Small Cap Value Report (Fri 21 May 2021) - ELTA, HEAD, GATC, CARD, STAF

Good morning, it’s Paul and Roland here, with the last SCVR of this week.

Timing – I’ve got to finish by 12:30 today, due to more zooms, and travel arrangements.

Yesterday was a bit of a nightmare, with so much to do (including 4 zooms), and very tricky accounts to decipher from N Brown (LON:BWNG) (I hold). This is just to flag up that I finally published my section on BWNG at about 7pm last night, so many subscribers may not have seen it. Here is the link to yesterday’s report, with the BWNG section, to start you off today.

Agenda -

Paul’s section:

Electra Private Equity (LON:ELTA) (I hold) – really good news today. The planned disposal of its 2 main investments (restaurant chain TGI, and Hotter Shoes) will now be through demergers, and separate listings. I think this could maximise value for ELTA shareholders. NAV has shot up 46% in 6 months, to around the current share price, but still looks well below possible sum-of-the-parts disposal values. So plenty more to come, in my opinion, even after a strong share price rise of late.

Headlam (LON:HEAD) (I hold) – a reassuring, in line with expectations AGM trading update. Revenues now almost back to 2019 pre-covid levels. Shares have risen a lot, but still look very good value to me. Bulletproof balance sheet includes c.£100m freehold property. Generous divis should resume. There’s lots to like here, for value investors.

Gattaca (LON:GATC) – “Improved outlook” – a positive update, although forecasts have been slashed to near-zero, so not madly exciting to be beating such a low forecast. Good signs of recovery. Share price has already tripled, and I don’t see obvious immediate upside on the current valuation. Balance sheet looks OK, so probably little to no dilution risk.

Roland’s section:

Roland:

Card Factory (LON:CARD) – this indebted retailer has now released details of the refinancing package it agreed in April. Shareholders seem likely to face dilution as the company needs to secure additional cash to fund accelerated debt repayments.

Staffline (LON:STAF) – this recruiter has just launched its second refinancing in 12 months. Existing shareholders face big dilution, but this could provide a more solid foundation for a recovery. However, the stock still looks quite fully priced.

(Paul: I hold)

One of the company webinars I attended yesterday was with management of Sanderson Design (LON:SDG) – the relatively new CEO Lisa Montague comes across tremendously well – with a crystal clear strategy, being implemented well. Her focus on efficiency has already delivered transformed results in H2, as I reported here on Tuesday.

In particular, efficiency gains have enabled a headcount reduction of 10% saving about £3m p.a. – obviously difficult for the people concerned, but in the interests of the business and the rest of the staff. A big reduction in the number of stock lines (SKUs) has freed up cash by reducing inventories, and improved manufacturing efficiency. SDG now produces fewer, but better new collections.

It struck me also (as with many other companies) that the pandemic has accelerated adoption of technology, and helped companies focus on better, more efficient ways of doing things For example, SDG said that they’ve now moved entirely to digital launches of new product ranges, whereas in the past a team of people would hit the road and physically show the new ranges to customers. That isn’t necessary any more, and the whole sector has happily adopted doing things online instead, including customer ordering (“not quite as slick as Amazon yet, but we’re getting there”).

Peak Earnings

I’ve largely abandoned broker forecasts for valuing companies, because they’re often way too pessimistic, and don’t really make sense. This is causing a lot of good shares to have apparently very high forward PERs, when they really don’t. This is providing us with opportunities, to spot companies where the forecasts are too low, and buy in ahead of forecasts being raised. Two shares I hold Vertu Motors (LON:VTU) and Joules (LON:JOUL) both saw large broker forecast increases last week, and I think many more are in the pipeline. I don’t think analysts are doing anyone any favours by being super-cautious, due to macro uncertainties, when the positive evidence is all around us of a V-shaped economic recovery underway, company profits rebounding, plentiful household savings, labour shortages, etc.

Instead of using broker forecasts, I’ve been tending to look back pre-covid, and see what peak (usually 2019) earnings were, and assuming that companies could return to that level over the next year or so. Providing covid is beaten, or at least brought under control, that is. It’s vital to check if there has been any new share issuance from placings during the pandemic, as that needs to be taken into account when working out EPS (more shares means lower EPS for a static level of profit).

More recently, it’s dawning on me that peak earnings pre-covid is not necessarily a big enough target. So many companies have stripped out costs, become more efficient, and increased margins during the last year. For that reason, I think the better companies could exceed previous peak earnings, giving further upside on some share prices. Although I need to see evidence of this, not just a wish.

For this reason, I’m not worried about share prices being too high generally. In some cases momentum seems to have gone too far, and there are lots of shares which are too pricey for me. However, in many recent SCVRs my conclusion is the same – that the share price has risen a lot, but that looks justified by fundamentals. As long as we’re only holding shares which are valued sensibly, then we should be reasonably OK, even if the market as a whole does correct from its highs. In fact, these dips can be nice topping up opportunities, as flaky holders (traders, etc) bank their profits, or panic sell at the slightest downturn.

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(I hold)

510p (pre market open) – £195m mkt cap

Half Year Report

This is a very interesting special situation, which a friend flagged up to me recently, as I never would have found it otherwise. So he’ll be getting a lavish lunch at my expense as a thank you, in due course!

I did a write-up about ELTA here about 3 weeks ago, explaining why I see hidden value in this share.

The short version is this: Electra is an investment company which is being closed down, through disposals of its holdings. There are 2 main holdings left – TGI Fridays (casual dining chain), and Hotter Shoes (mainly internet specialist shoe maker/retailer). Both are very attractive, profitable, growing businesses.

The sum of the parts could considerably exceed the current share price. The timescale for completing the winding up amp; distribution of cash to shareholders, is end 2021, so we don’t have to wait forever to get paid. I think the eventual payout could be as high as 1000p+ (double the current share price), but that depends on management achieving good sale prices for TGI and Hotter, which obviously isn’t guaranteed.

The big news today is this, which I’m delighted at, because I think this is more likely to maximise the value of the disposals above trade sale prices -

Decision to list Electra’s Two Largest Remaining Portfolio Assets, TGI Fridays (“Fridays”) and Hotter Shoes (“Hotter”), on the FTSE Main Market and AIM, Respectively

Both companies are ideal for separate listings, and should be attractive to private investors, since they are good quality consumer focused companies. Re-opening for TGIs restaurants also makes this ideal timing, with pent-up demand being unleashed, and there are very few listed restaurants, in the UK, so I imagine there could be good market appetite for these listings.

The new management teams at our two remaining larger portfolio assets, Fridays and Hotter, have performed admirably through the pandemic, not just sustaining their businesses in the most difficult circumstances, but also transforming them. In light of this, and their potential for further significant longer term value creation, the Board has decided that the optimal outcome for shareholders is likely to lie in a capital market solution for both businesses. It is our intention to demerge Fridays onto the FTSE Main Market late in the third quarter of this year and, subsequently, in the fourth quarter, to bring Hotter on to AIM through reclassification of the Electra entity. Plans are well advanced for both listings.”

NAV - has greatly increased, and still looks extremely conservative to me -

Net asset value (“NAV”) as at 31 March 2021 of £196.9 million or 514.3p per share (September 2020: £135.3 million or 353.4p per share)

Here is the table for how NAV is arrived at -

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As you can see above, there’s been a tremendous increase in NAV per share, up 46% in just the last 6 months, to 514.3p per share. This is why the share price has been rising, as the market anticipated that NAV would rise.

Remember too that NAV is calculated on cautious assumptions for how to value TGI and Hotter, the 2 main investments. The values at IPO should be considerably higher, in my opinion.

My opinion – as explained in my separate post about ELTA, I see considerable upside here on a sum-of-the-parts basis. Floating Hotter amp; TGI separately should maximise the value of the disposals.

Net debt at the individual companies is higher than I expected: TGI now has £62m net debt (I had worked on c.£40m), and Hotter has net debt of £12m. That would need to be taken into account in pricing the disposal values.

Reading through the commentary today, TGI has had a thorough sort-out during lockdowns, and is now revitalised under new management. It also has a strong pipeline of new sites, on attractive terms and often already fitted out (so lower capex than historically), plus a new format of USA themed cocktail bars called 63rd + 1st – which sounds like a reference to an address on the New York grid pattern road map.

Hotter is achieving +30% online sales growth, and is also decently profitable.

I think both would be very attractive new floats, which institutions may well snap up. If the valuations are decent, then ELTA shareholders could see a lucrative payday in the next 6-9 months. Hence I’m very happy to sit tight and await developments.

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466p (flat, at 09:52) – mkt cap £396m

AGM Trading Update

Headlam (LSE: HEAD), Europe’s leading floorcoverings distributor, provides the following trading update in respect of the first four months of the year…

It calls itself Europe’s leading floorcoverings distributor, but the UK is its biggest market by far. Also as previously announced, its small Swiss business has been disposed of, which has now completed. That’s fine by me, I think small overseas subsidiaries are probably a distraction for management, and don’t move the dial in terms of profit or growth potential.

Today’s update is encouraging, with the summary being -

Pleasing performance with trading improving throughout the Period

Main points -

• Trading in line with expectations
• Soft start to the year (Jan-Feb 2021), since improving – Mar, Apr, May 2021 all good
• Revenues for Jan-Apr 2021 up 30.6% vs 2020 (impacted by lockdown 1), and slightly below the more meaningful 2019 comparative
• Demand – residential strong, commercial soft
• Capital Markets Day 1 July 2021 – not sure why, as the balance sheet is strong, so it doesn’t need to raise fresh equity
• Sales team being reorganised, to make them more efficient

Valuation – the share price has risen almost continuously since the vaccine news broke in Nov 2020. Is it too expensive now?

Broker consensus is 26.0p EPS in FY 12/2020, and 30.4p in FY 12/2021. Those forecasts look too low to me. Since revenues are almost back to 2019 levels already, then we should be valuing the company on pre-covid earnings, which were c.40p EPS. Particularly as the company has been on a cost-cutting amp; efficiency drive, so there’s a good chance earnings could exceed previous peak, which ties in with what I was saying above in the preamble.

Hence I think it’s logical to ignore broker forecasts, and value HEAD shares on a multiple of 40p EPS pre-covid. That works out at a modest PER of 11.6 times. So not expensive at all, actually rather cheap.

Bear in mind also that HEAD has a smashing balance sheet, including c.£100m of freehold property. This increases the chance of a bid from private equity, or someone like Victoria (LON:VCP) – since they could sale amp; leaseback the property to help pay for the acquisition.

Dividends should also return, and a twice covered divi should yield about 4-5%, if my estimate of a return to 40p EPS is on the cards.

My opinion – I’m very happy to continue holding, as this share remains good value in my opinion. The price last summer/autumn was absurdly cheap, and it’s just recovered to a level which is more reasonable, but arguably still cheap, once a full recovery is factored in. In my head I’m valuing it at 600p+

With a bulletproof balance sheet, and strong cashflows (allowing a good divi yield to resume fairly soon), I see lots to like here, for value investors.

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151p (up lt;1% at 11:51) – mkt cap £48m

Trading Update – Improved Outlook

An interesting innovation – putting a two word summary in the RNS title. I wonder if it will catch on? It certainly drew my attention to the announcement.

Gattaca plc, the specialist Engineering and Technology recruitment solutions business, today issues a trading update for FY ending 31 July 2021.

… faster rate of recovery in NFI than originally expected

(NFI is Net Fee Income, which is revenues due to the company, stripping out the pass-through wages of the contractors they provide)

Q3 saw +13% sequential growth on Q2

changes arising from the introduction of new tax legislation (IR35) had less of an impact on the Company than we anticipated.

We now expect NFI in H2 to be in the order of 10% up on H1 2021.

making targeted investment in sales and delivery headcount, whilst closely managing our cost base.

New IT system launched successfully in April.

Outlook – this looks good -

Whilst there remains uncertainty around Covid-19, our current expectation is that this rate of recovery will continue, and we therefore expect our underlying continuing profit before tax for the year to 31 July 2021 will be significantly ahead of market expectations.

Dividends - a “modest” divi will be introduced for FY 07/2021

Why hasn’t the share price gone up today, in response to this? Possibly because they took an axe to forecasts a while back, and set the bar at zero! So it wasn’t hard to step over it, arguably -

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Dilution – we’re getting a lesson in the danger of investing in companies that have stretched finances today, with Staffline (LON:STAF) and Card Factory (LON:CARD) both tumbling on announcements of fundraisings. I’m sure there will be more to come. Banks have filled the gap in the short term, but once things settle down, then banks are looking to reduce their risk from demanding companies refinance at shareholders expense.

I’ve heard from city friends that the institutions are getting tougher on fundraisings now – things that would have gone through on the nod a few months ago, are now being challenged, and the price for institutional support is now a deeper discount. So this is becoming a much bigger issue, and we all need to be careful about holding shares which are under-capitalised, as the fundraising may not happen in a way which is helpful to private investors.

Does GATC need more equity raised? I’ve checked the last balance sheet in the interim results, and in my opinion it looks fine, with positive NTAV, and plenty of net cash. Hence I’ll stick my neck out here, and say that shareholders probably don’t have to worry about dilution risk.

Valuation – this is the tricky bit. Pre-covid performance was quite erratic, so there’s no obvious stable level of profitability to refer back to.

Consensus for FY 07/2022 is 13.4p, which looks reasonable to me, for a PER of about 11 – given the uncertainty, that looks about right to me. Smaller players in this sector tend to be permanently on low PERs.

My opinion – the share price has tripled in the last year, and looks about right to me now, but of course I don’t know what level of earnings are likely to be achieved.

The US legal action that GATC is defending worries me, as it’s already consumed a lot in legal costs.

On balance, I’ll say I’m neutral on Gattaca. There could be upside from a strong economic recovery, but a lot of that seems to be already priced in. The chart below is saying the same thing – fully recovering from the pandemic.

Note the very high StockRank of 99.

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86p (pre-market open) – £294m market cap

Trading update amp; Refinancing

Discount card and giftware retailer Card Factory has released details of a £225m refinancing plan to relieve the pressure on its balance sheet.

Card Factory, the UK’s leading specialist retailer of greeting cards, dressings and gifts, today announces both an update on trading post the re-opening of non-essential retail and the completion of a £225m refinancing with its current banking syndicate.

The pandemic hit the group hard, due to its dependence on store sales. But in reality, the business was having problems before Covid-19, due to a combination of stagnating sales and excessive debt.

Card Factory has been a popular recovery and the shares have doubled since the end of February. Many shareholders seem to have been happy to ignore the risk of dilution in any refinancing. Unfortunately, today’s news suggests to me that this remains a big risk.

Paul last commented on Card Factory in April, when the company announced that details of a refinancing package had been agreed, but not documented.

We now have that information, coupled with a solid post-reopening trading update.

Trading update

I’ll brief over Card Factory’s (brief) trading update first, to give some context. Stores across the UK have reopened in stages from 12 April based on national guidelines. Initial store sales were ahead of both expectations and the performance seen after last year’s lockdowns.

However, the company says that “initial strong demand has been satisfied”. Like-for-like sales for the first five weeks of reopening are said to be “marginally down compared to the same period in 2019” (my bold). I guess that’s to be expected, as in my experience, not all shoppers are ready to return to the high street yet.

One area of concern for me before the pandemic was that Card Factory was lagging behind other retailers online. The company has taken big steps forward in this regard over the last year. Sales online are said to have fallen since stores reopened, but still remain ahead of pre-pandemic levels.

Unfortunately today’s trading update does not include any numbers and does not mention total sales. As a result, I’m finding it hard to get an accurate feel of performance since reopening. On balance, my feeling is that trading is broadly in line with expectations so far, but with some risk of disappointment.

Refinancing

Card Factory has agreed a £225m package of facilities with its existing banks. This increases the company’s liquidity from £200m previously, although the term of the facilities is not extended – they will need renewing in September 2023.

Net debt stood at £110m on 16 May, so has fallen somewhat from last year’s half-year figure of £143.9m.

There are three elements to the new facilities:

• £100m revolving credit facility (RCF): This is the company’s main credit facility and is essentially an overdraft. The terms are said to be “substantially” unchanged, except for revised covenants.
• £75m term loan facility
• £50m in coronavirus loans under the government-backed CLBILS scheme.

Card Factory says these facilities should provide enough liquidity to strengthen the group’s online operations and provide the capacity to fulfil sales demand.

My reading of this is that additional borrowing will be needed to fund working capital as the business restocks and builds inventory for the remainder of the year. I expect net debt to rise, in the short term, at least.

£70m equity placing

This refinancing does not include a compulsory equity placing. But the company has agreed to use its best efforts to raise £70m in new equity. This cash will be used to fund a schedule of early repayments that runs from 30 November 2021 to 30 July 2022.

If Card Factory fails to make these prepayments, it will have to pay up to £5m in additional fees to its lenders.

Interestingly, the company’s lenders are also willing to accept prepayments funded from “other subordinated sources”.

My impression is that Card Factory’s lenders have decided that their best chance of getting their money back lies in continuing to support the business. But they aren’t happy with the current level of exposure, hence the prepayment schedule.

Covenants

Card Factory says that covenants on the new facilities will be based around total net debt and last 12 months’ EBITDA. No details are provided, but they will be tested monthly until March 2022.

After this, covenant tests will return to quarterly tests of net debt/EBITDA leverage and EBITDA to interest cover. The thresholds on these tests are phased “to return to 2.5x leverage and 2x interest cover by January 2023”.

Card Factory has historically enjoyed decent margins and strong free cash flow. But for a low-growth high street retailer, leverage of 2.5x EBITDA is still more than I’d want to see.

My view

Card Factory’s trading appears to be returning to normal. In my view, the refinancing package should mean that the group avoids the risk of administration, for now, at least.

However, shareholders are not out of the woods yet, as a £70m placing would generate significant dilution.

Card Factory’s share price has rocketed since the government reopening plans were announced in late February, but I suspect that a placing would have to be priced well below current levels to find buyers.

Stockopedia shows a consensus forecast for earnings of 2.6p per share in 2022 (y/e 31 Jan). Digging around for broker forecasts, I’ve found estimates for earnings of around 11p per share in 2022/23.

These forecasts put Card Factory on a P/E of 30 for FY22 and 7 for FY23. This suggests to me that a full recovery has already been priced into the stock. Hence any new shares issued could be at a significant discount.

On balance, I think that today’s news is positive for Card Factory’s business. But until funding for the prepayment schedule is secured, the shares remain uninvestable, in my view.

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59p (-16% at 09:25) – Market cap £39m

Proposed Placing, Open Offer amp; Debt Refinancing

Recruitment group Staffline (LON:STAF) is a big faller today, as the company has announced a £48.4m equity placing and open offer at 50p per share. This fundraising is linked to a refinancing deal that’s intended to stabilise the group’s balance sheet and provide headroom for a return to sustainable growth.

The company has also provided an update on recent trading. This doesn’t really add much to the first-quarter update which Paul covered in detail on 26 April, so I won’t reiterate it here. In summary, all three of the group’s divisions were profitable during Q1 and trading conditions are improving as the pandemic eases. The company is confident in the overall outlook.

Fundraising and refinancing

Staffline’s equity fundraising and refinancing deal are linked. The company must raise the equity cash in order to secure the new financing facilities. This is what I expected to see with Card Factory too – it’s a more typical scenario for a struggling firm.

Reasons for fundraising: In April’s update, Staffline revealed that its net debt of £54.9m included a £46.5m VAT deferral. These VAT payments are now starting to come due and will be paid with the proceeds of the equity fundraising.

Refinancing: The new arrangements will replace a number of the company’s existing facilities with new receivables financing facilities totalling £90m. The new facilities will be secured “on all the assets and undertakings of the company and certain other members of the Group”. However, some existing customer-specific invoice factoring arrangements will be maintained.

The new facilities have a 4.5 year term, which should provide some stability and headroom.

The extent of the group’s current leverage is clear from the lending terms – interest costs will start at 2.75% over SONIA (the successor to LIBOR) when the group’s leverage is greater than 5x net debt to EBITDA. The interest rate will fall to 2% when net debt is less than or equal to 3x EBITDA. These are high levels of leverage.

Equity fundraising: Staffline plans to raise up to £48.5m by issuing new shares at 50p.

This is a big equity raise that will more than double the current share count. It will need shareholder approval, but today’s update suggests that if this isn’t forthcoming, Staffline could run out of cash and fall into administration.

There will be three elements to this fundraising, targeting a range of investors:

• Placing of 87m shares (£44m) – to institutions and certain Directors/employees
• Direct subscription of 750k new shares (£375k) – to Directors/employees
• Open offer of 8.8m shares (£4.4m) – existing shareholders will be able to apply for 10 new shares for every 78 shares they own

The board are putting some cash in, although not vast amounts:

If this raise goes ahead in full, it will increase Staffline’s share count from 68.9m to 165.8m. That’s an increase of about 140%.

To recalculate earnings forecasts to reflect this dilution, we need to divide by 2.4.

Stockopedia is currently showing 2021 forecast earnings of 2.33p per share, giving a P/E of 30:

Recalculating this to reflect the dilution from the planned equity raise gives 2021 earnings of 0.97p per share and a forecast P/E of 50 (at the placing price of 50p).

Staffline looked fully priced to me before today’s news. The stock now looks decidedly more expensive.

As with Card Factory, these numbers suggest to me that Staffline shares were already priced for recovery, without any allowance for the risk of dilution.

My view

As with Card Factory, Staffline has provided a painful lesson about the risk of buying shares in highly-leveraged turnaround situations. With the stock trading at 59p as I write, it’s remarkable to think that Staffline once looked reasonably priced at 1,000p.

In my view, this refinancing package may finally be enough to provide solid foundations for Staffline’s recovery. But with an implied valuation of 50 times 2021 forecast earnings, I think the stock still looks expensive given the company’s mixed record in recent years.

Even if earnings double in 2022, the shares would still trade on a post-placing P/E of 25, without any capital appreciation.

Staffline still looks speculative and risky to me. I think there are far better listed choices elsewhere in the recruitment sector.

Stockopedia