Moves amongst UK small caps this week have quite bizarre in many cases. After a strong period when some more popular stocks bounced up to 50% on no news, purely due to recovery from an oversold position, we are now seeing renewed weakness in many cases. This leads to share price moves of 10% or more up or down on little news, presumably because traders are busy promoting different stocks to each other and in illiquid markets, this has a magnified effect. Although the nimble may be able to take advantage of these wild swings, the real money is often made by simply being patient. Investors may well be better off buying good, undervalued companies and turning off their price feeds, rather than risk the poor decision-making that typically accompanies volatile market conditions.
The illiquidity of small cap markets is also claiming victims amongst the lower quality companies, with a trend for de-listings. This week’s Sucker Stock (according to Stockopedia’s algorithms) to take their ball home in a huff is Deep Matter, causing a further 60% loss for long-suffering shareholders. Their rationale behind the move is because:
[the delisting] will provide greater opportunities to raise additional capital. This view has been supported to date by major shareholders.
So what’s going on? Are private markets likely to be less savvy than your average loss-making AIM investor when it comes to stumping up fresh capital? It seems unlikely. So what funds don’t seem to like is the idea of having the value of their holdings marked to market. Get them to delist and funds can mark to model. And they can claim it’s a model Ferrari, instead of the model Lada that they actually bought. Investors should be very wary of any funds making the dash to unquoted assets. This was one of the early warning signs in the Woodford scandal.
Small Caps
Van Elle (VANL.L) - Trading Update
This company presented at the recent Mello, and their story was one of shifting their work in order to make their rig fleet more productive. They have got off to a good start with this trading update:
Whilst recognising the current economic uncertainty in the UK, strong activity levels are expected to be sustained through the second half of the year, despite the winter months which traditionally deliver lower activity levels due to weather disruptions. The Board is pleased with the progress made in the first half of the year and anticipates trading for the full year to be slightly ahead of market expectations.
This is driven by their housing and general piling business which is the largest part of their activities. This has led to an upgrade in FY23 consensus:
However, worryingly, a downgrade for 2024. At Mello, they confirmed that the housing part of the business was strong, but surely this will be facing very major headwinds soon? They were confident they could move the rigs to where they are seeing more commercial demand where the outlook is very strong. This is perhaps an interesting read-through to companies such as Somero, where the market is pricing in severe drops in demand for commercial warehousing. Van Elle doesn’t look expensive, with a forward P/E of 11, until you compare it to Somero on a forward P/E of 7.
Halfords Group (HFD.L) - Interim Results: Financial Year 2023
Lots of positivity in these results, at least when using their preferred comparison against the pre-covid FY20:
Strong total revenue growth vs FY20, up +31.4%, or up +13.3% LFL. All segments delivering LFL growth over three years, with Autocentres +30.0%, Retail Motoring +10.2% and Cycling +8.6%.
Strong strategic progress evidenced through Motoring Loyalty Club membership numbers being above expectations, the acquisition of Lodge Tyre, the expansion of Avayler (our unique, proprietary software business) into Europe with ATU signed post period end, the rollout of a capital efficient Fusion programme, and the continued integration of National Tyres.
Strong net cash, pre-lease debt of £32.3m and good stock availability.
However, 13% LFL isn’t necessarily positive when you account for inflation over this period, and this positivity isn’t necessarily being reflected in the profits. They say H1 is in line:
Robust profit performance in the period, in-line with our expectations, with Underlying Profit Before Tax (PBT) of £29.0m, -£1.2m vs. FY20 and -£28.9m vs FY22 despite significant inflationary headwinds and low customer confidence. FY22 includes business rates relief of £9.2m.
However, there is a sting at the end:
Underlying profit before tax (“PBT”) expected to be at the lower end of our £65m to £75m range.
This means H2 is going to trade at a similar level to H1. Applying normalised tax rates means PAT would be £52m vs £54.4m consensus in Stockopedia, about 4% below.
The initial market reaction was to mark the stock down around 14%, perhaps reflecting that short-term momentum had been strong here with the shares up around 60% in the last 3 months (although still significantly down year on year). This appears to have been a knee-jerk reaction since the price bounced back to just 5% down on the day, perhaps better reflecting the drop in consensus. Since then the price has risen further and then now stands at a similar level to before this update.
The interim dividend is maintained at 3p, suggesting that the FY payout will be around 9p, giving a 4.5% yield. Good, but not exceptional in these markets. We also get some interesting news from their full-owned software developer:
Avayler Growth
Continued growth in our unique, proprietary software business.
Expansion into Europe following signing of third international customer post period end.
Signed ATU, part of the Mobivia group with the roll-out to start in Germany through ATU’s mobile fleet.
They don't tend to trumpet the developments here in separate RNSs, so we have to wait for the main company results to see progress. However, a new European customer for this fully-owned software business shows the progress made.
Even though growing software businesses are highly rated by the market, we doubt it is a significant part of the valuation of an almost £500m market cap company yet. The results say that all material operations are in the UK, so we presume the current software contracts are still non-material. So this remains more like a future option than a guaranteed extra profit centre. Even without this and following the small downgrades in response to these results, the valuation remains low.
ScS (SCS.L) - AGM Trading Update
Their last trading update was to the 6th October, which showed weak performance against strong post-lockdown comparisons. Since then they say that trading is encouraging, and ahead of last year:
This is very good news in the current climate:
The Board is encouraged by the Group's recent performance and current trading is in line with its expectations for the full year.
However, there are also two bits of data missing from today's update:
Order book - this was given at this time last year and in most/all updates from the end of the first lockdown until the full-year update at the start of August.
Pre-covid comparison - again, this was given in most/all updates where it was relevant, most recently for the trading to 8th October given in the FY 22 results.
Clearly, the pre-covid comparisons had to stop sometime and become increasingly difficult and less meaningful, especially on an LFL basis, but perhaps they could have gone to the end of the calendar year given the last lockdown ended in July and was distorting figures well into August.
House broker Shore help us out with the order book and provide guidance of £75-80m, slightly higher since 11th October. In the past, you'd expect a much bigger jump at this time of year. We suspect their revenue forecasts may be a little high with too much hanging on the boxing day / new year sales orders feeding into H2 revenue. Shore also expects growth in 2024, which looks overly optimistic given the massive order book tailwind in Q1 2023. However, they should be profitable in 2024. As Shore point out, three-quarters of costs vary with sales (e.g. advertising and commissions are very significant) and they have very little stock risk as most are made to order.
Regardless of trading, an argument for holding ScS has always been the excess cash on their balance sheet. The figure they quote of £89.7m compares very favourably with their circa £50m market cap. However, much of it is working capital (customer deposits held for months, final payments received on delivery held for 1-2 months ahead of suppliers being paid) and so would evaporate if trading turned down, or for that matter, if suppliers became jumpy. They are in a much much better position than market-leader DFS, who have the same risky supplier characteristics but net debt on top!
SCS don't normally give any cash figures in the AGM update, so knowing £90m is a bonus. However, it is of limited use without knowing at least the amount that is customer cash. But of course, they couldn't tell us that without giving away the size of the order book (they didn't provide this in the AGM updates pre-covid, but they did during, including last year, so you can debate how notable its absence today is).
Given that this is no longer a seasonal peak for customer cash (and never was for other movements), £89.7m versus £76.7m on 8th October after having spent approximately £0.6m on buybacks, albeit accrued wages being higher and no divided paid, is strong. It is also potentially pointed given that they did not give cash in the AGM statement this time last year. On 22nd March they announced a share buyback of up to £7m of shares. They noted:
In order to continue the Programme past the Group's 2022 AGM, typically held in November, a new shareholder authority will need to be obtained at the AGM.
In their case, the buyback is operated at arm's length, allowing it to continue through trading updates and results close periods. However, the last reported purchase was on 19th November. We are not quite sure why but think it can be expected to resume after this afternoon's vote. The annoying thing about the buyback is that it is so slow, with them being fully listed and subject to MAR rules (or at least choosing to interpret them more conservatively than others). However, it probably means they are getting a better average price given how weak markets have been lately.
The ongoing buyback should underpin the c.10% rise that accompanied this trading update, although it took a while for the market to realise this was good news.
National World (NWOR.L) / Reach (RCH.L) - End of takeover Talks
Perhaps not a surprise that National World didn’t get their much larger rival since this deal always looked a stretch, despite them saying the deal fell through:
…despite National World having received in principle financial support from within the investment community to fund a potential deal.
The sticking point may well have been price, since the Reach share price has almost doubled over the previous month. Despite the strategic rationale for the combination, National World is more cheaply-rated the Reach and doesn’t have the legacy pension deficit and phone-hacking provisions that Reach has. Paying a higher rating and taking on a massive amount of risk doesn’t look a great deal for National World shareholders.
Although the market clearly didn’t put a lot of faith in the deal, it is surprising that Reach quickly regained the initial drop on the news. It perhaps shows how hard Reach is to value, and the share price is largely driven by sentiment and momentum traders.
FinnCap (FCAP.L) - End of takeover Talks
This is another example of a company with smaller revenue trying to take over a larger one, and failing. Although the talks were clearly serious given the extension to the PUSU deadline, and the details leaked to the press, the mooted £37m valuation looked way too low. At just 20.4p this was lower than the company was trading at in June this year, and around 35% below where management last bought shares in the company.
As a result of initial discussions, the boards of directors of both finnCap and Panmure Gordon believed that there was sufficient cultural fit and strategic and commercial logic to merit examining a combination of the two businesses. However, following further discussions and in light of each company's strengths as independent entities, each board has concluded that it is not possible to find mutually acceptable terms or structure for such a combination.
Perhaps the only people willing to accept this sort of offer was any of the larger holders who thought the larger entity had strategic value and were willing to transfer their equity stake to the new company. But with finnCap perhaps being the most profitable and therefore most valuable business, it was always going to be an uphill task to get a deal where both parties were happy.
Given that the statement the companies put out were identical, this appears to have been an amicable parting:
Both Panmure Gordon and finnCap look forward to continuing to serve their respective clients as independent businesses.
This seems the best outcome despite some understandable short-term weakness in the finnCap share price as a result of the announcement.
De la Rue (DLAR.L) - 2022/23 HALF YEAR RESULTS
Richard Bernstein mentioned this company during his Mello talk, where he is trying to kick out the Chairman.
And you can see his point, the company say:
Nearing the end of the 3-year turnaround plan, which saved De La Rue and has significantly increased resilience.
Yet the numbers say:
IFRS operating loss of £12.6m (H1 22: operating profit £13.8m), after exceptional items charge of £21.4m
and:
Net debt increased by 21.1% to £86.5m (FY22: £71.4m); remains on track to full year guidance of £88-92m
and:
Therefore, there is a material uncertainty that may cast significant doubt on the Group's ability to continue as a going concern.
It has perhaps been shareholders’ willingness to put fresh capital in, including Crystal Amber, that has kept the company going, not their 3-yr turnaround plan. They quote an adjusted profit of £9.3m, but even after adjustments, this is just 2p EPS. On, exceptionals, they say:
Exceptional charges included £19.3m relating to Portals paper: £16.8m in relation to the termination of the Relationship Agreement ("RA") and £2.5m of non-cash additional expected credit loss provision on investments
They had to pay £16.7m to get out of an onerous paper purchase agreement. Plus describing credit loss provisions as non-cash looks a little bit out there, since surely the point of provisions is that they are likely to become cash costs at some point in the future!
For the first time in a long time, the current ratio doesn't look too bad with 194m of current assets and £127m of current liabilities giving a 1.53 ratio. This is because the debt is refinanced to long-term liabilities, although 1st Jan 2025 is only around 2 years away:
Existing bank facilities extended to 1 January 2025
Tangible assets excluding tax assets/liabilities are just £26.6m though. And this is with the IAS19 pension deficit of £36.8m. Helpfully, they give a view of the actuarial deficit:
In March 2022 payments of £15m per annum, payable quarterly in arrears were agreed under the Recovery Plan until 31 March 2029, following an April 2021 actuarial valuation of £119.5m on the trustees' formal funding measure.
An informal actuarial estimate of the scheme at 4 October 2022 gave a deficit of c£92m on the same funding measure.
So that gives a negative "real" tangible asset position. Plus they have LDI's, although these didn't require cash from the company to shore them up, there is the possibility that they had to crystallise losses on risk assets.
On the outlook they say:
As we have explained above, in FY24 we expect De La Rue to be a free cash generating business on a sustainable basis, after pension payments and to see an improved EBITDA.
Richard Bernstein seems to think that the company has strategic value and would be worth more to someone else. However, it doesn't look cheap on any financial metrics. And with the qualified going concern hanging over it is quite risky too. We wish him luck in his plan...but firmly from the sidelines.
Surface Transforms - OEM 10 Contract Award and Trading Update
Surface Transforms (AIM:SCE) manufacturers of carbon fibre reinforced ceramic automotive brake discs, is pleased to announce that the Company has been awarded a contract with a lifetime value in excess of £100m as a tier one supplier of a carbon ceramic brake disc to an automotive company - previously described by Surface Transforms as "OEM 10" - which is the single largest contract awarded to date, but crucially sees Surface Transform discs replacing those historically provided by its main competitor.
Here they are taking business from Brembo. However, we don’t know if they won this on performance or because they have undercut Brembo on price. They have previously claimed to have lower manufacturing costs than Brembo, implying they can undercut on the same margin, but that might not be true at current energy prices, or they properly take into account capital costs of equipment with a proper discount rate and level of depreciation. What we would really want to see is their product expanding the market into more mainstream vehicles, so it is actually disappointing that this contract is a replacement.
The lifetime revenue on this contract is estimated to be in excess of £100m over 6 years. The customer is currently estimating a start of production ("SOP") date in 2024. For prudence, the Company anticipates series production revenues will commence in the first half of 2025. Sales from this contract award are expected to be approximately £20m p.a., tailing off in the later years.
This is very material for the company, raising the order book by over 50%. However, note those dates and the tail-off: this sounds like a petrol car approaching the end of its life. This is a reminder of the possibility that SCE's business could be damaged by electrification rather than accelerated by it.
The second part of the update consists of a massive profits warning. In fact, we can't remember the last time we saw such a large profits warning so close to the year-end (31st December here). Revenue forecasts have literally halved. Losses are now forecast on all metrics, including EBITDA, which is quite a feat given the capital intensity.
This has primarily been caused by technical issues at OEM 8 unrelated to our discs, which delayed the production ramp following the customer's SOP and was more prolonged than the Company originally anticipated.
Are these the same production challenges they claimed to have rectified (in order to be able to raise more money from the market) or new ones. Basically, it is a mess
Nevertheless, the Company has been able to partly mitigate OEM 8's ramp delays through both a change in revenue mix which resulted in a higher than forecast gross margin and tight control of non-essential overheads.
This sounds like putting lipstick on a pig - perhaps, more likely, the OEM 8 contract was simply lower margin and so failing to deliver naturally led to higher margins. Added to this, there is a warning on phase 2 installation. All in all, this is a pretty poor show given that they last raised more cash on the basis of everything being fine less than two months ago.
And what are the chances that they just happen to have discovered that they are going to massively miss forecasts, 11 months into the financial year on the exact day that they get awarded a large contract? This update appears to have fooled shareholders, though, as the share price didn’t react to this miss.
House broker, finnCap, are only expecting a £1.9m hit to cash in the current year due to these problems, but are also now saying 2023 and 2024 year-end cash will be £3.6m lower than previously expected. This may reflect supply chain difficulties/delays on phase 2.
The FY 2023 EBITDA forecasts of £4.8m with year-end cash of £2.9m implies the low point for cash will be around zero, which means they will need some kind of borrowing facility. They have run with low levels of cash prior to 2021, but then they were a much smaller business. Further cash raises (making their 15th raise, we think) seem virtually certain, with a high probability of one next year. One may start to think that the main products they are selling are shares, not brakes!
That’s all for this week, have a great weekend!