Small Cap Value Report (Mon 13 June 2022) - MRK, RBG, GTLY, TGP, SOM

Good morning! It's Paul & Jack here with Monday's SCVR.

Mello is back with its virtual events tonight at 5pm, with three companies presenting plus a talk from Gervais Williams and the ever popular BASH. Stockopedia subscribers can get free tickets with the code FREE1306. You can sign up here.

Agenda -

Paul's Section:

Here is some material I wrote up over the weekend, my notes from 2 recent webinars with management - 

Marks Electrical (LON:MRK) - a really impressive & comprehensive webinar with the CEO & CFO. This looks a good business, with lean overheads enabling it to make a reasonable profit margin. Management come across very well, and being entrepreneurial, and on the ball. It's going on my watch list.

Revolution Bars (LON:RBG) (I hold) - a trade magazine interviews the CEO. There's lots of positive stuff going on here, despite tough macro conditions.

Jack's section:

Gateley Holdings (LON:GTLY) - ahead of expectations full year trading update is reassuring given the share price falls seen across this part of the market (Knights Group in particular). But Gateley is faring much better than Knights and probably deserves a modest premium to some of its peers. At 13.3x forecast earnings though, I think the shares are fairly priced rather than cheap.

Tekmar (LON:TGP) - c30% fall in share price this morning as the company announces a formal sale process, on account of not having enough cash to execute its turnaround strategy. Increased pressure on working capital and a precarious financial position, so it’s not initiating the FSP from a position of strength.

Somero Enterprises (LON:SOM) - a solid (if short) AGM update, with more detail expected in July. The stock looks cheap here, but there is a risk of earnings falling if macro conditions worsen. FY21 was also much more profitable than average, but if this level can be maintained (which so far appears to be the case for FY22) then the shares will have to rerate at some point.

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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.

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Marks Electrical (LON:MRK)

89p - market cap £93m

Webinar with management

I reviewed the recent results for this online electrical retailer, here last week.

It seems a good company, but my main concerns were whether the seemingly high net profit margin was sustainable, and that the valuation of the shares still seemed a bit toppy, with an IPO premium still in there.

Equity Development laid on a webinar late last week, 55 minutes, link to recording here.

I took detailed notes of the key points - not comprehensive, or verbatim, so as usual my notes might contain errors [hopefully not] or omissions. Subscribers here on Stocko seem to like it when I type up my notes, so I hope this is useful. Obviously I’ve added my personal comments (in brackets) below, which are subjective.

CEO - Mark Smithson - seems grounded, entrepreneurial.

CFO - Josh Egan - younger, seems switched on.

Good dynamic between CEO & CFO - i.e. CEO not overly dominant.

I didn’t catch the first 4 minutes, but from that point -

Some one-off benefits to profit margins during the pandemic (as I thought, but good they are being transparent about this)

Nearly 1.9 staff (average) one each van now, compared with 1.3 in pandemic - cheaper, but customer service not so good.

Marketing costs have risen to 5.0% of revenues - this is now the ongoing rate. Marketing was cheaper during the pandemic.

Other overheads are only 5.5%-6.0% of revenues, we’re very efficient.

EBITDA margin of 8-10% is sustainable in future (good to know, as I was worried it might still be excessive)

Delivery costs to customers are up 5%, but offset by higher density - i.e. more deliveries on each van trip, as revenues rise.

Fuel costs are up, but not a big proportion of costs.

Trade payables - in the 50s (days) - suppliers have increased our credit lines, which is helpful.

Low capex.

Operating cashflow conversion from profits, will be c.100% in future.

Key advantage - everyone is under one roof in Leicester, so very easy to manage - simple, but optimal.

Very good IT.

Based in Midlands - so it’s 5 hours to Cornwall or Glasgow - ideal location.

Top 10 brands are 66% of sales.

Learned from Hotpoint, not to put too many eggs in one basket. They unilaterally took away ⅔ of MRK’s profit, when MRK had become too dependent on them, so won’t happen again (good to hear mgt mention things they got wrong, and what they learned from it).

Focus on selling premium products - makes sense for many reasons, e.g. higher value on each van, less damage to product in transit due to better packaging, better instructions so fewer customer enquiries.

Extended warranties - we do sell add-ons, but we don’t rely on them. No balance sheet risk, as warranties are done via third parties, and we take a c.20% commission.

TrustPilot - we look very carefully at 1* negative reviews, to see what’s gone wrong & fix it. Example was a TV ad did really well, but volume of orders overwhelmed us, and Trustpilot reviews dropped as a result. Lesson learned, not to over-advertise.

We deliver almost everything ourselves, own vans/drivers is key part of the business.

Brand awareness - only 7% of public aware of us - this is an opportunity in future, to grow it.

AO.com is a very good business, has grown considerably.

We’re after the John Lewis customers - premium products.

CEO talking about the CFO - Josh has become a marketing guru, he’s all over the numbers (Paul: is this ideal? Surely the company should have marketing specialists in house?)

Rapid diminishing returns from online ads, so have to be careful with spend.

TV ads - expensive, but we’re doing some on Sky, and recently the electrical brands want to share the costs with us, to promote their products - a new development, exciting.

Marketing emails - we don’t send too many. One per week, maximum. If we do more, then we find the impact is negative, as people unsubscribe & database shrinks.

Transport - we’ve got 24 vans, and 120 driver/installers. Ordered 21 new Mercedes vans at a good price recently - good lorries are a necessity & are depreciated over just 3 years, then they’re free.

Warehouse space is currently 215k sq.ft., with better (higher) stacking of product. Operating 24/7 now.

Staff - work 4 days on, 4 days off - they love it! Motivated & well paid staff, paying at top end. Rewarded financially for good reviews. Paid extra to carry heavy/bulky items into customers houses, e.g. US fridge/freezers. Properly trained on how to handle different products - all have different features & installation/handling requirements.

Key point - we want to control our own destiny, not rely on third parties - e.g. own logistics (not third party couriers), own fuel tank (1 month supply in house), 2 mechanics for minor repairs to vans, own IT people.

Capacity - could do c.£250m revenues from existing site.

Relocation - eyeing a move to a much larger local site, 600k sq.ft.

Strengthening management team as the business grows.

Listing on the stock market has been a big advantage in recruiting people - CEO: I didn’t foresee that.

Avg revenue per employee is a key KPI, ours is £514k. Higher than competitors, which are £300-400k.

Major domestic appliances - market is down sharply in April, value down 12% (volume down 18%). We were UP 20% in April.

80% of our sales are “distressed purchases” (Paul - I’m not sure what this means, maybe when something breaks down & needs an urgent replacement? Needs clarifying).

Increased competitive pressure currently.

We’re not just grabbing market share, we want profitable growth.

Huge market - we only have 1.6% market share.

Competition? - we’re cheaper! And we deliver free, next day, using our own trucks. (Paul: we need to verify this, tried over the weekend on a price comparison site, but it’s not as simple as it looks. Have any readers compared prices?)

Overhead is now in place for a larger business.

“Stick to what we’re good at”, as my father told me.

My opinion - this was all music to my ears, so of course I have a much more positive impression of MRK than before the webinar. Trouble is, that nearly always happens with webinars! In a way you could argue there’s something badly wrong, if you don’t want to buy the shares after a good webinar.

Key points for me, are that MRK seems a lean, efficient business model, operating from one site in the Midlands, and delivering within 5 hours to most of the UK. As management explained, this is so much simpler than trying to manage multiple warehouses all over the country, with lots of things going wrong, and wasting resources moving product between warehouses.

This also might limit the scale of MRK though. How much larger can it grow, and still be kept a simple, efficient business?

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Revolution Bars (LON:RBG) (I hold)

15.25p - market cap £35m

Interview with CEO, Rob Pitcher

I came across an interview last week with Rob Pitcher, CEO of Revolution Bars. It’s here, and well worth watching if you have time. If not, then I’ve typed up the key points below. I think this interview demonstrates that a lot of progress has been made behind the scenes, but at the moment the stock market isn’t interested.

In my opinion, once macro, and stock market conditions have improved, then this share could be worth double the current market cap.

The below are just my notes, not a verbatim transcript.

What’s the mood at Revs? Optimistic, but a bit less optimistic than 3 months ago.

Property market - not as tenant-friendly as we’d hoped. 2 or 3 competitors are looking for similar sites to us, and we recently lost out to one of them for a new site we wanted.

Competitive socialising is a big content at the moment, and is popular with landlords. (see XP Factory, and also Revs has trialled its own gaming/bar concept, Playhouse, see more below). We might slow down a bit on new site acquisitions, because we think there will be better opportunities this coming winter.

Currently negotiating on 4 new sites, mostly former retail sites. Also we like former bank branches.

New formats have been trialled -

Founders & Co - trialled in Swansea site (existing, under-performer, so reformatted) - the concept is a bit like a community hub, with bookable rooms for flexible events, 4 independent catering outlets, a coffee shop, barbers, yoga classes, etc, all outsourced. Revs just runs the bar. So we sub-let some of the space. Also pop-up retail for local small businesses. Community feel, all day trading, it’s a brilliant place to hang out. We’re desperate to find a second site, this is a good potential roll-out.

[Note that the Trip Advisor reviews are excellent].

Playhouse - retro competitive gaming, together with food & cocktails. High margins. Fab pizza - absolutely brilliant - we’re no.1 restaurant in Northampton on Trip Advisor [Paul: I’ve verified this, and the reviews are superb]. We even have a beehive on the roof, the honey is used on our deserts & drinks. Vintage games on first floor, including a racing track. Revenue share of games income. Could be a good use for legacy (i.e. under-performing) sites - as we’re taking the same money from Northampton, but higher profits.

Concept proven, and is good enough to do standalone sites, not just conversions of existing.

Sustainability/environment - we’re founder member of zero carbon initiative. Staff like it, and it’s a fashionable thing to do at the moment. But it’s also morally the right thing to do, to be a first mover. When I grew up in Australia, the ozone layer was the big thing. I’ve now got an 8 year old daughter, and when she asks me what Revs are doing for the environment, I want to be able to say, we did this, and this…

Positive knock-on effect with staff & customers. Although our customers don’t want this stuff rammed down their throats. They come to us on a Saturday night, to have fun with their mates, and to forget about the world’s problems for the evening. So we put what we’re doing on our website, and quietly get on with it in the background.

Our team really care about the environment. We have a “zero hero” in every site, who come up with ideas. One said, we don’t need the passion fruit in pornstar martinis (best selling cocktails), and we were using tons of them, air freighted in from South America. So we’ve now switched to a paper picture of a passion fruit to garnish each pornstar martini! [Paul: nice idea, but actually I used to enjoy slurping the seeds out of the passion fruit. Oh well].

Our Reading branch of Revs de Cuba is now a low energy bar. We’ve published all the energy saving measures, so that independent operators can use our research & work to lower their own energy consumption too.

We’re trying to take a leadership position on the environment, it really is trying to save the planet.

Staff - our team are young. Our culture is very strong, the strongest ever maybe? Team looks to management to do what we say we’ll do.

Most management have done basic roles in the business earlier in our careers (I started as a KP [Paul: don’t know what a KP is, sorry!]

Very flat, open door structure. We often work in the bars. There’s no secret, we just listen really hard to the team. We can effect change quickly.

Recent staff survey had highest ever participation, at 85% of 3k staff.

Wellness of the team is really important to us.

Ordering App - pre-pandemic this had been on the pending list for ages! Had to do it in pandemic, when trading was restricted, the order & pay app became 90% of our business! This fell right back once restrictions lifted, but has settled at 15-18% of revenues, as guests like the app, as they don’t have to queue at the bar when it’s busy - ordering from table means they spend time with friends, and drinks are delivered to the table.

1.1m registered users of the app. Just employed a head of digital marketing, so we can start to monetise our customer database.

Question about share price.

It’s frustrating. When I joined Revs, people at HO seemed obsessed with the share price. My focus is on the business. The stock market will catch up. The current share price is not a reflection of the business. It frustrates me. Being stock market listed is brilliant - shareholders supported the business twice in the pandemic, with £15m and a £21m fundraises.

Question - will you be a consolidator, or get taken private?

I prefer the former! We have looked at some acquisitions, very much on the agenda, got to find the right one. Our existing team is capable of running a bigger business.

Question about tax.

We have good access to Govt for our size. Business rates is the main focus of our lobbying. Hospitality pays far too much tax. It’s got to change, but that could take a couple of years.

The future? It’s foggy. Costs are rising, wages, utilities, ingredients, it all hurts. Plus consumer uncertainty. But going to bars is an affordable luxury, even in a recession. We hope people will still come out, and we lift their spirits!

Rob signs off.

Hosts comment that he’s such an impressive operator, will surely get a bigger job in future [Paul: I hope not!]. There’s such clarity there, Rob’s really good at simplifying things.

My opinion - interim results from RBG were good, and current broker forecasts for FY 6/2022 strike me as far too low, even allowing for some likely softness in more recent trading. That said, RBG is rapidly refurbishing its existing sites, which has an excellent 2-year payback - i.e. it attracts business from competitors. With so many sites being refurbished, I suspect RBG is more likely to beat undemanding forecasts than miss.

Also, I’m quite excited about the new formats that have now been successfully trialled. This means RBG now has 4 brands, all of which can be rolled out.

It also has a strong balance sheet, with net cash, so can fund expansion & refurbs itself.

It’s obviously a pity that shareholders were so badly diluted in the pandemic, with the share count rising from 50m to 230m. So the share price won’t ever get back to the giddy heights of 200p+ when Stonegate bid unsuccessfully for it. What we didn’t know at the time, was that RBG’s sites were under-invested, and starting to struggle. Then the pandemic came. So we are where we are. Forget the history, all that matters is whether RBG shares are currently a good investment. It seems clear to me that the answer is yes. I’ll be increasing my position size when funds permit.

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Jack's section

Gateley Holdings (LON:GTLY)

Share price: 210.08p (-0.91%)

Shares in issue: 119,276,639

Market cap: £250.6m

Trading update for the year ended 30 April 2022

A lot of these professional services firms have been hit by the small cap downturn, with Knights in particular getting crushed (for company-specific reasons), so it’s encouraging to see this ‘ahead of expectations’ update from Gateley.

The company notes that, per Factset, consensus expectations were for revenue of £133.5m and adjusted PBT £20.9m

• Revenue up c13% to not less than £137m (with organic growth of 10%, up from 6.5%),
• Underlying adjusted PBT up c11% to not less than £21.5m,
• Profit before tax up c10% to not less than £18m,
• Adjusted earnings per share up c7% to not less than 14.1p,
• Net cash down from £19.6m to £10.4m (partly due to M&A and dividends returning),
• Net assets of not less than £70m,
• Proposed final dividend +10% to 5.5p and total dividend +13.3% to 8.5p.

The group enjoyed strong activity levels, with organic revenue growth from legal service lines up c.9% alongside exceptional organic growth of c.24% from consultancy service lines, which included three acquisitions: Tozer Gallagher in July 2021, Adamson Jones in January 2022 and Smithers Purslow in April 2022.

The Corporate Platform grew by c.18%, buoyed by the continuing strength of the UK M&A and Private Equity markets. The Property Platform grew by c.15%, enhanced by greater market share and larger transactions The People Platform saw a return to significant growth across both its legal and consultancy service lines, where combined revenue grew by c.40%. The Business Services Platform contracted by c.10%, as some long-term litigation projects stalled alongside new instructions not yet reaching billing thresholds.

On Business Services, Gateley expects the timing of ongoing and new projects to result in an improved FY23.

Total headcount at 30 April 2022 of 1,368. Average number of professional staff increased by 3.8% from 770 to 799.

As flagged previously, full year audited accounts will be delayed into September as the group implements a new financial accounting system. Gateley started to update the system in May, its quietest month of the year, to limit any potential impact.

Outlook

Trading at the start of the new financial year is in line with the Board's expectations, with the Group continuing to meet the challenges of the well-reported and ongoing inflationary headwinds. The considerable organic and acquisitive opportunities to develop the Group's Platforms further, combined with Gateley's diversified and resilient business model, underpin the Board's confidence in the prospects and the continuing growth of the business in line with current market expectations.

Conclusion

Good results, with a successful return to recruitment generating organic revenue growth of over 10%. With total revenue up 13% and underlying PBT up just 11% though, questions over longer term business model scalability remain.

Near term growth looks possible as long as inflation can be managed - there is still £16.1m of gross cash (including the new £30m Revolving Credit Facility) for further legal and consultancy services M&A and organic growth potential.

Concerns of a looming recession can’t be dismissed though and would likely have an impact on business here. Gateley itself flags inflationary macro headwinds. With such significant wage costs, navigating those conditions could be tricky. Double digit wage inflation is already happening here and this could continue, so that will have to be managed.

But the company has so far exhibited relatively low earnings volatility and consistent revenue growth, which to my mind suggests it could fare better than some others out there. Gateley is also developing a good track record for dividend payments which might help to allay some of the agency risk fears.

Management claims that the business has grown every year since 1986. March and April are typically the strongest months of the year and were again very busy in FY22, with staff utilisation back above the targeted 85%. That compares favourably to a quieter March and April at Knights at the time of its profit warning.

It’s a good operator, but given the outlook I think a forecast PER of 13.3x sounds fairly priced at the moment.

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Tekmar (LON:TGP)

Share price: 27.49p (-27.51%)

Shares in issue: 60,960,234

Market cap: £16.8m

Interim results for the 6 months ending 31 March 2022

Big share price fall here, with nearly a third of the market cap wiped out this morning. It’s an extremely illiquid share, you’re only reliably going to buy or sell around £800 worth so I won’t spend too long on it (is it just me, or has small cap liquidity in general fallen off a cliff recently?).

Tekmar designs, manufactures and supplies subsea stability and protection technology to the global offshore energy markets, predominantly Offshore Wind.

• Revenue down from £13.9m to £13m,
• Adjusted EBITDA loss of £1.8m compared to a loss of £1.1m in the previous period,
• Loss before tax up from £2.2m to £3.3m.

To be honest, the interim results are not as important as the news in a separate announcement that the group says it is now looking to sell itself.

Over the past year Tekmar has taken steps to improve its financial position, including enhancing its banking facilities, improving the efficiency of its contract tendering systems and more recently raising net proceeds of £3.7 million from a placing and open offer. However, despite all the steps taken, the Group's balance sheet has not been rebuilt and strengthened as much as Tekmar's board of directors ("Board") would have preferred in order to fully execute its growth strategy and address the industry headwinds and uncertainties that still remain.

Whilst the Group is currently operating with sufficient working capital for its present requirements, the combination of sustained trading losses and increased pressure on working capital mean that the Group may not have the necessary cash to make all the required investment to deliver fully the turnaround strategy to return the Group to profitable cash generation within the timescale targeted by the Board.

Conclusion

In my opinion, this highlights the importance of paying attention to low financial health scores and Quality Ranks, particularly in the current environment. High quality shares may disappoint on growth or become too expensive, but you won’t see them having to suddenly sell themselves on account of sustained trading losses and a lack of cash.

It reminds me of this quote by investment fund manager Anthony Bolton:

When I analysed the stocks that have lost me the most money, about two-thirds of the time it was due to weak balance sheets. You have to have your eyes open to the fact that if you are buying a company with a weak balance sheet and something changes, then that’s when you are going to be most exposed as a shareholder.

We all know the difficult conditions companies currently face, so extra care should be taken around companies with weak financials. Commiserations to any shareholders out there.

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Somero Enterprises (LON:SOM)

Share price: 380p (unchanged)

Shares in issue: 56,048,246

Market cap: £213m

AGM statement for the five months to 31 May 2022

A very short communication, here’s the key paragraph:

In the five months ended 31 May 2022, the non-residential construction market remained healthy and therefore trading has been tracking well. Consequently, the Board expects revenue, profitability, and cash generation to be in-line with the full year ending 31 December 2022 guidance provided in the 09 March 2022 final FY 2021 results statement.

Diary date - a more detailed trading update will be provided in July.

Tracking back to the March update, the group commented:

Momentum has continued into the current fiscal year and the Board expects 2022 will be a profitable year with healthy cash generation. Following an extraordinary year in 2021, with remarkable growth and record revenues and profits, 2022 revenues are expected to grow at a modest rate, and with the investments for future growth being made, 2022 EBITDA is expected to be comparable to 2021.

Conclusion

FY21 adjusted EBITDA was $47.8m. Given year-end net cash of $42.1m, that would make for an FY22 EV/EBITDA of roughly 4.7x.

Somero has some excellent profitability metrics, perhaps unrivalled among stocks trading on a single-digit forecast PER. Clearly cyclical and macro concerns are weighing on the shares.

In my view, the stock looks cheap but it’s never been particularly expensive in the past. I still think that there is good upside potential at a trailing twelve month PER of 7.6x and a dividend yield of 6.6% though.

Add in the net cash position and it seems like there is a lot of bad news priced in, but then again there’s the chance FY21 earnings represents something of a peak.

If you look at Stocko’s expected FY22 dividend of 48 cents, it’s on something like a 10% forecast yield which seems anomalously high. If the market rallies then this stock could really fly but for now it remains unfavoured and investors are clearly wary of taking on cyclical risk. I suspect this is one of the better single-digit PE stocks knocking around in a cheap market.