Small Caps Live Weekly Summary
Ukraine ASC BOO RBG RCH ZYT VTU
Apologies for the re-send, substack messed up the version history on the previous one!
Small cap news this week has, of course, been overshadowed by the ongoing war in Ukraine. The Russian assumption of a quick Ukrainian surrender has been proven false, and this battle plan has been shown to be foolhardy - many Russian conscripts don’t want to be fighting. Ukrainian defence has particularly focused on supply lines, and as they run out of fuel and food many demoralised Russians are surrendering to get a cup of tea and a bite to eat. Stalled convoys and an increasingly muddy Northern Ukrainian landscape that badly maintained Russian trucks seem unable to leave the roads and are, in many cases, sitting ducks if Ukraining armour or drones can get in position. Despite the losses, Russia still has formidable firepower and they seem to be now intent at targeting this at the civilian population in order to try to enforce submission.
This abhorrent behaviour is making Russia a world pariah and sanctions are likely to cause widespread economic collapse of the Russian economy. While this is an effective tool for targeting a state where independent media is now non-existent, this is likely to increase geopolitical tension in the short term. The knock-on effects are not trivial for Western countries either - oil, wheat and other commodities are hitting daily highs.
With this backdrop, now is not the time to be holding anything on stretched valuations. The DotDigital share price halved on Thursday on a weak outlook. Despite this magnitude of fall, the current 17x forward earnings doesn’t exactly look compelling for a company with just 5% forecast EPS growth. That is less than the current rate of inflation!
In this environment, even more modestly priced stocks can face selling pressure. As liquidity becomes constrained, those investors who are leveraged become forced sellers, which often triggers further sell-offs as stop losses are hit. It is perhaps not a coincidence that some of the biggest small cap fallers over the last week have been amongst the more popularly-held stocks - UP Global Sourcing, Renold, Mpac, and Creightons, for example. This can be a good time to go shopping. However, this is a time to check valuations and if anything fundamental in the company’s outlook has significantly deteriorated, and to make sure you aren’t simply anchoring on a previous high, but overvalued, price.
Asos were first out with a statement about their business in Russia on Thursday:
In FY21 Russia and Ukraine represented c.4% of Group revenue and contributed approximately £20m to Group profit.
4% of revenue is £156m. but £20m profit is c15% of their net profit. So this does seem to be significant for them, due to be higher than average margins. The initial reaction to this was, perhaps, an under-reaction, although
Boo Hoo also fell in sympathy before announcing their own update mid-morning:
Boohoo is deeply concerned about the tragic developments in Ukraine. Immediately following the invasion, the Group suspended sales to Russia, and also closed its Russian trading websites. Sales made by the Group into Russia are not material, totalling less than 0.1% of Group revenues.
So negligible impact here. Although this statement doesn’t appear to have reassured investors. Rightly or wrongly, BooHoo has regularly been challenged on corporate governance issues and as such has a much more flighty shareholder base.
Revolution Bars Group (RBG.L) - H1 Results
The on-the-ground evidence locally is that UK bars are currently trading exceptionally well for the time of year. Upstairs in Leo’s local Revolution de Cuba (Birmingham) is a really exceptional space with the previous less upmarket Revolution Bar on Broad Street closed down. So he has become more positive about the company recently.
This week Revolution issues its H1 results to 1st January, but given that a trading update has already been issued, the focus will be on the current trading.
After the release of trading restrictions under "Plan B" and the positive news of the removal of COVID-passports in England, we are delighted to have seen a return to strong LFL sales growth in February 2022;
LFL has been defined as being versus "comparative reporting periods". Elsewhere in the statement, they have given figures since both the previous year and the one prior to that. The decision to provide no numbers and not state the comparable period for the last two months of trading demonstrates a completely unacceptable attitude problem by the management and makes the shares utterly uninvestable in Leo’s view.
Ukraine is mentioned:
We continue to monitor the developing situation in Ukraine however we expect any impact on our business to be limited; and
We are at a loss as to why anybody would expect any first-order effects from Ukraine! However, a cost of living impact is certain.
Taking into account the above, despite the Government's response to Omicron, which in our view was overly cautious and caused a substantial loss of trade during the important festive season, the Board is now confident of delivering adjusted EBITDA (on an IAS 17 basis) towards the top end of the range of market expectations, which is currently between £8.0 and £10.0 million, assuming that the COVID-19 landscape does not significantly deteriorate.
Because they have refused to provide any trading figures it is impossible to know whether this is a premature, an optimistic or a pessimistic forecast. For Leo, this makes it worthless. Total equity remains at negative £21m, with no intangibles on the balance sheet. This is due to lease liabilities exceeding right of use assets. Non-current lease liabilities are massive compared to current ones, suggesting long leases.
At the time of the annual report, the vast majority of lease payments were due in five years or more, even on a present value basis. We cannot see disclosure of average lease length, but it appears to be in excess of 10 years. So this is at least half a property company investing in medium length leases and risking that economic values rise or at least stay constant.
Trade payables also seem to be very high compared to receivables. This may partly, or solely, be down to normal bar economics, but it is not rational for suppliers to give Revolution this kind of credit in the long term given their negative assets and poor historical performance, even pre-covid. Furthermore, they still have very considerable debt in the form of a CBILS loan. Although cash is in excess of this, it is not clear that it is sufficient to cover monthly and annual cash cycles.
So Leo calculates Enterprise Value as follows: £46m (market cap) + £41m (onerous leases) + £10m (excess payables) = £97m. So an EV/EBITDA of 10x.
On the positive side, the EBITDA they use does include lease payments. But an EV/EBITDA of 10x is an insane valuation for a high maintenance capex business like a bar. 5x is closer to the mark, which gives them a negative valuation, in line with the balance sheet.
Another way of looking at the company is via accounting profits. This includes depreciation, but of course, whether this is representative depends on the recent profile of investment and the accounting assumptions. A quick check is the cash flow statement. Here we see Depreciation of PP&E is slightly in excess of purchase of PP&E, suggesting the P&L will be a reasonable representation. 6 months is really too short to tell though, and historical figures may not be representative.
Here's the depreciation policy:
Fixtures and fittings seem on the long side for a nightclub type environment. Clearly, some fixtures will be closer to 2 years, though we don't doubt 10 is reasonable for others. Apparently, very long lease lengths will flatter leasehold improvement depreciation.
So, with these caveats, adjusted EPS forecasts are 0.2p for the full year. Given that they reported 1.9p in H1, that implies a large loss for H2, meaning this cannot be extrapolated forward for a positive valuation. And anyway, management has chosen to be evasive on current trading so we have no way of verifying how achievable this is. For FY 2023 forecasts are for 1p EPS, but they have a history of missing forecasts going back before covid.
So to remind you where we are, the company is worth less than zero on three metrics (balance sheet, EV/EBITDA, post-covid H2 EPS). But a limited company cannot be worth less than zero to shareholders. And it cannot be zero as there is always option value. Really crudely, the option value from something unexpectedly good happening has some relationship to sales with £150m seeming to be a reasonable run rate. So Leo is going to value it at £1.5m.
Reach (RCH.L) - Annual Results
These results were not well received by the market with the share price down 22% on the day. The story is as usual - mid-single-digit declines in print revenue, offset by rises in digital. Lots of bulls on Reach tend to make comments comparing it to google or Facebook. Forgetting, of course, that these are platform businesses where users generate the content for free.
Digital for Reach means attacking your eyeballs with as many ads as possible on an article written by a staff member. Although Reach clearly doesn't spend much on generating content per article, this is still the bulk of their cost base:
And surely there is a limit to the number of pop-ups they can put on a page before people just won't go there.
As usual, you can drive a bus between the adjusted and statutory profits:
So it is particularly important that investors take a view on how reasonable those adjustments are:
In particular, phone hacking payouts don't seem to be going away and if anything increasing. this is the other major exceptional cost:
The Group announced a Home and Hub project in March 2021 which set out the vision for how the Group's offices would look and where job roles would be based. As a consequence of the project a number of offices or floors have been closed. The project has resulted in charges of £23.7m (impairments of £2.3m relating to property, plant and equipment and £10.5m relating to right-of-use assets and a £10.9m property rationalisation charge relating to onerous costs of vacant properties).
As always, claiming that the savings from closing offices are normal business yet the cost of doing so is exceptional may seem a little bit aggressive to some. This statement on costs is what is likely to be doing the damage to the price this week:
However, the impact from inflation, which began to affect the business towards the end of 2021, has now intensified, particularly in print production. This has primarily been reflected in the cost of newsprint (paper for printed products), which having previously been impacted by rising distribution costs and supply challenges, now also reflects the significant increase in energy prices. As a result, the gross impact of inflation in 2022 is expected to be higher than in recent years.
While ongoing efficiencies are expected to partly mitigate this impact, we anticipate the net effect to be a modest year-on-year reduction in operating profit as we continue to invest for the future.
Given all the adjustments, plus historical depreciation etc. we really should be looking at the cash flow statement, not the income. Cashflow from operations comes in as £163.7m but £64.7 went back out as pension recovery payments. They haven't been able to agree on payments going forward with the trustee and we know the pension regulator is getting involved. We suspect Reach would like to keep payments the same but the Pension Trustee is pushing for increased payments.
Doing some simple estimates - we know operating profit will be slightly down going forward so let's say they generate £75m here and add back in £20m of depreciation to get £95m of OCF pre-Working Capital movements. About £70m could well go out as recovery payments, £13m tax on slightly lower profits, £10m capex or development, £8m capital lease payments. So you can easily see them being free cash flow negative next year before any working capital movements and can see why they don't want to pay more to the pension trustee. This would effectively have to be met from cash reserves.
The bull case s that cost inflation abates, digital keeps growing, lower pension payments can be agreed upon in a few years. The problem is that the market cap was £550m on Tuesday, even after the large fall. So you are already paying a lot for the hope that this can return to generating Free Cash Flow in the future, without relying on simply stretching working capital further. If it doesn't recover quickly, and inflation proves more extensive then this is easily a share that can go down to 50p or lower, as it does every few years or so. Consequently, the risk-reward doesn't look favourable despite this week’s falls.
Zytronic (ZYT.L) - AGM Trading Update
This statement was short but definitely sweet.
Revenues for the first five months are approximately 25% ahead year-on-year and we are maintaining operating margins at the improved levels of last year. The order book is 45% ahead of the same period last year, partly benefitting from some advance orders which improves visibility for the coming months and allows us to plan for any of the well-publicised electronic component supply issues.
With these figures, Mark estimates around £1.5m Free Cash Flow for FY22. With an Enterprise Value of around £7.5m, this is just 5x forward FCF, which seems too cheap for a business that should have further recovery momentum into FY23 and a number of innovative products that may start to gain traction into new markets.
One of the critiques in the past has been that you should discount the cash in the EV if they just sit on it. However, with a tender offer and now a large share buyback, the commitment to do something with the cash is now much higher than it has been in the past.
Vertu (VTU) - Trading Update & Buyback
This very detailed update is to 31st January, leaving just one month of the year left to report. This is a quiet time of the year for new and used car sales, but after-sales revenues can be higher as drivers prepare vehicles for winter. Usually, there are higher after-sales revenues as drivers crash cars on snow and ice, although due to global warming it is more likely to be repairing damage from flying storm debris this year, at least in England. As expected:
I am pleased to report that the Board now expects the trading result for the year ended 28 February 2022, at an adjusted1 profit before tax level, to be not less than £75m. This further upgrade would not have been delivered without a significant team effort and I would like to thank every single one of my colleagues for their hard work and dedication.
We make this the 6th profits upgrade for FY 2022. However, they continue to point out that:
The trading results have been aided by sector tailwinds and limited vehicle supply leading to augmented margins.
But their guidance has also been continuously conservative, not only for ongoing operations but for recent acquisitions. Yet again they say integration is running ahead of plan:
In addition, recent acquisitions have contributed at a higher level than initially envisaged due in part to a swift and successful integration process.
From a separate statement:
...the Company announces that it intends to commence a further £3m share buyback programme (the "Buyback Programme").
Under the Buyback Programme, the Company will seek to buy back its Ordinary Shares using the Company's existing cash resources for a further amount up to £3.0 million.
Share repurchases will be undertaken until the earlier of the Maximum Amount being repurchased and 28 February 2023. Any Ordinary Shares repurchased will be cancelled.
We will quickly see from the cadence of purchases whether this date is the real target end date or just a technicality. Based on recent history, this new share buyback is likely to be exhausted in around 3 months.
The debt capacity of the Company, current net cash position and positive cash flow is such that we will also continue to pay dividends and consider acquisition and investment opportunities as part of the pursuit of the ongoing growth of the business.
They seem to be saying they can do it all and so, barring a very large acquisition or the share price rising much closer to what they consider as fair value it is likely to be extended further. They have given a date of 11th May for the FY results and so there is no reason to think they'll be another gap in the buyback. They have only bought back 2.5% of shares since the last AGM authorisation and so limits there are unlikely to be a problem.
From the trading statement, the first thing to note is that the number of outlets is 159 versus 147 this time last year, and that some of those are not yet fully up to speed. If it were possible to adjust out the effects of car shortages then you would expect better underlying results next year as the increase it sites annualises and benefits from integration and optimisation accrue. Likewise, even ignoring the order book and pent up demand, you would expect better results than pre-covid.
We don't think there are any special factors that mean the LFL growth rates for the whole of H2 won't be similar to the 5-month ones. However, the actual growth rates will be higher due to additions:
On 10 December 2021 the Group acquired the entire issued share capital of Farmer & Carlisle Holdings Limited, which operated two Toyota franchise freehold dealerships located in Loughborough and Leicester.
On 1 January 2022, added the Peugeot franchise to the Group's Sunderland Vauxhall dealership, which brings the number of Peugeot outlets operated by the Group to 8.
The MG franchise was also included in the new development with the business having been acquired in December 2021.
So we are surely looking at 20% revenue growth for 22H2 on 21H2 as a base case. This is far better than Leo’s base case of flat H2 revenues from October. That produces £3.64b revenue for FY2022. This is in line with Liberum at £3.61b, but there is a cause for concern here: This is a significant cut from their previous forecast of £3.90b. As Liberum comment:
The shape of our numbers reflects a lower sales assumption, with low margin fleet LFL sales volumes down 7.6%, Motability down 32.1% and commercial vehicles -19.8%.
Zeus's is significantly out of line at £3.80m. They say:
a 2.2% revenue upgrade due to higher selling prices
It is relatively unusual to have such a wide variance between two forecasts at this stage in the year. This is likely to be due to one provider putting more emphasis on company guidance and one on independent calculations. Zeus Capital are named as their broker and therefore may be closer to the company, but neither are independent and the difference may reflect the questions the analysts happened to ask in the pre-update call. Either way, we now face the prospect of a possible miss to consensus revenue forecasts which is not ideal.
But with massive variations in the margins on different types of revenue, the revenue mix is at least as important as the revenue number. For example, external after-sales revenue has a margin of around 58% versus just 3.5-4% for fleet and commercial sales. And margins across the board have been higher of late, and the extent to which this continues is more important still.
Because margins on After Sales are so high, they split out Service Revenues in their March trading updates. But much higher used car revenues and margins than usual make this figure less useful than in the past.
Likewise, volumes for used retail vehicles are much less of a guide to revenues due to the massive used car inflation. And for new retail vehicles have suffered from unusual mix changes.
constrained supply drove the average price of a used car in the UK up approximately 25% year-on-year
Gross profit per unit grew 52.5% to record levels of £1,846 from £1,210. Gross margin percentages rose from 8.4% to 9.4% despite significantly increased sales prices. [versus 2019/20]
This is enough information to calculate average selling prices, used car revenue and gross profits. It also means that used car margins have been elevated for two full years, but that they have already fallen back from the super-exceptional 10.2% in H1.
As Leo has frequently discussed, some of this increased margin is due to rises in the value of the car while it is sitting on the forecourt, or in more general terms, FIFO inventory accounting. This element will disappear when prices stop rising and reverse when they fall. While new competition from online challengers focuses on convenience rather than pricing, it seems unlikely there has been a structural improvement in used car sales margins.
Committing some fairly major maths crimes for the sake of expediency: Prices rose around 17% in H1 and we saw 10.2% margins. Prices rose 8% in H2 leading to 9.4% margins. So if prices had been flat perhaps we would have seen margins fall half as much again, leading to margins of 9%. So at the very least, there doesn't appear to have been an obvious degradation in underlying used car margins. And a 20% fall in used car prices would still leave ample margins.
Moving further down the importance in terms of profit contribution, new car sales are outperforming the market, but still weak. Higher margins mean these sales have more immediate consequences than usual, but the real importance is the high margin aftersales revenue they drive.
The Group's like-for-like volumes of new retail vehicles fell by 8.2% representing an outperformance as the Group benefited from its mix of Manufacturers having better supply than the market as a whole.
Fleet and commercial margins have traditionally been the lowest of all, but exceptional demand for delivery vans has changed the mix and increased margins on the latter. Commercial demand however is now tailing off while the fleet market remains dead.
While all these profit upgrades will lead to more cash in the bank, exceptional FY 2022 profits are extraordinarily unlikely to be matched in FY 2023 and the outlook is all-important.
The strong balance sheet, experienced leadership team and strong systems capability of the Group ensures it is well placed to capitalise on the significant opportunities for growth that exist within the UK automotive retail sector. The Board considers that scale is a vital success factor in the sector given the need for strong brands and investment in digital developments and continues to have ambitious growth aspirations for the Group in the next few years.
Clearly, this is a reference to further acquisitions/franchise wins. A strongly agree that scale is important here and Vertu are theoretically in a position to buy a small group at a valuation discount to a larger one AND drive significant operational improvements AND cost savings. The issue is that Vertu itself is very cheap, and buying back shares is much easier and lower risk than expanding through acquisition. Still, they have done a good job so far and further attractive targets are likely to come along as owners retire etc.
Without doubt, FY22 has seen extraordinary trading conditions which have driven the exceptional financial performance. Whilst the outlook remains uncertain for FY23, it is clear that these highly favourable trading conditions are unlikely to recur. The FY23 financial outcome is likely to be some way below FY22, although we certainly expect performance to be well ahead of periods prior to FY22.
However, with upgrades to FY23 issued today and a record of conservative guidance, we don't think multiple further upgrades are too much to hope for. But:
Significant increases in operating expenses such as payroll, energy and investment in digitalisation and related marketing are evident…In addition, consumer confidence will be critical in the months ahead as cost-of-living inflationary rises become apparent and geopolitical uncertainty arises. These matters could impact vehicle sales.
Despite the strong performance, aftersales has been affected by capacity, but:
The Group is now in a better position to maximise aftersales revenues due to higher resource levels following pay reviews and a recruitment drive.
Aftersales margins are likely to reduce, as seen in the latest Period, with a potential offset with revenue growth. The last two-year decline in new vehicle sales will lead to a softening in the market for service and repair work in the UK for vehicles under three years old, the traditional core market for franchised retailers servicing. Increasing market share in the older vehicle service and repair market will be a critical objective to seek to offset this softness.
Initial modelling suggests FY 2023 forecasts of 7.4p are too low, even before adjusting for the deployment of excess capital for share buybacks and/or acquisitions. 10p looks quite possible.
Leo is less optimistic about FY 2024 when tailwinds will have run their course. A further fall seems likely before growth resumes, although this will depend on capital allocation (including how cheaply they can buy back shares!). The effects of the Ukraine invasion are unpredictable, but their OEM mix defends them against further cuts in German car production which could occur under many circumstances. There are also many scenarios under which car production elsewhere could be hit and while this would hit Vertu equally, it would lead to further and possibly even record exceptional profits from used sales.
Major risks are of course affordability, including disposable income and finance costs. With a share buyback in progress, massive undervaluation and potential to benefit from shocks, we continue to believe this is very cheap. A12x rating on 9p EPS gets you to a 108p valuation, for example.
That’s it for this week. Hoping for better times going forward for Ukraine, and us all.