Small Cap Value Report (Fri 15 Oct 2021) - SDG, GMS, LGRS, K3C

Good morning! It’s catch-up Friday, so here is something I prepared earlier.

Agenda -

Paul’s Section:

Sanderson Design (LON:SDG) (I hold) – luxury furnishings group, doing well, and reasonably priced. Super balance sheet. Ticks my boxes, as a value/GARP investor.

Gulf Marine Services (LON:GMS) (I hold) – *NB* High risk special situation. Worth a look, for experienced investors only, able to assess risk:reward at a problematic, highly indebted company.

Vertu Motors (LON:VTU) webinar

Jack’s section:

Loungers (LON:LGRS) – very good two-year like-for-like results for one of the best bar operators out there, but there’s been a strong recovery in share price since 2020 and the valuation looks full. There are supply chain and inflation risks to consider.

K3 Capital (LON:K3C) – thanks to readers for flagging this update hidden in a ‘Notice of Results’ RNS. Another upgrade – the company is making a habit of this. The growth rates and profitability metrics are impressive, and the acquisition opportunity remains fairly significant, so well worth checking out.

198p – mkt cap £140m

Interim Results – announced yesterday

Sanderson Design Group PLC (AIM: SDG), the luxury interior design and furnishings group, announces its financial results for the six months ended 31 July 2021.

Strong recovery continues with key financial metrics ahead of the previous two half years. Reinstatement of interim dividend. Full year trading in line with expectations

Top marks for clarity of presentation here – this is exactly how it should be done – giving us H1 comparisons with last year (pandemic), and the year before (pre-pandemic). In a table, not rambling text, and not cluttered up with percentage movements. Perfect!

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I’ve highlighted above how u/l PBT has bounced back to more than pre-pandemic levels. This is because SDG has undergone a very effective turnaround under new CEO Lisa Montague, who’s done a great job I think, judging from the numbers.

It’s all just common sense stuff – e.g. reducing product lines to focus on best-sellers (which has also reduced inventories – to the benefit of cash – note the very favourable progression in the net cash position). Also overheads have been cut, through efficiency gains (e.g. launching new lines online, instead of physically taking them round for customers to see).

Outlook -

“As we enter the second half of the financial year, we are mindful of the cost, supply chain and other issues affecting the UK and international business environment. We are focused on mitigating the potential impact of those issues on our business.

“Since the half year, manufacturing sales and licensing income remained robust and offset a slight softening in brand sales. Our key Autumn selling weeks in October and November have just started and we remain confident of meeting the Board’s expectations for the full year.”

The company doesn’t provide a footnote to explain what market expectations are. Nor can I find any broker research notes, so not great in that respect.

Stockopedia shows broker consensus of 12.1p. Given that 6.53p has already been achieved in H1, that looks reasonable. I can’t see any obvious seasonality from pre-covid results (which is confirmed in note 4).

Full year consensus of 12.1p equates to a PER of 16.4 – which seems a reasonable valuation, not stretched.

Results video – this is useful. I wish more companies would do these, as it’s easier to digest, than ploughing through a long RNS announcement. It also gives a flavour for the people running the company. The slides are too small to read, so if you click on the symbol with arrows going out in 4 directions, that makes it readable in the full screen mode.

Dividends – are back, but only a trifling 0.75p interim divi to begin with. Given the strong finances, and profitability, I expect that to rise in future.

Balance sheet - is very strong indeed. NAV: £71.5m, less intangibles of £27.6m, gives NTAV of £43.9m. That’s way more than is needed, for a business of this size. I’d say NTAV of c.£10-20m would be adequate.

Why does this matter? A strong balance sheet means little to no risk of dilution in a recession or other crisis, and that a business might be more attractive to a bidder. It also means better dividend paying capacity, ability to self-fund acquisitions, and that shareholders can sleep at night.

It scares me how many businesses are happy to risk the vagaries of the bank manager’s mood. In this recent crisis, the Govt took an unprecedented series of measures to prop up businesses and households, which has never happened before on anything like that scale.

What happens next time there’s a crisis, especially if interest rates globally are higher, and QE has stopped working? It could be carnage. Investors are learning very bad habits at the moment, in my view. People of my age amp; older remember what happened in the 1990-92 recession (and the early 1980s), when many geared businesses were wiped out, due to high interest rates.

I’m not saying things are going to collapse any time soon, but younger investors definitely need some historic perspective, and to understand that what’s happening at the moment is a complete aberration. In particular, the leniency of banks due to zero interest rates. They can afford to let problem borrowers find solutions, because the interest cost doesn’t mount up very much.

It’s my historic perspective (I was seconded to the insolvency division of PWC in 1991-92 (in a junior role), and saw a lot of fundamentally solid businesses fail, due to excessive debt) that is imprinted on my memory, and makes me avoid companies with weak balance sheets.

People who take crazy risks though, have been rewarded in many cases, during this pandemic. Don’t rely on that necessarily happening again, in future.

Pension deficit - the only negative I can find with SDG’s figures. The accounting deficit is only £4.7m, apparently insignificant. However, the cash outflows were £931k in H1, plus £199k admin costs, which is a fair chunk of profits. So this could be one of many cases where an apparently trivial accounting pension deficit is, in reality, a bigger cash drain than people expect. We’ve had several interesting discussions about this in recent SCVR comments sections. I’m no expert on pension schemes, so am only flagging up what I see, for your further more detailed research.

My opinion – sorry, I rambled off the point there. Getting back to SDG, it looks good to me. There’s a smashing turnaround underway.

From my limited sector knowledge, it sounds like more elaborate home decor is making a return, after years of minimalism. That plays to SDG’s strengths. I spotted a nice colour advert in the Sunday Times supplement for Sanderson last weekend. I do like their elaborate, historic designs, such as Morris amp; Co, and think there is a lot of potential value there. More importantly, the gross margin is c.60% – that is proof of pricing power, and matters more than anyone’s personal opinions.

Licensing revenues (which grew to £2.0 in H1) support that idea, and the deal with NEXT is going well, and being extended.

There’s a lot to like here, and I’m very happy to continue holding long-term.

4.6p – mkt cap £47m

NB. This is a high risk, special situation

Several shrewd investors have flagged this share to me, and I think it looks potentially interesting. This is outside my sector expertise, so please do your own research, carefully.

The company owns amp; operates about 13 specialised ships, which support oil rigs and offshore wind farms. The track record is dismal, with all sorts of problems, mainly excessive debt, and the company came close to insolvency last year.

However, the turnaround underway now looks interesting. Ships are chartered out on daily rates which are now rising. There’s limited competition. Stage 1 of a refinancing was successfully carried out by new management, including a placing, and renegotiation of bank facilities.

There’s more work to be done on refinancing in future.

However, the company is now set to generate huge EBITDA, with daily rates rising, due to the higher oil price. There’s only limited maintenance capex, because its fleet of specialist vessels are quite new (about 10 years old, of expected c.40 years life).

This should enable bank debt to be reduced considerably, which should in turn trigger more favourable lending conditions and interest rates.

The main risk is if the bank lending doesn’t improve as expected, and the bank plays hardball requiring more placings amp; dilution from warrants. So this is quite complex.

Interim Results

GMS, a leading provider of advanced self-propelled, self-elevating support vessels serving the offshore oil, gas and renewables industries, is pleased to announce its Interim Results for the six months ended 30 June 2021 (H1 2021).

This is the interesting bit – massive EBITDA for FY 12/2021, and high utilisation rates, which should drive further increases in daily hire out rates for the vessels (increases are subject to delays, because contracts tend to fix rates for say 12-18 months into the future, and then rise once the contracts expire).

EBITDA forecast for 2021 set at US$ 63-67 million

o Secured utilisation of 92% for H2 supporting FY 21 EBITDA forecast

Supply amp; demand means that higher utilisation rates tends to drive up daily hire rates – a virtuous circle.

My opinion – I’ve only scratched the surface of this, but wanted to flag it to experienced readers as a special situation that you might like to investigate properly.

What I like, is that the forward order book is clearly improving, and contracted revenues are rising. That means the anticipated rise in free cashflows should enable GMS to quite rapidly reduce its gearing, which is currently excessive, and the main reason why the share price is so bombed out.

Once the stock market realises that the company is now on the mend, then the benefit should all flow to equity, currently very bombed out.

Don’t be under any illusions though – this is a distressed situation, where something could go wrong, and I don’t know anything about the sector. So DYOR is more important than ever.

I’ve taken a small position personally (1% of my portfolio), and done a bit of research, and will see what happens. The timescale I anticipate is to wait until end 2022, which should hopefully show a marked improvement in the company’s finances, from free cashflows paying down debt.

The bear case is that thing could go worse than expected, and debt forces equity to step up with another placing (there’s a £50m additional placing potentially required), thus diluting holders. Hence it’s quite high risk.

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Share price: 303.36p (+3.71%)

Shares in issue: 102,738,664

Market cap: £311.7m

Loungers is one of the more recent Leisure sector listings, although it’s been around for a couple of years now. It’s often seen as best-in-class operator, offering a modern all-day proposition that partially reduces its dependency on key trading hours.

For all that though, it does look slightly expensive at 30.9x forecast earnings. This type of company can’t grow forever, there’s a limit to how many bars a concept can have without becoming oversaturated. Loungers does have two concepts – it’s got 150 Lounge cafe-bars and 31 Cosy Club restaurant-bars.

And there has been steady progress in revenue, which is forecast to continue. Nevertheless, a key consideration at today’s valuation is at what point growth might begin to moderate.

Trading update for the 24 weeks ending 3 October 2021

Loungers has maintained its ‘significant outperformance’ of the market since indoor trading recommenced. Over the 20 weeks to 3 October 2021, the group delivered two-year like for like sales growth of 26.6%. That does sound remarkably good. Typically, pub companies eke out single digit LfL gains, and after a lot of hard work at that.

So there must be something about Loungers’ concepts that genuinely resonate with the public. Somehow I’ve managed to never go to one but I’ll have to change that. If anybody has any of their own anecdotal reports on going to a Loungers site it would be great to hear those insights.

The LfL performance does benefit from a VAT reduction (not quantified in this update), however Loungers goes on to say that the strong performance ‘is testimony to the relevance and resilience of our brands.’

Net debt at 3 October 2021 was £11.9m, excluding a further £5.6m of outstanding rent and deferred liabilities payable to HMRC.

Since the start of the financial year the group has opened 13 new sites, comprising 12 Lounges and one Cosy Club, taking the portfolio to 181 sites. A further 10 sites are expected to open in the current financial year. So it’s expanding at pace. Again, I wonder where the ceiling is for sites.

In the 90s, successful restaurant chains could grow to 400 or so units in the UK but it’s become harder in recent years as customers turned to local, smaller operators. It’s still possible to operate in the hundreds – Loungers itself is a case in point – but my feeling is that the optimal limit for an estate of this type has reduced over the past decade or two.

Although not a direct competitor, Fulham Shore’s experienced management team sees scope for c150 additional Franco Manca and The Real Greek sites on top of its existing 70 or so units. So that’s about 220 in the medium term. Loungers is not far away from that target but then again with such strong like-for-likes, perhaps its concepts can support a larger estate.

Nick Collins, CEO, comments:

Our like for like sales have been consistently strong since re-opening, across all site age cohorts and both brands. In addition, I am particularly pleased with the strength of performance in the new sites we have opened in this financial year. Loungers continues to thrive as we put Covid behind us and manage the current challenges facing our sector. This success reinforces our roll-out strategy and we look ahead with confidence, with our pipeline of future sites as strong as it ever has been. I would like to say a special thank you to our teams across England and Wales for their fantastic performance over what was a demanding summer trading environment.

A more detailed half year update will be provided on 1 December 2021.

Conclusion

With such strong like-for-like momentum and given the pace of new openings, Loungers has the feel of a long term winner in this sector.

There could still be some upside in the shares from here, but I also suspect that there is a ceiling to be encountered, probably in the next five years if current store opening plans are anything to go by. It will be 23 new sites this year, close to its target of 25 per annum.

Successful bar and restaurant concepts tend to attract strong competition as canny operators refurb their own units after taking note of what works. I’ve seen exciting new concepts become mainstream and oft-imitated over a span of ten years or less.

It does look like Loungers is in a sweet spot though, with what for now remains a fairly unique proposition and sites located in suburban and market towns, where trade has recovered more strongly. Rent on new sites will also be more favourable. Over two-thirds of its estate has outdoor seating, and the group has used the pandemic period to reinvest in its already popular bars, so I can see the positive momentum continuing for some time yet.

Liberum’s broker note on ResearchTree states that Loungers has a medium term ambition of becoming a 250+ site business, with a longer term aim of around 500 units. That’s an impressive target. It’s very hard to successfully build up to ten sites, let alone 181 with talk of 500.

I do back the company to strongly outperform its peers for some time and could see a 10-20% rerate in the share price assuming trading conditions remain positive (and the wider economic backdrop supports a bullish environment), but I think the shares are quite fully priced for now. More detail on margin pressures and the outlook re. wage inflation and the rest would be good. The present valuation factors in a pretty benign outlook in my opinion.

It’s been a strong recovery so far and I suspect the time to make good money here (with the benefit of hindsight) was back in 2020.

Share price: 344.45p (+3.59%)

Shares in issue: 72,726,509

Market cap: £250.5m

K3 Capital Group is a multi-disciplinary professional services firm providing advisory services to SMEs.

It’s got three main services:

• Mergers and Acquisitions (Mamp;A) – Company sales, brokerage and corporate finance services to SME’s looking to achieve full or partial exit.
• Tax Advisory – Ramp;D tax credit advisory and fraud investigations.
• Restructuring Advisory – restructuring and financial advisory, creditor services, and forensic accounting.

The group’s medium-term strategy is to build a wider group of growing and complementary professional services businesses to provide SMEs with high quality advice across specialist disciplines.

So far this strategy has enabled some eye-catching profitability metrics with very little capex required, and the company is confident of its acquisition pipeline going forward.

Trading update

The company completed a number of acquisitions during the period including randd, Quantuma, Intax, Aspect Plus and Alchemy Cayman.

Following discussion with the Group’s auditor, BDO LLP, the results will be published on Monday, 1 November 2021. This will ensure sufficient time for completion of the financial reporting processes, including those relating to the accounting treatment for all acquisitions completed by the Group.

The board now expects revenue and adjusted EBITDA (before acquisition related costs and share based payments) for the year to be ahead of the numbers announced in its recent update, which stated revenue of c.£46m and adjusted EBITDA of not less than £14.25m.

Conclusion

There are a few of these professional services companies now listed. Most of them are following similar acquisitive, diversifying strategies so there’s a consolidation dynamic here. For now, it appears to be working very well.

Further acquisitions can be expected from K3C. I think this theme is an intriguing investment proposition, as the margins are high, the market is ripe for consolidation, and quite a few of these companies are clocking up impressive compound annual growth rates. What’s more, some of the acquired businesses boast attractive recurring revenue business models.

In a people business, the people are (obviously) important so one thing to watch out for is a bout of wage inflation, or a conflict over how much of profits go to employees and how much is retained by shareholders. Ultimately though, trading is strong and there’s a good growth opportunity for a few listed players.

K3C’s shares are not obviously cheap, with a forecast PER of 17x and a forecast PEG of 1x, but then again given the growth on display, they are not overly expensive either.

I imagine upgrades are on the way and K3C has proven it can grow at a good clip with its current strategy. The share price has been strong recently but the valuation is not demanding and the growth opportunity remains, so I think it’s not too late to start looking at this stock if you haven’t already.

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