trading space will increase by nearly 5%.

While the company is selling less per square metre, it hopes to offset those losses with more square metres.

That's only a viable policy if the stores remain profitable. Next says new space must:

● Be highly profitable (at least 15% return on sales, but preferably more than 20%)

● Pay back on capital invested within two years

● Be rented on relatively short leases, typically less than 10 years

Perhaps we can rest easy. Next earned a 22% return on sales from new stores opened in the previous 12 months with a forecast 22-month pay back on the capital invested in them. 93% of mainline stores currently meet or exceed its 15% return target (the average lease term is 7.3%), and only 0.5% make a loss.

Next isn't hoping for the best, it appears to be investing with a margin of safety. Thinking the uncomfortable, it says: "These criteria mean that even if there is a significant decline in like-for-like sales, new stores are likely to deliver healthy returns on capital and remain profitable for the life of their lease."

The prospect of continued declines in retail sales cannot be ignored because of the intensity of competition from rival stores and particularly the Internet, which Next has been slow to migrate Next Directory, its phenomenal catalogue business, to.

Good news for Next

There may be good news on that front. Next believes the launch of its mobile website and online marketing campaigns have helped Next Directory grow 9% faster than retail in the half-year, compared to 2% the previous half-year. It's also personalising the website enabling it target products and promotions at the most relevant customers.

Lower down the table, smoke alarm and carbon monoxide detector supplier Sprue Aegis is giving me a headache. The company's high recent profits may not be sustainable. In the short-term we know they're not. The company made a loss in the first half-year, and though it expects to rebound in the second half, it's not at all clear how far. For the longer-term, this year's results will lay bare the fragility in Sprue's business model that makes it so unpredictable.

Sprue may be too unpredictable for the Decision Engine to handle

Sprue's revenue more than halved in the half-year to June 2016 compared to the half-year to June 2015. All of that decline can be accounted for by a drop in sales in France where people had rushed to buy alarms to comply with new legislation requiring at least one working smoke alarm in each home. The fall in revenue was partly the result of lower demand, but it was exacerbated by the fact that whatever demand there was could be met by high levels of stock at Sprue's distributors, so orders collapsed. Sprue says it sees signs the market is normalising now, but it doesn't say what a normal level might be.

At the same time as boom was turning into bust in France, Sprue reported that it would have to replace a large but unknown number of alarms due to faulty batteries sealed within them. It seems to have managed the crisis quite well, losing no major customers, and confirming its initial estimates of the likely cost, which is substantial but easily covered by its cash balance.

Some states in Germany have also mandated smoke alarms by the end of 2016 and 2017, but the company's German distributor deferred orders until it could be supplied with alarms fitted with a different battery, which caused a decline in revenue there too. Now Sprue is supplying Germany again, the company will experience another wave of demand - of undetermined size. After that, it expects legislation in other parts of Europe.

As the company grows and adapts, its reliance on capricious waves of legislation to drive lumpy demand for smoke alarms may reduce and its volatile profitability moderate. The first generation of Sprue products is now 10 years old, and, due to the sealed-in battery, must be replaced. Sprue has launched the mains powered Sona range in the UK, aimed at the trade market. And it's acquired software developed for it by Intamac that enables customers to connect and monitor Sprue's alarms and detectors over the Internet, allowing the company to develop new products and services that may generate more reliable revenues.

It may be, though, that Sprue is too unpredictable for the Decision Engine to handle. I need to have a think about that when the full-year results are published next April and we see exactly what a really bad year looks like.

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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.