Small Cap Value Report (Weds 6 Oct 2021) - LOOK, NET, MMH

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

We'll leave it there for today. I hope subscribers are not getting too despondent about the damage to our portfolios in this current sell-off.

Agenda -

Paul's Section:

Lookers (LON:LOOK) - Q3 update - the good times continue to roll. Despite a huge fall in volumes of cars sold, high margins mean that FY 12/2021 profit expectations are "materially" raised. Zeus upgrades by 34%! Remarkable stuff. The party has to end at some point, but car dealers are becoming more valuable by the month. They're on very low earnings multiples still.

Marshall Motor Holdings (LON:MMH) - another car dealer, with a similar story - bumper Q3 profits due to profit margins rising more than enough to offset lower volumes. Profit guidance upped from >£40m, to >£50m. Sees no immediate end to extraordinarily inflated used car prices. Similar valuation to LOOK, so an interesting value share. Bear in mind that profits will probably at least halve in future, once things normalise.

Jack's section:

Netcall (LON:NET) - provides software solutions to customers with large, complex ecosystems in the financial services, healthcare, and public sectors. The trading momentum looks good and it could be that the group is approaching an inflection point, but the valuation looks full.

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 are analysing the company fundamentals, not trying to predict market sentiment.

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:

Lookers (LON:LOOK)

60.7p (pre-market open) - mkt cap £238m

Q3 Trading Update

Lookers plc, one of the leading UK motor retail and aftersales service groups, today provides a trading update covering the three month period ended 30 September 2021 ("Q3" or the "Period") and an increase in the Board's expectations for underlying profit before tax for the full year.

Strong performance in challenging conditions and increase in full year expectations

Just to make sure we get the point, they tell us twice at the top of the announcement!

I enjoyed the interesting discussion we had yesterday about new & used car sales, supply constraints (due mainly to semiconductor shortages), and electric vehicles. Some readers reckon that generating enough electricity for all these EVs won’t be a problem. Good luck with that. I’ll believe it when I see it, given this country’s tendency to mess up things like that.

Probably like a lot of other subscribers here, I’ve got an EV on order. Much though I love conventional cars (especially classics), now that we have the technology to avoid pumping filthy fumes into the air, we really should adopt it where possible. Something like 30-40% of the UK’s electricity now comes from wind turbines, so the argument that you have to pollute at power stations, in order to generate the electricity for EVs, is not true any more.

Totally bizarre and “unpredented” (CEOs of both Vertu Motors (LON:VTU) (I hold) and Lookers (LON:LOOK) have used this word in quotes) conditions in both new and used car markets continue.

This is what Lookers says about Q3 (July-Sept 2021) -

Supply shortages led to higher margins

Strong demand for used cars

UK new car market declined 31% in Q3

Lookers outperformed by 3.4%, implying it was down c.28%

(it’s not clear if this is a decline by value, or volume? I assume it’s probably by volume of cars sold. The decline by value might be less, because I’ve heard that manufacturers are prioritising production of higher value/profit cars over cheaper, lower margin production)

Supply of used vehicles also restricted

Used vehicles LFL unit sales down 16.9% in Q3

Volume drop more than offset by higher margins (reinforcing the point I made yesterday)

Unprecedented conditions

Aftersales revenue holding up comparatively well, down only 3.5% on LY

Net cash of £30.0m - a big improvement on net debt of £25.9m a year earlier

CJRS (furlough) received of £4.1m this year has been repaid

Electric vehicles are popular

Outlook -

The Group has a strong new car order bank which is above normalised levels. However there remains material and increasing uncertainty as to the availability of these vehicles which is dependent on specific brand and model related factors. The Group continues to work closely with all its OEM brand partners and customers to minimise the impact wherever possible, which is now widely expected to continue into next year.

Notwithstanding this considerable uncertainty for the final quarter of the year, given the strength of performance in the Period, the Board now expects underlying profit before tax for 2021 to be materially ahead of its previous expectations.

Electric vehicles -

Interest in electric vehicles continues to grow, particularly in light of the UK wide fuel shortage, and the Group remains well positioned to benefit from this exciting growth opportunity moving forward.

Broker update - many thanks to Zeus for issuing an update note.

It’s a massive upgrade (given where we are, ¾ of the way through the year - FY 12/2021 PBT (underlying) is upped by 34% to £81.4m. That’s a staggering number for a company valued at only £238m, and with net cash.

Forecasts for future years are left “unchanged for now” - which hints at possible future rises maybe?

In EPS terms, FY 12/2021 is now forecast at 16.7p, so at 60.7p share price, the PER is 3.6!

Obviously there’s a catch. Everyone knows that current highly profitable market conditions are a one-off, of unknown duration.

Therefore, when valuing car dealers, it makes sense to use more modest future earnings expectations. In this case, Zeus has EPS dropping from 16.7p this year, to 10.9p next year & year after. Nobody really knows, because we don’t know when supply of vehicles is likely to normalise.

EPS of 10.9p would raise the PER to a still tiny 5.6

My opinion - I can’t remember ever coming across a situation like this.

Investors have assumed that supply constraints would damage car dealers, but the opposite has happened. Strong demand, combined with limited supply, has driven up prices, and profit margins. Remember when supply is plentiful, car dealers only scrape off a small profit per car. In current conditions they seem to be able to name their price, and customers pay up.

Even when market conditions do normalise, this bonanza period now will leave a permanent strengthening of dealers balance sheets. Remember that the balance sheet grows each year by the same amount as retained profit (after tax) on the P&L. That’s the way double entry bookkeeping works. This opens up the possibility of future enhanced divis, buybacks, etc. Vertu Motors (LON:VTU) (I hold) has done buybacks in the past, and I would like to see it use some of the cash pile to do more aggressive buybacks now it must be trading at below 1 times NTAV.

Car dealers also have big freehold property assets too.

There’s a lot to like in this sector in my opinion. There must be takeover activity rumbling away in the background too. Those balance sheets groaning with freeholds (and now cash too) won’t escape the attention of private equity forever, in my opinion.

Fascinating times. We all know the party’s going to end at some point, but when, and how much cash will the dealers have accumulated when the good times do come to an end? The value of these companies is rising with each month of bumper profits that passes.

StockRank is consistently very high -

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Marshall Motor Holdings (LON:MMH)

221p (up 6.3% at 08:54) - mkt cap £173m

Trading Update

Another car dealer reporting. Marshalls is about ¾ of the market cap of Lookers. It’s handy when companies in the same sector report on the same day, maybe there could be a bit more co-ordination, as it helps investors focus on that sector & make comparisons whilst it’s fresh in our minds.

Ha! I see that Marshalls also tells us twice that it’s doing well. Maybe these RNSs are written by a descendent of Fred Elliot?! -

Trading Update - further increase to FY2021 expectations

Marshall Motor Holdings Plc, one of the UK's leading automotive retail groups, provides the following trading update and announces a further increase to its full year expectations for 2021.

My summary of today’s update -

Old guidance (August) - FY 12/2021 profits >£40m

New guidance (today) - FY 12/2021 profit before tax >£50m

New vehicle supply has deteriorated in August & Sept, and expected to continue “through 2022” (ambiguous - does that mean into 2022, or for the whole of 2022?)

Customer demand & orders are strong, but delivery times “significantly extended”

Marshalls says it outperformed new car market by 13.0% in Q3 (much better than +3.4% indicated today by Lookers), and 11.6% YTD

New cars - “... exceptionally strong new car margins as a result of supply shortages which has offset the impact of reduced volumes”

Used cars - the same situation - “Exceptionally strong margin performance in used cars in Q3 2021, more than offsetting a decline in volumes”

Outlook - this is important, suggesting no immediate end is in sight for bonanza profits, driven by strong demand and supply shortages.

However, the scale of the rise in used car prices is clearly absurd, and can’t possibly last -

… the impact of any downward price realignment in Q4 2021 is not anticipated to be significant. In Q3 2021, used vehicle values rose by an average of 12.7%*. This was the seventh month of consecutive growth in used vehicle values and over this period, used vehicle values have appreciated by 26.3%*; an unprecedented position.

Valuation - good old Zeus are being super-helpful today, with an update on this one too. It’s upgraded FY 12/2021 profit to £52.1m, up 24% on previous forecast.

That equates to 51.1p adj EPS, for a PER of 4.3 - similar ballpark to Lookers.

There are no forecasts from Zeus for 2022 or beyond as yet.

Interestingly, the analysts Mike Allen and Rachel Birkett comment -

… we do not see used car prices coming under pressure during the foreseeable future.

That’s important for valuations, and is a significant change today from what has been said by car dealers in the recent past.

My opinion - there’s not a lot to add, this update is very similar to the one from Lookers. The main difference seems to be that Marshalls (13%) is much further ahead of Lookers (3.4%) in outperformance against industry data on new car sales volumes.

Both Lookers and Marshalls are raking in spectacular profits, due to extreme market conditions (very high margins on new & particularly used) car prices, due to supply shortages.

Investors are sensibly treating this as a one-off, although I think valuations now look so low, that I’d say there’s scope for another decent leg up in prices across the sector.

Plus investors should be in line for bumper divis/buybacks and maybe takeovers in 2022. It’s certainly an interesting sector for value investors right now. Do bear in mind though that profits are not sustainable at this level in the medium, let alone longer term.

Note the StockRank is jammed on maximum -

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I've shortened the usual 3-year charts I tend to use here, to just 1 year (above), so that today's fairly big price rise shows up clearly.

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Jack’s section

Netcall (LON:NET)

Share price: 81.56p (-4.61%)

Shares in issue: 149,020,267

Market cap: £121.5m

There’s been some share price recovery at Netcall, which has more than trebled in value since its 2020 lows. The StockRank has also improved markedly, and the group is now firmly in ‘High Flyer’ territory with Quality and Momentum Ranks of 94.

And, while the forecast rolling PE ratio looks very high at more than 50x, the trailing twelve month free cash flow measure is far more reasonable. So whether or not the shares are good value depends on which of these metrics - earnings or free cash flow - are more representative of Netcall’s economic reality and future earnings power.

The group provides omnichannel messaging and contact centre solutions and ‘takes the pain out of big change projects’ for over 600 organisations in financial services, insurance, local government and healthcare.

Its Liberty Platform aids companies’ customer-facing and IT teams to implement changes and solve operational issues without embarking on costly and complex transformation programs.

This platform is built around two areas:

Intelligent Automation: low-code software solution enabling customers to automate workflows and processes, plus an ‘AI-powered robotic process automation solution’ that can act as a personal assistant of sorts to contact centre agents.

Customer engagement: an omni-channel contact centre solution for customer engagement including automated speech bots, plus a cloud messaging and bot platform that can be used across social media.

Netcall’s focus is primarily on sectors characterised by large, complex ecosystems of customers, suppliers or staff, which are often subject to high levels of regulation. The three largest are healthcare, public sector and financial services.

These three core market segments continue to see significant new demand and today represent 85% of group revenues.

The top line gapped up in 2018 (thanks at least in part to a c£11m acquisition by the looks of it), so it looks like there is demand for its services.

Final results

Highlights:

• Revenue +8% to £27.2m,
• Cloud business revenue +26% to £8.3m,
• Total annual contract value (ACV) +10% to £18.5m (30 June 2020: £16.8m),
• Cloud services ACV +25% to £9.4m,
• Adjusted EBITDA +21% to £5.34m and profit before tax +98% to £0.99m,
• Group cash up from £12.7m to £14.5m, offset against £6.86m of borrowings (up slightly from £6.75m),
• Final dividend of 0.37p, +48%.

ACV is the total of the value of each cloud and support contract divided by the total number of years of the contract.

Netcall notes the significant growth in cloud business, which now contributes over half of total ACV and improves future revenue visibility. There have been new customer wins across several verticals, including Financial Services, Utilities, Healthcare and Public Sectors. The cloud net retention rate increased from 113% to 116%, which is very healthy and confirms a growing business.

Furthermore, there’s been ‘continued cross-selling success’ with 22% total ACV from customers who have purchased both Intelligent Automation and Customer Engagement solutions, and the group notes ‘increased momentum’ in customer migrations from on-premise to cloud solutions (a favourable dynamic leading to higher quality revenue and earnings).

You can see this migration to Cloud in the following table:

Netcall points to a ‘significant increase in profitability’ but the PBT figure is still very low at less than £1m, especially against a market cap of c£121m, so against all the good news is still the question of whether or not the shares are good value.

Gross profit margin is very high, up by 2% to 90% (FY20: 88%) mainly due to higher margin media channels driving revenues within Communication services.

And the group is cash generative: cash generated from operations was £5.69m (FY20: £9.39m), or £6.72m (FY20: £7.18m) after adjusting for the effect of a VAT deferral scheme and a recent acquisition.

Balance sheet - some 58% of the £51.8m total assets is made up of intangible assets, although a further 28% is cash (£14.5m), set against current liabilities of £18.8m. Net assets are £24.6m but net tangible assets are therefore negative at -£5.5m. The group’s cash generation characteristics are an asset in this regard, so perhaps it can justify a lighter balance sheet but I’d want more security here at the current price.

Outlook

The Group's target markets represent a substantial and growing opportunity with our Liberty platform being well positioned to support customers' digital transformation strategies. Our growing cloud business is delivering enhanced profitability and revenue visibility which, combined with our product innovation, produces new growth opportunities. This, combined with a robust foundation of recurring revenues and a cash generative business model, provides the Board with confidence in the Group's growth prospects.

Conclusion

These come across as good results and there’s positive momentum in the 116% retention rate, conversion to cloud and accelerating ACV rates, and new customer wins.

How much business can Netcall win? With less than £1m in PBT for a market cap of more than £121m, that’s obviously an important consideration as a lot of growth is priced in. Cash generation is strong and gross margins are very high, so holders will be expecting profits to expand quite quickly.

The group’s focus is on sectors characterised by large, complex ecosystems of customers, suppliers or staff, often subject to high levels of regulation, such as healthcare, public sector and financial services. That suggests quite a large and potentially high margin addressable market.

The tricky thing about this type of company is it can reach an inflection point that drastically improves profitability. I think it’s worth investigating the scale of the opportunity and the depth of competition here for that reason, but the valuation looks pricey and I can’t see too much of an opportunity in the near term at these levels. Counter arguments regarding valuation are always welcome, of course.