Small Cap Value Report (Weds 2 Nov 2022) - NXT, CER, FOXT, AML, MGNS, MTRO

Good morning! It’s Paul amp; Graham here as usual.

Small caps discussion - Paul Hill of Vox Markets ( a highly accomplished investor, and small caps specialist/analyst) likes to touch base with me every few months, and we had a really interesting discussion yesterday on video, covering lots of topics amp; small cap shares. It’s also available on podcast format. Paul amp; I get on very well, so it’s a nice relaxed conversation, which I hope you find interesting.

Agenda

Paul’s Section:

Next (LON:NXT) – I quickly review the main points from a reassuring Q3 update today. As usual, the sector leader seems to be performing fine, despite all the macro headwinds. Remarkable stuff, and on a PER of only 9.0, this does look an attractive share. I always try to report on NXT, as a benchmark for how a well-run retailer is performing. Now wait for all the excuses from competitors to explain why they’re under-performing! 

Cerillion (LON:CER) [no section below] - I’m interviewing the CEO/Founder, Louis Hall today at 13:00, so the audio should go up around 14:00, I’ll put a link in here when it’s ready. The main thrust of my interview will really just be one key question, namely – “Why is the business performing so well, and is that likely to continue?”. There’s a superb results webinar here from ShareSoc, so I won’t be replicating this content. Hence I recommend anyone interested in CER to watch that presentation first, for background. This is such an impressive company, but the share price reflects that, with a hefty valuation. [no section below]

Morgan Sindall (LON:MGNS) – my first look at this sprawling construction/infrastructure group. It’s not really my cup of tea, doing low margin, major projects. However, the performance and outlook seem resilient (in line with exps for FY 12/2022), and a huge order book. Also I really like that it reports average daily cash, thus demonstrating clearly that its cash pile is not window-dressed for the balance sheet date, but a true reflection of reality throughout the year. Worth considering, with a PER = divi yield, at around 6.8.

Graham’s Section:

Foxtons (LON:FOXT) (£93m) (pre-market) [no section below] – I noticed some brilliant comments in recent days on the merits of buybacks versus other uses of cash. Without wanting to go over old ground, it caught my eye this morning that London-focused estate agent Foxtons has launched a new £3m share buyback programme, which is the second such buyback it has announced in 2022. This follows a positive Q3 update last week (covered by Paul). With trading ahead of expectations, the sales pipeline up 15% year-on-year, £6m in total buybacks this year, and a PE ratio of only around 11x, it would be easy to get carried away with bullishness here. However, I do think it’s worth noting that the new CEO’s bonus plan, announced in September, included a £2.5m LTIP arrangement. This award only pays out if the Foxtons share price rises above 70p, but if it did pay out, it would effectively nullify a big chunk of this year’s buybacks. Sometimes, even with large buybacks, you find that a company’s share count is not reducing all that much! [no section below]

Aston Martin Lagonda Global Holdings (LON:AML) (£654m) – another profit warning in a very long stream of bad financial news from this luxury car brand. It says it all that it now falls within our small-cap market cap remit. Covid was certainly unhelpful but Aston Martin’s shareholders had already suffered a huge fall in value prior to that event. Looking forward, the company’s recent large equity raise of £650m has enabled it to buy back some debt, but it still has a large chunk of secured, USD-denominated loan notes coming due in 2025. Who knows where interest rates will be then, and what the terms of any refinancing might be. I would continue to vigorously avoid these shares.

Metro Bank (LON:MTRO) (£141m) – the original challenger bank (that is twelve years old now!) reports that it had a profitable month in September. That might not sound terribly impressive, but it’s big news for a company that has had red ink spilled all over its recent financial statements. Rising interest rates at a macro level and tighter cost discipline at a micro level have combined to bring about this happy result. It may need rates to keep rising in order to build on this momentum. If that happens, I think shareholders with the courage to remain invested could do very well here.

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.

Q3 to 29 October 2022 – full price sales “slightly ahead of our expectations” at +0.4% vs LY.

Maintaining full year profit guidance (FY 1/2023) at £840m (up 2.1% vs LY)

EPS guidance: 554.5p (up 4.5% vs LY) – PER of 9.0 at 4963p/share.

Russia/Ukraine took 1.1% off sales.

Sales within Q3 – Aug soft (very hot), Sept v good, Oct slightly soft (my interpretation of a weekly sales chart)

My opinion - how do they do it?! Next seems to sail through economic difficulties with aplomb. It does make me ask, why buy small caps, when you can buy the sector leader on a PER of 9? OK, there’s limited upside as giants like this cannot gallop, but it just seems bulletproof in terms of performance.

Note that guidance for next year is being steadily reduced (very sensible in the circumstances), which quietly avoids having to issue a profit warning in future – I wish all companies would do this, it’s a sign of strong management who are in control, I think -

The stock market seems to have priced-in a downturn that, so far anyway, has not happened.

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1556p (down 1.4% at 08:34)

Market cap £735m

Trading Update

Morgan Sindall Group plc is a leading UK Construction amp; Regeneration group with annual revenue of £3.2bn, employing around 7,200 employees and operating in the public, regulated and private sectors. It reports through five divisions of Construction amp; Infrastructure, Fit Out, Property Services, Partnership Housing and Urban Regeneration.

I’ve not looked at this share before, because it’s been too big, and in a sector that is low margin, and prone to failures. A lot of previous mid-caps are starting to appear on my small cap radar at the moment, so there could be some opportunities maybe? Especially in property-related companies, many of which have sold off so much, that they could be interesting.

Morgan Sindall is a sprawling construction, infrastructure, and other property services group, its group website is here. I quickly realised that it’s too big amp; complex for me to get into the detail here, but I do want to mention a couple of interesting points which arose from my quick review of today’s trading update.

Macro uncertainty amp; inflation have created a “more challenging economic backdrop” – no surprise there.

Despite this, trading is “robust”, and on track to deliver FY 12/2022 in line with (company) expectations (so we have to assume also in line with broker forecasts).

It provides a brief comment on each of the 5 divisions.

Order book – impressive, at £8.8bn, up slightly. That seems to give decent visibility.

Balance sheet we’re told is strong. I’ve checked, and it’s OK, I wouldn’t say particularly strong given the size of the group. NTAV is £266m. However, the working capital cycle looks favourable, with net cash of £274m at 6/2022. There’s a fantastic additional disclosure here – average daily net cash – I would like this to become adopted by all companies as the gold standard of reporting. After all, period end snapshots of cash can be so easily manipulated, something I’ve mentioned in these reports so many times.

This is what MGNS says today about cash amp; liquidity, which is superb disclosure, and gives great confidence to me in the financial strength of the group (and hence lowers risk for investors, compared with competitors which might be jammed up at their overdraft limit!) -

The Group’s balance sheet remains strong and in an uncertain trading environment, the holding of a significant cash balance is more of a competitive advantage than ever. 

The average daily net cash for the period from 1 January to 28 October was £260m (of which £62m was held in jointly controlled operations or held for future payment to designated suppliers).

As previously guided at the time of the half year results, the average daily net cash for the full year is expected to be around £250m.

In addition, the Group has significant undrawn bank facilities available to it. These total £180m, of which £165m mature in 2025 and £15m in 2024.

Outlook – sounds solid -

“In recent months, increased general market uncertainty together with continued inflationary headwinds have provided for a more challenging economic backdrop.

Despite this, trading across the Group has been robust and with our high-quality secured workload giving good forward visibility, we’re on track to deliver a full year performance in line with our expectations.”

Broker forecasts - what is particularly noteworthy from a quick review of the StockReport, is that estimates have been rising this year – very unusual in a worsening economy, which suggests to me that MGNS has considerable resilience, at least so far, and well-structured contracts (e.g. they don’t seem to be suffering from increased costs, so must have factored in cost increases into their contracts – this sector is really all about how good management are at selecting viable projects, and drawing up watertight contracts, plus of course then executing well. But just one badly worded contract, with unforeseen consequences, can torpedo companies in this sector, which is why I normally avoid it altogether) -

Valuation - is looking attractive, with the forward PER (confirmed today with an in line update) being the same as the dividend yield. There’s a good track record paying divis too.

Some attractive metrics here -

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My opinion - neutral, as I don’t invest in this low margin, complicated sector. However, I can see plenty of positives for this share.

I see the MGNS has been careful about share issuance, showing the benefit of a decent cash position – it got through covid without having to do an equity raise. The share count is currently 47m, which has not changed since 2017.

If you do invest in this sector, the MGNS looks a sensible choice to me, whilst obviously taking into account that there might be headwinds from possibly project cancellations, and other economic headwinds?

As you can see from the long-term chart below, the share price crashed in the 2008 economic meltdown, and then took 10 years to recover. Although it was paying divis all the way through that period, so it looks as if the company is seasoned at surviving and coping OK with recessions. So it’s an income share really, and looks quite interesting to me.

Good StockRank too, as you can see below.

On balance, I think it’s something I’ll keep on my watch list, and consider buying if there was a share price meltdown on a profit warning, or a big general market sell-off -

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Share price: 93.6p (-11%)

Market cap: £654m

This was one of the most disastrous IPOs of the pre-Covid bull market, at least as far as the LSE is concerned. Today brings a fresh profit warning.

It hit the market in late 2018 at £19 per share, and now trades at only around £1.

And by the way, that’s after a 20:1 share consolidation: twenty old shares (originally priced at £19 each) were converted for one of the new shares (now trading at less than £1 each)!

After numerous fundraisings and changes in management, hopefully it is a different proposition to what it was at IPO.

Let’s get up to speed with the latest news from today’s Q3 update: results for the nine months to 30 September 2022:

• Revenue +16% to £857m
• Adjusted operating loss £128m (last year: loss £65m)
• Pre-tax loss £511m (last year: loss £189m)
• Net debt £833m

Ok, these numbers are worse than I expected! It appears that even after five years of terrible financial results, the company is no better than it was before.

The company points to adjusted EBITDA up 10% year-on-year, but this is a nonsense number for a business with large and very real depreciation and amortisation costs.

Here are the explanations for the really bad numbers:

Operating loss of £148m included a £71m year-on-year increase in depreciation and amortisation, driven by accelerated amortisation of capitalised development costs ahead of next generation GT/sports vehicles starting in 2023

Loss before tax of £511m was materially impacted by a £245m negative non-cash FX revaluation of US dollar-denominated debt as the GBP significantly weakened against the US dollar during the period

The depreciation of equipment and the amortisation of development spending are absolutely real costs: while accountants might argue over the exact pace at which they should be recognised, there is no doubt in my mind that the operating loss is a far more realistic reflection of what is happening here than EBITDA.

The £245m FX hit mentioned above, arising from currency movements, is of course beyond AML’s direct control. But the company did choose to borrow in US dollars and its lenders will eventually want to be repaid in the same US dollars, which have now risen in value.

Executive Chairman comment:

“On one hand, we have continued to see very impressive demand across our product range and the underlying fundamentals of Aston Martin are very strong…

“On the other hand, and in the context of supply chain and logistics disruption as well as inflationary pressures impacting the broader automotive industry, over the last two quarters we have encountered specific supply chain challenges that have delayed our ability to meet customer demand… Although these headwinds, which are already improving in Q4, have disrupted our near-term financial performance and modestly impacted our full year guidance, the medium and long-term outlook is robust.

Outlook: the outlook statement explains the company’s goals for vehicle sales, revenues and adjusted EBITDA, to be achieved by 2025. Unfortunately, there is no mention of positive operating profit.

Near-term, the supply chain problems will cost about £20m to resolve, and the working capital situation is going to take a few months longer to normalise (meaning that cash will remain tied up).

Net debt looked like this at the end of Q3: £1.6 billion of gross debt, including lease liabilities of £100m, offset by cash of £772m.

In recent weeks, the company has used some of its cash balance to buy back some of its debt:

The cash interest cost this year is about £130m.

My view

I’m dismayed to see so little progress here, since the last time I looked at it.

It remains hugely unprofitable – by a wide margin – and consensus earnings forecasts suggest that breakeven won’t be reached until 2024 (and I would suggest that this is an optimistic scenario).

The level of gearing remains a huge concern, despite the company raising £650m in fresh equity during Q3. Chairman Lawrence Stroll says that this equity raise is “the last foundation we need to realise our vision and start to unlock long-term shareholder value creation”.

He might be right. But think of the economic risks involved here: the company’s results have been rocked by FX and supply chain issues, and it is now going to have to face a much higher interest rate environment and perhaps a serious international recession. Its loan notes are due in 2025. Why will things get any easier? And how will the company survive, if the situation gets much worse?

Share price: 81.7p (+12%)

Market cap: £141m

Here’s a good news story: Metro’s performance in September is ahead of previous guidance.

Rising interest rates are, overall, supposed to be good news for banks – as they improve the spread between a bank’s borrowing and lending rates.

That is the case here, as Metro’s net interest margin (NIM) has been boosted:

Active balance sheet management and prevailing interest rates supported exit NIM of 2.04% 

Expect NIM to improve through 2023 given evolving balance sheet composition, base rate increases and deposit pricing discipline

NIM was 1.56% at the end of 2021, and then 1.73% at the end of H1 2022. So we have another nice increase just three months later, to 2.04%.

This “NIM expansion”, along with cost discipline, are cited as the reasons for Metro recording a profit in the month of September. Metro has been posting consistent losses in recent years, so this is significant news.

There’s not much change in deposits or loans: deposits are flat with the company focused on selling the cheapest, instant access accounts.

Loans are up 4% with an emphasis on residential mortgages and consumer unsecured lending. Importantly and perhaps this will come as a surprise, “there has been no deterioration in early warning indicators and no signs of stress or increased delinquency across the customer base”.

My view

I haven’t studied Metro’s interim results in detail but a superficial review shows tangible balance sheet equity of £742m, many multiples of the current market capitalisation.

While every company lives or dies according to its profitability, I think that Metro bank would experience a particularly impressive valuation uplift if its profitability improved, as investors started to look more positively on its enormous balance sheet.

There is no denying that it is highly leveraged and has struggled to generate cash. Fitch recognises this with a below-investment grade credit rating of only B.

However, as a risky play on rising interest rates and continued NIM expansion, these shares could have some merit.

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