Small Cap Value Report (Fri 1 Oct 20210) - MEAL, Supply chains/inflation, AO.

Good morning, it's just Paul here with the final SCVR for this week. I was travelling back from Madeira yesterday, so of course my largest position Boohoo (LON:BOO) put out a profit warning. Such is life. Think I'll book weekend flights in future.

Today's report is now finished. Wishing everyone an enjoyable & relaxing weekend, which I think many of us need!

Agenda -

Parsley Box (LON:MEAL) - my take on yesterday's profit warning. Even though the share price has crashed, I see little to no attraction in this share at 60p.

Supply chains/inflation - as it's a quiet news day, I've decided to have a ramble about these very important current topics. I foresee many more profit warnings, bringing some potentially good buying opportunities for the remainder of 2021.

Ao World (LON:AO.) - profit warning. I've never been impressed with this company, which has a poor business model in my view, and in reality generates little bottom line (post tax) profits. Shares have dropped heavily, and are down another 24% today. They still look far too expensive to me.

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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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Parsley Box (LON:MEAL)

60p - mkt cap £25m

Profit warning (yesterday)

I was going to write a full section on the profit warning from MEAL, but just spotted that Jack wrote about it yesterday. Reading Jack’s review, it sounds grim. I’ve been sceptical about this recent IPO from day 1, because it looked like an opportunistic, over-priced IPO, based on a one-off good year aided by the pandemic. Or rather, that was my suspicion, and it now looks to have been correct. Also there’s been a question mark over the effectiveness of the heavy marketing spend.

MEAL is an eCommerce business selling specialist food/drink mostly to the elderly, with its key point of difference being that many meals can be stored in a cupboard, and don’t require refrigeration or freezing.

I reviewed the interim results here on 7 Sept 2021 (when it was 110p), concluding that I’d only be interested if it fell further to 50-60p. Now that the share has hit my buying range, am I tempted to buy? With 42.2m shares in issue, at the current price of 60p, that’s a market cap of £25m, so very small (and illiquid) now.

H1 revenues were £14.0m (averaging £2.3m per month)

This has since increased to £17.8m for the 8 months to end Aug 2021, so £3.8m in July + August (averaging £1.9m for the 2 months, down on H1 run rate)

The latest guidance (from y’day’s trading update) is FY 12/2021 revenues of £25.0m. That’s £7.2m for the last 4 months (Sept-Dec 2021), a run rate of £1.8m per month.

That’s a big reduction in revenues, and a serious setback. It’s down to supply chain problems, but it’s not like MEAL is importing from the Far East with ready meals stuck in the Suez Canal or similar. It blames labour problems.

What I reckon is this - as a small producer, outsourcing production to factories that probably have much bigger & more important clients, then it seems likely MEAL is near the back of the queue. Hence it’s taken a production hit. Maybe that’s a problem with outsourcing - great when everything goes smoothly, but no control over production when things get difficult.

Thankfully, marketing spend is being slashed, so the cash pile of £5.7m at 31 Aug 2021 should last longer.

Finncap’s latest forecasts show a huge loss of £(8.3)m for FY 12/2021, at the adjusted PBT level. Checking the interims, it seemed to make a £(4.0)m adj PBT loss (I’ve worked that out manually, by deducting exceptional IPO costs). If marketing spend is being slashed, then why is the H2 loss slightly worse than the H1 loss? That doesn’t seem to make sense to me.

For the following 2 years, Finncap forecasts revenue growth largely stalling (makes sense given slashed marketing spend). Guidance is for smallish losses of £(0.65)m in 2022 & 2023.

My opinion - it’s very difficult to see any reason to buy this share, other than the bombed out share price. The business model doesn’t seem very good to me, and the story sold at IPO seems to have pretty-much collapsed. That leaves institutions with large, lumpy holdings that they’d probably rather not hold. So who’s going to buy the shares in sufficient size? Or will institutions sit tight and wait for a recovery (if one happens)?

All the marketing spend to date has not all been wasted. Consumers have very long memories, and brand building from advertising lasts a long time. So I do see some value from the sunk marketing spend.

How to value this share? No idea. The business model has fundamentally changed for the worse, so the shares should be cheap.

For me, it would only ever be a really distressed purchase - if institutions smash the price down to a market cap of say under £10m, that’s the level where I perceive risk:reward to be better balanced than the current £25m.

It joins the very long list of IPOs that, in hindsight were opportunistic sales, with the growth story exaggerated, and the pricing far too high. It makes me wonder how long the IPO gravy train can keep running before investors tire of the losses?

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Supply Chains & Inflation

It’s fair to say that supply chain disruption & increased costs are now the main investing themes - more so than covid I reckon.

We’re already seeing profit warnings, and it seems clear that every business which imports goods or components from the Far East, is likely to be impacted to varying degrees by delays (I’ve heard it’s now 80 days to import, as opposed to 40), and increased costs ($20k+ per container, as opposed to less than $2k).

A key question to ask companies on webinars, is the value of their goods in a typical container. I asked Portmeirion (LON:PMP) (I hold) and they replied that it’s about $100k per container. So previously the freight charges were under 2% of cost. Now it’s c.20%. That’s a massive impact, and means that companies have to either increase selling prices, or take a hit to their own margins. Hence the ability to raise selling prices is another key question to ask management on webinars - e.g. how much of increased costs are they passing on to customers?

I think it also reflects on the general competence of management. Did they build up buffer stocks when the problems began? Or have they just run into trouble with apparently no effective planning for disruption in advance? (e.g. In Style (LON:ITS) )

Is there flexibility in their supply chains? Can they re-shore production to the UK, or somewhere nearer (e.g. Europe)?

It seems obvious now that we’re heading for numerous profit warnings in the coming months. For long-term investors, does that matter? Not really, as with the pandemic, long-term holders can effectively ride out a period of disruption where there’s an end in sight. We don’t know when global supply chains will be sorted out, but they will be sorted out.

Which means that people holding cash, should have some lovely buying opportunities to buy great companies at discounted prices in the coming months. That’s quite exciting to a value/GARP investor, since I’ve turned away most shares this year as looking over-priced. Maybe I'll get a chance to buy some excellent companies at bargain basement prices?

Another key question, is whether it’s worth selling things now, in the hope of buying back cheaper, when (often inevitable) profit warnings come out? I think that depends on a few things, for each share individually -

Broker forecasts - how aggressive or cautious are they? I’ve been criticising analysts this year for being too cautious in many cases, leading to actual results often thrashing forecasts. However, with quite severe supply chain problems now impacting practically everyone who sells physical goods, then investors need to check forecasts again, to ensure they are prudent, and not overly optimistic. Going back to Portmeirion (LON:PMP) I challenged mgt as to why the bar had been set low for H2 2021. They replied that supply chain issues mean they want build in plenty of allowance for those costs/delays. Very sensible. We can no longer assume that companies are going to beat apparently cautious forecasts. So is that high PER really justified, for your favourite share?

De-rating - many shares have already de-rated. We never know why anyone is selling, but it’s safe to assume that e.g. Luceco (LON:LUCE) has crashed from a peak of c.500p to little more than 300p, despite strong figures, and a reasonable outlook recently. It did mention supply chain issues, but sounded confident in being able to handle them. Despite this, investors have severely punished this share. A Director repeatedly selling recently hasn’t helped sentiment either.

I thought LUCE was starting to look attractive at 380p, and began buying. I only dipped my toe in with a small initial purchase, thank goodness. A recent book I was reading (can’t remember which one, it might have been 100 Baggers) suggested buying in 3 stages, so that you can average down if the price falls (providing the fundamentals are sound). That stuck in my mind, so that’s what I did with LUCE. At 320p recently, I pushed the button again and bought stages 2 & 3, so am now up to a full position size on that one. So expect a profit warning any day!

Holding fire? - many shares are de-rating now, in expectation of supply chain problems, but then tend to lurch down again on the actual profit warning due to supply chain problems. Shareholders are therefore punished twice for the same issue.

For that reason, I’m now thinking in terms of building up cash, and waiting, rather than steaming in and buying shares now which have fallen a lot. I’d rather wait for the next trading update, and assess things at the time, with probably no rush to buy shares where sentiment is (for now anyway) very negative.

Rebounds - as we saw with covid, markets sold off very rapidly & deeply, but when it came, in late March 2020 I think, the rebounds were also very rapid, and large. I wonder if we might see a similar situation with supply chain problems? Maybe not such a large fall as with covid, but my hunch is we could see bigger drops in many shares over the next 4 months, as no doubt the media will be full of stories about shortages in the shops, etc. (a cynic might imagine possibly planted stories, to help stimulate earlier Xmas spending?!)

Cash? I know several shrewd investors/traders who have been moving into cash, which I think makes sense, if you’re good at market timing. That means side-stepping the inevitable profit warnings which we all know are coming. Then you can pick your moment to go back in. This strikes me as a good strategy right now, if you can execute it well, and there is the risk of missing out on takeover bids if you're sitting on the sidelines.

The trouble is, I’ve observed over the years, that people who are so cautious that they prefer holding cash, rarely deploy that cash at the market bottom, because they’re too scared. Hence they avoid the big downturns usually, but often also miss out on the big rebounds.

Personally, I prefer using index shorts (I tend to use the US indices, as they set the direction for UK markets) in times of uncertainty. That is working quite well at the moment, with my profits on Dow, Nasdaq & S&P500 shorts recouping all my current losses on Boohoo (LON:BOO) (I hold) and numerous other losses which have emerged in recent days. The trouble is that US markets tend to be so volatile, that the repeated “buy the dip” buyers often snatches away my shorting profits, whilst UK shares in my long portfolio don’t seem to rebound as much. Hence I need to give more thought to my strategy here.

Portfolio review - I’ve thought about all the shares in my portfolio, and tried to imagine how their supply chains might be impacted at the moment. Also it’s worth revisiting my notes here in the SCVRs, as I’ve been reporting on supply chain outlook comments for a while now, so it should all be here in the archive, for individual companies (access company comments here under the "Discuss" tab on any company's StockReport).

Anyway, pleasingly, there’s not a huge amount of stuff in my portfolio that is at risk, or at least wouldn’t hurt me that much, if say the price drops 10-20% on a profit warning due to supply chain problems. These are, after all, temporary/fixable problems, so the impact should be less than the company-specific, generic profit warning share price drop of c.30%.

When we buy shares, we’re not buying this year’s earnings only. We’re buying all future earnings forever. Therefore one bad year (OK, 2 bad years!) due to the pandemic & its aftershocks, should not impact profits from say 2023 onwards. Often companies emerge better, stronger businesses, from a crisis.

I’ll go through my portfolio again, and see what other things I might trim back on. For example, I've reduced my position size in Gear4music Holdings (LON:G4M) recently, as it imports most things from China, so is bound to be seeing some supply chain impact. There again, the forecasts seem cautious, so it could already be factored in somewhat, maybe? I can always buy them back later, if it’s a false alarm.

Holding shares is not a binary decision. I often trim positions, if there’s some uncertainty, keeping a core, smaller position, and building it back up again once I’m happier with the fundamentals, and uncertainty has receded.

What we need to avoid, is having large overweight position sizes in companies where it was fairly obvious in advance that supply chain problems would be having some impact (e.g. my position in Boohoo (LON:BOO) !)

Services sectors - I’m wondering if it might be best to avoid companies selling physical goods that are made in the Far East, for the time being? Instead, I might focus more on services companies, that don’t have any issues with importing goods.

Inflation - my hunch is that this is a more serious problem than central banks, Governments, and investors seem to currently think.

The trouble is that supply chains are disrupted, causing widespread shortages & delays in practically everything. Plus, labour disruption also exists in many countries, not just here - often because people needing work don’t have the right skills to fill the vacancies.

Then there’s the matter of arguably over-stimulus by Govt policy, with Bank of England data showing households & companies swimming in cash. So there’s demand for things like home improvements, and pricing is going up.

Anecdotally, I tried to book a decorator, who declined, because he’s booked up for the next 6 months. We’ve just had our carpets cleaned, which usually costs £60. We had to pay £130 today, the new going rate, because they’re booked up due to strong demand.

Put all that together, and it seems to me a recipe for longer-lasting inflation, maybe? Once companies put their prices up, and discover that customers are prepared to pay more, they’re not going to voluntarily reduce the prices in future, are they?

Conclusion - nobody knows what’s going to happen in future, so as always with shares, and economics, it’s little more than educated guesswork.

What we can say with certainty, is there is elevated uncertainty at the moment! Hence why I think it’s more important than ever not to over-pay for any share.

For new purchases from now on, I really want to see -

• A bang up-to-date trading update (so no guesswork, just recent facts)
• Strong balance sheets (as always) so insolvency/dilution risk is minimised
• Attractive valuation - so a PER in the low teens maybe, or high single digits, not mid to upper 20s or above
• Cautious broker forecasts, that already factor in supply chain disruption.
• No large scale recent Director selling - they know the business better than us, so if they’re cashing out in size, that tells me things are not looking rosey.

Profit warnings - I’d like to see the share price really smashed down, after having already de-rated, before committing new money, and it’s got to be a high quality company. New purchases have to be compelling value, for me to take the risk at this point in time, of buying something new.

That’s all I can think of, off the top of my head, and no doubt we’ll be revisiting this theme probably on a daily basis, for the rest of this year, at least.

Situations like this do create opportunities, and the profit warnings of today, could be the lucrative investment gains of 2022-2023, once supply chain issues begin to correct. In terms of timing though, I think we could see the news get a lot worse, so it’s probably too early to be opening new positions, as they could have further to fall maybe? Who knows, that depends on market sentiment in the short term.

EDIT: one final point. I've noticed that some small caps have been falling in price sharply, which are services companies, hence have no supply chain uncertainty. If they've put out positive recent trading updates, then I would be prepared to buy more. Examples that I particularly like are Beeks Financial Cloud (LON:BKS) and Cambridge Cognition Holdings (LON:COG) (I hold both, and am buying more). As always, please DYOR, because some of my ideas will be right, and some will be wrong, same as everyone. End of edit.

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Ao World (LON:AO.)

166p (down 24%, at 13:03) - mkt cap £768m

By the way, I always manually adjust the market caps here, to reflect today’s price move. Remember that the data on the StockReport is all updated overnight, so will reflect the previous day’s data, including market cap. That’s important to remember, especially when looking at shares that have moved dramatically in price today.

Trading Statement (profit warning)

AO World plc ("the Group" or "AO"), a leading European online electrical retailer, today issues a post close trading update for the six months ended 30 September 2021.

Company’s summary -

Continued growth in a challenging operating environment

Slow revenue growth in H1, only +5% against strong prior year comparatives (in lockdown 1). “Challenging market dynamics”

UK - revenues up 6%, growth impacted by supply chain problems, and shortage of delivery drivers.

Germany - revenues up 3% (constant currency) in competitive online market.

Two year like-for-like sales growth is very strong, demonstrating that all the growth was packed into last year, due to lockdowns, and it’s now more difficult to beat those exceptionally strong prior year numbers (similar to what Boohoo (LON:BOO) (I hold) said yesterday.

… on a two-year like-for-like basis, Group revenues grew c.66%, with our UK business growing c.63%. Like-for-like revenues in Germany grew c.84% over the same period.

Supply chain - I would have liked more information on this, instead it’s rather glossed over, possibly because it’s commercially sensitive? -

Whilst we continue to see industrywide issues relating to ongoing supply chain disruption, we have implemented measures to help mitigate these challenges in our logistics operations.

It sounds like they’re on top of the issues though, if this forward-looking statement turns out to be true. Q3 is Oct-Dec 2021 (March year end) -

Whilst the macro-outlook remains uncertain, we have confidence in the proven resilience of our business model and are well placed to meet customer demand in our peak third quarter sales period.

Guidance -

… anticipate that Group Adjusted EBITDA3 for the full year to be between £35m and £50m, with profits more heavily weighted than usual towards the second half of the year driven by the peak trading period…

3Group Adjusted EBITDA is defined as profit/(loss) before tax, depreciation, amortisation, net finance costs, and other adjusting items.

Diary date - 23 Nov 2021 for interim results.

Valuation - I can’t find any broker research, so let’s look back at previous company results, which are as follows -

FY 03/2020 (pre-pandemic): adj EBITDA £22m

FY 03/2021 (pandemic): adj EBITDA £64m

FY 03/2022 (company guidance): adj EBITDA £35-50m (significantly down on prior year)

My opinion - AO World has enjoyed a high rating on its shares for a long time, because strong growth was worth more to investors than modest profits.

Now that it’s becoming clear last year was an exceptionally good year for online businesses, and they’re struggling to generate any further top line growth, many have de-rated significantly (e.g. Boohoo (LON:BOO) (I hold), Asos (LON:ASC) (I hold), and many others internationally too, not just in the UK).

I think it’s probably fairer to average out the growth over the last 2 years, which looks a lot more impressive. So it could be the case of one amazing year, one lacklustre year, and then in future growth might settle down somewhere in between? That’s my guess. Therefore, we might possibly see eCommerce businesses re-rate back up again, at least partially, once they’ve passed through the current period of exceptionally strong prior year comps?

The problem I have with AO, is its business model is just not very good. It sells other companies brands, at low margins, against lots of competition, with quite high delivery overheads. So they have to shift a huge amount of goods, to eke out a 5% EBITDA margin.

The EBITDA margin doesn’t stand up to scrutiny, because depreciation/amortisation, and finance costs are quite high, so last year's £64m of adj EBITDA only flowed through to £17.1m of profit after tax. Not much really is it, and that was in an exceptionally good year.

Given that this year’s adj EBITDA is going to drop considerably, then at the profit after tax level it might only get to breakeven. Yet this business is still valued at £768m, despite having fallen in price a lot (see chart below).

Therefore, the way I look at the numbers, it’s a long way from being a bargain, for a not very good business, who are arguably busy fools - generating a ton of revenues, for very little bottom line profit.

As you can see from the 3-year chart below, it has now scrubbed off more than half the speculative boom which was triggered by the onset of the pandemic. Rightly so, as the fundamentals don’t justify that move at all.

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