Small Cap Value Report (Thu 21 Oct 2021) - LUCE, SOLI, GMS, WATR

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

Agenda –

Paul’s Section:

Luceco (LON:LUCE) (I hold) – this electrical goods maker reassures on FY 12/2021, keeping guidance unchanged. Although cost inflation amp; freight costs/delays have reduced its gross margin, and expects that to continue into H1 2022. The share price has already dropped c.40% from the peak, so arguably these short term issues are priced-in. Valuation looks reasonable.

Gulf Marine Services (LON:GMS) (I hold) – a special situation – bombed out shares, due to excessive bank debt. As mentioned in last Friday’s SCVR, there looks to be a promising turnaround underway here. Utilisation rates for its fleet of specialised support vessels (oil amp; renewables offshore sector) are rising, as are daily hire charges. 2 contracts are announced today. Good visibility amp; large cashflows should enable debt to be significantly reduced. Speculative, and risky, but good potential upside if positive newsflow continues.

Jack’s Section:

Solid State (LON:SOLI) – good interim results with recent acquisitions exceeding expectations. Group confident of meeting FY forecasts but scope for outperformance depending on how supply chain challenges play out. A good, growing company, but the shares are more expensive now than they have been in the past.

Water Intelligence (LON:WATR) – momentum continues here, with the group achieving last year’s total revenue, profit, and EBITDA by the end of the third quarter. The valuation is a concern and the company must continue to grow in order to justify this, but there’s nothing to suggest here that won’t happen.

Explanatory notes -

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 are analysing the company fundamentals, not trying to predict market sentiment.

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), and make your own investment decisions. Reader comments are welcomed – please be civil, rational, and include the company name/ticker, otherwise people won’t necessarily know what company you are referring to.

315p (pre market open) – mkt cap £507m

This group manufactures electrical accessories in China, and sells them mostly in the UK. I reviewed its excellent interim results here on 7 Sept 2021, concluding that storm clouds on the horizon (freight costs amp; delays, and softer demand in July amp; August), and a high valuation, made top-slicing look a good option at 474p. That was a good decision, as the share price subsequently went into a real nosedive, only bottoming out recently at c.300p, a c.40% drop from the peak. The peak did look a bit over-valued though, so some pullback seems sensible. Maybe it’s overshot on the downside now? That’s my view, hence I’ve been buying from 384p downwards, clearly jumping the gun with my purchases, which look a bit inept now (at least in the short term).

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Moving on, this is the latest news, out today -

Q3 2021 trading update

Luceco plc (“the Group” or “Luceco”), the manufacturer and distributor of wiring accessories, LED lighting and portable power products, is pleased to provide the following update on trading for the three months ended 30 September 2021 (‘Q3 2021′) and to confirm expectations of Adjusted Operating Profit of not less than £39m for the year to 31 December 2021.

Continued strong growth and profitability despite industry-wide supply chain challenges

The growth rate has slowed, as expected, but is still positive.

In H1, revenue growth (on LY) was +51%, which has now slowed to +31% YTD, given that Q3 was +15%

Gross margin has (as previously flagged) fallen, due to cost inflation: 37.0% in Q3, compared with 38.5% in H1 – a modest drop

Inflationary costs worse than expected, with an additional £5m impact.

Expects margin impact to continue into H1 2022, before recovering in H2 2022 from increased selling prices feeding through, with delays.

No change in long term margin expectations.

Guidance for 2021 -

Luceco seems to have absorbed the above problems, as guidance is unchanged from when it last reported in early Sept, although with wiggle room in case supply chain issues get worse -

We continue to expect Adjusted Operating Profit of not less than £39m, a record result for the Group, whilst recognising the potential for external supply chain factors to impact our short-term forecasts.

Guidance for 2022 -

We’re warned that H1 will be tough, but no figures provided -

· Temporary margin compression from cost inflation should peak in early 2022, resulting in a challenging H1, before margins are expected to recover in H2 as selling prices increases take effect.

· We expect to make steady organic progress in 2022, with a higher H2 weighting, supplemented with profits from the acquisition of DW Windsor and potential future Mamp;A opportunities.

My opinion – I think Luceco is managing investor expectations well. It flagged previously that conditions were getting more tough. Maintaining its guidance for 2021 is impressive I think – there must have been some fat in the original forecasts.

Supply problems continuing into H1 2022 is fairly predictable, I don’t think that should come as a surprise to anyone, and the share price has already adjusted for it.

It depends on your investing timescales. If you’re a longer term investor, then I would be pretty relaxed about the company’s prospects. Slightly softer margins, whilst it absorbs some cost pressures, before passing them on in price rises to customers, doesn’t strike me as particularly important long term.

Many thanks to Liberum, whose helpful update note this morning leaves forecasts unchanged at 19.5p for 2021, and 22.7p for 2022. The only problem with that, is 2022 is expected to be H2-weighted, which increases the risk that forecast may not be achieved.

It all boils down to valuation. At 315p, we’re only being asked to pay 16.2 times 2021 earnings, and 13.9 times 2022 forecast earnings. That’s not expensive. Given Luceco’s excellent track record in recent years, I think this share looks moderately attractive. Although we do have to recognise that supply chain issues mean there’s always the risk of another profit warning.

I think today’s update could be seen as glass half full, or glass half empty, so I’ve no idea what the market price will do – that depends on a small number of small trades, which is what sets the share price in the short term. Although given that today’s update doesn’t make any changes to the 2021 full year outlook, then I imagine we’re probably getting near to a short term low. If it does go below 300p, then I’ll be increasing my position here.

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5.85p (up 5% at 10:337) – mkt cap £59m

Contract

This share was flagged up to me by a special situations expert friend, who has a remarkably high hit rate. His specialism is to dig around for overlooked turnaround situations, or some of the parts worth more than the market cap. He flagged up Electra Private Equity (LON:ELTA) (I hold) to me originally at c.400p (now almost 50% higher), which readers are familiar with, and still looks very cheap to me.

I outlined the GMS situation on Friday last week, and it’s been shooting up ever since, due to positive newsflow. In a nutshell, this is a financially distressed (too much debt) owner of 13 specialist vessels, which are hired out to the oil, and renewable energy sectors.

The higher oil price has increased demand for its vessels, with daily hire rates increasing, and utilisation now being over 90%. Forward bookings are for about 18 months+, so it has great visibility of revenues amp; cashflows.

Cashflows are now prodigious, and maintenane capex for its young fleet is modest, which means it should be able to rapidly reduce debt, which we hope should leave a situation by end of 2022 where debt is no longer a problem – lowering finance costs, and allowing the resumption of divis.

All the benefits should therefore flow through to bombed out equity, as debt comes under better control, and reduces over time.

Today’s news is of a new contract, and a 2-year extension of an existing contract.

The comments today (below) from GMS’s Executive Chairman, seem to confirm the validity of the bull case which I explained above -

“The award of these two contracts, one of which at a significantly higher rate than its current contract, reinforce the point that we are seeing a tightening of the market and demand for our vessels continues to improve.

These awards, together with other contracts already secured for 2022 and a strong pipeline of additional opportunities, increases our confidence that the financial performance of the Company will see further improvement into next year.”

My opinion - as I mentioned here before, this is a high risk special situation. Companies with excessive bank debt require particularly careful research, because if we’ve got it wrong, then the downside case could involve significant dilution of existing holders.

However, I’ve crunched the numbers, and had a briefing from management, so am pretty confident I understand the situation.

Things are lined up nicely now, for a constant flow of positive news. The main downside risk is if the price of oil crashes again, which would stifle end user demand. However, with medium-term contracts already in place for most of the fleet, there’s really good visibility.

I haven’t got round to thinking about what I would eventually sell at, but am thinking in terms of this possibly being a 3-4 bagger over the next say 2-3 years. Providing nothing serious goes wrong of course, which can happen with any share.

As you can see below, the company’s performance since listing has been dismal. The share count has roughly doubled, so plenty of scope for improved performance now to feed through to a potentially higher share price.

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Share price: 1,185p (pre-open)

Shares in issue: 8,553,504

Market cap: £101.4m

This is an acquisitive manufacturer and design-in distributor to the commercial, industrial, and military markets, with a focus on durable products for use in specialist and harsh environments. The group has five trading companies: Solid State Supplies, Steatide, Pacer components, Active Silicon, and Willow Technologies.

Reputation is important when it comes to products that must be depended on in extreme environments, and Solid State says it has become synonymous with quality and reliability.

It has been flagged up by the StockRanks for a while now and has since rerated, changing its factor profile to that of a high QM High Flyer.

The shares are now beginning to look a little expensive on an earnings basis, but the group does have a happy track record of clocking up free cash flow per share notably in excess of EPS. The decent price to sales measure also suggests an opportunity if management is able to increase margins.

Trading update

The Board is pleased with progress in the Period and optimistic for the prospects for the year as a whole, however mindful of the broader economic, supply chain and global challenges.

The group expects half year revenue of c£39m (FY20: £33.1m) and adjusted PBT of c£3.25m (FY20: £2.55m). That’s compared to consensus full year forecasts of £74.2m and £5.2m, so perhaps scope for upgrades in time.

The improvement reflects strong trading and contributions from the Willow and Active Silicon acquisitions made in March 2021 ‘which have exceeded management’s expectations’. The board is confident of meeting full year expectations but says there is also potential upside in H2 dependent on supply chain challenges.

There’s a mix benefit and improved operating margins from the development of own brand products, value-added lines of business, and cost management. Meanwhile, the order book has seen ‘very strong growth’ as customers place longer order schedules to mitigate supply chain challenges.

Solid State’s order book on 30 September 2021 stood at a record level of £61.5m (31 May 2021: £51.0m), up 48% on the financial year end. The lengthening order coverage means that scheduled orders now span three financial years; FY22 (63%), FY23 (32%) and into FY24 (5%).

This is another dynamic some companies are reporting: unusually large order books as customers order ahead, but realising those sales in a timely fashion could be challenging due to those same supply chain issues driving the orders. It’s hard to say how it all shakes out but, for now, a stronger order book has to be a positive.

The company is working hard with customers and suppliers to manage these challenges, resulting in some stocking and investment in working capital, plus commitments to longer order schedules by both Solid State and its customers.

Net cash at 30 September 2021 stood at £3.3m and the group retains banking facilities of £7.5m to support capital investment and future growth. Solid State notes ‘a healthy acquisition pipeline currently being reviewed’.

Results for the six months ended 30 September 2021 will be announced on Tuesday 7 December 2021, followed by a presentation to retail investors on the 9th (https://www.investormeetcompany.com/solid-state-plc/register-investor).

Conclusion

Solid State is proving its acquisition abilities and has a good reputation for niche durable products sold into a range of markets. It’s a good company – not immune to the current supply chain challenges, but at least locking in business orders because of it. That signals the demand for its products from customers who likely cannot do without them and are unwilling to risk moving to an unknown manufacturer.

The shares are much more fully priced now than they have been in the past, but there’s also two acquisitions to take into account. Both of these are exceeding internal expectations.

There’s no mention of the semiconductor shortage explicitly but the group has been investing in working capital, so hopefully it has the stock that it needs in the short term.

It looks fairly valued on the prospects at 1,185p, having been as low as 306p in the wake of Covid and having traded at between 400p and 600p for much of the past five years. There is scope for longer term growth here though, so that should be factored in too.

There is also potential for near term upgrades. It’s a good company trading well, and could certainly make for a good investment at some point. But at the current historically high valuation and given the uncertain nature of the evolving supply chain situation, it remains on the watchlist for now.

Share price: 1,189p (+5.22%)

Shares in issue: 16,289,521

Market cap: £193.7m

(I hold)

Water Intelligence is a leading multinational provider of precision, minimally-invasive leak detection and remediation solutions for both potable and non-potable water. The company is growing strongly and the share price has more or less quadrupled over the past two years.

Trading at more than 50x forecast earnings, there is not much room for an expansion in multiples and any slowdown in growth rates could lead to a derating. But if it can maintain its current trajectory, the company can grow into that valuation over the next couple of years.

Q3 trading update

We are having a banner year and by the end of Q3, have already surpassed revenue, profit and EBITDA results for all of 2020. Encouraged by continued strong market demand for our solutions, even during Covid, and our team’s execution, we plan to further accelerate our already strong growth plan. We have opportunities for strong organic growth as well as for supplementary acquisition-led growth via our strong corporate development pipeline.

Highlights for the nine months to 30 September 2021:

• Revenue of $39.7m up 43% (Q3 2020: $27.8m; FY2020: $37.9m)
• EBITDA of $8.5m up 48% (Q3 2020: $5.8m; FY2020: $6.7m)
• Statutory profit before tax of $5.9m up 46% (Q3 2020: $4.0m; FY2020: $4.2m)
• Adjusted PBT up 42% to $6.5m (Q3 2020: $4.6m; FY2020: $5.1m)

The group continues to perform strongly and has surpassed FY20 revenue, profits, and EBITDA by the end of Q3 21. Profit for full year 2021 is now expected to be at the upper end of consensus analyst estimates.

Corporate developments include a national insurance contract win, a channel partnership with a Midwest US homebuilder, and three franchise reacquisitions during Q3. The pipeline going forwards remains strong.

There was an oversubscribed equity raise of $10.2m to support corporate development transactions (including three franchise reacquisitions) during Q3. Amati and Canaccord increased their stakes in June.

US Corporate-Operated Locations saw revenues grow by 79% to $22.8m (Q3 2020: $12.8m).

International Corporate-Operated Locations: revenues grew by 47% to $4.4m (Q3 2020: $3.0m).

Franchises: royalty income grew by 4% to $5.3m (Q3 2020: $5.1m) despite three franchise reacquisitions during the quarter. That suggests c$76m in year-to-date gross sales by franchise units from which royalty income is derived.

Franchise-related sales (national accounts; equipment sales; franchise territory sales) grew by 4% to $7.2m (Q3 2020: $6.9m).

Conclusion

Here is a prime example of a company growing strongly, with a large addressable market, supported by structural growth trends, that trades at a nosebleed multiple of earnings. Sometimes this type of company is a buy, even on a forecast PER of 50x.

It all depends on the future cash flows and how to discount them to arrive at a present value, which can be very subjective and uncertain. But some small companies listed today on WATR’s historic and forecast rolling multiples are in fact cheap.

Of course, there’s not much scope for multiple expansion. WATR has to continue growing at market-beating rates for years. This is what it has been doing, and is what brokers expect it to continue doing.

There is execution risk in expanding internationally, which can be more costly and complex, but the group’s services are in demand and the need to improve global wastewater infrastructure will only increase as people become more concerned with the green economy.

As a holder (through the Investment Club) I wouldn’t sell on these results, but if I was neutral I would also personally much rather identify the next Water Intelligence before the rerating.

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