Small Cap Value Report (Wed 11 Oct 2023) - FORT, CLX, WJG, BRCK

Good morning from Paul amp; Graham, here we go again! Busy again for news, and lots of backlog things too, so we’re already hard at work!

Graham’s Youtube show is live again at 11:30 today (recorded, so can be watched later if you’re interested – I think they’re very good, and an easier way to absorb the SCVRs if you have the free time), covering: Watkin Jones, Calnex, and Eneraqua. I’ll be taking a break and tuning in myself, with possibly some gentle heckling in the chat box  

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 (usually) between £10m and £1bn. We usually 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. Sometimes risky shares can produce high returns, if they survive/recover. So again, we’re not saying the share price will necessarily under-perform, we’re just flagging the high risk.

Forterra (LON:FORT) - down 6% to 135p (£288m) – Q3 TU – Paul – AMBER

It’s a profit warning, but the market seems sanguine about this, with only a relatively modest drop of 6% – possibly because industry statistics could have already been known by many investors. Also the share price has already fallen below pandemic lows, anticipating weaker trading. I go through the detail below, and can see this might be a good recovery trade in the medium term, but there are also some doubts.

Calnex Solutions (LON:CLX) - down 30% yesterday to 66p (£58m) – Trading Update (profit warning) – Graham – AMBER -  BLACK [PW] on summary spreadsheet

This was an awful profit warning with revenues now anticipated to be 20%-30% lower than expected for the full financial year. Large customers are responsible for a large chunk of Calnex revenues and they have been slow to place new orders. I’m keeping an open mind.

Watkin Jones (LON:WJG) – down 5% to 33p (£85m) – FY23 Trading Update (profit warning) – Graham – GREEN

This developer has had a very difficult year. It posted a huge profit warning in July and today brings another, albeit of a milder variety. A loss seems likely for FY23, then modest profits in FY24. But the cheapness has intrigued me, with NAV much higher than the market cap.

Brickability (LON:BRCK) – flat at 46.5p (£140m) – Trading Update amp; Acquisition – Paul – AMBER/GREEN

An in line with exps update for H1, but a FY 3/2024 downgrade is slipped out via Cavendish. The 10% impact on FY forecasts is partially offset by a significant sized acquisition also announced today. With a PER below 5x on updated numbers, I cannot ignore the value here, whilst acknowledging the macro headwinds. I like its capital-light distribution model, which seems better than the capital-intensive manufacturers.

Down 6% to 135p (£288m) – Q3 TU – Paul – AMBER

Forterra plc (the ‘Group’), a leading UK manufacturer of essential clay and concrete building products, provides this third quarter trading update for the nine-month period ending 30 September 2023 (the ‘period’).

It’s bad news, not entirely unexpected though, as there’s publicly available data about construction activity I believe, hence to some extent the market should have anticipated this news -

The signs of market improvement seen in May and June did not continue into the second half with market demand deteriorating in July and August.

Figures published by the Department of Business and Trade show UK brick despatches in July and August 2023 averaged 16% lower than in June 2023, and 28% lower than in the corresponding period in 2022. Within this, August was weaker than July and our own despatches suggest a further softening in September. These figures also highlight that UK brick industry despatches are currently running below the levels seen in 2009.

Pricing has “remained resilient”

The above has impacted profit -

…expect full year EBITDA to be below previous expectations.

Cutting production, consulting on mothballing a factory in Claughton.

Inventories building, as fall in demand faster than reduced production.

New brick factory in Desford is coming on line, seems rather ill-timed, but I’m assuming it will be more efficient, being new.

Outlook - it’s assuming 2024 will be similar to 2023 (no signs of green shoots yet then).

There are some positives though -

As we set out at the half year, we expect FY24 results to benefit from a more stable energy cost environment, a stabilisation of customer inventory, the substitution of imported bricks as well as the full year benefit of previously announced cost reductions, offset by reduced operating efficiency driven by a reduction in production.

Growing political focus on increasing housing supply ahead of a general election reinforces the Board’s confidence in the long-term industry fundamentals and the Board remains confident that the Group remains well placed to benefit when market demand recovers.

Broker update – there’s plenty of detail in the above, but no financial specifics.

So the next step is to see if any broker updates crunch the numbers for us? Yes, we have a company-sponsored update from Progressive.

Key points (it’s a Dec 2023 year-end) -

Forecast revenue reduced by 9% to £367m (FY22 actual was £456m)

Adj PBT forecast reduced by 26% to £27.9m (FY22 actual: £70.6m!)

This concerns me a bit – year end net debt now forecast at £82.2m (prev. f/c: £59.9m) – *check the last balance sheet* – see below.

Forecast EPS now 9.8p (FY22 actual: 26.0p) – vs StockReport consensus of 13.6p

What we’re clearly seeing above is a sharp downturn in revenues, and a geared impact on profit, with EPS down 62% comparing 2023 with 2022. Obviously that’s driven by macro factors, primarily soaring interest rates making a house purchase less, or unaffordable for many potential buyers. Corresponding retrenchment in house production by some of the big builders is clearly a knock-on effect. All of this is well-known, and explains why share prices of both builders, and building supplies companies, have been falling so much.

Then at some point share prices begin to factor in a recovery, usually months before an actual recovery is evident. We know the drill! It’s just the timing that is difficult to predict, with rallies so far often turning out to be false dawns.

Timing doesn’t matter so much if you’re patient and unflappable as an investor, and if companies have strong balance sheets (thus eradicating dilution or solvency risk).

Or, if you’re a risk-taker, then homing in on the more geared companies with bombed out share prices can (sometimes) deliver the biggest % gains, but at the risk of a wipe-out.

Your money, so your choice, in terms of what level of risk you’re prepared to take. FORT looks low-medium risk to me, depending on how macro develops.

In smaller caps, the lack of liquidity often means price moves are exaggerated too – which is what provides us with opportunities, but also causes us stress!

Valuation – I’m quite impressed that the share price has (so far anyway) only dropped c.6% to 135p (at 08:51), although on low volumes, so anything could happen in future. The most I can say is that at least there hasn’t been an early panic sell-off.

On the revised 2023 forecast of 9.8p, that’s a PER of 13.8x

Bear in mind this is a sharp downturn year, so paying 13.8x a bad year’s forecast earnings, seems to me pretty reasonable. The big question is, what extent of earnings recovery are we anticipating in future, and over what timescale? Also could pricing come under pressure in future, if a glut develops (sounds like that’s already happening, based on the inventories rising, and having too many factories). So we cannot just assume that everything returns to normal soon, especially as FORT says it sees 2024 being similar to 2023.

On balance then, I suspect earnings could remain under pressure, and reduce further, but that’s little more than guesswork.

Dividends – are likely to be cut sharply, from 14.7p in 2022, to 5.5p in 2023. A further deterioration in trading could see divis cut more, or completely, but they should rise again once performance recovers.

Balance sheet – always crucial for me, especially in a downturn.

NTAV was very strong at June 2023, at c.£193m, but that’s dominated by £245m tangible fixed assets – obviously making bricks requires a lot of land and equipment.

Working capital was £151m current assets (incl. £17m cash), and £126m current liabilities incl. negligible interest-bearing debt. Bad debt risk from big customers should be close to zero, given the balance sheet strength of the big housebuilders, assuming they buy direct (they might buy through Brickability (LON:BRCK) too possibly?)

The bank debt is all in long-term liabilities, of £67m, and I reckon this element will have risen to nearer £100m by year-end. Therefore it’s important to inspect the last Annual Report to check what the bank facility terms are, in particular the net debt: EBITDA covenant.

Forecast EBITDA for FY 12/23 (after today’s PW) is still high, at £53.9m (per Progressive note), which stacks up OK against the forecast Dec 2023 net debt of £82.2m, a multiple of 1.52x, which should be alright I think. That’s assuming the bank covenant definition of EBITDA is the same as the Progressive forecasts. So no alarm bells ringing here over debt, in my opinion.

Paul’s opinion – the muted initial reaction to this profit warning is quite encouraging I think.

Is it too early to be fishing for the bottom in the share price, given that FORT says it’s not expecting any recovery in 2024? Possibly. Prices could fall, worsening profits, if there’s a glut of bricks. Or, political measures to step up housebuilding might trigger a recovery. Also, interest rates are a big unknown too – a rapid fall could trigger a very strong asset price bounce, and rebound in housebuilding. We just don’t know!

Meanwhile I think FORT is securely financed, with a nice balance sheet, although net debt creeping up a little high.

It’s going on my watchlist, but I’m not ready to push the buy button yet. So for now, I’ll go with AMBER, but I can see attractions here as a recovery trade over the medium term.

Flat at 46.5p (£140m) – Trading Update amp; Acquisition – Paul – AMBER/GREEN

Brickability Group plc (AIM: BRCK), the leading construction materials distributor, issues the following trading update for the six-month period to 30 September 2023 and is also pleased to announce the acquisition of Group Topek Holdings Limited, a specialist cladding installation and remediation contractor (the “Acquisition”).

Continuing the bricks theme, this is a distributor of bricks, often on a drop-shipping model (where it acts as an intermediary, but doesn’t handle the physical goods). Lots of acquisitions mean it has also diversified into other building products.

I have a favourable impression of this company, and particularly liked the last webinar they did, when management struck me positively as tenacious, and answered all my questions very well. That’s just subjective of course, so could easily turn out to be wrong. Outsiders never know what’s really going on inside any company, although we like to think we do!

Acquisition of Topek - a substantial deal, £27m cash up-front, plus up to £17.7m in deferred consideration over 3 years, subject to performance, and encouragingly with BRCK having the option to pay in shares, at the then prevailing share price. I like that structure.

Topek is a specialist cladding installation amp; remediation business, and is said to complement BRCK’s other 3 cladding-related businesses.

It’s said to be earnings accretive, and is being funded from cash amp; an enlarged £100m debt facility. This helps reduce bricks from 80% at IPO, of revenue to 60%Sounds intriguing.

Trading Update – strikingly better than FORT, with H1 trading being in line with expectations.

However, it sounds more cautious, without quantifying it for H2 -

Whilst the Group has traded in line with Board expectations through H1 FY24, and the Acquisition will be immediately earnings accretive in the current year, forecast reductions in newbuild volumes are expected to have a corresponding impact upon the performance of the Group’s existing businesses throughout the second half of the current financial year.

Is that a veiled profit warning? Yes it is!

Let’s see what the brokers say.

Broker update – Cavendish comes to our rescue, many thanks, with a clear update which trims forecast underlying EBITDA in FY 3/2024 by 10%, and 20% in FY 3/2025. This is then partially offset by additional profit from the new acquisition.

New adj EPS is 9.4p for FY 3/2024 (StockReport consensus is 9.75p), and 9.5p for FY 3/2025.

These make the share price of 46.5p look very good value – a PER of only 4.9x.

Paul’s opinion – I can’t ignore the super-low PER, in a really tough sector, and really bad macro. Imagine what that PER could drop to, once recovery starts.

I’ve previously been green on BRCK, but went amber on 5/9/2023, after a wobbly-sounding update and the potential for a profit warning.

Today we basically do get a beautifully finessed, mild profit warning for H2. But that’s fine I think, as macro conditions are pretty horrible, and the share price has already tanked.

It’s been suggested that BRCK’s distribution (as opposed to manufacturing) of bricks is arguably a better, and less operationally geared business model. I think comparing FORT with BRCK today, that seems to stack up. Yet BRCK is much cheaper on a PER basis, despite seemingly being more robust, and less cyclical.

BRCK would be my sector pick, I like it at this bargain price, and I could be tempted to dip my toe back in with a starter position, at some stage, who knows?

Share price: 66p (-30% yesterday)

Market cap: £58m

Calnex Solutions plc (AIM: CLX), a leading provider of test and measurement solutions for the global telecommunications and cloud computing markets, provides an update on trading and outlook for the full year to 31 March 2024 (“FY24″) and beyond.

This share dropped like a stone on yesterday’s trading update. It already had a very serious profit warning last March:

Here are the key points:

• “Order inflow has remained at the subdued levels experienced at the start of the year, with the precise timing of future customer orders remaining uncertain”. The outlook for the sector “has not developed momentum”.

• Revenues for H2 should be higher than H1, but revenues for the year as a whole should be “20-30 per cent below market expectations”.

You probably don’t need me to tell you that this is a huge miss versus expectations.

Cavendish have suggested revenues for FY March 2024 of £17m; the previous consensus forecast was £24m.

Cash position is £13.5m, “following investment in inventory”. Scrolling back to the most recent full-year results (for FY March 2023), I see that the cash figure then was £19.1m.

That’s a £5.6m cash outflow in six months, apparently due to inventories increasing. But the total inventory balance six months ago was only £2.7m.

Does this mean that the inventory balance has doubled or even trebled in this short space of time? During a period when revenues fell?

This says to me that the company was truly blindsided by the reduction in orders. If they had predicted lower orders and lower revenues, then surely they wouldn’t want their inventories to increase like this?

CEO comment gets in the obligatory mention of AI!

Whilst the telecommunications market outlook is currently challenging, the expansion of our product portfolio to areas outside of telecommunications and our strong sales pipeline mean we are confident in a return to growth in FY25.

Looking to the longer-term, the underlying market drivers continue to build, such as the need to upgrade telecoms infrastructure to deliver the promise of 5G, and to enhance data centre operations to support the demand for cloud computing and advancements in AI and Virtual Reality technologies. As a result, our confidence in the long-term prospects for Calnex remains high.

Graham’s view

I feel hamstrung here by my lack of understanding of Calnex’s products. So instead of giving my conclusions, here are some questions which I would like to ask:

• To what extent is this company’s success due to technology that it owns, especially patents and owned software? The website GoodIP lists 11 patents globally for Calnex Solutions Ltd, which doesn’t strike me as a lot. A big company such as Google LLC has nearly 18,000. Strix Ltd ( Strix (LON:KETL) ) has over 1,000.

• If the company is not relying primarily on patented technology, then what is its unique selling point to customers? E.g. is it the design expertise of Calnex employees?

• How can the company manage its customer concentration risk better? I see that its top 10 customers were responsible for nearly half of its revenues over the past three years. It doesn’t take many of them to slow down their orders to produce a nasty profit warning such as that we have just witnessed.

Checking the StockReport, I see that Calnex passes some bullish stock screens that I usually quite like: the T Rowe Price Growth Screen, the Philip Fisher Growth Screen, and the Neglected Firms Value Screen.

The Quality Metrics have recently been excellent:

Also, as Roland has previously noted, the CEO Tommy Cook owns 20% of this one, so that’s a positive.

As you can probably tell, I haven’t formed a strong opinion on this one. So I’ll have to stay neutral for now. I’m open to the possibility that it’s a quality company that is simply going through a tough time with its concentrated customer base.

Share price: 33p (-5%)

Market cap: £85m

This homebuilder and developer provides a full-year trading update for FY September 2023.

The year just finished:

The company “was successful in achieving its operational objectives”, however there have been “certain additional costs, including acceleration costs to ensure successful completion on two schemes”.

The company now expects revenue of over £400m and underlying PBIT of “approximately breakeven”.

PBIT seems to be the same thing as adjusted EBIT, i.e. adjusted earnings before interest and taxes.

The RNS doesn’t give me all the information I need, but the latest note from Progressive Research helps a lot: they have reduced their pre-tax profit forecast by £3.5m, from breakeven to a £3.5m loss.

They also cut their revenue forecast by 7% to £419m. So it’s looking like a miss on revenues (on forecasts which had already been downgraded).

The current year:

There is no change to guidance for the current financial year, FY 2024.

The existing guidance (as set out in July) is that the company will generate PBIT of £15m to £20m in the current financial year.

The company already has secured revenue of £330m, but still has some work to do to get to the £400m total. I see that the StockReport shows an older £500m revenue estimate – estimates have fallen very significantly from that level.

Net cash is better than expected at £43m (prior estimate £20m).

Graham’s view

Paul has commented on this one much more frequently than I have (see the archives). The last time I looked at it was back in October 2022, at 100p per share, when I took a neutral stance, noting that the shares were trading at a high premium to NAV and worrying that the company’s strong earnings record might not be sustainable in a period of higher interest rates.

The most recent interim results showed net assets of £165m, or £153m excluding intangibles.

So whereas this stock previously traded at a big premium to NAV, it’s now at a significant discount.

Earnings have evaporated and the company is now likely to post a loss. So on a P/E basis, this is going to look expensive. Whereas when earnings were strong, it looked cheap!

But as we’ve previously observed, cyclical companies often look cheap when they are expensive, and then they look expensive when they are cheap.

Watkin Jones now satisfies the Ben Graham Deep Value checklist:

These shares are down by 67% year-to-date, and down by 83% over five years.

The net cash balance now covers half of the market cap.

So I’m going to turn positive on these shares. One for the bottom drawer, perhaps?

Stockopedia