There was no Large Caps Live this week, but it was a much busier week for results so plenty of small cap analysis this week.
Small Caps
Appreciate (APP.L) - Final Results & Acquisition
Unless you are a fan of footnotes, the first line isn't a great start:
Profit before tax and exceptional items+ of £8.4m (Restated* FY21: £2.3m)
As Leo has mentioned before, they had been capitalising configuration of their cloud-based ERP system which is not allowed following clarification of IFRS rules.
[As an aside, this could have implications for SaaS providers, making cloud-based systems a harder sell, as well as for other customers.]
In any case, ERP systems are notorious money pits and the baseline position for an investor should be to expense everything and ignore any depreciation or intangibles. Furthermore, they should assume that projects will overrun to at least 2x original estimates! Appreciate is a case in point for this:
Other costs incurred during the year associated with the Group's strategic ERP project which were deemed redundant in nature and therefore not eligible for capitalisation - £1,059k.
There was part of the new ERP project which was capitalised last year but in the current year, management decided to discontinue the use of that element of the asset. This has resulted in an impairment charge of £869k recorded in the year. There is also £1390k this year from the accounting "change". Not good.
The description implies most of it was an accounting adjustment whereas most of it was actually just wasted. And the accounting change has led them to restate the prior two years as well. And if you sum all the restatements they are bigger than the wasted amounts. But we're talking enormous amounts of money here, especially on a pre-tax basis. Their broker reports total spend on project configuration and customisation has been £10m, and it isn’t finished yet.
Despite these ERP concerns, the valuation here is very cheap with forecasts of £9.4m PBT for 2023. Not only that but they will do even better in a rising interest rate environment due to the cash balances they hold in trust:
Average funds held (including cash held in trust) were £178.6m (FY21: £181.2m).
For every 1% rise in interest rates that's £1.79m pre-tax profit.
Looking at 2023 forecasts, the revenue estimates look pretty full, but Leo thinks there is scope to beat profitability. In particular, the net interest of £0.1m Liberum looks far too low. Interest rate receivables on deposits lags base rates on the way up and down, but he sees at least £1.0m net interest, quite possibly £1.5m.
Pressure Technologies (PRES.L) - Interim Results
Mark last looked at Pressure Technologies following the FY21 results, when he concluded:
Perhaps more by fortune rather than any good judgement by management, Pressure may find itself in a favourable position in the next few years with hydrogen, defence and oil & gas all in strong cyclical up-trends. However, with the dreaded H2-weighting already being flagged for 2022 and no meaningful hydrogen revenues until 2023, the wait-and-see approach remains the best option here.
These results reflect that expected weakness:
Partly this is due to timing:
As expected, the timing of major defence contract placement and phasing of contract milestones resulted in significantly lower first-half revenue of £6.3 million (2021: £11.3 million) and adjusted EBITDA5 of £0.1 million (2021: £3.3 million)
But they are still reporting weak markets overall, which is surprising given their focus on defence and energy markets. Overall they say:
Notwithstanding the current economic climate and cost-inflationary pressures across the Group's operations and supply chains, the Board is excited about the future opportunities for the Group and remains confident in meeting full-year market expectations.
Stockopedia has these expectations as £29.4m revenue & 2.95p EPS. However, this would require them to do £20m in revenue in H2. This looks a stretch to Mark. CSC already has an £11m order book and we could see PMC doing £5m in H2 but that leaves 3 months to find immediate CSC work of c.£4m.
Even if they hit these figures then the current 70p share price puts them on a forward P/E of 24. Not cheap. Particularly since they look quite tight financially - their current ratio doesn't look bad, but they have maxed out their RCF of £4m and have just £1.3m of cash. This isn't a lot of leeway if they get a delayed payment or need higher inventories to mitigate any supply risk. Capex is running below depreciation too, which may indicate good capital discipline but may also be simply that they can't afford to invest at the moment. Given the history of underperformance, then we are not willing to give them the benefit of the doubt on this one.
The forecast for FY23, presumably from house broker, Singer, is for 6.44p EPS which would make them look better value at c.11 x P/E. This still isn't cheap in the current market, given the risky balance sheet. So anyone buying at 70 p this week is betting on that possible trend improving further into FY24. But given they have very little forward order book coverage into 2023, betting on a strong FY24 result today seems brave, bordering on the foolhardy.
IG Design Group (IGR.L) - Full Year Results
These are poor, as you would expect from a company whose share price has collapsed:
The pursuit of revenue at the expense of profits has cost them dearly. However, the share price has bounced strongly recently in response to their previously reported amended bank facilities:
A recent banking covenant amendment to March 2023, and facility extension to March 2024, has secured access to financing to support working capital requirements
Without this, they were in serious trouble, so this certainly was good news. However, this forbearance comes at a cost and they say:
…the Adjusted loss before tax expected to be broadly flat on the FY2022 results and driven primarily by the increased finance costs in the year ahead. Average debt across the Group is expected to increase to c. $75-80 million over FY2023, compared with c. $15 million in FY2022 reflecting the expected higher working capital requirements throughout FY2023 as the Group navigates the outlined challenges.
Unsurprisingly, given the expected loss, they won't pay a dividend with these results nor in 2023.
Listening to the results presentation on PI World, you could be forgiven for thinking that they had just had a great year and the share price was at all-time highs. To Mark, it sounded like they were blaming all their problems on external factors that they couldn’t possibly have foreseen, and claiming management credit for the few things that did go right. For example, to them, the reduction in bank facilities was because they didn’t need them and had nothing to do with the banks wanting to take less risk in return for the covenant waiver. This seems tone-deaf for a company where the CFO has already fallen on their sword and the share price is down almost 90% over the last year!
Given the massive uncertainty here on a number of fronts - when will they be able to return to profitability? will they be able to refinance in 2023? What is their inventory (and hence book value) actually worth? - we think any valuation here is impossible.
This means that this will largely be a traders’ share for the foreseeable future - great if you can accurately guess each day’s movement up or down, but not a game Mark has any interest (or skill!) in playing.
Wynnstay (WYN.L) - Interim Results
Those who haven’t been following Leo’s explainers on the impact of FIFO inventory accounting could be forgiven for seeing these results as great operational performance:
· Revenue up 34% to £335.66m (2021: £249.71m), with significant inflation - accounted for c.£80m of the rise, £6.4m first contribution from Humphrey acquisition, completed in March 2022
· Underlying pre-tax profit*up 85% to £10.21m (2021: £5.53m)/ Reported PBT up 78% to £9.56m (2021: £5.36m)
· Basic earnings per share, including non-recurring items, up 71% to 36.99p (2021: 21.62p)
However, when you do the maths, 250+80+6 = 336, which suggests all of the revenue increase was due to inflation and acquisition.
Apart from being one-off, the other issue with this is that the profit on inventory doesn't convert to cash as it must be replaced at a higher cost, but they do have to pay tax on it. But the operating cashflow here is more complex:
The increase in inventories means that a lot of the increased profit is going back out the door as increased inventory costs. Although the revenue impact of inflation is given, the profits impact is much harder and also a matter of judgement. We can calculate their inflation at 32% from the revenue breakdown. This can then be applied to the inventory.
But applying it to the average wouldn't be right, even if we knew it. Inflation has been very lumpy throughout the year. Using the 31st October figure of £50.6m gives a benefit of £16.2m. Clearly, underlying pre-tax profits up from £5.5m to £10.2m have not benefitted to that extent. Even accounting for the inherent uncertainty over when inflation occurred and what the mix is, this suggests there may be some difficulty in passing on price increases. In addition, receivables going up much faster than payables means that operating cash flow is actually negative. Further analysis is needed to check that these working capital movements are not leading to increasing credit risk.
It is important to point out that the profitability may not be real, but the increase in net assets is:
Net assets up 10.5% to £111.68m/£5.50 per share at period end (30 April 2021: £101.05m/£5.05 per share)
Net assets rising is a good reason for holding equities in an inflationary environment. However, there is £17.5m of goodwill there. And it doesn't look cheap compared to tangible assets anymore. They fell to 200p which was 50% of TBV in March / April 2020 despite being defensive. Now they are at 630p and on 1.4x.
Anyway, the future is what matters. Without inventory gains in 2023 EPS of 45.5p is forecast, below 2021's 45.9p but well above the 33-34p in prior years. Net cash is forecast to continue to deteriorate. Sadly, this doesn't look at all good for the current valuation. Stockopedia has this as a Super Stock, but the only really strong metric is Momentum. The lack of free cash flow is likely to negatively impact the Quality Rank. When that momentum fades, we could easily see a 30-40% retracement here.
MS International (MSI.L) - Final Results
Compared to Pressure Technologies, MS International is making much better use of the boom in defence and energy spending.
a significantly improved pre-tax profit of £5.97m (2021-£1.59m) on increased revenue of £74.52m (2021-£61.54m).
This works out to the 30.9p EPS making the P/E around 10 and with a decent cash balance too. We have to be careful making simple adjustments here since there is a pension deficit that is costing £900k per year in recovery payments. Plus, although the vast majority of the cash is unencumbered, there are large contract liabilities suggesting that customers have paid in advance. Generally, this is a good place to be and shows how valuable their defence products are, but it is a risk if a customer decides to cancel an order.
Even adjusting for the pension deficit this is on a historical Earnings Yield of c.15%. There are no forecasts in the market but the outlook is fairly positive for all business units, which suggests the current performance can at least be repeated in 2023. This is still a highly cyclical business though, and we have seen many of these boom & bust cycles at MS International over the years. So there is definitely a risk that current buyers are paying up for close to peak earnings today. This caution is also perhaps reflected in the dividend:
All matters considered the Board recommends the payment of a final dividend of 7.5p per share (2021 - 6.5p) making a total for the year of 9.25p (2021 - 8.25p).
So, although this is increased, it is still small compared to the cash balance & this year’s EPS. The management perhaps wants to retain the cash to pay themselves well during the next downturn. They have a controlling shareholder & board who pays themselves very well, whatever the weather. This will make it uninvestable for some despite some clear tailwinds to their business.
Shoezone (SHOE.L) - Trading Update
When we last looked at Shoezone in May we said:
Zeus leave their forecast inline implying results were as expected. At first sight, these forecasts of 10.4p look around 50% too low. However, we have not run a detailed model and the share price of 149p surely already has this priced in since this, rightfully, never trades at a high multiple. Anyone buying in October at 65p certainly has the right to be very pleased with themselves, but it isn't clear how much further this can go in the short term.
Looks like we were right about forecasts being too low. In this short statement they say that rent reductions and good supply chain management have improved margins and lowered costs, so that:
As a result, the Company now expects adjusted profit before tax for FY 2022, to be not less than £8.5m.
However, we appear to be wrong about this being in the price since the share price has reacted positively to this announcement. Perhaps helped by some enthusiastic commentary from some quarters.
Zeus upgrade EPS from 10.4p to 13.5p and dividend to 6.8p, but this is still below where we expected EPS to be. They have made no changes for 2023 (apart from cash), however, meaning falls in EPS and (rather unconvincingly) dividend now forecast. On that basis, the current share price looks a stretch at 15x. This hasn't stopped similar companies from over-reacting and getting bid up to twice fair value before falling all the way back down again (and more), but this is a different market now.
Lathams (LTHM.L) - Preliminary Results
When we last looked at Latham’s in any detail last year we concluded:
Unfortunately they continue to be too expensive on any reasonable assumptions. Clearly, they have benefited from an increase in value of those £48m of inventories at year end, as well as increased margins on a replacement cost basis. The former effect will reverse when timber prices fall back.
Following Wickes's results last October, we noticed the switch from DIY timber demand to trade and commented that this was likely to be supportive of Latham as a trade outlet. Even expecting this tailwind, this week’s results were something to behold:
I am therefore very pleased to report unprecedented trading results for the financial year to 31 March 2022…
Revenue for the financial year to 31 March 2022 was £385.4m, up 54.0% on last year's £250.2m…
Gross profit percentage for the financial year to 31 March 2022 was 23.8% compared with 18.0% in the previous financial year
And as a result:
Earnings per ordinary share is 229.3p (2021: 75.4p) an increase of 204.1%.
That would put them on a very cheap P/E of 6x if the accounting represented the economic profit. But it is the usual story:
Here the cash flow is a closer representation of the profit on a replacement cost basis, or if you prefer: the value added by the operations of the business rather than inventory inflation which they could have benefitted from just by filling up a big warehouse and leaving it.
Cash is still up though. Some of this is because their business is bigger due to inflation. Some will be because when there is inflation and shortages larger entities will benefit from market power, and they are larger than their customers.
The danger here, as with Vertu, Wynnstay etc. is not just that prices stop rising - thanks to inflation that would still leave them with higher revenues in £ terms and there is no reason to think their margins would shrink - but that if they fall back they could very easily see accounting losses. That eventuality might be a good time to buy as other investors might think the attractiveness of the business has fundamentally changed whereas in fact they'll be swimming in cash and paying less tax. There's evidence that price inflation in their products slowed in H2:
Gross profit percentage for the financial year to 31 March 2022 was 23.8% compared with 18.0% in the previous financial year, and 26.4% reported in the half year accounts.
So what's the outlook?
The strong results seen in this financial year have continued into the new financial year, with volumes and margins comparable to those achieved in the second half of 2021/22.
That seems very positive. Revenue was 193,937 in H1 and 191,431 in H2. So a similar run rate is good news. The lower gross margin we already know about. This was exaggerated at the operating profit level despite lower admin costs. H2 EPS was 96p in 2022. If that can be repeated then it would be 3x the normal H1 pre-covid level since there is no obvious historical H1/H2 pattern. So they are trading at a 190p EPS run-rate.
The trouble is that those 21% gross margins are not sustainable without price rises continuing. Pre-covid levels were 17-18%. Also, these are gross margins there is no reason to think cash admin costs won't rise with inflation. Modelling depreciation and amortisation also rising in line with inflation and gross margins normalising in H2 but with sales constant, we get 87p H1, 151p FY.
Further out, admin cost inflation is the killer if timber costs stay static. But 120p looks possible for 2024 which means that a P/E of 12 looks reasonable value. The risk is that if timber prices were to fall so much that sales went to 2019 levels on the same volume then they'd make a loss since staff costs are likely to be permanently higher.
Carclo (CAR.L) - Final Results
On first glance, a company on a P/E of around 8 and growing EPS at 30% looks good value.
However, those who know the history here know that it is a company that got itself in serious trouble and had to sell of one of its largest subsidiaries when it couldn't afford to invest to turn it around. This is a £17m market cap company, but the debt excluding IFRS16 is £21.5m. So a P/E ratio is not a suitable way to value such a business.
Then on top of this is a large pension deficit. The IAS19 deficit has been reducing with higher discount rates:
However, as we know, the IAS19 deficit is largely irrelevant when it comes to the actual payments made by the company. Here they have agreed to £3.5m per year, with the aim to eliminate the deficit within about 20 years!! It is clear that the company is not going to be in a position to pay any dividends to shareholders for about a decade with these debt & pension deficit levels.
The outlook is positive but cautious:
The Board expects market demand for both the CTP and Aerospace divisions to continue to grow in the next financial year but also that the headwinds that prevailed in the second half will continue during the first half.
Even if we were super generous and assumed a further 30% growth in EPS in FY23, and that the reduced IAS19 deficit was now realistic, then this is on a forward earnings yield of 3.8%. In the current market, there are much better quality companies, with better long-term prospects, that are much less risky and have much higher earnings yields.
Being less generous, given the size of the debt and Pension Deficit, it is still not clear that Carclo's equity has any value at all.
Hunting (HTG.L) - H1 Trading Update
H1 2022 trading has been in line with management expectations
Clearly this not the market to be issuing an in-line trading statement, with the share price down 15-20% in reaction to this. The obvious explanation is that the market's expectations were significantly above the management's. Let’s look into the details.
Group EBITDA in H1 2022 is expected to be in the range of $16m-$18m, before any adjusting items.
Q1 EBITDA was $6.7m, meaning Q2 is around $10.3m and Q3 & Q4 around $12.4m since they say:
The Q3 and Q4 2022 EBITDA run rate is also likely to improve c.20% from the Q2 result, as trading conditions continue to show signs of increased momentum for the remainder of the year.
This means c$42m EBITDA for the FY. The ITDA last year was around $32m so assuming similar figures this year we get to the $10m net profit that is the stockopedia consensus and aligns with the management’s in-line statement.
Some analysts seem to think this was a profit warning though:
…analysts at RBC Capital saying that the group's expected core profit run-rate for the third and fourth quarters implied annual profit below market expectations.
"Hunting expects the Q3 and Q4 EBITDA run-rate to increase about 20% from the second quarter, which implies a full-year EBITDA of about $44 million," RBC analysts wrote in a note. Analysts on average are expecting an annual core profit of $60.8 million, according to Eikon Refinitiv data.
Still a bit of a mystery why RBC believe the consensus was much higher than the Stockopedia one. But anyway, the current market cap is $457m and EV $380m so you can see why the market may not be enamoured with 9x EV/EBITDA as a forward rating at the moment.
This was never about one year's numbers though and the management indicates that the outlook is "extremely positive". The company still trades a long way below Tangible Book Value with the majority of the assets being cash and inventories.
The bear argument here is that the current oil market cycle is dead, ESG concerns mean that no price of oil, or level of political instability, is sufficient to stimulate production in "friendly" companies since no one will fund the development and the highly-profitable existing companies are simply going to pay out their exceptional returns and the oil price remains at elevated levels for the forseeable future, helping Russia to keep a stranglehold on Europe. Hunting's assets will remain unproductive.
The bull case is that ESG concerns have simply delayed the current oil cycle. Although banks won't lend extra finance to grow production, the high profitability of current producers means that those profits will eventually be reinvested into growing production, encouraged by governments that want to maximise "friendly" production and reduce Russia's ability to threaten its neighbours. The oil price will stabilise and slowly decline as production increases again. Hunting will generate large profits and its assets will be productive again, but just on a slower timeframe than in previous oil cycles.
Mark still leans towards the latter scenario, but that may simply be because the prospect of continuous very high petrol prices and an extended war in Europe is so depressing.
7digital Group (7DIG.L) - Final Results & Acquistion
The first line reads well:
In the first six months of 2022, the Group has already secured contracted licensing revenue for the full year that exceeds total 2021 licensing revenue by 21%
But you quickly realise that when a company leads with “Post Year End Highlights” the rest isn’t going to be great. Not least since they needed the full six months to get these 31st December 2021 results out:
2021 Financial Highlights
· Revenue increased to £6.7m (2020: £6.5m)
· Gross margin of 64.2% (2020: 63.4% adjusted*)
· Adjusted EBITDA loss of £2.0m (2020: £1.9m adjusted*)
· Operating loss of £3.6m (2020: £2.1m)
· Loss per share of 0.14p (2020: 0.05p)
· Cash and cash equivalents of £0.4m at 31 December 2021 (31 December 2020: £2.8m)
With a large loss and almost no cash this is where shareholders will want to skip ahead to the going concern statement:
Material Uncertainty related to Going Concern As discussed in note 1 to the financial statements, the Board of Directors of 7digital consider the Company to be a going concern, but acknowledge there to be a material uncertainty relating to going concern…
Taking the reasonable worst-case scenario that has been considered by the Directors, and if the Group is unable to raise finance from alternative sources, the Group is reliant on continued support from existing shareholders of up to £4m to ensure it can meet its liabilities as they fall due.
The only good news is that they have signed a £0.5m shareholder loan and have letters of support from shareholders for the rest of the £4m, without which they'd be bust. However, this means that the lending shareholders now have a first call on the profits and assets (if applicable) of the business ahead of other shareholders. This is often the beginning of the end for life as a listed company.
Seperately they also announce an acquisition. Not only does this sound a terrible idea post-covid and the crypto crash:
The Company and eMusic launched the eMusic Live platform, which had been developed and primarily funded by eMusic, in 2020 as a platform for the live music industry to stage virtual concerts and create unique artist-to-fan experiences…
The eMusic Live platform is purpose-built to prioritise the artist and maximise fan engagement and commercialisation, and is the only platform that offers livestream and non-fungible token ("NFT") bundling, allowing fans to buy a ticket, virtual merchandise and music in one purchase across all currencies.
But it is a related-party transaction:
During the year, the Group invoiced and recognised $100k (2020: $143k) of revenue to eMusic (a subsidiary of TriPlay Inc.), a group which Tamir Koch was a Director of during 2021. At 31 December 2021, the Group was owed £208k (2020: £327k); which was fully provided for at year end (2020: no provision was made).
We value this company at zero.
Capital Ltd (CAPD.L) - New Contract Awards
A three-year comprehensive drilling services contract with AngloGold Ashanti with its GEITA GOLD MINE LIMITED in Tanzania…
This contract further cements Capital's long-term relationship with AngloGold Ashanti, which started with the provision of grade control drilling services at the Geita site in 2006 and will now extend to mid-2025.
This is really a contract extension. I am not sure any one expected this not to be renewed, but this further validates their strategy of going for longer-term contracts that look through the current cycle. This should mean that they trade at a premium to competitors who have chosen more short-term exposure to the spot market. Although, so far, there has been little market recognition of this more conservative strategy.
The comprehensive new contract commenced in June 2022 and replaces and extends contracts announced in March 2021 and December 2021. It is anticipated to generate ~$150 million over the three year contract term, making it the second largest award of new business in the Company's history.
With their 25 rigs on site here this works out to be $167k ARPOR. Below their current average but this contract contains a material number of underground rigs which command lower rates, but are lower capex and higher margin.
Despite being only one rig so far, this contract win has the potential to be significant:
First contract with B2Gold Corporation at the Fekola Gold mine, one of largest gold mines in Africa: Capital has been awarded a reverse circulation drilling services contract at the Fekola Gold Mine, Mali. This contract is a further example of Capital's focus on large scale, long life and low cost assets. B2Gold Corporation has guided Fekola to produce between 570,000 - 600,000 ounces of gold in 2022, making it amongst the largest gold mines in Africa.
They have had a very successful “land and expand” strategy with large mines in the past and we don’t see why they wouldn’t be equally successful here. They also confirm that their end markets remain strong even if the stock market is weak:
We continue to see very strong demand across the market and today's announcement is testament to that.
More details will follow later this month with their Q2/H1 trading update:
Capital will be announcing its trading update for the six months to 30 June on 19 July, which will include a conference call and question and answer session.
We are not sure we will see any revenue range upgrades at this point but with them on a P/E of 5 and experiencing very strong markets and agreeing highly profitable long-term contracts out to at least 2025, then you don’t need any upgrades here to make a very strong investment case.
That’s all from a busy week, enjoy your weekend!