Small Cap Value Report (Weds 6 Sept 2023) - DOTD, RTN, HFD

Good morning from Paul amp; Graham!

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 £1bn. 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.

What does our colour-coding mean? Will it guarantee instant, easy riches? Sadly not! Share prices move up or down for many reasons, and can often detach from the company fundamentals. So we’re not making any predictions about what share prices will do.

Green (thumbs up) – means in our opinion, a company is well-financed (so low risk of dilution/insolvency), is trading well, and has a reasonably good outlook, with the shares reasonably priced.

Amber – means we don’t have a strong view either way, and can see some positives, and some negatives. Often companies like this are good, but expensive.

Red (thumbs down) – means we see significant, or serious problems, so anyone looking at the share needs to be aware of the high risk.

dotDigital (LON:DOTD) – up 2% to 86.6p (£259m) – Acquisition – Graham – GREEN

Dotdigital makes a £25m acquisition (mostly paid in cash) for a business with which it already works in partnership. The logic behind the combination makes perfect sense in my view and so even if Dotdigital is paying a full price for it, I think it’s good news for the stock.

Restaurant (LON:RTN) - up 1% to 44.2p (£337m) – Interim Results – Paul – AMBER/RED

Trading has improved, with quite good revenue growth in the circumstances. However, the profit margin is wafer thin. The dreadful balance sheet, with onerous leases, and far too much debt, completely puts me off. Why get involved in a highly indebted restaurant/pubs group that’s struggling to eke out anything in profit (and it largely comes from questionable adjustments)? Poor risk:reward in my view.

Halfords (LON:HFD) - up 2% to 190.6p (£417m) – Trading Update (in line) – Graham – AMBER

Things are going to plan at Halfords as Services/B2B revenues grow strongly, offsetting weaker performance in retailing (especially cycling, not helped by poor weather this year). It’s an interesting stock but with low margins and perhaps fairly valued at this level.

Up 1% to 44.2p (£337m) – Interim Results – Paul – AMBER/RED

The Restaurant Group plc (“TRG” or “The Group”) Interim results for the 26 weeks ended 2 July 2023 (“H1″)

Increase in management expectations for FY23 EBITDA and excellent progress in executing medium-term plan

That’s a strong-sounding headline from this chain of 380 restaurants/pubs (Wagamama, and others).

I see the word “moderate” didn’t make it through from the section below, to the headline above!

Outlook -

· FY23 costs in line with previous expectations and medium-term cost outlook continues to improve

· The trading performance supports a moderate increase in management’s FY23 Adjusted EBITDA1 expectations

o FY23 Net debt1 expected to be between £180m and £190m

I’ve searched the announcement using CTRL+F for the word “expectations”, as I was hoping there would be a footnote telling us what profit expectations are, but there’s nothing. Also no up-to-date broker notes are available, so this is all rather unsatisfactory and vague.

Key H1 figures -

• Revenue £467m (up 10%)
• Statutory profit (PBT) is only £2.3m! (£28.5m loss last time)
• Adjusted PBT is also small, at £7.2m pre- IFRS16, or £17.5m post-IFRS16.
• Exceptional costs of £15.2m, some of which is rationalising the store estate, which I would say is a normal cost of doing business, not really exceptional, groups like this will always be pruning out loss-making sites.

Balance sheet - as in the past, this is a the deal-breaker for me, it’s a desperately weak balance sheet with onerous leases, and too much debt.

Working capital is very thin, with payables looking too high to me – indicating it might be stretching its creditors to keep interest-bearing debt under control?

Lease entries indicate that there must be some loss-making individual sites, and quite a lot of them too, I reckon. RoA assets of £240m is an estimate of the value of trading from the leasehold sites. The related lease liabilities are much larger at £391m. So it definitely has some problem sites, which are costing it heavily.

NAV is £380m, which includes a massive £597m of goodwill. Take that off, and NTAV simplistically is negative £(217)m.

Debt is too high, with £214m in long-term borrowings. With debt costing more now, and lenders more cautious about wanting to lend to troubled sectors, I’m very wary of this balance sheet. Therefore I see dilution risk as high.

Paul’s opinion - I’m not going to go through all the rest of the detail, as checking the balance sheet has ruled it out as a potential investment for me.

The upbeat-sounding commentary seems out of step with the numbers, which show it barely above breakeven.

LFL sales growth looks pretty good, so revenues are growing more than enough to cover cost increases I think. But it’s still a pretty marginal business, like everything in this sector – a combination of rampant food price inflation, higher wages and energy, means it’s incredibly difficult to make any money at all from restaurants. That might change in future, if we’re being optimistic. There’s way too much capacity in the industry, although RTN might benefit from smaller competitors falling by the wayside perhaps? Wagamama seems a popular brand – which has always surprised me, as I can buy a packet of noodles for 60p, and stick a bit of chicken amp; spring onions in it myself, at a fraction of the cost charged by Wagamama. I’ll have to mystery shop it again to see if anything has changed. Last time it reminded me of my old university refectory.

So as investors, why would we want to get involved? I think it could take years for restaurants to rebuild margins, and in this case RTN needs to seriously repair its balance sheet as a priority. So the prospect of shareholder returns looks weak – no divis for now, and I think the dividend paying capacity is close to nil unless trading dramatically improves.

For me, risk:reward doesn’t work here at all, so I’m steering clear. Hence a moderate thumbs down, AMBER/RED.

Note that the share count has increased 2.7x compared with pre-covid, so this share is not likely to regain anywhere near to its previous highs.

Massive shareholder value destruction in the last 10 years -

Share price: 86.6p (+2%)

Market cap: £259m

These shares have retreated a very long way from the heights they reached during the Covid rally:

Let’s see if we can untangle some word salad:

Dotdigital Group plc (AIM: DOTD), the leading SaaS provider of an all-in-one customer experience and data platform (CXDP), is pleased to announce the acquisition of Fresh Relevance Limited (“Fresh Relevance”), a vendor of cross-channel personalisation technology (“the Acquisition”).

In simpler English, Dotdigital provides a marketing platform.

The company it’s buying, Fresh Relevance, helps companies to target individual customers with personalised product recommendations, personalised emails, etc.

The acquisition “accelerates Dotdigital’s CXDP roadmap, bringing highly complementary cross-channel personalisation and website technology together with technical expertise”.

The two companies are said to have “a strong existing relationship and a proven track record of joint success”. They already have joint customers and their respective products already enjoy a level of integration with each other.

The goal is that with them being fully integrated, customers will enjoy a more seamless experience and the improved joint offering will “open up substantial new, higher value customer acquisition opportunities”.

The Fresh Relevance brand will be maintained.

Price – it’s a £25m deal, £19m in cash and £6m in DOTD shares. Dotdigital will still have a cash balance of £38m after the deal, “giving the flexibility to look at further strategic acquisition opportunities”.

Valuation – not particularly cheap. Dotdigital is paying a price to sales multiple of 4x (expected revenues are £6m) and it sounds as if there will be no contribution to profits in the current financial year (FY June 2024)

CEO comment:

“The acquisition of Fresh Relevance and its expertise in the realm of web significantly enhances our personalisation capabilities and provides opportunity for average revenue per user expansion. Its addition marks a leap forward in our CXDP growth journey, bringing together customer insights, cross-channel engagement, and on-site personalisation capabilities to provide marketers with the tools to exert greater influence across the customer journey.

Graham’s view

Despite the full-looking price paid, I’m going to give this deal two thumbs up.

There are times when I have to do a lot of work to figure out the point of an acquisition. This is not one of those times: the companies already serve the same companies with products that are so complementary to each other that they have already been partly integrated.

In a situation like this, it’s harder to find a reason not to combine the two enterprises. They can now work together more efficiently for their existing customers and improve their service to target new ones.

On the financial side of things, Dotdigital can afford it and still has a significant cash balance.

As for the merits of DOTD shares, I see that Paul covered them in March (at 93p) and in November (at 85p) and was positive on each occasion.

Dotdigital itself trades on a P/S multiple of about 4x but it is profitable:

Although the SCVR doesn’t have a “House View”, I think I’ll maintain the positive view on these shares as the valuation doesn’t seem too excessive when you consider that it has net cash, a fine track record of profitability, and good quality metrics. So it’s worth studying in greater detail.

Today’s acquisition will boost revenues by around 10% and should eventually help to boost profitability, too. That might take a few years but then patience is a virtue!

Share price: 190.6p (+2%)

Market cap: £417m

Halfords Group plc (“Halfords” or the “Group”), the UK’s leading provider of Motoring and Cycling services and products, today announces its trading update for the 20 weeks to 18 August 2023 (the “Period”).

Here are the highlights from this trading update, which reports that trading is in line with expectations despite unfavourable weather:

• Like-for-like revenue +7.8% (i.e. keeping up with inflation).

• Services/B2B is now 48% of total revenues, up 6 percentage points.

• “Market share gains across all categories and in line with expectations.”

Cycling-related revenues reduced slightly, and this is attributed to bad weather and low consumer confidence.

CEO comment:

“It’s been a good start to the year for Halfords, and our ongoing focus on essential maintenance and servicing is driving a strong performance in our Autocentre and Retail Motoring business. Group Motoring, which now accounts for over 75% of our total sales, is a resilient sector and we’re progressing with our long-term plans to become a one-stop-shop for motoring ownership.

Here is a handy table showing how the Autocentres are growing faster than Retailing, even if you strip out acquisitions and focus only on the like-for-like column:

Strategy: on track for £30m of cost savings. Large commercial fleet servicing contract with Yodel. Motoring Loyalty Club has 2.5 million members.

Outlook: there’s a wide range of possibilities with full-year PBT for FY March 2024 expected between £48 – 58m. Total revenues are in the region of £1.7 billion so profit is the difference between two large numbers!

The cost savings are expected to improve profits in H2, while H1 will be held back by the accounting of some FX hedging contracts.

Graham’s view

On the face of it this stock is cheap:

They’ve done a lot to move away from their traditional cycling and retailing image, with a move into essential services. The intention is to be “a more resilient business with higher customer retention, lower risk profile and stronger and more sustainable returns on capital”.

It would therefore be incorrect to write this off as a low-quality retailer: with the help of acquisitions and strategic focus, it’s a different animal now.

But is it “quality”? It has a well-known brand but it’s operating in a very competitive sector. And despite its strategic changes it’s still a fundamentally low-margin business, although it’s hopefully less risky than it was before.

Paul did a great analysis of this one in June and I would echo what he said about the company’s balance sheet – not super strong (equity of £563m but that comes with a huge pile of intangibles, and large leases). Therefore I would also think that the dividend here could potentially be vulnerable in future.

I have little choice but to take a neutral stance. It’s an interesting stock but I wouldn’t be in a rush to buy it despite its superficial cheapness.

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