Small Cap Value Report (Tue 1 Dec 2020) - BILB, MERC, SOS

Good morning, it's Paul & Jack here with the SCVR for Tuesday.

Jack has kindly agreed to take the lead in the morning, to give me a rest. Then I (Paul) will be passed the baton probably around mid-morning, to do the afternoon shift.

Today's report is now finished.

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Jack’s section

Bilby (LON:BILB)

Share price: 26.45p (+10.2%)

Shares in issue: 58,721,845

Market cap: £15.5m

Bilby (LON:BILB) provides gas heating and building services in London and the South East. It does a lot of work for housing associations and local authorities - areas driven by government standards and legislation that tend to lead to long-term customer relationships.

Since its IPO in 2015, Bilby has acquired P&R Installation, Purdy Contracts, Spokemead Maintenance and DCB.

For all that though, it’s clearly been a rough ride for shareholders so far if you compare the 2015 IPO share price of 58p to today’s share price of 24p. Shares were closer to 150p at one point before falling dramatically in 2018/19.

It’s a volatile performance and the stock is rightly classified as Highly Speculative, but you can see there has been buying at these levels from value hunters:

This buying activity has come from private investors, but directors have also been buying in 2020.

Much of the share price drop appears to be a result of getting into ‘severely loss-making’ contracts. Checking out the Financial Summary, we can see that the group made a pretty chunky £8.6m loss in FY19:

It looks like lumpy, volatile earnings from that EPS Growth line. Couple that with persistently low operating margins (on average just 1.7% over the past six years), then the group’s cheap valuation appears to be justified.

But the StockRanks look promising, jumping by 40 or so points in August and currently suggesting improving Momentum and good Value:

So a mixed trading record in a lumpy, low margin, contract-driven market but with potentially good upside if management can execute on the turnaround strategy established in 2019.

Half year results for the six months to 30 September

This period obviously includes the first lockdown and so year-on-year comparability is reduced.

Financial highlights include:

• Revenue -21% to £23m,
• Gross profit -23% to £6m,
• Underlying operating profit -27% to £1.4m,
• Loss after tax of £0.16m,
• Basic EPS of -0.26p, and adjusted EPS of 1.92p

These are quite adjusted results and the company does not report its statutory operating profit or PBT/PAT in the highlights.

The group does say that work appears to have been deferred rather than canceled, and its ‘three year visible revenues’ increased from £172.1m to £182.4m. Net debt has come down and cash generation looks to be improving.

Turnaround

This is where things get a bit more interesting - the previous contract struggles and a £2m equity fundraise in 2019 have prompted an explicit turnaround strategy.

Progress here has probably been obscured by Covid, but underneath all the disruption there could be a fundamentally better business emerging.

Net debt fell to £4.9m in September from £7.2m as at 31 March 2020 - a reduction of 33% - and over the past twelve months, net debt has more than halved by £6.2m from £11.1m.

Cash generation has also improved markedly and the group is targeting additional debt reduction this year. Meanwhile, costs have been cut and will result in annualised savings of over £1m. That’s substantial for a company of Bilby’s size.

Conclusion

While regulation does indicate that Bilby will generate a certain level of trade, visibility on timing is poor. That and the group’s low margins and wobbly track record call for caution.

But there are also avenues worth investigating further: Bilby’s turnaround strategy and restructuring could result in a fundamentally better business. Net debt is reducing and cash generation is improving, but it’s still all quite early.

If it can stick the landing then today’s share price could offer good long term value. The company has a market cap of just above £15m on FY20 sales of £65m, which suggests promising scope for upside if the management team can steady the ship.

Three-year revenue visibility appears to be good and it does sound as though Bilby is transforming into a financially healthier and more cash generative outfit.

The improving StockRank, director buys, net debt reduction and the improving cash generation suggest Bilby is worth a closer look, but this potential must be balanced against the group's poor past performance and volatile share price.

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Mercia Asset Management (LON:MERC)

Share price: 24.65p (+5.6%)

Shares in issue: 440,109,707

Market cap: £108.5m

Mercia Asset Management (LON:MERC) is a specialist regional asset manager with £800m of assets under management (AUM) and around 400 portfolio companies. It is halfway through a three-year strategic plan to expand AUM ‘to at least £1bn’.

Its niche is in supporting regional SMEs and the group provides capital across four asset classes: balance sheet, venture, private equity and debt capital. The focus is on technology, software, and healthcare - all areas that can offer big returns.

The group initially nurtures businesses via its third-party funds under management (FUM), then over time Mercia can provide further funding to the most promising companies, by deploying direct investment follow-on capital from its own balance sheet.

What’s interesting right now, scrolling through the group’s portfolio companies, is the exposure to Life Sciences. Seven of Mercia’s top 20 holdings at 31 March 2020 were in this sector, valued at £29m in aggregate or 33% of total portfolio value, with another c 40 earlier-stage life sciences investments across its third-party managed funds.

COVID-19 has obviously accelerated the opportunity for this type of small company, with an explosion of potential new treatments, diagnostics, and support infrastructure. These are areas where Mercia is already invested through companies like lateral flow diagnostic testing specialist Abingdon Health. But is it a boom or a bubble in this space right now?

Given Mercia’s low StockRank of 18, an F-Score of 2, and the fact it qualifies for a short selling screen (James Montier 'Unholy Trinity'), it does look to be at the more speculative end of asset management though.

It’s an ex-Woodford holding - some of these ex-Woodford stocks could be due an eventual rerating now that a large, distressed seller has left. You can see the impact on Mercia’s share price:

Interim results for the six months ended 30 September 2020

It’s a ‘strong first half year performance’, driven by sector-specific recoveries in asset prices and a buoyant trade sale market in Mercia's leading areas of investment focus (small, regional tech and life science businesses).

The market likes these results, with shares up around 5% at the time of writing. Highlights include:

• Total AUM up 78% year-on-year to c.£872m,
• Revenue up 51% to £8.4m,
• Adjusted operating profit of £1.1m compared to an H1 2020 £0.6m loss,
• Profit after tax up from £2.1m to £8.2m, and EPS of 1.87p (H1 2020: 0.69p),
• Net assets up year-on-year from £128.4m to £149.9m,
• Maiden interim dividend of 0.1p.

The group is building scale in its third-party fund management business, which is improving adjusted operating profit. Total AuM have increased to c.£872m, c.£722m of which is third-party funds under management.

Mercia’s CEO says:

We are increasingly optimistic about the potential of the companies within our direct investment portfolio, many of which are in sectors such as Life Sciences, Software and Digital Entertainment which are experiencing strong tailwinds.

On that note, COVID-19 has accelerated structural changes in Mercia’s targeted sectors. In its key areas of Life Sciences, Software and Digital Entertainment (which represent c.82% by value of its direct investment portfolio) ‘there has been a marked acceleration in growth trends, positioning us well for the future.’

In the six months to 30 September 2020 it invested in 81 businesses, including 26 new companies in the third-party managed funds' portfolios. The total amount invested was £42.1m.

Notable exits include the sale of NAC at an 8.4x return on original direct investment cost and a c.65% IRR. This is a leading producer of infectious disease reagents that include antigens for COVID-19 antibody test kits.

A new company was also added to the portfolio: MIP Diagnostics Limited. Mercia holds a 3.3% fully diluted direct investment plus a c.30% fully diluted stake through its managed funds. MIP is a spinout from the University of Leicester that has developed a proprietary process to provide molecular imprinted polymers to the vitro diagnostic, bioprocessing and oil and gas industries.

Conclusion

I like the regional focus and Mercia’s chosen sectors. These are areas with potential for high returns.

A recent report published by Beauhurst ('Exits in the UK, Acquisitions and IPOs') states that between 2011 and 2019, c.70% of exits occurred from businesses located outside of London. Of these, c.98% were through acquisitions and c.87% were sold for £200million or less. This is the area in which Mercia operates.

It’s a tricky one to analyse here given the breadth of portfolio companies. The quality of this portfolio is what will ultimately drive or destroy shareholder value. There’s a lot of detail in this update and it arguably deserves much deeper research.

My interest has grown though due to the regional tech and life science focus. There is plenty of value outside of London, often with more attractive valuations and less spin attached.

Mercia claims to have net assets per share of 34.1p, so with the shares at 24.65p that’s a useful 28% discount to stated net asset value.

This is a company covered by Edison - you can find the coverage here. That will likely be my next port of call.

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Paul’s Section

Sosandar (LON:SOS)

Share price: 18.3p (down 8% at 10:40)
No. shares: 192.3m
Market cap: £35.2m

(I hold)

Interim results & trading update

There’s a webinar on PIWorld at noon, which I want to watch, so I’ll rattle through the numbers here and publish it just before noon. I'll put up the recording link, when it's ready)

• H1 revenues up 52% to £4.28m
• Seasonality is strongly weighted to H2 (LY: H1 £2.82m revs, H2 £6.18m revs, with heavy H2 marketing spend LY)
• Gross margin is very good for the small size of the business, at 52.3% - slightly down on LY H1 due to discounting at start of lockdown, since moved back to full price, so that’s fine by me
• Loss before tax in H1 drastically reduced, from £2.8m H1 LY, to £1.1m H1 TY. That is very important, and of key importance, in my view - deep cost-cutting, and marketing spending halved
• Repeat orders up 88% compared with revenue growth of 52%, is a strong sign of building customer loyalty, in my view - important
• Returns rate down from 49% LY to 42% TY - very good, but is it sustainable? Probably partly due to change in products sold, more casualwear during lockdown, as opposed to dresses, which have a high return rate due to more complex fit
• John Lewis & Next website sales going well, and ranges being increased. No figures given, but mgt have previously told us it’s starting small, then building
• Record sales in Oct, etc. Needs to be!

Estimating sales for H2 (my figures, as there are no broker forecasts, still suspended - disappointing!):

Method 1 - since H2 to date is up 115% compared with H1, then if this continues, suggests H2 might be £9.2m.

Method 2 - 17% Y-on-Y revenue growth, implies if continued, £7.2m sales in H2.

Average of these is £8.2m, which is my best guess for H2 revenues, giving £12.5m revenues for FY 02/2021 - this is a long way short of original forecasts for around £20m revenues in FY 03/2021. However, the cost base has been greatly reduced this year, so the breakeven point is now much lower.

Cash position - very impressive, the company is conserving cash (and with minimal, £80k, deferral of tax creditors) and still has c.£4m net cash yesterday. This is much better than I was expecting, especially as H1 is the quiet half, so I was expecting prodigious cash burn and another fundraise. This is probably the key, positive point from today’s results - cash burn drastically reduced, and I reckon it could possibly even be cash generative in H2, but let’s not jump the gun there!

Marketing spend efficiency - greatly improved. The marketing spend was turned on again in Sept, and is half the spend vs last year, but delivering the same results - very encouraging, but does indicate that half of the marketing budget was arguably wasted in the past! Still, it’s the future that matters. TV is very effective at driving signups, which later can be converted into sales. Spending is now split roughly equally between TV, social media, and direct mail glossy booklets. I think the cash burn/crunch has forced them to become leaner & more effective, a good thing.

Third party websites of Next & John Lewis, has started well, and ranges are being expanded. However, it’s negative for working capital, so is being restricted. What a pity - I’d like to see Sosandar explore loan funding options to expand this - maybe something along the lines of invoice discounting, or asset-backed lending (as done recently by French Connection (LON:FCCN) [I’m long]). It seems a pity to miss out on expanding a profitable opportunity due to working capital constraints.

Balance sheet - is good. There are negligible fixed assets, as everything is outsourced (IT, logistics, etc). So the £6.7m NTAV is almost all working capital.

Current assets total £8.9m (mainly inventories £3.8m, and cash of £4.5m)

Current liabilities total £2.5m, and there are zero longer term liabilities.

That’s a healthy surplus of £6.45m of net current assets, or a current ratio of a very strong 3.6

Cash burn in the seasonally slow H1 was only £795k. Hopefully H2 might even see little to no cash burn, given that sales are much higher in H2? This is looking like a potential game-changer. With high cash burn now behind us, and the breakeven point greatly lowered, the business looks to be on the cusp of commercial viability.

Based on these figures, I don’t think SOS needs another fundraise any time soon. Although costs are being squeezed hard, so once it moves into profit, I reckon company would need to increase costs, and stay at breakeven for a while. That’s fine by me. I don’t want profits, I’d rather see them grow the business, at cashflow breakeven, for a while, to maximise the opportunities.

Webinar today - Here are the key points I jotted down during today’s excellent PIWorld webinar;

• New CFO, Steve Dilks, sounds confident & has clearly hit the ground running
• Returns rate has settled in the mid 40s (percent) - good
• Huge learnings, so more efficient marketing spend now
• Latest cash figure is c.£4.0m at end November - very important, as I think they can manage without another fundraising
• Chart showed steep growth in repeat orders - now the bulk of sales - very important
• Conversion from website (was down to 2.58% in H1) has improved to 3.5% in Oct/Nov 2020 - very good, indicates to me that Autumn/Winter range is good
• “Incredibly successful Black Friday”
• Govt support was not a big element of admin cost savings achieved in H1 (i.e. furlough)
• Carbon negative bags to replace boxes currently used - cost saving too
• Customers are still buying glamorous styles (not just casualwear), because they want to cheer themselves up!
• Next/John Lewis - now 8% of total sales. Going very well, Next: 69 styles, J Lewis: 190 styles - constrained by working capital, “They would take as much stock as we could give them” - sounds like a big opportunity not being taken advantage of, due to cash restrictions - they need to find a way around this!
• Celebrities wearing Sosandar - lots going on, e.g. Strictly Come Dancing
• Email is biggest driver now - 37% of sales come from this (almost free) marketing channel, hence marketing spend drops as % of revenues as database grows
• Outlook - continued focus on cash conservation, and continued improvement in profitability
• Repeat orders drive profitability
• Suppliers - currently have 37, mainly in Turkey, India & China
• Denim doing very well, as they said it would last year, doing 15-20% of all revenues now
• Starting to look at international expansion opportunities. Not looking at doing menswear yet, that’s further out into the future

My opinion - I had gone rather lukewarm on Sosandar last year, as regulars here will know. This was because of repeated fundraisings, which increased the share count to almost double what it was when it listed, thus reducing the upside % per share. Also, I felt the high spending, rapid expansion model was burning through cash too fast. So I’m certainly not a blind perma-bull, I try to look at all shares rationally, and flex my view depending on developments.

After delving deeply into these interim numbers, and the excellent webinar today (which should be up on PIWorld’s website shortly, it’s not there at the time of writing), I’m warming up again somewhat on Sosandar. If I had to rate the share, for what the upside potential seems like, then I’d probably raise it from a C, to a B minus! If it trades well over Xmas, then I’d probably be inclined to move it up again to a B.

The game changer for me is the drastically reduced overheads, which has greatly lowered the breakeven point, from about £20m revenues, to maybe c.£12-15m revenues? There is no broker coverage, so those are just my very approximate workings. The point being that, at this lean level of overheads, the business is still growing nicely, yet is probably now quite close to breakeven.

Once people can see it’s at or near breakeven, then people tend to extrapolate out further growth, with operational gearing, and potentially exciting future profits. Then the share could re-rate to a much bigger market cap, pricing in future growth. Maybe! That's the bull case.

At the moment, I think the £35m market cap looks about right. So I’m not in any rush to buy more Sosandar right now, mainly because I’m concentrating all available spare cash into buying more Boohoo (LON:BOO) (my largest holding), which I think is more liquid, much less risky, and has bigger % upside than SOS. If BOO shares do what I think they should (i.e. go through the roof), then (a) it’s party time round at mine, and (b) I could see myself recycling some of the profits into buying more SOS.

The market crash in Feb-Mar this year has certainly made me much more wary about taking large, over-sized positions in tiny, illiquid shares, because you can't sell in a hurry, if at all, in a crisis - maybe that's a good thing, but not if you're geared, as I tend to be. Although to be fair, SOS is usually quite liquid.

That’s an interesting point actually. By reversing Sosandar into an existing cash shell, with lots of private investors, it created an immediately liquid market, despite being a small market cap. This has worked out much better than many other small floats, which the city brokers tend to place shares with institutions, nothing goes to PIs, resulting in almost zero liquidity for the first few years, or ever. Hence why bother listing shares at all, if you’re not going to create a liquid market? It’s crazy. For this reason I would look much more favourably on future new listings, where a company is reversed into an existing cash shell which has a decently liquid, fragmented shareholder base. That’s clearly a better way of listing small caps.

With cash burn so drastically reduced, and quite a lot of cash still in the kitty, then I think the bear case looks a lot weaker than it did earlier this year.

Sosandar floated at 15.1p. The fact that it's done a series of subsequent fundraises, and has burned through a lot more cash than originally planned, and is still about 20% above the float price, actually isn't bad at all - certainly not a disaster anyway.

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That's it for today.

Regards, Paul.