Small Cap Value Report (Fri 16 Oct 2020) - LGRS, JUP, MIND, ARC, NCYT

Morning all, it’s Jack here with Friday’s placeholder so drop by and leave a comment if anything catches your eye. Paul’s back next week.

The week started off with further lockdown announcements and it feels like yesterday money was leaving the market ahead of what could be a bumpy winter. There are ongoing whispers of circuit breaks and all the rest of it - how that all plays out is not in our hands so I don’t get too involved. I just focus on the controllables, ie. my own portfolio, but I do think we have to be braced for some tough days on the market.

Early indications suggest a positive start today though, with the FTSE 100 up 45 points or so.

Yesterday’s markdown was understandably felt most keenly in stocks directly affected by potential additional lockdowns. I retain my view that there will be some good mid to long term contrarian opportunities there, but for now most of the share price action will be news driven and volatile.

It’s not my usual patch, but there are also some strikingly ‘cheap’ blue chips out there. Royal Dutch Shell (LON:RDSB) below 1,000p, Rolls-Royce below 200p, Lloyds below 30p… It seems yesterday most of the damage was felt in the FTSE 100.

I’m not tempted personally. I own one large cap, Games Workshop (LON:GAW) and the only other one I’m considering is Computacenter (LON:CCC) .

Anyway, following on from yesterday’s coverage of a couple of Leisure stocks, Loungers has released an update. This is a well-regarded roll out so let’s see what it has to say on current conditions and outlook...

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Loungers (LON:LGRS)

Share price: 140p (pre-market open)

Shares in issue: 102,400,000

Market cap: £143.4m

Loungers (LON:LGRS) operates 168 all-day cafe/bar/restaurants across England and Wales. It’s done a great job of attracting trade throughout the day - a big issue for other operators that often have to capitalise on a few key trading hours.

This is a very brief update for the 24 weeks to 4 October. It looks like the bar group continues to outperform the market, with all 168 sites open and like-for-like sales up an impressive 25.1% over the 13 weeks from 4 July to 13 October. This probably includes a boost from Eat Out to Help Out.

Three sites were opened in that period: Ponto Lounge in Hull, Cosy Club in Brindleyplace in Birmingham, and Sentado Lounge opened in Sittingbourne. However LGRS says this pace won’t be maintained.

Group CEO, Nick Collins, comments:

We anticipate further interruptions to trade in the coming weeks and months, but take confidence from our continued market out-performance. We remain well-positioned to accelerate our growth and to continue to lead the market once Covid-19 is behind us.

Conclusion

The above bold is the key takeaway, really.

People in the trade often talk of LGRS as one of the most successful roll outs in the Leisure sector in recent years. For all that, then, I wonder why the group generates such large losses.

Free cash flow generation is more encouraging so it looks like there have been non-cash charges obscuring underlying progress.

The financial health measures leave a little to be desired, with low liquidity, F-Score, and Z-Score. Meanwhile I see about £45m of debt on the balance sheet (excluding capital lease obligations) and around £17m of exceptional charges hitting profitability in FY20.

The concept is good but from an investment point of view there are a few early flags here given the stormy conditions and outlook. I wonder why management pressed on with new openings - perhaps it would be better to strengthen the balance sheet. Easy to say in hindsight.

The like-for-like performance is very strong. In a normal market, LGRS is an exciting prospect that is well placed to open sites, pay down debt, and increase profit. But we’re not in that market.

If it does survive this pandemic and emerges on the other side, this is one of the stronger Leisure concepts out there. Right now though I think there’s better risk:reward elsewhere. The StockRanks are poor.

Jupiter Fund Management (LON:JUP)

Share price: 231.6p (-3%)

Shares in issue: 457,700,000

Market cap: £1.06bn

There’s a fair amount of consolidation going on in fund management given declining margins and the rise of passive investing.

Jupiter Fund Management (LON:JUP) is a case in point, with its recent integration of Merian Global Investors which increases Jupiter’s assets under management (AUM) by some £16.6bn and takes the group’s total AUM to £55.7bn as at 30 September.

For all that though JUP reports net outflows in the quarter of £1bn, partially offset by £0.8bn of market returns. Digging a little deeper into the outflows, Jupiter branded products actually reported £0.1bn of net inflows, which was offset by £1bn of net outflows in Merian branded products.

Among the net mutual fund outflows within the Merian products, £0.2bn was from the Global Equity Absolute Return fund, £0.4bn from the Systematic strategy and £0.1bn from funds where there was a change of fund manager relating to the acquisition.

Net mutual fund inflows within the Jupiter branded products were £0.3bn during the quarter, of which £0.9bn were from the Fixed Income strategy.

Conclusion

There’s not much commentary here, but given the scale of AUM and historic levels of earnings per share, it’s not hard to argue JUP could be good value on a longer term view.

If you take the average EPS over the past six years as an indicator of normalised earnings that’s 29.2p which would put its shares on a PE ratio of 8.2x. This assumption implies a market recovery - but it could provide some indication of value to a buy and hold investor.

On the other hand, broker EPS forecasts have in fact been edging down over the past 12 months.

When the purchase of Merian was announced in February, the combined firm was set to have more than £65bn in AUM, but the market slide sparked by COVID-19 and outflows at Merian have pushed that lower.

Active managers face a constant battle to convince investors to come to them rather than cheaper passive funds, so that’s a sector-wide headwind. Margins are likely to fall gradually over time and there is evidence of a downtrend on the StockReport.

This probably explains the acquisition activity in this space. As for Jupiter itself, the balance sheet looks strong with a net cash position and the group has built up an encouraging track record of ordinary and special dividends for income seekers.

The most recent dividend payment was 26 August, an interim payment of 7.9p the same as last year. Assuming the total dividend is held steady, that’s a 7.2% yield. The company scores well quantitatively, with a StockRank of 94, with a reassuringly high Quality Rank of 93.

Looking at the share price chart, perhaps we can expect a return to previous levels in time. It looks potentially like a geared play on a recovering market - I’m just not sure when that recovery is going to happen, or whether another fall comes first.

Mind Gym (LON:MIND)

Share price: 73p (-22%)

Shares in issue: 99,783,612

Market cap: £72.8m

The market really doesn’t like Mind Gym (LON:MIND) ‘s update today, with shares down 22%. This is a ‘global provider of human capital and business improvement solutions’ - it trains workers and increases productivity.

The group has a very high Quality Rank at 97, and it has racked up some encouraging double-digit revenue and EPS compound growth rates over the years so I’m curious to see what’s happened with this one.

That said, I’m not altogether sure what it is Mind Gym does. The investor relations website says it ‘uses the latest psychology and behavioural science to transform how people think, feel and behave’. Its coaches deliver 500 bite-size training courses a week, each designed by a team of psychologists using the latest behavioural science.

Ordinarily I would be skeptical of such an enterprise but MIND has proven itself as a profitable, growing small cap over the past few years.

Half year trading update

MIND shares more than halved between February and April and never recovered (and that’s before today’s 20%+ fall) so clearly it was hit hard by COVID.

It’s a pretty poorly looking price chart.

The group says most of the new work it usually receives was suspended between February and July. As a result of the disruption, H1 revenue is expected to be down 40% to £14.5m. In light of this reduced revenue, MIND has cut costs mainly in the form of temporary wage reductions.

As a consequence, MIND anticipates an adjusted loss before tax of between £1.0m and £1.5m excluding exceptional restructuring costs of £0.7m.

There are some positives though.

MIND has £14.5m of cash on the balance sheet as at 30 September 2020 (H1 2019: £10.7m) and no bank debt.

October is forecast to deliver a marked increase in revenue, continuing a month-on-month improvement in performance through August and September. In addition, MIND's pipeline has expanded substantially.

Octavius Black, Chief Executive Officer of Mind Gym, commented:

The Group has taken the opportunity to increase its focus on the medium to long term digital strategy and investment which will ensure Mind Gym grows its share of the corporate development and behaviourial change market. Growth is returning, showing up in both booked revenues and the opportunity pipeline and we are confident that revenue performance and profitability in H2 FY21 will be significantly better than H1.

There are also some board changes, with non-exec Baroness Dido Harding stepping down and Trevor Phillips joining.

Conclusion

The drop this morning might be overdone, particularly given the net cash position and apparent quality of the company.

A 40% fall in revenue is steep but the company is guiding towards a much improved H2 and has a strong net cash balance that allows it to continue investing in growth opportunities.

However, given the ongoing uncertainty and the sensitivity of the business to further lock-down restrictions the jury’s still out. The business is financially sound but at some point MIND will need to reinvest in working capital and growth projects. So cash could come down if there is another lockdown or similar disruption.

The group has grown encouragingly over the years and the size of the global training market suggests it could continue to gain share. But it also looks to be a very sensitive market and it’s likely that customer budgets will come under pressure in the short term.

Given that, this is not a company I’m looking at too closely right now. If it is a bargain, I'd like to see directors picking up some stock and that doesn't seem to be the case right now (see director dealings page here).

Arcontech (LON:ARC)

Share price: 205.3p (+4.2%)

Shares in issue: 13,290,510

Market cap: £27.3m

(I hold)

Agreement to upgrade longstanding Tier 1 Client

I first looked at Arcontech (LON:ARC) here and came away impressed by the group’s cash generation and potential for margin expansion. It’s not without risk though - a tiny, volatile, illiquid micro cap.

In fact as soon as I bought, shares fell nearly 30% over the ensuing weeks on no newsflow - the price could always drift back down again.

It’s far too small for institutions to be getting involved right now, so most of the volume I imagine is from private investors.

You can see on a one-year view that it is prone to down periods.

ARC provides financial market participants with software and solutions that help them integrate different financial data sets.

The overriding risk at ARC continues to be a long and complex sales cycle for convincing clients to integrate its solutions into their own systems.

Growing cash and profits have allowed ARC to invest in its sales capabilities though and we now have two RNS statements about client wins within weeks of each other.

The first (here) is what most recently drove the share price up in early October. And then we have the second announcement released today (linked above).

Today’s announcement sees ARC sign a new agreement with a longstanding Tier 1 bank client that will see it upgrade to Arcontech's new graphical user interface and monitoring functionality. This win plus the previously announced Factset deal will add recurring revenue of approximately £100,000 per annum.

One of the key points to the bull case is that new wins could continue to drive margin expansion.

Conclusion

That £100k takes ARC some way towards meeting its FY21 revenue forecast of £3.1m.

There’s some more detail in the CEO’s comments but what will be important to investors is ARC’s ongoing ability to win business and drive revenue and margins. We can see that ARC has managed to grow earnings well ahead of the top line, so winning more contracts is key.

In the meantime, stock remains illiquid and the sales cycle remains complex so it could be a bumpy ride - this is a risky micro cap - but the recent RNS statements do help build a picture of positive trading momentum.

Novacyt (LON:NCYT)

Share price: 934.3p (+11.2%)

Shares in issue: 70,626,248

Market cap: £659.9m

(I hold)

Just yesterday we covered Novacyt Sa (LON:NCYT) and concluded: The bull case puts forward a second act at Novacyt: one of continued positive trading and contract wins, the release of broker notes, and institutional buying.

As if on cue we have a broker note from Numis doing the rounds. When I first properly looked at NCYT back in July its share price was 267p. The late September update - a jaw-dropping contract win - took its shares to 565p.

Just a fortnight later shares are at 934.3p and Numis comes to the company afresh setting a near-term price target of 1,365p with a long-term goal of north of £30, running with the strapline: new diagnostics leader emerges.

The pace of development here is simply unlike anything I’ve encountered before. To summarise some of the main points from the front page of the note, which is floating around Twitter (see here):

• COVID-19 is driving ‘exponential demand’ for diagnostics,
• PCR testing is the gold standard and NCYT has first-mover advantage, as seen in its transformational H1 trading figures,
• The outlook into H2 and beyond is even stronger, with NCYT guiding to 2020 revenue of over €150m and EBITDA over €100m prior to a major new contract to supply its C-19 near-patient testing (NPT) system into the NHS that will drive further revenue of £150m+, and
• The rise in strategic importance of diagnostics is set to continue.

Looking at some of the near-term broker assumptions, we have:

• Base case 2020 forecast revenue of over €300m (and remember the 80%+ margins),
• 2021 revenue exceeding 2020, at €380m (base) to over €600m (bull)

So applying H1 EBITDA margins of 62% would make for €236m-€370m of FY21 EBITDA versus today’s market cap of about €735m, which still looks cheap.

Add to that the opportunity to build a long-term diagnostics winner with its strategy of expanding its existing respiratory, bacterial and viral diagnostics franchises via R&D, acquisitions, and organic growth and the picture does look exciting.

We saw the first signs of this with the strategically important acquisition of IT-IS yesterday. This purchase reduces execution risk and gives Novacyt end-to-end control of its NPT system, which could drive upgrades through its rollout into various decentralised settings (think hospitals and care homes). There will likely be more acquisitions to come.

If NCYT can execute and make smart, value-enhancing acquisitions (which a lot of management teams struggle to do), then Numis sees long-term value of as much as £34 a share. Things are progressing at breakneck speed here, so let’s see what the winter months bring.