Small Cap Value Report (Weds 17 Nov 2021) - CMCX, TAM, MCLS

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

Agenda –

Jack’s section:

Cmc Markets (LON:CMCX) – figures as expected, quite a sharp decline following once-in-a-generation conditions in 2020, when people were forced to stay at home and handed money from governments. The shares have subsequently fallen and there are strategic growth initiatives in place so worth monitoring, although regulatory risks are always a concern.

Tatton Asset Management (LON:TAM) – good update from a high margin, growing company trading ahead of expectations. The share price has increased significantly, so further upside depends on sustained earnings per share growth. There are some attractive business characteristics and growth prospects here. Cyclical risks remain but shareholders have so far been well rewarded for holding.

Mccoll’s Retail (LON:MCLS) – extremely risky special situation. Supply chain issues have deteriorated in Q4 and the financial position remains precarious despite a highly dilutive £30m fundraise. Bank support is key now, and further dilution is possible. A sustainable recovery could present quite a lot of upside but for now I’m waiting for more detail in the full year update on 8th December.

Explanatory notes -

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Share price: 252p (-7.18%)

Shares in issue: 291,417,473

Market cap: £734.4m

After recent falls, CMC Markets is just about returning to SCVR territory. This is a CFD provider, the number two in the market behind Ig Group (LON:IGG) .

Like a few stocks with an online platform, it performed well over lockdowns as newly furloughed workers found new (and temporary) ways to spend their disposable income. Market volatility helped as well, as it always does with this kind of company.

Conditions have since quietened, however, and the group most recently issued a profit warning with FY income expectations reduced from £330m to £250-£280m.

The StockRank remains an encouraging 89 though, and at these levels the valuation appears fairly modest, with a forecast yield of 4.53% and a forecast PER of just 10.2x for a company that has managed to grow quickly in the past, so worth looking at although the sentiment right now is negative.

Interim results

FY 2022 net operating income guidance reiterated at £250-280m.

Highlights:

• Net operating income -45% to £126.7m (but up 24% on a two year basis),
• Profit before tax -74% to £36m (+20% 2Y),
• Basic EPS -75% to 9.6p (+1% 2Y),
• Dividend per share -62% to 3.5p (+23% 2Y).

Within net operating income (which is total revenue net of introducing partner commissions and levies), leveraged net trading revenue fell 50% to £101m (up 19% 2Y), non-leveraged trading revenue fell 8% to £24.2m (up 67% 2Y), and other income reduced by 63% to £1.5m (down 43% 2Y).

Client non-leveraged Assets Under Administration (AUA) reached a new record high at AU$74.8bn, up 30% versus H1 2021 and up 67% versus pre-pandemic H1 2020 levels.

Non-leveraged represents stockbroking revenue, while leveraged includes CFDs and spread bets.

While non-leveraged active client numbers increased by 10% to 185,847, the number of leveraged active clients fell by 9% to 53,834 and revenue per active client here also reduced by 45% to £1,877. Non-leveraged net trading revenue grew from 11% of group net operating income to 19% year-on-year.

CMC cites a decrease in market volatility as the reason for lower client trading activity, with client income retention ‘reverting towards guided levels’ of 80% (down from 115%). Total client money (AUM) in the leveraged business stood at £557m, a new period-end record high.

Operating costs excluding variable remuneration were £83.7m (H1 2021: £79.1m), up due to investment in technology staff. Variable remuneration costs decreased to £6.0m (H1 2021: £9.8m).

Marketing spend was 10% lower in the period due to the quieter conditions but spend in H2 ‘is expected to increase to similar levels as spent in FY21.’

Strategy

I’ve missed this previously.

As announced on 15 November 2021, the Board intends to undertake an exploratory review to consider the viability of a managed separation of the Group’s non-leveraged and leveraged businesses in the interests of maximising shareholder value.

And later in the report:

In line with this strategy, we believe it is right for us to evaluate the viability of separating the businesses in order to unlock the significant value within the current Group structure. The Board is expected to start this review before year end and complete it by June 2022. We will update on progress in due course.

In the period, Leveraged generated £102m of net revenue and a 26.5% profit margin. Non-leveraged generated £24.3m of net revenue and generated a 37% profit margin, so it actually looks more profitable.

CMC is launching a UK non-leveraged platform and expects this to become a significant new business line. It expects to be able to take share by focusing on mobile digital delivery.

For CMC, diversifying our business from a primarily leveraged CFD provider to also include provision of non-leveraged wealth management platforms is a natural evolution. Our 30-year history has already allowed us to build a world class technology-based trading platform… The UK has already seen dramatic growth in direct to customer (“D2C”) investment platform AUA over recent years, with data suggesting that the UK’s D2C platform AUA currently stands at just below £300 billion and has been growing at 16 % p.a. since 2008.

Institutional (B2B) –

Looking at the growth of our Australian non-leveraged business over the past decade, it has been built on B2B partnerships. We now have some 160 B2B partners across the region. We ultimately see a similar opportunity for us to utilise the same strategy in the UK non-leveraged business. On the leveraged side, we continue to pursue leveraged institutional and B2C opportunities and our institutional offering continues to provide great growth potential for both business lines.

ANZ Bank client acquisition

During September 2021 CMC announced the acquisition of Australia and New Zealand Banking Group Limited’s Share Investing client base for a sum of AUD$25m, bringing in approximately 500,000 ANZ Share Investing clients, with total assets in excess of AUD$45bn. This will be funded from the group’s existing cash.

The transaction further establishes CMC as a financial technology leader in the Australian market and removes the uncertainty around the finite term of the existing ANZ white label partnership. The transaction is expected to take 12 to 18 months to fully transition clients and is another significant step in the ongoing diversification of the Group’s global business. These clients will continue to support multi-year growth in the region and remains core to our non-leveraged growth strategy.

Regulatory change

Always a risk for these companies.

The Australian Securities and Investments Commission (“ASIC”) announced new regulatory measures relating to CFDs in October 2020 that came into effect on 29 March 2021. We are supportive of the regulatory change, as we have always operated to the highest standards, and our experience with the European Securities and Markets Authority (“ESMA”) measures show that they are, in the medium to long term, positive for CMC and our clients.

Lord Cruddas, Chief Executive Officer, commented:

Encouragingly for the future, we closed our first half with client money in our leveraged business being maintained close to record highs. It was also encouraging to see active client numbers increase by 10% in our non-leveraged business in support of our diversification strategy. Our non-leveraged business continues to offer the greatest growth potential and now represents approximately 50% of our trading revenue in Australia and nearly 20% of Group net operating income… We are on a fast track to diversification, using our existing platform technology to win B2B and B2C non-leveraged business.

Conclusion

Last year saw exceptional conditions and a transient boost in business. Shares have since moderated but the group continues to invest in technology and sees ‘significant opportunities to deliver long-term value for shareholders’. So it could be that the current share price is an attractive entry point in the longer term.

It’s been a pretty dramatic reduction in trading figures though, and earnings per share has collapsed by around three-quarters, so holders will be hoping the trend can be arrested promptly.

The balance sheet looks fine, with £131.6m of cash and another £180.9m due from brokers set against £190.5m of current liabilities. Net assets are £365.1m and the company remains cash generative. Returns on capital are also high, so the group retains its strong Quality Rank, which bodes well for a potential recovery and future growth focusing as it does on long-term profitability and financial health trends.

That said, the figures are negative for the period, so it’s up for debate what the market focuses on: the immediate and steep reversion in trading, or the group’s profitability and medium to long term growth prospects. There are also regulatory and reputational risks with this kind of stock, so the justified earnings multiple is lower than for other companies with similar profitability metrics.

I’m surprised to learn that the non-leveraged division is framed as the growth driver but I can also see how a tech platform such as CMC’s might take share there. It could reduce earnings volatility. The UK investment platform should launch ‘in the early part of the next financial year [and] will offer both B2C and B2B potential’. Australia also looks like a promising market.

Enough, in my view, to keep the company interesting.

Share price: 605.5p (+4.4%)

Shares in issue: 58,914,887

Market cap: £356.7m

Tatton was founded by its CEO and major shareholder Paul Hogarth, with the aim of creating a range of services for independent financial advisors.

The company offers on-platform only discretionary fund management, regulatory, compliance and business consulting services, as well as market mortgage provision to Directly Authorised financial advisers across the UK.

This is achieved through two operating divisions: Tatton the Group’s investment management division and Paradigm, the Group’s IFA support services business.

It’s been a great investment for shareholders so far, but that makes me wonder if we’re a little late to the party here. There’s good growth and high levels of profitability on offer, so it depends on how long the company can continue along its current trajectory.

Interim results

Trading momentum has continued since the last market update and post Period end and, as a result, we now anticipate that trading for the current financial year will be ahead of the Board’s previous expectations.

Highlights:

• Revenue +26.4% to £13.8m,
• Adjusted operating profit +37.9% to £6.9m, adjusted operating margin up from 45.9% to 50.1%,
• Profit before tax rose from £3.1m to £6.9m,
• Adjusted diluted EPS +33.7% to 8.76p,
• Interim dividend +14.3% to 4p,
• Net cash of £1.7m and net assets of £27.5m (+37.5%).

Assets under management (AUM) increased by 20% or £1.8bn to £10.8bn and current AUM as of 12 November is c£11.2bn. Organic inflows were up from £321m to £652m with an average run rate of £109m per month. Strong investment performance increased AUM by over 5.0%, adding £495m, and the recent Verbatim acquisition contributed a further £650m.

Tatton – Revenue increased by 26.5% to £10.9m (78.6% of group total), while operating profit grew by 34.2% to £6.7m. The segment continues to grow and maintains its position as a leading provider of on-platform Managed Portfolio Services (MPS) and fund solutions. Revenue and profit growth is driven by its expanding distribution footprint and diversified proposition.

The group acquired £650m of Verbatim funds at the end of the period for £5.8m. These are a range of multi-index and multi-asset funds expected to contribute c£0.6m of adjusted operating profit this year and c£1.5m in its first full year, FY23.

Tatton has also entered into a five-year strategic distribution partnership with Fintel (LON:FNTL) providing access to over 3,800 new financial intermediary firms and its 6,000 Defaqto users. Strategic partnerships have also been initiated with Threesixty Services and Sesame Bankhall Group. Along with the Verbatim acquisition, Tatton expects these partnerships to significantly enhance its reach and distribution.

Paradigm – this is the group’s mortgage distribution and support services business. Revenue grew by 26.1% to £3m and adjusted operating profit rose by 96.2% to £1.3m. This has been helped by ‘an active housing market which has been underpinned by increasing demand with record mortgage applications, maturities and the UK Government’s stamp duty stimulus’.

Conclusion

Looks good, but I’d need to convince myself of the longer term prospects given the rerating to all-time highs over the past year or so. The share price is up from a Covid low of c200p to more than 600p at present.

The group is aiming to increase group AUM from £9bn (as of the end of last year) to £15bn over the next three years through a combination of organic and acquisitive growth. Tatton remains high margin and is finding lines of business to expand into.

The growth rates are encouraging, although at these levels the shares are no bargain. The high margin growth probably warrants such a price but it does mean further appreciation relies on continued earnings per share growth rather than any kind of multiple expansion. For now, the valuation looks justified given today’s ‘trading ahead’ statement.

Share price: 15.9p (-11.67%)

Shares in issue: 290,304,400

Market cap: £46.2m

Mccoll’s is very high risk and is only for the brave. Deep value situations – assuming that that is what this is now – can generate dramatic outperformance, so they are worth considering. But there’s the possibility of a permanent loss of capital if there is no margin of safety.

The group is low margin with a weak balance sheet and, for most operators, costs are only going one way right now. We all know about supply chain disruption, inflationary pressures, and labour shortages. We also know that already low margin companies face greater risk here. That looks to be borne out by today’s update. The more acute concern for now is being able to adequately stock its stores.

Trading update

Continued supply chain disruption impacts revenues in Q4. Strong performance from Morrisons Daily format leads to accelerated roll out with over 150 stores expected by end of November 2021

Supply chain disruption is affecting Mccoll’s ability to adequately stock its stores, which is impacting revenue. This dynamic has ‘intensified in the fourth quarter’.

The group now expects ‘significantly lower revenues than initially anticipated’. Mccoll’s says its lending banks remain supportive. FY21 adjusted EBITDA pre IFRS 16 is now expected to be in the range of £20m to £22m.

Its Morrisons Daily stores continue to deliver strong performance, with revenue growth significantly ahead of the rest of the estate, driven by a high grocery mix and wider product choice for customers.

The format allows us to grow customer spend, frequency and loyalty by growing the basket size, offering customers access to great value fresh food, under the Morrisons fascia, in their local community.

At its capital raise, Mccoll’s indicated a 2-3 year payback on investment. This is so far the shorter end of the stated 2-3 year range and the group is consequently accelerating the rollout.

Previously, Mccoll’s had been converting around six stores per week but now the group has picked up the pace and expects to reach 150 Morrisons Daily stores by the end of November. It should reach its targeted number of 350 conversions ‘well ahead’ of the original date of November 2022.

Diary date – full-year trading update for the 52 weeks to 28 November 2021 to be released on 8 December 2021.

Conclusion

This is an interesting proposition purely for the levels of risk and reward on offer at this point. As of the last balance sheet date, the group had £31.4m of cash, dwarfed by £218m of current liabilities. Total debt ex-leases was around £163m, far more than the value of the group’s equity, so it’s extremely high risk.

That picture has changed recently with a deeply discounted £30m placing that has massively diluted shareholders (the share count rose by 152% to 290m). The CEO notably put in £3m. I’m still not sure that’s enough and am waiting to see if there is further dilution. It may well be that there is a better time in the months ahead to consider this company.

The Morrisons tie up does have potential and is the one ray of sunshine, but the wider group is really struggling and the situation has deteriorated in Q4. This will hopefully improve, but Mccoll’s position is precarious. What’s more, Morrisons holds all the cards in that relationship.

I see Singer has its valuation under review ‘pending more details and guidance at the upcoming year end trading update and then subsequent prelims (in March).’

If the company is still around by then, there could be a good recovery opportunity. But for now the group’s future depends on supportive banks and a recovering supply chain, with shareholders in a very uncomfortable position. It’s a live situation that could change quite rapidly though, as could the risk:reward.

We’ll be getting a more detailed update in a couple of weeks so I’m not in any rush to make a decision before then. A lot of smart institutional investors who got involved in August/September have already seen their stakes fall c25%. On the other hand, there could be material upside in time. Neutral for now, waiting for 8th December.

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