Small Cap Value Report (Mon 17 May 2021) - CER, BOWL, DCTA, VLS

Good morning, it’s Paul amp; Jack here with the SCVR for Monday.

Timing – it’s a quiet day for newsflow, so we’ll be done well before 1pm official finish time. Update at 13:33 – ah well, the best laid plans amp; all that. Today’s report is now finished.

Agenda -

Paul -

Cerillion (LON:CER) – sparkling interim results, which are in line with the last trading update. This software company seems to be on a roll, with a record order book too. It’s risen a lot in price, but that higher valuation does look justified in my view.

Hollywood Bowl (LON:BOWL) – Half-year results severely impacted by lockdown, no surprise there. I delve into the balance sheet, to investigate the risk of further dilution, and come away reassured that it’s probably modest. Post-covid recovery looks already priced-in, so I can’t see a lot of upside on the current share price.

Jack -

Directa Plus (LON:DCTA) – good revenue growth and real potential for this graphene producer, but it remains loss-making, speculative, and high-risk.

Velocys (LON:VLS) – continued losses and equity dilution from this risky clean energy play, which boasts Chelsea FC owner Roman Abramovich as a major shareholder.

640p (up 5% at 08:34) – mkt cap £188m

See our archive here, where we’ve tracked the series of positive updates from this software company. It provides billing software for telecoms companies. A hat-tip to Graham Neary, who originally flagged up this interesting company, when it was less than a quarter of the current price. Although it’s been recent, larger amp; more frequent contract wins, which have really driven the share price upwards.

Plus of course the widespread multiple expansion (i.e. higher PERs) which has seen almost everything go up in price lately. Everyone’s a stock-picking genius at the moment!

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Interim Results

Cerillion plc, the billing, charging and customer relationship management software solutions provider, today issues its interim results for the six months ended 31 March 2021.

Record Six-month Period and Continuing Strong Prospects

The market likes these numbers, as the share price has risen 5% in early trading.

I covered the H1 trading update here on 19 April 2021.

Guidance (H1) was -

Revenues £12.8m
Adj EBITDA £4.8m
Net cash: £7.7m

Actual H1 numbers today are -

Revenues £12.8m (up 26% on H1 LY) – in line with guidance
Adj EBITDA £4.8m (up 77% on H1 LY) – in line with guidance
Net cash £7.7m (up 60% in last year) – in line with guidance

All good there, no surprises.

Those numbers don’t particularly matter, the actual profit numbers here are more of interest to me:

If we simplistically double the 11.5p H1 EPS to annualise it (which is what happened last year), that comes out at 23p, so at 640p per share, the PER is 27.8 times – quite high, but the company’s strong growth, and impressive order book growth make that rating look justified, in my view.

Broker forecast – many thanks to Liberum for making available an updated research note today, via Research Tree. Analyst Janardan Menon explains that his 15.5p EPS forecast for FY 09/2021, and 16.0p for the following year, are conservative. I’m thinking of treating those numbers as the worst case scenario, which don’t take into account potential new contract wins in H2, due to uncertainty of timing. That seems a very prudent approach.

Given the big order book growth, I’d be inclined to push the boat out a bit more, and value the company on the basis that forecasts could be comfortably beaten. Maybe 20p EPS forecast, and a PER of 30 to reflect the strong growth, might be about right? That would equate to 600p per share, hence the current share price of 640p is probably in the right ballpark for valuation.

EDIT: see comments further down, on much more aggressive forecasts from N+1 Singer. End of edit.

Outlook – all sounds good, but remember that H1 has already achieved the bulk of forecast FY 04/2021 results, so the bar is currently set very low. Hence, we should expect out-performance in H2 against low targets -

The business has made tremendous progress and remains very well placed operationally and financially. The robust balance sheet, which now carries no debt, and the significant increase in recurring income provide a strong underpinning and platform for future growth.

Existing major implementation projects and the strong back order book leave Cerillion very well-positioned to achieve its full year targets. The expanded pipeline of new business will also support continuing revenue and earnings growth. The Board therefore remains confident of future prospects this year and beyond.

Balance sheet – NAV is £17.2m, less intangibles of £6.1m, gives NTAV of £11.1m, which I would say is healthy for the smallish size of the company.

Lease liabilities are quite high for a small company, at £4.3m, offset mostly by a £4.0m notional right of use asset. Does it have excessive office space? We can’t really tell, as the IFRS 16 entries are pretty useless, and probably best just crossed out.

Receivables concern me. Trade and other receivables total £15.0m, which strikes me as too high. That is the total of work done but not yet invoiced, plus invoices which have not been paid yet. £15.0m seems a lot – more than revenues for H1. The risk is that revenue recognition could be too aggressive, or that receivables could contain items which might not turn into cash. I’m not suggesting anything is untoward, just flagging the risk that comes with unusually high receivables.

EDIT: I asked management about this point, see notes further down. End of edit.

Cash of £7.7m is good, but note that deferred income of £8.2m offsets the entire cash pile – i.e. the cash has all come from customers paying up-front.

Cashflow statement – cash generation wasn’t great in H1, due to increased working capital, which I suppose is inevitable when revenues are growing strongly. Looking at the prior year comparatives, cash generation was modest in H1, but better in H2, so perhaps there is some seasonality in cashflows?

Development spend of £484k was capitalised in H1, which looks fine to me – relatively modest.

Dividends - a rising stream of divis has been paid in recent years. Although the big rise in the share price has lowered the yield, which is only about 1.1%. Still, this is a growth stock so getting a modest divi on top, is a bonus, rather than the main reason to own this share.

My opinion – I haven’t delved into the narrative alongside the results, as it’s really your job to determine what you think the company’s future prospects are like, because that’s what will ultimately determine if it’s a good investment in future, or not.

In terms of the numbers, I think the current share price does stack up – it looks priced about right, on a fairly warm PER, but I think the strong performance amp; record order book justifies that.

Balance sheet – I’m a little concerned about the high level of receivables, because that introduces more risk. I might query that with the company. Maybe it builds up effectively work-in-progress, and then bills the client when the system goes live? I’ll ask them to give me some more colour on how working capital works. It’s probably fine, but just something I’d like to better understand.

Overall though, the company seems to be making really good progress, and I continue to be impressed with the size amp; quality of the contract wins, and that these contracts are sticky. Hence it’s building a stream of recurring revenues.

Substantial sales of shares by management look to have been premature, are they kicking themselves now?!

It’s not something I would be interested in buying at the current level, because I’ve missed the boat, but it’s on my watchlist of things to pounce on when we get the next market correction. Prices often go soft over the summer too, in illiquid shares. Offset against that, the forecasts are so low, that it’s probably just a matter of a couple of months before we get the next “ahead of expectations” trading update.

Note the low value score below is to some extent caused by the very conservative broker earnings forecast. Once the actual numbers come in, probably well ahead of forecast, then the value score is likely to rise. Hence I won’t let the low value score put me off.

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EDIT: Another broker note has just come through, from Harold Evans at N+1 Singer, many thanks for this. It puts a completely different perspective on things, with much higher EPS forecasts than Liberum. Singers is forecasting:

FY 09/2021: 23.7p

FY 09/2022: 40.8p

That’s a huge divergence from the figures Liberum has put out. It’s down to the company to manage the analyst expectations, so I cannot understand why it’s gone along with 2 wildly differing analyst forecasts? Although the Singers note is probably best seen as more independent than the house broker note from Liberum.

On the Singers figures, the PER would drop down to about 16 times next year’s earnings, which would make this share good value.

As mentioned above, the Liberum numbers look far too low to me, so I think the Singers forecasts seem more in line with the strong growth amp; record order book/pipeline.

Call with management

I’ve just had a quick Teams call with mgt.

Q1. High receivables query

A1. Milestone payments can be large (£1m+) so receivables balance reflects timing impact of how projects are progressing from signing, to going live . Mgt not concerned about bad debt risk. IFRS 15 determines revenue recognition, so timing differences will occur. Last year good cash collection in H2. They’re happy with cash collection this year too. Trajectory of revenues is up, so receivables will also rise. I think I’m happy with that explanation.

Q2. How dependent is the company on one-off licence wins?

A2. It’s becoming less of an issue as the company grows, building recurring revenue streams. My view – I think it’s fair to say this is still an important part of revenue/profits, so there’s always a risk that there might be a fallow year, without big contract wins, at some stage.

Q3. Director share sales – do they regret them now?

A3. The selling was mainly Guy O’Connor, which was a retirement sale. The risk of higher CGT was also a key driver.

Q4. Wide discrepancy between Liberum amp; Singers forecasts – why is this?

A4. Best to see Liberum forecasts as cautious (as stated in the note), and Singers have gone with more aggressive numbers, which assume further strong contract wins. My view – it’s unusual to have such wide differences between analyst forecasts, but at least this gives us a range of possible outcomes. I quite like having one cautious forecast, and one aggressive forecast.

Other points – more as feedback, I mentioned to management that many private investors like to see adjusted profit, and adjusted EPS quoted in trading updates, not just adj EBITDA. Also, I mentioned that it’s helpful to state in a footnote what profit expectations are, when issuing ahead of expectations trading updates. Management seemed interested in these points, and noted them down, so I hope it was useful to give them this feedback.

End of edit.

232p (down c.2% at 12:49) – mkt cap £396m

Half-year Results

Hollywood Bowl Group plc (“Hollywood Bowl” or the “Group”), the UK’s market leading ten-pin bowling operator, today announces its interim results for the six-month period ended 31 March 2021 (“H1 FY2021″).

STRONG CUSTOMER DEMAND EXPECTED UPON REOPENING

WELL POSITIONED TO RECOVER TO PRE-PANDEMIC PERFORMANCE

That’s fairly obvious. There’s no point in going through the numbers for the half year when enforced closure had such an impact, other than to check the balance sheet for the risk of more dilution – a very important point that I think many investors may not be factoring into their figures.

Pre-covid, the share count was about 154m (which you can check for any company in the StockReport, the “Average Shares” line, near the bottom). Then compare that with the latest number of shares in issue right at the bottom of the StockReport, which is 170.6m. That’s about 10.8% enlargement of the shares in issue. This means that, looking at the chart, the current share price of about 232p looks similar to the same price pre-covid. But it’s not! The market cap is now 10.8% higher, for any given share price. Or put another way, 232p pre-covid is now the same valuation to 209p per share with the larger number of shares in issue. In numbers, this is;

Pre-covid example valuation: 232p * 154m shares in issue = market cap £357m

Same valuation now: £357m market cap divided by 170.6m shares = 209p per share.

I’ve taken average share count above, the actual dilution is a bit lower, taken from the report today, but it’s near enough, I was explaining the concept rather than working out the numbers precisely:

Balance sheet strength has remained a core priority and on 12th March 2021, the Group issued the equivalent of 8.3per cent of its then issued share capital, raising net cash of £29.2m.

Hence it possibly doesn’t make any sense to draw lines on the chart, because the number of shares in issue has changed.

How many more companies will need to repair their balance sheets in future, with fresh equity raises, once the Government expects VAT/PAYE/NIC arrears to be paid up-to-date, and landlords are able to send bailiffs in again when the eviction moratorium ends? Plenty, I reckon.

I don’t think there’s much doubt that BOWL should have a decently profitable business again in the future, once they’re able to operate without restrictions. Plus pent-up demand.

Revenues in H1 were only £12.0m (down 83% on the comparable H1)

Loss before tax was about £14m in H1 and the previous H2, so the way I look at things, the company has effectively dissipated in losses a similar amount (roughly) to what it raised in the placing, hence is back to square one really, but with more shares in issue.

Balance sheet - not great actually. NAV of £91.6m is mainly intangibles (of £78.0m), so NTAV is only £13.6m.

However, as usual, IFRS 16 entries muddy the water, as follows:

Right of use asset £130.3m

Current lease liabilities £(16.9)m

Non-current lease liabilities £(156.0)m

Net deficit from IFRS 16: £(42.6)m

If we eliminate all these entries, then NTAV rises from £13.6m to a much more healthy £56.2m.

I’ve been told by the CFO of another hospitality sector company that the IFRS 16 entries are currently being calculated on a depressed trading basis. Therefore he reckons once trading normalises then deficits on IFRS 16 could reduce. Hence unless BOWL has any specific problem leases, then I think it’s probably best to assume its balance sheet might look a lot healthier in future, when sites are trading normally again (we hope).

What’s my conclusion about dilution risk then? Given that the balance sheet is probably OK, or near to OK, and the market cap is nearly £400m, and the bank borrowings don’t look at all excessive, then I reckon it’s probably fairly safe not to worry about dilution here. A small top-up placing of say £20m would only be 5% dilution, and I can’t see why any more than that would be necessary.

The big risk is obviously if covid takes a really bad turn again, and vaccines don’t work. In that scenario, a potentially bigger placing might be necessary in the event of renewed lockdowns.

My opinion - in future, assuming full recovery, BOWL could end up making c.15p EPS, hence at 232p the share is rated on a PER of 15.5 – which seems reasonable. That’s pricing in a trading recovery though, so I question whether there’s enough upside to justify buying now, given that recovery is already priced in?

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Share price: 112.5p (pre-open)

Shares in issue: 61,365,459

Market cap: £68.7m

Established in Italy in 2005 and listed on AIM in 2016, a quick skim of the Directa Plus (LON:DCTA) website shows that this company is focused on an eclectic mix of graphene-related products.

There’s no doubt that graphene (‘the thinnest material known to exist) has a host of promising properties with various potential applications. But, as a developing material, it also likely attracts a host of cash-burning blue-sky companies that might never make it to profitability.

So I’m already on an ‘amber’ risk warning here.

Stockopedia agrees, with a poor StockRank and a clear history of operating losses, cash burn, and equity dilution (albeit set against revenue growing at a compound annual rate of 32.6%).

Directa Plus is one of the largest producers and suppliers of graphene nanoplatelets-based products for use in consumer and industrial markets. It has some unique graphene blends, identified by the G+® brand, with commercial applications such as textiles, tyres, composite materials and environmental solutions.

It has a ‘unique and patented technology process’. On this point, the group notes:

We rely on an increasingly valuable intellectual property portfolio that continues to build and the benefits of our chemical-free production process that sets Directa Plus apart from its competitors in different areas, such as textiles and batteries, that are normally compromised by impurities.

Final results

The Group has maintained its focus on developing and delivering products and services in the Environmental Remediation and Textile verticals, whilst continuing to deliver graphene enhancements to products in other areas where Directa Plus has identified significant commercial opportunities such as Lithium-Sulphur batteries and composites.

Highlights:

• Product sales and service revenue +144% to €6.43m,
• Total income (including grants) +141% to €6.78m,
• Reported (basic) Loss per share €0.07,
• Cash and cash equivalents at year end of €7.08m (2019: €10.91m),
• Total patents granted at year end 38 (2019: 23).

Total income comprises revenue from product and service sales (€6.43m), and other income including government grants (€ 0.16m) and a €0.10m Research and Development Expenditure Credit.

Environmental remediation has grown from 33% to 68% of revenue. The business has won contracts for cleaning oil equipment and to provide waste management services and has a pipeline of active tenders across Europe.

Textiles has fallen from 63% to 30% of revenue. Composites – looks like early days but ‘asphalt applications of our G+ graphene technology is proving exceptional results, and the interest on the market of our product is also growing internationally.’

There is a selection of other verticals being targeted, including a new prototype Lithium-Sulphur battery, graphene-based automotive components, and consumer electronics applications.

Conclusion

I acknowledge the upside here. Patented graphene production has great longer term potential.

But there are more prosaic risks for investors to consider in the meantime, such as cash burn, equity dilution, the runway to profitability, and the commercialisation of products. Things tend to take longer than expected and if this proves to be the case with Directa, it is not yet in the self-funding position to tread water.

And, valued at more than 15x sales, there is quite a lot of growth already priced in.

That said, revenue is growing at a fair clip so if it can maintain that momentum then perhaps it can reach breakeven without further dilution and grow into the share price.

Directa notes that:

The Board is confident about future prospects and expects continuous growth. This is confirmed by the strong performances registered over the start of the current year: in the first four months of 2021 revenues have been around €2.8m, +49% compared to the previous year.

There’s certainly a case worth investigating here, although you will likely need a high risk tolerance and must go into it with your eyes open. This is a loss-making company with evident potential. Some of those come good, but the timing can be tricky.

In the dubious hierarchy of ambitious loss-making stocks, I would put this closer to the top of the pile given its revenue growth and patents. I wouldn’t want to hold the shares just yet, but it’s worth keeping an eye on for material developments or in case the share price weakens.

Velocys (LON:VLS)

Share price: 5.07p (-7.86%)

Shares in issue: 1,064,556,057

Market cap: £54m

Again we find ourselves in the more speculative end of the market, but if Directa starts with an amber light then Velocys (LON:VLS) has to be a red from the get go.

The bankruptcy risk is, apparently quite literally, off the charts.

This is a sustainable fuels technology company, which is currently developing projects in the US and the UK to produce fuels that reduce greenhouse gas emissions for aviation and road transport.

Revenue comes from licensing technology, supply of reactors and catalysts, and technical and project services. It is also invested in some related early stage projects.

Some of the financial data are eye-catching for all the wrong reasons. How does a trailing twelve month operating margin of -1,534% sound? Or a ROCE of -8,740%?

Given the above, it is unsurprising to see a Quality Rank of 4 and a StockRank of 3 for Velocys.

We’re spoiled for choice here, but we can point to the equity dilution as the final alarm bell for now: from 144m shares in issue in 2014 to 512m in 2019 and more than 1bn today.

Final results

• Fundraise of £21m (before expenses) in July 2020,
• Revenue of £0.2m (2019: £0.3m),
• Total deferred revenue of £8.2m including £2.1m invoiced and received from commercial customers during 2020,
• Administrative expenses before exceptional items reduced by 7% to £9.2m (2019: £9.9m),
• Operating loss of £8.8m (2019: £9.6m) before exceptional items
• Loss before income tax for the year of £9.6m (2019: £9.9m)
• Cash at year end of £13.1m (2019: £4.8m)

Even accounting for cost cutting, the cost base is too large here for the levels of revenue being generated.

It is possible that the group will reach some key inflection point soon, as seems to be suggested in the broker forecasts.

But it seems more likely that more cash will have to be raised given the rate of spending and the group’s track record in this regard.

Four achievements during the year were of particular note:

The successful completion of the manufacturing of four FT reactors and catalyst and delivery to Red Rock Biofuels’ Lakeview site in Oregon.

The group’s application for Planning Consent for the Altalto waste to jet fuel project was approved in May 2020 by North East Lincolnshire Council.

July saw an oversubscribed fund raise of £21m, and further contributions from both British Airways and Shell towards the technical development of its Altalto project.

Velocys concluded the wood chips to SAF NEDO demonstration project in Nagoya, Japan with its partner, Toyo Engineering Corporation.

The group also notes a ‘number of high-quality interviews with the CEO’ and ‘the mention of Velocys at the Downing Street daily briefing by the Secretary of State for Transport, Grant Shapps in June 2020’.

High quality interviews are presumably better than low quality interviews, but profitability would be better than either. And Grant Shapps mentioning your name isn’t much for investors to hang their hats on.

Conclusions

No qualms with Stockopedia’s description of Velocys as a ‘Highly Speculative Small Cap Sucker Stock’.

If there was a good risk:reward opportunity here wouldn’t directors be buying more shares at these levels?

I’m comfortable letting other investors take up the investment risk here. There is an investment case and a potentially large addressable market. There always is with these stocks, that’s why people get tempted in.

It might be that Velocys comes good and transforms into a clean energy powerhouse but, on balance, it is more likely that some kind of delay to revenue growth arises and further funds are required in my opinion.

The group exhibits a pattern of behaviour over time of raising cash from shareholders, spending that money, and then raising some more. In 2014 it raised almost as much as today’s entire market cap. Where has that capital gone?

Stockopedia