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Small Cap Value Report (Tue 25 Oct 2022) - SDRY, SDI, SHOE, SYS1, ALT

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Good morning from Paul amp; Graham!

Energy crisis – here are a couple of useful links, which I bookmarked, so I can follow what’s going on with energy prices. You might also find them useful -

Trading Economics – this page gives a chart of the UK price of natural gas, plus an excellent short summary at the top, explaining factors behind price movements. As you can see, the price of gas has absolutely plunged recently. I think this is just a spot price though, so might not be reflected in bills, if the supplier has agreed different contracted terms.

Clifford Talbot – this page gives a useful chart (change timeframe to year-to-date) showing the spot wholesale prices for UK electricity amp; gas. Note the colour coding determines whether the Y-axis is on the left, or the right hand side of the page. This is also encouraging, as the price of electricity for example now looks well below the Govt’s price cap. If it stays at that level, or below, then the Govt support measures could end up costing a lot less than initially feared.

Marketwatch – this page is useful, giving the current yield of benchmark 10-year Govt debt (Gilts). They’ve risen almost in lockstep with US Treasuries, so it’s important to remember that the trend is being dictated by international factors (as with so many things right now). The recent mini-budget kerfuffle caused a spike up to c.4.5% yield, which seems to be the level where big margin calls hit pension schemes due to their LDI derivatives. In recent days, the yield has dropped significantly as UK Govt policy has changed from increasing the deficit (hence more bond issuance) with tax cuts, to cancelling most of the mini-budget, and talk of more spending discipline (hence less issuance of new debt). Plus remember the key buyer was the Bank of England, using QE, but that’s now stopped. 


Paul’s Section:

Superdry (LON:SDRY) – thank you and well done to an eagle-eyed reader, Albm7, who spotted yesterday that Superdry’s auditor had resigned, leaving a letter that is critical of internal controls. This is very unusual (the last case I recall was Cake Box Holdings (LON:CBOX) ) and once the news leaks out, it tends to be very bad for the share price. I discuss it further below, but have taken SDRY off my potential buys list, as this is a serious matter.

Shoe Zone (LON:SHOE) – delivers a decent FY 9/2022 trading update – the year ended with a flourish, with profit 4.5% ahead of Zeus’s forecast. It’s been highly cash generative too, with the cash pile now over a quarter of the market cap. I remain positive on this company. 

Graham’s Section:

SDI (LON:SDI) (£186m) (+6% on Monday) [no section below] – this acquisitive group has spent £13m to purchase “a UK manufacturer of anti-static equipment”. The acquired company’s website can be viewed here. Deal terms appear reasonable: SDI is paying less than twice revenues, or an adjusted EBIT multiple of 8x, and also receives ownership of freehold property.

SDI is smaller than Judges Scientific (JDG), but they both face the challenge that comes with success: how to deploy larger amounts of capital? SDI’s last three acquisitions had price tags of £4.9m, £7.7m and £4.2m. Hopefully they can make slightly larger deals, such as the one just announced, and still find the same level of success that they have in the past. Management are highly credible although it is worth noting that they elected to sell 1.3 million shares in January at 195p, after exercising options. There tends to be less dilution and more insider ownership at JDG, so I do prefer JDG, but SDI also has an excellent overall track record. [no section below]

System1 (LON:SYS1) (£27m) – this marketing company updates for H1. Revenues are down 15% as its declining consultancy sales more than offset the growth in its data products. I was very supportive of System1’s plans to replace a labour-intensive, contract-driven business model with an automated, subscription-based service. However, it appears that the company itself is unsure about what to do. The results of a major strategic review will be announced at the end of November, and this will hopefully bring clarity to both existing and prospective investors. But for now, the company’s financial numbers are significantly worse than they were before, and it’s not even clear what form this business will take a year from now. With so much uncertainty and with a transition underway, I think the market is correct to price these shares at a modest level and perhaps should even let them drift lower from here.

Altitude (LON:ALT) (£15m) – this owner of a US-based marketplace for promotional products says that it is on track to be “at least in line” with market expectations for FY March 2023. I remain intrigued by the possibility that this could turn out to be a high-quality, valuable business. As the host of vast quantities of transactions between thousands of buyers and sellers, it seems that it should be possible to turn this into a success. For now, however, revenues and profitability are modest. Its cash balance is lower than it used to be, and the company opened a borrowing facility earlier this year. This looks finely balanced but I do see potentially very large upside for shareholders if the company succeeds in its goals.

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.

Superdry (LON:SDRY)


Market cap £98m

Auditor resignation

(Long section, with lengthy quotes, so [as with everything here] just skip to the “My Opinion” bit for a summary, if you’re not particularly interested in the detail. I’ll tidy up the formatting later, but want to check out SHOE before the opening bell at 8am).

Many thanks, and well done to one subscriber, Albm7, who spotted that Superdry’s auditor has resigned. This was buried in an announcement which looked harmless, so I ignored it originally. The title was “NOG – Notice of GM” – sounds trivial. But when you open the link,  the internal title is “Notification of General Meeting and Auditor Resignation” – a completely different, and much more serious matter. How deceptive is this, awful! They’ve obviously tried to bury the bad news and hope nobody spots it.

Superdry also announces that Deloitte LLP has resigned as the Company’s auditor…

A copy of the Statement of Circumstances which details reasons behind this resignation has today been sent to all shareholders alongside the Annual Report and Accounts for the year ended 30 April 2022 and the Notice of General Meeting.

This is the same thing that Cake Box Holdings (LON:CBOX) did when its auditor resigned, with a critical letter. The bad news was buried in the Annual Report, and not published to the market in a clear way. 

I’m reviewing the FY 4/2022 Annual Report now, and on page 104 (Audit Committee Report) there’s a section entitled “Review of the effectiveness of internal controls” which discussed this issue. Interestingly, it says that the auditor raised similar concerns about poor internal controls in FY 4/2020, and remediation work was implemented. Areas of concern cropped up again in FY 4/2021, causing a delay in the accounts being published.  

The Annual Report goes on to say (sorry this is quite detailed, but it’s all interesting, and pretty damning I think -

Current position – effectiveness of the Group’s controls in FY22
Deloitte has continued to identify significant weaknesses in the Group’s control environment during the course of the FY22 audit, highlighting a significant number of audit adjustments as a result. Their audit report continues to explain weaknesses in the Group’s transactional processing controls, month end close the books process, management review controls and general IT controls.
Unfortunately, particular issues have been identified in the accounts payable and inventory business processes (specifically inventory cost variance accounting) during the current year external audit, indicating a deterioration of controls in these areas. This has been exacerbated by high employee turnover within the Finance team resulting in the loss of knowledge of the Group’s processes in these areas which, in lieu of effective systems, is essential for the adequate maintenance of controls. Despite the  implementation of IFRS 16 accounting software, the process continues to be complex especially as the IFRS 16 accounting is maintained outside of the underlying general ledger and recorded as an overlay adjustment through the consolidation process.

Consistent with FY20 and FY21, the deferral of the
announcement of the FY22 results has again been necessary

to allow more time for the Finance team, the Board and
Audit Committee, and the external auditors to undertake
the additional work required to respond to the control
weaknesses identified and ensure there is no risk of
material error. The additional work performed has included
performing detailed, transaction verification testing in
certain areas. Further details are set out in the Independent
Auditor’s Report on page 132.

Finance Transformation Plan and future actions
A finance transformation plan (the ‘Plan’) was developed by
the new finance leadership team following the completion
of the FY21 audit in order to address the Group’s control
deficiencies. The Plan is establishing a framework for the
improvements required across the Group, focusing on the
four pillars of people, processes, policies and systems.
As part of the transformation plan, an internal control
questionnaire (ICQ) has been implemented. This requires
control owners to attest on a quarterly basis that the controls
in their areas are being operated as designed. Consistent
with the findings of internal and external audit referred to
above and in the Independent Auditor’s Report on pages 132
to 147, the results of the ICQ indicate that there remain
control deficiencies that need to be addressed.

It is clear that significant further work and focus is needed
to improve the effectiveness of the Group’s internal
controls and the pace of change is not as originally planned.
The deterioration in controls in inventory and accounts
payable in particular is disappointing
. Recruitment activity
in FY22 has sought to build the strength and depth of
the finance team and although some progress has been
made, further work is needed to increase the technical
competencies and seniority of the finance team across both
financial reporting and tax and establish a solid foundation
on which the transformation plan can be built.

The Group plans to implement a number of new systems in
FY23 including Blackline, a new reconciliation tool; SoftCo,
a new AP automation system, and an upgrade to the Group’s
accounting system. The new systems will help increase the
level of automation and standardisation in the Group’s
processes helping to ensure the control environment is
sustainable in the long term. However, it will take time to
implement the system changes needed
to ensure the Group
has an effective internal control environment and until then,
the Group will continue be reliant on a number of manual
review and reconciliation controls
, which as set out above
need to be improved as a matter of urgency

[I'll tidy up the formatting of this section later - Paul]

Auditor resignation – worryingly, this was advised to the company “During the year”, referring to FY 4/2022, but doesn’t seem to have been notified to the market (maybe it’s not required, but this is important information) -

During the year, Deloitte LLP advised the Company that they intended to step down as its auditor, following the completion of the audit of the Group’s results for the 53 weeks ended 30 April 2022. 

Indeed, on 9 May 2022 the main Board had a meeting which is described as “Potential new auditor presentation (RSM)” (page 89 of Annual Report), so this issue of auditor resignation has been known about for a long time, but it’s the first I’ve heard of it.

The audit report has a “material uncertainty” statement, re the bank facility, saying -

The Directors’ base case forecast indicates that a financing
facility of up to £70m will be required during the going
concern period. The ability of the Group to continue to trade
as a going concern is therefore dependent on the availability
of sufficient, committed bank facilities.
Current projections using the Directors’ base case together
with a reasonable downside scenario indicate that the
October 2022 covenant requirement of the existing ABL
facility will be met. The going concern material uncertainty is
therefore specifically in relation to the expiry of the existing
ABL facility in January 2023
and, currently, the absence of a
sufficient committed facility throughout the remainder of the
going concern period.

I’ve already flagged up this issue previously – renewal of the bank facilities is essential, which expire in Jan 2023. As things stand, I feel reasonably comfortable that the bank is likely to renew them, because it has security over the wholesale receivables book. Although a damning criticism of internal financial controls from the auditor, is bound to make the bank question whether the security is adequate. Poor internal controls can often hide black holes in the accounts. So I’m less sure than I was that the bank funding would necessarily be renewed. It probably will, but we can’t be 100% sure about that, which in a downside scenario might lead to an emergency equity fund raise, maybe at a deep discount, or worse. The clock is ticking, with Jan 2023 not being far away. that said, the auditors still gave the FY 4/2023 accounts a clean audit opinion.

The audit report itself includes some unusual items, including this -

Significant changes in our approach
We have designed our audit in light of the deficiencies within the Group’s control environment and our
findings from previous audits. The nature, extent and timing of our audit procedures continue to be
modified in order to respond to the pervasive risks arising from the control deficiencies. More details on
the impact the Group’s ongoing control deficiencies and associated finance transformation plan have had
on our audit approach are set out in the ‘impact of control deficiencies’ key audit matter below.

Also, see section 5.1 of the audit report, gives more detail on the control deficiencies, including this bit -

Furthermore, we have identified the deterioration of controls
compared to the prior year in inventory and accounts payable. In inventory in particular, controls around
inventory costing
and accounting for price and quantity variances were found to be deficient resulting in
management having to perform significant additional investigations to evidence and rationalise the
accounting entries and year end inventory balance. Correcting adjustments were recorded as a result of
these investigations. A lack of controls around matching payments to suppliers to the outstanding liability
means management has had to perform additional work to match unallocated debit balances on the
accounts payable (“AP”) ledger and in the AP suspense account at year end and record correcting journal
entries as necessary to clear down the balances. In all of these areas, there continues to be a need to
improve management review controls.

I recognise that issue from my CFO days! It’s where supplier accounts are not reconciled, so you just pay them round sum amounts of cash, to stop them nagging you for late payment. This builds up a large, unreconciled account, which can mean that some invoices have not been input onto the ledger (meaning profits are overstated). It’s a basic control that is lacking – supplier accounts should be reconciled every month to the statement from the supplier.

Adjustments to the accounts -

Consistent with previous years, a significant number of misstatements have been identified during the
FY22 audit, that in aggregate were material. The majority of these (net impact to the Income Statement
) have subsequently been corrected by management. The misstatements identified are indicative of
the ongoing control issues within the Group as highlighted above. The control environment will continue to
be a significant area of focus for the Audit Committee in the forthcoming year as discussed in their Report
on pages 104 to 105.

My opinion – there’s loads more detail in the audit report, and it just shows (as with Cakebox) that we as investors should download the Annual Reports as soon as they’re published, and go straight to the audit report, and read it carefully. In this case, SDRY has had ongoing sloppy financial controls for the last 3 years, all disclosed in the audit reports, but it’s the first time I’ve become aware of it!

I think this issue leaves SDRY shares wide open to a critical dossier, of the type that short sellers use to make money on a falling share price, often exaggerating the problems.  

Maynard Paton issued a critical report on CBOX not long ago, which also had a crushing impact on the share price, from which it’s never recovered. I don’t think he was shorting it though. 

The same sort of issues seem relevant at SDRY, and this issue has had almost no publicity so far as far as I know. Therefore, I think SDRY shares are probably best avoided for now, due to the depth of the problems in its finance department. This is a damning indictment of the CFO, although he’s only been in the role since 2021, and raised eyebrows as he had previously been sacked from the role in 2015 due to being made bankrupt by HMRC (since overturned).

This all looks a bit of a mess, so for now, I think SDRY shares are probably best avoided.

Shoe Zone (LON:SHOE)

180p (pre market open)

Market cap £88m

Full Year Trading Update

We’ve been enthusiastically reporting on SHOE this year, as it has repeatedly raised expectations. Its low priced Chinese-made footwear obviously strikes a chord with cash-strapped consumers. Also, with supply chains now easing, and sea container freight plunging in cost, the margins could improve further in future (although the strong dollar could be a negative factor).

With results statements or trading updates, to get a quick view early on (if you’re intending to buy or sell on the opening bell, for example), then I find it’s best to check for updates on Research Tree. In this case, many thanks to Zeus, which confirms that these flash figures for FY 9/2022 are 4.5% ahead of its forecast – this is now the 5th upgrade this year, really impressive stuff.

Forecast for FY 9/2023 has been raised by Zeus, up 20% to £8.5m Adj PBT, and Adj fd (fully diluted) EPS of 13.4p. Note that the forecast for FY 9/2023 looks modestly set – well down on actual results for FY 9/2022 announced today of 17.6p adj EPS. This gives me comfort that SHOE seems at low risk of profit warnings in future, indeed we might see it beat these modest forecasts. Although I do think it’s sensible to err on the side of caution, given the fragility of consumer confidence right now.

There again, there is an argument that I find quite persuasive, that SHOE’s customers are making essential purchases, not discretionary – e.g. kids needing new shoes for school due to their feet having grown over the summer holidays. Plus, the shoes are going to get trashed anyway, so might as well buy the cheapest option.

Key numbers – this is quite detailed for a trading update, so it looks as if the finance department has a good handle on things (unlike at Superdry!) -

FY 9/2022 -

Revenue £156.2m (prior year figure of £119.1m is not comparable, due to covid closures)

Digital revenues dropped from 26% to 17% of total revenues. So this is mainly a physical stores business, with covid having boosted the prior year’s online sales.

Gross margin is maintained at 61.3% – note this is a very good margin for a retailer, and shoes tend to have a low returns rate too.

Adj PBT “not less than £11.0m” – given the company’s cautious track record, the actual figure is likely to come in a little above this.

Adjustments look reasonable – re forex, and profit on freehold property sales.

Store numbers – a striking reduction, 410 down to 360 now, but remember the strategy is to close smaller stores, in favour of the better economics of bigger units on retail parks. So this is a good thing.

Net cash – striking here, at £24.4m (up £9.8m on a year ago’s £14.6m) – at a guess though, there might be some favourable working capital movements helping this a bit, possibly? It’s all the more impressive given that capex was £4.7m and a £4.4m CLBILS loan having been repaid. Yet still, even after those big cash outflows, the bank balance has risen £9.8m.

Growing divis, and a share buyback programme, reinforces that this is a nicely cash generative business, now generating surplus cash.

Management comment – there’s nothing said on current trading or outlook, but this sentence reassures in current macro uncertainty -

Shoe Zone continues to show how resilient it is, with a proven track record of delivering robust results during times of economic uncertainty.

My opinion – we remain fans of Shoezone here at the SCVR. It’s performed so well this year, and the valuation still looks modest, despite the share price having been a rare riser this year.

Selling cheap shoes, at high margins, from a low overheads base, looks an excellent business model.

In current conditions though, I personally wouldn’t be interested in chasing the share price higher. But for existing holders, I think there’s an obvious, and strong case, for just locking away the shares, collecting in the divis, and let management (owner managers with large stakes) carry on working their magic!

A very unusual chart below, but justified by repeated upgrades. Note also the StockRank – it’s stuck on maximum, but I’ve tapped the StockRanks dial, and it’s not jammed, that is the real score, currently 98!

Graham’s Section: System1 (LON:SYS1)

Share price: 213.5p (+2%)

Market cap: £27m

This marketing specialist announces an H1 update (for the period ending September 2022).

Key points:

  • Data revenue +38% to £6.2m. Now 59% of total revenue.

The “data” revenue is the high-quality income stream System1 has been building for the last few years. It’s high-quality because it’s a subscription-based, automated service, rather than a labour-intensive contract with a customer.

  • Consultancy revenue is down 46% to £4.3m.

The consultancy revenue stream is being allowed to shrink, as the company pursues its new strategy of focusing on data services.

Total revenues are therefore down 15% to £10.5m, in line with expectations.

Profitability: gross profit is down 18% to £8.5m and the company did not make an overall profit in H1, either on a statutory or adjusted basis.

Cash: the cash position is thankfully still good, but has reduced to £6.6m.

US litigation: the company’s efforts to sue an American business with a similar name continue. I believe that the American business being sued is this one.

Outlook: this is the closest we get to an outlook statement in this update:

The Board is encouraged by the strong growth in “Test Your” Data products… It is clear that the transition from bespoke research consultancy to platform-based “Test Your” data is well underway, and the Board expects the drag from declining bespoke research consultancy to reduce progressively.

My view

There’s great uncertainty hanging over these shares while the Board conducts a strategic review.

On 31st August, less than two months after announcing a share buyback and tender offer, it postponed these actions, saying that it needed time to consider alternatives to its existing strategic plans:

Whilst the Company can continue with its current strategy, the Board believes that it is important to ensure that it has explored all strategic options to capitalise on System1′s current market opportunity to deliver shareholder value, including considering the value it can create in its current form, the options for increasing organic growth through forming partnerships, and external or internal investment to grow revenue by leveraging the significant investment made in automated predictions technology.

This creates a problem for prospective investors in the company: it’s difficult to know what we might be buying into. It might just go back to its original strategy, or it might do something very different – a merger, a takeover by a larger company, a fundraising? Anything is possible.

The strategic review is being “supported” by the company’s Nomad/Broker. These things often do wind up with some sort of a transaction.

The other point is that there isn’t much current profitability to get excited about. Much of this is to do with the transition from one type of business to another, but it still leaves the share price vulnerable, when the numbers currently being printed in the financial reports are so much weaker than they used to be.

In July, I presented a list of bull and bear points around this company. Unfortunately, it looks as if the bearish arguments are winning. While it’s too soon to say that the company’s current strategy – or the strategy it eventually settles on – is doomed to failure, it does need to settle on a strategic direction as soon as possible.

Altitude (LON:ALT)

Share price: 21p (-2%)

Market cap: £15m

This share captured investors’ imagination a few years ago, before coming back to earth:

It operates a marketplace for promotional products – here’s the link. Based in the United States, this is described as “the largest organization of experienced and qualified promotional product distributors in the global promotional products industry”.

While the platform has supposedly hosted $2.1 billion of sales so far, this hasn’t translated into huge results for Altitude yet:

Let’s read this update for H1 (to September 2022):

The Board is pleased to report the Group has delivered another excellent period of growth, driven by successes across all key Services and Merchanting programmes.

Unaudited revenue for H1 23 is expected to be no less than c. £7.6 million (H1 22: £5.9 million) an increase of c.30%. As a result of the strong underlying business performance, an advantageous exchange rate and having not experienced any negative impact to date from the current macro-economic turbulence, we continue to trade well and expect to be at least in line with market expectations for the financial year to 31 March 2023*.

The company helpfully discloses market expectations: revenues of £13.9m (as seen on the StockReport) and adjusted EBITDA of £1.2 million.

My view

I think there is good encouragement to be had from this announcement. Many companies do blame the macro environment for their current performance, but Altitude appears to be doing fine.

I always like a “marketplace” type of business – something that connects buyers and suppliers. For me, this has the potential to be a high-quality business, even if it hasn’t shown up yet in the financials.

Management say that their “systems and people infrastructure have been developed and designed for continued scalable growth”. I do believe that they are thinking and acting with long-term success in mind.

Of course it’s still rather speculative at this stage but I don’t think the market cap of just £15m gives the company much credit for what it has done and for what it might do in future. The price to sales ratio is only at a small premium to 1x.

One possible issue is the cash balance, which fell to £900k as of March 2022. It will be unfortunate if the company ends up indebted to a bank: it needs to be very careful with its spending until it turns the corner to profitability, to avoid any need for an equity raise.



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