Small Cap Value Report (Thu 22 July 2021) - SOS, KETL, MGP, AUG, BOOM, RST, GOOD

Good morning, it's Paul & Roland here with the SCVR for Thursday. Thank you to Roland for helping out in a really busy week, very much appreciated.

Timing - TBC. We did our best with yesterday's deluge, focusing on what we thought was most interesting. Let's see what happens today.

Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to cover trading updates & 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 & nobody can predict the future with certainty.

We stick to companies that have issued news on the day, with market caps up to about £700m. We 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) - don't blame us if you buy something that doesn't work out. Reader comments are welcomed - please be civil, rational, and include the company name/ticker.

Agenda -

Paul's Section:

Sosandar (LON:SOS) (I hold) - here are my unstructured notes from yesterday's webinar. Typed up in the glorious sunshine, whilst fending off aggressive herring gulls (pluses and minuses of living in a penthouse in Bournemouth)

Takeover situations - I review 4 companies in bid situations with news out today.

Roland's Section:

Strix (LON:KETL) - this manufacturer of kettle safety controls has some attractive characteristics in my view, but I’m unsure about the quality of growth here.

Medica (LON:MGP) - demand for routine elective scans in hospitals is back to 75% of pre-Covid levels in NHS hospitals. Company says it is “well placed to continue our ambitious growth trajectory”.

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Paul's Section

Here’s something I prepared earlier -

Sosandar (LON:SOS)

(I hold)

28p (up 10% yesterday) - mkt cap £62m

My notes from Sosandar webinar yesterday - as usual, these are just my personal notes, not a comprehensive account of the webinar.

Fastest sell-through ever of new products in Q1 (Apr-Jun 2021)

Year-on-year % growth will be highest in Q1 due to soft prior year comps

3rd party sales (J Lewis, Next, MKS) “going from strength to strength”

Q1 gross margin up strongly to 56% (double check this, as I couldn’t see screen closely)

Only selling in the UK, not EU, so no impact from Brexit

Clear path to profitability

Customer loyalty good - repeat orders gone up from 3 times per year, to 4

Product categories - “barely scratched the surface” of new categories, huge opportunity to expand range further

Flex products to customer needs - diverse product (e.g; pivot to casualwear in lockdown)

Concession model - online only sales through the big 3 (J Lewis, Next, M&S) - they approached Sosandar, happy to engage. They distribute the product & handle returns. Revenue & gross profit are the same. There’s a commission charge lower down the P&L which contains all the costs, which the 3rd parties absorb. Profitable from day 1. Close relationship between inventories supplied, and sales by 3rd parties - supply more stock, sales go up, linear relationship. Going to double stock in autumn/winter 2021 - greater depth & breadth of product coming. Selling out v quickly in key styles. Larger order quantities means lower prices from suppliers.

Marketing strategy - refined in the last few years. Split between TV, glossy brochures, and social media. Learnings from data, much lower cost of customer acquisition now. TV drives traffic to website, leads to email signups, which then allow free customer contact. Website conversion rates spike up when glossy brochures land on doormats. Social media is all about engaging with customers & keeping them interested. Email is lifeblood of the business, like a daily newsdesk, producing relevant, daily contact. Very high open & conversion rates for emails.

Celebs/influencers - great since day 1. We don’t pay them anything, unlike other brands. They wear Sosandar because they like the product. Icing on the cake, not dependent on it.

Database 100k-400k, includes prospects.

Mgt option pool c.11% - 30 institutions were consulted, they all agreed

CAC - big decline in cost (customer acquisition)

ESG - main suppliers are China, India & Turkey - close relationships with suppliers, independent audits done, have to check what suppliers are doing what they say they do, ultimately based on trust.

Q&A - repeat orders? 70% of the total.

Addressable market? 12 million women in the UK, international markets are huge. Barely scratched the surface. Sky's the limit. We see ourselves becoming a major eCommerce business, same opportunity as Boohoo and Asos, in an older customer demographic.

EBITDA margin in future? Not a short term issue long term in double digits?

Stock turn with 3rd parties? Very fast - typically 3-4 weeks stock turn. Very good, very efficient way of selling.

My opinion - this is looking exciting. I should probably not write up anything within a 48 hour cooling off period of a webinar, and I do like Julie & Ali very much - you see, calling them by first names is a clear warning sign I’m emotionally involved!

Make up your own mind! For me, the Q1 growth means they’re now near breakeven, have plenty of cash, are scaling up the 3rd party sales, I like it a lot. This is now a coffee can stock for me personally - buy and hold forever. Is it cheap? No - £62m market cap looks pricey for where the company is now. That’s always the difficult choice isn’t it, with growth companies - how much to pay up-front for future growth?

There's a point of difference here - SOS is an older demographic, and understands it/ serves it well.

15p float price. Now close to double that - it's going well. Yes, needed a bit more funding, but I'm fairly comfortable I was right abut this from day 1. The key is passionate, committed management. Starting a new fashion brand from scratch is almost impossible. Julie & Ali have done it. Sit up & take notice. I think this could (not will!) be a good investment from here. Make up your own mind.

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Takeovers

As mentioned before, these are coming thick & fast, especially from overseas buyers, which is one of the reasons I generally feel bullish about the UK market right now.

Augean (LON:AUG)

An ongoing situation first announced on 27 May 2021, almost 2 months now. Augean says today that it is continuing to have discussions with Morgan Stanley Infrastructure Inc. , certainly a credible sounding name as a bidder. The PUSU (put up or shut up) deadline from the Takeover Panel has been extended again to 19 August 2021.

My view - it’s currently rated at 17.2 times forecast earnings for FY 12/2021, which personally I thought looks a fair price, so I sold my small position here in the market at around 300p, which had been in the back of my mind as a sensible price target when I bought at around 200p. I wasn’t particularly interested in speculating on whether a bid may or may not happen. There’s also a large ongoing dispute for allegedly overpaid landfill tax. Good luck to holders, I hope you get a satisfactory outcome.

Audioboom (LON:BOOM)

A much less credible bid approach was announced on 19 July - I covered it here. Audioboom has issued its response today, which rejects the approach. Reasons given are: undervalues the business (that’s arguable!), unattractive structure of deal (true, as mostly payable in toilet paper - no, not Accrol (!), I mean shares in suspended AAA), and no strategic reason for the deal.

Well said BOOM, this was a fairly daft approach, so best kicked into touch.

Note there is an InvestorMeetCompany presentation today at 15:00 which I'll be attending. Will report back if anything of interest is said. Growth has been very good lately, but still not profitable, so I don't know how to value BOOM.

Restore (LON:RST)

Announced today, Marlowe (LON:MRL) has said that it has made 2 possible takeover approaches for Restore, but both have been rejected. The latest offer was 530p, a 26% premium to last night’s close - not bad. Although the catch is that it’s only 71p in cash, and the remainder in new Marlowe shares. I’ve had a quick look at Marlowe, and it looks a decent company, about the same size as Restore. So there could be a benefit from a larger, combined group maybe? Restore shares are up 16% today to 489p.I thought Restore looked good, and reasonably priced, so have a call with management booked in for next week. Pity I didn’t pick up any shares, but never mind.

Restore put out its own announcement at 08:41 today. It says Marlowe offered 515p initially, mostly in shares, which was considered and rejected due to undervaluation, and poor structure (mostly in shares, with only 71p in cash). That was then raised to 530p, rejected by Restore on the same basis.

Restore management says they remain highly confident in its standalone prospects. Presumably they also want to keep their jobs!

I can’t see any new trading information, it reiterates the key points from the positive trading update on 5 July 2021, which I covered here, and was impressed, awarding it the coveted SCVR “could be worth a closer look” status An adviser did come back to me with my concern about the rapid pace of acquisitions at RST, by pointing out that it has 3 divisional teams, all of which are experienced in M&A, so it can cope with a considerable flow of deals..

Diary date - 27 July for its interim results.

The share price of 489p indicates that the market doesn’t see a deal at 530p happening. Could be worth top-slicing a bit of the profit maybe?

Good Energy (LON:GOOD)

I’ve never heard of this green energy company, but it’s received a cash 340p per share offer from its largest shareholder, Ecotricity. It’s only a paltry 10.6% premium. Looking back at previous announcements, on 12 July 2021 the company previously rejected a 340p approach from Ecotricity - saying it’s a highly opportunistic offer by a competitor, and undervalues the company.

This looks like a hostile takeover bid, with Ecotricity by-passing management of Good Energy (which they don’t seem to rate too highly judging from the comments in today’s announcement). It will be interesting to see how this pans out.

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Roland’s section

Strix (LON:KETL)

316p (pre-open)

Market cap £652m

Pre-close Trading update

Strix is an AIM-listed firm whose main product line is kettle safety controls - that’s the part that makes your kettle switch off when the water boils. In western markets this is a regulated component, for obvious safety reasons.

Strix is the world’s largest manufacturer of these controls and says its products are used by 10% of the world’s population. I know my kettle has a Strix control.

Of course, kettles are fairly cheap and most people who want a kettle (in developed markets) already have one. Finding new areas of growth has become a key focus for Strix since its IPO in 2017. Areas being targeted include instant water heaters, baby formula makers and more lightly regulated markets.

So far, I think it’s fair to say that Strix’s share price has performed more strongly than its business. Operating profit has been broadly flat since 2017, but the shares are up by 140%.

Is the current valuation justified? Let’s take a look at today’s update.

“Revenue growth of circa 50%”

The tone is bullish. The company says that the kettle controls category is performing strongly, especially in the regulated sector (i.e. developed markets, excluding China). The order book is said to be “positive”. No numbers are given but I guess this might mean that the order backlog has risen since the 2020 year end.

Here are the financial highlights:

• Revenue growth of 50% in H1 versus the Covid-affected prior year.
• Full-year revenue growth in 2021 expected to be 30% - this appears to be in line with consensus forecasts
• Gross margins are said to be in line with expectations - more detail promised with H1 results
• Price increases pushed through on some products to minimise the impact of cost inflation.

Full-year revenue growth of 30% sounds very impressive, given that average annual revenue growth between 2015 and 2019 was c.5% per year.

The main reason for this leap forwards seems to be last year’s acquisition of water purification appliance company LAICA. This business generated revenue of €20m in 2019. Sales are said to be up by 20% in H1 2021 -- assuming a similar full-year performance, I estimate this could add around 20% to Strix’s 2020 revenue.

This suggests to me that organic revenue growth, including in-house product launches, might be about 10% in 2021. Not bad, but not as impressive as the headline figures suggests.

One other area of interest for some investors will be Strix’s HaloPure technology, which it acquired in 2019. This is currently being used to sterilise water feed lines in industrial pig farms. It’s still in the early stages of commercialisation, working with some large Chinese companies.

I’m unsure about this - I’d be more encouraged if Strix was working with - say - Danish pig farms.

My view

I have mixed feelings about this business.

Positives: Strix has consistently generated operating margins of 25% or more since 2015. The group is a market leader and I believe its core products have some moat-like qualities, due to regulatory hurdles.

Negatives: In developed (regulated) markets, it’s not clear to me how much scope for growth exists. In less developed (lightly regulated/unregulated markets), the opportunities are greater, but so too is the scope for intellectual property infringements. China is the obvious example here. No doubt it’s a big market, but I struggle to believe that the Chinese can’t design and produce this technology domestically.

Strix is introducing new product lines and making acquisitions to try and stimulate growth, but I think it’s too soon to know how successful this strategy will be. The 2021 results may give a fairer idea - 2020 was disrupted, after all.

Balance sheet/cash flow: Strix has historically generated strong free cash flow, but this has weakened over the last few years, while net debt has risen.

Today’s update shows that net debt excluding lease liabilities has risen to £51.6m so far this year, up from £37.2m at the end of 2020. This increase isn’t explained, even though it’s fairly sizeable.

I appreciate that last year was difficult. The company has also been spending money on a new factory in China. But I’m not sure why cash generation hasn’t been a little stronger during the first half.

After recent gains, Strix is trading on around 20 times forecast earnings. The dividend yield is down to around 2.6%.

I’m not tempted to buy at this level, but I’ll await the H1 accounts with interest.

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Medica (LON:MGP)

160p (+4.9% at 0930)

Market cap: £198m

Trading and business update

Medica provides outsourced teleradiology and imaging services. In short, it employs qualified medical practitioners to interpret and report on scan results from home-based workstations. The NHS is the biggest client, but the group is expanding in other English-speaking markets, including Ireland, Australia and the US.

Demand for Medica’s services was hit last year as hospitals suspended a lot of elective activity to free up capacity to handle Covid-19 patients.

Today’s update tells us that a recovery is underway. NHS demand has returned to 75% of pre-Covid levels (Jan/Feb 2020). However, the company warns that the impact of the removal of Covid restrictions on hospitalisations has yet to be seen.

Looking beyond the pandemic, the backlog of NHS elective activity is expected to combine with structural growth in elective scanning to support strong demand in 2022 and beyond.

The firm’s emergency out-of-hours service, Nighthawk, is also said to be performing well.

Financial outlook: The financial guidance in today’s update seems somewhat nuanced to me.

An increase in gross margins during H1 may be offset by the effects of contract wins and changing case mix in H2. My reading of this is that gross margins may be lower in H2.

Gross margin for the full year is expected to be “at least in line with 2020 levels”.

However, revenue is expected to recover strongly this year, rising from £36.8m to £60.3m. To put this in context, 2019 revenue was £46.5m.

My sums suggest this should report a strong recovery in operating margins, to around 20%.

My view

I’ve had a favourable impression of Medica’s business since its 2017 flotation, although I’ve been unsure about the scope for growth outside the core NHS market.

That question remains, in my view, especially as regards US ambitions. As investors in Tristel (LON:TSTL) have found (see yesterday’s report), breaking into the US healthcare market is not easy for small, non-American companies.

Medica’s shares have had a strong run so far this year:

This has left the stock trading on a rolling forecast P/E of around 20, according to Stockopedia.

Today’s update does not refer to market expectations. My reading of it is that results are expected to be broadly in line, with some room for uncertainty on both the upside and downside.

I don’t see anything in today’s update to change my view on this business. I think the share price is probably up with events, but I don’t think the stock is obviously overpriced. If I held the shares, I’d continue to do so.