Small Cap Value Report (Thu 1 Sept 2022) - COG, CBOX, LOOP, JSG, ECEL, ALFA, CAM

Good morning from Paul amp; Graham. Today’s report is now finished.

Agenda - 

Paul’s Section:

Brief comments further down on -

Cambridge Cognition Holdings (LON:COG) (I hold) - another decent sized contract win.

Cake Box Holdings (LON:CBOX) – CEO spends £274k buying shares, after yesterday’s profit warning.

Loopup (LON:LOOP) – interesting commercial deal done, could delay the next fundraising? LOOP shares seem an interesting, but high risk speculation.

Brief section here  only (no section below) -

Camellia (LON:CAM) – an internationally sprawling agricultural group. I took a look at it here in May 2022, wondering why anyone would want to invest in this, given all the risks and volatility. Interim results today look poor, with a larger H1 loss than last year, but remember it harvests more crops in H2, so an H1 loss is normal.

A quick look through the commentary flags many risks, including war, supply chain, hurricanes, inflation – e.g. Bangladeshi tea workers getting a 42% pay rise. It says most operations have “weathered this unprecedented storm well”.

Full year outlook is for lower than market expectations, and lower than last year (which was only a trading profit just above breakeven).

On the upside, its balance sheet looks strong, and the divis are worth having (but not generous). Maybe I’m missing something, but this share doesn’t look very interesting to me.

Full section further down on -

Eurocell (LON:ECEL) – interims. I’m really impressed with performance, and outlook here. Looks a good quality business, at a bargain price – obviously reflecting tough macro conditions. Strong balance sheet, and a 6.8% divi yield add appeal. This is going on my potential buys list, I think it’s a bargain long-term, but obviously no idea what will happen shorter term.

Graham’s Section:

Johnson Service (LON:JSG) (£392m) – this textile rental business serves workplaces, hotels, gyms and restaurants. They argue they can still meet full-year expectations, so long as the collapse in discretionary spending doesn’t affect the normal seasonal pattern of their business! And also conditional on “no further material deterioration in the energy markets”. I think it would have been better to just cut their forecasts on the basis that the normal seasonal pattern is unlikely, and to allow for continued deterioration in energy prices. They could have done that and then possibly beat forecasts, which wouldn’t be the worst thing! I do like certain aspects of this business but it lies downstream from the hospitality industry whose recovery I’m starting to suspect has already run out of steam, or is about to.

Alfa Financial Software Holdings (LON:ALFA) (£521m) – these interim results include the statement that Alfa has “the opportunity to exceed” full-year expectations, as the company is confident of at least meeting these expectations. Alfa provides asset finance and equipment finance software to major banks and other financial institutions, and has produced some robust performances in recent years. So robust, in fact, that it is able to send £100m to shareholders in the form of dividends and share buybacks, and still have cash in the bank! I’m encouraged by the company’s reduced reliance on key customers, its strong cash flows, and a growing stream of recurring subscription revenues. The stock still isn’t cheap, but I feel there’s a lot to like about it.

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.

It’s the start of the Bournemouth Air Show today, which runs for 4 days. I’m so excited, as I love aviation, and indeed all forms of transport, apart from the boring stuff like trains, trucks, and buses. It’s another positive sign about us emerging slowly from the pandemic. Here’s a short video I took in 2018, when the red arrows flew directly over my flat (make sure the sound is up high!), which is a couple of blocks in from the beach. So I’ll be trying to get today’s report rattled out as fast as possible, in order to wander down the beach, watch amp; hear planes doing interesting things (the rumble from large piston-engined WWII planes is so evocative, and brings a lump to my throat), and share a beer with lots of wasps probably!

It’s free to attend, and is open air, on Bournemouth beach (15 miles of beautiful sand, strewn with litter by late in the day, thanks to the slovenly British public), and well worth attending – a nice family day out. The best thing is to park a mile or two away, and walk to the beach. Or it’s about 10 minutes walk from B’mth station. The whole thing is an undisguised recruitment exercise for the armed forces, but in a dangerous world, they’re highly necessary in my view.

Brief comments -

Cambridge Cognition Holdings (LON:COG) (I hold) – probably the share that causes me least anxiety to hold, because it has no relationship with consumer demand, or the economic cycle. It’s now profitable, and holds net cash, so no dilution or solvency risk. A £2.2m contract win (spread over 2 years) is announced today. The customer is the same one who signed a £2.1m contract in Feb 2022, “The quick succession of large contracts from this customer is a testament to both the efficacy of our products and quality of our service.”

COG is a key player in a growing niche, with little competition, and large barriers to entry (it has amassed key data amp; expertise over decades that can’t be simply replicated). Contracts are high margin too. I can’t see any broker updates yet, but imagine this new contract win further underpins existing forecasts, possibly some upside, who knows? The share price seems to have found a floor (famous last words!) around 120p. For me this one is just a hold forever share, as I think newish management are doing a great job, and building a decent business over time.

Cake Box Holdings (LON:CBOX) – CEO Sukh Chandal sends a meaningful signal to the market, spending £274k buying 225k shares at 121.9p. That takes his total shareholding to 10.0m shares, or 25% of the company. I see the share price bounced quite nicely from its c.100p low yesterday morning, on a profit warning. As mentioned yesterday, I can understand investors being annoyed, and perplexed at why the company allowed cost increases to eat into its own margins, before belatedly raising prices to franchisees. There have also been other problems at the company, so it’s proving rather accident-prone. However, having slept on it, I think the market cap of around £50m (at 125p per share) is probably fair. The new, reduced broker forecasts have already fed through onto the StockReport this morning, I see. How much upside is there from here? Probably not much, given the likelihood that end customer demand is likely to slip further. But I also think downside from the new, lower share price looks fairly modest too, unless we get another bombshell announcement from the company, which can’t be ruled out, given its track record of poor financial controls. Although a strong pipeline of new franchisees could keep profits flowing. Who knows?

Loopup (LON:LOOP) – an interesting announcement this morning, saying that it’s signed a material contract that could generate considerable cashflows, from its legacy online meetings product. It seems to be a transfer of customers from a competitor, and then a revenue share. Also, contract wins for its newer cloud telephony product are going well, although still only very small in total annual revenues, compared to a considerable cost base.

I think there’s something potentially interesting here, but LOOP has £8.0m net debt, which is a major concern, for a loss-making company. Another placing looks likely (I dread to think at what price, if the major shareholder who supported the last one has lost interest), although today’s deal (if cashflows actually happen as estimated) could keep the wolf from the door for a while. Guides for “material” out-performance in FY 12/2023, but not quantified. A new Cenkos note shows continuing losses amp; cash outflows. Hence speculative upside, but high risk I’d say. I’ll keep a watching brief. Management have been overly optimistic in the past, and have a poor track record – of shareholder value destruction.

159p (down 1% at 08:29)

Market cap £177m

I last looked at this building products group here in July 2022, when it issued a fairly upbeat, in line, trading update. I liked the solid finances, low PER, and generous 6% divi yield.

But obviously the macro picture has deteriorated since then, so let’s see how it’s getting on.

Half Year Report

Eurocell plc is a market leading, vertically integrated UK manufacturer, distributor and recycler of innovative window, door and roofline PVC building products

These numbers are for H1 of FY 12/2022.

The interim figures look good – here’s the highlights table -

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My heart skipped a beat, when I saw the £71.9m net debt, but then the line below shows a very much smaller £15.0m net bank debt - which is modest, and equivalent to only about 6 months profits.

Lease liabilities are high, because Eurocell has 219 branches across the UK. It seems to be vertically integrated, from manufacturing, through to selling to the trade from its stores – looking on its website, these stores seem to be smallish units on industrial estates, designed for trade (as opposed to retail) sales. 6 new branches are in the pipeline, suggesting this model works.

Basic EPS is up 13% on H1 LY, and up 29% on the pre-pandemic 2019 column.

Gross margin is good, at just over 50%, which tells me that ECEL has good products, that appeal to customers, and are being made efficiently, hence a healthy profit – selling for just over double cost price – not bad!

Inflation amp; Pricing power – probably the biggest single issue facing companies right now, and Eurocell reassures -

Selling price increases and surcharges successfully recovering unprecedented input cost inflation

Interim dividend up 9% to 3.5p – a key attraction for this share is the divi yield, so it’s good to see this being raised, as opposed to flat (which can sometimes be a warning sign of future divi cuts). Stockopedia is showing the forecast yield as 6.8% – very attractive in a higher inflationary environment, assuming it can be maintained.

Outlook – this has impressed me – no sign of a significant recession (yet) -

Demand has moderated from the unprecedented levels experienced in 2021. In the RMI market, a greater emphasis on higher-value project work is compensating for lower levels of general maintenance activity, and new build continues to be strong.

Against this backdrop, and driven by the continued success of our commercial strategies, it is pleasing to report that H1 sales volumes have kept pace with an exceptionally strong comparative period and that we have made substantial progress in sales and profits compared to the equivalent period of 2019. We also continue to take effective action to offset input cost inflation and have therefore delivered good financial results for the first half.

Our customers are reporting full order books and robust trading for July and August, and in all sectors, our sales teams continue to drive demand for our products. We believe we are continuing to take market share and our pipeline of potential new customers is strong, supported by recent investments in manufacturing and warehousing capacity and technology, which are also delivering improved operating efficiencies.

As a result, and notwithstanding macroeconomic uncertainty, we continue to trade in line with expectations and remain confident of delivering our medium-term ambitions for sales and margins.

I also liked this point in the commentary, which is a good sign of a strong business on the front foot (reminds me of what Fulham Shore (LON:FUL) said about greatly increasing staff wages, to attract the best staff from weaker competition) -

Availability of the operational labour we needed to service strong demand in 2021 was tight. However, the decisive action we took in H2 last year to secure more labour, which included a substantial increase in pay rates for operational and branch staff, ensured that we have the resources necessary to operate efficiently and support our growth aspirations for revenue and margins.

Balance sheet – is very good. NAV £112.5m, less intangible assets of £17.9m, gives a really healthy NTAV of £94.6m. That supports more than half the £177m market cap.

Net debt is modest, as mentioned above.

Working capital looks healthy, with a strong current ratio of 1.76.

Broker forecasts keep rising -

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Cashflow statement - looks fine to me, although being a multi-site operator, the lease costs are further down, thanks to IFRS 16, which inflates the numbers above unreasonably.

Capex is quite heavy, at about £7m per half year. That’s similar to the divis paid in H1 2022 of £7.2m.

My opinion - ECEL looks really good, I’m more impressed than last time.

The numbers, and positive commentary, suggest to me that ECEL is a very soundly financed group, that should be in a strong position against weaker competitors in an economic downturn.  Obviously, the big question is if, and how much, earnings are likely to fall, depending on how bad the next year or two turn out to be?

I’d say the share price already prices in a possible halving of profits in the shorter term, so it looks very cheap to me.

Dividend paying capacity looks high, so even in a downturn I would expect ECEL to continue paying divis.

It’s unusual to find what looks to me like a good quality business, at such a low valuation.

As I say with practically everything right now, short term, I have no idea what the share price will do. But I can spot companies that should do well longer term, and are priced cheaply, and ECEL fits that bill. I’d like to do an audio interview with management at some point I think, to learn more about the company.

As mentioned before, I find looking at chart, for the March 2020 low, to be a good reference point, where shares bottomed out, before mostly putting in a strong recovery. In this case, ECEL shares are now slightly below the pandemic low, which doesn’t strike me as the stock market being all that rational. Remember, we’re not just buying 2022 and 2023 earnings (which might drop), but all earnings for the rest of time. Hence, even if short term earnings do come under pressure, they should recover thereafter. Which will be reflected in share prices recovering, that’s what always happens in the long run, but it’s easy to lose sight of that in the depths of a nasty bear market.

Overall then, I’m adding ECEL to my potential buys list.

Good StockRank too -

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Share price: 88p (-8%)

Market cap: £392m

This company is in the textile rental business: you can see examples of what it does here and here. The gist of it is that they provide workwear for businesses, bed linen and towels for hotels, and table linen for restaurants.

Covid was obviously a disaster for their hospitality customers, and so this is another business where the comparison with early 2021 is not a meaningful one.

Here’s the 3-year chart: you can see that the share price hasn’t yet recovered from the collapse in March 2020:

Anyway, let’s see how the company performed in H1 2022:

• Revenue £176.2m.
• Organic revenue “broadly in line with H1 2019” (it would be helpful if they just told us the numbers here).
• Adjusted PBT £11.2m.
• PBT £5.1m.

I’ve looked up the interim report from 2019: it had revenue of £167.1m, adjusted PBT of £20.1m and actual PBT of £15.2m.

Given the significant reduction in profitability, it’s perhaps not surprising that the share price is yet to see a full recovery!

And while revenues in H1 2022 are up compared to H1 2019, much of that will be due to inflationary price increases, rather than an improvement in activity levels.

As I wrote yesterday in relation to Dalata Hotel (LON:DAL) the hotel sector is still not quite at pre-Covid levels of activity.

Indeed, Johnson Service Group say that the volume of business coming from the hotel and restaurant sector is “continuing to recover as hospitality returns to more normal and predictable levels; Q2 volumes at 91% of 2019 level”.

The CEO talks of “increased sales activity” and “a strengthening pipeline of new business”, which is good to hear, but it would be very disappointing if the company’s efforts to return to 2019 levels of activity had already stalled!

Balance sheet

Thankfully, the company offers more than just words to reassure us of their confidence: they also announce a £27.5m share buyback, and that’s in addition to the reinstatement of dividend payments from November. The interim dividend is worth about £3.5m.

Free cash flow was £30m in H1 so the company is effectively earmarking all of the cash it generated in the first six months of the year for shareholder returns.

It’s a brave move. I can’t find any evidence of JSG having done a buyback before, so it’s an original move, too. I also like the weighting of shareholder returns: 90% for buybacks and 10% for dividends!

Thankfully, JSG has the sort of balance sheet that is usually able to pull this off: tangible assets of £281m, and long-term borrowings of only £21m.

My only balance sheet quibble is that current assets (£72m) are less than current liabilities (£85m), and companies sometimes find it hard to maintain this. But JSG has access to a new £85m bank facility that the bank can increase by up to another £50m. If it needs some extra cash to cover current liabilities or the share buyback, it shouldn’t have any problem finding it.

Some positive features of the debt facility:

1. It charges only 1.45% over the benchmark interest rate. This indicates that the bank is a very comfortable lender, and makes it much easier for the company to use it profitably (because it’s cheap!).
2. JSG’s EBITDA multiple has to remain less than 4x, according to the bank covenant. This multiple was only 0.6x as of the end of H1. So JSG has plenty of room to use this facility, if it wants to.

Note that when I’m speaking to equity investors or thinking about investing in the equity of a business, I will ignore EBITDA, which I consider to be a useless measurement of a company’s long-term value. In the long run, depreciation and amortisation, and interest and taxes, all have to be paid for! (by shareholders).

However, I acknowledge that EBITDA is a useful measurement for lenders.

This is because as an approximation of short-term operational cash flow, it’s not bad. For example, JSG’s cash from operations was £41.9m in H1 (before changes in working capital), versus adjusted EBITDA of £42.8m.

If all you care about is how much cash can be squeezed out of a business in the next year or two, then adjusted EBITDA is an excellent metric!

But if you care about long-term value creation, then I’m afraid it’s worthless.

Anyway, JSG generates enough EBITDA to keep the bank very relaxed at its current debt levels, and can easily borrow more to fund working capital or shareholder returns.

Outlook

The outlook here is mixed. On the one hand, you have the continuation of post-Covid bounce and all of the sales opportunities and positive momentum that it brings.

Against that, you have the inflationary forces affecting both consumer demand for hospitality services and increasing JSG’s cost base.

Here’s how JSG analyses the situation:

Customer behaviour remains difficult to predict and, whilst there are inflationary pressures, which are expected to increase and continue at a heightened level, we have a resilient business model to help mitigate these challenges. We also have some protection through the fixing of a proportion of our energy costs, although the Board is cognisant that the energy market remains highly volatile. We continue to secure and implement price increases across our customer base which, along with expected additional volume which will better utilise our labour resource and improve processing efficiency, will help offset cost inflation.

They finish by saying:

…we do expect some margin pressure in the short term, particularly in respect of energy costs. However, based on our assumption that volumes follow the normal seasonal pattern over the coming months and are not impacted by a reduction in discretionary spending, or a further material deterioration in the energy markets, as a result of ongoing economic factors, we expect the full year outturn to be in line with current market expectations.

The market today is correctly (in my view) interpreting this as a semi-profit warning.

Maybe it would have made more sense to say that they expected the full-year result to be below expectations, due to a likely reduction in discretionary spending, and just get the profit warning over with?

Instead, they have deferred the official profit warning and suggested that they can still meet expectations, so long as things happen which aren’t very likely (i.e. that the normal seasonal pattern in hospitality is unaffected by the collapse in discretionary spending, and energy prices stop rising).

For what it’s worth, the most recently published EPS estimate for the current year is 7.4p, rising to 8.5p for next year.

My view

As you might be able to tell, I have mixed feelings about this one.

The balance sheet looks fine. So long as there is no collapse in EBITDA (which appears very unlikely), the company should be able to trade through any difficulties it faces this winter and also to afford the share buyback it has announced.

The post-Covid resumption of hospitality ought to be a tailwind, but I’m starting to wonder if hotels and restaurants have by this stage reached their “new normal”? UK hospitality has been open for over a year now. Remember that restaurants are closing in their hundreds and even thousands, not waiting around to enjoy the post-Covid bounce while energy bills wipe out the life savings of the owners.

Hotels might be doing a little better, but even there the signals we got from Dalata Hotel (LON:DAL) yesterday weren’t overly cheery. Hotels without good control over their energy bills are in big trouble.

I’m now beginning to suspect that the recovery in hospitality has run out of time. Covid might be “over” but there are new problems – principally inflation – bringing their own set of challenges.

That doesn’t mean I would want to avoid all hospitality shares, but it does mean that I’d want to be extra careful.

I’m worried for JSG, which looks like an energy-intensive business whose own margins could struggle along with those of its customers. If inflation cools down quickly, then perhaps these shares can find a bottom but my own view is that things are going to get worse before they get better.

This has a ValueRank of 30 when it should probably be in bargain basement territory, in my view:

Share price: 175p (+2%)

Market cap: £512m

This company provides asset finance software: in particular for auto finance and equipment finance.

It listed at 325p a few years ago. Anybody who waited until late 2019 or 2020 to invest in it has done fine:

Let’s see how it’s doing so far this year:

• H1 revenue +7% to £43.9m (constant currency +5%)
• H1 operating profit +25% to £14.2m (constant currency +21%)
• Cash generated from operations £17.8m

We can see from the above that revenues were boosted by 2% from currency movements, and profits were boosted by 4%. The growth figures in constant currency are more useful than the actual results, as a representation of underlying growth.

The company is paying out a special dividend worth £10.5m, which helps to prove that the cash generation is real and is of course a nice little bonus for patient shareholders.

Customer concentration – the top 5 customers are now responsible for 35% of revenues, which is still high but is down from 55% two years ago.

Customer concentration is a key risk factor for me, and something that I always want to be aware of. (For what it’s worth, so is supplier concentration: remember Phone 4u where half a dozen suppliers were able to kill the business overnight.)

When a company gets a large bulk of revenues from a small number of customers, I think you automatically have to write down the quality of those earnings to some extent. Because it would only take a few decision-makers to change their mind, and those revenues would vanish. But it’s good to see Alfa moving in the right direction at least, and reducing its customer concentration risk.

Recurring revenues – during the NASDAQ boom, and even today, investors are falling over themselves to buy shares in software subscription businesses.

Anecdotally, I wrote an article for Seeking Alpha last month, in which I argued that a fast-growing US cybersecurity stock was overvalued (I was writing about Crowdstrike – CRWD).

This stock trades at a P/S multiple of 20x, has never made a GAAP profit, and faces direct competition from a number of rivals. I didn’t think my argument was controversial, but it was hard to find even one person who agreed with me. I guess that explains why the stock price is trading where it is!

Alfa Financial can lay claim to the cloud-based, subscription-based software space. Its subscription revenues are now 31% of total revenues and are growing at a rate of 18%. It says that it takes a “cloud first approach to sales”, as it offers its own hosting service for customers.

Strong cash flow – I’ve already mentioned Alfa’s H1 cash flow of £17.8m, and intention to pay a £10.5m special dividend.

I should also mention that Alfa has reduced its share count with a small buyback this year, and has been paying dividends since mid-2020. Remarkably, between November 2020 and October 2022, it will have paid out £100m to shareholders in the form of dividends and buybacks.

For a company with a market cap of around £500m, I find that very impressive! And as of June 2022, Alfa still had a net cash position of nearly £21m.

Trading and outlook

There are some interesting comments on how asset finance broadly, and associated software sales, might perform in difficult economic conditions:

The asset finance market is a more secure form of lending and it has a history of gaining market share in uncertain times compared with non-asset backed lending markets although it will not be completely immune to these economic pressures.

In addition, the need for software is not associated with new business alone, large players in our market will have significant extant portfolios to manage whether they are writing new business or not and these portfolios will be subject to the same drivers of technical change as growing businesses. Regulatory change, digitalisation and the growing need for flexibility continue to drive customers to review their systems, particularly those still running on legacy platforms, and they will continue to select flexible modern systems.

There are also positive noises re: the sales pipeline and revenue outlook for 2023/2024. As for 2022, the company says it is confident it can meet full-year expectations and even has “the opportunity to exceed” them.

My view

I like this a lot more than I did around the time of its IPO. It was almost certainly overpriced back then, as you’d expect, but the air came out of the valuation and the company’s performance has been resilient in the years that have passed.

The amazing returns given to shareholders have warmed me to it, and it’s even something that I could potentially consider buying some day – it’s not cheap, but at least the cash flow is real.

Stockopedia