Small Cap Value Report (Weds 17 June 2020) - BOTB, DLAR, BOO, DOM, WIN

Good morning, it's Paul here with the SCVR for Weds. Please see the header above for company announcements that have caught my eye.

Estimated time of completion: 1pm
Edit at 13:04 - we're mostly done now, but I'm hoping to add a few more brief comments later.
Edit at 15:57 - I've added a bonus section on Wincanton. Today's report is now finished.

I'm scraping the barrel now, in terms of pre-prepared content, but have a couple of sections which might be of interest, as follows;

AIM Inheritance Tax relief

This is a valuable tax relief, which drives some investors into owning AIM shares. If qualifying shares are held for 2 years, then when the owner dies, there is no tax to pay. There are a number of very good fund managers who specialise in this field, that I have come across in my travels, and been impressed with, including Fundamental Asset Management, and Charles Stanley. They select the good quality companies on AIM for their client portfolios, not the speculative junk.

Recent press reports suggest that this tax relief could be a target for the Govt, as soon as this autumn, as a way of raising more tax, in a way which will not hurt the average person in the street.

The problem with this, is that if such a policy change occurs, it could reverse the fund inflows enjoyed by IHT tax planning portfolios. They have been repeat buyers of the same stocks, when funds were coming in, arguably pushing up prices quite high. Clearly what might happen if that goes into reverse, is that there could be relentless selling of the same stocks, to meet redemptions. Maybe not immediately, as the relevant fund managers could point to their strong performance, and suggest clients stick with them. Or there could be mitigation measures re tax, e.g. moving shares into a trust. Who knows? But it worries me as a potential downside catalyst for the better quality AIM shares, which could see a headwind if IHT tax relief is scrapped. Hence why I’m flagging it, as a potential risk to be aware of.

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Rent furlough scheme?

Meetings were apparently held last week, between the hospitality sector, and the Govt. A scheme has been mooted for the Govt to intervene with top-up payments towards rents, for businesses which were forced to close, such as bars & restaurants. If agreed, this could provide a badly needed boost for closed pubs/cafes/restaurants, etc. I think the Govt clearly needs to act, to prevent millions of jobs being lost imminently. The suggestion is that tenants pay one third of the rent, landlords waive one third, and the Govt picks up the other third. That makes complete sense to me, this needs to be done asap. IF it is, then expect a nice boost for the hospitality sector. Although I’m not sure if this will be agreed or not.

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Covid cases

All eyes are on China again, as it closes schools in Beijing, due to fresh covid outbreaks. A friend points out to me that the cases are small in number. But we saw what happened last time. It's now all about containing fresh outbreaks.

Medicine breakthrough

Medical experts are telling me that the trial results in Oxford, for dexamethozone Dexamethasone (a mild steroid, cheap and widely available) are a major breakthrough in treating the more severe hospitalised covid patients. This has apparently greatly reduced the death rate, in recent trials. Marvellous news, and let's hope further breakthroughs are achieved.

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Best Of The Best (LON:BOTB)

Share price: 1400p (up 12% today, at 09:06)
No. shares: 9.38m
Market cap: £131.3m

(I'm currently long)

Review of Options under Formal Sale Process

Best of the Best plc runs competitions online to win cars and other prizes.

The company has received;

...very preliminary expressions of interest which could potentially lead to an offer or offers being made for the Company.

How interesting! There's an obvious rationale for a larger gaming group to buy BOTB, and then feed its existing customer database into the company, hence scaling it up rapidly. BOTB has about 2 decades of experience in this niche, and considerable brand credibility from years of operating from UK airports - people still remember this, even though the company gradually went online-only over the past few years.

The Board of BOTB has confidence in the long term prospects for the Company but believes that it is in the best interest of all stakeholders to explore possible strategic options for the business (including a potential sale) by commencing a "formal sale process"

My opinion - I think we're in a nice position here. There's possible further upside if one or more bidders put in an offer to buy the company. Management has a controlling stake, so they won't sell it on the cheap. Their track record is such that I think we can trust them to look after small shareholders, as they have in the past.

If no acceptable bids are forthcoming, then we have very strong profit growth to look forward to, and the share price should continue rising long-term.

A cynic might say that the recent big hike in FY 04/2021 forecast earnings might have been at least partially motivated by maximising the sale value of the company? That said, the company has overshot forecasts 5 times in total in the last year, so clearly the previous forecasts were far too pessimistic, and didn't reflect the traction the company is gaining with its digital marketing. Plus other growth initiatives.

Forecast EPS is 70p for this year, so at 1400p we're only on a PER of 20 - arguably still cheap for a company that's just reported doubling its profit, and has extremely high operational gearing with more growth underway.

It's tempting to bank some profit, but I think it's worth 2000p+, hence logically I feel it makes sense for me to sit tight. Obviously that's just one person's opinion, other investors may be happy to bank profits. Your money = your call!

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De La Rue (LON:DLAR)

Share price: 151p (roughly flat on the day, at 09:30. Spiked down at the open, now recovered)
No. shares: 104.0m existing shares + 90.9m new shares = 194.9m
Market cap: £294.3m

Results and Fundraising

The links immediately above are for the 2 separate announcements.

Fundraising - this is probably more important, so I'll summarise the key points I noted down when reading the RNS;

• Raising £100m (pre costs) at 110p per share (a 28% discount)
• Underwritten, so the company will definitely get the money
• Firm placing of £50m, plus an open offer/placing of £50m - hence existing shareholders cannot complain too much about the dilution, given that they can also participate through an open offer (a good thing)
• Dilution is considerable, with an 87% increase in the share count - disappointingly high dilution in my view
• Bank facilities extended to Dec 2023 - so clearly the bank (very sensibly) linked continued support from them, to a fundraise from shareholders. We're seeing a lot of this at the moment - hence highly indebted companies are effectively being forced to raise fresh equity.
• Pension fund agreement reached to lower the deficit recovery payments to £15m p.a. for the next 3 years, then rising to £24.5m p.a. . I hadn't realised the scale of the pension scheme deficit. This has risen to an estimated actuarial deficit of £190m post-covid. That's a massive number, and clearly the equity doesn't look so cheap once you treat the pension scheme as part of net debt.
• Directors - taking up full open offer entitlement, plus £1.2m in the placing - a good sign of commitment & confidence, in my view
• Cost reductions - these are deep, and will be largely complete by Aug 2020. The group has been genuinely transformed recently, and looks a much better investment proposition than before.
• Outlook good - current year profits "largely underpinned" by contract wins & cost cutting
• Sales pipeline - some significant upside from possible large bank note contracts
  
• Order book strong, and only limited disruption from covid
  
• Turnaround plan is targeting 9% p.a. revenue growth, and strong operating margins in the mid-teens %, and growing - sounds excellent to me
  
• Sustainable divis possible, once cash outflows relating to capex & restructuring have been done
  
• Net debt - adopting a policy of limiting future net debt to 1x EBITDA. This is very sensible indeed, and I encourage other companies to adopt similar, more prudent policies. The one big lesson that companies need to learn from covid/shutdown, is that having too much debt on the balance sheet is an accident waiting to happen, sooner or later. So more emphasis is needed on prudence, and less on "efficient" (i.e. dangerously weak!) balance sheets, and putting the business at risk by chasing apparently high returns on capital - these are dangerous concepts that became too fashionable. I wonder how long it will be before all the lessons are forgotten, and everyone gears back up again?! Maybe 2 years, possibly less?!
• Dividends are banned for 18 months as part of banking agreement

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It's a long document, with lots more detail, so apologies if I've missed anything important. It's worth reading the whole thing if you're interested, as there's lots of detail about operational improvements & strategy.

My opinion - I like the turnaround underway at DLAR, which we've talked about here for some time. On balance though, I think the level of dilution today is too high, and the scale of the pension deficit has shocked me somewhat. For that reason, I've decided to watch from the sidelines for now.

That's already looking like it might be a mistake, as the share price has recouped the earlier spike down, and is now positive on the day. But never mind, nobody ever went bust banking a profit. And I can always buy back in at any point in the future, once I've had time to fully digest the figures & outlook. There's no broker research available for this company, which is very annoying. By withholding forecasts from private investors, the city is gaining an unfair advantage.

EDIT: I didn't properly emphasise the wider point about pension deficits. With interest rates now almost zero, this is very bad for traditional pension schemes. The liabilities become much larger, as they're discounted at a low interest rates. If markets sell off again, then that could also see asset values fall. A double whammy. Plus the third factor is that many companies' earnings in 2020 make it harder to find the cash to pump into pension schemes.

For these reasons, I think we should all be very careful indeed, when considering buying/holding shares in companies with large pension schemes. On that basis, I've decided to ditch my (very small) holding in Norcros (LON:NXR) . Pension schemes rarely pull a company down into insolvency, but they often limit the amount that can be paid in dividends. These are often multi-decade liabilities, as it's not only the retired worker that has to be paid, but also often a spouse too, after their death.

Therefore I see pension deficits lingering for many years to come, and I'm not convinced the market is properly discounting these liabilities. End of edit.

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Boohoo (LON:BOO)

Share price: 425p (up 9% today, at 10:15)
No. shares: 1,226.6m
Market cap: £5,213.1m

Trading Update

This is a multi-brand online fashion retailer. Today's update covers Q1 of FY 02/2021, so March-May 2020 trading.

Brand acquisitions - today it announces the purchase of 2 more brands, Warehouse & Oasis. I think that means both will now be online-only, within the BooHoo Group. BooHoo is clearly becoming the place where failed traditional fashion retailers are re-born online. What a fantastic business model BooHoo has. It picked up these new brands for only £5.25m. You can bet that, within a few years, both are likely to be booming under the new owners. They'll hit the ground running, with prior year combined online sales of £46.8m.

Q1 trading - group revenue is up a very strong 45% Y-on-Y. Growth is particularly strong in Europe +65%, and USA +83%. These are now quite big numbers, and shows the global reach (and hence major opportunity for more growth) that the group has.

Govt support packages - not used, due to strong performance of the business. My understanding is that businesses have to prove that covid has harmed their profitability in order to be eligible. So this is not altrusim, it's that they probably don't qualify for any taxpayer support.

Latest acquired brands (Karen Millen, Coast, and MissPap) are all trading well, having been integrated into the group.

Improved trading in April, and May was "robust" - although it should be, given that High Street competitors were shut!

Gross margin - strong, up 60bps to 55.6%

Minority interest in PrettyLittleThing now bought out, so it's 100% group owned, as we already know.

Net cash very comfortable, at over £350m at end May - I'm not sure if this is before or after the PLT deal completed? Do any readers know, to save me looking it up?

Outlook - very good;

For the current financial year ending 28 February 2021, the Group expects to deliver another year of strong profitable growth, and ahead of market expectations.

Revenue growth is anticipated to be approximately 25% for the current financial year, with an adjusted EBITDA margin of 9.5% to 10%...

The strength of our trading and operational performance in the period further underpins our confidence in our medium term guidance for 25% sales growth per annum and a 10% adjusted EBITDA margin, which remains unchanged.

My opinion - Warren Buffett says never bet against America. We might adapt that here in the UK to say, never bet against BooHoo! Just ask Matt Earl, with his bungled shorting attack recently.

The valuation looks expensive, but bear in mind BOO normally beats original forecasts by a lot. Hence the current year PER of over 60, is likely to turn out to have been a PER of maybe 30-40. Far from excessive, given the ongoing & almost unlimited global growth potential.

My only reservation is a short term factor, that the High Street re-opening gives BOO a lot more competition, and probably competitors are likely to be discounting very heavily in the next few months, to clear excess inventories. That possibly might trim BOO's growth rate in the short term. Longer term, how many High Street competitors are likely to survive? Not many, I reckon. It looks like All Saints, and Monsoon, could be the latest fashion retailers to jettison loss-making stores using a CVA or pre-pack administration. That gives them a shot in the arm to make them more competitive, but often just defers ultimate failure.

There's an interesting article here, giving the timeline of Monsoon's demise. I'm not a fan of its founder, Peter Simon, who struck me as very arrogant, and treated his small shareholders with complete contempt when Monsoon was listed. In a way it's quite satisfying to see the megalomaniac old guard of fashion retailing CEOs getting thrashed by online-only newer, more responsive competition. My sympathy goes to the staff when store closures happen. There's no avoiding the reality that we're heading for a period of very high unemployment amongst mainly lower paid, younger people. Excluded from the property market, and now facing mass unemployment, you can understand why anti-capitalism sentiments are finding fertile ground amongst the young.

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Some interesting snippets now;

Domino's Pizza (LON:DOM)

£1.44bn market cap, at 312p per share (down 8% today)

AGM Trading update - I toyed with the idea of buying some shares in this pizza delivery franchise business, when covid originally struck. Partly because when we were all ill, in my London home, we ordered "Domineros" (as my dyslexic friend calls them!) about every other day. Despite them being very expensive, and variable quality, they always arrive piping hot, and you don't care about the cost when you're lying in bed sick.

Today's update shows good (positive) LFL sales growth in the UK, improved a bit during lockcown. But negative in Ireland.

However, the company has incurred additional costs. I think this point is important, as I reckon this has wide read-across for many companies;

These significant and necessary changes have meant that we have incurred considerable additional costs across our operations during the lockdown period, which have more than offset the benefits from the increased sales we have achieved.

We therefore expect that EBITDA for the first half of the year will be slightly lower year on year.

Read-across - remember that DOM is a business that has traded very well in lockdown. Imagine what additional costs from social-distancing, additional cleaning, consumables such as face masks, etc, will have on companies that are suffering deep drops in sales? This reinforces my view that H1 results season could deliver some really shockingly bad results. Hence why I'm looking to sell more of my non-core positions in the coming weeks.

Remember also that many companies have withdrawn profit guidance. With few broker forecasts out there, we're flying blind at the moment. When the H1 figures roll in, then be sure to be ready for some very nasty shocks. The large caps, tech-heavy indices might fare better. But I think small caps are looking quite vulnerable, after the big recent rebound.

A lot of UK small cap punters seem to be so short-termist, that I'm sceptical that they'll disregard dire H1 2020 results. It only takes a few sells to smash prices down 20-30%. Hence why it might be best to lighten the risk now, rather than face a plunge in the autumn. I could be wrong of course, anything could happen, but this is a real worry for me at the moment.

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Wincanton (LON:WIN)

Share price: 190p (up 3% today, at 15:03)
No. shares: 124.5m
Market cap: £236.6m

Preliminary Results

Wincanton plc ('Wincanton' or the 'Group'), the largest British third party logistics company, today announces its preliminary results for the year ended 31 March 2020.

Here are my notes from reading through most of this results statement;

Revenues up 5.2% to £1,201m

Impressive client list, renewing contracts, so this is clearly a decent business

Underlying PBT up 7.3% to £52.9m - a lowish 4.4% profit margin, as you would expect from a logistics business. If they charge too much, then clients just take the work in-house, to save money

Underlying EPS 35.8p, up 6.9% - a PER of only 5.3

Net debt £10.1m - seems low, but there's loads of non-interest-bearing debt - look at the big deficit on working capital

Current trading - revenues down 10% YTD. But May was 7% up on April, so business is recovering. Profits down

Final dividend suspended

Uncertainty over full year performance

Pension contributions - £6m deferral negotiated to help cashflow

Pension scheme is a huge issue - note from cashflow statement that it's sucking out £17.8m p.a. in deficit recovery payments. Hence the low PER!

Utterly ludicrous accounting standards for pensions, show this big pension deficit as an asset on the balance sheet! Total madness - the accounting for pension funds urgently needs to be changed, to reflect reality, which this clearly does not

Balance sheet is not strong, as management keep saying. It's weak. NAV is only £14.7m, and if we strip out the daft pension scheme asset of £96.5m, and goodwill/intangibles of £85.6m, and the NTAV is negative at £(167.4m) - and that's valuing the pension fund at nil, when it's actually a large liability. The business benefits from negative working capital, and seems to be able to operate normally with this extremely weak balance sheet. Although we're seeing lots of circumstances where banks are requiring an equity raise, in return for continued support, relaxation of covenants, etc. Therefore I would say WIN might need to strengthen its balance sheet at some stage - probably another reason why the PER is so low, as EPS could be diluted in future from issuing more shares maybe? It's a risk anyway, hence why I'm flagging it.

Cashflow statement - good. It's a genuinely cash generative business.

Big lease liabilities, but these are warehouses, not retail space, so I don't see this as a risk. Warehouses are cheap in the UK, said to be below rebuild cost, hence leases are probably not a problem here.

Going Concern note is an essential read. The auditor drew attention to a "material uncertainty in respect of going concern". This is giving us useful guidance on trading in the current year, saying;

The base case assumes that Group revenue will reduce by c£40m and profit before tax by c£10m compared to normal levels in the 3 months until the end of June 2020 due to the impacts of COVID-19 before gradually recovering throughout the rest of the financial year to 31 March 2021....

It then also sets out a "severe but plausible" scenario, driven by a 2nd wave of covid. This would result in a breach of a banking covenant at 31 Mar 2021. The company says it would negotiate with the bank to flex the covenants, but points out;

In the context of this severe but plausible downside scenario, the absence as at the date of signing these accounts of amended loan documentation confirming the flexing of the leverage ratio covenant at 31 March 2021 gives rise to a material uncertainty, as defined in auditing and accounting standards, related to events or conditions that may cast significant doubt on the Group's ability to continue as a going concern and in such circumstances, it may therefore be unable to realise its assets and discharge its liabilities in the normal course of business.

This stuff is driven by the auditors, who I think have done a terrific job here, forcing the company to point out risk to investors. It also validates my view that the balance sheet is stretched.

My opinion - it looks a good business, but unfortunately the balance sheet is too sparse to make it investable for me. The problem with weak balance sheets, is that there's more pressure on companies from their banks, to repair them. Hence a dilutive fundraising here looks likely. That would increase the PER, as earnings would be spread over more shares. Hence it's not as cheap as it looks. Plus the cash outflows into the pension fund are hideous. Combine those factors, and it's difficult to see the company having much scope to pay meaningful dividends for the time being. Which makes it an unattractive investment in my view.

Overall then, I think there are probably better, lower risk opportunities elsewhere.

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That's me all done. See you tomorrow!

Best wishes, Paul.