Small Caps Live Weekly Summary

SOM VNET ZYT SDI GAW DWHT/A VTU RBN MSI

No Large Caps Live again this week, but lots of small cap news so we’ll dive straight in, pausing just briefly to say that it is not too late to add Mark’s excellent investing book to your Christmas Wish List, or even treat yourself to an early Christmas present!

Small Caps

Somero (SOM.L) - Trading Statement

Last time we looked at Somero we said:

[their guidance] is still behind the 20H2 run rate for revenue and I think this is the earliest they have issued an ahead statement, so there could well be another upgrade.

Which was prescient, as this week we got the following update:

The Board is pleased to report that it has seen strong trading momentum continue throughout H2 2021. This, combined with the Company's ability to consistently deliver on customer orders, means that the Company now expects to exceed previous guidance for FY 2021 established in the 8 September 2021 interim results statement. The Company's previous FY 2021 guidance indicated revenues were expected to approximate US$ 120.0m, adjusted EBITDA would approximate US$ 42.0m and net cash would approximate US$ 36.0m. The Board now expects FY 2021 annual revenues will approximate US$ 130.0m, adjusted EBITDA will approximate US$ 45.0m, and year end net cash will approximate US$ 39.0m.

Good news. However, this is not a scheduled trading update and is less than a 10% upgrade which is often considered "not material" and there is no obligation for a company to update the market.

So why have they updated the market now? It might be because if they didn't then further strong trading might take them 10% over guidance before 21st January, forcing them to issue two updates close together. Or it could be a sign that the company are being more promotional of its success. Mark’s favoured theory is that they didn’t feel comfortable continuing with the buyback when there was a high chance that they would be ahead of forecasts. The buyback stopped on 24th November despite some share price weakness and what we believe is capacity left on their buyback mandate. The timing of this weeks announcement would be after they completed Month End Close and hence had management accounts showing the latest trading performance.

The percentage rise in forecast EBITDA was lower than the rise in revenue, which means that costs are forecast to increase. In the H1 results they said:

The significant revenue growth in H1 2021 translated efficiently to strong profits and robust cash generation. The strong profits were underpinned by a considerable expansion of gross margin to 58.6% (H1 2020: 54.7%) driven by the benefits from increased volume and pricing increases offset modestly by higher material and logistical costs. The strong gross margin in turn supported a significant increase in adjusted EBITDA margin to 38.1% (H1 2020: 24.5% margin) an improvement that reflects considerable leveraging of support costs. These operating results underscore the scalability of the Company's operations and support functions to meet increased demand levels.

House broker, finnCap, are forecasting a 57.5% gross margin for the full year so expecting some moderation in H2. They are also expecting H2 SG&A costs to increase. However, given the number of new products that Somero are launching this year, and that they expense all their product development costs, this isn’t a concern.

These are the updated finnCap forecasts:

And they say:

Accordingly, we raise our forecasts in line with these increases, with adjusted PBT up 7.2% to $43.7m. For FY22, we similarly raise our forecasts, with a revenue increase of 7.9% to $137.8m and EBITDA up 6.4% to $46.6m, which results in adjusted PBT up 6.4% to $45.3m and EPS of 61.2ȼ. Consequently, we also uplift our dividend expectations, with a FY21 increase in total dividend of 8.8% to 44.9ȼ and up 20.4% to 46.2ȼ in FY22.

And raise their Target Price to 755p:

Valuation. Trading momentum clearly remains robust, and the group has posted a series of upgrades to expectations. We have a high regard for the group and its management, believing it to deserve a premium rating for its high quality and strong cash-flow characteristics, which then lead to an attractive dividend yield of 7.4%. We raise our price target by 8.0% to 755p, which offers strong upside to current levels based on a target P/E of 16.3x for FY22, which is not demanding. The current rating really looks too low, especially after drifting recently, trading on a FY23 P/E of 10.3x, and the shares should react well to this announcement.

The rise following this trading update is in line with the upgrade in EPS. However, looking further back, the share price is barely above where it was six months ago, and in that time revenue forecasts have increased 30% and EPS forecasts 48%.

This has always been a cheap share, though, as worries about the cyclicality of their business and still heavy reliance on the North American market have weighed on investors minds. As such, relying upon a re-rating of the shares to drive returns may be unwise. However, with a forward earnings yield of 10% and a dividend yield approaching 7% from a high quality and growing business, the returns from simply buying and holding are likely to be very good.

Vianet (VNET.L) - Interim Results

While the Group's recovery is assured, Vianet is not immune from global supply issues or further Covid-19 restrictions impacting our markets. As such, we remain focused on managing our cash balances to fund working capital and invest in growth. As a result, the Board will remain prudent and refrain from re-introducing an interim dividend for H1 2022. However, subject to no further lockdowns or restrictions on the hospitality sector and no deterioration of semi-conductor supply, we expect H2 cash generation will enable the Board to reinstate a dividend in July for FY2022.

This is in line with the trading update:

Subject to no further lockdowns or restrictions on the hospitality sector and no deterioration of semi-conductor supply, we expect H2 cash generation will enable the Board to reinstate a dividend in July for FY2022.

The focus has been on cash management...

As a result of working closely with our customers and suppliers, intelligent cash management...

Operational cash generation, post working capital, was £1.40 million, but:

So it can be seen that, ignoring financing, cash flow was just £0.2m. Here's the damage:

Over the last 12 months:

The net debt increase was primarily due to investment in our new sales and marketing team, maintaining product development spend through the pandemic and the introduction of significant one-off discounts to help our customers during the pandemic restrictions.

As ever, the treatment of what is BAU spending and what is an investment that can be capitalised is a key accounting question. However, we do note that the amortisation of intangibles was higher than capitalisation in the period.

Earlier this year, Leo did an analysis of why he thought they needed to raise money from the market. Nothing in these results leads to a significant change of opinion on that one, and as such, any further analysis would seem to be pointless at this time. Particularly since Omicron adds significant uncertainty for their draft beer monitoring business.

Zytronic (ZYT.L) - Final Results

The headlines were largely known from the recent trading update. Here is the summary from these results:

So EPS came out at 3p for the year and the good news is that a dividend is proposed. Although at 1.5p this isn't (yet) counted amongst the high yielders, this shows some confidence in the future.

The outlook is good:

The first two months of the year have seen an improvement in order intake, and with the improved margins and levels of demand across most sectors, this provides the basis for good progress in the coming year.

And this is backed up by very strong recent orders:

The order intake for October and November is a very encouraging 77% ahead and, although this does include some large orders for the Gaming market for delivery over several months, provides a sound basis for revenue for the coming months.

Balancing this, it seems that their financial sector may be in long-term decline:

As we consider that the Financial market was probably only slightly impacted by COVID-19 and the true market effect we continue to experience is related to the now well established major move towards a cashless society (digital and mobile banking) and with ZDL not being awarded with the new platform design wins for both of the major ATM global customers several years ago, which have since been launched, a sustained year-on-year decline is more likely and not reverse despite the H2 recovery.

And they have been unable to present at trade shows, which is their typical way of showcasing new technologies:

Unfortunately, the numerous travel bans and restrictions, have impacted the sales process, as work from home policies followed by a lot of our customers made and continue to make physical meetings impossible. Similarly, physical trade shows and the like, were also affected during H2 FY20 and H1 FY21, with numerous service providers experimenting pretty unsuccessfully with virtual attendance and participation. It was only towards the latter part of FY21 that physical trade shows reappeared, but unfortunately either the UK or destination country travel restrictions prevented any UK personnel attendance.  ZDL did undertake two physical trade shows in that period, Digital Signage Japan and Touch Taiwan, both being solely serviced by our locally based employees.

However, this bodes well for the future, in that we can expect further recovery as they can get back to normal sales activity and their new products more actively marketed:

Over the course of the year, a significant amount of time has been spent by the R&D team in identifying, approving and in some instances redesigning, to accommodate the various electronic component shortages that manifested; a number of key development projects were concluded, including finalising the release of the now multi-industry award-winning ZYBRID®hover (non-touch) technology and productionising the developed ZYBRID®edge controllers for multi-stacked sensor video wall designs, for formal release at the ISE expo in Spain during Q2 FY22.

In combination with the above, a significant amount of effort has also been undertaken to bring the developed ElectroglaZ™ concept to market, and although we have demonstrated facets of the technology at some of the FY21 digital signage and touch trade shows undertaken, it is intended to be more appropriately demonstrated at its own market-specific Light + Building expo in Germany during Q2 FY22.

Modelling the future here is tricky, particularly with the risk of further lockdowns and travel restrictions. However, with current order intake rates it is very possible that FY22 revenue is at least £15m, some 30% above FY21. This would put it on a forward EV/EBITDA of c.4. and a EV/FCF of c.6. This would seem good value, but given the illiquidity and uncertainty, a lot of patience will be required.

SDI (SDI.L) - Interim Results

The headlines read well:

Revenue increased by 75% to £24.7m (FY21 H1: £14.1m), including 42% organic growth

And a gold star for SDI for breaking out the growth into the different streams:

o Continued strong contribution from Atik Cameras due to one-time COVID-19-related contracts, expected to complete by January 2022

o £4.6m sales contribution from Monmouth Scientific and Uniform Engineering, acquired in FY21 H2

o Organic sales growth in all other businesses averaged 22%

They seem to be lacking some operational gearing though:

Adjusted diluted EPS* increased 59% to 3.92p (FY21 H1: 2.47p)

Which is down to slightly lower gross margin, higher taxes but primarily much higher operating costs. Operating Cash Flow is also weak due to prior customer down-payments reversing:

Cash generated from operations decreased by 6% to £4.4m (FY21 H1: £4.7m)

Overall, they say:

We look forward to delivering a full year performance in line with market expectations

And helpfully give what these expectations are:

Analysts from our Broker finnCap Limited and from Progressive Equity Research regularly provide research on the Company, and the Group considers the average of their forecasts to represent market expectations for FY 2022 being Revenue of £45.05m and Adjusted2 Profit Before Tax of £9.2m

This is not particularly great, however. Since this means that H2 sales will be 18% lower than H1, with H2 PBT dropping by a whopping 39%. That isn’t good and is presumably because the Atik Cameras sales for COVID PCR testing were one-off and are now mean reverting. finnCap reflect this mean reversion in their 2023 forecasts:

So £41m revenue and 5.3p adjusted EPS, which is below 2021 EPS as well as 2022E.

Still, this is a quality company, with an underlying organic revenue growth excluding Atik of 22% and the potential for further bolt-on acquisitions then it isn't hard to argue that a P/E of around 25x wouldn't be out of place.

However, a 25x P/E represents a share price of around 130p/share, some 30% below where the current price is. One to keep on the watchlist, though. The market tends to hate these mean reversion stories. Best of the Best, for example, dropped 80% when it became clear that their strong short-term performance was largely a one-off. As has happened multiple times in the past, a 50% drop in share price could make SDI look good value again.

Games Workshop (GAW.L) - Trading Statement

Not a small cap, we know. But it still trades like one, with a sometimes less than communicative management. This week we get a trading statement:

Games Workshop is pleased to confirm that trading since the last update in September 2021 is in line with expectations. The Board's estimate of the results for the six months to 28 November 2021, at actual exchange rates, is sales of not less than £190 million (2020: £186.8 million) and profit before tax of not less than £86 million (2020: £91.6 million).

The core business has been weaker though, with licencing taking up the slack:

Licensing income has increased to c.£19 million (2020: £8.7 million) driven by significant computer game licensing deals with Nexon and other major licensees. The related guarantee income is recognised on signing the contract in line with our usual accounting policy.

Licensing income is effecting 100% margin, which makes the fall in profits look worrying:

Our operating profit-pre royalties receivable is estimated to be down c.£15 million. However, excluding foreign exchange movements, increased carriage costs and the costs of paying more to our great staff, our core business operating profit is broadly in line with last year's exceptional performance.

“Broadly” is, of course, market code for slightly lower. However, forecasts from Edison are / were for profits to rise:

So this is a profit warning. For a company that is on a forward P/E somewhere between 25 and 30, going ex-growth would normally cause a large fall in the share price, especially in these more difficult market conditions. That the market hasn’t reacted to this trading statement means that shareholders appear to have escaped very lightly here.

Dewhurst (DWHT/A.L) - Preliminary Results

This company has a tightly held voting share (DWHT.L), which is daftly valued. The sensible investor looks at the economically identical A share (DWHA.L).

When we looked at these following their half-year results they were flagging that these were exceptional, due to pent-up demand. Going from 26.4p EPS to the stockopedia forecast of 71.9p looked a stretch too far to Mark, yet here we are:

So that's a big beat right? Well, probably not.

The calculation of basic and diluted earnings per share is based on the profit for the financial year of £7,029,423 and on 8,081,398 Ordinary 10p and 'A' non-voting ordinary 10p shares, being the weighted average number of shares in issue throughout the financial year.

There is £1.751m of profit from sales of Property in there. So that is 65.3p of EPS if we adjust that out. Then there is the question of amortisation of acquired intangibles. If we add back in this £1.111m charge then we get 79.1p EPS. In general, we are not always fans of excluding such charges. Although they are non-cash they represent the cost of acquiring a business, for which they have had the benefit of growth in EPS. However, it is notable that acquired intangibles are now negligible so this won't be an adjustment to argue over in the future (unless they acquire someone else).

What is a cash charge and doesn't go through the income statement is £1.357m of pension recovery payments. So overall, we get a “cash profit” of £5.033m and "cash EPS" of 62.3p. This compares quite favourably with the current A share price of 605p. i.e. a P/E just under 10. At 24x, the ordinary share, however, is clearly daftly priced in comparison.

The price looks even better when you consider that they have about £20m of cash on the balance sheet and almost £10m of NWC. There is, of course, the Pension deficit but it would be double-counting to adjust the balance sheet and the EPS for its effect.

The downside comes from the outlook statement:

Sales in the first quarter of 2022 are expected to be lower than last year in most of our businesses, with the absence of the bounce back from lockdowns and lower demand for cycleway products. Market conditions are uncertain and difficult to predict further into the year.

So we should be forecasting lower EPS for the coming year.

And we should perhaps not value that cash pile at face value. The dividend feels a little miserly in the circumstances:

The Board is proposing a final dividend of 9.75p (2020: 9.25p). If approved, this would result in a total dividend for 2021 of 14.0p per share which is 7.7% up on 2020 and is covered 6.6 times by earnings. Dividends are accounted for when paid or approved by shareholders, and not when proposed, therefore the proposed final dividend for 2021 has not been accrued at the end of the reporting period.

Perhaps they are concerned about optics at a time where they have had government support, although on a much-reduced level vs the prior year. But they have always underpaid their dividend compared to their FCF and cash pile.

Our balance sheet remains strong with available cash reserves and we continue to explore opportunities to invest this cash in appropriate acquisitions. Although we do not have any imminent prospects that meet our criteria, we will be expanding our efforts to develop our pipeline of possibilities. The Group remains well positioned in its markets to maximise opportunities as they arise.

If they weren't able to find an acquisition candidate in the past 18 months, perhaps they never will, or will overpay at the top of the market!

Mark sees Dewhurst as very similar to Zytronic in many ways. Both are cash-rich, cash-generative, fairly old-school industrial tech companies. However, Zytronic have always been keener to return any excess cash to shareholders and have the benefit of increasing EPS rather than decreasing over the next couple of years. Perhaps the real deep-value investor should plump for Dewhurst (at least through the A-Share), however, the smart money would perhaps favour Zytronic.

Vertu Motors (VTU.L) - Trading Statement

Group profitability in October and November 2021 continued to be delivered in excess of its business plan and also prior year levels.

We know why. As they say, it is a perfect storm:

Shortfalls in the supply of both new and used vehicles in the UK have continued due to the ongoing dislocation in supply chains impacting global vehicle production.

Nevertheless, new vehicle supply to the Group in October and November was better than envisaged and was sold at enhanced margins.

Their brand mix will have helped on the new side, and being a franchise dealer helps on the used side, with a natural stream of trade-ins. Like ScS, order books are growing, giving future revenue visibility:

Customer demand has remained positive, with strong future order banks in all new vehicle channels being evident.

We already knew that used car prices have plateaued because we read the trade press, which Vertu confirm:

Used vehicle supply constraints continued to underpin vehicle values, which have now plateaued and are starting to follow more normalised seasonal trends.

But still, this is something for the bears to worry about. Indications are the rises will resume in February though. This, together with the application of robust pricing disciplines in the Group, led to above normal margins being retained in used cars.

Having good central systems help here. Independents could easily end up letting used stock go too cheaply as prices rise almost daily, but as a larger group, they can and do monitor sales across the group on a daily basis.

The Group has made progress in its response to UK wide labour shortages as indicated in the Group's interim results announcement.

To pay more and retain margins, even in this market, you need to improve productivity. Vertu have made massive time savings on administration workflows over the past two years through investments that smaller groups cannot match.

So, what does this mean for profitability?

Considering the robust trading performance delivered for the year to date, the Board now anticipates that the Group's adjusted profit before tax for the year ending 28 February 2022 will be no less than £70m (previously not less than £65.0m).

So, a smaller upgrade than in the past:

20th August: £40-£45m => £50-£55m

13th October: £50-55m => At least £65m

An upgrade of "only" £5m reflects the fact there are fewer trading days to go until the year-end, and that we are now in the "low season". So, are these forecasts now fully cooked?

The Board remains cautious on the future outlook with the potential of further disruption from Covid-19 to our resource levels, consumer confidence and global supply chains.

Apparently not. They still build in considerable caution. And remember that they have excellent visibility on the high margin after-sales and an atypical backlog of new car deliveries. So there could well be another £5m upgrade in there, barring a hard lockdown without government support. And there is zero chance this statement was not issued without considering the likely impact of Omicron. The CEO is all over this kind of stuff, unlike the board of pubs which were issuing "not expecting covid disruption" statements well into last week.

These are one-off factors driving this upgrade. But the bear case is that they will unwind with losses on falling used car stock this time next year, so steady FY 23 forecasts are good. And of course, Omicron will affect order intake over the next three months, at least at the margins, impacting revenue recognised in FY23.

If we treat this as £4m post-tax on a market cap of £250m and it is worth 1.6% on the share price (if not already expected). But you should adjust that £250m for cash and freehold assets.

Broker Zeus say:

Our profit forecasts for FY23 and FY24 are unchanged, but even at the more normal levels of forecast FY23 profit, we see ratings upside for Vertu. Recent bid activity in the sector highlights the current industry undervaluation and supports our intrinsic value estimate of 85.9p per share, a 25% upside to current levels.

In their previous, 13th October update, they said:

We leave our FY23/24 forecasts unchanged for now. Our near term value per share increases to 86p implying a healthy risk reward profile from here.

So, if anything, they have rowed back on suggesting FY23/24 will be upgrades soon and on the intrinsic value estimate.

Investment view: Vertu now trades on a P/E of 4.7x FY22 and 10.9x FY23. This is below the mid-cycle average of 12.1x we have discussed in prior notes and below the MMH FY2 takeover multiple. At 16.3x FY23 EPS, Vertu would be valued at 101p per share. This more than supports our prior intrinsic value estimate of 85.9p, which did not include the potential upside from deploying £90m of M&A firepower.

On M&A, clearly, acquisition multiples for larger groups have increased recently, but perhaps not so much for smaller groups that are struggling to maintain the centralised investment levels required to keep up with trends in the role of online in the sales process. In light of this, the ability to do earnings enhancing bolt-ons remains strong.

Robinson (RBN.L) - Trading Statement

Not a great Trading Statement from Robinson:

Revenues for 2021 are anticipated to be £45m, which represents a 21% increase on the prior year. Excluding the effects of the Schela Plast business acquired in February, underlying sales are in line with 2020 but include significantly higher resin prices passed on.

That is an interesting effect of inflation that I hadn't considered before. You can get flat revenue on reduced product volume with cost increases.

We announced in August that we were seeing a lower-than-normal level of demand in the third quarter due to the ongoing uncertainty across FMCG supply networks and a varying pace of recovery from the pandemic. This volatility has continued in the final quarter and in some sectors, volume has deteriorated further as Brexit and Covid-19 have impacted customer demand.

This lines up with what fellow packaging company Macfarlane were saying in their latest trading update:

We expect the remainder of 2021 to remain challenging with input price inflation, supply constraints on certain raw materials and increased operating costs due to staffing pressures. Some customers are also experiencing supply chain issues which are affecting their demand for packaging. However, the Group's management team remains focussed on effectively managing these challenges.

However, Macfarlane are a distributor, not a manufacturer so seem to be able to more easily pass on cost increases, whereas Robinson say:

In the second half, we have seen further inflation in input costs including secondary packaging, energy, and freight, and in the UK specifically, limited labour availability has impacted customer service and increased costs. In the short-term, margins have reduced as we have been unable to immediately increase sales prices or remove fixed production costs.

And the impact is:

As a result of the lower sales volumes, the directors now anticipate that full year operating profit before exceptional costs and amortisation of intangible assets will be in the range of £1.2m - £1.3m.

We can expect another £4-500k of interest and tax costs on top which would be net profit excluding amortisation of intangibles of £0.7-0.9m. This is a big miss vs the current £2.3m net profit forecast on stockopedia. This is maybe around 4.8p underlying EPS. And on top of this disappointment, you have a very weak balance sheet with a current ratio of around 1.2.

Looking further out, they say:

However, we have begun to seek substantial price increases from all customers, which will start to recover margins in 2022. Additionally, a restructuring programme was implemented in November which will result in exceptional costs of £0.2m in 2021 and annual savings of £0.3m in 2022...

Profits in the 2022 financial year are expected to be ahead of 2021.

So cost-cutting is probably the right response but the absolute savings are small. And beating 2021 figures isn't exactly a challenging target. Perhaps the only thing preventing a much larger fall than Thursday’s 10% drop is the discount to Tangible Book Value. They highlight the property disposals:

We previously announced that we expected to dispose of two plots of land in 2021; completion is expected shortly on the first site, whilst planning approval is now required for the second site which will delay completion until the end of 2022. The gross proceeds are now expected to be marginally in excess of the £3.4m previously indicated for the two plots which have a book value of less than £1m.

Which might go some way to rebuilding the balance sheet. However, again this is a partial disappointment since they have been trying to sell this land for something like a decade and again some of it is delayed. And they haven't broken out the payment between the two plots. The sceptic might conclude that they are only managing to sell the less valuable one in the near term.

House broker, finnCap, have 4.4p adjusted EPS for 2021 and say:

We are withdrawing our FY2022E forecasts and price target.

So this isn’t exactly inspiring a lot of faith that they can turn things around. If discount to tangible book value is your thing, then there is likely to be much better opportunities than an underperforming Robinson.

MS International (MSI.L) - Half Year Report

When Mark last looked at MS International, he described it as a rite of passage for every value investor. Often superficially very cheap, this is a business that seems to take two steps forward, followed by two steps back, while the controlling management continue to be well-remunerated in all market conditions.

In the recent half year they seem to be back on the front foot:

Revenue in the latest period increased significantly to £33.16m (2020 - £26.34m) producing a profit of £0.77m (2020 - loss £1.08m).

Basic earnings per share 3.4p (2020 - loss 6.6p).

So a decent recovery. Although, with the share price above £2, this is clearly priced for a further strong recovery. They flag this in the outlook:

Furthermore, orders received in the period, when added to those already 'in hand', have placed the Group in a very advantageous position despite the global pandemic which will, no doubt, continue to disrupt current and prospective business activity across our operations.

Primarly this is in the defence business, where they say:

The first batch of our 30mm naval guns for supply to the US Navy is in production for delivery in the second part of this financial year, alongside various other export sales items.

The problem is that, with no forecasts in the market, it is really hard to tell how material these will be. The forgings part of the business, that makes forklift truck forks, is doing well as greater material handling is required. The acquisition they did a few years ago, which makes petrol station branding, is struggling since it is largely a continental business.

The reported net cash of £15.5m is a significant proportion of the market cap. However, this is flattered by working capital, such as large contract liabilities.

Then there is also a £6.5m pension deficit. This is on an IAS19 basis and the triennial figure, which is likely to be larger, wasn’t disclosed in the last annual report. Anyway, this requires a £900k per year recovery payment that doesn’t go through this income statement. If it did, then the net profit for the half-year would be negligable.

Given all this, MS International doesn’t look cheap anymore. This means that it is more likely to be on the downslope of its usual cycle, rather than the upslope.

For more on how to deal with pension deficits, Mark will be doing a talk at the upcoming Mello Monday.

That’s it for this week, enjoy the weekend!