Small Cap Value Report (Tue 1 Mar 2022) - CNIC, CLX, RCH

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

Agenda -

Jack's section

Centralnic (LON:CNIC) - Notes from yesterday's call with CEO Ben Crawford, with some comments on the group's strong growth, balance sheet, adjustments, and acquisition of VGL.

Calnex Solutions (LON:CLX) - component availability is becoming more of an issue, but if this can be managed then the group is on course to meet expectations for the financial year. That’s to be expected given the valuation, but what’s moved the shares today is a new contract win with a large datacentre partner that means FY23 operating profit is now expected to be materially ahead of expectations.

Reach (LON:RCH) - digital growth continues, although H2 was lower than H1. Inflation and rising energy prices are going to impact profits next year, hence the negative market reaction. The group also continues to negotiate pension contributions with some trustees, which adds a bit more uncertainty. It remains cheap compared to the cash it generates but the momentum looks poor right now.

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Explanatory notes -

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Jack's section

Centralnic (LON:CNIC)

Notes from meeting with management

I hold

No surprise that revenues are again up 71% to $410m as this is in keeping with a revenue CAGR of roughly 73% since IPO. But, importantly, a lot of this growth is now organic (39% according to the update, up from mid single digits a few years ago and 9% in FY20).

This follows years of significant work and investment into staff and systems, plus a centralised head office function that gives managers more freedom to grow their businesses. The other big factor is the impressive growth in online marketing. Today’s announcement marks the fourth acquisition here, one which significantly grows the scale of this segment.

Group adjusted EBITDA is up c60% and cash generation is up c50%. Operating profit is also up, so the revenue growth is dropping through to profits.

Online Presence - infrastructure online - is generally annual subscription products. Every company buys a suite of products & renews every year.

Online Marketing, however, sees CNIC paid every time the client wins a new customer, so the cadence can be many times every day. It’s also a far greater addressable market at c$400bn.

The company continues to be well positioned as Big Tech focuses on privacy.

Balance sheet

Net debt to EBITDA ratio is 1.6x and needs to be under 2.5, so CNIC is comfortable at these levels. It’s recurring cash generation gives interest cover of c4.5x and, given the nature of the company, perhaps these are the most important metrics against which to gauge debt.

This is a very asset light business. There’s just no need for factories, inventory, etc. hence the lack of tangible assets.

Intangibles is a large line item but this all comes from acquisitions. When you acquire a business, you allocate against assets, and when there’s no tangibles then it is classified as goodwill. Cash and receivables are a big part of the business, and the group’s cash generation is a more important point to consider.

Cash is generated fairly consistently - there are no big swings from, say, a key trading period that a retailer might have, so the figures we get today are a good indicator of the scale of the enterprise. Cash generation has been above adjusted EBITDA every year since IPO.

Customers must prepay & CNIC receives credit from suppliers - a favourable dynamic that leads to strong cash generation.

EPS

It’s fair to adjust the EPS as there’s a big chunk of amortisation relating entirely to intangible assets, so it’s not something that impacts on cash and is primarily a function of acquisitions. If the company stopped making acquisitions, these non-cash costs would fall away.

There are non-core expenses that fall below the EBITDA line, also driven by M&A. Again, the company could switch these off if it decided to stop acquiring, so they are not underlying costs. They’re also becoming a smaller and smaller part of EBITDA and this trend will continue. Adjustments could end up around 10% of EBITDA in future.

EPS +18% reflects strong growth in lower margin products, so it’s an expected change in mix; everything is holding its margin and the key thing is that EPS is going up.

Operational costs - CNIC is growing so fast that there will be spend here, but operating costs should go up at a fraction of revenue growth because of the ‘platform’ nature of CNIC’s businesses. There is a degree of scalability here, and the prospect of operational leverage.

VGL acquisition

This is a product comparison website company, similar to Which. It has a content team keeping product comparisons up to date, and brings in a commission from ecommerce companies once customers click through to their sites and make a purchase.

It has tens of millions of customers making purchases and is the market leader in Germany, which is a concentrated market.

$11m EBITDA from $55m revenues, so a healthy 20% margin, meaning the acquisition is not just double digit earnings accretive but also margin accretive going forward.

The placement raised £42m, and the open offer ensures that any investor can hold their corner and enjoy same pricing. Management has listened to retail investors here.

There is a small additional tranche of debt but this is proportionate. The bonds are issued at premium to the listed price so the effective interest rate is 4.3%. This bodes well for any debt renegotiation, which could happen from July onwards and could result in lower interest payments.

CNIC gets content creation expertise from VGL which is very helpful for its online marketing business. The group can also monetise the acquired traffic from the new websites, and VGL has some valuable relationships with ecommerce companies. So the transaction is helpful on multiple fronts.

CNIC operates in large, growing markets. The smartest way to address the opportunity is have access to lots of big traffic businesses, which it can buy. There’s scope to continue to do that rapidly due to CNIC’s strong finance and technology teams. It has the expertise to identify and integrate acquisitions, which also diversifies group revenue.

So it expects to continue moving forward via acquisition and organic growth in order to create a company of substantial scale.

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Calnex Solutions (LON:CLX)

Share price: 130p (+9.7%)

Shares in issue: 87,500,000

Market cap: £113.8m

Trading update

(I hold)

Calnex designs, produces and markets test instrumentation and solutions for network synchronization and network emulation. That allows customers to validate the performance of the critical infrastructure associated with telecoms networks. It has an excellent reputation, with customers including BT, China Mobile, NTT, Ericsson, Nokia, Intel, Qualcomm, IBM and Meta.

This IPO has actually done well - something of a rarity at the moment.

The strong levels of trading in the first six months of FY22 have continued and Calnex anticipates full year performance in FY22 will be in line with market expectations. We can see these expectations were upgraded towards the end of last year.

There is a caveat though. Calnex says this performance is ‘subject to the fulfilment of scheduled orders in March’, which is now a challenge due to the availability of components and the level of orders experienced by the group. That doesn’t sound too bad - yes, there are some supply chain challenges, but this temporary challenge is also due to the strong levels of customer orders.

Calnex begins FY23 with a record order book across all product lines and it is anticipated that revenue and operating profit for FY23 will be materially ahead of market expectations.

The company has experienced high demand for its test and measurement solutions, and the introduction of new regulation and standards for the telecoms industry continues to drive demand.

Final results will be out in May, at which point management will give more FY23 guidance.

CEO Tommy Cook comments:

We anticipate next year will see revenue and profits considerably ahead of initial forecasts, with the potential for further growth should the supply chain issues ease and we are able to capitalise on the significant opportunities within our markets.

Conclusion

Calnex remains highly profitable and cash generative. It continues to invest and is well positioned to grow in the telecoms and cloud computing markets, where there is an expanding appetite for testing.

The thing putting people off is likely valuation, and this is a risk for Calnex, particularly if growth stalls or the group opts to invest at the expense of profits in the short term. I’d be relaxed about the latter, but you never know what the next investor is expecting.

My sense is that this is a company run for the long term, with attractive multi-year growth drivers in place, hence why I’m okay with a premium valuation.

That doesn’t seem to be a concern for now anyway, component availability aside. The order book is at record levels, having been increased substantially following this significant order from a large datacentre customer. There’s no data on the exact impact of this new order, but I see Cenkos has upped its FY23 adjusted earnings per share estimate to 6.1p (compared to 5.1p on the StockReport).

Not a cheap stock, but one that has probably proven worthy of a higher valuation.

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Reach (LON:RCH)

Share price: 177.20p (-22%)

Shares in issue: 313,957,398

Market cap: £556.2m

Annual results

Reach has dropped back into SCVR territory today, let’s see what’s driving the 20% share price fall…

• Revenue +2.6% to £615.8m,
• Adjusted operating profit +9.2% to £146.1m,
• Statutory operating profit up from £7.6m to £79.3m,
• Adjusted earnings per share +9.3% to 37.6p,
• Statutory EPS up from a loss of 8.6p to 0.9p,
• Dividend per share up from 4.26p to 7.21p.

That looks fine. Operating adjusted items of £66.8m (2020: £126.2m) fell year on year, with transformation programme and print site closures costs included in 2020 comparative.

Digital revenue came in at £148.3m, up 25.4% (38.6% on two-year view) and taking it from 15% to 24% of group revenue. Most of this came in H1 however, which was up 42.7% compared to 13.3% in H2. Maintaining this dynamic over multiple years is key to the investment case. Reach says it remains on track to double digital revenue from 2020 to 2024.

Print revenue fell 4.7% like-for-like, with circulation down 4.6% and advertising down 4.9%.

This is probably the statement that has spooked investors:

The business is transitioning to become more digitally driven and the ongoing cost base reshaping will in part help fund continued investment. However, the impact from inflation, which began to affect the business towards the end of 2021, has now intensified, particularly in print production. This has primarily been reflected in the cost of newsprint (paper for printed products), which having previously been impacted by rising distribution costs and supply challenges, now also reflects the significant increase in energy prices. As a result, the gross impact of inflation in 2022 is expected to be higher than in recent years.

While ongoing efficiencies are expected to partly mitigate this impact, we anticipate the net effect to be a modest year-on-year reduction in operating profit as we continue to invest for the future.

That doesn’t sound too bad given the modest valuation, but there is the possibility that the cost situation worsens.

Balance sheet

A lot of intangibles here, but cash is growing and the pension deficit is reducing.

In November, we announced that we had secured an increase in our revolving credit facility with an expanded syndicate of relationship banks. The increase in available facilities from £65m to £120m demonstrates growing confidence in the strength of the business and provides us with the optionality to accelerate our growth plans should we identify investment opportunities which enable us to progress faster towards becoming a data-led, insight-driven business.

Pension deficit

The IAS 19 pension deficit (net of deferred tax) in respect of the Group's six defined benefit pension schemes decreased by £138.3m from £255.5m to £117.2m. The decrease was driven by an increase in the discount rate, asset returns and as a result of Group contributions. Changes in the accounting pension deficit do not have an immediate impact on the agreed funding commitments. The triennial valuation for funding of the defined benefit pension schemes as at 31 December 2019 would usually have been completed by 31 March 2021. We have agreed the funding for three of the schemes, and the discussions with the remaining three schemes are ongoing, having been delayed by COVID-19 and more recently differences between the Group and the Trustees as to possible de-risking and the required pace of funding. We continue to be in active discussions with both the Trustees and the Pensions Regulator.

I think that’s a question mark. Equity investors barely get a look in when it comes to pension funding negotiations, so the fact that the company is at odds with certain trustees introduces an additional element of uncertainty. With the deficit reducing, I’d be interested to know just how the parties differ on this point.

Group contributions in respect of the defined benefit pension schemes in the year were £64.7m (2020: £53.9m). This comprised £9.6m to the West Ferry scheme (in relation to closure of the Luton print site in 2021) and £55.1m under the current schedule of contributions of the remaining five schemes. The payment of £9.6m enabled the Trustees of the West Ferry scheme to purchase a bulk annuity and the scheme now has all pension liabilities covered by annuity policies. Contributions in 2022 are expected to be £55.1m under the current schedule of contributions for the remaining five schemes.

Cash generation

Net cash inflow from operating activities of £84.4m (after some £64.7m of pension deficit contributions) minus about £12.5m of tangible and intangible capex means free cash flow of £71.9m, or c22.5p per share.

Conclusion

This strategy was always going to take time to bear fruit. Reach remains on track to double Digital revenues by FY24, but Print still generates the bulk of revenue - £465.1m compared to £148.3m in Digital (up from £118.1m).

Those print revenues are quite resilient though (if in structural decline) while digital continues to grow. Cash on the balance sheet is increasing, even after pension contributions, growth investment, and dividend payments.

Investors seem uneasy about holding the shares though, as evidenced by the share price weakness.

The stock still looks cheap against adjusted earnings and cash generation, but the shift to digital remains a big change in direction. There’s also a risk that inflation spirals. The current impact on FY23 results being talked about is not enough to materially dent the longer term investment case in my view, but there is scope for the cost environment to worsen.

Clearly there are risks. Execution risk, inflation, pension negotiations.

Reach remains a cash cow though with an attractive free cash flow yield. That cash generation enables the group to pay out dividends, invest in content, and progress its digital strategy.

I’m going to watch the share price. Reach has its skeptics, but it chucks off cash and the shares have been far too cheap before. At some point it might get oversold, but is now that point? I think today’s reaction seems harsh, but the chart looks pretty dire and the market does not appear to be in a forgiving mood, so I’m staying on the sidelines for now.

More clarity on future pension contributions would also be a positive and we should presumably be getting more guidance on this over the next year or so.