Small Cap Value Report (Mon 14 Oct 2019) - CBOX, SYS1, RNO, YGEN, SPA

Good morning, it’s Paul here, I’m on duty this week.

Estimated completion time today is 4pm. So please check back later for the completed report. Update at 16:40 – today’s report is now finished.

I see there is another takeover bid of a UK-listed mid-cap, Sophos (LON:SOPH) – a cybersecurity group. It’s being bought (for cash, in a recommended [by its Directors] deal) at a 37% premium, for about £2.84bn.  It seems as if mid-caps is the most interesting area for takeover bids. Although Sophos looks very expensive, so the bidder must have been attracted by something that’s not obvious from the figures.

Cake Box Holdings (LON:CBOX)

Share price: 165p  (down 3% today, at 11:43)
No. shares: 40.0m
Market cap: £66.0m

Half-year trading update

Cake Box Holdings plc, the specialist retailer of fresh cream cakes, today announces its half year trading update for the six months ended 30 September 2019.

These cakes are suitable for vegetarians, but not vegans, because they use cream as a topping. I believe the egg-free cakes are suitable for Sikhs amp; Muslims, some of whom apparently don’t eat eggs. All in all, I’m surprised that Cake Box shops are economically viable, given that the market must be fairly small amp; niche.

It’s an in line update today;

The Group has continued to grow strongly during the period, both through its existing estate and the addition of new stores and expects to report revenues for the period up c.6% to c.£8.8m compared to the same period last year (HY18: £8.3m).

Within this, like-for-like sales* in existing franchise stores grew by 6.9%. As a result, the Board is confident that the Group will meet current market expectations for the year.

Something above strikes me as rather odd. H1 revenues are up 6%, and LFL sales in existing stores are up more, 6.9%. This would normally imply that there must have been a small contraction in the number of stores. Yet it refers to new stores having been opened. No mention is made of closures, so I wonder if some stores have closed, offsetting new openings?

Having a think about this, I reckon it could be something to do with the franchise model which means that revenues are generated from selling supplies to existing franchisees, and also for selling new franchises (at £125k+ VAT each).

I did a thorough review of Cake Box’s figures here on 24 June 2019 (there are 2 sections on CBOX, so you need to scroll down to the larger, second section). I came to the conclusion that a large part of its profits probably came from selling 24 new franchises per year, at a high margin probably (not stated). This is the big problem with investing in a franchise business that’s doing a rapid roll-out – it makes unusually high profits from selling each franchise. Then the profits slump when the next recession hits, as highly profitable new franchise sales dry up.

New store openings (franchised) are on track;

Nine new franchise stores were added during the period, bringing the total number of stores to 122. Recent store openings included Dartford, Derby Central and Slough Central.  In addition, three new franchise stores are expected to open imminently and post the period end. The new store pipeline remains strong and the Group is on track to achieve its store opening target for the year.

I think the first line above answers my question about why total revenues were only up 6% in H1, despite LFL sales being up 6.9%. It looks as if 3 new stores slipped past the H1 period end, and the profit on the franchise sale will be booked in H2. That’s confirmed in the CEO comments.

My opinion – I’d like the company to clearly disclose how much profit is generated from new franchise sales, and how much from its existing business. As this crucial information is not disclosed, it’s not possible to make a meaningful valuation on the shares – because a potentially large (I reckon it could be as much as half) part of profits could be coming from new franchise sales. That type of profit needs to be valued on a lower multiple than ongoing profit, because it could so easily dry up.

I am impressed with the LFL sales in existing franchise stores of +6.9% – that’s very impressive in the current depressed High Street retail environment, and is no doubt helped by the fact that customers can order online, and collect in-store.  Existing retailers really do need a strong online offering to survive, not just relying on declining passing trade.

To be generating +6.9% sales, these stores must be delivering a product that customers like, and return for. So maybe my concerns about where profits come from could be blinding me to a decent underlying business?

It’s interesting to note that the only Stockopedia screen which CBOX falls within, is a shorting screen;

I must look into this screen, as Montier’s books are excellent.

Although looking through the list of stocks that qualify for this screen currently, there are some good companies in there, such as XP Power, Next.

Overall, I’ve got my doubts about CakeBox, hence wouldn’t invest in it myself.

Looking at the chart, I see that this share has (so far) weathered the storm in small caps very well. Mind you, this might be due to lack of liquidity in the shares. When so few shares are traded, does the share price really tell us anything, given that buyers amp; sellers in size are not able to transact at all?

Share price: 187p (up 3% today, at 12:48)
No. shares: 12.58m
Market cap: £23.5m

Trading update

System1, the marketing services group, issues the following update on trading for the six months to end-September 2019.  The Company will announce its interim results on 7 November 2019.

Preamble – As you can see from the 3-year chart below, this share previously looked like the best thing since sliced bread walked through the door. But its bumper profits in 2017 turned out to be a one-off. A change of year end looks to have boosted the statutory figures too. This is a useful reminder of how hard growth companies fall, when they disappoint.

I think it’s also a reminder that broker forecasts can be far too optimistic sometimes, especially when the economy is slowing. Stockopedia is showing a forward PER of only 6.5 for this company, which is the market clearly indicating that it has doubts over the company’s ability to achieve forecasts.

Trading update – this reads quite well, I think;

Normalised H1 Pre-tax profits, excluding AdRatings and share based payments, are expected to be some £2.4m, approximately 24% higher than in the comparable period.

However, the problem is how do we interpret this? The company is trying to steer us towards treating AdRatings (its loss-making start-up) as if the losses didn’t exist. That seems to be stretching credibility, in my view.

I like that the company separately discloses the AdRatings losses, but ignoring those losses altogether, is not what I would call “normalised”. I suppose the idea is that if AdRatings fails to take off, then they could just shut it down, eliminating the losses.

Thinking it through, possibly the best way to value the business would be on a variety of scenarios, as follows;

Bull case – put the core business’s earnings on a rating of say 15 times, then add on a separate valuation for AdRatings, assuming it might become an additional earnings stream in future.

Medium case – Value the core business on 10 times earnings (to reflect the slowing economy), and value Ad Ratings at nothing.

Bear case – Value the core business on 5 times earnings, assuming that a recession would cause future earnings to fall. Value AdRatings at say minus c.£5m on the basis that it’s going to consume more cash, and then have to be shut down in say 2 years’ time.

It’s a really good idea generally, with all investments, to think through all 3 potential scenarios, as above. Most of us probably think too much about the bull case, and tend to block out the risks if the bear case pans out. That’s why many of us tend not to sell investments that are failing, in that we remain wedded to the bull case for too long after it’s become obvious that the bull case is not happening in reality.

I wish broker research would adopt the approach of 3 scenarios, to show the range of possible outcomes.

AdRatings – the group spent £1.2m “investing” in its AdRatings business. This monitors TV advertising, in the UK amp; USA, and allows subscription clients to access the data on which ads are most effective. Therefore money has to be spent up-front to build the database, before subscriptions build to (hopefully) enough to cover the costs, and move it into profit.

Therefore, it’s a considerable speculative element to this share – whether AdRatings will work commercially in the future, or not. Although I like the fact that the losses are comfortably covered by core business profits. So even if AdRatings doesn’t work, it won’t pull down the whole group.

Balance sheet – is strong.

Note that last year £923k of the spending on AdRatings was capitalised. Personally, I would write that off, as it’s speculative at this stage.

The cash pile is still comfortable;

Despite continued relatively high levels of investment and the payment of the 2018/19 final dividend during H1, the period-end cash balance was £4.1m, compared with a cash balance of £4.3m at the end of March 2019.  System1 has no debt.

I’m much happier with speculative projects like AdRatings being undertaken, where a company has plenty of cash, and a core business that’s generating more cash than the speculative project is burning. So a big tick in the box here.

My opinion – this share is difficult to value.

What about its activities? I’m certainly no expert on marketing, so am not the best person to judge. My background reading makes me feel that they’re either rather bonkers, or they’re onto something good – as regards measuring amp; targeting advertisements based on people being emotional, rather than rational.

This is a very interesting theme. I certainly understand the world amp; the people in it a lot better, since the penny dropped that people are not at all rational. Most decision-making is done simplistically, emotionally, and quickly. Hence this company’s name, which references the system 1 (fast, emotional, instinctive) brain, and the system 2 (slower, but more rational).

It’s interesting that SYS1 mentions the meerkat adverts in its narrative today, and the Felix cat. These devices are well known, as being attempts to connect emotionally with consumers. Bizarrely, they apparently do actually work.

I like the meerkat adverts, as they’re taking an extremely boring, stressful amp; repetitive subject matter (switching utility companies), and making it a bit more fun. Whereas competitors offer highly irritating, repetitive, ads with that fat opera singer with a huge moustache, or the other company that gets Toast of London to pretend that its product will make us caaaaaaaaalm.

It would be interesting to measure which approach gets the best results, which is exactly what SYS1 does.

Overall then, it seems to me that there could be something interesting here. When funds permit, I’m tempted to pick up a small, opening sized position in this share. The next step in my research process is to talk to some friends who are marketing experts. If they think it looks good too, then that might tempt me to buy some more.

On the downside, with the economy apparently slowing, and well-known negative global macro problems, why would anyone want to buying into a marketing company of any kind right now?

Tricky one this, it definitely needs more thought.

Stockopedia quite likes it;

Share price: 21.4p (down 4% today, at 14:14)
No. shares: 225.4m
Market cap: £48.2m

Trading update

Renold, a leading international supplier of industrial chains and related power transmission products, today issues a period end trading update covering the six months ended 30 September 2019 (the ‘period’) ahead of announcing interim results on 13 November 2019.

Preamble – the big problem with this share is the big pension deficit, which consumes a lot of cash that could otherwise be used for dividends.

Another problem, was the disclosure on 9 July 2019 here that they had discovered accounting irregularities within the gears division. Whilst apparently small, at only £0.9m for FY 03/2019, investors understandably ran for the hills, causing the share price to slump (it’s not recovered yet). Recent history of accounting problems at listed companies has been very ominous, with problems often far worse than initially thought and/or the bank being spooked, resulting in an emergency fundraising at a low price  (e.g. Patisserie Valerie, Staffline, Conviviality).

Maybe that attitude of sell now, at any price, at the first sign of trouble, could create buying opportunities, if the problems do turn out to be small, and ring-fenced at one subsidiary? Who knows, each case is different – therefore there is no one-size-fits-all golden rule for investors. That would be too easy!

Completion of investigation – this announcement came out on 27 Aug 2019, and seems to draw a line under the accounting misstatement – which turns out to have been small, and apparently at a local level within a subsidiary. A table of the small adjustments to the last 3 years results is given. This should have reassured the stock market, but it hasn’t, with the share price in the doldrums still. Maybe this could be a buying opportunity, with that mismatch between what actually happened, and what the share price has done? I’m starting to get interested!

Trading update today – is in line;

The ongoing focus on operational efficiency is helping to offset the impact of a challenging market environment and, assuming no significant further deterioration in trading conditions, the Group remains on course to deliver a result for the full-year in line with the Board’s expectations.

That’s better than I was expecting.

Order intake – down quite sharply though, suggesting storm clouds ahead maybe? Particularly that international data (e.g. USA, Germany) seems to be suggesting an industrial recession might be starting;

Cost-cutting – I like this bit, as it sounds like profits can be protected to a certain extent, by reducing costs;

Despite the backdrop, the Group continues to see the benefits of improved operational efficiency as a result of its strategic initiatives and ongoing investment.

In addition, proactive cost action is underway to align the business with demand levels and help mitigate the impact of market weakness.

Outlook - this is quite encouraging, as it suggests the group has prepared for a downturn, hence is being (hopefully) realistic in its outlook;

Recent order intake trends suggest that current market weakness will continue into the second half of the year. However, as previously indicated, the Group expects the second half to benefit from an increasing contribution from the ongoing ramp-up in efficiency at the new Chinese factory, together with further cost reduction activities across the Group resulting in a more equal weighting between the first and second halves of the year.

As a result, and assuming no significant further deterioration in trading conditions, the Group remains on track to deliver an overall result for the full year in line with the Board’s expectations.

Overall, this gives me the impression of a management team that is ahead of the curve, and in control of the situation, as demand reduces.

The big question is clearly how much more demand is likely to reduce by?

Also, given the US/China situation, is it wise to have a supply chain based in China? I think Western companies generally have been incredibly short-sighted by allowing China to gain so much power over supply chains, given that it’s a totalitarian dictatorship, in case we’d forgotten, and a clear adversary of the West, blatantly stealing IP and launching prolific cyber attacks.

I see it moved to AIM in Jun 2019, which might have caused some dislocation, with perhaps some Instis becoming forced sellers?

Dividends – there aren’t any.

A deteriorating outlook presumably means that the re-introduction of divis is less likely?

Cashflow instead is going into the pension fund – about £4.5m last year, plus £0.9m in admin costs. To put that into perspective, that would have funded an 11% dividend yield. Instead, shareholders get nothing.

My opinion – as mentioned before, it’s the scale of the pension deficit that concerns me here. Pension deficits are manageable though, and if you just see it as a long-term drag on cashflow, that restricts dividends, and then adjust the value of the share accordingly, it wouldn’t rule out my buying shares in this company.

Almost regardless of valuation, it feels like the wrong time to be buying into an industrials company, when all the macro news seems to be negative about that sector.

On the upside, Renold seems to be well run, generates a good operating profit margin, and management has seemingly taken the right steps to reduce costs and cope with a downturn.

Tricky one, but on balance I’ll probably steer clear.

A couple of quick comments to finish off;

Yourgene Health (LON:YGEN) – an eye-catching H1 trading update today, with revenues up 98%, helped by an acquisition. Organic growth was still very impressive, at +56% – in line with management expectations.

I would have liked to see some comments on profits, as this company has been historically loss-making.

… We remain on track to hit our ambitious growth targets for the enlarged Group and to meet market expectations for the full year.”

Consensus forecast on Stockopedia is showing a considerable narrowing of full year losses to only -£0.5m post tax. Rapid growth amp; nearing breakeven, is a potentially good combination.

It might be worth a look for people who understand this type of business. Although I see the £68m market cap already bakes in considerable upside potential.

Earlier this year, a mutual friend introduced me to Adam Reynolds, the Chairman of this (and other) companies, and he was absolutely raving about the potential for this particular share. Personally I’m not interested in loss-making, medical companies, as I’ve always lost money on them in the past.

1Spatial (LON:SPA) – I’ve had a look through its interim accounts, but gradually lost interest. Cashflow seems poor, with the adjusted EBITDA not translating into cash. There are lots of adjustments, plus an acquisition, all leaving me with the general impression that it’s not worth spending any more time trying to work out why the market values this group at £37m.

The outlook statement is reasonably good, saying that it’s on track to meet full year market expectations.

I’ll leave it there for today.

See you tomorrow. As regulars know, I prefer writing in the afternoon, so if you work on the basis that my reports this week will be complete by roughly around the close of market hours. I publish the sections individually, so that nothing vanishes if the IT gremlins strike.

Best wishes, Paul.

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