Small Caps Live Weekly Summary

AVCT BSE GKP LUCE MACF ORCH

Here is the highlights from this week’s discussions:

Avacta (AVCT.L) - Placing

The fundraising shouldn’t really come as a surprise to anyone, given the price action and that this is a pre-revenue business. The pricing should raise some eyebrows, though:

The Offer Price represents a discount of approximately 34.0 per cent. to the middle market closing price of a Share on 27 February 2024.

Given that the amount of money raised is relatively small, this level of discount, on top of a weak share price in 2024, shows that institutions were less than supportive.

We have no real view on the tech here, or the commercialism of their product, but it must be said those promoting this at much higher prices on Twitter should hang their heads in shame. We are sure many of them genuinely believed in the company and have been caught out as much as anyone else, but posting non-stop positive stuff about a single company, no matter how good the opportunity is, is likely to encourage others to invest without sufficient due diligence. It seems that many of these did so with money they couldn’t afford to lose. We are all for investors taking responsibility for their own investment decisions, but one of those decisions has to include being cautious and balanced in public statements.

Base Resources (BSE.L) - Half-Year Results

These results were largely known to those who could run the numbers on the quarterly results:

• H1 FY24 revenue of US$73.1 million.

• Group EBITDA of US$14.7 million and a net loss after tax of US$1.5 million.

• Free cashflow of US$14.8 million (operating cashflows of US$25.2 million less investing cashflows of US$10.4 million).

• Net cash position of US$78.9 million at 31 December 2023.

The accounting loss is a function of the depreciation towards an end-of-life asset. We can only guess that the share price responded so negatively due to this:

In this context and in light of the approaching conclusion of mining at Kwale Operations, we believe it is appropriate that cash now be retained for the anticipated progression of the Toliara Project.

No dividend is declared. The reality is that we don’t see how they could pay one. When you factor in that, Kwale ceases production soon and, with lower grade and pricing, will generate a relatively minor amount of free cash flow. This means that the cash will be completely consumed by the rehabilitation costs, redundancy payments, plus the deferred consideration and ongoing corporate costs if Toliara is approved.

With the idea of customers taking an equity stake in Toliara no longer on the table, this means that the company will need to fund the equity portion of the Toliaria development by raising equity. 20% is the typical number for this sort of thing, which, with stage 1 capex set at $591m, means they will need to raise almost twice their current market cap when you include some contingency.

It feels to us that they are massively naive regarding funding Toliara. The company have said they expect to raise equity at a premium due to the price rising on any announcement that Toliara permissions are granted. However, they started saying this when the share price was twice the current level. We are sure the price will go up when they announce Toliara approval, but there is no guarantee where it will get to before they get the approval, so it may end up below today’s price. Unless they announce funding at the same time, then all eyes will immediately turn to how they will fund the equity. Perhaps institutions have a plan, but as a smaller investor, why take the chance on something that is currently unfunded, unapproved, and won’t be in production for at least three years?

Gulf Keystone (GKP.L) - Production Update

There is a big rebound in local sales in February, and the company flags that they have scope to increase them further:

Local sales volumes have rebounded in recent weeks with gross average sales this month to 26 February of c.38,400 bopd, reflecting higher market demand for certain refined products, the easing of seasonal logistic challenges

The price they receive is a little lower than in the past at $25/bbl. The net effect is:

At current volumes and realised prices, sales for February 2024 are expected to be c.$10m net to GKP, above expected monthly net capex and costs of c.$6 million

Although significantly below what they would get for export if the pipeline re-opened, the local sales are paid upfront. Compared to being paid maybe never for export sales, it is actually a benefit.

$4m/month FCF is $48m per annum, and with a $260m market cap, this is just 5x FCF. However, at the moment, the cash is going to pay trade payables, and there is no guarantee of how long the demand will remain at this level. There is still a huge political risk on this one, but with this production, the company’s finances have been significantly de-risked for those who believe the export pipeline will eventually re-open.

Luceco (LUCE.L) - Acquisition

The last “strategic investment” the company made was really a debt-for-equity swap in eEnergy, who found themselves unable to pay Luceco, and rather than take the accounting hit, Luceco said we’ll take payment in shares. Hence, we read this RNS with some trepidation. However, looking at the disclosed details, this looks like a good bolt-on acquisition, potentially at a reasonable price:

…has acquired the entire issued share capital of D-Line (Europe) Limited, the supplier of cable management solutions, from sellers including the founder for initial cash consideration of £8.6m and up to £3.8m of contingent consideration, on a cash and debt-free basis.

We are given three valuation metrics to calculate: price to sales, price to earnings and price to assets. To get a price to book value, we have to estimate liabilities, but we are told that the price is on a "cash-free debt-free" basis and (effectively) that receivables are £0.8m above what might be considered normal for a company of this type (and/or just possibly there are excess inventories). We can probably expect Luceco to make these assets more productive over time by adding scale and operational excellence.

The most obvious valuation metric is 6x operating profit. This is reasonable but not super cheap for a private business. Presumably, D-Line face the same challenging market conditions as Luceco, and these can be considered close to trough earnings, at which point this metric looks very good. It seems right to exclude the £3m CoCo as this is dependent on a big contract win that is presumably out for tender and will have a big impact on profitability that isn’t in the historical figures. The other £0.8m sounds like it is reflective of overdue debt, and Luceco have said you get paid if we do. Being debt-funded, the acquisition adds to earnings:

The Acquisition is expected to be earnings enhancing, achieving an operating margin consistent with that of the Company, in its first full year of ownership.

Plus geographic expansion possibilities:

…we are particularly excited about the opportunity to leverage D-Line's operation in North America to support our growing business in the territory.

So, a thumbs up from us on this one.

Macfarlane (MACF.L) - FY Results

Revenue is down despite acquisitions, but gross profit is presumably due to commodity deflation on the products they distribute. Or they increased prices more than the drop in demand:

So PBT is up just 2%, adjusted PBT is up 10%. Ignoring amortisation is normal, although perhaps more questionable for a serial acquirer. The main difference between previous years is that they are paying £1.5m contingent consideration. We are in two minds about this. On the one hand, if they paid upfront, then this wouldn’t have gone through the income statement. But it is a cash cost, and they are paying it because the business is performing, which the benefit is in the rest of the results. So, a bit of having your cake and eating it.

They’ve faced severe headwinds recently with weaker eCommerce and cost inflation, so these aren’t bad in that context. And a 10x P/E isn’t expensive. However, they are not alone in facing these sorts of challenges, and other UK small caps are materially cheaper than this. Plus, forecasts are for just 3% growth, although this could just be management conservatism. A distributor is never going to be particularly highly rated by the market, but there is certainly the cash to be made for this to be part of a conservative investor’s portfolio. Particularly those who value consistency over excitement.

Orchard (ORCH.L) - Trading Update

It seems it doesn’t just rain, but it pours in the orchard:

…provides notification that it has suffered an instance of fraud, arising from dealings with a fraudulent introducer and fraudulent credit agreements funded by the Company as a result.

The Board has made a provision of approximately £500k in respect of these fraudulent credit agreements, which will have a knock-on impact on the Group's year-end financials. The Provision represents the Group's total exposure to these fraudulent credit agreements, and there are no other agreements in place involving the Group which have been introduced via this introducer.

This is 10% of tbe market cap, but given the discount to TBV only 3% of NAV. The market reaction is, of course, much worse due to a further erosion of confidence in the management & business. This once again underlines the black-box nature of many financial companies. And when investors get their first glimpse inside, the discovery it is "bigger on the inside" is rarely the happy moment depicted on TV, despite the initial provisions being relatively modest.

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