Small Cap Value Report (Mon 6 Sep 2021) - HEAD, WJG, BLV, SPSY, PCIP

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

In between exploring the Senglea and Burgu areas of Malta over the weekend, I also took a look at interim results from Headlam (LON:HEAD) - not a current holding of mine, but something I would like to buy back into, when funds permit. So there's a section on that below, to get you started today.

Mello Monday is back today, at 6pm - details here.

Agenda -

Paul's Section:

Headlam (LON:HEAD) - my review of the recent interim results, to supplement Roland's review last week. I'm impressed with the recovery to pre-pandemic levels, plus the very strong balance sheet (with net cash, and freehold property) could attract a bidder maybe? Still seems good value to me. Although the commercial sector remains subdued, and there is a new competitor Likewise, set up by former HEAD leaders.

Watkin Jones (LON:WJG) (I hold) - a frustrating trading update that sounds reassuring, and gives lots of detail on developments, but says nothing specific about performance versus market expectations. A research update from Progressive says that today's update reinforces confidence in forecasts.

Pci- Pal (LON:PCIP) (I hold) - very strong organic growth in mainly recurring revenues. However, all the additional gross profit has been consumed by considerably higher admin costs - although this was flagged as a deliberate policy to help accelerate growth. I ponder the bull & bear points.

Roland's Section:

Belvoir (LON:BLV): an excellent set of figures from this estate agency group, boosted by rapid growth in revenue from sales and mortgage broking.

Spectra Systems (LON:SPSY): strong numbers and excellent cash generation from the banknote authentication specialist. But I’m struggling to get a clear picture on growth.

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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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Paul's Section

Headlam (LON:HEAD)

(I do not currently hold)

480p - mkt cap £409m

Interim Results

Headlam Group plc (LSE: HEAD), Europe's leading floorcoverings distributor, today announces its interim results for the six months ended 30 June 2021 (the 'Period') and an update on current trading.

Strong recovery to 2019 levels

There’s a deck of presentation slides here, which I find a much more user friendly way of reviewing results. Although you always must keep in mind that presentations give the most positive picture of events, and negatives can sometimes be harder to spot, or glossed over.

H1 Revenues - impressively, have returned almost to pre-pandemic levels (continuing operations - they’ve stripped out the Swiss subsidiary, because it’s been sold) -

Strong recovery to 2019 levels, with total revenue of £329.9 million being in-line with H1 2019 (£335.0 million), and 45.2% ahead of H1 2020 (£227.2 million)

Note that 68.5% of revenues are for residential floorcoverings, with the balance being commercial - which is still under pressure due to working from home causing an understandable slowdown.

Profit margin - cost increases are being offset by operational improvements, and the aspiration is to achieve a 7.5% margin over the next few years -

Underlying² operating margin in-line with H1 2019 at 5.3%

Therefore we should be able to extrapolate increased profits, if all goes according to plan. A rise from 5.3% margin to 7.5% margin is a 42% rise in profits, which should feed through to a similar rise in future EPS, looking 2 years ahead - that’s a key point supporting the investment case for HEAD shares.

Underlying profit before tax (PBT) of £17.4m in H1

Underlying diluted EPS is 14.4p for H1.

Therefore the current forecast of c.32p for FY 12/2021 should be comfortably achieved, in my opinion, due to the seasonally stronger H2.

Seasonality - using this handy feature here, you can quickly check the H1/H2 seasonality for any company. Ignoring 2020, due to pandemic distortions, you can see that HEAD previously had a seasonal bias, with stronger profits in H2. I would expect that to occur this year too, hence full year EPS should be considerably more than just doubling H1 profits.

Balance sheet - I particularly like that HEAD also reports average daily net debt/cash. This is a far more realistic measure of liquidity than the usual snapshot on a period end date (which is often window-dressed by many companies) -

· Average net funds³ of £30.5 million, representing a strong reversal of the £35.3 million and £8.6 million average net debt³ position for H1 2020 and full-year 2020 respectively

· Net funds at Period-end, excluding impact of IFRS 16 'Leases', of £53.9 million (as at 30 June 2020: £22.4 million net debt; 31 December 2020: £51.6 million net funds)

Cash has been piling up in the group’s bank account, helped by a pause in dividends, and working capital returning to normal (trade creditors were unusually low a year earlier at the height of the pandemic)

Overall, a key point with HEAD is that the balance sheet is significantly over-capitalised. This makes the company attractive to bidders, who could do a sale & leaseback on the c.£100m freehold property, strip out all the cash, and load it up with debt. That could easily fund about three quarters (or more) of the current market cap! So don’t be surprised if this business attracts takeover approaches.

NAV is £226.1m, with only £19.0m intangibles to deduct - giving NTAV of £207.1m.

Therefore shareholders are not only sitting on a low PER business, performing well, but you’re getting a bulletproof balance sheet with surplus assets thrown in for free. What’s not to like about that?!

Dividends - with the coffers brimming full of cash, I think we can look forward to generous divis in future. The company says -

Resumption of normalised level of dividend payments with 2021 interim ordinary dividend of 5.8 pence per share

Forecast divis are about 15p, which is too low in my view. I reckon a return to peak divis of c.25p is more realistic, which means buying now could lock in a future divi yield of c. 5.2% - appealing for income seekers. Plus the divis should be protected against inflation, because HEAD is the type of business which can pass on inflationary pressures to its customers.

We also know it has proven resilient in the pandemic, so risk is low.

The more I look at this share, the more I like it.

Why did the share price ease off last week then, when these numbers were published? I think it might be the cautious outlook remarks about the (smaller) commercial sector -

Post Period-End and Current Trading

· Subdued commercial sector activity, although with regional variations, and residential sector performance pleasing

· Continuing to trade in-line with market expectations4 which were significantly upgraded in July 2021

4 Company-compiled consensus market expectations for 2021 revenue and underlying profit before tax are £684.8 million and £35.0 million respectively (on a mean and post IFRS 16 adoption basis).

There’s also the issue of smaller competitor Likewise plc, which recently floated at 25p, valuing it at £48m (see here for its AIM admission document). The CEO is formerly from Headlam, which does raise the question of how fair it is to take all that knowhow & trade secrets with you, and set up in competition? Although as Headlam’s slide deck points out, HEAD has the advantage of scale, being >6x the size of its nearest competitor. Nevertheless, with all his knowhow of the sector, the former HEAD CEO could prove a thorn in HEAD’s side, and maybe curtail its ability to increase margins, if it has to discount to retain customers maybe?

My opinion - I reckon HEAD should be moving towards EPS of 40-50p over the next couple of years, so at 480p it looks attractively cheap.

Generous divis are on the cards, as it has a bulging & growing bank balance.

The balance sheet provides immense financial strength, and could attract a private equity bid - fine, if they pay a 30%+ premium then they’re welcome to it.

On the downside, the commercial sector could continue to be a drag, and there is a risk of increased competition.

The recent Capital Markets Day (CMD) was interesting, and gave many detailed examples of where the company has under-performed, and sees upside. Although it did leave me questioning why it has allowed so many operational areas to go quite badly wrong & become so inefficient in the first place?!

On balance, I have decided to buy back into HEAD shares, when funds permit (which they don’t at present). It looks an attractive value share, with decent potential upside, providing nothing goes wrong. Let’s hope Likewise doesn’t eat its lunch, so that would need careful monitoring.

I’ve just re-read Roland’s review of the interim results last Thursday (when I was travelling), and it’s interesting to see he picks up on a couple of points that I missed. There’s a lot of duplication obviously, but I thought it would be interesting nonetheless to do my own separate review of the interims, and compare my view with Roland’s. It looks like we both see this as a good value share.

Since writing the above, I’ve had a rummage through the Admission Document of recently floated Likewise. It’s small, but growing fast, and still loss-making. Even after the c.£9m raised in its transfer to AIM (from a Guernsey listing), the balance sheet will still be a sliver of HEAD’s bulletproof financial clout.

So I think it’s likely to take Likewise 5-years+ to get anywhere near the size of Headlam. So it’s a simple choice - buy the relatively cheap (on PER, divi yield, and balance sheet metrics) larger player. Or gamble on the growth of a loss-making small competitor. I’ll go for the value investment. It’s a capital-intensive business, with lots of premises & capex needed, in order to expand, so Likewise may not find it easy, and is almost certainly going to need follow-on funding, to drive expansion.

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Watkin Jones (LON:WJG) (I hold)

240p (Friday’s close) - mkt cap £614m

Market Update

Watkin Jones plc (AIM:WJG), the UK's leading developer and manager of residential for rent homes, provides the following update on developments since the Group issued its half-year results on 18 May 2021 (the 'period').

The current financial year ends 30 Sept 2021.

This doesn’t seem to be a scheduled update, so it’s not clear why the company has updated us today. The heading sounds positive -

Strong momentum continuing in H2; development pipeline enhanced

Continued delivery of developments on time despite COVID-19

All remaining FY21 developments (one BtR scheme for 184 apartments in Leicester and two PBSA schemes for 1,121 beds in Glasgow and Wembley) on track for completion in September.

Institutional demand across asset classes driving forward sales

The problem with this update, is that whilst it gives granular detail on each development’s progress, which I haven’t copied here, but it doesn’t give us any detail on the overview! Are they trading in line with expectations, or ahead? We’re not told.

Research update - I’ve checked to see if Progressive Equity Research has updated, which it has here. It’s commissioned research, so in effect is coming from WJG, which is fine. Forecasts for FY 09/2021 are left unchanged, but today’s update “reinforces confidence” in the forecasts.

Adj EPS is forecast at 15.8p for FY 09/2021, giving a PER of 15.2 - that looks about right to me.

Dividends are useful here, forecast at 7.8p this year, a yield of 3.3% - the business model at WJG is unusual, in that it recycles capital quickly by forward-selling developments to institutions. Therefore it has good dividend paying capacity, which in my view is more important than the actual dividend yield. I.e. I’d rather have a 3% yield that is well-covered, from a company that holds & generates plenty of cash, than a say 6% yield from an indebted company that is struggling to maintain that level of payout, and is probably heading for problems.

My opinion - I very much like the business model at WJG, and the company has executed so well in recent years. The main downside risk is that the whole business rests on the expertise of the management/staff, and the relationships they have built with institutions. So it’s a know-how company, the actual construction work is outsourced I think. Therefore the danger is that the key people might decide to up sticks & set up in competition.

Hopefully that won’t happen, however note that the family have been part-selling in secondary placings.

The main attraction of this share, as I’ve pointed out before, is the planned growth in pipeline particularly for build to rent. Therefore, assuming nothing goes wrong, the next couple of years should see a decent rise in revenues & profits, from the projects already in the pipeline at various stages of development.

For that reason, I’m planning on sitting tight for a while, with a standard position size - i.e. not something I would want too much exposure to.

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Pci- Pal (LON:PCIP)

93.5p (up 1%, at 09:52) - mkt cap £61.0m

Final Results & Investor Presentation

PCI-PAL PLC (AIM: PCIP), the global provider of secure payment solutions, is pleased to announce full year results for the year ended 30 June 2021 (the "Period").

Substantial increase in revenues and continued strong new business momentum

There’s an results webinar at 4.00pm (UK time) on Wednesday 8 September 2021 on InvestorMeetCompany - worth a watch I think, as this is an interesting growth company.

Key numbers for FY 06/2021 -

Revenues small, but growing fast, at £7.4m (67% growth - all organic)

Recurring revenues are 88% of the total - so the company is building a sticky, long-term revenue stream

Heavily loss-making still, with a loss after tax of £(4.04)m, similar to last year’s £(4.13)m

Gross profit rose strongly, from £3.0m LY to £5.56m this year, but the increase was consumed by a big increase in costs - admin exps rose from £7.25m to £9.52m. This shouldn’t come as a surprise to anyone paying attention, as the company’s stated intention was to ramp up the growth rate into new markets, which involves cash expenditure up-front. This was explained at the time of the last placing.

Even so, I do cringe a bit at the numbers, and personally I would have preferred the company to focus on its existing markets (which include the huge USA), and make faster progress towards breakeven.

The bull argument is that if you have a remarkable growth opportunity, then you should maximise it, even if that involves prolonging the short term losses.

There’s no right or wrong about this - it’s up to each investor to weigh things up for ourselves, and form our own view on the share, same with everything.

In the current environment, bull markets do prefer rapid growth, and are often impervious to short term losses. So on balance the more rapid growth strategy is probably likely to create more shareholder value than a more cautious, lower cash burning strategy.

Is there enough cash? Yes - since a placing raised £5.5m before expenses in April 2021 at 95p per share. Dilution was just under 10%, so it’s not a big deal. More money could be raised if needs be, so I don’t worry about liquidity, it’s fine.

Development spending - note that £920k was capitalised in the year.

Current trading - is in line - several new contract wins are noted -

Strong start to new financial year with new ACV in line with management expectations...

Outlook -

After a strong year I believe that the business is set to take another sizeable step forward in the next financial year. Whilst we do continue to be mindful of the pandemic, we believe that the momentum we have built, together with our ability to deliver new customer deployments, and our near-term sales pipelines means we are well-positioned to have another year of substantial progress…

There are 2 more paragraphs in a similar vein.

I don’t think there’s anything to be gained from going through the numbers, because historic figures are not what this investment is about, it’s a growth company. Let’s summarise the bull & bear points -

Bull points

• Very rapid organic growth - the market is currently happy to pay high valuation multiples for software companies achieving rapid growth
• 88% recurring revenues, very sticky
• Operational gearing is high, with gross margins rising further
• Huge markets, global
• Little competition for the niche that PCIP operates in
• Sold via resellers, so doesn’t need a large central overhead
• Cloud-based software, so cheaper & easier to implement

Bear points

• Still loss-making, with rising costs
• Breakeven has been deferred by policy to increase the rate of expansion, so shareholders need to be patient - several years yet until profitability
• Risk of a de-rating if bull market in tech fizzles out
• How to value it? £60m could be expensive, or cheap, depending on your point of view
• What short-term catalyst is there for further share price rises?

My opinion - overall, I’m happy to keep a standard position sized holding in my personal portfolio. I don’t want to go big into PCIP, because it’s probably valued about right for now, and it requires several years of patience for the company to grow into the valuation. Anything could happen in that time.

On the more bullish side of things, the company clearly has a great product, that is attracting many new clients, who sign up for long-term, high margin recurring revenues. As that builds, the company becomes more valuable.

I’d prefer the company to be more profit-focused though. The problem with this type of growth company, is that management always seem to find ways to increase costs, thus breakeven can sometimes feel like a mirage in the distance.

On balance though, the very rapid organic growth excites me more than the downside risks, so I’m broadly positive on PCIP. What do you think? All views are of interest.

Note that the StockRank system really doesn't like permanently loss-making companies, as you can see below -

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Roland’s section

Belvoir (LON:BLV)

Share price: 280p (pre-open)

Shares in issue:36.4m

Market cap: £102m

Half-year results

This estate agency group has triple-bagged since the market crashed in March 2020.

These half-year results are flagged as “significantly ahead of management’s expectations as at the start of the year”. This is a reminder that Belvoir put out a trading update at the start of August, upgrading its guidance.

Today’s numbers are in line with last months’ update, but nevertheless appear to be very strong indeed. Earnings are significantly ahead of both last year and the same period in 2019.

Financial highlights: Belvoir acquired the Nicholas Humphreys network of agencies (which specialises in student lettings) for £4.4m in March. This deal has added to both revenue and profits. Happily, the company has split out the contribution from this deal so we can see the split between acquired profits and organic growth.

• Revenue +41% to £13.8m (H1 2020: £9.8m)
• 33% of revenue growth from underlying business, 8% came from the NH network
• Pre-tax profit +51% to £4.8m (H1 2020: £3.2m)
• 42% of profit growth from underlying business, 9% from acquired NH network)
• Earnings per share: +36% to 9.9p (H1 2020: 7.3p)
• Interim dividend:+18% to 4p (H1 2020: 3.4p)
• Net debt: £4.0m (H1 2020: £5.7m)

Belvoir has 467 branches and 242 financial advisors, operating under a number of brands. The majority of branches are franchised, which helps to keep costs low and margins high.

Using today’s figures, I calculate a trailing 12-month operating margin of 32% and a TTM return on capital employed of 21%.

These excellent figures are consistent with, but slightly ahead of, the group’s performance in recent years:

The franchise model also lends itself to strong cash generation, which is evident here:

• H1 21 operating cash conversion: 119% (H1 2020: 113%) - percentage of operating profit converted into operating cash flow

Results boosted by sales growth: Like most large estate agency groups these days, Belvoir’s revenue comes from a mix of lettings, sales and financial services.

Helpfully, the company has split out the revenue growth, allowing us to see how the gains during the half year were driven by a sharp increase in sales:

• Lettings revenue +21% (56% of gross profit)
• Sales revenue +78% (21% of gross profit)
• Financial services +51% (18% of gross profit)

We can see that lettings generated the majority of gross profit, but was the slowest growing area during the first half of this year.

Belvoir’s strong growth in financial services and sales isn’t a surprise, given current booming housing market conditions, super-cheap mortgages and strong employment. How much longer will this continue? I really don’t know. But I’d argue there is some cyclical risk for investors at this point in the cycle.

Incidentally, financial services growth may continue to run ahead of previous trends, as Belvoir acquired The Nottingham Building Society’s mortgage business during July. This added 21 financial advisers who will work in Nottingham branches, servicing the society’s customers.

Outlook: Belvoir’s house broker, FinnCap, has issued an updated note this morning which is available on Research Tree. The note makes the interesting point that Belvoir’s growth strategy has supported “24 years of unbroken profit growth”. I have to admit I haven’t looked that far back - that’s an impressive achievement in a cyclical sector, in my view.

However, this record may be broken in 2022, if current forecasts are correct. FinnCap suggests earnings of 19.8p per share this year, falling to 18.8p in 2022. Stockopedia’s consensus figures (not yet updated) suggest a similar trend, with adjusted eps of 20.6p in 2021, falling to 19.8p in 2022.

Today’s outlook statement indicates the board is confident of “a strong trading performance for the full year”, but Belvoir has stopped short of another guidance upgrade.

My view: Belvoir appears to be operating well and delivering strong financial results. Profitability and cash generation are excellent and the balance sheet looks sound to me.

Based on the group’s record of profitability and growth, the stock’s forecast P/E of 14 and 2.6% dividend yield don’t look overly expensive.

However, I can’t shake off the feeling that we may be getting close to the top of the market. If I held Belvoir shares I would continue to do so, but this probably isn’t a stock I’d rush to buy at current levels. Despite my favourable view of the business, I’d prefer to wait for the next market correction to begin building a position.

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Spectra Systems (LON:SPSY)

Share price: 163p (+6% at 9am)

Shares in issue: 45.3m

Market cap: £62m

Interim results + New contract win

Spectra Systems specialises in machine-readable high speed banknote authentication, brand protection technologies and gaming security software.

This company’s high margins, strong cash generation and useful dividend yield have caught my eye over the last year, but I’ve been unsure about the long-term growth potential of businesses reliant on banknote technology.

Financial highlights: Today’s results strike a bullish tone that’s supported by a strong financial performance:

• Revenue +23% to $8.0m
• Pre-tax profit +53% to $3.0m
• Earnings per share +50% to $0.06
• Net cash $12.9m (H1 2020: $10.9m)
• Free cash flow: $4.3m (H1 2020: $1.8m)

Spectra’s operating margin for the half year was 38%, giving a trailing 12-month figure of 40%. This appears to continue the trend of improving margins seen in recent years:

High margins and strong cash generation are paired with a dividend payout ratio of around 90% - unusually high for a growth stock.

These payouts appear to be affordable and give Spectra shares an attractive 4.5% yield. But I am a little puzzled that more money isn’t required for R&D. Today’s accounts show R&D spending running at around 10% of TTM revenue. Is that a little low?

Too reliant on legacy sectors? Nearly 90% of Spectra’s revenue comes from its Authentication Systems business. This sells the materials, equipment and services needed to create and authenticate security features in customer products.

The largest market is banknotes. Spectra has a number of central bank customers who purchase “covert materials” and equipment from them. The company’s main growth opportunity in this area appears to be facilitating a switch from paper to polymer banknotes.

Interestingly, Spectra says it has now upgraded its print-ready polymer substrate so that it is able to compete directly with other suppliers in the industry, including £DLAR.

The company’s second-largest business appears to be providing brand authentication for consumer goods with its TruBrand product. The main client industry mentioned is tobacco. New opportunities cited include “a European tax stamp”, “motor vehicle registrations” and “foodstuffs in a large Asian country”.

I don’t have any way of putting a value on these opportunities. But the conclusion I draw is that most of Spectra’s current revenue derives from what I’d view as legacy industries - banknotes and tobacco. I wonder if this accounts for the relatively modest valuation of this business, given its profitability.

Security software: In 2012 Spectra acquired some gaming technology businesses. These provide security software services for gaming groups, mostly lotteries, as far as I can tell. This business generated $920k of revenue in H1, up from $693k last year. However, adjusted EBITDA fell from $156k to $112k. The company says this is due to investment in a new software platform that will cut future development costs.

Again, I’m not sure lotteries are really a growth sector.

Contract win: Today’s results are supplemented by a contract win RNS which reports a major new contract to provide the materials needed for a security feature in K-Cups for Keurig brewers (a US alternative to Nespresso).

The new customer is expected to spend more than $500k per annum and sales for this business are expected to reach $1m in 2022. Management describe it as “high margin” and say that additional sales will not require new staff, providing attractive operating leverage.

This seems to be good news, but again I’d argue that it’s not necessarily a growth sector. The coffee pods market is pretty mature now. I suspect demand for authentication is being driven by Keurig and its licensees trying to protect their margins in the face of cheaper generic competition.

Outlook: CEO Nabil Lawandy strikes a bullish note in today’s results and there’s a lot more information about new opportunities, mostly in banknotes.

The outlook statement is brief but confident:

"The Board therefore believes that the Company is on track to achieve record earnings and meet market expectations for the full year."

My view: Current broker forecasts in Stockopedia show adjusted earnings of 11.8 cents per share for 2021. That’s in line with the adjusted earnings of 11.9 cents reported by the company in 2020, so I’m unsure how much earnings growth is expected this year. I’ve not been able to access an updated broker note yet.

These forecasts put Spectra shares on 18 times forecast earnings, with a dividend yield of 4.9%. That seems cheap to me for such a profitable business, unless the market is pricing in a risk that profits will stagnate in future years.

I’m concerned about the growth prospects in banknotes, but from a global perspective, perhaps that view is too cautious? I don’t have any insight into this.

I’m impressed by Spectra and want to like the shares. But I’m a little concerned that the majority of the group’s profits come from what might be described as legacy businesses.

However, I suppose the other way of looking at this is that authentication often only becomes a major concern when a product or brand is well-established. Hence it’s natural that Spectra will get involved with mature businesses.

On balance, I’m afraid I’m undecided. Spectra Systems is performing well financially, but I’d need to do more research to understand the growth opportunity here.