Small Cap Value Report (Thurs 2 Sept 2021) - MPAC, GYM, INSE, HEAD

Good morning, it's Jack & Roland here with the SCVR for Thursday. Paul's currently at the airport, heading for some sun.

Agenda -

Jack's section:

Mpac (LON:MPAC) - robust half year statement, with acquisitions going well and trading recovering. Full year expectations are upgraded by the company and Equity Development has nudged up its forecasts. There's a fairly significant pension scheme here, and the valuation looks reasonably full, but momentum is good and the outlook suggests this is warranted.

Inspired (LON:INSE) - Improving figures from a company focusing on ESG solutions in the Energy sector. The opportunity could be big here, but the current market cap already suggests a degree of growth is priced in.

Roland’s section

Gym (LON:GYM) - this gym operator says demand has been strong since reopening, but it’s rebuilding from a lower membership base than one year ago. Is the valuation ahead of events?

Headlam (LON:HEAD) - a solid half-year has seen sales (and underlying profits) return to 2019 levels. Not the bargain it was, but still a good business at a fair price, I suspect.

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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

Mpac (LON:MPAC)

Share price: 626.7p (+4.45%)

Shares in issue: 20,171,540

Market cap: £126.4m

MPAC is a specialist provider of automated packaging systems, an area very much in demand for operators looking to drive efficiencies. These products allow manufacturers across the food & beverage, healthcare, and pharmaceuticals sectors to meet regulatory requirements at high levels of volume output. MPAC expects these end markets to enjoy long term annual growth rates of between 4% and 5%.

Revenue has not gone up in a steady line though. MPAC has had to work hard to get itself into a promising position, but the company is now back in growth mode.

MPAC is using its end-to-end solution to help reduce single-use plastics, encourage ‘green’ packaging alternatives, and reduce unit sizes. The resulting offering appears to be quite high-tech and stretches from design concepts through to training programmes and system upgrades or full line modernisation.

Shares have had a fantastic run over the past few years and there are signs its strategy is a successful one, with rising revenue, profit, and cash flows.

Half year results

We remain well placed, serving markets with strong underlying demand and are pleased to be upgrading expectations for the full year results given the strength of current trading and our outlook for the second half.

Financial highlights:

• 69% increase in order intake to £51.7m; closing order book grew 12% to £62.0m,
• Revenue +20.1% to £44.2m, with a 25% growth in Original Equipment revenue and continued progression in service revenues,
• Underlying profit before tax of £4.7m (2020: £2.5m),
• Underlying earnings per share of 18.3p (2020: 11.0p),
• Net cash of £10.3m (down from £14.6m on 31 December 2020).

MPAC notes strong momentum on order intake and an enlarged order book, with the Americas region driving performance. The outlook in EMEA is also improving.

Regarding the US, the newly acquired Mpac Switchback business is fully integrated and exceeding expectations. This business is relocating to a showcase facility which will also function as Mpac USA headquarters. The new site will allow the company to demonstrate to its US customers ‘the full suite of Mpac brands, solutions, and services in this critical market’.

Underlying results are stated before pension related charges of £0.5m (2020: £0.3m), amortisation of acquired intangible assets of £0.9m (2020: £0.8m), acquisition-related reorganisation expenses of £0.2m, and other non-underlying items of £0.3m.

Net cash outflow from operating activities in the first half of the year was £3.3m, after an increase in working capital levels of £7.2m, due mainly to the timing of project execution, and deficit recovery payments to the group's defined benefit pension schemes of £1.6m. So the cash charge on the pension fund was more than that reported in the P&L.

The IAS 19 valuation of the UK scheme as at 30 June 2021 shows a surplus of £26.8m (£17.4m net of deferred tax), compared with a surplus of £14.0m (£9.1m net of deferred tax) at 31 December 2020. You could write thousands of words on any one company’s pension fund situation so I won’t go into detail too much here but to summarise:

• UK scheme has £429.4m of assets and £402.6m of liabilities as of 30 June 2021, meaning a net surplus of £26.8m,
• The USA schemes are much smaller: £10m of assets and £12.3m of liabilities for a £2.3m net liability,
• Together it’s a £24.5m net surplus for the group on a combined basis.

So a large combined pension scheme for the size of the operating company, but one that is in surplus.

A formal valuation of the UK defined benefit pension scheme (by far the most significant) was carried out as at 30 June 2018. The terms below are effective until 31 July 2024 but subject to reassessment every 3 years:

• the Company will pay a sum of £1.9m per annum to the fund (increasing at 2.1% per annum) in deficit recovery payments,
• if underlying operating profit exceeds £5.5m, the company will pay to the fund 33% of the difference between the annual underlying operating profit and £5.5m, subject to a cap on underlying operating profit of £10.0m - this part of the agreement will fall away in 2021 if the funding deficit is below certain levels, and
• Dividends to shareholders will not exceed the value of payments being made to the fund in any one year.

These points are worth revisiting as it reminds shareholders that the pension schemes have a say on the company’s profits. That said the situation looks ok here and there’s every chance that MPAC can negotiate more favourable terms going forwards, with a reassessment due any time now.

One Mpac’s unified business processes strategy reached a milestone with the go-live of its global ERP (enterprise resource planning) systems. ERP systems implementation can be risky but, if executed well, can lead to much more streamlined operations.

The group also notes an uptick in sales of newly developed products and a continuation of customer developed options.

Contract with FREYR, a developer of clean, next-generation, battery cell production capacity - this sounds like a first step into a potentially large new vertical. There is clear global demand for electric vehicles and the associated establishment of battery Gigafactories and MPAC’s automation products look well suited to this growing market.

Conclusion

The price is back to all-time highs and that looks to be fully justified based on the company’s performance, its strategy, and the scope for organic and inorganic growth. Trading is ahead of expectations and in the longer term, there’s potential for growth rates of around 5% plus gains from acquisition synergies and any additional acquisitions in future.

The US market could drive organic growth, as could new product development.

Earnings per share are forecast to grow to 33.5p in FY21 and then 36.4p in FY22, which would mean a PER of 17.9x falling to 16.5x. I would say it’s getting back to around fair value at that level, but then again we have the current trading momentum hinting that these forecasts might need to be nudged upwards.

Indeed, Equity Development follows the company and has a new note out with revised forecasts: FY21 revenue raised from £95.0m to £97.5m (+16.4%YoY) and FY22 raised from £100.0m to £105.0m. Its fair value / share estimate has also been increased from 600p to 660p. That sounds like a reasonable interpretation: a previously fair to full valuation nudged upwards by 10% on strong trading and outlook.

MPAC’s services look to be well positioned to enable companies to automate their production lines, and the group has built up positions in verticals with solid long term growth prospects. The pension scheme is a bit of a question mark but is currently in good shape on an accounting basis.

All in all this looks like a good company exposed to growth markets that can continue to drive both organic and inorganic growth going forwards. The shares are up today and at these levels you would be hoping for strong ongoing growth in the years ahead, but MPAC continues to execute.

Inspired (LON:INSE)

Share price: 21.03 (+1.08%)

Shares in issue: 973,787,427

Market cap: £204.8m

Inspired is a leading technology enabled service provider supporting businesses in their drive to net zero. It controls energy costs and manages company responses to climate change.

In fact, it recently changed its name to Inspired from Inspired Energy in order to reflect this shift to a technology enabled ESG service provider. Operations are now structured across three divisions and four reporting segments, all underpinned by long term structural growth drivers:

• Inspired Energy - Energy Solutions (comprising two reporting segments, Energy Assurance Services and Energy Optimisation Services)
• Inspired Software - Software Solutions
• Inspired ESG - ESG Solutions

Half year results

Financial highlights:

• Revenue +31% to £32.62m,
• Gross profit +19% to £24.09m,
• Adjusted profit before tax +18% to £6m,
• Statutory PBT -1% to £0.94m,
• Adjusted diluted EPS -20% to 0.53p; diluted EPS -50% to 0.07p,
• Net debt -10% to £30.17m,
• Order book +12% to £69m,
• Interim dividend per share +20% to 0.12p

Half year revenue growth of 31% against 2020 achieving organic growth of 19% as the group's customers, markets and economic activity continues to recover.

Industrial and commercial energy consumption levels in H1 were in line with expectations (down 13% on 2019 levels in Q1 and 9% below in Q2), with H2 consumption to date reflecting the continuing economic recovery from the pandemic.

Despite continued disruption, Optimisation Services has shown a strong rebound in performance with revenue growth of 59% in H1 2021. Group adjusted EBITDA increased 15%, to £8.8m (H1 2020: £7.6m).

Underlying cash generated from continuing operations (excluding the impact of deal fees, restructuring costs and repayment of Q2 2020 VAT deferrals) of £1.08m (H1 2020: £7.21m) includes:

• £5.3m increase in trade receivables in the period, the balance of which is expected to be recovered during H2 2021.
• Increase in accrued income on optimisation projects of £0.8m due to timing, with projects restarting and progressed during Q2 2021, with the relevant project invoices raised subsequent to the half-year period end.
• Management expects cash conversion ratios in FY2021 onwards to remain consistent with the levels seen in FY2020.

Inspired is a much-changed company - it completed the acquisitions of Businesswise Solutions and General Energy Management ("GEM") in March 2021.

The group made further strategic progress during the first half of the year, with a strengthened platform capable of generating long term growth as its markets continue to recover from the period of reduced energy consumption during the pandemic

Trading in the year to date in the core Energy Assurance Services business remains in line with management's expectations.

The group's Energy Optimisation Services business also performed in line, with a recovery in Q2 after lockdown disruption in Q1. Demand for optimisation services is continuing to recover in H2 2021 as clients' attention turns to the reopening of premises.

Software Solutions and the recently launched ESG Solutions divisions continue to gain traction.

Conclusion

Positioning business towards the secular trends of ESG and sustainable energy usage seems one of the better long term plays in the energy sector.

It’s hard to gauge where Inspired is on that path on account of Covid disruption and its own turnaround strategy, complete with recent disposal of the SME business. It raised £31.3m gross in a placing last July so has funds for acquisitions aligned to its green strategy. On the one hand that sounds promising, but on the other it makes it hard to anticipate where Inspired is heading and just what it might acquire.

The group is now moving to further differentiate its services, organising into three new divisions: Energy Assurance, Energy Optimisation and ESG Services & Software Solutions. It is also beginning to look to international opportunities to service its clients.

There’s been a rebound in the first half of the year for Inspired and it’s possible that this will be sustained assuming economies continue to open up. So a lot is changing here: acquisitions are being made, a green strategy is being established, and there’s scope for a more sustained rebound in trading assuming there is no more Covid disruption.

Brokers are forecasting FY21 EPS of 1.30p, rising to 1.50p in FY22 and then 1.59p in FY23. So that would be an FY23 PE ratio of 13.2x. Maybe with a fair wind it could beat those forecasts. It’s worth investigating to get a feel for the value of Inspired’s ESG solutions and the size of those markets. It’s certainly managed to grow revenue at a fair clip so far.

But then again, the same can be said for the shares in issue. 460m back in FY15, up to 974m today. So this top line growth has not translated so well into earnings per share growth.

With that many shares in issue, Inspired has a market cap north of £200m on annual revenue of £60m-£65m, so the size of the market opportunity is key here. It’s probably worth doing some more work into the exact nature of Inspired’s services but clearly there is some growth priced in at these levels. The balance sheet looks ok, although I would flag that goodwill and intangibles account for nearly 62.5% of total assets, up from about 58% at the previous balance sheet date.

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Roland's section

Gym (LON:GYM)

Share price 283p (pre-open)

Shares in issue: 178m

Market cap: £502m

Half-year results

“Strong recovery since re-opening and opportunities for accelerated growth”

The Gym Group runs a chain of 190 low cost, 24/7, no contract gyms. The company says it has seen strong demand for memberships since Covid restrictions were lifted in England in July and is now looking forward to a period of sustained recovery.

Today’s half-year results were only ever likely to be a work-in-progress, as they cover trading for the six months to 30 June. Obviously much of this period was spent in lockdown and when gyms reopened in April, restrictions remained.

Let’s start with a look at the financial highlights:

• Revenue: £29.3m (H1 2020: £37.3m, H1 2019: £74.0m)
• Adjusted EBITDA: £6.7m (H1 2020: £6.7m, H1 2019: £24.0m)
• Adjusted EBITDA less normalised rent: £(8.1m) (H1 2020: £(8.2m), H1 2019: £24.0m)
• Adjusted earnings: £(20.9)m (H1 2020: £(22.1m), H1 2019: £7.1m)

We can see that revenue is still less than half pre-pandemic levels. Additionally, Gym Group is still losing money when normal rental costs are factored in (excluding agreed deferments).

One challenge is that membership numbers have fallen sharply since March 2020. However, today’s numbers suggest to me that members are returning to the business at a reasonably strong pace:

• 18 March 2020: 870,000 members
• February 2021: 547,000 members
• 30 June 2021: 730,000 members
• 31 August 2021 721,000 members (company says this fall is due to university holidays)

Assuming no further Covid restrictions, I don’t see any reason why Gym Group won’t continue to recover its lost members and attract new customers over the remainder of this year.

Balance sheet: Gym Group has raised £70m through two equity placings since the start of the pandemic. The group has also secured new debt facilities. These have left the business with non-property net debt of £28m at the end of August and £73m of financing headroom.

The balance sheet looks comfortable to me. At the expense of some shareholder dilution, I think the group looks reasonably well funded.

Outlook: Chief executive Richard Darwin says the group has seen “a higher rate of visits per member and a rapid recovery in overall membership levels” since April. Mr Darwin says the company has identified a number of growth facilities and expects to open 40 new sites by the end of 2022.

This seems ambitious to me, but the market has proved supportive of this story and the company’s product offer seems well-pitched for mass-market consumers, in my view.

My reading of today’s results is that they are in line with expectations.

Valuation: Investors have been buying into this story ahead of the news. Gym Group shares are now trading close to their pre-pandemic highs.

Indeed, factoring in the dilution from two equity placings since March 2020, my sums suggest the shares are now effectively higher than they were before the pandemic.

This rapid rise has left Gym Group shares trading on 69 times 2022 forecast earnings. Stockopedia is now classifying the shares as a Momentum Trap.

My view: I think that Gym Group’s valuation may now be somewhat ahead of events, but this business did seem like a convincing growth story before the pandemic.

For me personally, the valuation is too rich at the moment. However, I can see the potential for medium-term gains, if the company can maintain its planned rate of growth.

Headlam (LON:HEAD)

Share price: 501p (-2.8% at 09:16)

Shares in issue: 85.3m

Market cap: £438m

Half-year results

“Strong recovery to 2019 levels”

One of the main things I’m looking for in company results at the moment is evidence that performance is returning to 2019 levels. As I don’t have a crystal ball, achieving pre-pandemic levels of trading seems to me like a good indicator of a company that’s performing well.

Floorcovering distributor Headlam is a company I’ve rated highly for a while. I know that Paul has commented favourably on the business in previous reports, too. Investors have been buying into the recovery - as with Gym Group, Headlam shares are now trading at or above pre-pandemic levels:

I’m interested to see how the group has performed during the first half of this year, which saw lockdowns in many of the company’s markets.

Half-year results: Today’s results cover the six months to 30 June 2021.

The commentary starts with the welcome news that revenue during the first half of 2021 was in line with 2019 levels. On an underlying basis, profits and margins are also comparable with the first half of 2019.

Here are the main financial highlights:

• Revenue: £329.9m (H1 2019: £335.0m)
• Gross margin: 32.7% (H1 2019: 32.4%)
• Underlying pre-tax profit: £16.7m (H1 2019: £16.8m)
• Statutory pre-tax profit: £14.0m (H1 2019: £15.8m)
• Net cash excluding leases: £53.9m
• Interim dividend of 5.8p per share (H1 2019: 7.55p per share)

I think these are a creditable set of figures. I’m not too concerned by the adjustments included in the underlying profit figures. According to the notes these relatively small amounts relate to the amortisation of acquired intangibles and various other factors, such as the profit on disposal of a freehold property.

I’m satisfied that the underlying profit figure provides a realistic view of Headlam’s current trading performance.

Balance sheet: Net cash was £53.9m at the end of the half year, excluding IFRS 16 lease liabilities.

Even when I include lease liabilities, my sums suggest a statutory net cash position of £15.5m.

In addition to this, Headlam has nearly £100m of headroom on its main revolving credit facility.

There’s no material pension deficit and - historically - cash generation has been strong, providing good cash dividend cover.

Headlam’s balance sheet looks very sound to me.

Trading overview: Headlam trades in continental Europe as well as the UK. However, more than 85% of sales (and profit) is generated in the UK, so market conditions here are likely to dominate the group’s trading results.

Unsurprisingly, the company says that strong residential demand drove sales through the half year, offsetting weakness in the commercial sector. Residential sales during the half year were 4.7% ahead of H1 2019, while commercial sales were 12.8% below H1 2019.

Commercial revenue is now said to be recovering and was only 3.2% below 2019 levels in June.

However, residential remains the standout performer, with sales 22% ahead of 2019 levels in June 2021.

Outlook: After such strong performance, I wonder if we can expect sales growth to soften as life returns to normal.

My reading of Headlam’s commentary on current trading (from 1 July onwards) suggests this might already be happening, albeit only slightly.

The company says that group trading in July and August 2021 was slightly below the same months in 2019. This is attributed to commercial demand remaining relatively subdued, compared to more normal times. Management believes a proportion of this lost activity relates to essential maintenance and so has been delayed, rather than lost altogether.

Residential performance over the summer is said to be “pleasing”, although no explicit comparison with 2019 is provided for July and August 2021.

Overall trading is said to be in line with market expectations, following an upgrade in July.

My view: I’m reassured by today’s results and continue to be impressed by this business. Although I think there’s some risk that residential demand will soften this autumn, I don’t see this as a serious concern.

Historically, Headlam has generated stable profit margins and attractive mid-teens returns on capital employed:

I don’t see any reason why the company can’t return to this level of performance in the future. Costs have been controlled well and management sees growth opportunities in areas such as ecommerce, larger retail chains, and trade counters. There’s also the potential for a return to bolt-on acquisitions when market conditions stabilise.

Headlam shares have doubled since the vaccine rally started at the beginning of November. But Stockopedia’s consensus forecasts suggest to me that the business could still be reasonably priced:

I remain a fan of this well-run business. Although I’d prefer to wait for the next market correction to buy, I would be comfortable buying the shares at current levels for a long-term holding.