Small Cap Value Report (Tue 16 Nov 2021) - G4M, KINO, RBG, DOTD

Good morning! It’s Paul amp; Jack here with the SCVR for Tuesday.

Mello – starting at 17:00 tonight, there is a free online event, on Investment Trusts amp; Funds. More details here. Also, we’d like to add our hearty congratulations to Mello’s founder, David Stredder, who has won a lifetime achievement award at the recent Small Caps Awards. It’s a very popular choice, as David has been a good friend to many of us over the last two decades, and has done more to connect private investors and small caps management, than anyone else I can think of. Well done David, and keep up the great work!

Agenda -

Paul’s Section:

Gear4music Holdings (LON:G4M) (I hold) – Interim results are in line with expectations. However, there’s a profit warning, due to Q3 (Oct-Dec 2021) sales being slower than expected, blamed on Brexit-related distribution problems. Recently opened new distribution centres in Spain amp; Ireland should resolve this problem in Q4, so doesn’t look particularly worrisome. EBITDA guidance is reduced back to where it was back in June 2021, before a previous upgrade. Not a disaster, but clearly a setback.

Revolution Bars (LON:RBG) (I hold) – results for FY 06/2021 are as expected (awful, due to the pandemic). Current trading is still strong, although growth has moderated somewhat from the last reported number. Plenty of cash amp; facility headroom, means the company is now back in expansion mode, with 8 new sites, and many refurbs planned. I continue to believe this share is a good value opportunity, if you look forwards, rather than back.

Jack’s Section:

Kinovo (LON:KINO) – positive update with revenue and profits up, and net debt down. This is an active turnaround, management is doing a good job, and there is further upside potential. But the historical performance has been patchy, the shares are illiquid, margins are typically low, and there are ongoing challenges around supply chain inflation and labour availability, so it’s firmly in the higher risk bucket.

Dotdigital (LON:DOTD) – revenue up double digits but profit up by less. FinnCap is forecasting a declining trend in profit margins through to FY23, and the near-term growth forecasts don’t appear to support the valuation in my view. Perhaps longer term there is a stronger case?

Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to review 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.

800p (pre market open) – mkt cap £168m

Interim Results

Gear4music (Holdings) plc, (“Gear4music” or “the Group”) (LSE: G4M), the largest UK based online retailer of musical instruments and music equipment, today announces its unaudited financial results for the six months ended 30 September 2021 (“the Period”).

H1 numbers are in line with management expectations – i.e. well down on the exceptional figures last year, which were heavily boosted by lockdown 1. This is as expected, and brokers have for some time been forecasting a sharp reduction in profits this year, FY 03/2022, so no surprises there.

Profit warning for the full year – less pleasing is a shortfall in Q3 (Oct-Dec 2021) to date revenues. The problem is said to be Brexit-related supply chain problems – i.e. difficulty in despatching goods from the UK to the EU. This seems to be a temporary problem, caused by a slower than expected build up of the new distribution centres recently opened in Spain amp; Ireland.

The supply problems look very much temporary in nature, so I would imagine most shareholders are likely to look through this issue, with the company specifically reassuring -

… we are confident that the remaining Brexit related challenges will be resolved by FY22 Q4 and our European customer proposition will be significantly strengthened.

Guidance – is exceptionally clear -

… leading the Board to revise FY22 full year EBITDA guidance to not less than £12m (FY21 EBITDA: £18.9m, FY20: £7.8m)…

* Gear4music believes that consensus market expectations for the year ending 31 March 2022 (i) prior to release of this announcement are currently revenue of £156.6 million and EBITDA of £14 million; and (ii) before 22 June 2021 were revenues of £152.3 million and EBITDA of £11.5 million.

In other words, EBITDA guidance was raised on 22 June 2021 from £11.5m to £14.0m, but has now been reduced back down to £12.0m. That’s clearly a bit disappointing, but it’s not the end of the world, particularly as the solution (2 new distribution centres in the EU) is already underway.

Balance sheet - looks OK. Note that inventories have risen a lot, which the company says is deliberate, to stock up for peak trading period, underway now. Sounds sensible to me, given the known issues with freight coming in from the Far East.

My opinion - I’ve only quickly skimmed the figures, and have not yet seen any revised broker forecasts. Singers were forecasting 30.3p EPS for FY 3/2022, based on £14.2m EBITDA. So it looks as if a fall in forecast EPS to c.25p might be on the cards, given that the new guidance is £12.0m EBITDA.

EDIT: new forecasts have since come through, as follows:

Progressive: 21.5p this year, 29.4p next year

Singers: 18.6p this year, 29.8p next year – the analyst notes that this might be an excessive downgrade, and it doesn’t yet factor in upside from the recent acquisition of AV.com, which is being relaunched, and widens the product range. So I think it’s probably safe to assume the new forecasts could be overly pessimistic, time will tell.

End of edit.

This is clearly a setback, but it’s only a temporary distribution issue that’s being fixed, so logically it shouldn’t do too much damage. Maybe a 10-15% drop in share price today? (written before the market opened). Although with a relatively illiquid share, you never know, because it only takes a few trades to move the price a lot.

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25.75p (down 3.5% at 09:03) – mkt cap £59m

Preliminary Results

Revolution Bars Group plc (“the Group”), a leading UK operator of 67 premium bars, trading under the Revolution and Revolución de Cuba brands, today announces its preliminary results for the 53 weeks ended 3 July 2021.

Exciting return to normal trade following investment in all brands

It’s striking that FY 06/2021 was disrupted in some way, in all 53 weeks of the year. Hence these historic numbers are only of passing interest.

Revenues £39.4m (down 64% on FY 6/2020, which was itself impacted partially by lockdown 1 in Q4 (mar-Jun 2020)

Loss before tax of £(22.8)m

Losses were more than replenished by shareholders, in two equity fundraisings during the year, both at 20p, raising £34m net of fees. Horrible dilution occurred, taking the share count from 50m to 230m. Hence the business is well-financed now, with latest net cash reported as at 15 Nov 2021 of £4.6m

Balance sheet - this shows negative NTAV of £(25.2)m at 30 June 2021. However on closer inspection, this is caused by the IFRS 16 lease entries. These are -

Right of use assets: £64.0m

Current lease liabilities: £(5.1)m

Long-term lease liabilities: £(100.0)m

Overall IFRS 16 entries, net: £(41.1)m

I’ve queried this with the company, because a huge deficit on the lease entries doesn’t make sense to me, given that during the pandemic, the group did a CVA, to dispose of all the loss-making sites. Hence now the bars are trading profitably again (which they must be, given strong pre-pandemic like-for-like sales increases, and the strong cash generation evident in the elimination of year end (3 July) net debt of £3.6m, which has since (in 4 months + 2 weeks) turned into net cash of £4.6m), then there should now be no need for any deficit on the IFRS 16 entries.

My understanding is that when the balance sheet is next published for the half year, and assuming no further interruptions to trading from covid restrictions, then this big deficit on IFRS 16 entries should disappear.

For this reason, I’m going to delete the IFRS 16 entries altogether, as there is not a problem with lease liabilities, that issue has been dealt with via the CVA.

Adjusting NTAV to add back the £(41.1)m IFRS 16 entries, turns NTAV positive £15.9m, which is fine.

Current trading – like-for-like (LFL) revenues are reported at +14% versus pre-pandemic trading, since full re-opening on 19 July 2021, almost 4 months.

When last reported, LFL was +17%, so growth has slowed somewhat in the most recent 6 weeks.

I’ve put these numbers into a spreadsheet, to estimate what the slower growth rate is in the last 6 weeks, which comes out at +8.6% – still a very respectable number, but evidence that the pent-up demand is easing somewhat. That’s what I would expect, and we heard something similar from Nightcap (LON:NGHT) very recently, whose LFL growth had also moderated somewhat very recently.

Broker forecasts – seem ludicrously low to me. I queried this last time, and was told that the company doesn’t want to over-promise, so they’re keeping the forecasts low, especially because of uncertainty over possible covid restrictions over the winter, and uncertainty over corporate Christmas parties, which are widely expected to be smaller, if they happen at all, and often booked at the last minute.

In my opinion, and assuming no covid restrictions, then the upside case is that RBG could thrash the existing forecast. You can work that out yourself, given that LFLs are +14% on pre-pandemic numbers, for a third of the new financial year. That should mean it’s way ahead of forecasts already.

Finncap’s note today hints at upgrades to come, but says it would not even consider revising up the forecasts before peak trading in Xmas/NYE is in the bag.

I would much prefer if brokers would give a range of scenarios in this type of situation – upside case, middle case, and downside case.

Instead they just leave super-cautious numbers out there. Hence why very often, broker consensus numbers need to be taken with a pinch of salt, as profit is a geared number, so no matter how good the analyst, they’re often wildly out from reality. Especially at a high gross margin business like RBG, where each extra drink sold is c.75% gross profit.

New formats – the company reminds us that its existing 2 brands are highly cash generative when allowed to trade without restrictions. For investors who feel the brands are tired, then there’s potential further growth from 2 new brands.

Founders amp; Co – has recently been launched by RBG, in a trial site in Swansea – see its website here. It looks an interesting hybrid concept, to generate more business (from coffee shop, artisanal traders, etc) throughout the day, rather than having empty sites during the day, then being rammed at peak times -

We have also been very proud of the launch of our third brand, Founders amp; Co. The new venture, in Swansea, has been performing well so far and receiving positive guest feedback. We are building a great business in partnership with our Founders, the food traders we collaborate with, and continue to offer a variety of events and reasons for our guests to keep returning. The test site for our fourth brand will open in November 2021, offering a competitive socialising experience, and we couldn’t be more excited to see our guests reaction to this new offering.

Refurbs amp; new sites – RBG is back on a growth trajectory. 8 new sites are planned. Mgt has previously said it is targeting larger sites that will move the dial, not marginal locations in small towns.

3 sites have been refurbished already this new financial year, and I believe many more are to be refurbished in early calendar 2022. The company now has plenty of cash amp; bank facility headroom, and with less competition, this is an ideal time to be expanding again.

That should drive upgrades to earnings, and a higher PER multiple, in due course, as investor perceptions about the business gradually improve – admittedly a process which takes time, given all the problems of the last 4-5 years.

The fundamental, underlying problem with RBG, was that too many sites had been allowed (by previous management) to become tatty. That drove sales down, with an operationally geared impact on the bottom line. This issue should finally be fixed in 2022.

My opinion – it’s working out well now. I think we’re lined up for a substantial earnings beat, if peak trading over the Christmas holidays does well. The main risk is reimposed covid restrictions, so each investor can weigh up for ourselves how much emphasis we want to put on that.

There’s a lot of value here, at only £59m market cap, and all the historic problems fixed, or soon to be fixed.

Refurbishing the rest of the sites in 2022 should generate decent further sales growth, which at high gross margins, could transform the bottom line. Time will tell!

Plus the company now has plenty of funding to open new sites, and potentially roll out its 2 new formats as well, plus there’s scope to make some bolt-on acquisitions too.

I talk to management every 6 months, and find them operationally strong, hands-on managers, with ambitions to fix, and grow the group.

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Share price: 51.44p (+2.88%)

Shares in issue: 62,137,757

Market cap: £32m

Kinovo is a UK provider of specialist property services centred on safety and regulatory compliance, home and community regeneration and sustainable living through the installation of efficient and greener energy alternatives.

It’s focused on Regulation, regeneration, and renewables and is currently in turnaround mode. The direction of travel here is positive but the share price has also rerated, so the risk/reward is beginning to shift from immediate financial recovery to sustainable growth prospects.

Trading update

Kinovo has continued to demonstrate resilient progress, delivering strong growth in revenues as COVID restrictions eased, earnings and cash generation from its continuing operations, despite the market challenges of supply chain inflation and material and labour availability.

In the six months to 30 September 2021, revenue from continuing operations has increased by 64% to £23.8m, with adjusted EBITDA growing 75% to £1.8m and operating profit up from a loss of £0.2m to £1.2m. Total profit after tax was £0.6m, up from a loss of £0.2m.

Kinovo has won a number of new contracts, most of which will be initiated in H2, ‘with a total potential value of £43.6m over the life of the contracts’.

The group also announces the likely sale of its Construction Division:

Following its rebranding and strategic review, Kinovo announces that it is currently in advanced discussions regarding the planned sale of DCB Kent Limited (DCB), the Company’s non-core construction business. The disposal of DCB will allow the Company to harmonise its operations and increase the focus on its three strategic workflow pillars; Regulation, Regeneration and Renewables. These pillars are centred on compliance driven, regulatory led specialist services that offer long-term contracts, recurring revenue streams and strong cash generation. There can be no certainty that the sale will proceed, however further announcements will be made as appropriate.

Balance sheet – Net debt has reduced from £2.7m to £1.7m and the cash balance has increased from £1.3m back in March to £2.2m. The final dividend has been reinstated (£0.3m) and the group has also repaid £0.6m of deferred VAT.

Diary date – interim results for the period ended 30 September 2021 to be released on Tuesday 7th December 2021.

Conclusion

These look like encouraging results for a small company actively turning around. The share price has rerated in the days leading up to this announcement.

It’s a small, illiquid stock, so smaller trades can push the share price one way or the other. It also makes the company hard to get out of if anything goes wrong, which further adds to the risk here. There is upside potential remaining, but whether or not to get involved here depends on your risk profile.

Kinovo generates quite a lot of revenue – it’s still only trading on around 0.5x sales – but this can be lumpy, with the potential for setbacks, which exacerbates the liquidity risk. It’s also a low margin business, so any worsening in supply chain inflation and material and labour availability could also become a problem.

On the flip side, there’s an opportunity to improve profits, as well as take further market share here. And management does appear to be executing on the turnaround.

From these levels though, the investment case moves from immediate financial recovery to the group’s ability to meaningfully grow revenues and profits. The ‘non-discretionary’ aspect of Kinovo’s core business lines is a key part of the investment case. Disruption over Covid led to delays rather than permanently lost business as a lot of the services Kinovo provides are requirements for its property clients.

The potential sale of DCB will hopefully bring some more cash in and allow the group to focus on its core business. I can’t see any valuation attached to DCB, but perhaps it will be enough to move Kinovo into net cash, which would be a positive step.

The upside has reduced after the recent rerating and this does remain a risky investment due to the lack of liquidity in the shares and the volatility in the historical results. That said, the market cap remains small, management is executing a successful turnaround, and Kinovo is exposed to some promising structural growth trends, so there’s every chance the company can realise the growth it needs in order to drive further share price gains.

The current trading momentum is certainly in the group’s favour and I can see the appeal for more risk tolerant investors. I am positive on the prospects and what management has achieved so far, but there are also important risks to consider like the lack of liquidity and the possibility of inflationary pressures impacting margins.

Share price: 228p (-8.8%)

Shares in issue: 298,118,630

Market cap: £679.7m

Dotdigital connects marketers with customers through an automation platform that ‘unifies all digital channels’. This enables marketing teams to launch highly targeted and relevant campaigns at every touchpoint (with a particular strength in emails), resulting in faster and more effective marketing campaigns ‘with increased engagement and demonstrable ROI’.

There’s been an extremely strong post-Covid rally here, taking the shares firmly into all-time high territory. Market sentiment has moved on from the ‘everything rally’, however, and investors appear to be a lot more risk-aware at the moment, so companies with premium valuations and a lot of growth priced in are at risk of derating in my opinion.

Such sentiment swings can end up being minor fluctuations in the longer term growth trajectory for successful software companies of course, but they can still be psychologically painful, so worth preparing for! DotDigital does have its fair share of bulls who see a long term investment case.

Final results

As we enter the new year, trading remains strong. Our healthy balance sheet, strong recurring revenues and cash generation provides the flexibility to invest in our growth strategy, giving the Board confidence in the Group’s long-term prospects.

Highlights:

• Organic revenue growth of 23% to £58.1m, recurring revenue up from 91% to 93%, and monthly average revenue per customer (ARPC) up 16% to £1,251,
• Adjusted EBITDA up 9% to £19.8m,
• Adjusted operating profit up 5% to £13.7m,
• Adjusted EPS up from 3.9p to 4.06p,
• Net cash up from £25.4m to £32m,
• Final dividend up from 0.83p to 0.86p.

The profit growth on display here is not tallying with the premium valuation in my view. The opposite of operational gearing seems to be in effect, with 23% revenue growth but just a 5% increase in adjusted operating profit, while adjusted earnings per share is up by 4.1%. The final dividend increase of +3.6% again seems rather meagre for a company valued at 56x FY22 earnings.

The forecast rolling PEG is some 17.2x, so understanding where the growth is going to come from is essential at these levels. Perhaps Covid disruption has obscured the underlying growth potential for now.

The decline in overall group gross margin comes from the growth of premium messaging channels such as SMS. Cost of sales has increased from 8.2% of revenue to 17.8% of revenue.

At the EPS level, there’s also a higher effective tax rate of 8%, (FY20: 5%). This results from Ramp;D tax credits. I wonder how long companies can enjoy this kind of credit? Presumably, we can’t assume an 8% tax rate in perpetuity but then again, I’m not sure when rates would normalise either.

In fact, when you look at the actual income statement rather than the headline results, we see that EPS from all operations actually fell, from 3.9p to 3.76p (adjusted diluted). Not much information is provided on the nature of these discontinued operations in this particular update. It is actually the Dynmark/Donky part of Compai, acquired in 2017.

I note HHR’s comment below, which warrants further investigation. A cursory search does suggest the discontinued Dynmark business specialises in the type of SMS messaging that is currently a growing part of DotDigital’s revenue mix.

Cash generation was good – net CFO of just under £17m and free cash flow of around £10m, meaning strong cash conversion. The balance sheet is also fine, with no debt and cash growing from £25.4m to £32m (comfortably covering current liabilities of £10.4m). Around 34% of group total assets is intangibles and goodwill, which seems reasonable for a software company.

One of the group’s ‘Three Growth Pillars’ is international diversification.

• EMEA revenue increased by 23% to £44.6m,
• North America revenue was +19% to $12.5m and ‘presents the largest market opportunity for the group’, and
• APACrevenue grew by 47% to A$7.7m.

Mamp;A – the board continues to evaluate the market for complementary acquisitions and its acquisition strategy is focused on: synergy technology for new revenue streams; bolt-on functionality to accelerate platform development, new talent acquisition and the expansion of expertise, and extension of the customer base in strategic territories.

Outlook –

High level of confidence in delivery of management expectations for the new financial year following a strong start…

As we enter the new year, we do so within a more normalised trading environment as our end markets transition out of the immediate implications from the pandemic. Trading remains in line with management expectation and our technology platform is uniquely positioned to capture the transition to online marketing across the mid-tier enterprise space. Whilst we remain mindful of the wider economic uncertainty, our healthy balance sheet, strong recurring revenues and cash generation provides the flexibility to invest in our growth strategy. The Board is therefore confident in the Group’s long-term growth prospects.

Conclusion

FY22 targets seem quite undemanding, factoring in revenue growth of 11.3% and normalised EPS growth of 3.8%. I would expect most companies valued at more than 14x revenue and 61.8x forecast earnings to grow EPS by multiples of 3.8%. FY23 estimates are for revenue of £75m and adjusted EPS of 4.4p.

I wonder why this trend of double digit revenue growth translating into much lower profit growth is expected to continue. FinnCap expects the adjusted profit margin to fall from 27.4% in FY20 and 23.4% in FY21 to 21.7% in FY22 and then 20.7% in FY23.

Currently, there’s a shift towards more SMS messaging which is impacting margins. Perhaps this is the sole reason. If so, forecasts imply this trend is expected to stay for at least the next 18 months or so.

The company definitely has good Quality characteristics. A Quality Rank of 99, a strong and improving net cash position, no debt, 93% recurring revenue, and reliable cash generation. But I would need more from this update in order to get interested at the current valuation.

DotDigital has done tremendously well as an investment recently and it keeps clocking up double-digit revenue growth, so it must be doing something right. I don’t have any great insight into its ‘uniquely positioned technology platform’ and that’s the key to understanding if it’s worth such a premium.

I currently have more questions than answers though and I just can’t get comfortable with the valuation for now. Even after FinnCap ups its price target by 10% to 275p today, that still just reflects the price shares were trading at a couple of weeks ago.

Perhaps holders can present the counter-argument? It’s a growing market, and perhaps DotDigital’s platform is just miles ahead of the pack meaning long term and material growth is more or less guaranteed. That’s what I would be assuming if I held the shares anyway.

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