Small Cap Value Report (Mon 23 Aug 2021) - ZOO, RNO, SRC UPGS

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

Agenda -

Paul's Section:

Renold (LON:RNO) (I hold) - a positive trading update, ahead of expectations, with strong order intake in particular. Supply chain problems are mentioned, but despite this expects performance to beat market expectations. Don't forget the large pension scheme deficit.

Up Global Sourcing Holdings (LON:UPGS) - another positive trading update. FY 07/2021 ended well, with profits 4% ahead of market expectations. Current trading is in line, despite supply chain disruption. Equity Development raises current year EPS forecast by 3%. Valuation still looks reasonable, despite multi-bagging from the pandemic lows last year. Looks good, providing nothing goes badly wrong with shipping from the Far East - which is a risk, albeit one that UPGS has managed well to date.

Jack's Section:

Zoo Digital (LON:ZOO) - revenue ahead of expectations and conversion of a loan note. Momentum is returning here, but the valuation is high and the group has so far struggled to generate profits.

Sigmaroc (LON:SRC) - impressive update from this highly acquisitive construction company. The pace of inorganic growth is very high and Nordkalk adds to that (although it should pave the way for organic growth as well), but the team has so far shown that they are up to the task of capitalising on the identified consolidation opportunity. The scale of equity dilution and the quality of asset acquisitions going forward are key.

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), and make your own investment decisions. 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.

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Paul's Section

Renold (LON:RNO)

(I hold)

19.5p (pre market open) - mkt cap £44m

AGM Trading Update

Renold, a leading international supplier of industrial chains and related power transmission products, issues a trading update covering the four months ended 31 July 2021 (the "period") ahead of the Company's Annual General Meeting ("AGM") being held at 10 am today.

This is a positive update -

The Board is pleased to report that the strong momentum experienced in the fourth quarter of the last financial year has been maintained in the new financial year, resulting in the continued recovery of both revenues and order intake.

This is the most important bit -

Renold benefits from significant geographic, customer and sector diversification. Consequently, and despite uncertainty caused by considerable raw material and transport cost inflation and continuing supply chain disruption, the Board now expects adjusted operating profit for both the first half and full year of FY22 to be higher than both market expectations and the equivalent prior year period.

Higher than market expectations is the key phrase within the above.

Order intake was £79.7m in the 4 months, up strongly on prior year - up 61% in reported currency, up 69% in constant currency, and up 39% in reported currency if a large £11m long-term military contract is excluded.

Comparisons against last year are not terribly valid, as it was impacted by lockdown one. So I’ve checked back to last year’s interim results (April-Sept 2020), which show order intake down 21%, and total order intake in H1 LY was £76m (NB not the same as revenues).

Therefore, to have achieved £79.7m order intake in the the first 4 months of this year, which beats the order intake of £76m in 6 months of the previous year, looks good. The commentary last year said that customers were de-stocking when covid first hit, but orders gradually returned.

Renold has the benefit of reliable maintenance cycles for many of its products, so customers often have to buy replacement chains on long-term maintenance cycles, to prevent machines breaking down. It’s not quite recurring revenues, but a lot of revenues are repeating revenues over long term cycles. Renold also says that a key competitive advantage it has, is a reputation for high quality and reliability - which enables it to charge premium prices. The driving chains are a relatively small part of the total cost of the machinery, so customers generally don't skimp buying lower quality replacements.

Order intake was down 21% last year H1, and up 39% this year (4 months), means up c.15% on a 2 year basis - i.e. I think it’s correct to say order intake has now recovered to well above pre-pandemic levels, although the company doesn’t specifically say this in today’s update. Some of that could be catching up on pent-up demand, so it’s probably safest to say the company looks to have recovered to at least pre-pandemic levels or order intake. Remember it also stripped out a lot of cost over the last 2 years, so profitability should be looking healthy. Hence we could see another surge in interest for this share when interim results come out later in 2021 (probably November).

Revenue - because of the time lag between orders being placed, and being delivered, the percentages for revenue growth won’t be as large as the gain in order intake -

Sales revenue for the period, at £62.5m, represents an increase of 13.6% on the prior year equivalent period or 19.9% at constant exchange rates.

H1 LY revenues were down 17%, so being up 13.6% this year, means so far it’s recouped most of last year’s fall in revenues. With a much stronger order intake, then it’s logical to assume the recovery in revenues should gradually improve as FY 03/2022 progresses.

Net debt - this is also impressive. Remember that companies often face their biggest squeeze on liquidity not during a slowdown, but in the subsequent recovery, as inventories and receivables both suck in cashflow once expansion is underway again. Therefore I’m impressed that net debt at Renold remains low.

Also note what it says about much lengthened supply chains - it’s becoming very clear that supply chain problems with the Far East, and a chronic shortage of lorry drivers in the UK, is likely to be the main problem facing companies and investors over the coming months - expect plenty of profit warnings from companies which don’t rise to the challenges, or are too small to have the negotiating power possessed by larger companies -

Net debt remained stable during the period and totalled £18.5m as at 31 July 2021, despite an increase in working capital due to the improved activity levels and much lengthened supply chains, compared to £18.4m on 31 March 2021.

Broker updates - these are restricted to paying clients only, so my request to the house broker this morning for an update note was refused.

My opinion - I see this as an encouraging update.

Renold shares looks ridiculously cheap on the surface, but there is a reason - a large pension deficit. The way I see it, the pension deficit sucks c.£5m p.a. in cash out of the business, which could otherwise be used for dividends.

The bear arguments for RNO are that the business has been restructuring for many years, and has only generated enough cashflow to fund capex & the pension deficit in recent years. That’s a fair point actually.

On closer inspection though, I feel there are good signs here of a more resilient business emerging. Today’s update reinforces my conviction on that.

Renold operates in a fragmented market, with lots of potential bolt on acquisitions, small businesses that operate in specialised niches. Therefore I hope to see Renold act as a consolidator, which over time would grow the group, and hence dilute the pension scheme problem. Remember that Renold got through the pandemic without having to dilute shareholders, no mean feat.

Renold itself could become a bid target too, with all the transatlantic interest in UK companies currently.

Overall, I see much more upside potential than downside risk at the current valuation (note it’s up 17% to 22.5p whilst I’ve been typing up the above).

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Up Global Sourcing Holdings (LON:UPGS)

224p (up 6% at 08:55) - mkt cap £237m

Ultimate Products, the owner, manager, designer and developer of an extensive range of value-focused consumer goods brands, announces its trading update for the financial year ended 31 July 2021 ("FY21").

I’ve lost count of the number of positive updates we’ve had from this company since the pandemic lows last year. Shares have performed amazingly well since, and it’s fully justified by strong growth in profits. I last looked at UPGS here in late June, on a sensible-looking acquisition of Salter, concluding that the shares looked fairly priced (i.e. not expensive) at 214p.

Here’s my summary of today’s update -

• Salter - acquisition completed on 15 July. Going as planned. Significantly earnings enhancing in FY 07/2022
• Revenues FY 07/2021 up 18% to £136.4m, despite “significant operational & shipping disruption” caused by the pandemic
• Underlying profit before tax (PBT) up an impressive 37% to £11.2m
• Underlying PBT is £0.4m, or c.4% ahead of market consensus, we’re told

Net debt -

Net bank debt increased by £15.1m to £18.9m (FY20: £3.8m), reflecting £17.2m of increased borrowings to fund the acquisition of Salter in July, offset by strong operating cash flows during the financial year

That section doesn’t really stand up to scrutiny. I understand the point that the Salter acquisition (part funded by 8% dilution from an equity fundraise at 215p, the balance by borrowings) caused net debt to rise by £15.1m. It says £17.2m of that was to fund Salter. So surely that means other operational cash flows were only £2.1m? That doesn’t sound much from a profit of £11.2m. I’d need to see all the figures to be sure, so await the published results in due course.

It doesn’t really matter though, as net debt looks fine overall, at 1.4x EBITDA, and as the company says today, it has plenty of headroom on its facilities. It’s not a problem when companies are trading well, to take on a bit of debt, and this looks perfectly manageable.

Current trading/outlook -

Order book for core business is ahead of this time last year (no figures provided)

Shipping problems -

Shipping availability continues to present challenges with forward orders from the Group's retail customers being prioritised ahead of stock purchases. Management expects that global shipping will remain disrupted until after Chinese New Year (February 2022)

I’m really not sure how much emphasis we should put on the current widespread disruption to shipping, and higher costs? It’s obviously a temporary phenomenon, but highly likely to cause some profit warnings. Will investors look through those profit warnings? No, I don’t think so - look what happened recently with Avon Protection (LON:AVON) - it plunged 28% on short term, fixable problems, which doesn’t make a lot of sense to me. But who said markets were rational? The share price is only the balance of immediate buyers & sellers, not a rational valuation of any business, so prices can & do detach from reality all the time. Especially with smaller caps with limited liquidity. It only takes one fund manager to dump aggressively in the market, and the price gets trashed, and often takes a long time to recover.

This reminds me a bit of the discussions we had last year before the pandemic took hold. My view at the time was that if you’re nervous & likely to be spooked by profit warnings, then it’s best to sell first and ask questions later. If you’re a long-term holder and don’t let short-term issues bother you, then it probably makes sense to ride out any short term, fixable problems. The worst thing to do, in my opinion, is to do nothing, then panic sell when the bad news comes out. But it depends what that news is, every profit warning is unique, so there isn't a strict rule that applies in every case.

I wish we had a crystal ball, and could predict which companies can successfully trade through these supply chain issues, and which ones are likely to falter. Your guess is as good as, or possibly better than mine on such a big uncertainty.

All I would say with UPGS, is that it’s demonstrated considerable ability to manage supply chain problems well throughout all the disruption of the last 18 months. That makes me lean towards thinking it might be at lower risk than some other importers in the coming expected c.6 months of further disruption, but nobody really knows, it’s largely guesswork.

Current trading remains in line with expectations, with growth expected in FY22 both from the core business and through the acquisition of Salter

It’s worth checking broker updates, to see if companies are quietly guiding analysts down, if management think tough times are ahead (although that often doesn’t happen - e.g. the brick wall that Best Of The Best (LON:BOTB) (I hold) recently ran into).

Broker upgrades - Equity Development has issued an update this morning, and it’s pencilled in 10.5p for FY 07/2021 and 14.1p (previously 13.7p) for FY 07/2022. That’s reassuring. The big year-on-year jump is justified, since Salter will add a lot of extra profit into the new year, and is only included for about 2 weeks’ trading in FY 07/2021. Hence I think the ED forecasts look credible.

Valuation - at 224p per share, and using the 14.1p EPS forecast for this new year, FY 07/2022, gives a PER of 15.9 times. I think that’s a fair valuation, given how well the company has done, and is doing.

Dividends - ED is forecasting 5p for the year just finished, and 7p divis for FY 07/2022, quite a useful yield of 3.1%

My opinion - there were problems in the past, but that seems to be well and truly in the rear view mirror. This company is performing very well, making a decent profit margin, growing nicely with a sensible recent acquisition, and debt looks comfortably under control.

There’s a lot to like here, providing nothing goes wrong again.

Well done to anyone who bought at or near the lows. Although it certainly was not obvious at the time that recovery would be so strong.

Stockopedia consistently likes this share, with a high StockRank - not a panacea for individual stocks, we know, but it does work on a portfolio basis most of the time, hence is part of my toolkit.

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Jack’s section

Zoo Digital (LON:ZOO)

Share price: 140.4p (-0.78%)

Shares in issue: 82,291,998

Market cap: £115.5m

Zoo Digital collaborates with a global network of thousands of freelance workers, ‘reduc[ing] the human capital requirements of service fulfilment’ and increasing the reach of content. It does this for Hollywood studios and others by providing technology-enabled localisation and media services.

Services include dubbing, subtitling & captioning, metadata creation & localisation, artwork localisation and media processing.

It says its business model leads to high operational gearing but that’s not yet obvious from the financial results alone. It can be hard to tell with loss-making software companies - some are building the great businesses of tomorrow, others will forever struggle to turn a profit.

Zoo was founded in 2001. That’s quite a long time, and to remain at this stage now is a slight concern. It was loss-making in the most recent financial year - a net loss of $3.16m - with negative earnings per share of 4.24 cents.

The top line has been increasing by about 27.7% per year for the past five years though. In FY21 it made $39.5m in revenue, forecast to increase to $45.9m, which would be up another 16%. After today’s update, FY22 revenue forecasts may well be increased.

There has been some equity dilution as the group funded this growth, so a share price of 141.5p makes for a market cap comfortably higher than £100m. It does say the addressable market is around $1.3bn. So there is growth priced in but also improving momentum and a reasonably large opportunity should the group capitalise on that demand.

Trading update

Based on the strong performance in the first half of the year and the pipeline of orders that extends only into the first months of the second half, the Board is confident of exceeding current full year revenue expectations. The additional gross profit generated will be utilised to continue to invest for future growth and take advantage of the many opportunities present in our marketplace to build our business further.

Revenue for the half year is expected to be at least up 51% to $25m. This growth is due to services provided to support the migration of catalogue titles to streaming platforms. Zoo is also seeing the gradual return of orders relating to new titles and the group expects the pipeline here to ‘build gradually over the coming months’.

There are plans to establish regional hubs and it’s working on strategic investments that will provide a presence in India and other international locations.

Convertible loan note

The board expects the majority of a £2.56m loan note to be converted into shares at a conversion price of 48p per share before the 30th of September.

Assuming all of that is converted:

• share capital will increase by 5.3 million new Shares,
• current liabilities will reduce by approximately $3.5m due to the conversion of the loan and a further $4.5m due to the elimination of the current liability shown as a separable embedded derivative linked to the loan, and
• From November, finance cost savings will amount to c$263,000 on an annualised basis.

Conclusion

Momentum is improving here, with new production returning. I wonder how capital intensive setting up new regional hubs will be.

The group talks about operational gearing but I can’t immediately see high levels of profitability from outsourced subbing and dubbing work. Zoo says it is clearly differentiated from similar service providers by its proprietary cloud computing systems but that’s not yet reflected in the results and the group has been around for two decades now. How much would content providers pay for this kind of service?

It’s quite possible that the losses / lack of meaningful profitability actually reflect ongoing investments into future business. The group says as much for the current year, with the extra gross profit from better-than-expected revenues to be reinvested into growth opportunities.

I can see how there’s demand for its services, but I wonder if this is the right place to be as an investor in the value chain. On a long term view, where will the bulk of profits reside: with the content creators or the outsourced help? I would imagine the former.

There’s an opportunity to grow but the long term margins are unclear to me and the valuation puts me off for now. Even if we ignore earnings as intentionally low, the group still trades on 4x trailing twelve month revenue.

Sigmaroc (LON:SRC)

Share price: 103.98p (+2.44%)

Shares in issue: 279,876,576

Market cap: £291m

This is a rapidly developing buy and build group in the construction sector. Management identified a consolidation opportunity in Europe, with much larger construction companies going through a phase of divesting non-core assets, so SigmaRoc stepped up to re-package some of the choice quarry and construction sites into new ‘platforms’ of businesses.

So far it looks to have been a rewarding ride for shareholders, albeit one in which the majority of gains have come in the past year or so.

This is a highly acquisitive company that has a track record of raising funds from shareholders, so shares in issue have more than doubled since 2017. There’s a balancing act to get right there but the management team certainly has a sense of ambition and urgency about it.

Interim results

Highlights:

• Underlying revenue +55.5% to £84.8m (+13% pro-forma),
• Underlying EBITDA +39.8% to £15.2m (+17% pro-forma),
• Underlying profit before tax +63.8% to £8.7m,
• Underlying earnings per share +35.4% to 2.68p,
• Cash and equivalents +15.4% to £19.9m.

Underlying results are stated before acquisition related expenses, some finance costs, redundancy and reorganisation costs, impairments, amortisation, and share option expenses.

Revenue and underlying EBITDA have increased in part due to the inclusion of G.D. Harries which was previously equity accounted (meaning only the group’s share of profit was reflected), together with the acquisition of B-Mix and Casters in April 2021.

Operational highlights include the launch of Greenbloc, which is a cement-free low carbon concrete block, the expansion of Belgian aggregates operations, the acquisition of B-Mix and new European platforms, a joint venture with Carrières du Boulonnais, and the conditional acquisition of Nordkalk via reverse takeover.

It’s an impressive rate of activity and in a rapidly evolving venture like this, acquisition and execution risks are high. The management team needs to be competent and focused.

Max Vermorken, CEO, commented:

We have delivered attractive acquisitions in Belgium, which are already providing meaningful contribution to the Group's top and bottom line. The acquisition of Nordkalk will be a great stepping stone in the evolution of the Group, expanding our footprint across Northern European markets, and will bring significant earnings growth and cash generation to the Group.

The group's Adjusted Leverage Ratio, after the deployment of the funds raised in December 2020, stands at 1.71x compared to 1.69x at the end of 2020.

The proposed acquisition of Nordkalk constitutes a reverse takeover and is being funded with a placing of 305.9 million shares at 85 pence per share. That’s huge, much bigger than I’d realised. For context, shares in issue have gone up from 117m in 2017 to 280m today so it’s a big acquisition that materially changes the group’s profile. The total consideration is some €470m subject to certain adjustments including in respect of cash, debt and working capital.

Nordkalk was founded in 1898 in Finland and is one of Europe's prime limestone products operators. Its asset base is properly positioned to competitively supply all key pockets of demand of the jurisdictions it operates in. That’s an important point to the investment case: location is key here. A better located quarry outcompetes a less well-located one, and you can’t just set up a competitor next door unless it has the right raw materials.

Following completion, Nordkalk will form SigmaRoc's sixth platform and add a core limestone products stream to the Group. Abiding by SigmaRoc's successful and decentralised operating principle of "federation of companies", Nordkalk's senior management team will remain in place under the leadership of Paul Gustavsson, who will join the Group's Executive Committee.

SigmaRoc generated underlying revenue of £84.8m and underlying EBITDA of £15.2m in the six months to 30 June 2021. Nordkalk generated revenue of approximately £126.5m and EBITDA of approximately £31.3m.

Conclusion

Sigmaroc is a very interesting company, but the sheer pace of development here might make some wary.

The management team looks to have done a great job so far though and there’s no doubting the sense of ambition here. But you are essentially handing over your cash to help Vermoken et al build a large enterprise through a mixture of equity dilution and debt, while reporting adjusted results.

From a business standpoint, the progress is impressive and the group is assembling well-located assets that are difficult to compete against. But from an equity holder perspective results must be considered on a per-share basis.

One way or the other, I feel that SigmaRoc is a name to look out for in the years ahead. But will the story be a successful one for shareholders, or a tale of empire-building equity value destruction? My sense is that it will probably be good, with a clear strategy of acquiring well located quarry assets, strong routes to markets, and a correctly identified consolidation opportunity. A philosophy of extreme delegation to on-site experienced management teams, with the head office remaining small and focused on capital deployment, strikes me as the right way to play it.

But the dilution needs to be closely monitored, and the acquisitions must remain earnings per share accretive. Nordkalk is by far the most significant (and therefore riskiest) development, but the team here has shown that they are so far up to the task. You need to trust that the management is building this enterprise with today’s shareholders in mind.

That aside, so far, the progress has been impressive.