Small Cap Value Report (Thu 3 Sept 2020) - RBG, HEAD, MPAC

Good morning, it’s Paul here with the SCVR for Thursday.

Estimated timings – I need a lunch break now (at 12:57), but will get a new section on MPAC up by 5pm. Update at 17:05 – sorry it took so long, but today’s report is now finished.

Results webinars – I’ve watched 2 webinars/conf calls today, which eats up a lot of time, but is very useful in expanding my understanding of businesses that are already in my “looks interesting” tray;

Mpac (LON:MPAC) is 11am, courtesy of Equity Development, signup link here.

Headlam (LON:HEAD) (I hold) is a conf call, not a webinar, sorry I got that wrong earlier. I’ll feed back anything interesting to you.

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Companies being covered in today’s report are;

Revolution Bars (LON:RBG) – (I hold) – trading update on re-opening of its bars

Headlam (LON:HEAD) – (I hold) – Interim results, 6m to 30 June 2020

Mpac (LON:MPAC) – Half year results

That might be all there’s time for today, since it will involve me looking at 2 webinars, in addition to going through the results RNSs. But as always, do flag up in the comments below, if there’s something really good that I might have missed.

If you’re new here, just FYI, I try to focus my time on shares that seem to have good potential upside, not on poorer quality, or over-priced things. After all, my main activity is investing my own money, with report writing here really being a sideline to recycle research that I would be doing normally anyway.

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US markets – euphoria

I see the relentless rally in US markets is continuing, with the most remarkable V-shaped rebound in markets that I’ve ever seen. It seems obvious to me that the markets across the pond seem to be in something of a speculative frenzy. Valuations generally don’t make sense to me, and I’m braced for a big correction at some point. When significant parts of the market begin to completely disregard valuation, and instead valuations of growth companies are based on their story alone, then you know you’re close to the end of the bull run. It’s 1999 all over again, in my view. Whilst acknowledging that the top tech stocks are remarkable businesses, it’s the next tier down that worry me in valuation terms.

UK small caps

These seem a lot more grounded, and UK small caps in general look priced about right to me. Valuations of UK small caps have correctly reflected the decent economic recovery that is underway. Many companies I look at each day, are showing strong rebounds in current trading, hence that strengthens the case for disregarding the covid period, and valuing companies on the level of business they are getting back to. Hence PERs should be applied to likely 2021 earnings, not 2020 earnings.

Second wave of covid?

Possibly, but the economic risk seems to be receding, because treatments are getting better, and the death rate is now very low. This is because vulnerable people are locked down, and most healthy people are adopting social distancing. The combination seems to work well. Cases may be rising again (more testing?), but daily deaths are now just in high single digits, which is statistically little more than a rounding error, and more damage is being done with lockdown measures. Of course, as I’ve experienced twice this year, every death is a tragedy to family amp; other loved ones.

This has always been a virus that overwhelmingly (over 99% according to data from PHE) kills sick amp; elderly people, not normal weight, healthy people. Therefore I feel the risk of another national lockdown is very low, now we understand covid better, and treatments have improved so much. I could be wrong of course, nobody can be sure – our job as investors is to weigh up probabilities, based on the facts we have, and you don’t have to be a medical expert to make a decent job of that. It’s not necessarily about having an effective vaccine any more. The death rate is now so low, that stringent lockdown measures cannot possibly be justified any more.

Overall, in strategy terms, I remain fully invested, and think there are still plenty of opportunities for UK small cap shares which have not properly recovered, despite trading gradually getting back to normal. So very much pockets of value around, that could be good purchases at current levels. It’s strange how UK investor sentiment is lagging so far behind US investor sentiment. As I always say, they can’t both be right.

Resumption of divis

I particularly like shares which have previously paid out good divis from strong cashflows, which have temporarily stopped paying divis. As those divis come back, then it makes sense that such shares would re-rate upwards, since income seekers are likely to be buying up shares that should once again become high yielders. Hence a good area to sniff around in, is resumption of divis being paid. We could lock in a strong future yield, and get a (say) 50% recovery in share price too, from current levels, with some overlooked smaller cap shares.

When the growth shares bubble pops, then value shares often recover nicely as money rotates from the frothy areas into the overlooked cheap shares.

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Share price: 14.5p ( pre market open)
No. shares: 125.0m
Market cap: £18.1m

(I hold)

Trading Update

Revolution Bars Group plc (“the Group”), the leading operator of premium bars trading across the UK under the Revolution and Revolucion de Cuba brands, is today providing a trading update for period since it commenced the reopening of its bars on 6 July 2020.

Bars have been re-opened on a phased basis. The specific problem RBG has, is that it previously made the bulk of profits from Fri amp; Sat late nights. That trading has reduced now, due to licensing restrictions (the bars have to shut at 11pm for now), and of course social distancing measures required, reducing capacity.

Most bars are now open again, or about to open.

Trading since re-opening;

4 weeks to 1 Aug 2020 LFL sales down 40% on last year (LY)

4 weeks to 29 Aug 2020 LFL sales down 22.5% on LY – boosted by EOTHO* scheme

Combine the above, and the 8 weeks to 29 Aug 2020 – LFL sales down 27.5% on last year (LY)

(* = Eat Out To Help Out – the Govt subsidy for Mon-Wed dining amp; soft drinks. This boosted Mon-Wed sales by +88.4% of LY. Due to its success, the company is extending this scheme at its own cost in Sept, and possibly further extend after that)

These figures are better than expectations given in the fundraising announcement, on 5 June 2020, which assumed a;

… base case scenario of venues reopening in August and delivering 55 per cent of prior year sales with only marginal improvement in September and October…

Rents – some progress seems to have been made here, with about half landlords being co-operative. One site in Liverpool has been surrendered back to the landlord.

Remember the company had already done amp; announced a deal to sort out its onerous leases, by surrenders of the non-viable sites, and re-gears on the viable ones. That reduces future cash outgoing by about £1m p.a..

Costs -

The Group remains focused on reducing costs whilst trade is constrained by social distancing restrictions.

Remember that business rates (a substantial cost) is not being charged. Plus there are considerable costs associated with the late night trading (security guards, DJs, dancers, etc.) which are not currently required. Plus staffing rotas can be reduced by about 10%, I am told.

Outlook -

Overall, the Board’s expectations for the year ahead remain unchanged.

My opinion – the re-opening trading figures are reassuring, rather than good. I was worried that losing Fri amp; Sat late night trade could mean sales down 50% or more. So being down 27.5%, on a reduced cost base, should make it better to continue trading, than being closed and on furlough.

Management here are experienced, good, hands-on operators, who know what they’re doing. Hence it’s just a question of seeing if the business is able to adapt to new circumstances long enough, to survive into the post-covid boom that they’re likely to see next year.

It’s such a pity that covid happened, because this share would have been probably 120-150p by now, if covid hadn’t happened – the business was undergoing a good turnaround, with LFL sales turning positive, and profit beginning to rise. It was highly cash generative, and self-funding a refurbishment programme delivering good ROI.

I’ve looked closely at the bear arguments, and they’re just not accurate. I think people who never liked the share in the first place, like to invent reasons why the share has done so badly. When the truth is very simply – it’s covid that did the damage. Then of course a dilutive fundraising at 20p which now means we have an increase in share count from 50m to 125m, which limits the upside on the higher number of shares. Still, once we’re post-covid restrictions, then there’s no reason this couldn’t get to 50p with a bit of patience.

Debt should reduce over time, because add back the depreciation charges, and RBG would be cash generative even if trading at a loss on the Pamp;L.

Overall, given today’s reassuring news on trading, I think this is worth holding on for a recovery. It’s not a share I want to hold forever, but the current valuation could look very appealing to anyone looking at it from say 1 year in the future. The main risk is obvious – a serious covid resurgence in the autumn/winter, leading to bars being forced to close again.

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Share price: 306p (up lt;1%, at 10:12)
No. shares: 84.9m
Market cap: £259.8m

(I hold)

Interim Results

Headlam Group plc (LSE: HEAD), Europe’s leading floorcoverings distributor, today announces its interim results for the six months ended 30 June 2020 (the ‘Period’) and an update on current trading.

I’m not really interested in results covering the covid period, as it’s not representative of how businesses are likely to perform in future (which is what matters for valuation purposes). My main criteria for assessing covid period results are that;

1. Losses are not too bad, breakeven or a small profit is better, but I’m looking through any modest losses
2. The balance sheet amp; debt are robust enough to make a future equity fundraising unnecessary/unlikely
3. Current trading amp; outlook are positive, showing a decent recovery underway amp; likely to continue

If those boxes are ticked, then I’m interested in investing, if the valuation (based on reasonable forecasts for 2021) is sensible, or attractive.

Remember that in an economic recovery, broker forecasts are often too pessimistic, just as they are too optimistic going into a downturn. We don’t know at this stage what lingering economic effects there are likely to be from covid. It’s likely to vary from sector to sector, and depends very much on what action the Govt takes. Withdrawal of support amp; over-eager tax rises would conceivably shatter economic confidence, and be counter-productive if it pushes us into a prolonged recession.

I loved Rishi Sunak’s obviously pre-arranged “gaffe” of very prominently holding a memo with the key bits even highlighted for the press to catch with their zoom lenses, today. He’s way too clever to be that stupid, do they think we were born yesterday? Quite funny though! Sorry for straying into politics slightly, but I think Sunak is one of the few politicians that has emerged from this with credit – making fast, and generally quite sensible decisions. Although with hindsight we can quibble over the wisdom of various policies, at least he took action that has saved the day. And of course it’s all been paid for with funny money so far (£200bn of QE). Sorry, I’m rambling off the point, or in danger of losing my HEAD! (badoom, tish!). Sorry.

Interim results key points -

Obviously heavily impacted by covid/lockdown

H1 revenues down 30.6% on LY, at £242.1m (still a substantial business)

Underlying profitability: H1 LY was £17.0m profit, H1 TY fell to a small loss, of £(1.2m) – that’s fine by me, a small loss ticks box number 1 in my list above

Revised bank covenants, and going concern statement seems fine to me, so I don’t have any concerns about solvency. Loads of headroom on facilities

Balance sheet is strong by my usual tests. Note that receivables amp; inventories are well down, but trade creditors also sharply down – hence no evidence of stretching creditors, which is good

Current trading - all important – July 2020 was above LY, and August only marginally below LY. There could be an element of re-stocking, and pent-up demand here, so current trading is reassuring rather than spectacular

Properties - this is interesting. I’ve just had a look through the 2019 Annual Report, and land amp; buildings (which I think are freehold) are in the books at a net book value of £88.5m. These properties are owned by the holding company, and leased to its subsidiaries (intra-group transactions which would normally be eliminated on consolidation of the group accounts, I assume). The notes show that £7.1m of property was long leasehold, so the rest could be freeholds? [Edit - yes, confirmed in the webcast]. Buried at the end of note 10, it says that market value is well above book value;

The Company obtains a valuation triennially, and this is always by an external valuer. Investment properties were last valued by an independent professional valuer on 9 January 2020. This valuation of the investment properties, not including those under construction at 31 December 2019, was £101.4 million, however the Company has chosen to hold them at cost. .

Why does this matter? It means the bank won’t be a problem, as the group has plenty of property assets to underpin its bank borrowings. Also, it means there’s hidden value for investors, with almost 40% of the share price backed by property. Some people argue that this is double-counting, since the property ownership boosts earnings, since it doesn’t have to pay rent on properties it occupies. That’s a fair point. But I’d still rather have a load of property on the balance sheet than not, even if it is ignored for valuation purposes.

My opinion - difficult to value at the moment. The question is whether profit is likely to return to pre-covid levels? It may take some time, as I imagine commercial property demand for floor coverings is likely to be subdued for some time, due to the work from home trend, which may or may not reverse partially, who knows? (Edit: confirmed with management that it has little exposure to commercial or housebuilding. Average order size is tiny, at £136, dispersed over large number (70k) of small customers).

I think we can probably assume, that in say 2 years, earnings should return to historic levels of say 30-40p. Therefore, at 306p, the future PER might be between about 7.7 and 10 – which looks a bargain, for a decent business with good cashflows, and a strong balance sheet that is stuffed full of property.

Going back to my theme above about divis, I reckon a purchase now, could lock in a future divi yield of 6%+, which is very attractive in a zero interest rate environment.

Overall then, this could become a nice long-term investment for income seekers. I think it looks quite cheap at the moment.

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Share price: 282.5p (down 10.3% at 16:02)
No. shares: 19.8m
Market cap: £55.9m

Half Year Results

Mpac, the global packaging and automation solutions Group, today announces its unaudited results for the six months to 30 June 2020

The PR title given to the announcement is this;

Resilient performance with strong cash generation in headwind of the COVID-19 pandemic

Whilst that is true, it doesn’t tell the full picture – the cash generation was considerably helped by the reduction of receivables in H1. The CFO said that some of this will unwind in H2, so I think it’s stretching things a little to put that as a main feature in the summary.

Key points -

H1 revenues down 20% to £36.8m – due to project deferrals re covid (not cancellations)

Gross profit only down 14%, due to improved margins (driven by improved sales mix, especially increased sales of higher margin spare parts)

Underlying profit before tax (PBT) down 45% to £2.5m – due to operational gearing working in reverse

Order book – this is good, at £45.4m (was £39.9m this time last year)

Dividends – paused for the moment, will revisit end 2020. I think mgt is being too cautious. With pots of cash on the balance sheet, it could have paid an interim divi

Balance sheet – a strange item is the £25.7m asset shown re the pension scheme. This needs looking into, as accounting surpluses are often not real. There’s also a pension liability shown separately, and a deferred tax creditor which might relate to the pension scheme(s). Note 7 says it is making £1.9m p.a. pension recovery payments – that’s a big chunk of its cashflows, so it looks like pensions are a significant issue here, that needs more work (no time today to look into it, sorry). Additional contributions would be required if profits rise above £5.5m – see note 7, this is a very important point, hence me flagging it.

The £23.4m cash pile is impressive, but there are some quite hefty liabilities, including “contract liabilities” of £10.9m, which could be up-front deposits from customers, hence the overall position is healthy, but not quite as impressive as that cash pile suggests, i.e. it’s not completely surplus cash, and could partially unwind in future, depending on working capital timings. It sounded like the CFO is on top of the situation, as he outlined his focus on getting customers to pay on agreed terms, etc, music to my ears.

Tax – the company benefits from Ramp;D tax credits, and b/fwd tax losses being utilised, this is expected to benefit the company for the medium term.

My opinion – the figures look alright to me. It ticks my 3 boxes mentioned above with Headlam – i.e. H1 results are fine in the context of covid, resilient actually. The outlook is positive, with a strong order book. Finally the balance sheet is strong, with no need for any fundraising.

In my call today with management, I was impressed – they seem on top of the business. In particular I liked all the stuff about digitising the business – i.e. eliminating travel, and instead having engineers doing stuff remotely to manage customer equipment. Working from home, obviously, and it had previously (before covid) installed remote communications equipment. Customers can see, test, and approve equipment remotely now too. It sees competitive advantage here by being ahead of things, and implementing a fast recovery plan. CFO indicated cost savings of about £0.5m achieved from eliminating travel amp; other wasteful costs. Reducing UK staff numbers by 40, mainly an efficiency drive, but will also reduce costs further.

Acquisitions – with cash and an unused £10m borrowing facility, the company has capacity to make acquisitions.

Re-shoring – seeing a strong trend for American companies to bring back production to the USA. CEO used phrases, “Absolutely”, and “Racing ahead” when talking about this re-shoring issue.

Overall – I like it, worth a closer look. I need to spend more time looking at the pension deficit amp; cash outflows associated with this, as those look material to the valuation.

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Sorry this last section took time to gestate. Following 2 webinar/calls simultaneously late morning fried my brain a bit!

Jack’s taking the helm tomorrow, as I’m off to Warsaw for a long weekend, visiting extended family who has just had stents fitted, so needs cheering up! I’m hoping to visit a couple of museums too, fascinating but horrific WWII history of course, especially the Jewish uprising. I still find it so astonishing that such atrocities happened in living memory. It just shows what a thin veneer of civilisation human beings really have, a warning to the future.

Best wishes, Paul.

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