Small Cap Value Report (Thu 29 July 2021) - VLX, WATR, EMAN, HEAD, TPFG, VTU

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

Timing - today's report is now finished.

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, otherwise people won't necessarily know what company you are referring to.

Agenda -

Paul's Section:

Volex (LON:VLX) (I hold) - an encouraging trading update for Q1, "slightly ahead". Some potential headwinds are mentioned, more generic than company-specific. Valuation looks reasonable. Remains a "coffee can" holding for me.

Headlam (LON:HEAD) - I'm feeling a bit smug about this one, which has panned out exactly as predicted here - broker forecasts were way too low (fairly obvious, it has to be said), and divis are resuming. Still good value.

Vertu Motors (LON:VTU) - astonishingly good H1 guidance announced today, with car dealers seemingly enjoying a bonanza, driven by buoyant used car prices. Although this looks a one-off, exceptional effect, but even on a more cautious outlook, this share looks outstandingly cheap. And it's fully backed with freehold property as well. Very attractive value share in my view. Potential for takeovers?

Jack's Section:

Water Intelligence (LON:WATR) - very strong momentum here and the group remains upbeat about a global opportunity. Valuation remains high but over the longer term this company can continue to grow.

Everyman Media (LON:EMAN) - premium cinema operator is making its way out of lockdown and looks ready to continue taking market share, but the stock is illiquid and pricey.

Property Franchise (LON:TPFG) - trade has rebounded strongly thanks to government initiatives and generally favourable conditions. This might turn at some point, but the group has a resilient and cash generative business model and is modestly valued with scope for long term growth.

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Paul’s Section

Volex (LON:VLX)

(I hold)

340p (at yesterday’s close) - mkt cap £540m

AGM Statement

Volex plc (AIM:VLX), the global manufacturer supplying power products and integrated manufacturing services, is today holding its Annual General Meeting. At the meeting, Executive Chairman, Nat Rothschild, will make the following statement on trading for the three months ended June 2021.

• Strong customer demand has continued
• Consumer electricals “remains very strong”
• Electric vehicle revenues “continue to grow”
• Medical & complex industrial technology - seeing a “healthy recovery”
• Recent acquisition (DE-KA, in Turkey) “continued to trade well”
• Outlook - potential impact on trading from - supply chain shortages, cost inflation of materials, freight challenges, and the pandemic
• Key point - increased price of copper has been “successfully passed through” to customers
• Robust cashflow in Q1
• Acquisitions - pipeline is being advanced, helped by financial flexibility

Guidance raised -

Overall, whilst still early in the year, the positive trends in the first quarter lead the Board to expect to deliver full year underlying operating profit slightly ahead of current market expectations1."

1 Latest company compiled view of market expectations shows an underlying operating profit consensus of $50.0m with a range of $48.9 million to $51.0 million.

Valuation - remember that results for FY 03/2021 benefited from an unusually advantageous tax charge, hence EPS will fall this year, despite pre-tax profits forecast to be up about 20%.

Stockopedia shows a consensus of 24.6c, so that’s probably likely to rise to about 26c after today’s update. Divide by 1.39 to go from dollars into sterling, that’s 18.7p EPS.

(EDIT: an updated note from Singers has just come through via Research Tree, they've up current year forecast to 26.5 US cents. So my guess at 26 cents is very similar. End of edit).

At 340p per share, the PER is 18.2.

We also have the likelihood of more acquisitions to boost earnings further, which should be possible without issuing fresh equity, because the balance sheet is strong, with only negligible net debt reported at FY 03/2021 - here are my notes on those results.

My opinion - this company is a class act, and remains one of my core, long-term holdings. Management with a major equity stake, are doing a terrific job. There are also industry tailwinds from electric vehicles, and the 1-2 year replacement cycle of cabling in data centres.

Today’s update confirms my view that this is an excellent company, reasonably priced, trading well, and with a successful acquisitions strategy.

Plenty to like here. The price doesn’t look stretched at all, despite having almost quadrupled in the last 2 years - performance has fully justified it.

I’m not sure why the StockRank has been falling of late.

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Headlam (LON:HEAD)

524p (up 7% at 08:25) - mkt cap £447m

Annoyingly, I don’t currently hold this one, as my position was in a spread betting account which got the mother of all margin calls in the recent flash crash, so I was forced to close something. Was hoping to buy back in, but looks like I’ve missed the boat now, with this positive update today, drat.

It’s playing out exactly as indicated here previously - i.e. broker forecasts ludicrously low, and out of step with trading updates from the company. So it’s not a surprise to see forecasts raised today, it was inevitable.

Pre-Close Trading Update

Headlam (LSE: HEAD), Europe's leading floorcoverings distributor, is pleased to provide a trading update ahead of announcing its interim results for the six months ended 30 June 2021 ('H1 2021') on 2 September 2021.

Trading is going well, with u/l PBT guidance going up from £29m to £35m, up 21% -

Given this sustained year-to-date performance and the Company's traditional second-half revenue weighting, the Company now expects full year performance to be materially ahead of current market expectations². After factoring in prudent revenue assumptions, and performance-related employee bonus payments due to the current outperformance, it is anticipated that 2021 underlying profit before tax will be no less than £35.0 million¹(,)² (unless exceptional or unforeseen circumstances prevail).

² Company-compiled consensus market expectations for 2021 revenue and underlying profit before tax (prior to any updates following this announcement) are £653.5 million and £29.0 million respectively (on a mean and post IFRS 16 adoption basis).

Valuation - Stockopedia is showing 26.0p EPS forecast for FY 12/2021, so if we raise that 21% then it comes out at 31.5p. At 524p per share, the PER is 16.6

Personally I’ve been working on the basis that, after cost-cutting and an efficiency drive, Headlam should be able to reach c.50p EPS in due course, maybe next year. If I’m right, that would bring the PER down to only 10.5 - hence this share still looks good value, and further upgrades to guidance seem likely later this year.

Dividends - Headlam says it will return to normalised level of dividends, as previously predicted here! A key reason to hold this share is the dividend paying capacity of the company is considerable, given its strong balance sheet, and trading returning to normal pre-pandemic levels.

Footnote 3 says the target is dividend cover of two. Therefore if my 50p EPS target is right, that would mean 25p in annual divis, yielding 4.8% - an attractive, and sustainable yield. Also this has inflation-protection too, because a distribution business like this would be able to just pass on cost inflation to its customers with price rises.

My opinion - this was an entirely predictable, even obvious situation, and has been flagged here frequently in the last year or so. Hence I hope some readers have made a bob or two on this!

Based on my figures above, it still looks good value, with the attraction of a generous, twice covered dividend resuming.

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Vertu Motors (LON:VTU)

(I hold)

46.5p (up 7%, at 11:32) - mkt cap £171m

Trading Update

As a consequence of the continuing strong trading performance, the Group is providing an update on current trading and an upgrade to the full year outlook.

• Exceptional UK used car market conditions
• High gross margins
• “Material positive” effect on profits & cashflow
• Despite tight supply, sales & inventories of used vehicles have been higher than expected
• New vehicle volumes & margins have “remained strong”
• New vehicle supply constraints have had “no material impact” on H1 trading
• Service revenues & profit “strengthened in recent weeks”, mirroring patterns of last year

Revised guidance - this is just for H1 (March-August 2021) -

The Board now anticipates that the Group's adjusted profit before tax for the six-month period ending 31 August 2021 will be no less than £40m.

Seasonality - given that VTU is flagging a huge £40m profit for H1, I wondered what seasonality there is to the business in normal times?

Stockopedia has a really neat feature, which splits the Income Statement for any company into H1 & H2, going back several years. It’s under the “Accounts” menu on any company’s StockReport, then you select Income Statement, then click on “INTERIM” - I’ve done a screenshot below, with the relevant bits highlighted.

As you can see below, in each of the 3 years before the pandemic, Vertu did make a larger profit in H1 (highlighted) than H2, so yes there does appear to be a usual H1-weighting to profitability.

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H2 Outlook -

VTU flags various uncertainties -

• New vehicle supply may be constrained, hurting profits
• That could cause a knock-on restriction in supplies of used vehicles
• Covid uncertainty
• Upward pressure on employment costs
• Therefore it is guiding for only £0-5m profit in H2, added to the £40m made in H1, giving £40-45m for the full year (ending 28 Feb 2022).

Forecasts - both Liberum and Zeus (who both produce excellent research) update their numbers today.

FY 02/2022 - Zeus raise by 35%, to 8.4p. Liberum is even more punchy, at 9.7p.

My feeling is that something exceptional, and one-off in nature seems to be happening this year, hence I wouldn’t value the shares on an exceptional year’s earnings.

FY 02/2023 - more normalised trading expected, with an average of 6.3p forecast by the two brokers. I’m happy to put that on a PER of say 12, which gives my price target of 76p. That’s 63% upside on the current share price, which is more than enough to keep me interested, hence is a strong hold for me personally.

My opinion - H1 has been staggeringly profitable for Vertu (and presumably other car dealers too). However, it does look a bit of a one-off.

Even so, valuing the shares on next year’s lower forecast earnings, still gets me to a price target 63% above the current price.

What’s even better is that downside protection is almost complete, with a strong balance sheet groaning with freehold property.

The valuation makes no sense to me, I think the market is just pricing car dealers wrongly at the moment. Even if internet competitors (e.g. Cazoo, Cinch) do take a chunk out of Vertu’s business, it’s still a very big market, and I reckon most people will still want to touch, and test drive, a car before buying it. Furthermore, if you look at Vertu’s website, it also has the same click & collect, 14 day money-back guarantee, free delivery offer that the internet companies do. If I decide to buy a car online, would I feel more comfortable buying from an internet startup, or an established local dealer? The latter. Writing off existing dealers seems premature to me.

The other argument against car dealers, is that electric cars won’t need as much servicing as conventional cars, and we might end up buying direct from the manufacturers, cutting out the dealers. Even assuming that analysis is right (which I’m not convinced about, as plenty of things can go wrong with electrics, as they age), then car dealers could just convert their redundant sites into supermarkets or residential, morphing into property companies which in the case of Vertu fully supports the current market cap, before adding on any development upside on its extensive freehold property portfolio.

Hence risk:reward looks very attractive to me. Copper-bottomed thanks to the property assets, and on an amazingly low PER for current business which is booming. You don’t see that combination very often.

Finally, I think sector consolidation is looking very likely now. With all these takeover bids happening, there must be private equity people crunching the numbers for buying up dirt cheap UK car dealerships. It’s tailor-made for private equity - do a sale & leaseback on the property, and you get the business practically for free! If someone offers me say 50% bid premium on the current price of Vertu, I would be delighted.

Note that the StockRank has got jammed on maximum! That's before the latest big broker upgrades feed through, so this could start blowing some servers at Stockopedia HQ! It also has the coveted "Super Stock" classification.

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Jack’s section

Water Intelligence (LON:WATR)

Share price: 990p (+1.54%)

Shares in issue: 16,289,521

Market cap: £161.3m

(I hold)

This is a fast-growing water lead detection company that has built up a strong market position in the US and UK with its proprietary non-invasive technologies. These allow the detection of leaks without breaking down walls, meaning customers save money.

The group operates a hybrid corporate-franchise model, which allows for both high returns and profitability margins, as well as strategic optionality - it can encourage higher margin franchise stores, set up its own corporate outlets where it has more control, or buy back franchises as it sees fit.

More recently, Water Intelligence has set about a more global expansion. The growth rates here are very impressive and there’s plenty of scope for expansion.

International requires more corporate expansion though, tying up more capital and potentially lowering returns compared to the more established US business.

That aside, the momentum here is excellent. The recent final results also contained a trading update for the first four months of the current year, which showed revenue growth picking up from 38% to end-March to 47% to end-April. Profit growth improved from 152% after three months to 154% after four. It’s rare to find such numbers.

Which is why the shares look very expensive.

H1 trading update

The Group's acceleration in performance reported in 1Q continued during 2Q, producing a strong 1H. Moreover, transactions executed at the end of 2Q and beginning of 3Q fuel further anticipated growth for 2H and beyond… Implied total annualized sales to customers (gross sales from which franchise royalty is derived plus direct sales from corporate locations) has surpassed $140 million providing critical mass

Highlights:

• H1 revenue +44% to $24.7m,
• EBITDA +73% to $5.4m,
• Statutory profit before tax +92% to $3.8m; adjusted PBT +77% to $4.2m,

Both core business units - American Lead Detection (ADL) and Water Intelligence International (WII) grew strongly across residential, commercial, and municipal markets.

ALD revenue grew by 42% to $21.9m (1H 2020: $15.4m). Royalty income from franchisees grew in absolute terms by 6% to $3.7m, despite eight franchise reacquisitions during 2020 and one during 1Q. Franchise-related sales (national accounts; parts and equipment; franchise territory sales) grew 14% to $4.9m. Corporate location sales grew 75% to $13.3m.

The insurance business-to-business channel grew 15% to $4.5m. Four national insurance contracts have been won.

WII revenue comprising international corporate locations grew 65% to $2.8m and statutory PBT grew by 92% to $3.8m.

Adjusted for acquisitions and the recent July placing, WATR has $11.2m of cash and $9.2m of bank borrowings, meaning net cash of $2m.

The acquisitions include the eight franchises noted above, as well as a plumbing company in Louisville, Kentucky, and the IP assets for irrigation and stormwater run-off and launch of Intelliditch.

WATR is also commercialising a proprietary sewer diagnostic product and has strengthened its board with two hires: one with financial markets experience and the other with additional industry experience.

Exec chairman, Dr. Patrick DeSouza comments:

We are accelerating our efforts to build and deliver a world-class company because we are on a mission to provide private sector leadership and solutions to water and wastewater infrastructure problems, especially in light of climate change...

We look forward to attacking this global market opportunity… As jurisdictions around the world invest in infrastructure in the aftermath of the pandemic - underscored by Biden Administration's American Jobs Plan and its anticipated $100 billion investment in water and wastewater infrastructure - we anticipate strong demand for our solutions to safeguard the world's most precious resource.

The group plans to announce its interim results in mid-September 2021.

Conclusion

This is the type of momentum, operating activity, and financial results that we are coming to expect of this company.

These first half results follow a strong full year 2020 which, despite Covid-19, produced 17% revenue growth to $37.9m and 78% statutory PBT growth to $4.2m. Since 2016, WATR has achieved a CAGR of 33% in terms of revenue and 53% in terms of statutory PBT.

After 44% revenue growth in the first half of this year to $24.7m, the consensus revenue figure for 2021 of $47m looks set to be beaten. I would expect further upgrades this year and into FY22 if past performance and present conditions are anything to go by.

Edit - I've received a WH Ireland comment (one of the brokers):

We have upgraded several times recently, notably on July 8th, when we raised FY22E PBT forecasts by 17%. However we see further scope in the future, given the strong momentum, and our fair value estimate now stands at 1100p (1075p) in recognition of this.

The only real sticking point for now is relative valuation. Not many companies deserve a 43.7x forecast earnings ratio and in the short term, that valuation might temper further share price gains. But over the medium and longer term, Water Intelligence faces a global opportunity and has decades of experience doing what it does, so I would back it to continue growing.

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Everyman Media (LON:EMAN)

Share price: 140p (-0.36%)

Shares in issue: 91,155,469

Market cap: £127.6m

Everyman is an independent UK cinema chain that has built a useful market position by offering customers a premium experience, with more comfortable seating and good food. It sticks to unique venues and aims to make cinema trips more memorable.

It’s a smaller company and the free float is 43%, so liquidity is an issue. The top ten holders actually have about 76% of the stock.

I’m a fan of the company and its sites but the shares have always looked pricey to me after a run up in 2017 - a peak that has never been topped.

Of course, the past year has been heavily disrupted, so what’s of interest here is the degree of recovery currently being experienced and the outlook in the months ahead.

Trading update for the 26wks to 1 July 2021

Highlights:

• 33 venues re-opened on 17 May, with Glasgow re-opening on 6 June and Belsize Park closed for refurbishment,
• £21m liquidity headroom,
• Return to profit and cash generation on re-opening.

All venues were closed for the first 20 weeks of FY21 due to the Covid-19 Lockdown. Everyman used this time to conserve cash and upgrade kitchens.

Admissions in the period since re-opening until 1 July reached 66% of 2019 levels despite restrictions such as the Rule of Six, table service, 50% capacity restrictions in venues, and social distancing. So in context, it is quite positive.

Market share has grown since re-opening and the business is well positioned to return to pre-COVID-19 Lockdown levels of trading and to grow beyond.

Everyman expects to announce its half year results on 23 September 2021.

Conclusion

Everyman has every chance of continuing to carve out a position in the UK market. It’s a great cinema operator offering a superior product that people want to pay for. We all want to spend a great time out with friends and family now more than ever.

But the valuation here is too rich for me given the nature of the business. It trades at nearly 3x tangible book and roughly 2x FY19 revenue - and that year the profit margin was just 2.7%. If you apply FY19 EPS to today’s share price, that would be a PER of 57.4x.

Compare it to Water Intelligence above, for example. Just by nature of being a cinema operator, Everyman produces lower returns on capital, lower profit margins, and has to spend far more on capital expenditure. Water on the other hand is already executing its global rollout and has more optionality in its hybrid business model.

It’s true that Everyman has been firmly in expansion mode in recent years, acquiring and refurbishing new sites, so perhaps capex will moderate. But by that point older sites will need new fixtures and fittings and it will have more sites to keep up to spec, so I imagine this will remain a relatively capex-heavy enterprise.

Meanwhile, the lack of liquidity makes it tricky to buy (or sell) in scale.

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Property Franchise (LON:TPFG)

Share price: 314.8p (+0.9%)

Shares in issue: 32,041,966

Market cap: £100.9m

The Property Franchise Group is the UK's largest property franchisor. I’m a fan of this business model, which is shared by Belvoir (LON:BLV) and M Winkworth (LON:WINK) . All have fantastic returns on capital, profit margins, and cash generation along with solid runways for steady future growth.

They are very profitable and resilient enterprises with sticky revenues, so I’m not at all surprised to see TPFG retain its 99 Q Rank.

I sold this one back in the 2020 post-lockdown market turmoil - the share price had held up relatively well and I wanted to free up funds for more opportunistic investments amid exceptional market conditions.

But, as is so often the case with these steady quality stocks, I needn’t have bothered as TPFG has comprehensively surged to new all time highs.

Admittedly this has been helped by an acquisition, but management has repeatedly flagged they will buy at the right price, and there is plenty of scope for further acquisitions in what is a large and relatively fragmented market.

Half year trading update

The Group has achieved strong results in the first six months of 2021. Pleasingly, like for like revenue and Management Service Fees were significantly up on the same period in 2020 and, more importantly, 2019. This is owing to a very active residential housing market, and the acquisition of Hunters Property PLC ("Hunters"), which completed on 19 March 2021.

Highlights:

• Group revenue +111% to £11.4m; like-for-like (LfL) revenue +35% to £7.2m on H1 20 and +33% on H1 19,
• Management service fees (MSF) +69% to £7.1m; +35% LfL on H1 20 and +23% on H1 19,
• Network income +118% to £89.4m; +38% LfL to £56.3m,
• Sales agreed pipeline +247% to £29.5m; +64% LfL
• Managed rental properties up from 58,000 in 2020 to 73,000 today,
• EweMove sold 37 new territories (2020: 6),
• Net debt of £5m after borrowing £12.5m to fund the acquisition of Hunters.

The increase in network income and group revenue has been driven by two factors: government initiatives to support the housing market and remote working leading to more demand, plus a 10% increase in average sales fee charged (in line with increasing house prices).

Sales agreed are considerably higher than 2019 and this momentum has continued beyond the reported period. Given its pipeline, TPFG remains optimistic about the sales market this year.

Lettings income is proving to be resilient, with a 7% like for like increase in MSF over the same period in 2020.

EweMove, the hybrid estate agency, has continued to build on its brand positioning, with the sale of 37 new territories in the period setting a new record for the total number of territories operating of 149. It’s on track to double the size of territories to 230 by end 2022.

The integration of Hunters continues to progress well. TPFG has historically focused on lettings, so this acquisition of a more sales-focused estate agent was well-timed.

Chief Executive Officer, Gareth Samples, commented:

We are delighted to report that the first six months of trading have been an exceptional period for the Group. The UK's housing market has seen activity levels that I have not witnessed before in my career, supported by peoples' desires to move homes.

Conclusion

Given the strong trading and favourable market dynamics, TPFG is confident of a ‘very strong trading performance for the full financial year’.

And it remains modestly valued at 13.8x forecast earnings and with a forecast yield of 3.5% even after its rerating. It has a smaller market cap than Everyman, for example, but with market-leading profitability and quality characteristics.

Are current conditions sustainable? At some point the wider housing market might turn and government initiatives could be withdrawn or changed.

But while the share price could fall at some point due to changing macro conditions, TPFG itself will survive because of its strong finances, sticky lettings revenue, and cash generation. And over the longer term, through the cycles, the group has proven its ability to grow steadily in a large market. So it looks like a sensible buy and hold candidate to me.