Small Cap Value Report (Tue 5 Oct 2021) - new cars, GHH, SCS, WIN

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

Free! Mello online event tonight at 5pm, trusts amp; funds. More details here.

Agenda -

Paul’s section:

The BBC reports on SMMT data showing a big drop in new car sales.

Scs (LON:SCS) (I hold) – I’m spending most of this morning working through the numbers amp; narrative. So please bear with me, hope to have a big section up on this by lunchtime.

Wincanton (LON:WIN) – an in line with expectations year end trading update reassures, and has put +8% on the share price today. We do need to adjust for the large pension scheme cash outflows, which will limit divis until 2027. However, even allowing for that, the valuation looks quite attractive to me. Could be worth a closer look, in my view.

Jack’s section:

Gooch amp; Housego (LON:GHH) – Profit slightly ahead of mgmt expectations. Looks like a good company that emerges from lockdowns with a reduced cost base and an improved outlook. Acquisition opportunities going forward, and work continues in collaboration with customers on new product development. The valuation prices a lot in for now though, I’d want a lower price.

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 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.

The BBC reports (using SMMT data) that UK new car registrations have fallen to the lowest level for two decades, due to widely reported problems that automotive manufacturers are having in sourcing essential supplies (particularly semiconductors).

Even though the total is low for September at 214k cars, it’s striking that 15% of those were electric. Maybe the recent ludicrous panic buying of fuel might trigger further increases in the sale of electric vehicles. Until of course the next logical step being electricity shortages amp; blackouts, because nobody thought to build enough power stations to cope with electrification of vehicles. That we have to look forward to in future, but it has a certain inevitability about it.

Sales of secondhand cars continue to boom.

I noticed that Vertu Motors (LON:VTU) (I hold) has been drifting down of late. Checking a few other competitors shares, they’ve also been dropping, e.g. Marshall Motor Holdings (LON:MMH) is down about 20% from its recent peak. This could be due to the sharp reduction in sales of new cars, possibly?

The interesting thing is that shortages of cars actually boosts profits at car dealers, because they can raise prices. The CEO of VTU pointed out this fact in the excellent recent webinar from PIWorld, available here.

Therefore I’m wondering if it might be time for me to top up my car dealer positions? On the basis that shortages of new cars mean higher margins, and a stimulus to secondhand sales. Although the unprecedented rise in used car prices can’t last forever. Also bear in mind that this year, they won’t benefit from business rates relief and CJRS (furlough) support. So it will be interesting to see how things pan out.

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272p (y’day’s close) – mkt cap £103m

Preliminary Results

It’s taken me ages to go through these numbers from SCS with a fine toothcomb, but as it’s a big holding for me, and many readers, the time is well spent. Also, with the headline numbers strong (a considerable beat against forecast underlying EPS), and the outlook statement in line, I’ve been scratching my head as to why the share price has fallen 6% today, when I think it should have risen!

We need to bear in mind the backdrop though, with some small cap trader/investors in a general panic at the moment (belatedly) over supply chain problems, probably stop losses kicking in, etc. It seems ridiculous to me (given that supply chain problems are temporary amp; widely known about for months), but with many small caps, the low liquidity means that it only takes a few people to sell at the same time, and the price is marked down heavily. Then other people start panicking amp; sell to protect their profits, etc.

Conversely, with so much uncertainty out there re inflation/supply chains, I think we might be seeing something of a buyers strike too. I’ve not heard from anyone in my network of investors sitting on cash, who is deploying that cash yet. Why would they, when prices are coming down on a daily basis? There will be a buying stampede for beaten down small caps at some point, we just don’t know when, or which ones. I tend to buy too early, when we get sell-offs, so ignore me!

Anyway, let’s take a look at the numbers.

ScS, one of the UK’s largest retailers of upholstered furniture and floorings, is pleased to announce its audited preliminary results for the 53 weeks ended 31 July 2021.

53 weeks impact on cashflow – I’m grateful to an an eagle-eyed friend (also a former retailing CFO) who messaged me first thing on this point. Most retailers internally account on a weekly basis. 52 weeks * 7 days is 364 days, one (or two in a leap year) days less than a 365 day year. Hence every c.5 years, they need to do a 53 week year to realign financial years. Usually though, the distortion is not material to profitability, but can cause significant balance sheet amp; cashflow distortions due to the timing of payroll and creditor payment runs. That’s what’s happened in this case.

Buried in the commentary (it should have been highlighted at the top), is this -

The cash generated from operating activities has decreased by £17.9m.
In the prior year working capital inflow totalled £27.9m largely due to a significant increase in customer deposits as our stores reopened following the first government lockdown. The level of customer deposits in the current year has increased by £2.4m.

However, this is offset by a working capital outflow as a result of the 53 week year capturing July month end payroll and supplier payments, together with a repayment of £3.4m VAT and PAYE/NI balances which were previously deferred in line with the government support offered as part of its response to COVID-19.

Supplier payments amp; payroll are typically the biggest cash outflows for retailers, with the other big one being property costs (rent + rates). Therefore, in this 53 week financial period, the cashflow and balance sheets will have been impacted by including 13 months supplier amp; payroll payments. The Pamp;L won’t be impacted, because costs are apportioned to fit the period. It’s the cashflow amp; balance sheet effect which is significant.

I suspect that many investors have not spotted this – understandably, because it’s an important point which is not flagged in the highlights section. People don’t have time to plough through all the narrative, when we only have 7-8am to digest RNSs from multiple companies. So I wonder if this is a case of a few people selling, and asking questions later maybe? It doesn’t really matter to me anyway, as a long-term holder, but I just like trying to figure things out.

A deterioration in cashflow is always something that needs to be looked into carefully, as it can be a tell-tale warning sign of fanciful accounting. In this case, it’s perfectly straightforward – cashflows last year benefited from a number of one-off factors (e.g. inflow of customer deposits post lockdown, and stretching creditors (e.g. taxes). Whereas this year sees the unwinding of stretched creditors, and the impact of 13 monthly supplier/payroll runs in the period. That last factor will unwind next year, so cashflow will look better next year. This is all absolutely fine, and not a concern at all. Cash balances also remain enormous, and are nearly equivalent to the market cap of the company, even immediately after paying suppliers amp; staff for the month.

Hence anyone who thinks cash generation is poor, has got it wrong for the above reasons.

Revenues £310.6m, up 21.6% on last year. Last year was hit harder by the first lockdown, and this year had benefited from delivering products which were backed up in the extended order book at end of last year.

Order book at year end (31 July 2021) is also very large, at a similar level to last year, at £103.5m (inc.VAT), versus £104.7m a year earlier. In more normal conditions, pre-covid, the order book closed at £43m, so you can see the extent of pent-up, unfulfilled demand there, being about £60.6m (inc. VAT), so £50m in revenues terms (ex VAT) – about 13.5% of the new year’s revenue possibly, if supply chains do normalise by July 2022).

Therefore, SCS still has a substantial backlog of orders to work through, to benefit this new year FY 07/2022. This refutes the suggestion that FY -7/2021 was a one-off good year due to demand pulled forward.

Current trading amp; outlook - also good, with continued strong orders flowing in (I’m ignoring the -21% comp against LY, as that was an unusual spike (I’ve checked back), following re-opening from lockdown 1, so not comparable conditions at all) -

Supply chain comments – in my opinion, this is such a crucial issue at present, that companies need to give us a lot more information. Saying they’re mindful of disruption is nowhere near enough. I want to know how much it’s impacting things, do they have fixed price shipping contracts or paying inflated spot rates, how long the delays are, attitude of customers to delays, etc.

Flexible business model – furniture retail is a lovely sector, where almost everything is made to order, and many costs (e.g. staff commissions, and marketing) are variable, right down to zero, in extremis.

This shines through in SCS’s numbers. It coped astonishingly well with the whole pandemic period, had no need to dilute shareholders (unlike weakly financed larger competitor, Dfs Furniture (LON:DFS) ). Therefore, shareholders here can sleep very easily at night, even on a lumpy old mattress. Especially given the huge cash pile which has arisen from both balance sheet strength, and the negative working capital business model common to the sector.

Earnings – underlying diluted EPS came in way ahead of forecast, at 39.8p.

Stockopedia is showing broker consensus of 31.4p

In more normal market conditions, where people were not worrying about inflation/supply chain, then I think this share would have easily risen 10%+ on publication of such good numbers. Still, the way I see it, that’s just an investment profit deferred for shareholders, and an opportunity to buy more, in a seemingly irrational market, which is focused on short term macro problems. Although I suppose the bear argument is that short term problems could turn into a recession, something to ponder.

Dividends – 3p interim, and 7p final, giving 10p, a yield of about 4.0%.

Bear in mind the divis are highly likely to be increased back to historic levels (peak at 16.7p), which means anyone holding now is probably sitting on a future cash cow, which could be yielding 6-7% by this time next year, based on the current share price.

There’s also the future possibility of special divis or buybacks, with all that cash sitting there doing nothing.

Taxpayer support – now is not the time for big shareholder payouts, as SCS has benefited from taxpayer support measures (the last thing needed is a social media backlash, for example).

Business rates relief added a material £10m to profits, although profits were of course suppressed by the stores being closed for a long period in lockdown 3.

The CJRS (furlough) grant of £3.0m for FY 07/2021 has been repaid by the company – good stuff, that is the right thing to do.

Online sales – grew 146% to £46.9m, 15.1% of total revenues. Good growth, but note that DFS showed very much better growth, and total online sales. Plus of course newer competitor Made.com (LON:MADE) is mainly online, and young people in particular seem to like buying furniture online, which is surprising to people of my generation amp; older.

Although as SCS points out in the commentary today, it’s complicated, because a lot of people like to visit a showroom after having done their research online. Or maybe order online, after having pondered a purchase after viewing an item in store.

Bear in mind also, that I’ve seen some retailers call sales online, when ordered in store on a tablet! Which of course are not really online sales (thinking about Mothercare (LON:MTC) which used to do that when they had their own stores, pre-restructuring, which made them look desperate – which they were at the time, not now though).

New mission statement amp; growth plan – I’m fine with this. This section of the commentary just reads like basic common sense for running any business – e.g. focus on the customer journey, move more online, train amp; retain good staff properly, good product amp; showrooms, gain market share. Nothing at all earth-shattering there, which I like! The last thing I want is a new CEO coming in, wanting to make their mark with wacky amp; expensive changes in direction.

It’s easy to scoff at the basic points in today’s strategy update, but for me it’s perfect. Just sell decent sofas cheaply amp; profitably, then everyone is happy.

Exceptional items – is a credit this year, of £4.2m, hence the statutory profit being above adjusted profit – nice to see. This relates to reversal of some impairment charges last year, see note 4. I think we’ll see more of these reversals, because impairments (of leases amp; fixed assets) are not necessarily required, once problem sites recover.

EBITDA - my blood is boiling, looking at the total mess that IFRS 16 has made of these numbers. EBITDA looks stunning, at £48.5m (after exceptionals), but the number (required by IFRS 16) is pure fantasy. As the cashflow statement shows, “financing activities” includes £3.7m of interest on lease liabilities, and a huge £22.7m capital repayment of leases (I think this is inflated by about £6m due to catching up on deferred rents?). Paying rents is just part of the operating costs of the business. The result is that IFRS16 produces a massively inflated EBITDA number that is highly misleading. Blame the accounting standards people, not SCS (who are just following the rules).

Balance sheet – is lovely as ever, stuffed full of cash, an astonishing £87.7m, which is stated immediately after paying the monthly payroll amp; supplier payment run. I need to do some more work on this, but I reckon the figure would be nearer £100m once that one-off cashflow issue is taken into account. That’s the entire market cap of the company!

It benefits substantially from customer deposits (which would reduce somewhat as delivery times normalise in the long run), and the negative working capital cycle – which is permanent, and revolving, so we don’t need to net off creditors.

I remain of the view that it’s probably only a matter of time before private equity spot the anomalously low valuation amp; massive cash pile. Although SCS could be too small for many PE firms maybe?

Going concern - I do like these sections, when they include stress testing.

As I would expect, SCS sails through, even a severe but plausible scenario, with heaps of surplus cash still (which involves another short lockdown at peak trading period).

Also, I like the comments about trade credit insurance, saying that SCS could cope easily if all credit insurance was withdrawn. Trade creditors are only £15.4m (see note 9) so could all be paid off fully and only dent the £87.7m cash pile.

If I ran SCS, I would do deals with suppliers to pay them cash on delivery, in return for a say 1-3% discount. Might as well do something useful with the cash, and that would also mean that SCS would move up the pecking order in terms of what work the factories prioritise – the cash buyer gets their stuff made amp; shipped first, in my experience.

Valuation - I’m working on 30-40p EPS in future (remember it did c.40p for FY 07/2021). I’m basing that on a further recovery in sales from the order backlog, and stores (hopefully) being open 52 weeks per year in future. Offset by withdrawal of business rates relief, and allowing for additional costs from freight, etc.

At the current share price of 260p, that gives a PER of between 6.5 and 8.7 – cheap, with maybe 50% upside on a re-rating?

In addition, we have the entire market cap in cash! So we’re really getting the business for free.

Some people argue with that, who I would direct to study the balance sheet of Dfs Furniture (LON:DFS) and compare it with SCS. This demonstrates that it’s entirely possible to remove the entire cash pile, increase the debt facilities, and the business could continue to function as normal.

I’m not advocating that, just saying that it’s entirely possible.

Sooner or later a financial engineer is going to spot that, and make something happen.

My opinion - I continue to believe, based on these numbers, that this is probably the cheapest value share on the UK market, certainly in the sectors I look at anyway. There could be some obscure resources stock that looks cheaper, but is much riskier amp; more cyclical probably. A combination of low PER, and a massive cash pile, and high dividend paying capacity, is extremely unusual. I can’t think of anything that’s even remotely close to this.

But, the market absolutely hates SCS. Investors are just not interested. That happens sometimes, which is where patience is a virtue that should eventually pay off in the long run.

In the short term, there’s a risk that shipping problems could get worse, and trigger a profit warning. But as we saw with the pandemic, for furniture retailers, that just defers profit into a future period, so it doesn’t matter to long-term holders.

As you can probably guess, I think this looks an excellent value share, and the share price doesn’t make any sense at all to me.

Bear views – I’d be interested in hearing contrarian, negative views, as I may have missed something. These are things I’ve spotted other investors saying -

• Supply chain worries, as discussed above,
• Tougher competition from online, e.g. Made.com (LON:MADE) (probably a different customer though)
• Pandemic may have pulled forward future demand, e.g. WFH, home improvements popular
• Poor cashflow (discussed above, this is a red herring)
• Dashed hopes for special divis/buybacks (be patient!)
• Short term punters getting bored amp; moving on
• Resumption of lockdowns (not a problem, as SCS has shown it recoups sales later amp; has long order book to work through uninterrupted
• Something else could go wrong unexpectedly (true of all shares)

None of those points worry me at all, and as a long-term investor mostly, the prospect of doing nothing for the next few years other than collect in bumper divis, hopefully gain from a re-rating, and possibly receive a takeover bid, seems very attractive risk:reward in my opinion. Obviously, as always, DYOR, as you may come to a different conclusion.

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357p (up 8% at 12:18) – mkt cap £445m

Widespread daily news about the severe lorry driver shortage (caused by a variety of multi-year reasons) must have spooked some WIN investors, since it’s a logistics company. Hence the price drifting down. Today’s update has given it a decent 8% boost but we’re still almost 20% below the 440p price where Jack reviewed it here in early July.

We like Wincanton’s business, here at the SCVR, but we don’t like its poor balance sheet, and in particular the large scheduled cash outflows into the pension scheme, which total about £137m between now and 2027. We can’t just ignore that. These are major cash outflows, and will increase above that with inflation too (now elevated). That’s about 31% of the market cap, very much a material issue.

Trading Update – issued today.

Wincanton plc, a leading supply chain partner for UK business, today issues the following trading update ahead of its half year results for the six months ended 30 September 2021.

My summary -

Strong revenue growth throughout H1

All 4 sectors doing well, especially retailers

Acquisition (£23.9m) in Sept 2021 going as planned so far

Pipeline of new amp; extended business “remains encouraging”

Lorry driver shortages – this is interesting -

Wincanton continues to work closely with its customers in taking active steps to address the impact of the shortage of HGV drivers in the UK and to both attract and retain drivers. Closed book transport contracts, particularly in construction and FMCG, have been the most impacted parts of the business, however the Group has made good progress in agreeing rate changes to optimise service levels. A significant majority of Wincanton’s contractual arrangements provide mitigation against cost pressures. The recent fuel shortages have not impacted Group profitability.

I saw a press article recently, saying that Wincanton is training up loads of new drivers – good stuff, but obviously that costs money, whereas in the past, cheap labour could be more easily imported, boosting company profits but suppressing overall wage rises, due to simple supply amp; demand – a point that is clearly being proven by current events. Apparently many drivers have left the sector, due to taxation changes, and unhappiness with ropey working conditions (sleeping in cabs in laybys, etc). Pay them properly, and the shortage will disappear over time.

Guidance – sounds fine – although I wonder if it might have out-performed, had it not been for the current problems with drivers, etc?

The Group remains on track to deliver full year profits in line with market expectations, reflecting the combination of strong retail volumes and the rate changes in closed book contracts. The Board remains confident in the future growth opportunities.

My opinion - I think Wincanton is clearly a good business, that has performed well in recent years.

Investors obviously need to factor in the pension scheme cash outflows, and stress test it, in case they get worse in future (or better, I have no idea, not my area of specialism). With inflation rising a lot, that could increase pension scheme liabilities, but rising interest rates (if that happens) could reduce liabilities. Lots of moving parts, so something for experts to consider.

Stockopedia shows a forward PER of 8.9. Even raising that (crudely) by 31% (see above) to take into account pension scheme outflows, I get to an adjusted PER of 11.7. Not sure if that’s a valid way to adjust for the pension scheme, but if it is, then WIN looks good value.

I wonder to what extent the lorry driver issue would impact the new year’s profits? Salaries seem to have gone up a lot, from c.£30k to £50-70k, although WIN seems to be passing on some of that to customers. Will this feed through to forklift drivers, and general warehouse staff I wonder? Staffing costs are likely to be a headwind anyway.

Overall, I think this looks interesting, and worth a closer look possibly by readers, if it floats your boat.

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Share price: 1,265p (pre-open)

Shares in issue: 25,040,919

Market cap: £316.8m

Gooch amp; Housego manufactures photonic components amp; systems, working as a supply chain partner in aerospace amp; defence, industrial, life science and scientific research sectors.

Founded in 1948, it has transformed over the past 20 years from a craft-based company into a more technology-focused one after a spate of targeted acquisitions.

Key purchases include:

• Cleveland Crystals in 1999.
• SIFAM Fiber Optics in 2007.
• General Optics in 2008.
• EM4 and Crystal Technology in 2011.
• Spanoptic and Constelex in 2013.
• Alfalight and Kent Periscopes in 2016.
• StingRay Optics in 2017.
• ITL and Gould Fiber Optics in 2018.

All of the above businesses deal in optic instruments of one kind or another.

Alongside manufacturing sites in the US, the UK, and China are sales offices in France, Germany, Hong Kong, Japan and Singapore. Gooch has additional representation via a global network of distributors.

Full year trading update

Gamp;H’s strong revenue performance in the second half of the financial year together with the benefits of our streamlining programme mean that Group profits are expected to be slightly ahead of management’s previous expectations.

Trading in the second half has been good thanks to further strengthening in end market demand, despite currency headwinds and some supply chain constraints.

Industrial laser demand continues to be strong, in particular the semiconductor market where the group identifies a range of growth opportunities. Life science markets are performing well. Demand for medical diagnostics remains at previous high levels and orders for specialist medical laser products have been strong as this market recovers from the low levels of elective surgery during the pandemic.

Commercial aerospace volumes are not expected to recover until 2023.

Gooch has reduced its manufacturing facilities in the year from 12 down to nine, which should help reduce costs and improve profits.

Strong operating cashflow has allowed the group to further reduce its level of borrowings, although no figures are given in today’s update.

Outlook -

​​Gamp;H has entered its new financial year with a ‘robust’ order book of £97.8m as at 30 September (2020: £92.4m), up 8.4% on a constant currency basis.

Industrial and medical lasers are demonstrating sustained recovery, while telecommunications and life sciences continue to perform well.

Active development portfolio targets key growth sectors and Gooch is working closely with its customers on their next generation products.

There remains substantial long term growth potential for our photonic technologies and system capabilities in all of our target sectors. Gamp;H is well placed to execute on acquisitions that support our strategy.

Conclusion

There has been some ‘drag’ on performance due to currency headwinds, self isolation and supply chain issues. That aside, Gooch has weathered the storm well and emerges from lockdowns with a reduced cost base and lower debt, a robust order book, no equity dilution, and organic and acquisitive growth opportunities.

All in all, it strikes me as a good company that is well managed, a view probably reflected in the Quality Rank of 92.

But the valuation is rich, with a forecast PE ratio of some 30.4x. Forecast EPS will get nudged up but I imagine there’s still quite a premium. It is growing, but I’m not sure that such a high multiple is warranted.

The balance sheet looks fine, with c£15m of cash set against nearly £20m of current liabilities and debt of nearly £22m. Note though that these figures are from the March balance sheet date and the company says the situation has improved further since then. The group has positive net tangible assets of around £60m (again, this has possibly improved – we’ll see in the full year results).

It’s reliably cash generative, too. There are a few signs here that indicate Gooch could be a good long term hold at the right price, but I don’t think today’s slight profit upgrade is enough to justify the high PER.

Putting the valuation to one side, I do like the company, so it’s one for the watchlist in case the market presents us with a more attractive entry point.

Stockopedia