Small Cap Value Report (Mon 9 May 2022) - IDEA, MIDW, CER, IOF, WATR

Good morning, it's Paul & Jack here with Monday's SCVR.

Mello is back tonight and David will be interviewing Richard Crow (you might know him as Cockney Rebel on Twitter). Richard has been investing for a long time and is a great character, so it will be interesting to hear his thoughts on current market conditions.

Agenda -

Paul's Section:

Ideagen (LON:IDEA) - congratulations to shareholders here, with a 350p recommended bid announced from HG. Very unusually, IDEA announces that it is continuing discussions with another potential bidder, so I wonder if there's a chance of an increased bid?

Midwich (LON:MIDW) - in line with expectations trading update, and a confident-sounding outlook. No signs yet of any downturn. The business is doing well, but the valuation looks full, given macro uncertainties. It's only a low margin distributor, so it doesn't interest me at the current price.

Water Intelligence (LON:WATR) - a trading update that is a bit ambiguous in places. The valuation still looks much too high, to me. WATR has a good long-term track record though, and is accelerating expansion now. So maybe the punchy rating will turn out to be justified?

Jack's Section: 

Cerillion (LON:CER) - strong interim results continue the positive momentum at Cerillion. The shares touched 600p recently and I missed that window as they have since bounced back. A high quality stock with double digit growth - an attractive combination - but I’m mindful of the valuation and a fall in orders and software revenue could cause a wobble. The group has real potential for long term organic growth though, so it's on the watchlist.

Iofina (LON:IOF) - signs of progress with good net debt reduction but there are also a couple of issues. A hemp-based joint venture is unrelated to the core business and has been written off. Results depend on iodine spot prices, which I don’t have a view on. The share price is volatile and the stock is relatively illiquid. So it’s higher risk, with a chance of doing well, but probably not one I will prioritise.

---

Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to review 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.

---

Paul’s Section:

Ideagen (LON:IDEA)

Recommended takeover

Congratulations to shareholders in IDEA.

This morning brings news of a 350p cash recommended takeover deal, from HG Pooled Management.

That’s an all-time high, and a 44% premium to Friday’s closing price.

The timing is also impeccable, as it will give IDEA shareholders a fresh pot of enlarged cash, to deploy at a time when many other share prices look cheap, thus giving a double benefit - getting a premium payout, and being able to buy the next investment cheaply with the proceeds.

Strangely, IDEA has issued a statement this morning saying that it remains in discussions with another potential bidder, Astorg. So IDEA management seem to be riding two horses at the same time - recommending HG’s bid, whilst also discussing (and granting due diligence access) to Astorg. Which seems to be opening up the potential of a higher competing offer, maybe? I can’t remember ever seeing this situation before - normally once a bid is recommended by management, then that’s it. So to publicly state that discussions are continuing with another party strikes me as very unusual.

My opinion - not that it matters now, but we never really got behind IDEA here at the SCVR. That was a combination of its weak balance sheet, and the rapid pace of acquisitions making it difficult to work out if the cashflows were real or not. Anyway, it’s resulted in an excellent outcome for shareholders, which is always pleasing to see.

Takeover bids at a decent premium might begin to restore confidence in UK small caps, if we see them continuing. It will be interesting to see where the share price settles today - if it goes to a premium to the 350p bid, then that would suggest the market thinks an increased competing bid might be on the coming?

.

.

---

Midwich (LON:MIDW)

585p (up c.1% at 08:24)

Market cap £520m

AGM Statement (trading update)

Midwich Group (AIM: MIDW), a global specialist audio visual ("AV") distributor to the trade market…

MIDW current financial year ends 12/2022.

Current trading - is in line -

Trading in the first four months of the current year has been in line with the Board's expectations and we look forward with confidence."

My opinion - this strikes me as quite interesting. I’m expecting to hear companies publish cautious outlooks, due to the widely reported inflationary pressures, and the increasing likelihood of a possible recession.

Hence this brief, but confident-sounding update from MIDW seems to suggest it is still seeing good demand.

Broker forecasts have been rising, which also suggests business is going well -

.

Stockopedia’s graphical history is interesting, below. We can clearly see the impact of the pandemic, but with the previous growth trend now apparently resuming.

The big unknown is, what (if any) impact the current more cautious economic outlook might have. Also, is current trading benefiting from pent-up demand deferred by covid?

Hence it’s particularly difficult to work out where earnings are likely to go in future.

.

With an in line update today confirming the forecast trend above, that’s a pretty good track record over the last 6 years, suggesting that MIDW seems a well-run business, with a good strategy.

Given all the macro uncertainties, I don’t find the current valuation appealing at all. There seem to be much better bargains elsewhere right now -

.

.

---

Water Intelligence (LON:WATR)

740p (down 3% at 09:36)

Market cap £129m

Q1 Trading Update

Water Intelligence plc (AIM: WATR.L) (the "Group" or "Water Intelligence"), a leading multinational provider of precision, minimally-invasive leak detection and remediation solutions for both potable and non-potable water is pleased to provide its unaudited Q1 Trading Update.

The share price here is similar to most other small caps, in that it overshot on the upside last year, and is now in a painful correction period.

Just because share prices are falling, doesn’t mean there’s necessarily anything wrong with the company or its prospects. We’re just in a bear market, where people are probably selling mainly out of fear of further paper losses from the uncertain macro outlook, and negative momentum where selling feeds on selling.

Eventually the selling stops, and there are bargains galore. Timing is the difficult bit, and on that, your guess is as good or probably better than mine.

I’m making a list of obvious buying opportunities, ready to pounce when signs of life emerge. Remembering that the market is meant to look ahead, so usually share prices start to rise before the actual data shows an economic recovery.

The key turning point often seems to be when the negative news stops getting any worse. John Authers latest daily email suggests early signs that inflation may be peaking in the US at 8%, and that commodity prices seem to now be falling. So who knows?

.

Today’s Update

Accelerating growth, through increased headcount, new sites, and buying out franchisees.

Q1 revenues up 44% at $16.5m (of which 26% is organic growth)

Adj PBT up 16% to $2.1m

Adjustments to profitability measures - seem very aggressive to me, so I’d be more comfortable valuing this share on the lower, statutory profit -

*Adjusted EBITDA adds back one-time costs of approximately $400,000 from (i) Salesforce training and implementation and (ii) Australian extreme rain and flood conditions limiting service delivery ("One-Time Costs")   

**Adjusted PBT adds back (1) One-time Costs as per Adjusted EBITDA and (2) non-cash costs of share-based payments and amortization

Q1 statutory profit fell 17% to $1.4m

Net cash $10m, and $8m undrawn bank facilities.

Diary date - late May 2022, for FY 12/2021 results.

Valuation - on current forecasts it’s still nowhere near a value share.

Remember that the bottom has fallen out of growth company valuations, so we need to be very careful indeed not to anchor to the previous share price, in the boom last year, and assume that it’s cheap now. Just to support the current share price (let alone rise), WATR would need to strongly out-perform existing forecasts -

My opinion - WATR has demonstrated a good long-term track record, as you can see -

.

I would have liked to see a less wordy, and more specific update today. For example, it ducks the issue of performance vs market expectations. Instead we get this -

And we are delivering both organic growth and acquisition-led growth in line with our plan...  

Following its Q4 2021 fund raise, the Group has accelerated its strategic growth plan through new investments geared to capture additional market share and increase profitable growth in H2 2022 and beyond.

I dislike the phrase “increase profitable growth”, which we’re seeing gain popularity in recent trading updates. It’s a deliberately ambiguous phrase that the PRs seem to have latched onto. It could mean anything you want it to mean! It falls short of saying profits will grow. Just that there will be growth, and the company will remain profitable, but not stating at what level of profit. So profits could actually go down a lot, but as long as revenues rise, then that could still be described as “profitable growth”. Growth in profits would be much more meaningful wording, and unambiguous.

Overall, the high PER, combined with rather creative accounting adjustments, put me off. We’re in a nasty bear market, and there are loads of shares around from companies with a strong long-term track record, at bargain prices (for patient investors, who are looking through a short-term cost of living squeeze). So why would I want to pay a PER of 28 for WATR? Only if I thought it was likely to smash forecasts, and there’s nothing in today’s update which gives me that confidence.

.

---

Jack's section

Cerillion (LON:CER)

Share price: 731p (-4.44%)

Shares in issue: 29,485,454

Market cap: £215.5m

Cerillion has done fantastically well over the past couple of years. I started to get more seriously interested in the stock when it touched 600p but it didn’t stay there for long.

The bounce brings it back up to around 23x forecast rolling earnings. Not cheap, but not the most expensive either for a company that has been really outperforming for a few financial periods now.

Cerillion is a software-as-a-service business founded in 1999 following a management buyout from Logica. It provides billing, charging and CRM software solutions, mostly to the telecommunications sector but also to other industry sectors, including finance and utilities.

Interim results for the six months ended 31 March 2022

The results continue to look good here.

• Revenue +26% to £16.1m,
• Adjusted EBITDA +50% to £7.2m,
• Adjusted profit before tax +65% to £6.3m,
• Adjusted earnings per share +62% to 18.6p,
• Dividend per share +24% to 2.6p,
• Net cash +114% to £16.5m.

Revenue is up by 26% year-on-year to £16.1m and annualised recurring revenue is 9% higher than a year ago at £9.8m.

The revenue mix was more weighted towards Services, up from 51% to 63% of total revenue and up 57% year-on-year to £10.2m. Software revenue (software licence, support and maintenance sales) made up 31% of total revenue, decreasing by 15% to £5.0m. This mainly reflected the timing of software licence recognition, a recurring theme in management commentary.

We should see this figure recover in H2. The same time last year it stood at 46% of total.

Cerillion’s back-order book of £39.7m is down 6% and total new orders fell to £10.9m from £23.6m. Management again says this is due to timing and should correct in the second half.

New orders from existing customers increased by 12% to £10.9m, which bodes well for future customer wins and organic growth. On that note, the new customer pipeline is up 31% to a record £172m and new major customer signings are expected in H2.

Net cash generated from operations rose by 145% to £6.5m.

Outlook

Looking ahead over the balance of the current financial year, we are very confident of continuing progress, supported by our strong back-order book and new customer sales pipeline.

From a market perspective, we are seeing no let-up in investment in 5G and broadband infrastructure, and we continue to see strong opportunity for Cerillion, derived from the need to monetise those new assets and trickle-down investment into the ancillary systems that we provide.

Conclusion

Although the timing issue introduces some uncertainty, Cerillion has good visibility on future earnings and these remain strong results. Revenue, adjusted PBT, and net cash are all at record levels. Cerillion also has a strong net cash balance sheet, so this stock is firmly in Quality territory.

When you couple that with the double digit organic growth, it suggests a premium is warranted. But the valuation is nevertheless a bit of a sticking point.

There are more expensive SaaS shares out there though, and I would argue that they do not have superior prospects. So I can see the argument for why the shares are still worth a buy at these levels.

I’m personally wary of higher multiples at the moment and the H2 timing might come as a surprise to shareholders who have become used to undisrupted good news. Cerillion remains a strong performer with competent management and attractive prospects though, so it remains on my watchlist.

---

Iofina (LON:IOF)

Share price: 21.37p (+6.85%)

Shares in issue: 191,858,408

Market cap: £41m

A new one for me, noted as Highly Speculative by Stocko and with a history of net losses and equity dilution. Iofina is a micro cap with a 500bps spread and a c22% free float, so put it all together and it’s a higher risk stock.

And a quick look at the F and Z-Scores suggest a strengthening but still fragile financial position.

Iofina’s results are also dependent on Iodine spot prices - not something I’m familiar with. Commodity price exposure can be a positive or a negative depending on conditions, but it is always an important variable beyond management’s control. As such, I generally tend to view it as a weakness in the business model which can provide a shorter term trading opportunity (sometimes longer depending on structural market dynamics).

Iodine is found in thyroid hormones. It is used in things like table salt to ensure we get enough of it and is also a core commodity in some other products. According to the group, current global iodine spot prices have reached $60/kg and above, up 20% since the beginning of 2022.

Iofina Resources operates five iodine extraction facilities in the Anadarko Basin in western Oklahoma. Iofina Chemical makes specialized chlorides, fluorides, and iodides. IofinaEX is a Joint Venture agreement with Organic Vines OP, a feminised hemp seed production and genetics company.

I’m wary of anything to do with hemp, a very hyped up sector in recent years. It also seems to have nothing to do with Iofina’s core operations. The group’s results today show that this hemp seed project has not delivered the expected returns, and the entire investment has been written off. It sounds like a waste of money then.

Final results for the year to 31 December 2021

• Revenue +31% to $39m,
• Gross profit +28% to $10.7m,
• Operating profit +78% to $5.2m,
• Profit before tax +301% to $5.1m.

The group generated $5.9m of cash and reduced net debt from $8.9m to $3m, driving an 83% reduction in finance expense to $0.3m. The prior year did include $1.4m of interest and fees relating to the September 2020 refinancing though, so I’m not sure a direct comparison is appropriate.

This latest net debt decrease is not reflected in the chart below, but the picture does show additional good progress by the group in previous years.

Operating profit is flattered by a $1.1m gain from Iofina’s COVID-related US Paycheck Protection Program (PPP) loan being forgiven, offset by a $0.9m impairment of its Organic Vine venture.

Today we are proud to announce that 2021 was our fourth consecutive year of record revenues and EBITDA. By executing our fundamental business plans coupled with a strong bounce back in demand for iodine and its end-use products in the wake of the COVID-19 pandemic, we were able to deliver enhanced revenues and profits and significantly reduce our debt through strong cash generation. Our margins have been bolstered by a strong iodine price particularly over the last 6 months, and we expect these high prices to continue during 2022.

Conclusion

The group has been capex heavy in the past, and future performance depends on how wisely this cash has been spent.

A lot of money has been invested, net debt is reducing, the company has started to make profits, and revenues have grown. So there are signs of a potential inflection point emerging.

It’s perhaps worth a look, but I have limited insight and no edge here, so probably won’t take it any further. The group’s results depend to some degree on iodine spot prices, and last year brine water volumes and weak oil prices impacted business. So there are a few dependencies and risks to get a handle on.

Inflationary cost pressures and higher energy costs could become a problem going forward. This is the fourth consecutive year of revenue and EBITDA growth though, with brokers forecasting that record to continue for at least the next two years.

The valuation, at 8.2x forecast rolling earnings, is undemanding so I can see why it might attract more risk tolerant value investors. It strikes me as high risk, high reward. A cheap valuation and potentially improving prospects, but also a couple of strategic missteps, business model dependencies, and past equity dilution.

I think the five-year chart below tells a bit of a story. The stock is cheap and could go higher, but it has disappointed in the past and the five year hold would have been a rough, volatile ride.

On the other hand, Iofina has been growing its revenues and has recently started to make a profit.

This is not my typical investment. It could do well, but there are also risks. Ultimately it’s a volatile micro cap with some share price liquidity issues, operating in an area I’m not familiar with, so I’ll leave it for others to discuss.