Small Cap Value Report (Thu 2 April 2020) - G4M, BAKK, SAA

Good morning, it's Paul here with the SCVR for Thursday.

Estimated timings - as you might have gathered, I'm still struggling with fatigue, so can only do roughly 2 hour stints of writing, in between resting. It's currently 13:24, so I'll do another 2 hour stint, should be finished by 15:30. Today's report is now finished - sorry for unreliable timings this week.

Press reports say that a staggering 1 million people in the UK have applied for Universal Credit. I think that's likely to be the tip of the iceberg, as the policy of economic shutdown starts to bite. We're therefore heading for a severe recession. Investors have to decide whether we think this is likely to a V-shaped recession - i.e. short & sharp with a rapid recovery, or something more serious & extended. At this stage, I haven't made up my mind what is more likely. That is one of several factors which makes it so difficult to assess individual shares at the moment. I'm still leaning towards caution, and am generally holding back from buying most things on my watch list, until we have some more clarity.

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Gear4Music (LON:G4M)

Share price: 170p (pre market open)
No. shares: 20.9m
Market cap: £35.5m

(at the time of writing, I hold a long position in this share)

Gear4music (Holdings) plc ("Gear4music" or "the Group"), the largest UK based online retailer of musical instruments and music equipment, announces the following trading update for the financial year ended 31 March 2020, following the announcements made on 23 January 2020 and 18 March 2020.

This company is a rare beacon of light in current grim circumstances;

As a result of the commercial and operational progress we have made during the last 12 months, we now expect profits for the financial year ended 31 March 2020 to be ahead of previous expectations.

It is pleasing to see that the company has adapted, in order to continue trading normally by the sounds of it;

Following the necessary Government restrictions put in place to tackle the spread of COVID-19, we are pleased to say we have been able to quickly reconfigure our operations to ensure that we are keeping our teams safe. This has been due to the huge effort our incredible staff have made during this very challenging time.

The health and safety of our employees and customers has been our absolute priority, and we have implemented fundamental changes across our business to ensure a safe environment in line with current Government guidance. Our call centre and administrative teams are successfully working from home, and we have implemented a wide range of social distancing measures and safety protocols designed to protect employees working in our distribution centres in the UK and Europe.

That's really good to hear. I was shocked that Next (LON:NXT) shut down its online operations, and that badly dented my previous hope that online businesses could ride out the COVID-19 crisis. Another great disappointment was that Sosandar (LON:SOS) issued a profit warning, saying that online business had gone downhill. I was probably naive in thinking that fashion sales would shift online. After all, why would people on lockdown at home buy new frocks? People usually buy new clothing for specific social events, not for sitting around at home accumulating biscuit crumbs and coffee stains (or is that just me? - I always seem to end up wearing part of every meal, splattered down my shirt).

I suppose musical equipment might be more appealing to people on lockdown, as a leisure activity. I'm sure parents trapped at home with young children would love the idea of entertaining their kids with lots of squeaking recorders, and drums! Some might, anyway. This is alluded to in the CEO comments today;

"Whilst it is impossible to predict what further operational actions may become necessary during the coming weeks and months, we remain committed to operating safely and serving our valued customers for as long as Government guidance allows. In addition to the economic benefits of uninterrupted trading, we are driven by the knowledge that learning a new instrument or improving musical skills can bring enormous mental wellbeing benefits to people of all ages, particularly in challenging times like these."

My opinion - it's vague on details, but sounds like G4M is navigating its way through the crisis, unscathed so far.

After chasing growth at any price in previous years, the company revised its strategy to concentrate more on earning higher (but still low!) gross margins. That seems to be working, although current forecasts show it only marginally profitable for FY 03/2020.

I dipped my toe back in with a small purchase earlier this year, and this update today reassures me. The main risk is that the company might be forced to halt its operations in future. At this stage though, that doesn't sound likely. Clearly by continuing to work, G4M's staff are made of sterner stuff than those at Next, who decided they didn't want to continue working.

I should mention that professional musicians are having a terrible time at the moment. Family members tell me that literally everything in their diaries (gigs, teaching projects, etc) has been cancelled. Although, as with many other sectors, they are adapting, e.g. teaching remotely via Skype, and even doing morale-boosting socials online. I think we're already seeing remarkable changes in working patterns. Bosses of some major businesses have been interviewed on CNBC, saying how they are managing to operate their businesses almost normally, with most of their staff working from home. Which makes me wonder whether long cloud computing, short commercial property, might be an interesting theme?

Today's positive update might be good to boost the share price back up to c.200p, at a guess (writing this before the market opens)

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Bakkavor (LON:BAKK)

Share price: 91p (down 8% at 08:10)
No. shares: 579.4m
Market cap: £527.3m

Trading update

I've been meaning to look at this convenience, ready meal food company for a while. I've probably eaten lots of its product without knowing it! BAKK floated in Nov 2017. I vaguely recall there was something funny about the float - maybe it was deferred or pulled at some point, before going ahead later? Something like that anyway.

Its update today strikes me as rather disappointing. Supermarkets are trading strongly at the moment, partly due to some initial panic buying by selfish idiots. But also for the simple reason that with restaurants & cafes mostly shut, we have no alternative than to buy more food from supermarkets. To my mind, that should have put the wind in the sails for suppliers like BAKK, but apparently not.

Its biggest market is the UK;

In the UK, which represents around 90% of Group Adjusted EBITDA, the impact of COVID-19 has resulted in a reduction in orders across all of our categories, most notably in our salads and food-to-go products

USA and China are also down.

Guidance -

Guidance and mitigating actions

Given that market conditions are likely to remain highly uncertain for the foreseeable future, Bakkavor is withdrawing its guidance for 2020, issued on 27 February 2020, and committing to a number of important actions to preserve liquidity:

· A tight control on costs will be maintained, and all non-essential capital investment and discretionary expenditure has been placed on hold.

· We are reviewing capacity across our facilities to better match the current levels of demand and, wherever possible, we will be supporting any impacted colleagues by making use of the Job Retention Scheme (Furlough) introduced by the Government in the UK.

· In addition to the pro-active steps we are taking around cash and investment, the Board has decided to suspend the proposed final dividend. We will review our dividend policy in due course.

· Members of the Board and Management Board have also agreed voluntary reductions in remuneration for the coming three months: the Chairman and Non-executive Directors' have agreed to a 50% reduction in base salaries and fees, while the Group's founders (CEO, Agust Gudmundsson and Non-executive Director, Lydur Gudmundsson) have volunteered not to take a salary in the period. The wider Management Board have also agreed to a voluntary 20% reduction in base salaries.

Bravo for the voluntary pay cuts. We're seeing that increasingly at various companies, and I think it's an absolutely excellent idea. Sharing the pain, and leading from the front, is what leadership should be all about. Banks are particularly receptive to Directors taking pay cuts too, in my experience.

My burning question with BAKK remains, why is it struggling at the moment, when demand should be buoyant? Maybe it supplies cafes & restaurants as well as supermarkets, I probably should have checked that. Do any readers know?

Debt - this looks to be the big issue. These strike me as worryingly high figures;

Together with a number of bilateral facilities, the Group currently has facilities in place of £562m. As at December 2019, the Group had operational net debt of £355m and leverage of 2.3 times against a covenant of 3.0 times.

With a downturn in business underway, that covenant could come under pressure in future, perhaps?

Balance sheet - looking back to the last reported balance sheet, it's got way too much debt on it, in my view. Deducting large intangible assets, results in NTAV of negative -£80.4m. I rarely invest in any business with negative NTAV.

This brings me on to the issue that many companies have used cheap debt to over-gear their balance sheets in recent years. It's a good way for management to boost EPS and hence trigger lucrative share options, etc. Yet this has left many companies extremely vulnerable now that we've had a totally unexpected crisis emerge.

The coronavirus crisis has also demonstrated that many business models, across lots of sectors, were all wrong. Risk had been badly under-estimated. I'm thinking here of travel, retail & hospitality sectors in particular. It's always been a given that business would flow continuously. Even something like a volcano erupting only delayed flights for a few weeks. But now we have a new world, where large parts of the economy need to be shut down, in order to contain a virus outbreak. This changes everything, in many sectors. What companies will need to do in future, is operate with much stronger balance sheets - more financial reserves, and restructure their costs to ensure that fixed costs are not fixed any more - e.g. maybe new forms of property leases are needed, which allow for rents being waived if closure is forced? Maybe travel companies should be forced to put aside customer deposits into segregated, untouchable accounts? Maybe we need tighter rules on payment of divis?

There's also the question that many companies have turned out to have some form of taxpayer support. Shouldn't companies be charged for that? (a bit like the bank levy?). Why should shareholders receive lucrative dividends in the good times, but then demand taxpayer bail outs when something goes wrong? I feel that companies receiving taxpayer support should have to give up some equity to the taxpayer, with the option to buy it back at a later date.

My opinion - for these reasons and others, I'm not touching any companies with highly indebted balance sheets right now. Banks may (and hopefully will) remain supportive for now, but they're likely to want to reduce risk in future - making a wave of equity fundraisings likely, once the dust has settled. Dividends are being widely scrapped too, so shareholders face a double whammy of lost income, and possibility of dilution from equity fundraisings to repair balance sheets.

Overall then, I don't see any attraction to BAKK shares.

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M&c Saatchi (LON:SAA)

Share price: 31.3p (down 0.5% today, at 13:25)
No. shares: 96.2m
Market cap: £30.1m

Covid-19 update

This is the famous advertising & marketing group. Obviously in a recession, this type of company gets whacked, because customers often rein in non-essential spending. Hence the sick-looking share price. Could it be a recovery share, and will it survive, are the 2 questions that I'm interested in. It might be worth looking back to 2008-9, to see what happened then. From the data I can find, it seems to have remained decently profitable throughout the 2008-9 financial crisis/recession, which is quite surprising.

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Covid-19 impact - this is what it says today -

Trading in the first two months of 2020 was in line with the Board's expectations. We began to feel the impact of COVD-19 in March, with a reduction in activity in several of our markets following government restrictions on movement and the consequent reduction in economic activity.

No surprises there. This next bit sounds encouraging, although no figures are given;

The Board has been undertaking strenuous stress-testing of the financial models under different scenarios (and will continue to do so) and remains confident about the liquidity status of the Group for the foreseeable future.

The good thing about people businesses, is that the cost base is flexible. If they have to, they can let people go, and close or sub-let offices.

Other points;

• Remote working policy for staff, so can continue operating
• Sharp drop in demand, but some areas still have steady demand (e.g. talent & influencer businesses)
• Performance in March substantially weaker, and not possible to predict scale or duration of downturn - hence no guidance currently
• Preparing for further worsening, taking actions to protect liquidity
• Cost-cutting, and tight focus on improving cashflow - all sounds sensible
• Seeking Govt support where available
• Reducing salaries for higher paid staff, including 20% reduction for Directors & senior staff - good
• Divis suspended, as is becoming the norm

Cash & debt - it's clearly dependent on bank facilities, but it sounds as if the covenants should be OK;

The Group had approximately £45m of cash worldwide as at 23^rd March 2020. This includes a fully drawn revolving credit facility (RCF) with NatWest of £36m, leaving a net cash position of £9m. Although the Group is in a net cash position, the RCF and cash is typically required for working capital purposes. The £36m RCF and £5m overdraft facility (which is undrawn), was recently extended through to 31 July 2021, and has a 2.5x Gross Borrowings / Adjusted EBITDA covenant and a 5x Adjusted PBIT / borrowing costs (interest cover) covenant. Despite the increased pressure on cash, the company forecasts it has sufficient liquidity and expects to be able to continue to operate within these covenant levels for the foreseeable future.

That last sentence which I've bolded, is key, and does reassure.

Like many other companies, SAA has fully drawn down its available RCF facility, which looks sensible. Better to have the cash on hand, than to worry about whether the bank might not allow them to draw down on the facility at a later date. If I were the CFO, I'd make sure the cash balance was moved to a different bank, if allowed.

Balance sheet - not great, and there are lots of strange items on it. So I'm not entirely comfortable with this, and would need to look more closely at this, if I were inclined to buy some shares.

My opinion - it's lost over 90% of share price value, yet doesn't appear to be in any imminent danger of going bust, thanks to bank facilities being utilised.

For that reason, I would certainly put this on my watch list as something speculative, which could rebound strongly once the economy starts to recover. Potentially interesting at this lowly valuation.

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All done for today.

Best wishes, Paul.