Small Caps Live Weekly Summary

Happy Christmas! APP CCT MSI TGP THRU

Happy Christmas Everyone! Hope you find time to enjoy the break from the markets. The Santa Rally hasn’t really arrived this year, particularly in the US, with Tesla leading the falls. This is not really surprising since most seasonality effects have little behind them and certainly aren’t consistently tradable. The US moves have the feel of the tech bubble continuing to pop rather than anything that should concern the typical UK-focused investor.

However, on the days the market is open over Christmas, it is worth keeping one eye on your small cap watchlist. There are two reasons. The first is that illiquidity, which magnifies moves far more than any underlying newsflow should. The second is that it can be a time when fund managers re-balance their portfolios. Most fund managers are really in the asset-gathering business, not the investment performance business. This means that it is often far more important for them to look wise than generate results. There is a tendency for them to sell their losers at the end of the year and buy stocks that are winners, making the writing of their year-end performance letter a far easier task. The natural thing for a buyer of a stock that has been declining is to wait until January when they have a whole year to wait for recovery.

This means that if you have a winning stock you need to top slice, you may get a favourable price. Conversely, you may see some bargains appear. Once the year-end reporting period is over, these bargains start to look attractive to the fund managers again and can bounce back. The effect is largely random since it relies on the whim of a particular fund manager. So it may or may not provide opportunities this year.

Small Caps

Appreciate (APP.L) - Arb Opportunity

We previously reported that Appreciate had received an agreed takeover from Paypoint. The terms of the deal are 33p in cash, and 0.019 Paypoint shares per share. Shareholder will also receive the 0.8p declared dividend.

Since the announcement believe that much of Lord Lee's shareholding went to Samson Rock - he reported at Mello he had sold much of it ahead of the Autumn Statement / 3rd mini-budget on capital gains tax concerns. Since then , Samson Rock have further built their position to 19.65%. They have also been shorting Paypoint. So clearly playing an arbitrage game. The Paypoint share price has been weak, presumably due to people selling the shares to arbitrage the takeover.

However, the Appreciate share price hasn’t been particularly strong and at several points this week has been available to buy below 40p. At this level, shareholders are getting over an 8% return. While not outstanding in itself, this could represent an annualised return of over 30% if the deal completes in reasonable time. Here is what we know for voting:

Actual completion depends on a few other pre-conditions, such as FCA approval. The other risk is that shareholders vote the deal down, after all, with the drop in Paypoint shares the deal is worth less than when first proposed. They only had 19% letters of intent when the scheme document was published. However, the arbitragers, particularly those who have shorted Paypoint stock, want this deal to complete. If they don’t get the 75% for a scheme of arrangement Paypoint reserve the right to go for a takeover. It is highly likely that they get over this threshold, which means any shareholders who want the cash and Paypoint shares will likely get them.

Character (CCT.L) - Annual Results

So revenue is up, but profit is flat. Adjustments seem fair because they exclude FX gain and property sale from the prior year's comparative. Cash is down, but the dividend payment is up. The cash balance reflects both increased inventories early for Christmas this year plus shareholder return:

The Group continued to be cash generative, delivering £4.2m of cash from operations in the year (2021: £27.3m), despite an increase in inventories of £15.3m due to a conscious decision to bring stock in early. We finished the year with a net cash balance of £20.0m (2021: £35.9m), after funding the £13.6m tender offer buyback of shares, which completed in February 2022.

But these results include last Christmas, not this one. And here, the outlook is weak:

As we anticipated at the time of the update in October 2022, trading conditions have become more challenging and sales have slowed in the lead up to Christmas. Whilst this has been a trend in both our domestic markets and in our other major international markets, the effect has been particularly discernible in the USA. In addition, the weakening of sterling in September and October 2022 has continued to squeeze margins in our domestic markets. These factors will adversely affect the Group's performance in the first half of the current financial year. The slow-down in sales means the Group's stock levels remain unseasonably high but the Board expects these will sell through as it is largely current inventory.

So get your discount toys in the Boxing Day sales, everyone!

Stockopedia consensus has the EPS halving to 22p this year, so this doesn't look cheap even after adjusting for a quarter of the market cap in cash. At least on this year’s earnings. There doesn’t seem to have been any further broker downgrade in response to this statement, though. However, this outlook statement does seem weak compared to the October note that forecasted the 22p.

The current share price is pricing in this year as a one-off and a strong bounce back in 2024. This has never been a particularly highly-rated business, though, despite often being very cash generative, because it doesn’t really own much of its own IP but licenses it.

So 7-10x P/E has often been the norm. Not helped by a management team that pays themselves very well, whatever the prevailing business conditions. So we have the company trading on a forward P/E of around 19 or double what it usually does, with the likelihood of a bounce back the following year, but it will be 18 months before these start to show up in any actual figures. The market is forward-looking, but there is still a large amount of uncertainty about Christmas 2023 trading.

It seems high risk paying £4+ today for a hope of a swift recovery that won’t appear in figures for another 18 months. That said, the cash pile means if this drops to, say, b a more normal P/E of say 10, then this will look good value on any potential recovery. There seems no point in paying up for that recovery today when it may not happen, at least on a timescale that makes it worth holding.

A P/E of 7 seems to be where the market is currently pricing companies facing a challenging market outlook. 7x 22p + 104p cash = £2.60/share. So would need to come down some way before it may look interesting again.

Tekmar (TGP.L) - Contract Award re Dogger Bank C

Tekmar has become a great trading share. The share price collapsed this year from over 50p to 6p on news that they are running out of money and they put themselves up for sale. That they have announced no firm interest six months later suggests that no one really wants them. However, the share price doubled in July on news of a contract win, before slowly giving up all of its gains.

Until this week, when the share price has doubled again on news of another contract win. However, the announcement contained no figures and, if everything goes well, will be starting in Q3 2024! We assume the move is not due to the contract itself, but because now at least 2 people now think it will still be around in 2024!

MS International (MSI.L) - First Sales of New Land Based Mobile Gun System

This is another company whose share price has soared this week on contract news. However, this one is much more substantive:

The total contract value to the Company is £22.4 million and we are aiming to fulfil the contract as soon as practicable. Revenues under the contract are expected to be recognised during the 2023 calendar year. This contract represents the Company's first sales of this new gun system.

In response to this, the company’s EV has risen by £45m. Clearly, the market is pricing this as the first of many contracts, rather than a one-off. MS International’s Gross Margin is around 28%. So the market reaction here is assuming that, if the GM’s on this product are similar, the company will generate £160m of incremental revenue ad that this order represents just a fraction of their eventual orders for this product. To buy the stock after today’s rise, buyers have to assume the the NPV of this incremental revenue will be far higher than £160m.

The problem is that MSI has a long history of boom periods followed by disappointment, and it would be a brave person who takes a gamble on this being the exception that doesn’t mean revert. Mark has long memories of being so hopeful for this one over the years and having the initial excitement of better trading dashed every time.

What doesn’t mean revert is board pay. Dividends last year were £1.4m and have been pretty much flat for a decade, despite cash balances averaging about £17m over the same time period. Board pay was £1.7m last year. What’s the betting that board pay continues to be higher than the dividends paid to shareholders over the next decade, no matter how well the company trades in the short term?

Thruvision (THRU.L) - Interim Results

These results look in line with what we’d expected:

Management comments about breaking even but then this being at an adjusted EBITDA level look a bit cheeky, but looking back they originally did say EBITDA at the FY results and progressive forecast £0.0 adjusted EBITDA with £-0.5m PBT. This was revised to £0.1 and £-0.4 at after the H1 update.

Cash balance would be worrying without then giving the Dec 15 value, which is clearly why they include it:

Cash balance as at 30 September 2022 was £1.1 million (31 March 2022: £5.4 million), with cash at 15 December 2022 of £4.3 million.

But this does re-assure.

The product is good, and they are well managed. As always, the lumpiness of orders is the biggest risk. They could do EBITDA break even this year but then go back into a loss next year if further large customs orders don’t occur. So what do they say about this:

As announced on 22 September and 5 October 2022, we received two strategically important orders from US Customs and Border Protection (CBP), via our US Government contracting partner, totalling $9.7 million.

…it is worth noting that in total, Thruvision received orders worth $14.0 million from CBP in the US Government's last financial year (1 Oct 2021 to 30 September 2022).

At Mello they said they expected to receive significant orders every year, I think for 5 years, under a framework agreement, so this goes some way to de-lumpify revenue from customs. Of course, the US government is the best possible reference customer in this area and:

Strategic adoption by CBP clearly assists our broader sales efforts with other international Customs agencies. We received an order for a sixth tranche of cameras from an existing Asian Customs agency customer in November and we have several live opportunities with other agencies where we expect to see progress in 2023.

Broker, Progressive say:

Once [announced orders] delivered, CBP will have deployed over 100 of Thruvision’s latest, high-performance cameras. The total CBP spend with Thruvision for the last US Government fiscal year was $14m, which gives an indication of the potential scale of the opportunity. Earlier in 2022, CBP made public its intentions to acquire 500 ‘passive body scanners’ over the next five years

Given that they are replacing their older cameras, we think earlier orders can be neglected and apparently we are looking at somewhere between $9.7 and $14m per year in US customs orders alone. So customs continues to a reasanable business.

The Profit Protection part should be where the real scale is, however:

Despite challenging economic conditions for retailers, Profit Protection product revenue for H1 was unchanged at £1.0 million (H1 2022: £1.0 million) with good order intake since 1 October from a combination of existing and new customers.

The disappointing H1 figures were flagged up well in advance, and it looks like there will be somewhat of a recovery in H2. They have an new walk-through product in this area. Also they point out:

one major UK retailer calculating a payback within six months of deploying Thruvision products.

Hopefully this will encourage spend at a time when many warehouse operators are cautious with capital allocation.

Progressive's revenue forecasts are conservative at £9.9m for H2. The Chair's commentary says £8.7m alone from US Customs if all are delivered as expected. He also says he's confident of maintaining Profit Protection performance. Given that H1 was flat YoY it doesn't matter whether he meant H2 or FY, that means another £2.5m for H2. So already you have £11.2m there.

They don't capitalise any expenditure and in any case the main thing they might increase if things are going well is marketing, but with a commitment to EBITDA breakeven and revenue likely to be unclear until near the end I just don't see any element of overheads that will increase ahead of inflation. As such almost 50% of revenue beat will drop through into the bottom line. And yes, they have tax losses, and no, they haven't previously been recognised giving another potential boost.

Using slightly more conservative estimates of £11.5m revenue I get £0.9m EBITDA / 0.34p EPS, of which 1.6p is in H2. 2024 could look more like 1p EPS. Making the current 22p share price expensive, but not crazy for a growth stock with a strong and unique product.

The new CFO and husband bought around £20k of shares post-results. This is nice to see, but nowhere near backing the truck up. They are also doing an EBT share buyback to cover option exercise which could be interesting on such an illiquid stock.

That’s it for this week, Happy Christmas!