Small Cap Value Report (Weds 19 May 2021) - DIA, SAG, CREO, KGH

Good morning, it’s Paul and Roland here. A big welcome to Roland Head, who has kindly agreed to step in and help out here at the SCVR, to give Jack some study leave. Roland is a highly experienced investment analyst and writer, and can be found on Twitter: @rolandhead

StockSlam – a reminder that this popular free webinar starts tonight at 18:00. Anyone can do a 3 minute pitch for any stock, so why not get involved?! It’s good fun. Register here.

Timing – we should be finished by 1pm.

Agenda -

Paul’s Section:

Dialight (LON:DIA) – in line with expectations trading update, but orders above expectations. Does this mean the turnaround could be gathering pace? Who knows, not enough information is provided.

Science (LON:SAG) – A strong trading update, with H1 profit guidance 30% up on last year’s excellent H1. Mentions potential supply chain problems (as many companies are saying). Valuation still looks attractive to me. A thumbs up from me – holders should be pleased with the group’s progress.

Roland’s Section:

Creo Medical (LON:CREO) – a promising update from this medical device firm, but it remains a speculative situation.

Knights Group (LON:KGH) – This acquisitive legal services business says that revenue for the year to 30 April should be ahead of consensus. Knights Group has delivered strong growth since flotation, but the firm doesn’t yet have a very long track record as a listed business.

320p (pre market open) – £104m market cap

Trading Statement

Dialight plc (LSE: DIA.L), the global leader in sustainable LED lighting for industrial applications, is today issuing the following AGM trading update.

AGM trading update - encouraging start to the year

This relates to the FY 12/2021.

Looking back at its last results for FY 12/2020, the figures were a £(6.4)m underlying operating loss, not bad considering covid hit revenues hard, down 21% to £119m.

The outlook comments alongside these results sounded OK – this was published on 31 March 2021, so I’m providing it now for context -

Full year guidance for 2021

We are experiencing an increase in quoting activity early in the year and while the Group will continue to be impacted by COVID-19 during 2021 and will take steps to mitigate to the extent possible, we see a range of profitable outcomes for the full year.

Longer term the actions taken during 2020 will help ensure we are strongly positioned to return to significant growth as the pandemic eases, and as a market leader to satisfy the increased structural demand for more environmentally friendly products.

[Paul: this was published on 31 March 2021]

Today’s trading update -

While previously highlighted Covid-19 impacts continue, current trading is in line with management expectations, with orders ahead of expectations. Our focus will continue to be on meeting our customer needs and thereby growing our revenues. The Group’s outlook for the year remains unchanged.

For the longer term, the actions we took during 2020 mean we are strongly positioned to return to significant growth as the pandemic eases. The demand for more environmentally friendly lighting products is growing as the focus on net zero continues to gain momentum around the globe.

What a pity the company failed to provide a footnote, to tell us what their expectations are, how are we supposed to know?!

There’s no broker research available on Research Tree.

Broker consensus figures on Stockopedia are -

FY 12/2021: 8.65p (PER 37)
FY 12/2022: 20.45p (PER 15.6)

Net debt – has gone up – note the comment about raw materials shortages -

We have mitigated against potential raw material shortages by increasing our inventory. As a result, net debt at 30 April 2021 was £14.4 million compared to £11.4 million at 31 December 2020.

My opinion - I don’t have enough information to form a view. If the company wants investors to buy into the turnaround story, then it would be helpful to get some research notes out there for us to read.

I can’t see anything particularly attractive about buying shares in a company with a poor track record, which made losses in 2019 and 2020, where the share price looks about right if Dialight achieves 2022 forecast earnings.

The turnaround might work, it might not, how am I supposed to assess the probability of that happening? It’s not much more than guesswork, based on the limited information available.

I’m happy to look into it in more detail, if more information is provided. I think there might be a webinar coming up, which would be of interest. I like turnaround situations, so would be interested in finding out more.

As you can see from the long-term chart below, Dialight was previously very successful, before it all went wrong. Interestingly though, there doesn’t seem to have been any dilution in the last 6 years I have data for, with 32.6m shares in issue throughout. Therefore, in theory the share price could recover to previous highs, if profitability also recovers to previous highs.

Stockopedia is also unsure, with a middling StockRank of 50.

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370p (up 6% at 08:55) – mkt cap £152m

Trading amp; Business Update

This is an AGM update, relating to FY 12/2021.

Here is my review of the FY 12/2020 results, which is useful as a quick reminder to get up to speed. I have a positive view of this share, due to its strong track record, impressive 2020 results, and decent balance sheet. Plus management has plenty of skin in the game, very important in my view.

Today’s update – very clear, and positive-sounding -

All three divisions of the Group have had a good start to the year.

In the Services businesses, the Ramp;D Consultancy division has seen particularly strong momentum in the Medical sector, while the Regulatory amp; Compliance division has continued the progress demonstrated in 2020.

The Frontier product division continues to perform well with material supply constraints likely to be the biggest risk in the current year.

So many companies are now reporting supply constraints. I don’t have a clue how long, or how serious such supply constraints could become, so it does worry me. That ties in with the risk of higher inflation – prices go up when things are in short supply, and people start hoarding, making the supply problems worse. However, higher prices then trigger more production, hence re-balancing supply amp; demand, and bringing prices back down again. Who knows how long this process might take? Anyone who claims to know is probably making it up as they go along!

H1 Guidance – this sounds impressive, but H1 last year was the worst affected period for covid/lockdown 1, so I’ll need to check the numbers next -

Given the continued business momentum, the Board now anticipates that the Group will report adjusted operating profit (“AOP”) for the first half of 2021 around 30% higher than in the same period of the prior year. This is a particularly notable performance since H1 2020 reported a record AOP for the Group and the current year includes a significant currency exchange rate headwind relative to the strong 2020 comparator.

OK, I’ve checked the H1 2020 results, and fair do’s, they were strong numbers – e.g. adj operating profit up 50% to £4.9m. Although I would deduct from that £376k in finance costs, and £691k in share-based payments (the company is rather too generous with share based payments in my view, and we can’t just ignore these, as they’re a form of staff remuneration).

This means H1 2021 should see adj operating profit of c.£6.4m – very impressive.

In EPS terms, it was 8.5p (adj. diluted) in H1 2020, add 30% to that, we get to just over 11.0p EPS in H1 2021.

Seasonality - there doesn’t seem to be any particular bias from H1 to H2, with both 2019 amp; 2020 seeing sequential half years roughly in the same ballpark, or maybe a bit of a favourable H2 profit bias.

Put that together, and it looks to me as if SAG is probably on track to beat broker consensus of 19.9p EPS for FY 12/2021. Maybe 23-25p could be on the cards (my guess)?

Liquidity – looks fine, and could give scope for Mamp;A deals -

Gross cash at 30 April 2021 was £29.5 million with net funds of £13.3 million.

Strategic review – SAG has been looking at options for its digital radio business, called Frontier, for a while now. It’s decided to keep it -

… the Board has concluded that retaining Frontier in the Group is the most attractive option for Science Group shareholders and has decided to terminate potential sale discussions.

That makes sense to me. An excellent turnaround has been achieved at Frontier, and it’s now contributing strongly to group profits, so why sell it? The only reason I can see would be if someone offered a big premium price. If not, then keeping it seems a good idea, but obviously management are the best judge of that.

Freeholds – I’m not entirely sure what they’re saying here, it mentions a sale amp; leaseback valuation. The upshot seems to be that valuation hasn’t changed much, and ownership of one of the properties is being moved within the group, I think.

My opinion – the only thing that puts me off buying this share is that it’s painfully illiquid, with a wide spread (although often the real prices for small caps are inside the published spread).

Today’s update is excellent I think, and shows that the group appears to be well on track to beat full year market expectations of 19.9p EPS. If it gets to say 23-25p, as I suspect could be on the cards, then at 370p the valuation is between 15-16 PER.

That looks attractive value to me, for a quality business. Hence a thumbs up from me, as previously. A thumbs up from the Stockopedia computers too, with the StockRank currently very high, at 92.

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197p (pre-market open) – £303m market cap

Trading update

Creo Medical Group is a medical device company focused on the field of surgical endoscopy. From what I understand, the company’s products use microwave energy and other techniques to provide less invasive treatment options than traditional methods.

Today’s trading update starts with an upgrade to full-year revenue guidance - even though we’re only in May. That seems an encouraging start.

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Creo was founded in 2003 and only floated in 2016. It’s yet to make a profit, but my initial impression is that it’s a credible medical tech business that could do well over time. I note that Baillie Gifford is the second-largest shareholder. Founder and chief technology officer Chris Hancock has a 2.8% stake in the business, so also has some skin in the game.

After an initial post-IPO surge, Creo shares have remained somewhat range bound. But the firm has not destroyed shareholder value like some new floats. Despite some equity fundraising, dilution hasn’t been too awful either, in my view.

Trading update

Creo’s sales into hospitals were hit by Covid-19 last year, which caused many elective surgeries to be postponed. However, management says that activity levels are returning to pre-COVID levels more quickly than expected, especially in the UK and France. This has led the company to upgrade its revenue guidance for 2021.

The board now expects revenue for 2021 to be “at least 10% ahead of current market expectations of £20.1m”.

This clear guidance suggests a figure of £22m or more, which shows a strong rate of growth from the £9m expected in 2020.

Management says that there has been “an increase in commercial activity from Creo’s core products” but also notes “strong contributions from Albyn Medical and Boucart Medical”. Both of these firms were acquired during 2020, for a combined consideration of up to €32.5m.

Although I’m often sceptical about acquisition-led growth, Albyn and Boucart do seem to be well matched to Creo. Both of the acquired firms sell endoscopy products and consumables in Creo’s target markets. They should provide the firm with stronger distribution channels and improved commercial scale. Interestingly, it seems that Albyn was acting as a consolidator in its markets before being acquired itself by Creo.

Creo plans to use a similar acquisition strategy to build out its presence in the US market. Management are currently said to be looking at “high-quality prospective acquisition candidates”.

My view

Creo’s technology appears to have the potential to deliver commercial and medical benefits. The firm’s picturesquely-named Speedboat Inject device is said to offer potential savings to the NHS of £5,000 per procedure, compared to traditional open surgery.

My knowledge of this sector is limited, so I’m not in a position to judge Creo’s technology or its clinical credentials. However, I can take a look at the company’s equity.

Stockopedia awards this share a lowly StockRank of 13, understandably. Creo has never generated a profit and only started generating any revenue in 2020:

Fortunately, this company appears to be quite well funded. The most recent accounts (30 June 2020) show a cash balance of £71m.

Half-year cash burn last year was around £10.5m and the company has also completed the acquisition of Boucart for €4.5m upfront since then. But I’d guess that the current cash balance could still be in the region of £50m. We’ll get an update when the firm’s 2020 results are published in early June.

Creo’s cash balance should give the firm room to keep growing, at least for a while. However, the firm’s £303m market cap values the business at around 13 times 2021 forecast sales, even after deducting cash.

This valuation suggests to me that significant levels of growth are already priced in. The firm’s technology and strategy seem credible to me, but I don’t have the sector knowledge needed to judge the potential scale of Creo’s markets. For this reason, this situation is too speculative for me to want to get involved. But I’ll watch with interest.

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444p (+2% at 08.30) – £371m market cap

Full-year trading update

Listed legal services businesses seem to be multiplying fast on the London market. Knights Group says it was one of the first to convert from a partnership model to a corporate structure, in 2012. This company is a full-service legal business serving corporate clients and high-net worth individuals, who are typically clients of its corporate customers.

CEO David Beech is the largest shareholder, with a 20% holding.

Trading update

Knights Group floated on AIM in 2018 and has since tripled its revenues. Today’s full-year update for the year to 30 April continues this theme, guiding investors to expect “revenue for the full year to be in excess of the market consensus of £100.8m”. This implies growth of at least 36% from last year’s figure of £74m.

Profits are also expected to be ahead, at least on an adjusted basis. Management says that underlying pre-tax profit should be “moderately in excess of market consensus” of £18m. This represents a minimum increase of 32% from FY20.

As with Creo, Knight’s RNS writers have helpfully included the consensus, rather than just referring to it. Great stuff.

Trading is said to have been much stronger during the second half, as “momentum returned”. However, although these growth figures look strong, Knights Group has been highly acquisitive since its flotation. Organic growth has been much more modest over the last year:

• H1 FY21: organic revenue -15% (Covid-19 impact)
• H2 FY21: organic revenue +8%

For some historical context, organic revenue growth was 10% in FY20, which ended on 30 April 2020.

Acquisitions: Covid-19 did not stop Knights from making acquisitions. The company acquired OTB Eveling LLP (£2.1m) and Mundays LLP (£5.3m) during the year. Since the year end, the acquisition of Sheffield firm Keebles LLP has been agreed for £11.5m.

Knights expects to “selectively execute on an attractive acquisition pipeline” during the current year.

Balance sheet amp; liquidity: Knights says that year-end net debt was £21.2m, excluding lease liabilities. This represents 0.9x underlying EBITDA, according to today’s update. I prefer to use a more concrete measure of profitability, but this level of leverage doesn’t seem excessive when measured against guidance for underlying pre-tax profit of at least £18m.

IFRS 16 lease liabilities are excluded from the figure above, but are quite material. Knights’ half-year accounts showed lease liabilities of £32m. I imagine these relate to long-term office leases, which shouldn’t be problematic unless the space becomes surplus to requirements. But I think this liability is worth noting, all the same.

CEO comment: CEO David Beech says that the group’s growth through acquisition has helped to achieve “critical mass”. Mr Beech says that this has enhanced Knights’ credibility and is helping to attract “high calibre talent and an increasing number of [client] opportunities”.

My view

Despite Knight’s strong share price performance since listing, Stockopedia’s algorithms take a cautious view on this stock, awarding a StockRank of just 19.

To some extent I share this view, for a couple of reasons.

Knights’ profitability seems to have worsened since its flotation. On a statutory basis, profit growth has not kept pace with revenue growth:

Although Covid-19 hit performance last year, I think the main reason for this decline in profitability is the ever-increasing set of costs relating to acquisitions. These are excluded from Knights’ underlying measure of profit but remain very material:

For a company that’s executing an acquisition-led growth strategy, I don’t think all of these costs should be treated as non-underlying. In my view, they’re clearly part of the cost of doing business.

We could argue that as the group’s scale improves and the pace of acquisitions slow, these underlying costs will drop out and profitability will improve. That’s perfectly plausible, in my view.

However, my second concern is that I’m not convinced a plc structure is ideal for services businesses that have traditionally been operated as partnerships.

In general terms, I think the partnership model for professional services firms creates a balanced alignment of rewards and responsibilities for partners. In contrast, I’d argue that a corporate structure introduces the risk of moral hazard.

More tangibly, I think that shareholder returns are likely to be limited by variable remuneration to fee earners, in lieu of partnership earnings.

I think we can see this with Knights’ dividend. Despite relatively conservative gearing and good cash conversion, consensus forecasts for 2021 and 2022 suggest that the dividend will be covered around five times by earnings in both years. That’s a pretty mean payout ratio in my opinion, unless there’s not really much cash to spare.

The bullish argument here is that Knights is preserving cash to use on acquisitions and support growth. I see that. But the accounts show that staff costs accounted for more than 60% of revenue. Each acquisition brings more fee earners, so I expect remuneration as a percentage of revenue to remain high.

Final thoughts: So far my scepticism has proved unfounded. Knights Group’s share price has risen by around 150% since its flotation in 2018 and no problems have yet emerged.

However, the stock now trades on around 20 times 2022 forecast earnings and offers a yield of just 1%. Until I see evidence of a material improvement in profitability, this isn’t a situation that interests me.

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Stockopedia