Small Cap Value Report (Fri 16 July 2021) - RNO, EVE, LUCE, RBGP

Good morning, it’s Paul amp; Jack here with the SCVR for Friday. Welcome back Jack!

Disclaimer -

A quick reminder that we don’t recommend any stocks. We aim to cover trading updates amp; results of the day and offer our opinions on them as possible candidates for further research if they interest you. Our opinions will sometimes turn out to be right, and sometimes wrong, because it’s anybody’s guess what direction market sentiment will take amp; nobody can predict the future with certainty.

We stick to companies that have issued news on the day, with market caps up to about £700m. We avoid the smallest, and most speculative companies, and also avoid a few specialist sectors (e.g. natural resources, pharma/biotech).

A key assumption is that readers DYOR (do your own research) – don’t blame us if you buy something that doesn’t work out. Reader comments are welcomed – please be civil, rational, and include the company name/ticker.

Timing - TBC

Agenda –

Paul’s Section:

Renold (LON:RNO) (I hold) – delayed results are in line with expectations. Strong closing order book, and positive trends throughout the year, markets recovering well. Management seem upbeat on analyst call, and now looking at acquisitions. Dramatic drop in net debt, due to very strong cashflow. This could be quite good long term, maybe priced about right for now, taking into account the big pension deficit?

Eve Sleep (LON:EVE) (I hold) – in line with expectations update is not enough to please the market. Super-low market cap, and cash pile, are the main interesting aspects of this company. I’m not convinced this will turn out well, and am not inspired by management/strategy either.

Jack’s Section:

Luceco (LON:LUCE) – excellent results and an upgrade in FY guidance from a stock that has performed strongly over the past year. In truth, it has been growing well for a while now and this could be a well managed company with a bright future. The valuation is becoming a little rich, but some companies deserve their premium. Luceco might be one of them.

Rbg Holdings (LON:RBGP) – growing, acquisitive professional services group comes out with an in line statement. Perhaps the market is unimpressed with a setback in a large litigation financing case, but the valuation looks undemanding once Memery is fully integrated, and the longer term growth opportunity remains intact in my view

(I hold)

22.7p (down c.1% at 10:01) – mkt cap £52m

Final Results

Apologies for this section taking a while to gestate. I’ve had one of those mornings when it’s been really busy, but so far my productive output has been nil!

Holding this share has been a bit stressful this year, because it twice delayed publication of results for FY 03/2021. As it turns out, the reason given (auditors slow) does appear to have been genuine, although I fully understand why people (including myself) got anxious that there might have been some unfolding horror show imminent.

In overview, the figures are in line with guidance previously provided, few key numbers –

Revenue £165.3m, down 12% on prior year, due to pandemic impact – the signs are that this shortfall could be recovered in future years, so I think there’s upside looking very likely from these new, soft comparatives.

Adjusted operating profit is highlighted, at £11.2m, down 16% on prior year (I’m using the actual exchange rate table, not the constant exchange rate table). This is a decent outcome actually, because a 12% revenue drop would normally be amplified considerably at the profit level, due to oeprational gearing (i.e. falling gross profit meets fixed overheads). However in this case, there’s been the benefit of last year’s cost-cutting through restructuring (now complete). Hence a resilient performance, and in line with expectations (previous guidance).

I’m not keen on operating profit these days, because IFRS 16 has shifted some rental costs into finance charges. Note 3 shows the breakdown of heavy financing costs of £4.6m, which includes £2.2m relating to the pension schemes, an ongoing cost, so I wouldn’t want to strip that out. Profit before tax of £5.9m is the more meaningful profit measure in my view, which is actually up 20% on LY, due to last year’s £2.4m restructuring costs (nil this year).

Adjusted EPS is 2.0p, in line with broker consensus. That’s down 31% on LY. I think it’s realistic to assume that, on the new lower cost base, future trading should recover to 3.0p per share, so I’m happy to value the business on say 10 times that, so 30p per share – decent enough upside on the current price, in due course.

Balance sheet – the stand-out issue, which we’ve discussed here before, is the large pension deficit. This is on the balance sheet at £102.4m. The best way to view this, is a long-term liability, that has a long-term funding plan in place, costing about £5.5m p.a. in cash contributions. That’s a lot, but Renold has successfully shouldered this burden, without needing to raise fresh equity. But it does explain why there aren’t any dividends for now.

Other than that, the rest of the balance sheet looks fine to me, and this year has seen a dramatic reduction in net bank debt, down by about half to only £18.4m – so the company should not be seen as financially distressed any more, it’s pretty solid now.

Cashflow statement – is very impressive. Tighter management of working capital (e.g. reduced inventories), combined with reducing capex to maintenance level only, has resulted in a whacking great cash inflow, allowing it to reduce bank borrowings by £17.1m.

Analyst briefing

We’ll be here all day if I keep going through the RNS, so instead I’ll share my notes from this morning’s analyst call. As usual these notes don’t cover everything, I tend to just jot down the most important points.

Excellent cash generation – big reduction in net debt

Gradual improvement as the year progressed, eg. Q4 revenues down 5.4%

Increasingly flexible cost base

Chinese factory doing well amp; scope to expand amp; increase profitability

Major restructuring complete – lower cost base

Net debt down from £36.6m to £18.4m in the year

Head office costs absorbed £1.0m cost of environmental provision in France (old Calais site)

Capex reduced to just £2.9m (maintenance level) – major capex now done over last 9 years factories have been modernised

Pension cash outflow has averaged £5.5m over long term, expect it to remain at that level, stable, for 17 more years

Bank covenants were amended, but complied with original covenants anyway

Order intake signficantly increasing

Customer amp; sector diversity protects Renold from sector-specific problems

Supply chain – still a problem, but varies, daily problems to be navigated. Containers very expensive, and don’t see this resolving itself any time soon – important point, as numerous companies are saying the same thing at the moment. Does it matter long-term though, I’d say not, as this is clearly a fixable issue.

Markets now extremely buoyant – we could be selling more if we didn’t have supply constraints amp; delays

Cost increases – are being passed on to customers quickly

Torque transmission division (smaller than chains) is a later cycle recovery, but now winning some nice orders, like RNS recently said. Also long gestation, but have won order for escalators on Budapest underground system

Using Indian amp; Chinese factories interchangeably, to get round issues like tariffs, lockdowns, etc, becoming a more global, integrated business

Acquisitions – much more of an area of focus now that reduced debt gives scope to make £10-20m acquisition. Very fragmented market, lots of opportunities.

My opinion – this looks fine to me. Nothing unexpected, and the outlook is clearly very much better than at the interim stage. I think the share is probably priced about right for now, but I see good upside to 30p+ with a bit of patience, due to the stronger order book, and ability to pass on cost increases to customers.

I like the focus on acquisitions, as that should dilute the pension deficit over time – i.e. if the size of the group were to say double over time, then £5m p.a. going out for the pension scheme wouldn’t really matter that much. Management seem very grounded, and they know the sector inside out, so know which businesses to acquire in complementary areas, in a fragmented market with small, specialist producers of chains in particular industry niches. So a good opportunity to be a sector consolidator, if handled well.

There’s also the wild card that someone else might decide to bid for Renold, that wouldn’t surprise me.

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(I hold)

3.95p (down 14% at 12:28) – mkt cap £11m

Trading Update

eve Sleep (“eve”, the “Company), the direct to consumer sleep wellness brand operating in the UK, Ireland (together “UKamp;I”) and France announces a trading update for the six months ended 30 June 2021.

It’s an in line with expectations update today, but clearly traders were hoping for better. I say traders because you can see from bulletin boards that this share has attracted speculative money, hoping for another spike up in share price.

I picked up some at 4.8p, attracted by the big cash pile relative to the market cap, and that it is actually generating reasonable, and modestly growing revenues.

The thing that put me off, on a recent company webinar, was that the CEO commented: we’re up against several very well-funded competitors. E.g. possibly Emma, Simba, I’ve seen TV ads from them on quite a lot. Eve went down the high cash burn, heavy advertising route a while ago, and failed to reach critical mass. That said, TV ads are often remembered by people for many years, so I think there could be brand value in Eve above the current market cap.

I wasn’t convinced by the strategy to broaden the product range into sleep wellness either. Although it does say in today’s update that some new products are selling well.

Management didn’t really fit my personal preference for dynamic founder/entrepreneurs, and I have no real conviction that their strategy is likely to work. Let’s hope they can [pull something out of the hat.

H1 sales rose 13% to £13.9m, so that’s maybe £30m annual run rate, not too shabby for a £11m market cap company, and memory foam mattresses are high gross margin products, with Eve selling a lot online. Marketing is a big chunk of overheads, so completely variable, giving flexibility.

Net cash is down, to £5.2m, but that’s almost half the market cap, and cash burn is much lower than in previous years.

Supply chain problems – interestingly Eve says these are abating somewhat, and it has increased stock levels to cope. That got me thinking, how much of the current international supply problems are being caused by companies increasing stock levels? That’s the natural response to any supply problems – hoard supplies. But that in turn makes supply problems worse, if everyone does it!

My opinion – there are signs of life here. It’s not a good business, but at £11m market cap, with plenty of cash remaining, and meaningful revenues, I wonder if someone might bid for it?

My feeling is that Eve is in an impossible middle ground – too small to be able to grow aggressively without a lot more funding, but costs that are too high to operate profitably on a shoestring as a small market participant.

This share is a bit of a special situation. Am wishing I hadn’t bought them now actually, but never mind. It’s too cheap to sell at 4p.

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Share price: 396.78p (+4.14%)

Shares in issue: 160,800,000

Market cap: £638m

Luceco is a manufacturer and distributor of high quality and innovative wiring accessories, LED lighting and portable power products for a global customer base. It’s been on a storming run for quite some time now, with a one-year relative strength reading of +163%.

The initial Covid slide already looks like a small bump in the rear view mirror.

The group supplies trade distributors, retailers, wholesalers and project developers with a wide range of products which broadly fall into the following brands:

• British General (“BG”): wiring accessories including switches and sockets, circuit protection, and cable management products;

• Luceco and Kingfisher Lighting: energy efficient LED lighting products and associated accessories; and
• Masterplug: cable reels, extension leads, EV chargers, surge protection, timers and adaptor products.

Trading update

Full year guidance that is ahead of current market expectations… We now expect to report H1 2021 revenue of £108m and Adjusted Operating Profit of £19m, versus previous guidance of £105m and £18m respectively.

Highlights:

• Revenue of £108m is +51% on H1 2020 and +31% on H1 2019, with ongoing market share gains ‘particularly during Covid’,
• Retail revenue +27% on H1 2019; Hybrid +70%; Professional Wholesale +34%; Professional Projects -8%,
• Residential demand continues to be strong with continuing high levels of home improvement activity,
• Commercial and institutional demand is improving,
• Gross margin up by 10bps to 38.5%, ‘protected from significant industry-wide cost inflation to date’,
• Adjusted Operating Profit more than doubles year-on-year to £19m, with Adjusted Operating Margin of 17.6%.

The strong performance comes from a mix of high sales growth, protected gross margin, and controlled overheads. Conditions have improved throughout the second quarter and ‘demand has been stronger and broader than expected’.

Luceco has a strong order book and H2 revenue is generally higher than H1, so there’s every chance of sustained good news.

Inflationary pressures are increasing, however. Luceco estimates the annualised cost impact has increased from £15m to £20m and these headwinds will increase in the second half. The group has so far protected its margins against inflation on raw material and freight prices – an encouraging sign that suggests a degree of pricing power – and it expects to be able to continue to do so.

Full year 2021 outlook:

• Revenue of at least £220m, 25% higher than 2020 and 28% higher than 2019,
• Adjusted Operating Profit of at least £39m, 30% higher than 2020 and more than double 2019,
• Adjusted Operating Margin of 18%, 1 percentage point higher than 2020 despite inflationary pressures,
• Net debt is expected to be approximately 0.25x LTM Adjusted EBITDA at year-end (before any Mamp;A activity),
• Cash conversion is expected to improve in H2, as extra inventory held in H1 to compensate for supply chain disruption is progressively released.

Conclusion

When times get tough, that’s when quality operators can really shine and take market share. This looks to have been the case at Luceco:

Superior and improving product availability in a tight market, as a result of our vertically integrated manufacturing model, has accelerated our market share gains toward the end of the half

Clearly, here’s a company with the wind in its sails. It’s growing strongly.

How sustainable are these growth rates? Luceco appears to have wobbled in 2018, but apart from that it has actually strung together a consistent record of net income growth.

Shares in issue have held steady over that time at around 161m, so a good amount of this progression is flowing through to shareholders.

If I assume another £3m of costs comes off after the forecast adjusted operating profit of £39m (as has roughly been the case in previous years) and apply a 20% tax rate, that would give a net income estimate of £28.8m or 17.9p of earnings per share. That’s pretty much right in line with the Stocko forecast of 18p and gives a forecast 2021 PE ratio of just around 22x.

The financial data and management commentary here suggest a stock worth investigating but with a market cap of more than £600m on forecast 2021 revenue of £208m and at the current valuation, is there limited scope for a further rerating or can Luceco continue to outperform? It’s probably a fair price given the track record and trading prospects, with upside potential should the company continue to impress organically or identify a promising acquisition.

That’s what I would want to look at: Can it become a materially larger company via organic and acquisitive growth? And does it have a clear runway for that growth?

It looks like a fine company in a sweet spot that is taking market share. The confidence in being able to protect against further inflation is reassuring.

Share price: 131.49p (-11.16%)

Shares in issue: 95,331,236

Market cap: £125.4m

RBG Holdings is a professional services group. Recently more of these companies have come to the fore on the back of changing regulations paving the way for easier acquisitions in this space. It looks to have triggered a wave of consolidation and ‘roll-up’ strategies.

RBG has the following divisions:

Rosenblatt – a pioneering UK law firm leading in dispute resolution, with a growing international footprint advising on complex cross-jurisdictional disputes.

Memery Crystal – specialist international law firm offering legal services across corporate, real estate, commercial, IP amp; technology (CIPT), banking amp; finance, tax amp; wealth structuring, employment, and dispute resolution. ‘One of the leading firms in the UK to advise the emerging cannabis sector on a wide range of business issues’.

Together, these two form RBG’s Legal Services Division (RBGLS).

LionFish Litigation Finance – finances litigation matters being run by other solicitors in return for a significant return on the outcome of those cases. RBG has two types of litigation assets – Rosenblatt’s own client matters, and litigation matters run by third-party solicitors.

Convex Capital – specialist sell-side corporate finance boutique based in Manchester focussed on helping smaller owner-managed companies realise sales to large corporates.

The stock’s done very well since January but the shares have been marked down somewhat this morning.

Trading update

It’s an in line statement today for the six months ending 30 June 2021. More details will be released in the interims on the 15th September 2021.

RBGLS – Rosenblatt and Memery Crystal have performed well. Memery was acquired on the 28th May of this year and integration is ongoing. RBG says the two brands are highly complementary and will be combined into one legal services business.

Opportunities should arise for the two firms from the combined client base, and RBG also aims to realise synergies by combining support functions and technology platforms. Further details on the integration plans will be provided with the Group’s interim results in September.

Litigation finance – The current litigation assets include three large cases project named Neptune, Shango, and Mercury. In the case of Project Neptune, the Court of Appeal recently found that because there was a 19-month delay in the judge providing a judgment, this judgment is not safe. Therefore, a full re-trial has been ordered with the date not yet set.

That’s a long time! I’m curious to know why there was a nineteen month delay. Perhaps this is in part down to Covid, or perhaps not – either way it sounds like a bit of a set back.

LionFish is actively invested in 10 cases in total however, with a total cash investment of £3.2m across and a total capital commitment of £8m if all cases go to trial.

Convex Capital – ‘After a challenging 2020, where deals were postponed or delayed due to Covid, the Convex Capital team worked to pivot its sector focus to rebuild its transaction pipeline.’

That suggests an interesting contrast between the public and private markets over Covid. We’ve just covered Numis (here), which is reporting bumper conditions amid equity placings and stock market IPOs. FinnCap too. And yet here we have Convex Capital further down the size chain reporting disruption. The group talks about ‘pivoting its sector focus’, so perhaps this is an issue more specific to Convex and its positioning, rather than the private market as a whole.

Following the change in direction, Convex Capital has completed eight deals generating revenue of £5.0m since the 1st of January this year and has a strong pipeline of 25 deals with several currently at various stages of completion.

Conclusion

Full year expectations are for FY21E (from Singer at least) are £45.5m of revenue, and adjusted EBITDA of £12.6m. Forecast EPS is expected to be down on 2020 and more or less back to 2019 levels at 7.92p per share, for a forecast PE ratio of 16.6x falling to 13.9x in FY22.

That’s quite modest if you expect RBG to continue growing at its historic double digit compound annual rates. Truthfully I’m not sure why the shares are down so much – probably a combination of profit-taking and the delays to the Neptune case.

Litigation financing is a tricky business to anticipate. There could be big wins here down the line but it’s hard to say when they might materialise. The Neptune delay is a case in point.

One thing to look for in these fast-moving acquisitive companies is just how adjusted ‘adjusted EBITDA’ is. In the past, cash flows per share have not tracked earnings per share all that well, so the extra detail provided in the upcoming interims will be enlightening.

With such an asset light people business, the balance sheet is also quite small so debt levels must be managed carefully. Interest cover is well in hand so this is not an issue for now but could change quickly depending on the nature of future acquisitions.

Apart from that, the growth strategy appears to be intact so I’d say this latest share price fall is an opportunity to dust off some notes and reassess the potential here.

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