Thanks to everyone who attended the Small Caps Live Investor Meet this week, it was great to put a face to some names and catch up with some old friends.
In small caps, this has definitely been a difficult period for investors. Many small cap companies have had weak share prices for six months or more, despite some strength in broader markets. Then, when markets were hit by concerns about the Omicron coronavirus strain last week, small caps fell further. At times, it can feel like we face the worst of both worlds.
However, it has always been like this. Small caps, by their nature, are much more volatile and more reliant on the more fickle fund flows of individual investors. Since the majority of investors are not willing to trade at current prices, small amounts of buys and sells can move market caps by multiples of the volume traded. It is common for investors to complain about this effect, but again, this is a feature of markets, not a bug - the price is always set by the keenest buyer and keenest seller. So, if you get a small but keen seller with no buyers, the price can move significantly on little volume. The effect is often made worse when stop losses create a new set of keen sellers at a lower price.
However, if you have done your homework and are confident in your assessment of the future earnings of the businesses in which you are invested this is good news - your expected return has actually gone up. Conversely, the higher volatility may be the wake-up call you needed to adjust your portfolio where the outlook really has soured for a business, or perhaps where you followed others into a stock without any real understanding of it. If you are struggling with the current volatility, it is also worth considering if your current strategy matches your personality well. Thankfully, Mark has written a book that covers this topic:
And it’s not too late to add it to your Christmas wishlist for some inspired holiday reading!
(There was no Large Caps Live on Monday.)
Small Caps
Arcontech (ARC.L) - Trading Update
And sadly, it is not good news:
trading performance has regrettably fallen below current market expectations
There are two reasons given:
…one customer reducing its market data spend with the Company, and notification from another customer that it will not be renewing its contract from the start of second half of 2022. The two changes are unrelated and do not involve customers with Arcontech's core MVCS server-side solution.
Usefully, they quantity the effect:
The Company is consequently revising its year end market guidance to reflect this net reduction of revenue. The reductions will take effect at the beginning of the second half of Arcontech's financial year and consequently will negatively impact revenue by annualised c.£300K, half of which will impact in the current financial year.
As is usual in these cases, then you get the confident outlook:
However, notwithstanding the above the Company senses an overall improvement in the business outlook which until now has seen growth affected by Covid. Its clients are now renewing interest in new business projects and the Company's sales pipeline continues to be healthy.
The problem is that they seem to have been talking about that sales pipeline for a long time, during which they have lost clients not gained them.
The house broker, finnCap, have updated their forecasts to reflect this trading update:
With £5.4m of cash on the balance sheet, then 6p of adjusted EPS works out to be an earnings yield of about 9.5% at the current 95p share price. This is pretty cheap for a software company. Buying after a profit warning is only for the very brave, however, and given that this is really a microcap you’d really want to be sure that some of that sales pipeline can be converted to orders. Historical numbers and forecasts for both sales and profits are quite uninspiring, and microcap companies that fail to grow often remain cheap forever. Perhaps one to add to the watchlist for when/if they start to win new contracts or find something good to do with their cash pile.
D4T4 Solutions (D4T4.L) - Half Year Results
Staying with software, D4T4 released their H1 results this week:
· Revenue of £7.6m (H1 FY21: £5.1m)
· Strong growth in new license revenue to £1.8m (H1 FY21: £0.3m)
· Gross margin increased to 53.2% (H1 FY21: 48.6%)
· Annual recurring revenue ("ARR") stable at £10.4m (H1 FY21: £10.1m, FY21: £10.6m)*
· Adjusted profit before tax of £0.1m (H1 FY21: loss £0.6m)**
· Adjusted EPS profit of 0.22p (H1 FY21: loss of 2.38p)**
Revenue has recovered after a COVID affected period where they made very little licence sales and only booked recurring revenue. However, only being break-even doesn’t look great.
There is no reason that D4T4 should necessarily be a seasonal business, but it does seem to have a habit of having a weak H1 followed by catch-up in H2. A few years ago it gained a following by having a really strong H2 to hit its forecasts even though many commentators expected it to miss. This year is no different in this respect:
The contracts won in the first half along with the high visibility of opportunities expected to close in the second half underpin the Board's confidence in achieving expectations for the full year and driving incremental growth in ARR.
Like Arcontech, we turn to house broker, finnCap for what these expectations are:
Like Arcontech, these historical numbers and forecasts for both sales and profits are deeply uninspiring. Indeed, the forecast EPS that D4T4 are saying they will hit, is some 60% down on 2019.
Like Arcontech, D4T4 is cash-rich:
Strong cash position of £16.1m (H1 FY21: £12.1m) with no debt
And like Arcontech, D4T4 has a strong outlook statement:
We are excited by the potential for the business and look forward to reporting further progress in the coming months.
However, unlike Arcontech, the recent years of poor results at D4T4 have been ignored by the market and, despite a c.10% drop in the share price this week the shares still trade on a forward earnings yield of 2.3%. This is a cash-adjusted forward P/E of over 40. This seems daft for a company with this record of recent underperformance.
The story here, of course, is that this is a switch from lumpy license revenue to recurring SaaS revenue and therefore this dip is to be expected and we should give this a very high multiple. Mark is not convinced by this argument, though, since:
a) ARR has been static recently.
b) The company is still dependent on license revenue in each period to be profitable.
c) If you have a 3-year cycle to shift customers from one-off licenses to recurring fees, then you would expect the dip to be over after 3 years.
It does show how much investors love a story, though.
Belvoir Group (BLV.L) - Trading Update
Current substantial pipelines of house sales and written mortgages support our end of year forecasts. Consequently, the Board expects that the performance for the full year, in terms of profit before tax, will be ahead of management's expectations for 2021 and substantially ahead of 2020.
That’s good news then. Given that Belvoir value their record of continuous EPS growth, you can imagine that they probably didn’t want to upgrade for this year and would rather have kept it in reserve for 2022. However, lettings isn’t exactly the sort of business where you have any leeway on revenue recognition.
They highlight the headwinds they face here:
In 2021 we have seen our franchisees and mortgage advisers take advantage of an exceptionally strong sales market. The sector undoubtedly benefitted hugely from the Government's decision to extend the stamp duty holiday until September 2021, following which we have seen a predictable slowing in the number of new instructions as the market normalises. We anticipate that given the ongoing pent-up demand from buyers, the market will return to more usual transaction levels in 2022.
So while house broker, finnCap, have upgraded 2021E EPS from 19.8p to 20.3p, they leave 2022/3 forecasts the same:
This is a well-run company, and may well outperform these forecasts. However, the share price is already up 65% YTD. And, at the moment, the market really doesn't like companies that have had a short-term boom and are now facing headwinds. finnCap themselves are on a forward P/E of just 6 with an adjusted EPS forecast to fall 6% year-on-year (although there is a high amount of uncertainty about 2022.) Whereas Belvoir are on a 2022 P/E of 14 with a similar forecast drop in EPS coming. Both are companies with good long term growth prospects.
If Belvoir can beat again, or if they hit forecasts but the market really does take fright at a temporary drop in EPS, this could make Belvoir look pretty cheap, but at the current rating, the risk/reward looks finely balanced.
SRT Marine Systems (SRT.L) - Half Year Report
As usual, you know the current numbers are going to be bad when the summary doesn't mention anything about the bottom line:
The loss before tax comes in at a whopping £3.1m for the half-year, which is mainly due to £4.5m of admin expenses for the period.
SRT has three parts to its business: AIS Transceivers, primarily for the leisure boating market, GeoVS surveillance platform, and projects that deliver transceivers to national governments to maritime surveillance. It has been the last part of the business that has struggled since COVID:
Whilst much progress has been made, the timing of Covid delayed the expected conversion of multiple new system contracts as customers' attention was temporarily deviated.
However, they say things are about to change in this area:
Our systems business has done well to progress existing projects and £71m of new project contracts from our VSP pipeline are expected to commence during the second half, with the potential of follow on contracts thereafter.
Of course, not all this revenue will be booked in H2 even if these projects do start progressing. But this compares well to the £59m market cap. The big question is - can they afford to deliver this though?
Cash balances were £2.0m as at 30th September 2021
Which doesn't compare particularly favourable with a £9m annual admin expense and a transceivers business, that while growing, only generates about £3m in gross profit. They say that they have other sources of capital though - primarily upfront payments from systems customers:
During the second half we will receive further substantial payments from existing systems customers as well as the first payments from expected new contracts.
If they can get governments to pay upfront, this shows how vital these countries consider the systems to be (although clearly not as vital as covid response!) Plus they have access to loan notes:
I am pleased to report we have also increased the capacity of our non-dilutive flexible working capital loan note program by up to a further £10m.
These loan notes are not cheap though:
Other loans all relate to drawdowns on a £20 million secured loan note programme which has been arranged by LGB Corporate Finance and which is secured by a floating charge over the Group's assets. The loans have terms of up to 3 years and interest rates of 8-10%.
And they missed a covenant, which was waived. This meant that the loan note debt had to be classified as a current liability in the accounts and makes the current ratio appear much worse than reality. But still, this doesn't scream financial strength:
During the period, a covenant in relation to debt service cover was breached and a waiver from loan note holders was obtained shortly after the period end.
Working capital perhaps isn't too much of an issue if they receive upfront payments, since they also say:
As we have previously reported there are four specific projects worth an aggregate of £71m which we know are at their final stage before contracting and, based upon explicit information provide to us by the customers in question, we are confident that these will be signed and started during the second half.
They have very aggressive delivery timescales and we have therefore already purchased much of the standard SRT-MDA System equipment necessary to deliver the initial phases within the required timescales of the contract.
We struggle to see this in the balance sheet though, with inventories flat on the last year-end and down from a year ago. With inventory at £2.352m, this doesn't seem a lot of equipment to have pre-bought. The systems business is likely to have higher gross margins than the transceiver but still, this doesn't look like the balance sheet of a company about to deliver significant products in H2.
In general, shareholders should perhaps not be scared by lumpy revenue since, without the need to report returns annually to others, this can be a risk that individual investors are willing to bear in return for higher returns in the long term. However, in SRT’s case, we are amazed at their ability to claim to be at the cusp of significant revenue growth for over a decade without delivering any of it!
To be fair to them, this is exactly the sort of business whose sales cycle relies on meeting government officials in far-flung lands and therefore it is very easy to see that it will be severely disrupted by COVID. But in light of this, with omicron leading to a new round of severe travel restrictions, this doesn't seem to be the time to be buying a company that is selling into governments around the world.
That said, in normal times, Mark would be much happier holding SRT with the potential of large, if lumpy, sales of largely validated technology than betting on similar “growth companies” who have much less-proven technology and are on even higher ratings.
That’s it for a fairly quiet news week for the companies we follow. We are expecting a busier week next week. Have a great weekend!