Small Cap Value Report (Thu 10 Nov 2022) - BME, TTG, NXR, SMV, PCF

Good morning, it’s Paul amp; Graham here!

Agenda

Paul’s Section:

CEO Interviews – people seem to be finding these interesting, so I’ve lined up 2 more companies to interview tomorrow. Please remember these are definitely not recommendations or tips. I’m just flagging up companies that seem to be trading alright in the current difficult circumstances, and seem sound on long-term fundamentals. Some will be right, and some will be wrong, inevitably, as I cannot predict the future. So please DYOR – remember we just flag up lots of ideas here, but it’s up to each investor to apply your own filters to our ideas, and select the things that float your boat, with your own insights amp; more detailed research.

Virgin Wines UK (LON:VINO) – this has bounced a fair bit recently, so the opportunity might have passed. But I did flag it here on 28 July, and again here on 1 November, as a share that looks potentially interesting. The key question I’ll be exploring, is whether it can weather a recession whilst still keeping its subscribers?

Norcros (LON:NXR) – perpetually cheap, but with known issues. Is it too cheap now? See section below for my review of its interim figures. I think NXR shares are looking attractively cheap now, and providing a nice dividend yield. Although a large recent acquisition has increased net debt significantly. Overall though, I think the low valuation means it justifies a thumbs up on valuation grounds.

Bamp;M European Value Retail SA (LON:BME) [no section below] – one of the mid-cap retailers I keep an eye on. Interim trading update today for 6m to 24 Sept 2022 looks pretty decent. Profit guidance is maintained for FY 3/2023. Q2 much better than Q1, and current trading in Q3 is good. Divi maintained (decent yield of c.5%), and net debt seems reasonable. Profits down on pandemic-boosted period, but still strongly up on pre-pandemic. As a value products retailer from large sheds, I think this company should fare well. The shares have bounced strongly recently, but still look sound value. [no section below]

Graham’s Section:

TT electronics (LON:TTG) (£263m) – a solid H2 update from this provider of electronic components. Revenues have shifted higher, as anticipated, but the important book-to-bill ratio remains over 100% as old customer orders are replaced with new ones. Inflation is being passed onto customers and financial leverage is being reduced. And yet the share price is down by nearly 50% since the high it reached last year At a PE ratio of only around 8x according to Stocko, I think these shares could offer nice recovery prospects when sentiment in small-cap equities eventually improves.

Smoove (LON:SMV) (£22m) – poor H1 results from this company. It owns and runs websites that make the home buying process easier, but recently its activities have been led by the remortgage segment. This is low-margin work. When combined with an increase in administrative expenses and revenue growth of only 4%, the underlying loss doubles in H1, compared to last year. I remain interested in the possibility that Smoove’s growth initiatives might actually work, as it also has £17m in cash to help support the valuation. £5m will soon be returned to shareholders. I’m neutral on this share but I could quickly turn bullish if there is some more positive news from the company, or if the market cap gets much lower.

PCF (LON:PCF) (£1m) [no section below] – I thought I’d provide a short note on this failed challenger bank. It issued a statement yesterday that appears to spell the end: the additional “growth capital” it wanted has not materialised, and so it will “commence a process of withdrawing from the UK banking market”. The loan and savings portfolio will run down, and the AIM listing will be cancelled. I previously thought that PCF’s problems were unfortunate symptoms of over-expansion and some bad apples inside the company. However, I think we also have to consider the role played by the majority shareholder, Somers (a Bermuda-listed investment holding company). While I’m under no illusions that they are a charitable enterprise, it’s gravely disappointing to see them allow PCF to delist and to see PCF’s minority shareholders left with no bid at all for their shares. There were only a few warning signs at PCF to get out before the whole thing fell apart. But perhaps I should have been more wary of the presence of a majority shareholder whose intentions and whose influence on the company were unclear. In the end, the majority shareholder has enabled a situation where PCF’s shares are deemed almost worthless by the market: a sad end to what looked so promising, just a few years ago.

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.

181p (up 3% at 12:49)

Market cap £161m

Interim Results

Norcros, a market leading supplier of high quality and innovative bathroom and kitchen products, today announces its results for the six months ended 30 September 2022.

‘Resilient performance reflecting strength of business model.’

The headline figures look pretty solid. Given macro conditions, I’m not expecting companies to be reporting earnings growth, and nor is Mr Market, judging by how beaten down so many share prices are, in anticipation of a slowing economy amp; hence falls in profit.

A few key numbers -

H1 revenues £219.9m (up 21% vs H1 LY)

Underlying PBT £19.9m, down 5%

Statutory PBT £14.0m, down 21%

Adjustments of £5.9m are £1.0m pension admin costs, and £4.9m acquisition-related costs (seems a lot. But note 4 explains that £3.1m of this is goodwill amortisation, so that’s OK to ignore)

Diluted underlying EPS 17.8p, down 11%

Full year broker consensus EPS is about 38p, which looks consistent with H1 performance.

Interim divi of 3.4p is up 10%, and well-covered by earnings. Total divi yield is close to 6%.

Presentation slides are here, under “Latest downloads”

Balance sheet - NAV is £214.5m, but this includes £108.1m + £68.0m in intangible assets (relating to acquisitions). Eliminate those, and NTAV becomes a fairly modest £38.4m. Although there is an argument for also eliminating the deferred tax liability (which relates to acquisitions – see note 6) which would boost NTAV by £17.3m to £55.7m, which is getting more sensible for the size of business.

Working capital looks healthy, with current assets of £229.1m, less current liabilities of £121.6m, giving a surplus of £107.5m. The current ratio is strong at 1.88.

This is financed with £90.0m in gross bank debt, in non-current liabilities.

Bank facilities mature in Oct 2025, and there’s decent headroom on a RCF of £130m (plus £70m accordion). I wouldn’t want to see the company draw down any more on this, and hope they reduce bank debt as we are probably entering a recession.

Interest charges seem to be at floating rates (per note 8), which could mean finance costs increase.

There was £31.1m in cash, so net debt looks more manageable at £58.9m (at end Sept 2022), but it would be nice to see that coming down in a slowing economy, rather than more acquisitions being undertaken, just my opinion, you don’t have to agree!

Prior to the big acquisition of Grant Westfield, NXR had reached a net cash position of £8.6m at end March 2022.

Cashflow statement is dominated by a large acquisition, with a £78.3m cash outflow for this, partly offset by a £18.1m equity raise cash inflow.

Pension scheme - the problem here is that the numbers are very big, running into hundreds of millions, so only small movements in asset or liabilities can make a big difference. My main worry with big pension schemes at the moment, is that the real world value of assets (often heavy holders of bonds) has plummeted recently. Whereas liabilities may have technically fallen (because they’re valued using bond yields), but the real world liabilities haven’t fallen at all – they still have to pay out to pensioners, and with higher inflation, those actual liabilities have gone up, not down. This makes me very wary of any company with a big pension scheme.

NXR says its accounting valuation on the pension scheme is in surplus, although that has deteriorated from £19.6m at Mar 2022, to £8.2m at Sept 2022. Sounds harmless, a surplus.

I tend to look for the actuarial calculations, as that is what drives real world cash payments into the pension scheme. At the end of note 3, it says that pension fund deficit recovery contributions in H1 were £1.9m. That’s about 10% of underlying PBT, so it looks a relatively minor problem. I would just discount the PER by 10%, to allow for these manageable pension recovery payments. Or if we include the £1m admin costs onto that, the total looks to be about 15% of adj PBT. Not ideal, but it seems OK, nothing to panic about, unless something extreme happened with asset values or assumptions. If interest rates come back down again next year, but asset prices remain depressed, that could be a problem.

Valuation - there are no broker notes available on Research Tree. Although Stockopedia does have consensus figures based on 5 brokers, as follows -

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At 181p/share currently, that gives us a PER of only 4.8

Why is it so cheap, given that the pension scheme doesn’t seem to be much of a problem? Maybe the market thinks earnings could drop below forecasts, in a recession?

A big chunk of the business is based in South Africa, which makes some UK investors nervous.

Net debt of £59m is 37% of the £161 market cap, so has to be taken into account with valuation.

My opinion - this looks oversold to me.

I like the group’s strategy, of growing by reasonably-priced acquisitions, which then dilutes the problems (like the pension scheme) over time. That strategy seems to be working.

The problem is, with its equity valued so low, Norcros can’t issue much equity to fund deals, as that would be too dilutive. Plus it’s at the top end of what I’m comfortable with on bank debt.

Overall, I think this is a decent business, and the current valuation looks too low to me. The downside risk is obviously that earnings could plunge if we go into a deep recession here, and in S.Africa. So we all have to make up our own minds on whether the low valuation factors in that risk adequately, or whether it’s better to sit on the sidelines and wait to see how things pan out? Your money, your choice! Sometimes, being bold in downturns can produce excellent long-term results.

See below, the StockRank has been very high for the last 3 years, so the Stockopedia computers like the data.  I’m happier when my own stock ideas also have a high StockRank.

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Share price: 149p (pre-market)

Market cap: £263m

This electronics supplier issues an update for the four-month period to 29/10/2022. It is in line with expectations.

Revenue growth has accelerated, as expected. Year-to-date organic, underlying revenue growth is now 18%. This metric was only 8% in the interim results, so that’s a very significant movement.

Book to bill is the ratio of orders received to orders fulfilled and billed to customers, and is a useful indicator of future revenue growth. In simple terms, it measures whether or not the order book is increasing.

This ratio cooled down to 106% in the four-month period (it was at the lofty heights of 144% in the interims).

But the key point is that despite very fast revenue growth in the period, TTG’s book-to-bill remained over 100%. This means that the company was not simply running down its order book as quickly as possible, but was also replacing the orders it fulfilled with new ones!

For the entire year to date, book to bill is now 127%, which I would say is still a very healthy level.

And as noted previously, the company is passing inflation onto customers:

Global supply chain constraints persist alongside continued inflation pressure from wages, material costs and energy. Prices are under continuous review to recover these costs; the ongoing nature of inflation dynamics will mean some lag in recovery.

Balance sheet: net debt was last seen at £142m (including leases), which looked on the high side to me. The company says today that it remains on track to achieve a leverage multiple of 1-2x by year-end, in accordance with its previous guidance.

This leverage multiple is defined as net debt (excluding leases) divided by adjusted EBITDA. A multiple of between 1x and 2x would normally be considered modest, and I think it’s important they achieve that.

Outlook

Despite the challenging backdrop, given the strong performance of the Group, we expect to report adjusted profit before tax in line with the Board’s expectations for the full year, with benefits of foreign exchange offsetting the headwinds from increased interest costs.

The CEO says “While mindful of the wider macroeconomic backdrop, the continued growth in order book extends our visibility of revenues for 2023.”

My view

The company helpfully informs the market that it believes the adjusted PBT expectations to be between £35.4m and £39.8m.

For a company that is apparently firing on all cylinders, enjoying a positive book-to-bill ratio despite fast revenue growth, and passing inflation onto customers, perhaps the market isn’t giving it enough credit?

Let’s remind ourselves of the borrowing situation: as of June 2022, the company had £267.6 million of total borrowings. Of this amount, £75m was in the form of medium-term notes at a fixed rate (average rate 2.9%). These notes don’t worry me at all.

The company’s major source of borrowing is an RCF. This charges a floating rate of interest and I’m looking forward to seeing how much of it the company can pay off by the year-end. When they don’t need to worry about paying a floating rate, that will be one less headwind to deal with in this environment.

Overall, I do think that these shares could be undervalued at current levels. To me, it looks like a decent-quality company with an ability to pass on inflation to customers (albeit at a lag) and with a management team that does attempt to earn a respectable return on invested capital for its investors. So I think this one could be worth investigating in further detail.

Share price: 35p (-3.5%)

Market cap: £22m

This company, formerly known as ULS Technology, owns eConveyancer, DigitalMove and Legal Eye. Today it issues interim results for the period ending September 2022.

The stock came to my attention due to it having a £20m cash pile as of last March (currently £17m). The company is about to launch a £5m tender offer to return some cash to shareholders.

But unfortunately, there is little to cheer about in these numbers. The company made an underlying loss before tax of £3m (H1 last year: £1.5m), “reflecting increased investment in eConveyander and new product areas”. Revenues were up 4% to £10.6m.

Operationally, there are a range of growth initiatives to offer some hope of an improved future:

• The remortgage segment on eConveyancer was developed and took up a larger share of instructions (remortgages are low-margin work but are very busy right now)..
• Smoove Start has been launched.
• Smoove Complete is launching, too – this is “a co-working platform that is designed to bring together self-employed conveyancers”.

In an acknowledgement that the recent rate of losses is unacceptable, the company has carried out a series of cost reduction measures. It announces today that its administrative expenses peaked in Q1 and “are expected to decline continuously into the first half of the next financial year”.

That’s important, because it’s much easier to make a case for owning these shares on the basis of the cash balance than it is on the basis of business performance. Having said that, I do find Smoove’s growth initiatives intriguing and I’d like them to succeed, to improve the homebuying experience for everyone!

Outlook

Signs of a slowdown in the property market are starting to emerge, as banks take a more cautious approach to lending and potential home buyers delay purchases… the outlook for house prices and transaction levels is less certain than before.

Our new propositions, Smoove Start and Smoove Complete, are performing ahead of our expectations and have very exciting prospects. The Board believes that these new propositions will make the Group more resilient over the long term by diversifying sources of revenue. Our future investments in these businesses will be subject to continued validation of market demand for the propositions.

My view

The slowdown in the property market is a concern but other important factors are at play here.

With costs reducing, growth initiatives underway, and a very strong balance sheet, I’ll take a neutral stance on this share for now.

I’d want to switch to a bullish stance if the market cap slipped below its cash balance without any deterioration in trading, or if we get a trading update or results statement indicating that the company has stopped burning its cash pile.

Note that when the £5m tender offer is complete, the market cap here should have more to do with the valuation of the business, rather than the balance sheet.

Stockopedia