Fewer companies we are interested in reported this week plus a higher number of personal commitments meant we didn’t cast a wider net. We still found time for some detailed analysis of the news we were interested in, though.
As usual, if you agree, disagree or simply want to have your say on UK stocks, join the debate on discord.
Next week also sees Mello Monday returning to our screens, with Mark presenting some educational content plus, hopefully, some further details of the in-person Mello event in London on 24-26th May. These are excellent events and well worth putting in your diary and booking the time off work now to be able to attend.
Small Caps
Thruvision (THRU.L) -Trading Update
At the H1 results, Leo’s concern was that FY forecasts included a lumpy US Customs order which seemed imprudent given that large public sector bodies can be quite bureaucratic. However:
As expected, the second half of our financial year [to 31st March] showed a significant improvement over the first, driven by a considerable increase in our Profit Protection revenues and further orderflow for US Customs and Border Protection (CBP).
Progressive put out a note in November forecasting £8m FY Revenue. Leo’s modelling from inventory build, signed contracts and commentary suggested a split in broad terms of £4m Profit Protection, £3m Customs and £1m from Other. So this is a beat:
Full year revenue is expected to be around £8.4 million (FY21: £6.7 million)
This is good, but it should be pointed out that this is only 5% above the pre-covid £8m in 2020. The difference is the split: back then it was just £1.4m Profit protection with exceptional orders from Customs totalling £4.1 Customs. The split is an essential measure of earnings quality. Customs orders have been very lumpy in the past, whereas Profit Protection tends to be smoother as they land new commercial customers who quickly expand if/when they see commercial benefits. Furthermore, profit protection has recently tended to come through in Q3 as customers invest in streamlining warehouses ahead of peak trading periods. This reduces the risks of a last-minute FY earnings miss.
Full year Profit Protection revenue performance was very strong, increasing more than 70% over the prior year.
FY 2021 profit protection revenue has previously been given as £2.0m so this implies £3.5m, which is a slight miss on Leo’s model. From his notes, it is in line with his forecast after the October trading update when they said "in October alone, sales are to expected to exceed those of the entire the first half as our customers prepare for Christmas trading". However, it looks like Leo was overoptimistic due to the inventory build in the H1 results. Warehouse operators are very cautious about making changes in the run-up to peak trading periods, and with Black Friday bringing this forward in the UK in recent years it is a testament to the confidence in Thruvision that they would even make changes in October. It was just unrealistic to think this would continue into November.
Much of the commentary around retailers is already known:
We received a significant order from Tesco in our second half and added 3 further new profit protection customers including our first major European customer, Zalando. We were also very pleased with the level of follow-on orders from customers who made their initial purchases in FY21...
In the US, our strengthened Profit Protection team secured an initial order from Republic National Distributing Company (RNDC), one of the US's largest alcohol distributors operating across 38 states. Given our strengthening sales pipeline and the very evident size of market opportunity in the US, we will continue to actively pursue growth here.
However, it is important to emphasise that many of these prospects are still at the "land" stage, with plenty of runway left to "expand". In particular, CEVA is massive.
So, ignoring any earlier over-optimism, 70% growth year-on-year, on a comparable period is excellent. And strong momentum is implied as they further comment in the outlook statement:
...Profit Protection where increasing traction in the US and Europe means we are very positive about the Group's prospects
But the real story today in the short term is customs. It looks like this is where the 5% beat came from and that the momentum is continuing:
As reported in our Interim Results in November, we supported US CBP in deploying its existing units to the Southern Border to enable it to manage the very high levels of migration there. This close engagement has proven the significant value our solution provides, both in terms of actual seizures of drugs and cash, and the very positive feedback from front-line officers. As a result, we received material orders in the second half to start the process of upgrading CBP's existing 8-channel cameras to the latest, 16-channel model, a process that will extend into FY23. At the very end of our financial year CBP publicly announced procurement plans to acquire significant numbers of additional "passive body scanners" during 2022 and beyond and this gives us confidence that further orders will follow in the coming months.
That 5% full-year revenue beat translates to approximately a 15% beat in H2 customs, assuming revenue protection was in line. One of the issues with Thruvision is that they sell capital goods that are subject to deferrals or even cancellations of investment decisions. In contrast, recurring revenue businesses have much smoother and more predictable revenues and rightly demand a premium.
Furthermore, revenues will fall once the addressed market is saturated. In profit protection, the established trends of existing customers expanding their fleet and knowledge of how many warehouses they have mitigates this. But another source of recurring revenues across all customers is the replacement cycle as improved products come along. Therefore confirmation that a major customer is upgrading from 8 to 16 channels is particularly good news.
As well as profit protection and customs, the company continues to target aviation. At one point this was seen as by far the largest possible market, but extreme inertia and likely lobbying by incumbents has stalled progress for many years even pre-covid. They have quite rightly put more focus on other unregulated areas. Indeed, their strategy here should probably be to just maintain a profile with a view to licensing their technology or getting taken over.
As a result of this update, Leo has upgraded his 2023 percentage growth forecasts for customs to 15% on top of a higher base. He maintains a 45% forecast for profit protection on a lower-than-expected base. The net result is £11.7m revenue for 2023, up slightly from his previous forecast. He continues to see a small EPS loss.
Although he expects to see profits in 2024, the company continues to be loss-making until then and so the cash situation is important:
our cash balance has increased since the half year to £5.5 million on 31 March 2022 (30 September 2021: £4.1 million; 31 March 2021: £7.3 million).
Of course, cash was expected to improve as they were explicit about the inventory build. However, you can see there has still been a £2m cash burn in a year and that large working capital swings have happened in the past and so may happen in the future. Consistently low current liabilities, leading to a high current ratio reassure here. The main issue is high levels of inventory, but of course, this is a positive for profits in an inflationary environment and inventory turn might be expected to improve as they grow. Receivables have also swung around a lot, but these should be financeable if required, potentially at low cost via export credits. In the last two periods, trade receivables were particularly low by historical standards, suggesting possible off-balance-sheet receivables financing in the form of non-recourse loans. Leo scanned the last annual report and found no details of this though.
Cash performance is in line with Leo’s profit forecasts, but still, cash levels are getting to the "not ideal" stage where the wrong kind of problem or a large order could cause problems. We’ll be looking closely at the balance sheet with the FY results. As ever, the risk is having to raise money from a position of weakness at a low share price. 30th September 2022 should be the low point on cash, so if they get past that I'll be a bit more relaxed.
Progressive have updated their note. Their newly introduced FY 2023 forecast is below Leo’s. They have usefully calculated EV/EBITDA as 17541.3x - the decimal point perhaps being unnecessary in this case!!
They see £1m further cash burn down to £4.5m. The end of 23H1 not the end of 22FY will likely be the low point, so this is indeed looking a little tight.
Beeks Financial (BKS.L) - Placing
When we looked at Beeks’ interim results two weeks ago we flagged that this was one of the worst balance sheets we had seen in a while and suggested that they needed a placing to rebuild it. We received a certain amount of pushback given that the management appeared to be indicating that they had funding options in the way of increased debt or customer pre-payments. We remained sceptical, however, since the company had been talking about customer pre-payments for a number of years with no obvious tangible progress on this front. We were right to be sceptical it seems, since this week the placing arrived:
…announces its intention to conduct a fundraising to raise gross proceeds of approximately £15 million through a placing to new and existing institutional investors
£15m is a relatively large raise and was conducted by a bookbuild. On top of this there was a retail offering:
In conjunction with the New Share Placing, a retail offer of new Ordinary Shares at the Issue Price will be made by the Company via PrimaryBid to provide retail investors with an opportunity to participate in the equity fundraise.
This seemed a particularly poor deal to us since our understanding is that retail investors had to commit to a fundraise where they had no ability to control the price that they received the shares. This was made worse by the use of the retail proceeds:
In the event of suitable oversubscriptions, the Company has been notified by Gordon McArthur, Chief Executive Officer of the Company, that he would sell up to approximately £2.8 million worth of existing Ordinary Shares at the Issue Price.
House broker Canaccord has always been able to sell the story here so it isn’t completely surprising that they got this away at a minimal discount:
The Company has raised total gross proceeds of approximately £15 million at a price of 165 pence per Ordinary Share (the "Issue Price") through the aggregate issuance of 9,090,910 New Ordinary Shares, comprising 8,787,879 Placing Shares and 303,031 PrimaryBid Shares. In addition, the Vendor has sold 1,696,970 Sale Shares at the same Issue Price to raise gross sale proceeds of approximately £2.8 million.
But note that the intended £15m gross placing had to be made up partially by the Primary Bid Offering, so when the company say:
The Fundraising was significantly oversubscribed.
This is true, but since this is a bookbuild, it was potentially not oversubscribed by institutions at the 165p placing price. This book build is a clever way of doing the raise, however, since the “blank cheque” that retail investors had written via PrimaryBid forced the institutions that had bid at 165p to take that level whereas if the bookbuild had cleared the full £15m from institutional investors it would presumably be at a lower figure. And then the management sales get to through at the same higher level.
The size of the “blank cheque” retail investor support bodes well for future market conditions. The brokers must be pleased that the risk appetite among retail investors and smaller institutions is back.
With the share price at 175p and now 63m shares in issue, the £110m market cap still compares unfavourably with their forecast £2.2m net profit. The company needs to demonstrate that they are on the cusp of very significant growth in EPS to justify even the current rating let alone a higher share price.
The problem, as Mark sees it, is not the ability to generate revenue growth, but the capital intensity of the business. It is easy to win contracts and grow revenue if you offer to pay upfront for a lot of capex that a customer would normally have to fund themselves. This is similar to the Ocado model, which has seen no shortage of capital-constrained businesses wanting to sign long-term ARR contracts as long as Ocado funds all their large upfront capital costs. As Ocado shows, while equity holders are willing to fund this capex, the growth can continue indefinitely. This is effectively an arbitrage between the high cost of capital of the customer and the continued low cost of equity of the highly-rated supplier. Of course, by investing in such a business, by definition, the equity holder is providing capital at low expected rates of return.
CMC Markets (CMCX.L) - Trading Update
Yes, we know, CMC Markets isn’t really a small cap anymore! However, we follow it since its financials are relatively easy to model, and we have direct firsthand experience of some of the drivers of its success i.e. the state of financial markets. We tend not to invest in larger companies since it is more difficult to analyse a larger business and there is a larger analyst following making an analytical edge harder to come by too. With CMC markets, however, we are not sure these challenges apply, and there have been some market dynamics that have made this a particularly interesting period to be following the company.
The company have clearly felt recently that the market undervalues their business at the moment. They have been investing heavily into platform development to launch a new unleveraged trading platform. We calculate that if they weren’t doing this investment then they would probably be reporting double their current EPS. There is no guarantee that this investment pays off, of course, but we can see why the company have implemented a share buyback, and attempted to highlight the value of this development in recent announcements. This signalling had been a partial success with the share price rising above £2.90 last week.
However, on the 31st March, broker Canaccord published a sell note out, cutting their price target from 463p to 257p on the back of cutting 23 and 24 EPS to 8% and 25% below consensus. For mid-caps broker changes can have a disproportionate effect - it seems that investors that can move prices in this space perhaps don’t have large research teams of their own and hence rely on these third-party opinions. The market then potentially over-reacted with the share price dropping close to £2.30 over the next week.
Our research showed that they still were potential beneficiaries of increased current market volatility, although with a lot of uncertainty to the extent of that:
It is in this context that Friday’s trading update arrived:
Q4 performance drives net operating income to the top end of guidance
They are now reporting £280m net operating income, literally at the top of the £250-280m range that they've been quoting since September. Client income retention in H2 is similar to the 80% of H1 and unsurprisingly far lower than 2020 and 2021. Assuming rebates and levies remained at a similar proportion of gross leveraged client income, this suggests that there has been no bounce back in "risk management gains/losses" despite the recent volatility. This level, therefore, appears to be the new normal going forward.
This means the heavy lifting is from gross client income i.e. recruiting, retaining and maintaining high engagement from customers. Here they have done very well in H2 with income up 27% vs H1 and flat YoY against very strong comparables. On customer numbers they say:
Active monthly trading client numbers continue to remain at similar levels as reported earlier in the year.
This means that revenue per active client is actually at 21H1 levels and up significantly on 22H1.
In contrast, stockbroking revenue has been disappointing. You would expect a “land and expand” type effect to be present as they win net new customers and existing ones add increasing amounts of money. But either this has not been happening, or trading volumes have been down significantly half-on-half because stockbroking revenue is actually down overly slightly on H1. The commentary says that customers/assets are at record levels but fails to say whether they have grown materially or not. Expansion into the UK should help, where they say:
CMC Invest, the UK non-leveraged platform already launched internally. Full market release set for mid-2022. The platform is ahead of schedule and on budget.
We are slightly disappointed that they were not able to launch this prior to the start of the new tax year, which is where a lot of new accounts are opened.
Operating costs for FY 2022, excluding variable remuneration, are expected to be approximately £173 million (FY 2021: £168 million). The increase primarily reflects higher personnel costs to deliver strategic objectives.
Costs are slightly below our expectations, so good news. However, they are flagging further increases in 2023:
FY 2023 will be another year of investment in these strategic initiatives, which aim to deliver future revenue growth. In addition to the incremental investment, FY 2023 costs are expected to grow with higher marketing spend together with further investment in personnel.
As variable remuneration figures have not been given and have been highly variable in the last several periods, it is unfortunately not possible to accurately estimate profits from the figures provided today, but to us it looks like a beat, perhaps coming in at above 25p EPS vs a 19.9p consensus on Stockopedia.
In light of this, the initial market reaction this morning looked wrong, with the price only up a couple of per cent. Especially since they had already sold off massively on the Canaccord sell note a week or so ago. Those who were able to run their own numbers on this perhaps got a bargain. Since then, the price action has been more favourable, advancing above £2.60, presumably as the brokers have updated their models and this has been slowly communicated to clients. With a P/E of around 10 in a period of exceptional fully-expensed investment, this still looks cheap.
The downside is that they are doing all this investment, with more to come, yet the demand for the new unleveraged products is unproven, as is the profitability of the new clients they will gain. Our understanding is that the likes of Hargreaves Landsdown and AJ Bell make a lot of their money from the customers who buy and hold expensive funds, not clients who trade a lot. CMC may well be able to attract a lot of clients who value the robustness of the platform and the ability to trade during periods of market dislocation, however. Anecdotally, Hargreaves Landsdown has struggled with uptime during periods of market volatility, and even IG Index has been slow at times, whereas CMC Markets don’t appear to have suffered from these issues. Whether this is enough to dislodge the incumbents from the pedestals remains to be seen.
Lookers (LOOK.L) - Preliminary Results
This is a somewhat negative update for Lookers with the word “uncertain” being used eight times.
The business and our customers face some uncertainties in 2022. Trading in Q1 has been strong despite new vehicle supply remaining tight. The current crisis in Ukraine and significant cost of living increases will put pressure on consumer sentiment and disposable incomes.
Headwinds caused by high levels of inflation in areas such as utilities, mean the Group will experience material cost increases. Wider inflationary pressures and the macro-economic impacts of the crisis in the Ukraine add significant uncertainty to the trading conditions faced by the Group.
We are mindful of the continuing COVID-19 pandemic, the deeply concerning current crisis in Ukraine, and significant cost of living increases putting pressure on disposable incomes, all of which mean some uncertainty for the business and our customers over the coming months. New car supply challenges also remain an issue and one that has continued into the current financial year.
As described elsewhere in this statement, the impact of the ongoing semiconductor shortage, wider inflationary pressures and the macro-economic impacts of the crisis in Ukraine also add significant uncertainty.
Secondly:
In January the Board was delighted to welcome Constellation Automotive Group as a significant shareholder in the Group. Their investment endorses the Board's view that the Group has excellent prospects and is significantly undervalued. The 19.9% holding was purchased from Tony Bramall and family, who remain shareholders in the Group, and the Board would like to thank Tony for his years of service as a Director and for his support for Lookers.
This serves as a reminder that the situation has remained stable for a while here and there are no signs of a contested takeover battle. It is also consistent with the note that Zeus put out on the 2nd of February that said:
Constellation Automotive’s recent purchase of a 19.9% stake in Lookers should be seen as a financial investment for now, with Constellation reportedly being supportive of Lookers’ current strategy and senior leadership. In our view, this is a shrewd move by Constellation to acquire a blocking stake in an undervalued business with exciting growth prospects.
Of course, all of the above factors were already known and did cause the share price to fall back as low as 75p in early March, but it then recovered:
No new broker updates were available premarket, and the shares actually opened up slightly, perhaps picking up on the strong Q1 trading and the re-iteration of property values. Of course, only the former is new news:
Trading in Q1 has been strong despite new vehicle supply remaining tight.
As frequently explained, used car profits should be strong in these conditions.
The momentum of last year has continued into trading in the first quarter of 2022. Robust consumer demand and supply constraints on both new and used vehicles have seen gross margins being maintained at 2021 levels. This, combined with a tight control on costs sees the business ahead of 2021 on an underlying profit basis.
That clearly only refers to Q1, but perhaps investors are extrapolating across the whole year? Given that normalised EPS was expected to fall from 17.4p to 10.7p this would lead to a big beat although we have long been arguing that forecasts were looking too low in the face of ongoing strong performance across the sector.
Also, on the face of it, this week’s results appear to be a beat at approximately adjusted 20p EPS on both a basic and fully-diluted basis. However, the market subsequently started to focus more on the outlook and the shares started to sell off, dropping to 86p on Friday. In light of this, it bears digging a bit more into this statement:
On 25 March 2022 the Group completed a sale and leaseback of its property at York Road, Battersea. The sale generated cash proceeds of £28m before costs, resulting in a gain on sale of c.£6m. The Group has signed a 20-year lease on the property which is occupied by its Volkswagen Battersea franchise. The Group now holds property assets with a net book value of c.£290m (74p per share).
They said this before, but the trouble with that is property assets include long-term leases and they failed to take the opportunity to say "freehold property". But as we now have full relatively recent accounts it may be possible to unpick. Note 10 says freehold property was £227.2m at 31st December 2021, with leasehold accounting for a further £76.3m, with £4.7m under construction. No purchases have been announced, so freehold is presumably now £227m - 28 + 6 = £205m.
The leasehold property in PP&E has of course been bought and paid for (no ongoing liability), but it is being depreciated over the term. The charge of £2.9m suggests 26 years, but presumably, NPV effects also come into play.
20-year leases are a risk since we think the dealer landscape will look a lot different in 4-5 years and may even be largely gone in the current format after a decade. That doesn't mean there won't be a place for current franchise dealers to work as agents, albeit in smaller numbers.
We think there is every indication that order backlogs, pent-up demand and further supply disruption mean that the motor dealers will enjoy another 6 months in the sun. Markets will at times look through that and at other times focus on the immediate cash flow and buybacks presenting opportunities for investors. In the long term, we think the franchise model is probably dead, which is why we place such emphasis on short-term profits and freehold asset values. And hence why Vertu remains our pick in this sector.
However, Vertu has not been immune to the read-across from the Lookers results, dropping 11% this week as well. There are a few differences with Vertu:
* While Lookers follow the standard industry practice of not including vehicle stocking loans (of £248.1m) in net debt, Vertu does include vehicle stocking in debt. We believe they do this because they think it is the right treatment and doing otherwise risks misleading both investors and themselves when making capital allocation decisions.
* Vertu’s year-end is 28th February rather than 31st December.
* As at 28th February 2021 Vertu had £229m of freeholds. This is similar to Lookers in monetary terms, but is 83% of EV (including lease liabilities) versus 60% for Lookers. Given additions at Vertu and disposals at Lookers, the figures will be closer to 100% and 50% now.
The last trading update from Vertu was on 2nd March (post-year-end) when they said:
Without doubt, FY22 has seen extraordinary trading conditions which have driven the exceptional financial performance. Whilst the outlook remains uncertain for FY23, it is clear that these highly favourable trading conditions are unlikely to recur. The FY23 financial outcome is likely to be some way below FY22, although we certainly expect performance to be well ahead of periods prior to FY22. As the year progresses, we will update the market accordingly. Significant increases in operating expenses such as payroll, energy and investment in digitalisation and related marketing are evident. In addition, rates and vehicle expenses are expected to normalise. The enhanced vehicle sales margins seen in FY22 are anticipated to continue but at a reduced augmented rate as supply in new and used cars normalises in the year ahead. Considerable uncertainties remain over new vehicle supply and the timing of market normalisation. In addition, consumer confidence will be critical in the months ahead as cost-of-living inflationary rises become apparent and geopolitical uncertainty arises. These matters could impact vehicle sales.
There's no reason to believe that Vertu trading will be much different from Lookers, and so it appears that highly favourable trading conditions have in fact recurred for the first month of their FY 2023. Lookers also suggest that consumer confidence issues have not yet hit and higher costs are not yet sufficient to have hit profits. So a complex situation, but one that Vertu perhaps looks better positioned to navigate.
Have a great weekend!