There was no Large Caps Live again this week.
Last week we looked at the problem with popularity concluding that it was good news that we are unpopular! This week a current market theme we thought it worth considering is how much investors seem to have an intense dislike of anything that looks like it may be a one-off boom.
In recent times, investors seem happy to bid something up to a P/E of 30 or above if it can generate a couple of years of consistent 10% earnings growth, even though a combination of history and maths says that a stock with these valuation characteristics is highly unlikely to generate market-beating returns over the long-term.
However, if the next couple of years look like they may be exceptional for a company, yet the long-term is a bit more uncertain, then investors don’t seem to want to own these stocks at almost any price.
Part of this may be a rational response to low interest rates. If there is little discount required for future earnings streams versus the present then there is little reason to prefer present earnings. However, in our opinion, this misses one of the fundamental reasons why there is a time value to money: you will die at some point in the future and not be able to spend it! Interest rates are just one component of the discount rate too. The biggest part is to adjust for the risk of things not turning out how you expect.
This rise in investor scepticism for short-term earnings may also be due to the recent performance of companies such as Best of the Best. This became an investor darling on the assumption that recent strong performance was a long-term growth trajectory, helped by enthusiastic commentary from some quarters. When it was revealed to be, at least partly, a short-term boom, it saddled investors with an 80% loss from the peak.
In light of this, it may be right to be cautious about being the bag-holder. However, in our opinion, it is wrong to dismiss all investments where the near-term earnings outlook is stronger than the one in future years.
The boom often provides exceptional profits, but the wise management can use this extra cash to invest capital into long-term projects that will generate earnings growth for years to come, as Capital Ltd. has, or to expand into complementary areas, as finnCap has. The short-term boom can become a driver of long-term growth in such companies.
Or the company can use the cash to build a level of balance-sheet strength that ensures the company is bullet-proof against any future downturn, plus return excess cash to shareholders, as Somero has done and we expect SCS to do in time (see below.)
The key is to identify those companies that would be under-priced even without the boom year(s), as all of Capital, SCS, finnCap, Somero and also Vertu (again see below) appear to be to us. By investing in such companies, investors are likely to be getting their cake and eating it. Even if it takes time for the market to spot that there is cake left on the plate of future years.
Small Caps Live Wednesday 6th October
SCS (SCS.L) - Preliminary Results
It can be difficult to compare the forecasts from SCS’s house broker, Shore, due to some differences in their reporting to the company’s. Firstly, the Shore's revenue is what ScS calls Gross Sales, before the cost of interest-free credit. Secondly, Shore's EBITDA seems to be on an IAS 17 basis, whereas ScS's are IFRS 16 and exclude lease costs. Thirdly, Shore's CPTP varies from ScS's underlying profit before tax figure (which was £0.9m in FY 2020) and we can't find the reason. Adjusted EPS also varies significantly, with ScS reporting 2.6p in 2020. Clearly, the difference is too much to be share option dilution.
But with that caveat, today's 2021 figures appear to be a significant profitability beat on forecasts from broker, Shore:
· Profit before tax of £22.7m (2020: loss of £3.1m)
· Underlying earnings per share* of 41.3p (2020: 2.6p)
Let’s go through each cost in turn
The cost of interest-free credit came in at just 3.9% of sales in H2 versus 4.2-4.7% in previous years. This likely continues the pattern seen in H1 of a lower proportion of customers paying cash and, presumably, low interest rates. From the commentary:
Gross margin* increased to 45.3% (2020: 44.6%). The increase of 69 basis points is largely due to the reduced take-up and cost of interest free finance together with...
Outlook:
We expect ... customer credit requirements to return to normal levels in the new financial year.
Distribution costs were elevated in H2 at 6.7% of goods sold (versus 5.4% in 2019 and 5.8% in H1), but far lower than the 7.9% seen in H2 2020:
…property and staff related costs increased, driven by cost pressures being seen in the logistics sector.
Outlook:
we are cognisant of the ongoing challenges we, and many other businesses, are facing with regards to the supply chain, including driver shortages.
Marketing costs were down to 4.2% of revenue in H2, compared to 6.6% in H1 and 7.4% in H2. Marketing costs are more closely related to order intake as the revenue from sales typically lags 12 weeks (more at the moment), and, in particular, H1 marketing costs tend to be higher as a percentage of sales due to Boxing Day (etc) sales promotions incurred in H1 where revenue is not recognised until H2. Unfortunately, we have no clean numbers for order intake for H2 alone, but at the FY it was down just 6.5% (vs 2019) while marketing costs were down from £22.4m to £17.2m, representing a significant improvement in marketing efficiency:
Marketing costs decreased by £3.2m to £17.2m in the year (2020: £20.4m), as the business adjusted investment in advertising as a result of temporary store closures. We invested in a strong re-opening launch campaign and this increased investment helped achieve the significant level of post-lockdown sales order growth.
Outlook:
There will be an increased focus on digital marketing investment, which will be underpinned by improved analytical tools, modelling and targeting
Performance-related payroll (5.4% of FY revenue) was in line with H1 and our expectations, given the strong performance. Other costs were as expected. The repayment of furlough from the government received in H1 had already been flagged up. So, lots of drivers for lower costs, many greater than we expected, but unfortunately many of them temporary.
Our best guess of Shore's methodology gives a Shore EPS figure of 45p (42p if adjusting out tax gains) from these results, a significant beat over their 32.2p forecast.
Gross margin on revenue is up on 2020 at the full-year and steady in H2 year-on-year but is slightly down in H2 compared to 2019 and 2018. So there is some evidence that cost increases are reducing margin. Outside of this, distribution costs are also up significantly on historical norms. For the moment, however, this has been compensated by a lower cost of credit and lower marketing costs.
Here is some question over the ability to pass on cost increases. It should have been no surprise to the market that these cost increases exist, however:
Positive about prospects for the full year although we are mindful of the ongoing disruption to supply chains and cost inflation
…we are cognisant of the ongoing challenges we, and many other businesses, are facing with regards to the supply chain, including driver shortages, raw material increases and shipping costs and delays.
As far as macro effects, there is no evidence of any headwinds as yet. They do not mention the relative rise in stamp duty, cuts in universal credit, or ending of furlough. Recent trading has been strong:
Trading since the start of the new financial year has remained strong, with two year like-for-like order intake* growth of 11.9% for the nine weeks to 2 October 2021.
…We are delighted with the strong orders performance since the start of the new financial year.
2022 is incredibly hard to forecast. Although the gross margins are fairly decent for ScS, the net margins are quite tight. This means that a couple of percentage points move on gross margin or costs can double or halve the net profit. It can make a bigger difference to forecasts +10% sales, for example. It is possible to see sales increase 20% and EPS to halve with just small margin erosions.
You would expect this sort of company to be able to pass on any extra raw material or distribution costs on to customers given rises will be industry-wide. They still need to deliver the order book based on the previous pricing, though, which may provide a short term drag. This is one thing to keep an eye on in future reporting.
The only weakness in these results is that H2 is weaker than H1 and H2 free cash flow appears to be negative - this isn't unusual for ScS where in normal years H2 tends to generate the bulk of the profit but see negative free cash flow due to working capital moves. There is also a timing part to this: these results are 53-week to 31st July they include 13 supplier payments and 13 payrolls. Of course, this is a cash issue only - at the P&L there is a benefit from the extra week.
Despite this, the balance sheet remains exceptionally strong. To capture the effect of working capital, we’ve created our own metric of “shareholders cash”. Basically, it is Cash + Net Working Capital (which is negative of course) - Provisions. This is the cash they could happily return to shareholders without risking working capital flow problems in a downturn. It is £36.5m in these results, up from £22.8m in 2020FY results, or 93p per share.
Perhaps a disappointment is that there was no share buyback announcement with these results. Sensitivity over government support may play a role here. Perhaps their main objective was to avoid newspaper headlines saying that they were trading incredibly well and a comparison between the amount of government support and the amount returned to shareholders. They have avoided news stories in any mainstream news outlets (to date) and they have even guided that they'll receive another £2.6m rates relief next year (presumably all in H1).
The FY dividend of 10p is a slight beat over the 9p forecast, though, so there is a commitment to return cash to shareholders albeit at a limited level. Going forward we expect that some kind of payout is inevitable. We just can’t see a way they can deploy the current large, and growing, cash pile at acceptable rates of return in the current business. At current prices a share buyback would make a lot of sense, but perhaps a special dividend would be more their style. In either case, any such payment will have to wait for times when having received government support during the lockdown is less a politically sensitive topic.
finnCap (FCAP.L) - Trading Update
…unaudited revenue for the six months ended 30 September 2021 is expected to be approximately 31.8m, an increase of 55% on the prior period.
55% growth on a year that already appeared exceptional (although with H2 as the biggest driver) is very strong. finnCap Cavendish is the stand-out performer in this period whereas the strength in the last year was from transactions:
Note that this is a further upgrade since the AGM just a week ago since they...
…closed 4 further M&A deals between our AGM update on 23rd September and the end of the first half of the year
This shows a) how lumpy revenue can be, b) how strong the market has been for M&A and c) that finnCap is not simply a one-trick pony but has a whole field of ponies and they are running towards you.
They now say:
Our pipeline is healthy and we now feel confident in delivering a revenue outcome for the year within an upgraded range of £45-50m.
This has been narrowed from £40-50m
On the pipeline – they only did one IPO in H1, Poolbeg Pharma, which was a spin-off from Open Orphan where they are broker but not NOMAD, so this was a good win. We expect that they still have an IPO or two to come in H2, assuming markets don’t fall off a cliff. A large investment trust IPO has also been announced but not completed. But they were previously talking about "several" IPOs and this was not reiterated in Monday’s trading statement. IPOs are especially sensitive to market conditions.
For more precise estimates we turn to Progressive:
They have gone for slap bang middle of the guidance.
The lowest ever transactions for a half year (ok, they have a limited life as a listed company but this still a good guidance) is £4.3m. Cavendish was £2.4m and trading £1.4m. Retainers will likely be static at £3.2m which gives £11.3m in total. So, even if H2 is the worst half since listing for all of their businesses then they do £43.1m in revenue. You can see why they narrowed the range.
In reality, even with some normalisation, then it is easy to see £20m+ for H2 given that M&A didn't suddenly drop off a cliff 6 days ago, and there is a "healthy pipeline" for transactions. It is very possible that there are further upgrades to come here.
Talking of upgrades, we had two from car dealerships this morning…
Lookers (LOOK.L) – Q3 Trading Update
…the Board now expects underlying profit before tax for 2021 to be materially ahead of its previous expectations.
As we noted on Monday the new car registration figures were significantly down both on previous years and on expectations implied by industry surveys taken in July. And September is one of the two big months for new car sales. So why are Lookers so bullish?
Well firstly the initial margin on new car sales is tiny anyway, so this is mainly a revenue issue. The big margins are on after-sales and so reduced sales do however reduce future prospects. But the lack of new car sales is due to lack of supply, not lack of demand. Order levels are high and many of these sales will still take place, they just can't be recognised yet. But, also:
Trading in Q3 remained strong and above the Board's expectations driven by new vehicle market outperformance, excellent new and used vehicle margins and continued tight cost and working capital control.
It has always been the case that used car prices are determined by the number of new cars being sold. Higher used-car prices mean higher revenue, temporary revaluation upwards of stock and higher profits at a fixed margin. But in today's market franchise dealers have a massive advantage over others in getting hold of new car stock.
In the past competitors could buy at auction from fleet (company and hire) sales, but these are in particularly short supply and of course, are at market spot prices which have risen the most. And so they continue to have much higher margins on much higher prices in used cars.
Supply of used vehicles also remained restricted during the Period. Like-for-like used unit sales were down 16.9% in Q3 versus strong comparatives. This was more than offset by unprecedented margin retention driven by ongoing strong customer demand and improvement to the Group's stock management processes.
Margins are also up in new car sales and the outlook seems particularly strong for Lookers:
The Group continued to outperform [industry new car sales] by approximately 3.4 percentage points
This bodes well for the next 3 years+ of very high margin after-sales.
The Group has a strong new car order bank which is above normalised levels.
Which also looks very positive. But basically, the good news here is that despite the worst new car sales figures for decades (and worse than recently expected), they have weathered it well:
Notwithstanding this considerable uncertainty for the final quarter of the year, given the strength of performance in the Period, the Board now expects underlying profit before tax for 2021 to be materially ahead of its previous expectations.
The whole sector is seeing forecast upgrades. Zeus on Lookers:
We have increased our full year underlying PBT forecasts by 33.9% to £81.4m, with our 2022 and 2023 estimates left unchanged for now.
Marshall Motor Holdings (MMH.L) - Trading Update
Marshalls are, if anything, even more bullish:
In Q3 2021, the Group's like-for-like new vehicle unit sales outperformed the wider new vehicle market by 13.0% and have outperformed the wider new vehicle market in the year-to-date by 11.6%.
The Group has benefited from exceptionally strong new car margins as a result of supply shortages which has offset the impact of reduced volumes.
So not fully offsetting, but this is the first we've heard of "exceptionally" strong margins on the new side.
The used car market has continued to benefit from previously reported exceptional market tailwinds as a result of new car supply shortages and so the impact of any downward price realignment in Q4 2021 is not anticipated to be significant. In Q3 2021, used vehicle values rose by an average of 12.7%. This was the seventh month of consecutive growth in used vehicle values and over this period, used vehicle values have appreciated by 26.3%; an unprecedented position.
On the used car the wording has been upgraded from "exceptional" to "unprecedented". However, this was already widely known from surveys e.g. reported in the trade press.
This focus, together with market tailwinds, resulted in an exceptionally strong margin performance in used cars in Q3 2021, more than offsetting a decline in volumes as a consequence of used vehicle supply shortages.
As reported elsewhere, both groups repeated that they are repaying some government support. Taking Marshall's first:
…commitment to repay all CJRS and non-essential retail sector grants received for this financial year.
So that's CJRS and rates rebates. Whereas Lookers says:
As previously announced the Board has undertaken to repay all CJRS receipts in 2021
We'd have to check to see whether they mean all receipts from the start of the pandemic or just the ones received in 2021. All CJRS receipts are likely to be more than all support just from January 2021.
These commitments contrast strongly with Vertu who in their last statement on the matter says they had no plans to repay anything. However, if VTU were pressured to repay then it will help that their financial year starts from March 2021, thus they would almost certainly get to keep everything from the lockdown in Jan/Feb.
Zeus have materially upgraded forecasts as a result of these updates.
we increase our FY21 underlying PBT forecasts by 23.8% to £52.1m.
Vertu Motors (VTU.L) - Sector read-across
Some caution is again required when applying a read-through to Vertu. Firstly, with these two having claimed to have outperformed the market, can Vertu have also done so?
It seems that Lookers and Marshalls have a record of claiming to have outperformed whereas Vertu has never done so. So we’re not really sure we trust these claims or whether they are particularly relevant. And underperforming the new car sales market has little immediate impact on profits. The fact is that owners can get their cars services at any dealer, even if they have paid in advance for a service plan.
But the biggest issue with assuming that Vertu will now immediately upgrade is the timing. Vertu last updated (with an upgrade) on 20th August, whereas Lookers and Marshalls updated on 29th July and 4th August respectively. Therefore we shouldn't expect an immediate update from Vertu of the same order of magnitude.
However, nothing should be read into the lack of any update from Vertu as they are currently in a close period. A quick guess would be that these trading conditions are worth another £10m for Vertu since the last update, though. Many investors will have been worrying about September.
One advantage Vertu have over ScS is a greater commitment to share buybacks, which is the obvious way to release value when a company is undervalued. Here there has been some confusion. With their last trading update, which was effectively a pre-close update and was called as such in previous years, they announced a £3m buyback to be completed before 28th Feburary.
Often companies would have given all discretion to the broker at the point at which current trading was public so that it could continue during the close period. The broker then started buying really quite aggressively, pushing the price up from 50 to nearly 60p, and at a rate which would be finished by the publication of the results in early-mid October, paving the way for an extension.
However they then mysteriously stopped buying, and stayed stopped even after the share price had fallen back. The CEO claimed on twitter that they had to stop as they were in the close period. We know from other buybacks this is simply not always the case, provided you have given the broker discretion (and there are of course Chinese walls in brokers).
However, looking at the wording, we don't think they did give discretion:
The Company will seek to buy back its Ordinary Shares at appropriate times and considers, at the present time, the Buyback Programme to be in the best interests of all shareholders.
Equally importantly, we have looked at previous buybacks by Vertu. For example, the one started in July 2017 continued after their explicitly named "pre-close update" on 1st September, but paused from the 9th until after the interim results were actually published. That buyback was to finish at the time of the following AGM (i.e. for 11 months) but was extended with the H1 results. It was then further extended in the January trading update. It then paused from 23rd November, before resuming again, with an extension to the maximum 10% allowed without further authorisation, after the January trading update.
Therefore, we can expect to see an extension and resumption with the results on the 13th of October and possibly further extensions.
Small Caps Live Friday 8th October
CMC Markets (CMCX.L) - Pre-close Update
There are no surprises in this trading update, unlike the previous unscheduled one. Investors here had gotten used to this company beating forecasts so it came as a shock to the market that they reduced their net operating income guidance. This week they re-iterated this new guidance:
· H1 2022 net operating income expected to be approximately £126 million. FY 2022 net operating income guidance reiterated at £250-280 million.
· H1 2022 leveraged gross client income is expected to be approximately £127 million (H1 2021: £174 million).
· H1 2022 leveraged net trading revenue is expected to be approximately £100 million (H1 2021: £200 million).
· H1 2022 non-leveraged net trading revenue is expected to be approximately £24 million (H1 2021: £26 million) representing 19% of Group net operating income versus 11% in H1 2021.
As before it is the amount of trading that is the issue rather than a particular loss of clients:
Overall client AUM remains near record levels. H1 2022 active clients are moderately lower compared to H1 2021, nevertheless the monthly trading client numbers continue to remain at similar levels to those reported earlier in the year. Increased market activity exiting September led to improved client trading volumes.
So pleasing that September is looking better. Still seems strange that CMC were so badly affected in July & August vs IG index & Plus500. Perhaps their focus on the larger, more active professional clients meant that these were people more likely to have taken holidays?
It is pretty hard to forecast, as they have found out to their (or anyone who held the shares recently) cost. One bright spot is that client retention was at 79%. Although this is down on where they were recently, this is close to their 80% target. We know this was above 80% in Q1 though, so presumably, Q2 was mid-to-low-70’s which may represent their hedging strategy merely struggling on lower volume or more worryingly a return to more normal levels after the exceptional levels of recent years.
The active client numbers are slightly confusing too. These were given as 59k for 21H1 and 77k for 21H2. So similar levels to 21H1 would be a big decrease from 21H2. Based on previous statements this would have implied 70-75k active clients remaining in 22H1.
Anyway, probably the best forecast we can make is two times the 21H1 figures which would be the bottom end of the new guidance range. This is what they say on operating costs:
Operating costs for H1 2022, excluding variable remuneration, are expected to be approximately £84 million (H1 2021: £79 million). As already highlighted, this is primarily a result of the Group's continued investment in technology which has resulted in higher personnel costs.
Variable costs are hard to predict but if we assume they are similar to 2020, this gives 19p EPS for the FY. So a slight miss on what they give as the analyst consensus of 20.5p on the 6th October.
The big question that remains is if the extra IT spend will lead to sustainable growth and their long-term plan of eating the soft underbelly of Hargreaves Lansdown and AJ Bell. It is not unrealistic to assume that some £20m a year of IT spending could be considered growth spend, to that aim, compared to historical trends. If they capitalised development costs like companies in a different industry might do then this would add c.5p to EPS. But then again the potential return from this investment is uncertain.
In summary, those who like short term certainty in their outcomes will not want to hold here given the wide range of possible outcomes. But even on reduced forecasts, this isn't exactly expensive given that the costs of growing their platform are all expensed so the vast majority of earnings end up as free cash flow. Investors have to believe that long-term growth story to make this good value at the moment, though.
Pendragon (PDG.L) - Trading Update
Completing our look at motor dealers this week, Pendragon also produced a trading statement:
Pendragon PLC (the "Group") today provides a trading update and increases underlying profit before tax guidance for the full year to 31 December 2021 from approximately £55.0m - £60.0m to approximately £70.0m.
So, very much in line with what we've seen from the others. And they make very similar comments. But this is new:
The level of new vehicle order-take has remained robust throughout the quarter and remains above the same period last year.
We have no reason to suspect this is any different with Vertu, Lookers and MMH. These sales appear to not being lost but being deferred. As with ScS, this creates unprecedented levels of forward visibility.
…with a number of the volume brands which we represent being more heavily impacted.
Vertu also suffers somewhat from overexposure to volume brands (something they have tried to rectify in recent years). We’d noticed before that first, it was the quality brands that had the shortages, but now the volume brands were being affected more. So the fact that Pendragon are still doing well bodes well for Vertu.
Some of the performance is being driven by used cars appreciating while sitting on the forecourt, and this will work the other way at some point.
Whilst we also continue to expect a realignment of used vehicle margins over time, we expect these to remain strong for the remainder of this financial year, providing us with some mitigation to lower new vehicle volumes in particular.
Their previous update to the market was only 3 weeks ago too, a similar timeframe to Vertu. However, they didn't update three weeks ago, saying simply:
Whilst uncertainty remains for the remainder of the second half, we remain confident that underlying profit before tax for the full year will be £55m to £60m
In any case, it looks like the market had been paying attention and saw this update coming - the shares are flattish today.
Revolution Bars Group (RBG.L) - Trading Update
In the period from 19 July 2021 to 2 October 2021 our sites have experienced strong demand delivering same site sales growth of 17% when compared to the same period 2 years ago, when the business traded normally pre Covid.
This may be less impressive than it first appears since there was a big reduction in the VAT on food & soft drinks. If Revolution kept their prices constant then maybe 40% of their sales would have benefitted from the tax cut and be responsible for maybe 6% of that sales increase.
Plus, they were heavily investing in their refurbishing their estate just before covid so how like-for-like this is is open for debate.
They say:
...costs have continued to be well controlled resulting in good profit generation from these sales.
This is good news, but surprising that they are not having the labour issues that others in the industry have been having.
The Group's balance sheet remains strong, with net cash of £3.7m and £36.5m facility headroom as at 6 October 2021.
This sounds good until you realise they had £8.4m net debt at the half-year and raised £19.9m after expenses since then. So this is a £7.8m cash outflow during the last 9 months.
At a market cap of over £50m, a lot of future positive trading is already priced in the stock, something Revolution is not renowned for!
Ramsdens (RFX.L) - Trading Update
These are described as "resilient".
The Group has continued to control its overheads and with the benefit of government support during the Period, the Board is pleased to announce that it anticipates, subject to review and audit, reporting profit before tax of at least £0.5m.
This doesn't seem that great given that they appear to still be claiming government support.
The loan book is at 2/3rd of pre-covid and FX at 30%. It is likely the loan book will get back to historical levels given that new lending is back to pre-covid levels. But we do wonder if the FX is subject to permanent changes in how people travel - fewer cheap weekends away drinking, and more payments with Monzo & Starling cards. And FX has represented around half of the profits historically.
Although this is a very well run company, and well-financed with net cash, but the market here appears to have at least priced in a return close to normal for most of the business parts and there appears to be a risk that at least travel may struggle to get there.
That’s all for this week, have a great weekend!