Small Cap Value Report (Fri 5 March 2021) - SAGA, New floats, Hill Report, HOTC

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

Many thanks to Jack for covering yesterday.

Timing - you have my full, undivided attention today, so I’ll be working all day. Finish time about 16:00. Am hoping to catch up on HOTC amp; a few other backlog items. Update at 16:36 – I’m just finishing off HOTC, it should be up by 5pm. Update at 17:19 – today’s report is now finished.

Agenda -

Saga (LON:SAGA) (I hold) – successful refinancing of borrowings

New floats – regulatory developments, and a quick look at InTheStyle

Hill Report – a few comments

Hotel Chocolat (LON:HOTC) – Interim results from earlier this week. Interesting company, but very expensive.

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400p (pre market open) – mkt cap £560m

Corporate and cruise ship finance facilities

Preamble – Renegotiation of the group’s borrowings was the last remaining significant question mark hanging over this share. That’s now sorted with today’s announcement.

I’m going to keep reporting on SAGA here, despite the market cap being £560m now, it having tripled in price from the lows in Oct 2020. This is because SAGA is a big holding for me personally, and lots of Stockopedia subscribers too. So far the bull case is playing out exactly as I’d hoped. All we now need to see, is the 2 cruise ships, plus the rest of the travel division, resume operations. Given the target over-50s market have now mostly been vaccinated, then it shouldn’t be long.

I note that Carnival announced this week that its Pamp;O division will soon be doing some cruises in UK coastal waters, instead of going further afield. The idea being that a lot of people would be happy just to go cruising, and right now don’t really care where the ship actually goes! Given that Europe is lagging so far behind the UK in vaccinations, that sounds sensible as a stop-gap.

A few years ago I went on short (3 and 5 day) cruises in UK waters, and we loved it – just being on the ship, enjoying all the facilities, lovely food amp; wine, shows, gym, etc, was really relaxing. Not suitable for everyone I know, but in my view there would probably be plenty of demand given current circumstances.

Today’s update -

Ship loans - this is by far the largest element of the group’s borrowings, and provided the bulk of the financing for its 2 owned mid-size cruise ships, which have barely been used since construction, due to covid lockdown.

• Agreement has been reached for a one-year extension of the existing deferral of debt repayments on the ship loans.
• Repayments of principal due £51.8m, are deferred until 31 March 2022, then repaid over 5 years
• Covenants are waived until March 2022
• Dividends restricted – that’s fine, as the group had already stated it has no intention of paying divis for several years, because debt reduction is the priority
• Minimum liquidity requirement of £40m (cash and undrawn facilities) – an increasingly popular condition that banks are requiring, I’ve seen this at other companies too.

Bank borrowings - are small, given that the equity refinancing last year paid off a lot of the bank debt.

The Group has reached agreement to amend covenants on the term loan and revolving credit facilities ….

The table in the appendix shows only a minor amendment to the leverage ratio covenant in Jan 2022. The main changes being relaxation of the interest cover covenant. Both covenants return to normal on 31 July 2022.

Given the backdrop of continued disruption to the Travel business, the actions taken provide sufficient headroom should the period of Travel suspension, which is subject to government guidance, continue well into the second half of the year.

£250m Bond – nothing mentioned about this, because it didn’t need any attention.

Outlook –

We continue to see strong pent-up demand for travel among our customers and remain well placed to deliver on this opportunity when the guidance on international travel changes.”

Diary date - 7 April 2021 for preliminary results for FY 01/2021.

My opinion - this announcement today reduces risk significantly, so it’s good news. Although I personally never had any particular worries about the group getting a further relaxation on the borrowing facilities.

Remember the key point with SAGA is that its insurance division is a cash cow, and has been trading resiliently. Thus providing cash flows to subsidise the fairly modest £6-8m per month outflows in the mothballed travel division. Therefore this share provided a nice, lower risk, way of backing the resumption of travel. As opposed to shares in airlines amp; pure play holiday companies, which typically have had to keep coming back for more equity.

So far, so good! I’m treating SAGA as a long term position, so remain of the view that the longer term price could be a multiple of say 50-100p future EPS? I really like the turnaround story here, with the founder’s son, himself a successful former CEO of SAGA, Sir Roger de Haan, having returned to run the company last autumn, and take it back to its core values, after years of mismanagement.

I know many punters are short-term focused, so might want to bank profits along the way at some stage, but personally that doesn’t interest me. There’s a bigger prize longer-term, if the turnaround is successfully executed, and there’s not actually a great deal to be fixed here. Also, I think cruise ship operators are likely to be on the cusp of a boom, from the pent-up demand mentioned in today’s update.

I thought I was going mad last autumn, when the share price hit ridiculous, irrational lows, so it’s good to see things recover so strongly, as inevitably you do question whether you’ve got it right, when the market is so wildly out of tune with my own analysis. It’s difficult to swim against the tide, but sometimes lucrative, as in this case! Anyway, let’s not jinx things by doing a victory lap at this early stage.

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Recent newspaper articles have flagged that there is a strong pipeline of companies intending to float their shares on the London market. Deliveroo has apparently chosen the London market for its mooted £8bn float. That follows Dr Martens (LON:DOCS) and Moonpig (LON:MOON) having successfully floated this year, at substantial valuations.

I very much welcome this, as the London market generally feels stale, and dominated by stagnant companies in traditional, declining sectors. We don’t have enough growth companies to chose from.

ThomsonReuters seem to be a bit slow in updating the information here for some new floats, so I’ve just flagged the issue to Stockopedia HQ and Alex is on the case. So there’s no need to raise a green blob to alert them, as I’ve already done it.

UK Listing Review

Chaired by Lord Hill, former UK EU Commissioner for financial services. This project was commissioned by the Treasury in Nov 2020, and has reported this week. The quick summary is here.

I’m surprised at some of the key recommendations (e.g. reducing the free float minimum from 25% to just 15%). For smaller caps, I would say the opposite should have been done – we need larger free floats, to improve liquidity, and that can help prevent fraud too. A lot of previous frauds (e.g. all those Chinese frauds like Naibu amp; Camkids) I think might have had dominant shareholders. They just used a London listing to blatantly fleece gullible London investors, and nothing ever happens to the perpetrators. I roared with laughter when reading the Hill Report, and it talking of maintaining London’s high standards!

The full Hill Report is here, 88 pages. I’ll read it over the weekend, but have jumped to Section 5 – Empowering retail investors, and there’s some really good stuff in there, e.g. considering how technology can be used to give shareholders more power in company votes. I also like section 5.2, which suggests using technology to make it quicker amp; more efficient for existing listed companies to raise capital, and more easily involve retail investors. Hallelujah! This is also about 20 years overdue, but a positive intention. I would like to see fundraisings done quickly, electronically, with the minimum of paperwork amp; costs, and shares suspended for (say) 7 days whilst fundraisings are one. And pre-emption rights should be respected in every case – i.e. give existing shareholders first refusal, then allow other investors to participate. Price new offerings through an online auction process. It’s so simple, and we’ve had the tech to do this for at least 20 years, or longer. There are too many vested interests, earning fat fees, getting in the way of reform.

This information is quite interesting from the report, and shows how effective London was at refinancing many existing companies, which we should be proud of. Although the system could be improved in future -

The speed at which the various bodies were able to move and the
amount of capital raised quickly is a testament to the agility of
the London ecosystem when it puts its mind to it.

In total, capitalof £11.7bn and £42.7bn respectively was raised through IPOs and
secondary issuances respectively on the LSE from March 2020
to December 2020, representing 36.1% of capital raised in
Europe over the same period

The need to publish cumbersome, expensive prospectuses, is also under review. Again, very welcome, but long overdue. I think a prospectus should only be necessary when companies originally list. Subsequent fundraisings should be possible with just a short document explaining what the money is for. Nothing more than that is needed. The Australian system is noted as being worthy of investigation, to copy elements of it maybe. Sounds good. I don’t know anything about Australian markets, but do recall some readers commenting here that their systems are much better than the UK’s. I’d be interested in hearing any views on this from our Australian friends, I’m told we have quite a few subscribers amp; readers here from Australasia.

Different classes of shares are also being considered, to attract tech floats, where the founders are left in control, despite dilution. Why not? If that’s a key advantage for US markets, then let’s embrace it. After all, nobody is forced to buy any shares, so if you don’t like it, don’t buy the shares.

My opinion - too soon to judge, I need to read the full report. In principle though, I really like the idea of freeing up London from unnecessary restrictions, in order to attract more business. That’s a key opportunity from leaving the EU, and hopefully offset some of the lost business that the EU is (understandably) trying to claw back from London – e.g. Amsterdam has apparently overtaken London recently for stock market activity. Nothing wrong with a bit of healthy competition!

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In The Style (“ITS”)

Intention to Float on AIM – issued on 1 March

This caught my eye because it’s a “fast growing e-commerce womenswear fashion brand” – very much a sector that interests me.

Key points -

• Founded in 2013 by Adam Frisby (quite young, doesn’t seem to have a rag trade background)
• Product looks a little more middle-of-the-road compared with BOO or PLT, but similar young demographic targeted
• Prices seem higher than fast fashion competitors
• Promotes female empowerment, and uses influencers, just like all their competitors!
• “Unbroken revenue growth” since inception in 2013
• Revenue of £41.0m in Y/E 12/2020 – so still small compared with the main BOO brands
• Active customers 0.7m, up 61% on LY
• Very good performance since covid/lockdown started – £35.4m revenues (up 159% vs LY), and £3.6m adj EBITDA for the nine months to 31 Dec 2020 – small, but very fast growth amp; an impressive EBITDA margin
• Admission date on AIM expected to be 17 March 2021
• Liberum is running the placing, and will be NOMAD
• Causeway Capital bought 49% of the company in early 2018
• ITS featured in a TV documentary called “Breaking Fashion” on the BBC, I must see if it’s on iPlayer or YouTube and have a watch
• Recently started selling via third parties, including Asos, Lipsy, and Shop Direct (importance of marketplace platforms)

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Historic financial information – intention to float announcements typically just cherry-pick a few positive financial bits of info, as in this case, so I tend to visit Companies House website to look at the historic accounts. It can sometimes be difficult to find the correct limited company, but this seems to be the one here, company number 08792519.

The most recently filed accounts are for FY 03/2020, and they look poor, e.g. revenue of £19.3m (up 13% on LY), and a loss before tax of £(2.2)m (LY: loss of £(1.9)m).

The balance sheet is also weak, with negative NAV of £(2.9)m.

ITS capitalises intangible assets, probably IT development spend, which was £616k in FY 03/2020. Therefore caution is needed with EBITDA, which would overstate real world cashflows due to this effect, and IFRS 16 might have further distorted it. Hence I’m treating the £3.6m positive EBITDA mentioned in the RNS with scepticism.

The losses were funded with a £2.5m issue of preference shares in 2019 – probably injected by the PR backer, I imagine.

My opinion – this looks potentially interesting. The historic financial information at Companies House shows a slowly growing, loss-making business – not impressive at all. However, it seems to have had a stellar year in 2020, which looks far too good to be just boosted by lockdown. Therefore it looks like there must be some other reason for the tremendous growth in 2020 as well.

The big question is whether the 2020 growth is a one-off, that might ebb away as physical shops re-open, or whether this company is a star in the making?

We also don’t yet know what the valuation is going to be, which is all-important. If it’s £20m I’d have a punt on it. If it’s £200m then I’d walk away laughing.

I’ve asked my broker to keep me in the loop on this one, as anything eCommerce-related is potentially interesting. Once we have more information, I’ll pass it on here.

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405p – mkt cap £509m

Interim Results

Hotel Chocolat Group plc, a direct-to-consumer premium chocolate brand, today announces its interim results for the 26 weeks ended 27 December 2020. All numbers are shown post-IFRS16 unless otherwise stated.

At first glance these numbers look really good, considering that the period concerned was disrupted by intermittent and partial lockdowns, and reduced footfall to its shops amp; cafes.

H1 trading update on 19 Jan 2021, which in summary said -

• H1 revenues up 11% vs LY
• Accelerating revenues trend, with Q2 +19% vs LY Q2
• Online growth more than offset closure of retail outlet – this is highly significant I think, and the only other multi-site retailer in my universe of stocks which I can remember saying the same thing, was Joules (LON:JOUL) (I hold)
• Good growth in USA and Japan, with more expected
• Outlook – continues to be in line with expectations, despite higher costs due to increased digital marketing, and covid

So a decent update in January 2021, which it looks like I didn’t get round to covering here at the time. Moving on to the…

Interim results for the same period, H1, published earlier this week, on 2 March 2021.

• Revenues in line, at +11% to £101.9m
• NB – ignore the £24.9m EBITDA number, it’s not real! It’s badly distorted by IFRS 16, which strips out a £5.1m notional depreciation charge on property leases. It’s nonsensical to effectively exclude property rents from EBITDA, so the £24.9m underlying EBITDA figure shown in the financial highlights is bogus, ignore it!
• Profit before tax is however a reliable number, at £15.5m, up 3% on LY H1
• EPS is 9.7p (ot 9.6p diluted, not much difference), down from 11.5p in H1 LY – note there was dilution from a £22m equity fundraising in March 2020. The other factor affecting EPS is that the tax charge was more normal this year, after being low last year
• NB – Seasonality – H1 (containing Christamas) makes all the profit, so you can’t double profit to get to a full year figure, that would be far too high. In fact Liberum is forecasting a whacking great loss of £(12.0)m in H2, similar to the H2 loss of £(12.6)m generated LY. That puts a very different perspective on things. I wonder what the H1/H2 profit/loss split would be in a non-covid time? It would be worth checking back to pre-2020 results. Hence likely future seasonality is a big issue to follow up on
• Online – comprised 51% of sales in H1, very impressive – HOTC seems to be successful at moving physical customers online, making it very resilient during covid
• Gross margin – is high at 61.0%, but down from 65.0% in H1 LY, due to discounting driven by lockdown, which is understandable. I see upside here, in that future gross margin could recover to or nearer to 65.0%
• No dividends – fair enough, growth companies should be investing in growth, although it does remind us that HOTC is quite capex hungry – expansion requires big investment in stores amp; other facilities
• Leases – 13% saw rent reductions, and 56% have a lease event (i.e. expiry or break clause) in the next 2 years – good news, as rents should continue reducing overall
• Interesting aside – HOTC says sites in Japan (a key market expanding via a JV) are typically turnover rents. We really do need to the see the UK move in that direction too
• Brexit – no disruption to supplies, and few sales are made into the EU, so this sounds OK
• Broker forecasts are now rising, but from a low base

Balance Sheet – quite capex heavy. Note the £9.7m loan to Japanese JV. Big lease liabilities. Current ratio not that great, possible creditor stretch as trade creditors looks high. Freeholds of £14.1m is good – hidden value. Overall the balance sheet looks OK, but not as good as high cash figure initially suggests.

Liquidity looks fine, with most recent net cash of £26.3m at 28 Feb 2021.

Owner/Managers - Christopher Mayer’s book, “100 Baggers” (highly recommended), has had a big influence on me recently, so I’m now prioritising investments in companies with entrepreneurial management (preferably the founders) who still have large shareholdings. HOTC gets a big tick in that box, with the founders being the two largest shareholders. They’re spent 28 years building up this business – serious commitment, so imagine how motivated they must be, this is their life’s work, something I see as very positive -

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My opinion – I’ve got mixed feelings about HOTC.

Bull points -

• Owner/managers with big shareholdings, which is exactly what I’m looking for
• Impressive H1 results, moving lost physical sales online very successfully, and repeat online business through subscriptions, VIP club, etc
• High gross margins with scope to increase further
• International expansion in USA and Japan could transform long-term scale of the business
• Sailed through the covid crisis, showing resilience of the business model, despite temporary closures
• If you see HOTC more as a stylish/aspirational international brand, than a retailer – seen this way, the £500m market cap may not be so outrageous

Bear points -

• Hideously expensive on a PER basis, for years to come, unless it greatly exceeds broker forecasts
• Expansion requires heavy capex, although less so with online sales, so maybe that’s less of a worry given how well online is doing
• Priced aggressively as a growth company, but growth has actually been quite modest – 28 years from formation to where we are today, reinforces that. Revenue took about 7 years to double more recently. Growth would need to greatly accelerate to justify a £500m+ valuation, in my view.

On balance then, whilst I see an attractive business here, the valuation seems way too high to me, given the relatively pedestrian growth rate, and limited profitability to date.

One final point, I just didn’t like the product when I tried it. It tasted unpleasant to me and was wildly over-priced. That’s only one person’s view of course. Therefore, my worry is that fancy branding and packaging might only take it so far, before sales peak, and customers drift away. It would be interesting to drill down into customer churn rates – how long do subscribers remain subscribers on average, I wonder?

I think I’ve talked myself out of wanting to buy this share, but good luck with it to holders, I do understand the upside case, but it’s much too expensive for me.

Surprisingly, the chart has gone sideways for the last 3 years, which I wasn’t expecting to see.

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Right, that’s me done for today. I hope you have a lovely weekend, we might even get some sunshine apparently!
Best wishes, Paul.

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