Small Cap Value Report (Mon 6 Dec 2021) - SCS, SNWS, SPSY, MMH, FUL, VRS, HDD

Good morning! (first section posted early, on Sunday evening). It’s Paul amp; Jack here with the SCVR for Monday.

Many thanks to Jack amp; Roland for looking after things last week. Jack thought I needed a week off, and that coincided nicely with a trip to Manchester, to help my nephew celebrate his graduation. So fully refreshed, I’m now raring to go!

Agenda -

Paul’s Section:

Scs (LON:SCS) (I hold) – I’ve made a video primarily to analyse the balance sheet, comparing it with larger competitor Dfs Furniture (LON:DFS) . There’s an astonishing contrast – with DFS having no net cash, and SCS having more than its entire market cap in net cash. I demonstrate that there is clearly an opportunity for an acquirer to strip out a large amount of cash – making the company vulnerable to a takeover bid. Furniture retailers have a highly favourable business model – few inventories or receivables, and goods made to order, with some cash received up-front, and suppliers paid later.

Smiths News (LON:SNWS) – confirms receipt of £8.1m cash from pension scheme surplus. Divi being upped. Amazingly cheap on a fwd PER basis, at 3.7 – which looks too low, even allowing for the structurally declining nature of its business model (distribution of newspapers amp; magazines).

Marshall Motor Holdings (LON:MMH) – confirmation that the 400p cash takeover bid from Constellation is approved by MMH management. It’s a formality, as the controlling shareholder of MMH has agreed the bid. This deal demonstrates the value in the sector, and I would expect to see more takeover bids for other listed car dealerships – so there could be some nice opportunities here.

Fulham Shore (LON:FUL) – strong interim results, but there are so many distortions from covid and taxpayer support measures, that it’s difficult to determine what future profitability would be. Balance sheet look OK. More rapid expansion is starting. Looks a good company, but the valuation strikes me as up with events.

Versarien (LON:VRS) – interim results show more losses, from this jam tomorrow disappointer. Why take the risk?

Hardide (LON:HDD) – poor results for FY 9/2021, but upbeat about the outlook. After many years trying amp; failing, can this specialist coatings company convert all the exciting potential into sustainable profits? Maybe, but why would I want to gamble on that outcome?

Jack’s section:

Spectra Systems (LON:SPSY) – new customer win in the group’s K-cup business (coffee) signals good momentum and potential here. It’s a short update with no reference to other parts of Spectra’s operations, but a positive one nonetheless. The valuation appears reasonable given the prospects, although liquidity is a consideration.

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.

I made the video below last night, primarily focused on comparing the structure of the balance sheets of Scs (LON:SCS) with its larger rival Dfs Furniture (LON:DFS) . As you can see, SCS is hoarding an unnecessarily large cash pile, whilst DFS has done the opposite – spending all its cash pile, taking advantage of the permanently favourable working capital structure of the furniture retailing sector. The contrast is striking, and highlights the value in SCS shares – cheap on a PER basis, and groaning with surplus cash.

SCS’s approach is super-cautious, whilst DFS is arguably reckless, but it demonstrates what could be done, e.g. by an acquirer of SCS, hence the cash pile could attract a takeover bid. Also note that DFS had to do a dilutive equity raise in the pandemic last year, whilst the much more conservatively financed SCS did not need to dilute shareholders. So there are advantages to having a bulletproof balance sheet.

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If you would like to download my SCS/DFS spreadsheet, this link should open it in GoogleDocs, and you can then save your own copy amp; change it any way you want.

There’s also an excellent recap on SCS (also on video) from a recent Mello presentation, by sector expert Alan Charlton, worth a watch here -

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My opinion - the risk has definitely increased since the last update (although SCS is still trading in line with current year market expectations).

A sharp slowdown in order intake in the last 7 weeks could just be things normalising (after a previous surge in pent-up demand). Or, there’s a risk it could be a more enduring downturn, we just don’t know at this stage.

Also, I am a bit concerned that the order book has continued growing, which means there’s an increasing backlog of manufacturing amp; deliveries, that the company will have to work its way through by 31 July 2022 year end. That could mean poor interim results to end Jan 2022.

Hence I suspect we could have short term volatility, but personally I invest long-term, and reckon the current price could be locking in a near-10% dividend yield (plus special divis/ more buybacks) once conditions normalise. Plus the possibility of a takeover bid. Hence overall, I’ve got no idea what the share price is likely to do in the short term (same with everything!), but for me the medium term fundamentals look very attractive.

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36p (pre market open) – mkt cap £89m

Pension Surplus amp; Dividend Declaration

Receipt of pension surplus and increased final dividend for FY2021

This is an interesting turnaround, where everything has been going (almost) according to plan. The latest news is that the company has received £8.1m cash from the winding up of it pension scheme. This is being used to further reduce bank debt. All of this is as expected, but it’s encouraging to have confirmation, and the amount is significant at 9% of the market cap.

Dividends – have resumed, and the final divi for FY 8/2021 is being upped slightly from a previously announced 1.0p, to 1.15p now.

My opinion - I’m really pleased with how this one is panning out. See the archive for more details about the turnaround here, but this is the brief version -

• Disposal of the disastrous Tuffnells acquisition completed a while ago, so SNWS is now focused on the core business of rapid overnight distribution of newspapers amp; magazines.
• It’s a structurally declining business, but revenues are based on cover prices, which offsets some of the volume reductions each year.
• Costs are mainly volume-related, and are reduced on a 3-year planned basis.
• This results in predictable, reliable, EBITDA of about £10m per quarter.
• Debt is reducing, and is no longer a problem – allowing the resumption of well-covered divis, with a yield that is set to grow significantly once debt falls below an agreed level with the bank
• PER is extremely low (fwd PER of just 3.7!)
• Pension scheme now gone

Everything management said would happen, has happened. The last trading update did indicate slightly higher costs, but nothing too bad.

Overall, I think this share looks mis-priced. I think there’s a re-rating opportunity here, and personally I’m targeting an exit price of about 70p, which I think is a more realistic valuation.

I reckon there could be a chance of someone swooping on it, with a takeover bid, to add a cash cow to an existing business, and maybe use SNWS’s rapid overnight delivery network for additional purposes?

So a thumbs up from me, as a value share/turnaround/income special situation. Although we do have to bear in mind the structurally declining nature of the business.

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395p – mkt cap £307m

Intention to Recommend Offer

This announcement looks a formality under Takeover Panel rules, as the 400p cash bid was previously announced, and necessarily hinges on the support of the controlling shareholder, which owns 64.4% of MMH -

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Note that the FCA has 60 days to approve the change of control, so there might be a risk of them throwing a spanner in the works. For that reason, and a higher competing bid looking unlikely (as the price being offered is good), then personally I would be inclined to bank the profits, in case the bid falls through for regulatory reasons.

The bidder, Constellation, is a large group in the automotive sector, and already owns brands such as BCA (takeover bid in 2019), WeBuyAnyCar, and Cinch. Which does make me wonder about competition rules, and the risk that might pose to this bid?

Taking a look at the sector, CAMB was taken private in an opportunistic deal. Looking at other car dealer shares on the chart below, which is 2021 YTD (year to date), we can see the extent of the lovely bid premium being offered for MMH.

If you struggle with colours, here are the share price rises from the top down, for 2021 YTD:

Marshalls +189%
Vertu +92%
Pendragon +77%
Lookers +41%
Motorpoint +17%

I think this shows the opportunity in the sector. These shares are generally backed by strong balance sheets with loads of freehold property, so they’re extremely attractive to bidders, and I’ve been saying for ages that a wave of consolidation in the sector looked likely.

My opinion - this sector is enjoying ridiculously super-normal profits at the moment, mainly because shortages of new (and used) cars are pushing up gross margins. Everyone knows that won’t last forever, but valuations still look cheap based on reduced profit forecasts in future years.

I’m expecting to see more takeover bids in the sector.

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17.5p (up c.4%, at 12:15) – mkt cap £110m

Half-year Report – 6 months ended 26 Sept 2021

Strong revenue growth in the Half Year and continued buoyant current trading ahead of management’s expectations

The chart below shows 2021 YTD (year to date) share prices of FUL (up 87%) and larger competitor RTN (up 36.6%). It’s interesting to note that RTN was tracking ahead, but there’s been a big reversal in market sentiment since Sept, with RTN tanking (along with many other hospitality shares), whilst FUL has remained robust.

Newly listed MORE (I hold) and tiny TAST (I no longer hold) just cluttered up the chart, so I removed them.

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Interim results – there are so many complicating factors, that it’s difficult to draw conclusions from the numbers – e.g.

• Covid restrictions of some kind impacted 16 out of the 26 weeks trading
• Substantial benefit from business rates relief, and reduced VAT rate
• Profitability has bounced back from the losses last year, with £3.1m profit before tax for H1
• Revenues have doubled from the c.£20m in both H1 amp; H2 last year, to £39.5m in H1 this year – driven mainly by reduced covid trading restrictions, also 3 new sites opening (72 to 75, with a further 3 opened post H1 period end, and 21 new sites in solicitors’ hands – so it seems this is a roll-out that is accelerating in pace)
• Headline operating profit is £5.1m in H1, but that looks inflated, because it ignores £1.4m finance costs, which these days includes some of the rental costs under IFRS 16
• Other profit measures include £10.6m headline EBITDA, and adj headline EBITDA of £6.9m – so take your pick!

Outlook/ current trading -

“We have seen continued trading momentum in recent weeks, with revenues in October and November ahead of 2019 comparatives. This includes our office and theatre district located restaurants which are continuing to trade positively, over the four weeks in November 2021, achieving revenues ahead of the same weeks in 2019.

“With strong revenue growth in the Half Year and continued buoyant current trading, Fulham Shore is performing ahead of management’s expectations with many restaurants throughout the UK continuing to break weekly trading records. This augurs well for the Group’s full year performance, which we expect to be now ahead of market expectations, and our UK wide expansion plans. We have 21 more potential sites in solicitors’ hands across both businesses and look forward with confidence to the continued growth of both of our fantastic restaurant businesses over the coming years.”

Balance sheet - is dominated by £100.4m property, plant amp; equipment. That can’t possibly all be fit-out costs for 75 smallish restaurants, which would be over £1.3m each. So I’ve checked the last annual report, note 8 shows that £66m of the total was “Right of use assets” – i.e. capitalised leases under IFRS 16.

Similarly, the “Borrowings” numbers look horrendous, at £12.3m in current liabilities, and £75.0m in non-current liabilities, but checking note 7 in today’s interim results, it’s mostly lease liabilities under IFRS 16.

Why on earth is FUL reporting its figures in this adverse way? Most companies split out the IFRS 16 entries on the face of the balance sheet, which is much more sensible. FUL’s presentation is an own goal, making the balance sheet look a lot worse than it really is.

Shareholders should explain this to management, and get them to present the IFRS 16 figures more openly, on the balance sheet, rather than lumping them together with other fixed assets and borrowings.

Many investors, like myself, want to remove all the IFRS 16 numbers, but we can’t do that in this case, because no breakdown is given of the interim fixed assets figure of £100.4m.

NAV is £37.8m, less intangible assets of £23.7m, gives NTAV of £14.1m – adequate, but not particularly strong.

Restaurants have very little tied up in inventories and receivables, so can operate fine with a light balance sheet, so I don’t have any concerns here.

Cash generation has been good in H1, although with lots of new sites in the pipeline, it’s likely to see capex rise considerably over the next couple of years, which might need more use of the bank facility perhaps?

My opinion – I think this is an interesting roll-out, now accelerating in pace.

How to value it is the tricky bit. There are too many distortions in the figures reported today, so I can’t ascertain what future profitability is likely to be. Hence the only option is to rely on broker research, who should have taken all these issues into account in their spreadsheets, and of course they have access to the company and confidential information which we can’t see.

Many thanks to Singers, for publishing updated forecasts today.

On a PER basis the share looks expensive, with FY 3/2023 EPS of 0.4p, doubling to 0.8p the following year (PER of 44 amp; 22 respectively). So we’re being asked to pay up-front for the next 2 years’ growth.

EV/EBITDA is an alternative valuation method, widely used in the sector, which looks more reasonable at 11.2x for this year FY 3/2022, dropping to 8.5, then 6.6 in subsequent years.

Overall, I’m neutral on FUL shares – I very much like its restaurant formats, it’s trading well, but the valuation looks a bit toppy to me, and I don’t want to wait 2-3 years for a company to grow into the valuation.

My sector pick is Hostmore (LON:MORE) (I hold) which has bombed out on a very badly handled demerger, with forced sellers recently depressing the share price – that’s more my kind of situation, because it has better scope to re-rate, than something already pricing in the upside.

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28p (up 5% at 13:30) – mkt cap £54m

Interim results

This is a jam tomorrow cash burner.

I’ve had a quick look at the numbers, and there doesn’t seem any evidence that this is a viable business yet.

Revenues are up, at £3.8m (LY H1: £2.7m), but there’s a loss of £(3.0)m on continuing operations. That is massaged down to £(0.7)m loss at the adjusted EBITDA level.

Why are there share based payments of £0.6m in H1 this year, and H1 last year? I thought share based payments were to reward success?

Balance sheet – receivables look way too high – is that money collectable? It seems to me that another cash raise could be needed, because the company is running up debt, although it has gross cash of £3.5m.

My opinion – jam tomorrow shares hardly ever make good investments. As things stand, this doesn’t look like a viable business, having never made a profit. Why risk money on something like this? Unless you’re an expert on graphene, then buying this share is gambling, not investing.

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31.5p (down 3%, at 13:42) – mkt cap £18m

Results for FY 9/2021

No good, I’m afraid. Revenues are down, and it’s another year of (worsening) losses.

Order intake did improve in H2.

Very impressive client list, including Airbus – can it convert these exciting-sounding clients amp; products into sustainable profits though? It’s spent years trying, and got nowhere so far.

Stronger trading in Q1 of the new financial year, so upbeat about prospects.

My opinion – I wouldn’t completely dismiss Hardide, even though its long track record as a listed company has been so disappointing. It clearly has an interesting niche (a special coating for high value industrial components, e.g. in aerospace, to reduce wear). Can it convert the opportunities into profits though? The jury’s out on that. Also, what IP protection does it have?

The cash position is looking tight, if losses continue then a fundraise might be needed.

Share price: 164.5p (+6.13%)

Shares in action: 45,303,644

Market cap: £74.5m

Despite some attractive financial characteristics, positive news flow, and an impressive breadth of use cases for its intellectual property, the Spectra Systems share price has struggled for momentum over the past year or so.

If I had to speculate as to why, I’d say one reason is its communications with the market. I’ve never seen the management present and, after taking a look at the group a number of times, it’s still quite hard to fully grasp the scope of the enterprise and its prospects going forward – although much of it sounds promising given the valuation.

An example of this is the group’s K-Cup product, which is the subject of today’s announcement. I’ve been scouring the website and most recent annual report to uncover some more details here and the best I’ve found is the following:

Spectra Systems’ coating formulation will allow coffee suppliers producing their K-cup lids at LMI Packaging Solutions to have complete functionality in the Keurig K-cup system.

It would be nice to know more – what are the economics, the potential market size, the demand dynamics? How much power do customers have, will they prove to be quite concentrated and will SPSY have pricing power? Perhaps this information is available, but it does not seem to be easily attainable.

Spectra does a lot. It’s a leader in machine-readable high speed banknote authentication, brand protection technologies, and gaming security software among other things. It also now invests in early stage companies, so is something of an incubator.

The common thread (save for the software bit) is the leveraging of its proprietary materials knowledge and technology for security purposes and other commercial applications.

There’s a 645 bps spread to take into account and an all-round lack of liquidity in the share price. The last time I looked, you couldn’t actually buy the shares on Barclays SmartInvestor either. I’m unsure what the availability is like on other platforms, so it’s worth checking.

Q4 trading update

This is actually a very short update.

[Spectra] is pleased to announce that its newest customer using the company’s optical materials in K-cups for Keurig brewers has already placed three orders totaling $394,000 since September. The orders from the new customer are already 93% of the expected 2021 revenues from this product and 46% higher than total orders in 2020.

Founder and CEO Dr. Nabil Lawandy comments:

We are very pleased to have received such large orders for our optical materials from our newest K-cup printing customer. Based on this order pattern, we expect that this new customer, along with the existing customer, will result in over $1MM of high margin revenue in 2022.

Conclusion

This update is solely to do with one line of business for the group, representing about 6.1% of FY22 forecast revenue (using the revised $1m+ guidance). It’s good news but it is just a small part of the overall enterprise at present, so if this does pique your interest then it’s worth going over the company’s other operations.

The bank notes business, for example, continues to make up the bulk of Spectra’s revenue and profits.

The orders from the new customer (of $394,000) are 93% of expected FY21 revenue, which suggests just over $419,000 for the current year ending 31 December. They are 46% higher than total orders in FY20, which suggests $269,863 for that year.

So there’s good momentum here, and Spectra says this is high margin revenue. If just one customer can come along and transform this business line’s revenue outlook, then perhaps the opportunity is substantial. But it is only one piece of a puzzle with quite a few parts to it.

That said, the valuation continues to look attractive here. Where else can you find a growth stock on a forecast PER of 15.9x and a trailing twelve month price to free cash flow of 11.4x (SPSY often generates more FCF than EPS)? There’s also a 4.63% forecast dividend yield to receive while you wait for earnings growth to drive a rerating.

It continues to look undervalued and neglected to me given the prospects, so potentially attractive. There’s the liquidity to consider as well though – if anything does go wrong then the share price reaction could be aggressive, so you need to have a certain risk tolerance.

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