Small Cap Value Report (Weds 25 Aug 2021) - SPE, COST, CLG

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

Agenda -

Jack's section:

Sopheon (LON:SPE) - product lifecycle software company with some good blue chip clients and an encouraging track record of investment back into its products. Growth has been slow, stalled by its transition to a longer-term SaaS-based business model, but there are good signs of growth in this latest update.

Costain (LON:COST) - the scale of this business is large in comparison to the market cap, so there is scope for a rerating if trends are favourable and infrastructure activity picks up. But this is a low margin business with large and complex contracts. There's not much security if things go wrong.

Clipper Logistics (LON:CLG) - impressive full year results from an in-demand e-fulfilment logistics operator. It's well placed for further organic growth in the UK and Europe and appears to have carved out a strong market position in what can be an unforgiving sector. The valuation is quite pricey but the fundamentals are strong so a premium looks to be justified.

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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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Jack’s section

Sopheon (LON:SPE)

Share price: 980p

Shares in issue: 10,499,613

Market cap: £102.9m

Sopheon is an international provider of software and services for product life cycle management. Its Accolade® solution supports strategic roadmapping, idea development, product portfolio management and the creation, commercialization and replacement of products. It’s got operating bases in the US, the UK, and the Netherlands, with distribution, implementation and support channels worldwide.

The valuation looks high given the historic rates of growth but these growth rates are restrained by the transition to a SaaS model. Like many software companies, Sopheon is gradually shifting from one-off licence fees to annual recurring revenues. That means lower revenues in the short term, but a higher quality recurring revenue base building in the long term, which provides greater visibility and stability of results.

Even so, with all the R&D the group spends, faster growth is required and shareholders have so far had to be quite patient. In FY20, the group made just 14.1 cents in earnings per share against a current share price of 980p.

The trouble with this, is that it makes the business look ex-growth, and the transition takes years. And then there’s Covid, which is bound to have had an effect. The company does spend a lot on R&D though, and its balance sheet is strong, so that growth could come. Churn is relatively low, which suggests its products are good.

Interim results

Highlights:

• Revenue +19% to $16.5m, annual recurring revenue (ARR) +20% to $19.8m,
• Gross ARR retention is up from 94% to 97%,
• Full year revenue visibility +22.4% to $31.2m,
• Total contract value (TCV) is 1.3x that of the same period last year, 1.5x for SaaS bookings,
• Adjusted EBITDA +7.7% to $2.8m,
• Net cash up from $21.9m to $24.1m, no debt.

These growth rates are better than the average - so are all the previous investments into R&D and the rest about to come good?

Sopheon has increased product investment in the period, and marketing initiatives are planned. A milestone was the launch of Accolade® for Smart Products, while the release of Accolade 14.0 brings additional improvements to its flagship product.

The group also earned the Authority to Operate (ATO) from the US Navy, permitting dozens of other departments to leverage the Navy's security authorization.

Further product development and marketing and communication expenses are planned for H2. In fact, given where Sopheon is in its SaaS transition and strengthening market opportunities, it is pursuing ‘more aggressive market visibility’.

It says that buyer behaviors have changed permanently, and now rely much more on online research and resources to identify and qualify suppliers. Catering to this channel is where a lot of the investment will be. The goal is to accelerate lead generation and top-line growth.

Increasing TCV is a positive sign, as this will contribute to future growth. The transition to SaaS continues, with all new customers taking these contracts, although extensions from the base will continue to drive perpetual licensing ‘for the foreseeable future’. Growth in both areas has led to total TCV being up by 28%.

The company hopes to transition perpetual licensing customers to SaaS with its "Cloud Lift" program, introduced last year. Four perpetual customers took advantage of Cloud Lift during 2020, and a further five in the first half of 2021.

The improvement in gross ARR to 97% is obviously positive, and the group is seeing less cost-control driven attrition in 2021 compared to last year as confidence builds post pandemic. New orders are ahead of attrition and on the whole, the group’s key indicators are painting a positive picture.

Gross margin rose from 67% to 71% due to a slight decline in consulting revenue. That’s high, but profit before tax for the period was steady at just $0.5m. The extra costs were in sales & marketing, R&D, and admin. Some of this is presumably discretionary and reflects growth investment. Net cash from operations was higher at $4.7m at the halfway stage, which is more interesting for a £102m market cap.

The main cost component is the cost of delivery and support teams. Competition for technical staff has returned and costs of employment in this area continue to accelerate. Staff turnover is higher as well, so this will be a margin headwind but it looks like it’s being outweighed by revenue growth.

Greg Coticchia was appointed CEO earlier in the year to focus on organic growth, giving Andy Michuda capacity to focus on M&A. There have been other senior hires: Mike Bauer as Chief Product Officer, John Beischer as Americas VP of Sales, and Ann Marie Beasley as Chief Marketing Officer amongst others.

Conclusion

There’s potential here - a great client list here and low churn, so that implies the products are good.

The tricky thing with growth investing is that often the companies that do it right are not focusing on earnings, but investment for the future, which can depress the former. So things like the PE ratio become less useful. Sopheon often looks expensive, but it also reinvests a lot of the revenue and cash it generates.

A more earnings focused company might look cheaper but be constraining its growth prospects and reducing its true value by spending less on R&D for example. It’s clear that Sopheon does just the opposite.

Revenue growth is encouraging, but profit levels are rising more slowly through the SaaS transition period, reflecting the switch of revenue model and the rising investment in the business.

Performance has remained solid in the face of the pandemic. The new leadership, embedded in the last 12 months, is spearheading new marketing and product strategies for organic growth. Finally we might see additional business through partnerships and M&A.

If you can get past the lack of profit growth and think longer term, it looks like solid results from a good company investing in the right places. I like the company itself, but the valuation is the thing given how long shareholders have had to remain patient. You’re paying for future growth, but these results do show some promising hints of this.

Costain (LON:COST)

Share price: 62.63p (-1.05%)

Shares in issue: 274,949,741

Market cap: £172.2m

Costain is an infrastructure management company, providing services to rail, aviation, highways, water, energy, and defence operators. It’s very low margin.

Meanwhile, the initial financial checks flag up concerns.

Cash flows have been hit recently, the Quality metrics are uniformly poor, and the group has had to raise a lot of funds from shareholders, with a more than trebling of the share count since 2019 to c275m shares. And no surprise to see a dramatic fall in the share price to coincide with these fundraisings.

All in all, this is not the kind of stock I tend to look for. They can be opportunities for the brave - Costain trades at a fraction of price to sales (just 0.18x) and qualifies for Walter Schloss 'New Lows' Screen for example.

As an aside, it’s interesting to see this screen has performed well in the wake of Covid, but this comes after years of poor performance and brings performance since inception up to just below the All Share over nearly a decade. That’s presumably at higher risk to the investor as well given the potentially distressed nature of the businesses it picks up.

I think it says something about how undiscerning the market rally over the past year has been.

Interim results

Highlights:

• Adjusted revenue +1.7% to £556.8m,
• £334.3m of new work secured and a high level of tendering activity,
• Operating profit up from £5.7m to £11.5m, in line with board expectations,
• Adjusted PBT +147% to £9.4m,
• Adjusted basic earnings per share +33% to 2.8p,
• Net cash of £113m, up from £102.9m.

So improved revenue, profitability, and a solid net cash position. The total order book was £4.0bn as at 30 June 2021, broadly similar to 31 December 2020, which is huge for the c£175m market cap. Costain says it has good visibility on the completion of contracts for the remainder of the year which gives ‘confidence in delivering full year results in line with our expectations’.

It looks like that’s for normalised earnings per share of around 7.6p per share, which gives a forecast PE ratio of less than 10x.

The group says it ‘is in a strong position with a high volume of secured long term programmes and a positive market outlook, in particular the UK Government's commitment to invest in infrastructure to support the levelling up of our economic activity and decarbonisation of our environment.’

I wouldn’t say it looks like it’s in a particularly strong position. But the current environment and outlook does seem supportive for a recovery.

The group has some exposure to HS2. If a project like this were to be aborted, is the group robust enough to survive? Perhaps it’s an unlikely worst case scenario, but it’s certainly possible, and I think potential downside risks are something to consider here.

On the flip side, assuming management successfully wins new business and improves margins, there’s potentially good upside as well.

Conclusion

It’s just not a business model or situation that interests me, frankly. Low margin with a lot of risk. It’s the type of situation where, if it recovers, then it looks obvious in hindsight. But people might forget the level of risk that was involved at the time.

That said, Costain does have a fairly good net cash position. Current liabilities are high though at £273.4m, the bulk of which (£252.5m) is trade payables. This is set against £157m of cash (which comfortably dwarfs the £35.8m of interest-bearing loans) and £221.7m of trade receivables. The pension fund situation is healthier than it has been in the past.

The strategy to reduce contract risk sounds sensible and the new contract wins are good news, especially if matched with ‘clear bidding discipline’ as management says. And the total pipeline is £4bn on revenue of more than £1bn - the market cap is very small for the size of the business.

It could be a buying opportunity and I can see the company continuing to recover, but this is probably also an accident-prone sector. Complicated, large contracts, on low margins... In fact, I see that Paul opted to drop coverage back in September.

It’s a big company, the risks are high, and, while a rerating could be substantial, I’d kick myself if I bought in and new issues crept up. What if labour costs increase substantially, or other input pressures arise? On the other hand, if conditions remain supportive and management successfully executes, then the shares will rerate. The government will be spending quite a lot of money on infrastructure in the years ahead.

Perhaps if you reduced the company-specific risk in the portfolio by holding smaller weightings of more companies, you could argue to include Costain in a basket of recovery stocks, but I can’t say I’m tempted.

Clipper Logistics (LON:CLG)

Share price: 810p (-0.25%)

Shares in issue: 101,830,439

Market cap: £824.8m

Clipper has carved out a strong position in the logistics sector as a value-added provider of e-fulfilment and returns management services. The demand for this strategy can be seen in the group’s impressive revenue growth.

And it has also led to an excellent return for shareholders.

But now the shares trade on historically high multiples. The compound annual growth rates in the Financial Summary are impressive, and this is forecast to continue over 2021 and 2022. Beyond that, I wonder if the competition from other logistics operators will increase - or perhaps the group is just so good at what it does that they will struggle to catch up.

E-fulfilment and returns are very important to online operators so they presumably wouldn’t want to go to other logistics operators undercutting on price unless they could be sure of similar levels of service and reliability.

Additionally, the outlook here could be important as society opens back up. Some Covid winners are reporting a sudden reversion in trade but there doesn’t seem to be any sign of that from Clippers today.

Final results

The Group has made a strong start to the new financial year and is trading in line with its recently upgraded guidance for FY22. The Group's pipeline of new opportunities remains buoyant and further momentum with new contract wins is expected during the year.

Highlights:

• Revenue +39.1% to £696.2m,
• Underlying operating profit +52.4% to £31.4m,
• Profit after tax +33.8% to £21.7m; +61.9% on an underlying basis,
• Basic earnings per share +34% to 21.3p; +62.6% on an underlying basis,
• Total dividend +14.4% to 11.1p,
• Net debt down from £45.1m to £16.9m.

That gives a dividend yield of 1.36% and a PE ratio of 38x. Quite pricey. Cash flow is much better though: net cash from operations of £86.9m and capital expenditures of £9.7m suggesting free cash flow of £77.2m, or 76p per share, which is just a 10.7x multiple.

The business continues to be highly cash generative. It is typically paid in the month in which services are delivered on open book and minimum volume guarantee contracts, making for a typically net favourable impact on working capital, while in the commercial vehicles division working capital is substantially funded by the manufacturer through stocking facilities for new vehicles and trade credit.

The group has clearly benefited from significant organic growth driven by e-fulfilment volumes as a result of the ‘permanent’ structural shift to online. Notable existing contract extensions include ASOS, Farfetch, John Lewis, Westwing, and Wilko. Non e-fulfilment volume growth came from Asda, and Morrisons.

Meanwhile, Clipper’s ‘technology-led end-to-end’ e-commerce logistics proposition resulted in multiple new contract wins including Linenbundle, Revolution Beauty and Unipart.

Technical Services saw significant increases in activity on the Amazon, Panasonic and Vestel contracts. Nintendo repair volumes continued to grow from the prior year. Additional investment has been made to increase processing capacity here.

Post year end events include the acquisition of Wippet (which will launch an online B2B marketplace to service the broader healthcare sector in the UK), new operations with Mountain Warehouse and JD Sports, the integration of a River Island site in Milton Keynes following the outsourcing of their logistics, the opening of a new facility for Farfetch in the Netherlands, and additional business in Ireland for John Lewis and Life Style Sports.

The group has significantly expanded its estate portfolio to 16.0 million sq. ft. of space now under management in over 50 locations in five territories across Europe, reflected in some £51m of additional property leases. 2,000 new colleagues have been added to the company.

You’ve got to say it’s an impressive rate of activity and expansion, with a high calibre of clients.

Looking to the next year, Clipper expects the full benefit of new online business wins to be reflected, along with growth from existing customers, and the ongoing conversion of its new business pipeline. It sounds very positive.

Steve Parkin, Executive Chairman of Clipper commented:

The market has witnessed significant recent change particularly with the acceleration of the growth in e-fulfilment which now represents 70% of our logistics revenue. Our unique proposition, which offers the full end to end range of services within the e-commerce field, has allowed the Group to benefit from this strong dynamic and will provide further momentum in the coming years. Our recent contract wins demonstrate that we are our customers' partner of choice both in and outside of the UK, for delivering innovative, sustainable, and resilient added value solutions… The prospects for the Group remain strong and we are confident that we will deliver further shareholder value accretion in the coming years".

Conclusion

This looks like an excellent business and the calibre of clients coming to Clipper really does suggest it is the e-fulfilment logistics partner of choice in the UK (and potentially Europe). Will any of this revert as physical stores open back up? The group’s organic momentum seems very strong.

But so too is the share price - in fact, Clipper is now outside of the usual SCVR remit. But this really does seem like a quality player that I wish I’d paid more attention to earlier. I’d back the company to continue growing, but am unsure if I would buy in at these levels.

If I had held the shares for a long time already, I’d be tempted to continue holding though as it seems to have really nailed its strategy.

The group continues to be a leading provider of value-added logistics and e-fulfilment solutions to the retail sector in the UK, and is growing its operations in Mainland Europe. The pipeline of new opportunities remains strong and management expects further momentum with contract wins in the current financial year.

It’s well placed to continue benefiting from the structural shift to online, its services are in high demand, and it has also proven its appetite for acquisitions. The current price is above what I would pay but the fundamentals are strong, certainly one for the watchlist.