Small Caps Live Weekly Summary

House Prices, Tips, UPGS VTU NWOR RCH DFS GATC FUL

Another fairly quiet week. However, there are signs that life may be returning to the small cap market. Of particular note is that tips appear to be moving the market again. The most notable example was UPGS which rose 20% on a tip in The Times (more below). Mark has a theory as to what is going on:

For small cap stocks, the price is set at the margin, which typically means the individual investor. On top of this, investor sentiment determines the flows into small cap funds. With sentiment weak due to inflation & Ukraine, funds have seen outflows. Combined with the pension LDI issues, this has seen liquidity removed from the market and some forced selling by funds. The average investor is scared by the falls in share prices and the economic outlook, and they are holding much higher levels of cash in their portfolios than usual. Perhaps, logically so.

In this environment, it takes something special to get investors to initiate a new position. In such a scary environment they want to feel safe and secure, and they become heavily reliant on external voices to provide that reassurance. And tips offer that comfort. It doesn't matter that the journalist may be a 25-year-old that has never bought an individual stock in their life, being in a national newspaper adds gravitas and certainty in a highly uncertain world.

More experienced tipsters who run their own paid newsletter, or are active on Twitter, tend to promote growth stocks. The level of excitement that can be generated by an exhilarating story is what the tipster really wants to push their holdings higher. However, that doesn't work (at least not as well) in the current market since these sorts of growth stocks are also very risky, meaning the fear factor isn't overcome. So the type of tips that work in the current market is the familiar, companies where investors know the name and have been to the store, or the suppliers to such companies. The familiarity overcomes the fear that people feel and provides the hand-holding that investors need in the current market.

UPGS sits nicely in the intersection between a Mainstream Media tip and a level of familiarity with the products. The more interesting corollary is that, as strange as it sounds, UK retail is perhaps the place to invest at the moment, at least from the point of view of investor asset flows. The familiarity overcomes the fear factor for many and there is a much higher chance of a tip-driven spike to sell into.

Large Caps Live

This week, WayneJ looked at Central Bank actions and the potential outlook for house prices. Check out the full discussion on our discord server, here.

Small Caps

UP Global Sourcing (UPGS.L) - Final Results

After being tipped over the weekend, the Final Results arrived on Thursday. Given the recent excitement, the outlook is the most important for the short-term share price direction:

The Board anticipates profit performance for FY23 will be in line with current market expectations. Whilst the current cost of living crisis represents a substantial challenge to all consumer-facing businesses, the Group is well placed to respond to this given its relentless focus on delivering value and growth.

Leo flagged that UPGS looked great value two weeks ago when they were 92p to buy. However, their heavy reliance on China sourcing meant that he was not willing to take the risk. This week they seem to be more positive on this:

The Group has successfully navigated the worst of the shipping and wider supply chain crisis, and, as the situation continues to normalise, we see this providing significant upside to the business in the medium term through the reversing of the downward pressure on margins that it represented and the additional revenue opportunities that have arisen from improved stock availability.

Although there seems to be little progress on sourcing outside of China. They are making positive noises for FY23:

We are delighted that the brand [Petra] will be launched with one of Germany's largest hypermarket groups in late 2022, with a substantial initial order received for products including waffle makers, air fryers and multi-meal makers….

The prospects for our international business, which is mainly focused on Europe, remain very encouraging.

Particularly their online offering:

We expect this strong online momentum to continue into FY23 and are targeting 30% of overall revenue to come from online over the medium term.

Looking through the volatility that has been caused by the pandemic, discount remains, we believe, a growth segment within overall retail and we will continue to target it as one of our key growth channels.

Costs are also increasing, though. Such as their continued investment into their head office, and support for their warehouse automation. This is certainly the right thing to do operationally - getting somebody external to come in, do the automation and then leave without continuity of support would be a recipe for disaster. IT spending (or at least resources) is only going to increase and so the permanent staff up to speed with the business will always be useful. But it does mean that from an accounting perspective this will come through as increased costs.

Broker Equity Development only ever forecast a 6% revenue growth, and their latest note is no different with the introduction of FY 2024 forecasts. The EBITDA forecast for 2023 is steady, but EPS has been reduced from 15.3p to 15.1p. FY 2024 EPS forecasts are for a further rise of only 3.3% despite a forecasted rise in gross margins. This is not particularly impressive, although there is perhaps room for them to beat these rather rough estimates.

These are even less impressive if you remember that they acquired Salter just before the start of the FY. Results show £16.348m for the acquired business, so organic growth is a measly 1%. So negative in real terms. 2024 sales estimates are also negative in real terms.

So what is a company like UPGS, as forecast, worth? The yield is about 5.5%, with doubts over whether it can rise with inflation. But you can easily argue that capital return will be another 5%pa, so a 10% sustainable return. But cash flow is probably a better way to look at it. Cash flow was very poor this year due to large increases in inventories and receivables with very little on payables. Free cash flow before dividends of £7.2m is forecast for FY 2023 (would be £8.2m without what looks like a contingent consideration for Salter) then £10.7m in FY 2024. So that's a 9% cash flow yield for 2023 followed by 12%.

Not expensive, then, but that seems fairly valued in the current market. It has already shown that it can swing rapidly in how the market views it. From irrational exuberance to pessimism to exuberance in just a few months. Given the reasonable cash flow yield, those who are comfortable with the risks here may be happy to keep holding. However, to a fresh buyer, it looks like a better price may be available soon. Especially as the short-term tip buyers start to exit.

Vertu Motors (VTU.L) - Motorcycle Acquisition

Given the lack of buybacks here, we have been expecting a material acquisition from this motor dealer group. This week we get the following purchase:

The Business has been acquired from Saltaire Motor Company Limited, which trades as Allan Jefferies. Allan Jefferies has been trading as a family-run business, spanning four generations over 120 years, since 1901 and has represented the BMW brand since 1971.

This is exactly the sort of business that provides opportunities for the larger groups to add value. Issues with family succession lead to sales of this nature all the time but are especially true at the moment given full employment and the difficulty of competing with larger groups in the digital world.

However, this doesn’t look particularly cheap or material:

For the year ended 29 September 2021, the Business achieved revenue of £20.5m and an operating profit of £463,000. Total consideration is estimated at £4.2m, subject to finalisation of completion accounts. The consideration includes a freehold property value of £1.85m and a payment in respect of goodwill of £0.5m. This consideration will be paid from the Group's existing cash resources.

This cannot be wholly valued on historical profits as these will be suffering from lack of scale. Likewise, revenue will be suffering from lower digital promotion than will be possible as part of Vertu. Assuming that the property is fairly valued in this world of volatile discount rates, the key figure is, therefore the payment in respect of goodwill of £0.5m.

The problem is that, given that the share trade at a material discount to the freehold property value, the goodwill paid on a share bought back in the market is effectively negative 25p! So if they bought back £4.2m of extra shares they would have paid -£2.3m of goodwill. So this deal needs to deliver strategic benefits of more than £2.8m to be beneficial. Part of that effect is due to the market price of their shares which they can’t control, but they can choose where to allocate capital in response.

We strongly suspect that there is another acquisition in process since have yet to see any further share buybacks. On 1st July they announced the £3.5m acquisition of Wiper Blades and they bought back shares the previous day. Our hope is that the rationale behind this is more compelling (if it ends up being completed.) Or that they are the ones being acquired at a healthy premium to book value, of course.

Reach (RCH.L) & National World (NWOR.L) - Possible Offer

Seeing the title of this announcement, we expected the offer to be the other way round. National World with a Market cap of around £50m are looking to buy Reach with a market cap of over £300m!

National World was specifically set up to consolidate the publishing industry and have around £25m in cash to put to use, but this is clearly nowhere near enough. The National World board are not daft, though, so must think they can structure something that works. If an offer is forthcoming, then it must be almost completely shares. This probably won’t be at a level that smaller Reach shareholders will be happy with either. The real sell will be to larger shareholders, who get a stake in a combined entity and a better management team at the helm. However, that really precludes any offer being recommended by management since it would be like turkeys voting for Christmas!

This article suggests that there may be a certain amount of personal ambition too, on the part of National World Exec Chair, David Montgomery. The problem is that, when you take into account the pension deficit payments and provisions for phone hacking that Reach has on their balance sheet, the National World shares trade at a much cheaper rating than the Reach shares at current prices. So why would National World shareholders want to significantly dilute their earnings plus take on all of that extra risk that owning a business that has such onerous historical liabilities?

Overall, this makes the whole thing a non-starter. So what is really going on? We can’t find any press coverage prior to these RNS’s. So how has this ended up in the public domain? The term "Press Speculation" is occasionally used to mean that a journalist contacted them for comment prior to publishing the story. Another option is that one of the companies has contacted journalists themselves, either as a bid defence, or a way of forcing the other company to engage with them.

Given the relative sizes, we don’t think we can count out the eventual offer coming the other way. Reach has about £40m cash and could easily raise £60m of debt making a £100m counteroffer easily doable. A 40p/share cash offer would probably get the nod from the independent National World shareholders, even if the company has grander long-term plans as a separate entity. Reach would get £25m cash back immediately and the combined group could probably pay the debt off in less than a year. That could be a very welcome way of the problem going away for the current Reach board.

DFS (DFS.L) - AGM Trading Update

A surprisingly upbeat statement from this sofa retailer:

Since early September we have observed a more positive trend, with Group order volumes growing relative to FY22 and also relative to the pre pandemic FY19 financial year.

Both DFS and ScS (perhaps slightly more so the latter) are heavily dependent on TV advertising of "promotions" to drive orders.

We have also seen continued evidence of positive market share gains from the latest Barclays / CACI market data.

So perhaps ScS or other competitors have cut down advertising? That could easily be the effect of Made stopping trading. Perhaps all who survived saw increased market share!

The general authority for the programme expires at today's AGM, where a resolution to renew the authority will be considered by shareholders and subject to approval of that resolution, it is the Board's intention to continue the programme for the balance of the £10m of shares.

Continuing the buyback looks folly, given how weak their balance sheet is going into a period of expected economic turmoil. But then they have to style this one out since if they stop it is a sign they are in trouble, which may then precipitate their failure. ScS failed in the GFC, not because of a lack of sales but because insurers pulled trade credit insurance. The reborn ScS have made sure they will never be exposed to this kind of risk again. However, DFS doesn’t appear to have learnt that lesson…yet.

Gattaca (GATC.L) - Preliminary Results

These come out as break-even on an underlying basis, but report a big accounting loss due to writing off pretty much all the assets of one subsidiary.

During the year, we took a further impairment charge of £4.6m (2021: £0.2m), writing off all remaining goodwill, intangible assets and right-of-use leased asset values relating to the Resourcing Solutions business acquired in 2017, due to an expected sustained reduction in future profitability of the division

Mostly non-cash but those onerous leases will be costing them real cash. Their end markets were actually pretty strong, but they were completely wrong-footed:

Our expected growth within the contract placement market failed to materialise. Whilst the market demand was there, the combination of major client losses, increased focus on permanent recruitment and the business adapting to new systems and operating model meant we didn't capture the market opportunity. We have continued to invest in our technology and our sales people and we are confident we can move forward with these building blocks in place.

They are forecasting £2.5m profit this year, but would you really bet that they’ve got it right this time?

Net Tangible Assets come out at around £27.5m of which £17m is in cash. However, that cash is likely to go into net working capital if trading recovers. Hence the lack of any dividends this year. The market cap is £24m, so the discount doesn’t look high enough to be attractive on a discount to TBV, despite the bulk of these assets being liquid.

Fulham Shore (FUL.L) - Business and Trading Update

Remember when Pizza Express started selling in supermarkets? And Thorntons? Was it only us who thought this detracted from the restaurants/stores and started their downfall as a brand, however profitable in the short term?

The Group has launched its debut range of five premium Franco Manca Chef's Selection cook-at-home pizzas. The range has been developed through a licensing partnership with the fine Italian food business Rondanini and is available to purchase in over 500 supermarkets across the UK from this week.

This is a far cry from their former USP of slow-rise, flash-cooked sourdough pizzas made in a real pizza oven with super-fresh ingredients. So does none of that stuff matter after all? Tellingly, none of the pizzas offered are the same or even much similar to those offered in the restaurant. But of course, there's a great reason for doing this:

Fulham Shore's expansion into retail operations complements its portfolio of restaurants, will drive brand awareness and enable the Group to introduce the Franco Manca brand to consumers throughout UK, especially where Franco Manca does not yet have a restaurant presence.

Even if they make no money from the supermarket offering, provided the quality is better than the rest then it acts as free advertising. And on the other side, the restaurants may act as free advertising for the supermarket pizzas.

That’s all for this week. Have a great weekend.