The list of Mello 2022 companies and speakers has been announced. All of us are planning to be there, and Mark is doing a talk called “A Portfolio with Personality & Style”. Don’t miss it! The code “TwitMM50” should still work for half price tickets.
There was an interesting discussion this week on the SCL discord server about how much cash investors are holding. The implication was that many are finding it hard to find investment ideas in the current market.
If you are a short term trader or look mainly for trends then being long will, of course, be a challenge. However, despite some challenges in the world with inflation, wars, and supply chains, this is not March 2020. When COVID hit, it was incredibly hard to invest - you couldn't rely on earnings estimates, the dividends were all cut, and even asset values such as property were highly uncertain. Anything a covid beneficiary, such as biotech was already expensive, and stocks that were highly defensive in previous recessions, such as cinema chains, were no longer defensive. So all the usual fundamental investing metrics were largely useless.
The current environment is still a challenging one to make predictions in, but, in contrast to March 2020, lots of companies are throwing off cash and using that to pay large dividends and/or buy back shares. That the bonkers 50xPrice/Sales companies on the US markets are now selling off doesn't mean that your growing, conservatively-financed company on an EV/EBITDA of 3 is suddenly worth a lot less.
There are a few reasons that this market isn't being bought by investors. The first is simply fear, the rabbit in the headlights effect. The second is that people are good at comparative, very short term, judgements, and bad at long-term valuation-based judgements. For example, if Tesla is down 20% this month and something else is flat it makes Tesla seem cheaper and worth making a switch even if Tesla remains on a 100x+ forward P/E. This is perhaps why the Ark Innovation ETF is seeing investor inflows even as the performance of the ETF is dire. In reality, many of the ETF holdings could drop a further 90% and still look expensive by historical standards.
This preference for short term comparatives versus long term valuation is why small cap stocks often go up or down together. That, plus the tendency during periods of high uncertainty for markets to simply have risk-on, risk-off days. On these days, the size of the moves is often proportional to the popularity of the stocks or assets.
It is, perhaps, daft that the big response to increasing inflation fears is for investors to sell risk assets in preference for holding cash that is losing 5-10% a year in real terms. But this is what we are seeing. Equity markets, bond markets, gold, oil, crypto are all pretty correlated at the moment, which means that this isn't about asset rotation, but simply a varying cash preference day-to-day. It works if you expect the risk assets to lose more than you lose in cash, but this is largely a herding effect, rather than a rational response to inflation fears.
In the long-term, the only thing that matters is cash flow, however, in the short term, the only thing that matters is asset flows. And this is why we are seeing the risk-off, risk-on days in small caps. The key to long-term investment outperformance is to be able to identify those cash flows ahead of time and get in ahead of those asset flows. This is never easy, but it is a lot easier today than it was in March 2020.
Large Caps Live
This week WayneJ looked at house prices, the outlook and their impact on the economy. Check out the discussion on discord here.
Small Caps
Vertu Motors (VTU.L) - Final Results
Revenue is slightly ahead of Liberum's forecast but behind Zeus's. That may put it behind consensus. There was no public guidance for revenue so no worries there. What there was guidance for was adjusted PBT which they said on 2nd March would be “not less than £75m”.
Although the statement was to 2nd March it only explicitly covered the period to 31st January (i.e. the first 11 months of the year), leaving some scope to outperform in the last month. Indeed, they have done significantly, with an adjusted PBT of £80.7m. This is well ahead of Liberum and Zeus, the former coming in higher at £75.8m, a beat of 6.5%. That compares with a beat of 7% this time last year. Momentum and conservatism still seem to be with them based on these numbers. This also translates to a significant EPS beat of 9%, ignoring Zeus's now dodgy-looking forecasting.
Of course, all motor retailers have been doing well, but Vertu claim to be doing better:
Vehicle sales volumes ahead of market trends in all areas on a like-for-like basis compared to FY20 (year ended 29 February 2020)
And of course, there have been several acquisitions / new franchise awards since FY 20. One of the tailwinds all motor dealers have had is the one-off effect of vehicle price inflation on profits. One way this comes through is as a lower cash flow conversion as inventory must be replaced at a higher price. So it is not surprising to see free cash flow below profits:
Free Cash Flow of £44.2m in the Year
This is below last year's number of £48.4m which was achieved on PBT of £22.4m, although there were special factors the other way back then.
Net tangible assets per share of 66.8p (FY21: 50.2p) reflecting strong asset base, net cash position and cashflow generation
This includes the pension surplus which the company could never access, probably not at all and certainly not in full. We would exclude that to give a NTAV closer to 65p.
Application of stringent capital allocation disciplines. Acquisitions are only undertaken if they meet required return levels. Dividends were re-established and over 9.7m shares bought back in the Year, with the buyback programme continuing.
It is good to have this confirmed. This is a strong indication that the buyback would be extended if the share price remains at the current level, well below their claimed TBV.
Final Dividend of 1.05p per share recommended, payable in July
This is as forecasted. Being the same as in 2019 when the interim had been lower it hardly seems generous. But it still equates to a yield of around 4%.
Outlook
Strong trading performance delivered in key months of March and April with trading profit of £19.1m (FY22: £19.2m)
So this is the bit that should be getting investors excited. March is a plate change month which, while less significant than pre-supply constraints, significantly drives new car sales, and also used cars due to trade-ins. So you can't just multiply £19.1m by 6 to get £114.6m as a FY forecast. BUT the fact is that trading is materially just as profitable as it was this time last year when the outcome was 17.92p.
Nor does it mean FY 2022's result will be repeated and the company is now on a PE of 2.7x. We don't know what the FY 2023 result will be, but we are 99% certain it will be lower than 17.92p. Things will get tougher and tougher from here onwards. Still, these first two months are far far better than we were expecting, coming during a period when used car prices were essentially flat. Used car margin seems to have fallen off in the last month - they gave 9.4% for the 5 months to 31st January 2022, but Leo calculates H2 to be 9.2%. This is to be expected. FY 2020 margins were 8.3% and FIFO accounting will drag on margins during any period of price falls.
there remains significant firepower available to facilitate the Group's future growth ambitions. This is estimated at around £90m.
This is committed borrowings only, ignoring the mortgageable property they have accumulated for example.
The Group has also identified appropriate capital investment to drive savings, for example in the fitting of LED lighting in all of the Group's vehicle repair workshops, an 18-month project of approx. £1.2m capital investment, to save significant energy use going forward.
Presumably you'd want a 5-year payback on that, especially considering the lighting equipment costs may still be falling. That's a lot of electricity saved!
Looking forward, external revenue on after-sales remains subdued according to the numbers, with growth since FY to 29th February 2020 below growth in sites. Including internal, LFL revenues are just 1.6% higher according to their own breakdown. They say this is partly due to a lack of capacity now resolved, but there are long-term post-covid trends including less miles driven and less nearly new cars on the road due to lack of demand closely followed by lack of supply. External gross margins at 57% make them far more expensive than the independent sector which will be a drag as disposable income falls. However, they are working hard to improve marketing and have expanded accident repair, particularly with tangible results.
Finally, they now have some dealerships which were not open or mature even for the whole of H2. Therefore, Leo expects the normal H1 weighting to reassert itself using H2 as a basis. He is forecasting total revenue of £300m for after-sales. Despite improvements to systems, he expects gross margins to fall back to 2020 levels due to wage increases. On used cars he takes a very conservative view on revenues, assuming they grow just with the increase in outlets. Although average selling prices will undoubtedly remain significantly higher, volumes were already down and may fall further. If people can't buy new cars, how much of a merry-go-round can there be on used?
On margins it is clear that prices are not going to fall significantly in Q1. The first two-months PBT figures from Vertu also support that. But we expect prices will also hold up over most of Q2.
The major risk has to be energy prices when the cap is reviewed in October just as we enter winter. This is a big unknown but could be brutal with big percentage increases on something that has become a much bigger share of living costs. Also there has been resistance to energy companies raising direct debits to build up credits ahead of winter, so monthly payments could rise disproportionately. So we expect to see price falls in H2 due to reduced demand and also pockets of better new supply. These will hit margins much more than sales volumes.
On new cars, they have 48% order book coverage of last year's sales, so again, there is very little than can go wrong in H1. Pockets of improvements in supply should help H2. But still, Leo is conservatively assuming growth only inline with outlet growth. However, he does expect margins to remain at high levels, especially in H1 given that order book.
Fleet and commercial we expect to continue to be weak. The former is probably a structurally smaller market post-covid. The latter may be oversupplied with delivery vehicles in the short term. Also there has been less increase in capacity of sites serving these markets. However, average sale prices will be higher. On margins, Leo thinks most fleet is on an agency basis and he is unclear why gross margins were 5.1% in H2 versus 4.0% pre-covid. Again, partly due to order backlog, he does not expect an immediate normalisation.
So Leo gets total revenue flat for 2023 at £3.6bn. This is significantly behind Liberum’s estimate of £3.95bn. But he sees gross margins higher than them at 11.3% (they have 10.9%) and also lower admin costs, despite the lack of government "support". They don't break it down, but he also sees support from lower finance costs.
The net result is 8.4p adj. FD EPS versus their 7.5p on what we consider to be pretty conservative assumptions. More than all of that in H1, with a loss in H2. The Liberum forecast of 8.1p for 2024 appears to assume no further allocation of capital, but looks closer to Leo’s assumptions on a LFL basis. With potentially £90m to spend on acquisitions that could easily bring in another 2p of EPS by then, however.
Cash and undrawn borrowings came in slightly below expectations at £178m. Much of this is required for contingencies and peaks & troughs in the working capital cycle (this is a £3.6bn turnover company remember), but importantly this is £37m more than they had this time in 2019. So potentially there is £37m which could be spent on buybacks without even going to banks, a significant proportion of the current market cap.
We also note that the Marshall Motor Holdings takeover was declared unconditional this week with funds paid within 14 days. There are not many listed car dealers left to reinvest in right now which may drive asset flows Vertu’s way.
Concurrent Technologies (CNC.L) - Final Results
These results were delayed slightly, the reason given was staff illness. The company had said in their post-close trading statement in January:
Based on its unaudited management accounts for 2021, the Company expects to report revenues and profitability slightly ahead of market expectations despite the ongoing challenges that the worldwide component supply chain is experiencing.
House broker Cenkos didn’t update their forecast of 4.68p adjusted EPS so investors were clearly expecting this to be beaten and perhaps come in above the 4.97p that Cenkos had for the previous year. This is what they got:
We are showing the Cenkos numbers here so that we are comparing like-with-like on the adjustments. These are disappointing in Mark’s opinion. Having given a post-year-end trading update where they said they were slightly ahead of expectations, to then miss the Cenkos EPS forecast of 4.68p, even very slightly is not a good look.
There has been a change in management here and the new CEO is very positive in his comments, but prior to this week’s results Mark said:
I also said yesterday that the dividend may give a better indication of how the management really feel the business is performing and not the management commentary.
And here we have a second disappointment - having increased the interim dividend, they now cut the final dividend, so the full-year amount is flat - again below what we assume Cenkos had previously been guided by management.
Then the third disappointment is that the 2022 estimates are significantly below those of the previous three years. Given all this disappointment, then it is surprising that the shares only fell 18% in response to these results. Investors are, perhaps, assuaged by the indication that this year’s poor trading is due to deferred rather than lost business:
Component shortage represents challenge to ship product in 2022, particularly in H1 with order delivery expected to be delayed and revenues recognised over a longer period than during normal market conditions.
And 2023 Estimates show the effect of this catch-up, however, this can't be relied upon as the future growth rate and 2024 could then look weak again. Cenkos are also forecasting an increase in Capitalised R&D. If they expensed this then FY22 would be loss-making and FY23 would be at similar levels to this year.
In general, we agree with adjusting out amortisation of acquired intangibles as long as a company isn't a serial acquirer. But capitalising R&D spend and then excluding amortisation seems aggressive. This makes P/E and EV/EBITDA metrics potentially misleading. One way to balance all of this out would be to simply look at the cash flow:
The cash balance increases by just over £1m a year plus they pay out £1.9m in dividends. Say 15x long term average FCF is therefore around £45m + £11.8m = £56.8m. This makes the current market cap of £55.8m at 76p look about right.
However, this is embarrassing:
A prior year adjustment of £0.3m has been made to the closing 2019 balance sheet to correct for an error on consolidation outside our underlying records dating back before 2019, which has under reported profit, net assets and total equity by this amount. As a result of not being able to definitively trace the cause of the issue, and with investigations ongoing, the auditors are required to qualify their opinion in regard to there being a limitation of scope on other creditors and opening reserves.
Perhaps the delay in issuing the results wasn’t purely due to staff illness?
Assuming the auditors are doing their job properly and have actually been checking the cash balances then this shouldn't affect free cash flow. But cautious investors may want a greater discount to fair value before considering buying given the increased risk of accounting issues. After all, the new management has given us three potential red flags: the delay, the inability to find why the accounts were out, and the miss on EPS and dividends despite issuing a slightly ahead statement after year-end.
And perhaps a further discount should be demanded due the weak short term outlook.
Norcros (NXR.L) - Proposed Acquisition & Placing
Norcros, a market leading supplier of high quality and innovative bathroom and kitchen products, is pleased to announce that it has conditionally agreed to acquire Granfit Holdings Limited…for an enterprise value of £80 million with an additional potential earnout of up to £12 million
The Acquisition will be funded from the Company's debt facilities and the proceeds of a proposed placing of new ordinary shares in the Company, to raise approximately £18 million (the "Placing").
When Leo last covered the company he pointed out that the apparent 6.6x PE was really 10x when considering the pension deficit, but that was starting to look interesting. Since then, the price has fallen about 10%.
Here's the result of the placing:
price of 230 pence per Placing Share (the "Placing Price"), raising gross proceeds of approximately £18.6 million (before expenses)
The Placing Shares represent approximately 9.9 per cent. of the issued ordinary share capital of the Company prior to the Placing. The Placing Price is equal to the closing price of 230 pence on 11 May 2022, being the last practicable date prior to the date of this Announcement.
So only a small dilution and no discount. Because it is mostly funded by debt they say:
The Acquisition is expected to be double digit earnings enhancing in the first full financial year post completion of the transaction.
(We have to assume that means EPS).
The price looked like it may have already bottomed, like many stocks right now. If you don't mind a bit of debt then this looks even more interesting than yesterday.
That’s it for this week, have a great weekend all.