Small Cap Value Report (Weds 14 April 2021) - RNO, WJG, KOO, TMG

Good morning, Paul amp; Jack here, with the SCVR for Wednesday.

In case you missed it, I added some additional sections to yesterday’s SCVR in the afternoon. So here’s yesterday’s full report.

Timing – TBC – probably early to mid afternoon finish time today, as there’s a fair bit to get through.

Agenda -

Paul -

Renold (LON:RNO) (I hold) – in line trading update for FY 03/2021. Order intake recovered, and has ended the year up. Renold has proven itself to be resilient in FY 03/2021, and net debt greatly reduced. Big pension deficit though, which sucks out £5m p.a., hence why market cap is so low. Too low, in my opinion.

Watkin Jones (LON:WJG) (I hold) – I go into quite a bit of detail on the business model (which I think is very good). An in line update for the half year to 31 March 2021. Judging from the company’s previous results presentation slides, I think existing forecasts look far too conservative, because there’s a big pipeline of Build To Rent projects for the next 3 years. One for long-term investors, not punters!

Kooth (LON:KOO) – readers have flagged this one, in the comments section below. It’s speculative, and I don’t think I can add any value by crunching the numbers in detail, as it’s still loss-making. Hence I won’t write up a full section on it, instead having replied in the comments below, and several subscribers have written up interesting posts about it below, so this note here is to draw your attention to the comments section below. I’ll add a tag for KOO so that we can search and find this post easily in future. Thanks to all.

Jack -

Mission (LON:TMG) – Improving results for this cyclical marketing small cap. Negative NTAV but net debt is down and the pipeline is strengthening.

.

(I hold)

21.8p (pre market open) – mkt cap £47m

Trading Update

Renold, a leading international supplier of industrial chains and related power transmission products, today issues a trading update covering the year ended 31 March 2021 (the “Year”), ahead of the preliminary results announcement for the Year on 8 June 2021, together with the completion of a small bolt on acquisition in the UK.

Acquisition – very small, but Renold is paying a maximum of £0.6m, to bolt on £0.2m p.a. additional operating profit. Small, but good! Apparently the industrial chains market is very fragmented, so Renold could become a consolidator (or a bid target itself).

Trading overall - is in line with expectations -

The recovery in both order intake and revenues has continued and trading for the Year has been in line with the Board’s revised expectations, as announced in the Company’s trading update on 13 January 2021.

Checking my notes here from 14 Jan 2021, Renold said that it expected H2 adj operating profit should be “broadly similar” to H1. H1 saw a £5.8m adj op profit, so double that, and we get £11.6m for the FY 03/2021.

Revenues – down 12.7% on last year, to £165.3m. This is split £81.5m in H1, and £83.8m in H2. Trading improved (a little) as the year went on. It mentions supply constraints today -

Trading improved in the latter part of the Year and Group revenue in Q4 was behind the prior year by 8.3% (5.6% at constant exchange rates), being held back in the short term by constraints on global supply chains emerging from the pandemic.

Last year’s supply constraints could be this year’s catch up sales, so I’m not bothered about this.

Order intake – as with so many companies, Renold took an initial hit from covid/lockdown, and has been gradually recovering. As results are in line with expectations, the only number that matters, is the closing order book -

… the order book at 31 March 2021 of £53.6m was 3.6% ahead of the prior year figure (9.3% at constant exchange rates).

Note that currency changes are having quite a big impact, we haven’t seen that for a while, so expect to see this at other companies trading internationally.

Order intake for the whole of FY 03/2021 was down 7.4% – not bad considering what a disrupted year everybody has experienced. An interesting point that management made when I spoke to them a while back, is that the industrial chains made by Renold are essential items, usually bought on a planned maintenance basis by clients. I.e. the chains have to be replaced, or the often large amp; expensive equipment using them, is at risk of failure. Renold is a very well regarded, high quality brand name, and can charge up to 5 times what competitors charge, due to the high quality amp; reliability of its products, often used in mission-critical machinery.

A large part of Renold’s business is repeating business, and hence it’s not as cyclical (hence vulnerable) as some other businesses in economic downturns.

I think the stock market has not recognised this resilience of Renold’s business model. Maybe it will in future?

Interim results to 30 Sept 2020, during the worst initial shock from covid, were also resilient, with adj operating profit of £5.8m for the 6 months, down 25%. Note that profit is stated after a large depreciation charge of £5.2m (for 6 months), so EBITDA was a hefty £11.0m in H1, and will be similar in H2. That’s a nicely cash generative business, which has been steadily modernising its fixed assets in recent years.

Net debt - greatly reduced -

During the Year, cash generation outperformed initial expectations, as a strong focus on cash management resulted in a c.50% reduction of net debt to £18.4m (2020: £36.6m).

Diary date – 8 June 2021 for the FY 03/2021 results.

My opinion - so far, so good. I’ve held this share for a while now, and added to my position after the solid trading update in Jan 2021. The reason this share is so cheap, is due to the large pension deficit, which sucks out c.£5m p.a. in cash recovery payments.

My hope is that higher bond yields might lead to a reduction in the deficit, but nobody really knows with pension deficits, because there are many moving parts.

A friend emailed me over the weekend, to say that, for the first time in ages, the (monthly reported) transfer value of his defined benefit pension scheme reduced sharply. This made him ponder whether there was a wider move afoot, for pension deficits to start falling (due to pension scheme liabilities being discounted more heavily with higher bond yields). Do we have any pensions experts in the house, who might be able to comment on that?

Renold shares are really a geared bet on two things -

• Continued efficiency improvements from a long-running turnaround plan – a previous broker note indicated that another round of restructuring in 2021 could deliver higher operating margins – if so that would feed through to equity, leaving the pension deficit unchanged (which accounts for most of the enterprise value effectively).
• Pension scheme cash outflows reducing over time, leaving more of the (hopefully increasing) profits for equity holders, in cluding a resumption of dividends.

In terms of valuation, the market cap of £47m is extremely low, for a business making over £20m p.a. EBITDA, with that forecast to increase further as more restructuring occurs this year.

The closing order book is now up on last year, after a good intake in Q4, suggesting that FY 03/2022 profits could increase on FY 03/2021.

We’re in the dark somewhat, because there’s no broker research available to private investors. I’ve mentioned to the company that they need to get the message out there to PIs, who are the people who create the liquidity amp; set the share price.

The two steps needed to raise awareness about what a decent business this is, are broker notes being made publicly available, and doing some results presentations. I’ve suggested that the company starts doing results webinars for PIs, and appoints a broker that publishes its research on Research Tree, where we can get hold of it.

There’s a lot to like about Renold, with a strong underlying business, obscured by a large pension deficit. If management can further improve the operating margin, which is their plan, then the payments into the pension scheme would become less onerous, which would lead to a re-rating of the shares.

I suspect Renold could be attractive to an overseas bidder, e.g. from America.

I appreciate that historically Renold has not covered itself in glory, hence why there seems a generally negative perception about the business with investors. In my view that’s changing, and the company has an increasingly interesting investment proposition. It got through covid, and has service the pension deficit for years, all without any dilution for shareholders.

The StockRank sums it up nicely – a medium quality business, with good earnings amp; share price momentum, which is dirt cheap! (although the pension deficit is partly the cause of that cheapness).

.

.

(I hold)

230p (up lt;1%, at 08:50) – mkt cap £587m

Too big? – the market cap has been going up of late, but I really like this company, so it would be a pity to stop covering it. That’s the problem with a small caps report – if we stick to a market cap limit, then we stop covering the best companies as they grow too big, and keep reporting on the laggards, which doesn’t make a lot of sense, does it?! Hence why I like to continue covering good companies that grow in size, for a while anyway.

Preamble - What I like about WJG’s business model is that it’s a construction company with a difference – it pre-sells building projects (typically student accommodation blocks, but also a growing “build to let” housing division) to institutional investors (e.g. pension funds that want inflation-protected long-term future income streams, to match their liabilities). This locks in WJG’s profit margin on each build project, before it’s even built, and means there’s very little balance sheet risk. That’s a really nice business model.

The reason I jumped in and bought some shares personally a while back, was that, although I found the valuation a little warm, the last webinar showed that the contracted pipeline was already in place for a substantial increase in profitability over the next few years.

My last point, is that WJG has a great track record, and seems able to manage big construction projects on time, and on budget. The company seems to have a niche specialism, and great relationships with institutional investors. There’s limited competition in this space (hence good margins), and considerable barriers to entry – smaller building companies are effectively locked out of this sector, as institutions won’t take the risk of them going bust, or messing up the build. Whereas WJG has the reputation, track record, and balance sheet strength, to be a very credible partner to large institutions.

The student blocks that WJG builds look like office blocks. They’ve built a couple near where I live, and I was amazed at how fast they go up, with a steel frame, and quite high (one is about 14 stories).

The only bear case I can think of, is that founder/management made very large disposals of shares. Although they remain big shareholders.

Trading Update

Watkin Jones plc (AIM:WJG), the UK’s leading developer and manager of residential for rent, with a focus on the build to rent (‘BtR’) and purpose built student accommodation (‘PBSA’) sectors, provides the following trading update for the half year ended 31 March 2021 (the ‘period’ or ‘H1-2021′).

‘Maintaining momentum as the economy reopens’

H1 trading – this looks OK, it’s in line -

“We anticipate our profit for the first half of the year to be in line with our expectations and slightly below last year, which was before the onset of the disruption caused by the pandemic.

Other points mentioned -

• Covid curtailment is “beginning to restore some normality and confidence to the UK economy and our market sectors. “
• “Further good progress in securing new forward sales, adding to our development pipeline”
• “Construction activities all on track”

Outlook -

“The fundamentals supporting the markets for high quality build to rent and student accommodation assets remain strong and with the continued progress we have made in the first half of the year, gives us confidence in our future trading.”

Liquidity – looks fine -

Good half year liquidity position, with gross cash of c.£88.0 million (H1-2020: £72.4 million) and net cash of c.£31.0 million (H1-2020: £37.5 million), after deducting site specific loans.

Director retirements – both the Chairman and CEO CFO are planning to retire which might introduce some risk possibly? Non-Exec Chairmen are not really important, so I’m not worried about that change.

EDIT: Thanks to Martin for pointing out an error, I incorrectly typed CEO above, instead of CFO. Sorry about that. I’ve corrected the error. End of edit.

Valuation - as we’ve just had an inline update, then we should be able to rely on the company achieving the broker consensus numbers. As you can see below, despite recent rises, this share remains good value, and there’s quite a good divi yield too. I think this share deserves a higher rating than, say a standard housebuilder, because it has a superior, less cyclical, lower risk business model in my opinion.

Also note the high return on capital amp; equity in the quality scores -

.

.

Note that WJG did not need to raise any new share capital in the pandemic, so it’s a resilient business. There’s hardly been any dilution in the last 6 years, one of the benefits of investing in a family owner-managed business – they tend to be very protective of existing shareholders, reluctant to issue new shares, and run the finances more conservatively than hired hands might do.

Broker forecasts, as you can see from the graph below, estimates have been reduced. This doesn’t seem to tie in with the more upbeat outlook I recall from the company’s last webinar, which seemed to show earnings poised to rise about 50%, from the existing pipeline. Maybe that was over a longer timeframe?

.

.

Pipeline – ah yes, I’ve found the presentation slides on the company’s website. These are a little old now, from Jan 2021, but show the pipeline graphically.

The full slide deck is here. Which gives a very nice detailed view of the company (45 slides). Well worth a look.

Slide 25 below, shows how the pipeline gradually progresses from being in negotiation, to legals, to requiring planning permission, to planning permission granted, to forward sold. It’s a nice visual summary of the purpose built student accommodation division (PBSA) – the biggest division.

.

.

Clearly there will always be a risk that one or more large projects could go wrong, or be delayed, so not an entirely risk-free business model.

That’s all good, and shows that c.£300m p.a. revenues look to be fairly secure.

What interests me more, and the reason I bought shares personally, is that strong growth is coming through (subject to planning) from the Build To Rent (BTR) division. Check out these numbers, from slide 26 below. It’s set to grow from only a small part of the business, to a similar size as the main division, by 2023.

That should drive a big increase in earnings, and hence share price. This is what’s particularly interesting about this share.

.

.

My opinion - there’s a lot more detail in the update today, about various projects, but I’m only really interested in the overview, which is: results in line, and confident outlook. So for my purposes, that’s enough.

It’s the rapid growth in pipeline, for the Build To Rent division, that makes this share interesting. It’s already good value, but there’s a clear, measurable, catalyst here to expect future earnings to rise strongly – if all goes well, of course nothing is ever guaranteed, nobody can predict the future with certainty, same with all shares.

We’re all making loads of money at the moment, because everything is going up. But are the foundations solid enough to last? I don’t think so. We’re seeing pockets of mania developing in lots of speculative areas, and the parallels with 1998-9 are vivid, in my view.

It’s great that people are making money, and I hope they manage to bank the profits before the most speculative shares crash, as they always do, eventually.

My preference is to focus on shares where I can see that the fundamentals fully support a higher share price. I’m not comfortable to rely on ever-increasing market euphoria to keep taking share prices up. There has to be a measurable reason why the share price is highly likely to keep going up, even if speculative shares do crash.

Hopefully I’ve demonstrated above, with the pipeline information, that it’s very easy to forecast that WJG should see a considerable rise in earnings over the next 3 years.

There’s no guesswork, or hope, involved (well apart from hoping they get planning permission).

For that reason, this share is in my coffee can portfolio. I think it’s a nice long-term hold, due to the earnings being likely to grow strongly, and it’s also paying out decent divis along the way because it has a capital-light business model.

As always, I have absolutely no idea what the short term share price is likely to do, I cannot predict that. I’m only interested in where the fundamentals are in 2-3 years time, and that should in theory drive a higher share price then, compared with now.

An encouraging chart below, I think the recovery from the covid crash is justified by the fundamentals amp; good pipeline. Note also the consistently strong StockRank, which I find a reassuring backup to my own research. Neither are infallible of course, because buying shares is all educated guesswork to a large extent!

.

.

Please see the comment section below, for an interesting discussion about this mental health app company, which floated last year. Looks speculative, and difficult to value, but I like the concept. Potentially interesting as a bull market punt! It’s got meaningful revenues too, recurring, so it’s a proper company, and has contracts with the overloaded NHS. Just not profitable yet, and difficult to value.

Share price: 87.5p (pre-open)

Shares in issue: 89,028,484

Market cap: £77.9m

We’ve seen quite a lot of small cap cyclical share prices rallying ahead of lockdowns lifting, and it looks like Mission (LON:TMG) is no different as it is more or less back to all-time highs.

This is a UK-based marketing communications and advertising company, with segments including Branding, Advertising and Digital; Media; Events and Learning, and Public Relations. Subsidiaries include April Six Ltd, which is engaged in marketing communications and specializes in the technology sector; Big Dog Agency Ltd, which is engaged in Marketing communications, Speed Communications Agency Ltd, which is engaged in public relations, and Bray Leino Ltd, which is engaged in advertising, media buying, digital marketing, events and training, among others.

What’s interesting here is that Mission appears to still offer good value even at these levels, and the Ranks are quite strong across the board. So if you did think you’ve missed the rerating here, it’s worth quickly reexamining that.

Final results

Highlights:

• Revenue -24% to £61.5m,
• Operating profit -82% to £1.9m,
• Headline profit before tax -88% to £1.2m; reported loss of £2.1m
• Diluted earnings per share -89% to 1p

Results have been improving sequentially, with losses in the first half but notably better results in H2, and cash conservation measures mean the group ended the year with net bank debt down from £4.9m to £1.2m.

Client retention remained strong, with well over 50% of revenues generated from Clients of five years or more with a useful amount of business coming from more resilient sectors like healthcare and technology.

Mission also completed the acquisitions of Innovationbubble, the psychological insights and behavioural solutions consultancy, and brand activation consultancy, ALIVE.

And the outlook is positive, with trading in the first quarter of FY21 in line with the group’s expectations and a ‘robust and growing’ pipeline of new business opportunities. Removal of uncertainty around Brexit negotiations also opens up further opportunities across international markets.

Conclusion

To achieve profitability whilst at the same time reducing debt is good, all things considered. And this is a marketing agency, so caution is required in interpreting the commentary, but it does sound like things are picking up.

In the medium term, Mission is focussed on leveraging infrastructure by adding high margin, high engagement capabilities in data, analytics, and performance media. It has set a 14% margin target by 2022, which would be a big improvement on the historical average of between 4-5%.

At the height of uncertainty in Q2, the Group deferred roughly £6m of VAT, PAYE and National Insurance taxes. All deferred PAYE and National Insurance was repaid in Q3 and all deferred VAT has been repaid in Q1 2021.

However some 65% of total assets are composed of goodwill and this proportion has increased over the year. That means the group actually has negative net tangible assets of £6m.

The group is quite cash generative, at least.

The key balance sheet ratio measured and monitored by the board is the ratio of debt to headline EBITDA (“leverage ratio”). The group started the year in a strong financial position, with a bank debt leverage ratio of less than x0.5 and committed bank facilities of £15m.

I note the spate of director sells in February of this year… But even accounting for that it looks like management retains a decent stake in the business. Still something to be aware of though.

Mission looks worth investigating as a riskier cyclical small cap that could continue to rebound, although I’d like to see a further strengthening of the balance sheet.

Stockopedia