The energy crisis continues to hit the news headlines. The fear has moved on from simply the reduced disposable income of households, and onto the energy costs for businesses. This will be a double-whammy for many businesses with reduced demand due to both the squeezed consumer and the higher prices they will have to pass on. Understandably, many companies have a poor outlook and are facing increased selling pressure. However, the knock-on effect of poor sentiment seems to be hitting all small caps, including dollar earners with no exposure to the UK consumer. Often these companies have operations in countries that would be considered risky. However, for some, the current political climate in the UK may be considered even riskier. Everything has a price, though, and when the summer lull of low liquidity ends, investors may re-assess how much cash they are holding. Share brokerages rarely pay any interest on cash holdings, and anyone with a large cash holding is losing 10% a year in real terms. Markets are also forward-looking and bottom when everyone is most bearish.
There was no Large Caps Live as WayneJ wisely prioritised summer sun.
Small Caps
Macfarlane (MACF.L) - Half-Year Report
This company has a strong following from a lot of investors that we regard highly, so these results were always going to be of interest. They sold off their labels division recently, so continuing operations are the best comparators:
14% revenue growth isn't too bad. However, only 7% of this is organic. And Operating Profit growth of 4% is not great, particularly since this is a distributor. As Leo regularly points out, FIFO accounting standards tend to flatter the profits of such businesses. By how much really depends on what rate of input cost inflation they are facing. Since they don't give this figure, we are a little bit blind here. This is what the Fed has for wood pulps:
There's a 15.5% rise in pulp prices, and they started the period with £21.3m of inventories. So, if the price of packaging goes up with these (without clear guidance from the company, we have to make tenuous assumptions), inventory value will have gone up by £3.3m. Days Sales in Inventory is around 100 days so perhaps makes sense that around half of that is extra FIFO profit for the period, or £1.65m. This fits quite well with the £1.5m of inventory build during the period:
The good news is that stripping out that approx inflationary impact, the growth rates are more impressive:
The bad news is that "true" 12 months’ profitability is some 11% lower than the headline figures, so conservative investors will want to adjust their ratings for this. And the other bad news is that, if we assume packaging costs have been largely in line with the US pulp cost figures, organic packaging volumes have dropped by 15%:
The other thing that Mark is a little wary about here is the balance sheet. The current ratio is only 1.08. With £16.5m of gross debt, they say:
Net bank debt on 30 June 2022 was £9.7m - a cash outflow of £12.1m from 31 December 2021, including £9.1m of net investment in acquisitions and disposals. The Group is operating well within its existing bank facility of £30.0m which runs until 31 December 2025.
Clearly, the bank is supportive since they have been acquisitive, and they have run with this sort of balance sheet successfully for many years. The Days Sales Payables is 123 days which seems a little high. Of course, not all of this is trade receivables, some represents contingent consideration on acquisitions. Here is the breakdown from the last annual report:
Of course, contingent consideration is worse than trade receivables since this is a probable liability (paying for acquisitions), not a possible liability (trade terms normalising). The only way this is better is if the acquisitions are underperforming expectations! That contingent consideration must all be current now.
The other big part is accruals & deferred income. There is no explanation of what these accruals are, though, why they have risen and when they are due. They also note:
· Pension scheme surplus increased to £8.8m at 30 June 2022 (31 December 2021: £8.3m). The improvement is due to continued contributions from the Group and an increase in the discount rate, offset by lower investment returns in H1 2022. An additional contribution of £0.7m was paid into the pension scheme in H1 2022 to satisfy the debt on exit of the Labels business.
But, of course, this IAS19 surplus is still a deficit on actuarial figures. Ongoing contributions aren't massive at £1.3m per annum and should be eliminated after 2024. £0.6m was paid in H1 net of the Labels business exit payment. So this should be treated as an additional £3.3m of debt in valuations.
This makes the adjusted earnings yield about 9.5%, without adjusting out the exceptional profits from FIFO accounting. While not crazy, this is not particularly good value in the current market, particularly given a relatively weak balance sheet and inflation masking a potential drop in packaging volumes. We know many expect this to beat expectations, which it may do. If it does, it looks like it will be more due to inventory inflation than strong trading volumes.
Base Resources (BSE.L) - Full Year Results
When they issued their Q4 operating results at the end of July, we could largely infer the financial results and knew these were going to be a record second half of the year. Compared to Mark’s estimates, PBT came in slightly higher than expected due to lower depreciation due to the extended mine life at Kwale. Free cash flow before changes in working capital was slightly lower than Mark’s forecast due to extra taxes, mainly due to them repatriating more cash out of Kenya, which is subject to a withholding tax:
That cash is being used to pay a AUD3c dividend, meaning that the dividend here remains exceptional. Management are still flagging that these dividends will end when Toliara is approved and all indications are that the wait here might finally be over.
The post-tax NPV of Toliara is around $1b versus a Market Cap of around $280m, so there is a lot of upside here. The downside is protected by c$200m+ of free cash flow that Kwale is likely to produce before the end of life there, even if they don’t find extensional resources. However, there is now likely to be a production gap between Kwale and Toliara which will change the risk profile for the company. This may cause some investor churn as those who have invested for dividends look to exit. Long-term holders should benefit from a capital market cycle that remains highly supportive for heavy mineral sands producers.
Lookers (LOOK.L) - Interim Results
Our favoured play in this sector is Vertu because the tangible asset coverage should provide some protection against changes coming down the line in this sector. Hence, this is largely through the lens of read-across to them. These results were to 30th June, so pretty prompt, but refers to conditions a while ago now.
H1 trading strong despite OEM supply constraints on new vehicles and good progress against strategic priorities. Revenue of £2,230.0m (2021: £2,153.2m) driven by increases in used vehicles and aftersales, whilst outperforming the UK new car market by 1.7%.
Everybody always seems to report outperformance. Perhaps they are taking share from independents, and this is direct evidence of the economies of scale that are increasing across the sector. Or just everyone carefully picks their comparators!
Unlike Vertu, these sales figures are well down on pre-covid as they seem to be shrinking rather than growing. Perhaps they were more involved in fleet sales which were low margin and pretty much pass-through revenue in the before times. This is expected to take at least another year to recover as OEMs prioritise higher margin models and sales. What matters is profits:
· Profit performance underpinned by material improvement in new vehicle gross profit margin.
· H1 profit before tax in line with prior year at £49.9m (2021: £50.4m).
Again, these levels are far ahead of pre-covid, excluding one-offs. 2020 did see significant trading disruption, but this was balanced by £12.7m of government support.
Cash and property portfolio is equivalent to 95p per share, but that is not net assets. In particular, they have £770m of trade payables, which are likely car stocking loans - accounting at car dealers is a bit special. TBV is £224m vs a £335m market cap making P/TBV 1.5 vs 0.79 for Vertu.
On the outlook, the " backdrop of increasing inflationary pressures, including both employment and utility costs" is mentioned a few times. They say:
Our margin performance has also been underpinned by the material improvement in vehicle gross profit, which largely reflects the ongoing supply constraints and self-help measures.
Trading during July and August has been in line with expectations. Margins remain at H1 levels and the Group continues to maintain a strong order book for the remainder of 2022. (Empasis added)
This seems exceptionally strong to us. However, there is little guidance on sales, with them waiting for figures from the key plate-change month of September. New cars, used cars and aftersales each make up around a third of reported gross profits at Lookers, but new cars are a smaller third than the other two. If they include commissions in admin costs like Vertu does, then the true figure could be more like a quarter. So there is less risk for new cars than many might suppose.
It is disappointing to see no guidance on aftersales or used car transaction levels. Leo is expecting a reduction in used car volumes due to disposable incomes being squeezed. After all, they make £2,100 on each car sold which ultimately comes out of the pocket of anybody trading up.
It is after-sales where the picture is less clear. This could be approaching 50% of profits when commissions are adjusted for due to exceptionally high margins of 43%. With the average age of cars increasing and budgets squeezed, people may increasingly take their cars to cheaper alternatives to be serviced. A shortage of mechanics who can fairly readily negotiate pay rises and a renewed focus on the area being reported by several listed groups means that margins might also come under pressure.
The forecasts for Lookers, prior to this update, were for a 15% drop in EPS. However, Vertu’s EPS is forecast to drop 50% with a year-end just 2 months later. Barring a complete collapse in Jan/Feb 2023, Vertu's implied profits forecasts continue to look too low. Wider conditions continue to deteriorate, but everybody keeps reporting margins are holding up. This fundamentally reflects a shortage of supply that the legacy OEMs are making no attempt to resolve and (at least they believe) have no incentive to do so.
The market liked these Lookers results, with the share price up around 13% on the day. Vertu was unmoved. We expect a trading update from Vertu next week or the week after, with their Interim Results scheduled for the 5th of October.
Hunting (HTG.L) - 6-Month Results & Trading Update
We never like it when companies issue separate results and trading statements at the same time. It smacks of PR - "These are bad results, but hey, we are trading great." or "Great results, we'll hide the bad news in a separate RNS we hope you'll miss". However, in this case, it seems more likely that it is their habit of only releasing a summary of the results as an RNS and including a link to the accounts. This is much more common in the U.S. An extra click isn’t the end of the world but does highlight that this is a bit of a fish out of water - a largely US-based company listed only on the UK market and not always following the UK market norms.
As for the results themselves, a decent recovery at the EBITDA level ends up a loss at the EPS level:
· Revenue $336.1m (H2 2021 - $277.2m; H1 2021 - $244.4m)
· Gross profit $75.8m (H2 2021 - $20.9m; H1 2021 - $44.0m)
· Profit from operations $1.7m (H2 2021 - $53.2m loss; H1 2021 - $26.5m loss)
· Diluted loss per share 2.4 cents (H2 2021 - 34.3 cents LPS; H1 2021 - 18.9 cents LPS)
The market has liked these results (or, more likely, the accompanying trading statement), with the share price up almost 20%. This is the big headline:
In August 2022, Hunting's Asia Pacific operating segment won an Oil Country Tubular Goods ("OCTG") contract that management estimates to be worth up to $86 million with CNOOC for an offshore project in China. The order will be completed between August 2022 and June 2023 and will utilise Hunting's proprietary SEAL-LOCK XDTM premium connection.
This is about 14% of annualised H1 revenue, so is very good news, but not alone enough to recover revenue to previous highs. Listening to the conference call, it is pretty much endlessly positive about all the developments. Again this may be an American cultural thing, but shows where they see the market going.
Overall, we don't see much in these results or the trading statement that changes the narrative here. The bulls believe what the management says about this oil cycle is just slow; there is nothing fundamentally wrong with Hunting; and trading will return to levels that make the assets productive again. Buying at a discount to TBV makes sense. The bears will argue that they are a long way from an acceptable return on capital and/or that the oil market is in terminal decline. The only thing that has happened today is that the market has believed the management narrative a little bit more.
RM (RM.L) - Interim Results
The share price was down 35% on these results. Revenue is up 4%, but EPS is down 46%. Looks like costs going up are the culprit. Net debt up to £41.5m from £10.5m. They have had to get a banking covenant waiver on their leverage covenant, which means these have become current debts. Giving them a current ratio of just 0.71. They say this will revert to non-current debt in the future, though:
The extension of the May 2022 net debt to EBITDA leverage covenant was granted after 31 May 2022, the borrowings have been reclassified at the balance sheet date to current liabilities notwithstanding that the lenders have made clear they currently have no intention of accelerating all or any part of the loan repayments. The borrowings are anticipated to revert to non-current liabilities at 30 November 2022.
Even without this, the balance sheet is not strong. They talk about an IAS19 Pension surplus, but as so often, they still have a triennial deficit:
The 31 May 2021 triennial valuation for the current schemes has been completed with the total scheme deficit reducing from £46.5m to £21.6m. The deficit recovery payments of £4.4m per annum will continue until end 2024, before reducing to £1.2m until the end of 2026 when recovery payments cease.
So that looks is a £13.4m deficit based on the payment schedule to us.
Quite rightly, they are not paying a dividend - they can't afford it, and the banks are unlikely to allow it. Net tangible assets are negative once you account for these effects. The savvy Richard Beddard spots that they’ve added debt as a risk too:
This is NOT an investment.
Alumasc (ALU.L) - Sale of Levolux
Alumssc sells their Levolux for £1 plus £1m of deferred consideration in order to stem the losses from this part of the business. However, they are including the £1.4m of cash in the deal! So sold for less than cash balance. They only get the £1m if the buyer manages to sell on the business in the future.
£3.8m of tangible assets are included in the deal, which will be written down. Not sure if that includes the cash or if that is on top, but either way, this isn’t great. They are also taking a large goodwill write-down as they acquired this business for far more back in 2007. It is also not clear if the company retains the pension liabilities of Levolux. Overall the company has a pension deficit and is making recovery payments so we have to assume these remain with the group.
FinnCap have a note out. But it doesn’t really answer any key questions. finnCap haven’t changed EPS forecasts for FY22, which suggests Alumasc may have had to get rid of Levolux before the publication of the results to get rid of its losses into discontinued operations in order to hit their numbers. This may explain the £1 deal. Guess we’ll see when these figures are released on 6th September.
That’s all for this week, enjoy the BH Weekend.