Small Cap Value Report (Wed 30 Nov 2022) - IGR, MUL, LINV, KETL

Good morning from Paul amp; Graham.

Agenda

Paul’s Section:

IG Design (LON:IGR) – H1 figures look good, but the outlook is only for about breakeven for FY 3/2023, so I’m publishing the first part of this section to alert readers to this point – caution needed! The rest of this section is now up. It could be an interesting turnaround, especially if input costs fall in future, but so far there’s not enough evidence to convince me. Plus there’s bank refinancing risk to consider.

Strix (LON:KETL) – drops about a third today, on a profit warning. I raise several concerns over the historic accounts, so this share gets a thumbs down from me.

Graham’s Section:

Mulberry (LON:MUL) (£150m) – disappointing numbers from this luxury handbags and leather goods company. It swings to an H1 loss and also suffers a large cash outflow as it builds up a large pile of inventories, betting on a big festive season. Expenses have ramped up across marketing, technology, and expanding the store network. It’s an ambitious plan and hopefully it will pay off over time with improved revenues and operating margins. We’ve seen false dawns here before and I believe that Mulberry should allow itself to be taken over by a larger group who can run it profitably. The shares are currently priced at a level where I think buyers would be interested, but it’s not clear if Mulberry’s major shareholders would be willing to let go.

Lendinvest (LON:LINV) (£113m) – the property investment platform and lender confirms its H1 numbers and leaves its expectations for the current year unchanged. It no longer expects any improvement in PBT for this year, but it thinks that the issues are temporary and that it can get back into a strong growth trend in FY 2024. I’ve reviewed its key numbers and am disappointed that it hasn’t already securitised more of its portfolio, in order to reduce its own leverage. As things stand, it remains very highly leveraged and I’m concerned that its balance sheet would not be able to withstand a few more heavy blows.

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.

114p (pre market open)

Market cap £111m

Interim Results

IG Design Group plc, one of the world’s leading designers, innovators and manufacturers of Gift Packaging, Celebrations, Craft amp; Creative Play, Stationery, Gifting and related product categories announces its results for the six months ended 30 September 2022.

Webinar – today at noon – register here if interested.

Headline numbers look impressive -

However, there are several points that should temper our excitement – incidentally well done to the company amp; its advisers for giving prominence to the cautionary points -

• A “full refinancing” is underway, which they hope to complete by FY 3/2023 year end. The existing bank facilities (needed to cope with the seasonal spike in working capital prior to Christmas) expire in Mar 2024. I wonder does “full refinancing” possibly involve an equity element, if the bank wants to reduce its exposure? So dilution could be a risk for shareholders.
• Acceleration in orders for H1, due to customers wanting seasonal (Christmas) stock in earlier, given last year’s supply chain issues. Hence demand pulled into H1 from H2, and a “strong first half weighting” for FY 3/2023.
• Cautious outlook beyond this financial year.

Outlook - the key guidance is a bit vague -

The Group has also seen stronger trading in certain Everyday categories than previously had been anticipated. Due to this, the Board believes that the financial results for the full year to 31 March 2023 will be ahead of expectations, delivering a small full year adjusted profit before tax. As previously communicated the Board remains cautious on its outlook due to uncertainties relating to the current macroeconomic environment.

What does “small” mean? Does this imply that H2 might be loss-making, since it made an H1 adj PBT of $27.4m – which doesn’t sound small to me. Although as a percentage of revenue of $521m, it’s 5.3%, which is lowish. All rather confusing. It’s annoying when we have to check broker notes for the full picture. It’s much better (and fairer) when full guidance is provided in the RNS itself.

Broker updates - see notes from both Canaccord, and Progressive, both are on Research Tree. This gives much more clarity. It turns out that yes, H2 is expected to be loss-making, and is likely to wipe out nearly all H1 profit!

Indeed, Canaccord slashes its FY 3/2023 revenues target considerable, from $965m to $909m.

Although profit guidance is raised, but barely above breakeven – Progressive reckons $1.9m adj PBT. It’s now become clearer what a “small” profit is, they really are talking small, almost nothing, in plainer language. Not very good at all. I wonder if people might buy on the opening bell, not having realised that the outlook is nowhere near as good as the strong H1 numbers suggest?

I’ll publish this now actually, to alert readers, as it’s just before 8am, and finish the section in the next hour…

Since the full year outlook is only for just above breakeven, I don’t think we should be over-analysing the H1 figures, which are not representative of the full year.

Cost inflation – the comments below on sea freight costs surprise me, because this cost has absolutely crashed in price more recently. I wonder if IGR might have contractually locked in at higher prices? That would be a good question for the webinar. Spot rates are actually now right back to pre-pandemic levels, so why isn’t IGR reporting this?

Since the summer of 2021, the Group has experienced significant cost increases, particularly in relation to freight, raw materials and labour. Freight presented the most significant challenge across the Group with the scarce availability of sea containers significantly increasing the freight rates paid. Freight rates in FY2023 so far, though stabilising, have remained higher than the prior period on a number of our key shipping routes.

Raw material costs have increased significantly during this year, especially where higher energy costs are a factor. The average prices paid for paper, the Group’s major category of material purchases, increased around 50% compared to the prior period.

Balance sheet – is quite strong. NAV of $371m becomes $273m after writing off intangible assets.

Working capital is good, with current assets of $616m, and current liabilities of $413m, a healthy surplus. Note that both inventories amp; receivables are very large numbers. The interim figures as at 30 September, show working capital probably at or near a seasonal peak. The 31 March comparative shows receivables more than halve, and the bank debt paid off, which would be seen positively at the bank (because in extremis, it could cancel facilities when they’ve already been paid off from seasonal cash inflows, thus greatly reducing risk).

The problem is, as a seasonal business, it needs large bank facilities to operate. In normal times, that wouldn’t be a problem, but I’m worried banks are now probably being a lot more cautious than normal.

Bank covenants - this sounds positive, and could make it easier to refinance the bank facilities (which expire March 2024) -

The Group has operated well within its banking covenants, with working capital requirements tightly managed and net debt lower than expected throughout the period.

My opinion – It seems to me that the fundamental flaw in IGR’s business model, is that it’s a low margin business, and was not able to pass on big, unexpected increases in costs, to its customers. That should, over time, be fixable, and see the PBT margin possibly return to around the previous level of c.5%. The same core problem has hit many other companies. The answer is to somehow build in flexibility in costs into contracts, although customers won’t want that, so in a competitive, low margin sector, this may not be possible.

IGR’s other problem is that it’s highly vulnerable to supply chain delays, because the product has to be in its customers shops before Christmas, because if deadlines are missed, then the product effectively becomes worthless (who else likes buying wrapping paper for 10p per roll in January each year, or is it just me?!) Hence it was hit particularly hard with all the supply chain problems, and I recall last year that it was forced into over-staffing warehouses at considerable cost, in order to get the delayed Xmas orders out. It talks about excellent customer service, but it didn’t have a lot of choice, as customers would just reject orders that arrive too late for Xmas. About half its revenues are Xmas-related.

The big picture problem, is that wrapping paper, cards, etc, really don’t come with any pricing power, so cheap competition from China, etc, is always likely to erode IGR’s profit margins. For these reasons, I think this is a fundamentally poor business model.

It seems to me that these strong H1 numbers are best ignored, since the bigger picture is that the FY 3/2023 is only going to be around breakeven.

There’s also refinancing risk – will the bank really want a large seasonal exposure to a company that has demonstrated how vulnerable it is to supply chain disruption? Especially when the Xmas-related products become worthless after Xmas? So what would the fire sale value of inventories be, in the worst case scenario? Not very much, I reckon.

On the upside, the recently appointed new CEO could improve things with a turnaround plan, and if profit margins return to previous levels, then on c.$1bn revenues, the effect could be exciting – that’s the bull case for this share.

Overall, IGR shares could go either way. If profit margins recover to previous levels, then you could maybe have a 2-4 bagger on your hands, which would be marvellous.

On the downside, there’s dilution amp; bank refinancing risk over the next 6 months – clearly a bad time to be renegotiating the necessary seasonal bank funding, when lenders are cautious.

Also, there’s very little evidence so far of a profits turnaround – remember it’s only expecting around breakeven for the current FY 3/2023, which to me is not a turnaround, it’s more a case of having stabilised the business, and it not getting any worse, rather than a convincing turnaround at this stage.

If cost headwinds turn into tailwinds, from e.g. falling paper amp; energy prices, then that could be a nice catalyst for profits to recover. Set against that, will consumers cut back on spending for celebrations? I don’t know, it would be good to ask management if amp; how much demand changed in previous recessions.

Overall, I’m probably neutral on this one. It’s a possible turnaround, but so far there’s not enough evidence for me to get excited about it, and still considerable risk. In a rebounding stock market, maybe investors will ignore those risks, who knows?

The share price seems to have formed a base this year, indicating more solid investor sentiment, during a nasty bear market. So maybe anyone likely to sell has already moved on? That could be a positive, for traders.

.

84p (down 33% at 09:02)

Market cap £183m

A nasty reaction to this update, so it must be a profit warning.

Completion of Acquisition

This is an Australian company called Billi, which does instant hot water taps. They look high end, with google showing prices of £4-6k per tap.

A previous RNS says the acquisition is £38m cash, with £10m raised from a recent placing at 115p, the rest funded from a new term loan.

Trading Update

Strix Group Plc (AIM:KETL), the AIM quoted global leader in the design, manufacture and supply of kettle safety controls and other complementary water temperature management components…

Problems in China, and with demand, result in revised guidance (but annoyingly, not stating what previous guidance was, a common omission which wastes all our time whilst we try to find it) -

As a result of lockdown situations as described above and continued macroeconomic and geopolitical uncertainty, not only in China but across a number of its key export markets it now anticipates adjusted profit after tax for the full year to be approximately £23m. The Board recognises that these uncertainties could continue into 2023.

Looking back, the interim results (released on 21 Sept 2022) talked about reduced demand, and uncertainty, but seemed to be saying conditions in China were improving. Whereas today it seems to be saying that conditions are worsening in China.

The guidance in Sept was for £27-29m adj PBT for FY 12/2022. That’s now down to £23m after tax, but tax seems to be negligible for this company (why?!)

Broker update – there’s an excellent note out today from Zeus (on Research Tree), which lowers forecasts, but includes an additional column for the Billi acquisition, which is very helpful to see before amp; after, as this acquisition is material in terms of the group numbers which it will start to be included within from today.

Something to flag up that I noticed from Zeus’s forecasts, is that Strix has negligible corporation tax each year. Does anyone know why that could be? Brought forward losses perhaps? But when valuing any company we should put in a normalised tax charge, otherwise EPS is flattered, and you end up over-valuing the shares if you don’t adjust for it.

Zeus lowers FY 12/2022 from 13.3p to 10.9p. Normalising corporation tax would take that down to about 8p.

Balance sheet – looks weak, and has too much bank debt.

Cashflow statements - I’ve looked back at the last 2 full years, and the pattern is – operating cashflow is nearly all used up by capex. Debt rising each year. Generous divis funded through increased debt, not internal cashflow. Hence I doubt generous divis can be maintained.

My opinion - I don’t like this share. My main reasons are these -

• Profit margin looks unrealistically high.
• No corporation tax payable – why? Are the profits real?
• Too much bank debt, especially after latest acquisition.
• Cashflow nearly all used up by capex.
• Debt increasing each year, funding big dividends (hence not sustainable).

So it gets a thumbs down from me I’m afraid.

Share price: 250p (-12%)

Market cap: £150m

I’ve noticed some curious moves in this luxury handbag maker’s shares recently. You can see from the chart below that volumes have picked up recently, too:

Burberry (LON:BRBY) (in which I hold a long position) issued results on November 17th, and that is what appears to have kicked things off here at Mulberry.

In its results, Burberry outlined plans to “broadly double sales of leather goods” in the medium term, and an “ambition to grow accessories to more than 50% of Group sales in the long term”.

It also said it would “refocus on Britishness and strengthen our connection with British design, craft and culture”.

The Washington Post published a paywalled article on the same day, with the headline “Burberry taps heritage to become a British LVMH”. LVMH is a house of brands that includes fashion and leather, perfume, cosmetics, jewellery and watches.

So I guess people are now inclined to believe that it’s only a matter of time before Burberry ends up owning Mulberry.

It’s probably also worth mentioning that Burberry’s new chief designer, Daniel Lee, has been particularly successful with handbag design. So he will already know a thing or two about Mulberry.

Before we get into today’s interim results, there’s one other important piece of context worth mentioning: Mulberry is majority owned by the Singaporean retailers, the Ong family, and also has a 37% shareholder in the form of Frasers (LON:FRAS) . This means that less than 10% of the company is in the free float.

Ok, here are Mulberry’s interim results:

• Sales down 1% to £64.9m.
• UK sales (about half of total) down 10%, “impacted by the broader economic environment”.
• China retail sales +6%. International retail sales unchanged vs. last year.
• Gross margin 71% (last year: 69%), thanks to “a continued strategic focus on full-price sales”.

Gross margins of around 70% are one of the things that keep me interested at Burberry and it’s good to see Mulberry maintaining its margins, too. They raised prices globally in March and September this year.

The pre-tax loss for H1 is £3.8m (last year: profit of £10.2m). Last year’s profits were boosted by one or two exceptional items and the company says that its results for the current year reflect “additional investment in the Group”.

Outlook

The first eight weeks of H2 have seen “an improved trend in retail revenue… compared to the same period last year, however there remains ongoing uncertainty in the economic and geopolitical environment”.

They are “well prepared for the important festive trading season and the usual second half weighting to trading”.

A new store has opened at Battersea Power Station (they have about 40 retail stores in the UK, including 21 concessions).

Interestingly, they fixed their energy price in October 2021, for a three-year period. That gives plenty of time to adjust to whatever new circumstances they might face by late 2024!

Higher operating expenses

I’m looking for specific reasons as to the operating loss in the period.

“Other operating expenses” increased from £34.3m in H1 last year to £48.6m in H1 this year.

Some of the factors here include:

• Higher marketing spending, particularly to build brand awareness in Asia-Pacific.
• Higher technology spending, “to improve the group’s legacy systems”, and software costs being expensed rather than capitalised.
• They acquired stores in Australia, which needed to be financially supported, and also acquired stores in Sweden from franchisees. They launched “Mulberry Sweden”.
• A new store in China and a new store in Korea. Store relocation in New York and store refurbishment in Amsterdam.

Putting it all together, I can see why expenses might have increased so much – but it’s a very expensive bill for the six-month period. It needs to translate to improved sales in all of these various countries and regions!

Balance sheet

Net cash has reduced to £6.5m (last year: £30m). The company has an RCF, a small overdraft facility, and loans from shareholders at its Chinese and Japanese subsidiaries.

I think I also need to flag the large increase in inventories, from £32m a year ago to £48.7m this year. This is responsible for a large element of the cash outflow.

Inventories have increased “to support our strategy to focus on a direct-to-customer model, to mitigate cost increases, and to prepare for the important festive trading season.”

It might be a smart move, but there’s clearly an increased risk that the company will be left with valuable unsold stock at the end of the season that it will need to write off.

My view

For people who’ve been watching Mulberry for a while, these results don’t come as a huge surprise. (Mulberry was one of the first companies I covered in the SCVR, back in 2016!)

It has always been financially suspect: unable to earn consistent profits and with a top line performance that ebbs and flows. Covid didn’t help:

But it still has enough positive features to keep me interested:

• It rarely dilutes its shareholders. Little movement in the share count for the past decade.
• The major shareholders – the Ong family and Frasers – have relevant expertise and connections. Mulberry is a concession holder at Frasers.
• The growth opportunity in Asia (where Burberry has been so successful) remains of interest.
• When there’s a boom in luxury spending, and Mulberry gets the formula right, it has performed exceptionally well.

One final, speculative point: if Burberry acquired it, then many of Mulberry’s duplicate costs could be eliminated, and there would be wonderful economies of scale. Profitability could improve straight away.

Overall, therefore, I think there’s enough for me to rate these shares positively at the current valuation. They are now trading at a P/S multiple of less than 1x (Burberry trades at 2.8x).

Share price: 82p (+5%)

Market cap: £113m

I took an initial look at this share in October. It’s a 2021 IPO that has gone badly so far:

The company provides a range of bridging and development loans to the property sector, and allows individuals and institutions to invest with it in a variety of ways. See more on its website.

In October, it issued a profit warning due to an expected fall-off in the buy-to-let sector, as it sought to protect itself from falling property prices.

Today’s interim results, therefore, are of less interest than the outlook and the latest trading information.

For what it’s worth, the highlights from the results are:

• Platform assets under management +33% to £2.4 billion
• Funds under management +20% to £3.4 billion
• Revenue minus 8% to £42.5m
• PBT plus 45% to £14.8m

The mismatch between falling revenues and rising PBT is due to what it calls “mark-to-market gains on interest rate swap pipeline hedges on the BTL portfolio”.

In plain English, it sounds like the company is sitting on nice gains from derivatives that benefit from rising rates.

The company also benefited from a securitisation deal (selling off a portfolio of loans it made).

These might not be the most impressive ways to earn a profit – rising revenues would be better – but I guess they will have to do!

The securitisation deals are helpful because they get assets and liabilities off Lendinvest’s balance sheet, i.e. they help it to manage its own risk profile.

Current trading and outlook

There is no change to the guidance issued in October. The rise in the LINV share price today might therefore reflect some relief that the situation has at least to some extent stabilised, after the drama of September/October.

PBT is not expected to improve this year (it was £14.2m last year). Some reasons:

• In the short-term, AuM are not expected to grow as quickly as previously thought.
• Margins will temporarily be under pressure from rising interest rates, before normalising towards the end of the financial year (FY March 2023).
• The existing cost base was built on overly optimistic assumptions (although the company did talk about trimming opex in its last update). The cost base has grown faster than AuM.
• The gains on swap derivatives could easily be reversed, wiping out the gains made in H1.

It’s expected that these issues will iron themselves out in due course:

Given the transient nature of these factors and the upcoming launch of our specialist homeowner product we have confidence in our ability to return to growth in profitability in FY24.

Lendinvest also says that the “vast majority” of its borrowers are developers and professional landlords, and are able to withstand the current macro headwinds thanks to fixed rate borrowing and LTVs below 70%.

Lendinvest can reprice its mortgages “overnight”, in response to changing market conditions, and this does sound like a useful competitive advantage (vs. banks who tend to pull their products from the market when they can’t change rates quickly enough).

My view

I’m still getting to grips with an understanding of this company. In theory, I like the business model of providing an investment platform to 3rd parties while also having the company invest its own assets in deals with developers and landlords.

My major concern now is obviously interest rates and the economy.

According to today’s results, Lendinvest had net assets at the end of September of just £60m, down from £97.5m at the end of March.

This fall is directly caused by rising interest rates and how they affect the resale value of Lendinvest’s buy-to-let portfolio. The BTL portfolio fell in value by over £80m during H1. The company does say that more recent interest rate movements imply that net asset value has recovered by £7m.

And then you have to consider the leverage involved: Lendinvest has outstanding loans and advances of £1.1 billion.

Therefore, I have to take the view that this stock is too highly leveraged for comfort. I’m not sure that there would be a margin of safety even if it was priced at a steep discount to book, since the equity cushion looks very, very thin.

Which is a shame, because in theory I like the idea of investing in a property investment platform. The problem is that this company is both a platform and an investor, and it looks like a very risky investor based on these numbers.

If it securitised another very large chunk of its portfolio, to reduce its leverage, I’d be interested to look at it again.

Stockopedia