Small Cap Value Report (Tue 23 Nov 2021) - CLX, SFR

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

Agenda -

Jack’s section:

Calnex Solutions (LON:CLX) (I hold) – highly rated provider of network testing products and services. The valuation is expensive but Calnex has several promising growth drivers and a track record of successful product development. The valuation currently assumes the company executes on these opportunities, with a degree of future growth priced in. Notes from call with management now added.

Severfield (LON:SFR) – structural steel designer. A tough industry, but Severfield does have a leading position in the UK and is one of the biggest in Europe. Current trading looks good, although with some signs of customers delaying projects. It’s not the type of company to trade on a premium rating but the current valuation is quite modest with a single-digit PER and forecast dividend of 4.5%.

Explanatory notes -

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Share price: 135p (+2.27%)

Shares in issue: 87,500,000

Market cap: £118.1m

(I hold)

Calnex is one of the more promising floats from the class of 2020. It’s a provider of test and measurement solutions for the global telecommunications sector, which has built up a strong market position, a global distribution capability, and whose business is exposed to several growth trends.

The long term growth drivers for test instrumentation and solutions include the ongoing growth of data creation, a vast migration to the cloud, and an equally significant shift to 5G networks. The telecom infrastructure, networking and services markets are seeing an expanding number of market participants requiring testing solutions, so Calnex is well placed to benefit.

Its products have been used in over 600 customer sites in 68 countries across the world, and customers include BT, China Mobile, NTT, Ericsson, Nokia, Intel, Qualcomm, IBM and Facebook.

At the head of it all is the group’s founder, CEO, and major shareholder Tommy Cook, who founded the company in 2006. It remains headquartered in Linlithgow, Scotland, with additional locations in Belfast, Northern Ireland and California in the US, supported by sales teams in China and India.

The group generates good profitability metrics, but as you might expect, the shares are now quite expensive relative to other stocks.

Interim results

The board is pleased to report that the group has experienced continued strong levels of trading in the first half of the year and expects this trend to continue through the second half of the year. The group’s robust cash position has allowed the group to bring forward planned investment in the team to increase operational capability, in line with order growth.

Highlights:

• Revenue +19.8% to £9.25m,
• Gross profit +16.8% to £7.05m,m
• Adjusted PBT -4.4% to £2.31m, statutory PBT +18.4% to £2.31m,
• Adjusted diluted EPS -17.8% to 1.99p, statutory diluted EPS +3.1% to 1.99p,
• Maiden interim dividend of 0.28p,
• Closing cash up from £4.51m to £13.64m.

Revenue is up as a result of strong demand for telecoms testing equipment, ahead of management’s expectations at the start of FY22.

Revenue rose by 22% in North America and by 33% in Rest of the World, with North Asia flat ‘due in part to the ongoing geopolitical tensions between the US and China’. Given the shift in sales, Americas now accounts for 35% of total revenues (FY21: 32%), ROW 41% (FY21: 35%) and North Asia 24% (FY21: 33%).

Some of the decline in adjusted profit comes from previously highlighted investment in product development and operational scalability, to support future growth. ‘All profit measures [are] ahead of management expectations at the start of FY22’.

Calnex has invested in business development resources, placing more sales team members in regions that are experiencing strong growth, such as the US and India, as well as adding to the operational teams to support growth.

The variance against the prior period [in underlying EBITDA margin] is driven by the planned step change in our cost base for FY22 as a result of investment to support the continued growth of the business.

Cash generated from operations during H1 was £3.1m (H1 2021: £3.0m) with a net increase in cash of £0.8m (H1 2021: £1.0m) to £13.6m despite an increase in Ramp;D spending of £0.4m, an increase in PPE investment of £0.2m and £0.5m higher administrative costs (ex Ramp;D) during the period.

Investment in Ramp;D has continued across all product categories, with a total of £1.9m Ramp;D investment in the period (H1/21: £1.5m). It looks likely that the full year figure here will be higher than FY20, reflecting the group’s comments re. investment.

Customers have returned to pre-Covid spending patterns in all regions apart from China, where demand has been in line with the previous year.

The transition to 5G and growth in cloud computing continue to drive demand for test instrumentation, from both new and existing customers, across each of the Group’s customer categories. Factors driving the strong performance include a sustained positive response to the launch of the enhanced Paragon-Neo, Calnex’s Lab Sync platform which is being adopted both by existing customers and new customers looking to deliver products addressing the new O-RAN standards. The latest version of Sentinel, Calnex’s Field Sync platform, has also seen strong uptake from the telecoms customer base, plus hyperscale and enterprise customers who are investing in their own data centre operations.

Product development – Continued product innovation has allowed the group to capitalise on the transition to 5G. Calnex has experienced strong demand for its Lab Synchronisation solutions, with its newly launched enhanced Paragon-Neo Lab Sync Platform (a very high-speed interface) seeing strong early orders as existing customers and new customers look to deliver products addressing the new O-RAN (Radio Access Network) standards.

O-RAN is an industry initiative designed to open the RAN (Open Radio Access Network) network to wider vendor competition, which is leading to new companies entering the market, as well as additional developments with the established vendors creating products aligned to the O-RAN Implementation Recommendations.

The release in June of the new 5G OTA (Over-the-air) capability in Sentinel, Calnex’s Field Sync solution, has experienced significant uptake from the telecoms customer base. This second-generation OTA implementation addresses 3G, 4G and the emerging 5G signal formats, and is driving growth in the telecoms market space.

In addition, sales to hyperscale customers who are investing in their data centre operations continue to grow.

The implementation of time distribution across data centres is creating a secondary market for testing of time distribution accuracy inside data centres. Together, both have meant that Calnex’s Sentinel product has delivered ahead of target performance with a positive outlook moving forward.

The O-RAN initiative is also having a positive impact on Cloud amp; IT product lines as it requires testing using Network Emulators to prove interoperation between the various network elements defined by O-RAN.

Outlook – Strong H1 levels of trading seen have continued into the second half, demand for telecoms testing equipment remains strong, and the global semiconductor shortage is being closely monitored with ‘no negative impacts to date’.

Calnex remains confident of meeting upgraded market forecasts (the Cenkos note on Research Tree indicates FY22 and FY23 revenue upgrades of 17.5% and 16.2% to £20.2m and £22.1m respectively. FY22 and FY23 PBT forecasts raised by 27.2% and 20.4% to £5.6m and £6m).

Targeted acquisitions remain a favourable route to growth to complement the Group’s organic growth. The Board continually assesses the market for select Mamp;A opportunities, against strict criteria to ensure that any acquisitions are strategic and earnings enhancing. Opportunities that the Board would consider include complementary products or technologies that can enhance Calnex’s existing portfolio, or where the acquisition target provides the Group with access to a related or adjacent growth market.

Interim results are due to be announced on 23 November 2021.

Conclusion

Calnex has invested in sales, business development resources, and Ramp;D in order to support strong growth in order intake. New products have been well received, which speaks to the company’s established track record of successful Ramp;D and product development.

The trends and organic growth prospects are favourable here, as reflected in the strong share price. At these levels, any dip in revenue growth or more of an impact from the semiconductor shortage could cause a derating in the short term. It wouldn’t be a terminal issue, but it could lead to better buying opportunities in future.

The requirement for design validation, and conformance and maintenance testing is more prevalent than ever. New standards and technology movements drive the need for network operators, equipment and component vendors and hyperscale/enterprise customers to validate equipment and network performance.

I view this as a good long term growth prospect, with multi-year drivers, albeit one you have to pay a premium for. I’m not sure these results are enough to drive any kind of immediate rerating given the existing valuation but everything appears to be on track.

Edit – call with management

A brief catch up with CEO Tommy Cook and CFO Ashleigh Greenan. Impressions are that they’re very down to earth and focused on the business of network testing, much more interested in new product development than the share price, for example. I mentioned the high ROCE figures and it doesn’t seem to be how the company thinks – rather it just identifies areas for improvement or growth and the good metrics follow common business sense. From the notes:

It all boils down to new things to sell to people, building them, and investing in teams where there is more opportunity to accelerate business growth.

No surprises in the period, business has been strong. The update spends time on the new products (which are being well received) and opportunities, but the established customer base has also been doing well. Calnex has now seen an extended period of good growth and the sales funnel fills nicely, with new deals coming through and underpinning confidence.

The group is excited about the new applications for its products. When asked to elaborate, Cook talked about how time is an increasingly important consideration. It wasn’t always the case but a shift has occurred and this increasing importance was Calnex’s big ‘lucky break’, appearing at just the right time to capitalise.

The emphasis on time and the new applications come from data communications and finance. Datacomms – accurate time syncing is important as it requires less ‘handshakes’ (an automated process of negotiation between two participants through the exchange of information) and enables greater throughput in data centres. Financial – this is to do with high frequency trading and MIFID.

Are there any big trends beyond the stated ones (Cloud, 5G, Data)? Can you quantify these trends in terms of scale and persistence?

It keeps changing. Hard to quantify, but it’s promising. The catalyst for the testing world is change, and there is a huge amount of evolution. Cook sees 5G as more of a euphemism for the future networks of smart cities, which suggests a huge implicit demand for increased levels of data. Networks will have to innovate to meet this demand, and as the picture keeps shifting, demand for testing should continue to grow. The cloud migration is also a strong driver.

Where do you see the industry heading over the next 10 years?

The challenge is to always find something new – mentality is to continually enhance the product and assume a need for new products every two years (even if that’s not the case). They’re always looking for the new emerging opportunity and keep close to the industry and market thought leaders.

ORAN network (the bit behind the radio towers) is a good example as it has been opened up. It was dominated by three big players, but five big networks have cracked it open, leading to new entrants and a disrupted market structure. More competition should be a good thing for the market and Calnex.

Mamp;A

The company has form here, but the list of likely candidates is not huge (‘in the tens’) so the group is ready to act if an opportunity comes up. But there’s nothing immediately on the horizon and management seems focused on internal investment and organic growth.

Share price: 71.13p (+0.18%)

Shares in issue: 309,301,108

Market cap: £220m

Severfield’s main activities are the design, fabrication and construction of structural steel for construction projects. It’s the largest of its kind in the UK and one of the largest in Europe, with a total steel capacity of around 165,000 tonnes in its five UK plants.

After incurring significant losses and a major restructuring in 2013, the company has since assembled a steady track record of profitable growth and has recently made a couple of acquisitions.

These include Harry Peers amp; Co in 2019 and Dam Structures in February 2021. Both have boosted capacity into sectors like nuclear and rail. The outlook appears positive for now, with pent up demand and a record order book.

Interim results

Highlights:

• Revenue +5.3% to £195.9m,
• Underlying profit before tax +7.4% to £10.2m (before joint ventures and associates),
• Operating profit +1.2% to £8.2m,
• Underlying PBT +22.6% to £10.3m,
• Underlying EPS +22.7% to 2.7p,
• Interim dividend +9.1% to 1.2p.

Record UK and Europe order book of £393m at 1 November 2021 (1 June 2021: £301m), includes new industrial and distribution and bridge orders and the new stadium for Everton F.C. The India order book is stable at £140m. A share of profit from JSSL of £0.3m (H1 2020: loss of £0.7m) reflects ‘clear signs of recovery from second wave of COVID-19’ in this market.

UK and Europe - In terms of geographical spread of the order book of £393m, 95% represents projects in the UK, with the remaining 5% representing projects for delivery in Europe and the Republic of Ireland. The more UK-centric nature of the current order book is driven by the inclusion of DAM Structures’ UK order book, following its acquisition in the previous year, together with a lower proportion of work in the Republic of Ireland.

We remain very encouraged by the current level of tendering and pipeline activity across the Group and are well-positioned to take advantage of some significant opportunities in the industrial and distribution (battery plants and distribution centres), transport infrastructure, nuclear and data centre sectors. We are also seeing new opportunities in the commercial office market, including in London, a trend which we expect to increase over the coming years, given that some of the challenges recently experienced by this sector are now alleviating.

Modular construction – this includes the growing product ranges of Severfield (Products amp; Processing) (‘SPP’) based in Sherburn and of CMF, a cold rolled steel joint venture business based in Wales.

SPP – originally established in 2019 to address smaller scale projects and provide a one-stop shop for smaller fabricators to source high-quality processed steel and ancillary products. The focus is on its ‘Severstor’ modular product range and ‘Rotoflo’ products, both of which attract higher margins.

CMF – has continued to develop its product range which now includes load bearing frame and deck profiles, purlins and side rail systems to service a cold formed steel market which has grown significantly in recent years through the increased use of steel in off-site and modular construction.

India – After a difficult start to the first half, JSSL has continued its recovery from the effects of the second wave of COVID-19. JSSL’s revenue has increased from £23.1m to £41.2m, with an operating margin of 5.6%.

In terms of mix, 62% of the £140m order book represents higher margin commercial work, with the remaining 38% representing industrial projects.

JSSL’s pipeline of potential orders continues to include several commercial projects for key developers and clients with whom it has established strong relationships, including in the commercial office, data centre and healthcare sectors. This, together with JSSL’s healthy order book, reflects a strong and growing underlying demand for structural steel in India, leaving the business very well-positioned as the market continues to recover well from the second wave of COVID-19.

Supply chain -

During the first half, the Group has also experienced some increases in lead times and supply restrictions for a limited number of other products, together with upward pressures on costs due to tighter labour markets and more general inflationary pressures for certain products and services. Whilst not immune to this, the impact has been managed without any significant disruption to operations, and the Group is managing these pressures through contractual protection, operating efficiencies and by forward purchasing as appropriate, leveraging the Group’s scale and supply chain and sub-contract management strengths.

Outlook

• UK and Europe – tendering and pipeline activity remain very encouraging, including opportunities in the industrial and distribution, transport infrastructure, nuclear and data centre sectors,
• India – strong and growing underlying demand for structural steel, JSSL is very well-positioned to take advantage of an improving economy,
• Expectations are unchanged despite ongoing supply chain and inflationary pressures for us and our clients,
• Record UK and Europe order book gives good profit visibility through FY23.

Alan Dunsmore, Chief Executive Officer commented:

While the inflationary outlook and labour market and supply chain pressures present challenges, our strong order book position and operational experience give us confidence for the rest of this year and provide good visibility through FY23.

Conclusion

Severfield has a strong market position, albeit in a business which brings risk (see the 2013 restructuring). Operating margins are fairly low currently, hovering around the 5% mark, with inflationary pressures being managed.

I’m wary of companies reporting an H2 bias, as this sometimes turns out to be a delayed profit warning. That does not appear to be the case here though, with good revenue visibility, although with some signs of delayed projects.

Longer term, Severfield stands to benefit from sectors such as infrastructure, logistics and datacentres going forward and has worked on diversifying its revenue base.

Current trading looks good considering those pressures across the construction industry. Steel prices have doubled in some places over the past year but have stabilised more recently. They are largely a pass-through cost for Severfield but there is some evidence that higher costs are leading to delays in clients starting projects.

Perhaps more important is the ongoing pent up demand shown in the record order books though, and, when you consider the single-digit PE valuation, this looks like decent value.

That said, I don’t think it’s the type of business to command a premium valuation, so any such rerating might be fairly modest. That comes across in the five-year share price chart, so it’s of limited interest to me.

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