Small Cap Value Report (Mon 15 Aug 2022) - JOUL, PMP, GUS, TET, SEE

Good morning from Paul & Graham!

Weekend Podcast - for anyone interested. I've no idea how many listeners these are getting! It went up on Sunday morning this weekend, as I was out on the razzle on Friday night in Bournemouth, so nothing much got done the next day.

Agenda - 

Paul's Section:

Joules (LON:JOUL) (I hold) - good news that a new CEO has been found. I recap on the various issues that have made this share such a disaster in the last year. So it all hinges now on shoring up the balance sheet, and swift action needed from the new CEO to sort out its problematic supply chain & excessive inventories. Could be a good turnaround, but risks remain.

Gusbourne (LON:GUS) 67p up 5% at 08:45 (mkt cap £41m) [no section below] - I’ll keep this brief, as GUS shares are illiquid, given that Lord Ashcroft owns 66% of it. H1 (to 6/2022) revenues are small at £3.0m, but that’s up 108% Y-on-Y. Asset-backed borrowing facility increases from £10.5m to £16.5m, for 5 years, “at a competitive rate”, 2.5% over BoE base rate. GUS is spending £1.6m buying 137 acres of adjoining land from one of its own Directors. Vines will be planted in May 2024, so it’s long-term in nature. I reviewed GUS’s last accounts here in June, and was unimpressed. On the same day I also looked at fellow English wine maker, Chapel Down (OFEX:CDGP) and think that looks a far better financial bet, if you have to own one of these shares CDGP is clearly the better investment proposition - bigger, already profitable, and with a decent balance sheet.

Graham's Section:

Portmeirion (LON:PMP) (£56m) (pre-market) - a very small acquisition for Portmeirion but the new brand “Aromaworks” could have significant long-term growth potential in the hands of Portmeirion (time will tell). I use the opportunity to discuss why companies in administration often make for spectacular investment opportunities for the people who buy up the assets or who buy the debt and wipe out existing equity holders. We can’t take part in these deals ourselves, but we can look for listed companies who are able to do it, and share in the rewards.

Treatt (LON:TET) (£340m) - there’s a major profit warning from this provider of extracts and ingredients. The macro headwinds are more difficult to overcome than either the company or its investors expected, and have appeared rather suddenly over the past three months. This does raise some questions about the underlying quality of the business. However, if the problems are temporary and can gradually be resolved, as I suspect, then this remains an attractive business to own and the outlook for investors willing to own it for many years has not fundamentally changed.

Seeing Machines (LON:SEE) (£263m) (+3.6%) [no section below] - this FY June 2022 trading update is in line with expectations. The company is keen to stress that its cash position is ahead of expectations. SEE is a loss-making cash-guzzler that is not expected to be profitable for the foreseeable future, but it commands a large market cap due to its driver monitoring system (DMS). This technology can save lives and is in a niche likely to experience rapid growth in the years ahead. Today’s RNS includes huge percentage growth figures at the top; lower down, it acknowledges that revenues are only up by 15%. This is an interesting company but as an investment it sits firmly within the category of extremely risky stocks, along with lottery tickets and racetrack betting slips.

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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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Paul’s Section:

Joules (LON:JOUL) (I hold)

42p (before market opens)

Market cap £47m

Appointment of CEO

The Board of Joules, the premium British lifestyle Group, is pleased to announce that following a thorough selection process, Jonathon Brown will become the Group's new Chief Executive Officer (CEO). This follows the Group's announcement in May 2022 that Nick Jones would be stepping down from the role during 2022. Jonathon will initially join the Group as CEO designate on 7th September 2022 and will become CEO on 30th September following a short handover period from Nick.

The section about the new CEO Designate’s background shows he was most recently CEO of Compare the Market. I wonder if he’ll be bringing in adorable furry animals to represent Joules in its adverts too? Have you noticed how they’ve watered down the meerkats’ Russian accents in the latest ads?!

Brown seems to have a fair bit of other big company experience (Aviva, British Airways, Coca-Cola, etc.), but not exactly a fashion focused CV. Although arguably Joules has got too many creatives already, and above all it needs someone to keep them in line, and stop over-ordering stock that doesn’t sell. It’s the logistics (and excessive costs) that have gone wrong at Joules, so let’s hope he can straighten that out. Although it could be tricky with the lurking presence of the founder Tom Joule as Chief Brand Officer, and 22% shareholder.

Pricing power is key at the moment, and when I get a daily email from Joules offering 50% off large numbers of lines, it concerns me. Permanent sales means that customers wait for the discounts, so margins are permanently under pressure. Superdry (LON:SDRY) (I hold) has been rigorous on this, only selling full price product in its stores.

Also the new CEO will need to shore up the finances, as banks don’t like exposure to companies that are performing badly, and are over-stocked. The last broker note on JOUL said that the business was being run for cash, not profits, which is obviously concerning.

Although being a decent-sized listed company, banks don’t normally pull the plug, they nearly always give companies time to raise fresh funding from shareholders. Although that can sometimes be at a deep discount, if raised from a position of weakness.

Joules also has a large freehold head office, which plenty of people think was a vanity project costing far too much. Although it could in theory be used to reduce bank debt, via a sale & leaseback. The existing bank debt is secured on it.

The final issue, is negotiations underway with Next (LON:NXT) reported in the press, and confirmed by the company recently on the RNS. That would involve dilution of course, but having Next on board as a key strategic investor would make total sense, given Next’s expertise in supply chain & logistics, which is Joules’ persistent weak spot. Also JOUL product would clearly be prioritised on Next’s multi-brand eCommerce platform, if NXT owned the mooted 25% of JOUL which has been suggested it might pay £15m for (enough to pacify the bank, I imagine).

My opinion - it’s been grim, but there are signs of hope now. It all depends on how the new CEO performs, and whether he’s able to make sweeping changes to unlock what I still think is an excellent mid-market brand.

Shares are very difficult to value at the moment, because we don't know if, or how quickly, the business can be turned around. Sorry it's been such a disaster, I didn't realise how badly things were going wrong at the company. Although I note that in the last couple of months, broker forecasts have edged up, from breakeven to a small profit, so maybe some progress is already being made?

We saw recently with Revolution Beauty (LON:REVB) that excessive inventories have delayed the audit, and a (currently unknown) write-off is going to be necessary - which hits profits of course. JOUL might need the same thing, due to it also being over-stocked.

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Graham’s Section:

Portmeirion (LON:PMP)

• Share price: 402.5p (pre-market)
• Market cap: £56m

This well-known crockery group acquires a small home fragrances company. Portmeirion already owns Wax Lyrical, a brand that provides candles and diffusers.

To be more precise, however, Portmeirion has not actually announced that it’s buying a company today: it’s only buying the intellectual property, inventory and certain assets of the target company (which is in administration).

While this deal is very small (<£1m), it does give Portmeirion ownership of a new brand that is already listed in major retailers in the UK and the US. That brings with it both an opportunity to use its own resources to grow this brand, and potential cross-selling opportunities for all of Portmeirion’s brands. So despite the low price, there is optionality for a much bigger financial outcome.

This comes back to a theme I’ve been thinking about recently and which is only going to get more relevant as more companies experience financial distress: the best financial deals often involve companies in administration. The amounts paid in these deals tend to be tiny, as brands and assets with significant long-term potential are auctioned off for a song.

There are sound structural reasons for this: it’s a private market in which few buyers can take part. And on top of that, the sale happens in a timeframe which may not suit every potential buyer. For these reasons, companies in administration often turn out to be spectacular investments.

Unfortunately, it’s difficult for private investors to gain access to these deals. The most convenient substitute we have is to invest in listed companies who are able to pull off these deals intelligently and build business empires on the cheap. I think Portmeirion investors should be very pleased with this bit of business announced today.

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Treatt (LON:TET)

• Share price: 560p (-30%)
• Market cap: £340m

Well done to Jack, who sounded the alarm re: Treatt’s valuation in May (at a share price of 934p).

This is (was?) a very highly-rated extracts and ingredients company.

However, it turns out that Treatt’s ability to withstand macro headwinds is not as robust as expected, and when you have a highly-rated stock, that can cause big swings in the share price.

Stockopedia’s metrics (using last night’s share price) demonstrate how little value was on offer here. The poor value score goes a long way towards explaining why the company’s StockRank was below average:

Let’s get into today’s trading update for FY September 2022. Key points:

• Adjusted PBT will be £15m - £15.3m.

According to a note published by Edison last month, the “normalised PBT” estimate was £24m. So this looks like a very significant shortfall.

As highlighted in an excellent comment below by MichaelFBS, the company said only three months ago that it was on track to deliver expectations for the year.

So what is going on?

• Weak consumer demand in the US has reduced margins in the Tea category.

The US government argues that the country is not in recession, despite two quarters of negative GDP growth. My view is that we have recessionary conditions in many countries, even where a recession has not officially been declared.

• The “rapid devaluation” of the pound against the dollar has had a “significant impact” on margins.

The note from Edison highlighted Treatt’s FX risks. Many of the company’s commodity inputs are denominated in US dollars. As for sales, they are partially in the US but are also spread out internationally to more than 90 countries.

These risks are managed with the help of forward contracts, but hedges are never perfect and always have an expiration date.

Ever since the mess at Accrol group (LON:ACRL) in 2018, I’ve been more keenly aware of how companies can appear strongly profitable when in reality they are benefiting from temporary commodity or FX rates, and are successful for only as long as those rates stay where they are.

Treatt is a far superior business to Accrol: Treatt has been profitable year in and year out for many, many years. Treatt’s gross margin has been within a range of 22%-34%, so that even when rates go against it, it can still generate a positive result. That should be true again this year. But even a good business like this can suffer from FX volatility.

• Inflation - this is hardly news. Treatt is suffering from significant input cost inflation. What may be news is that there are long-term contracts preventing price increases from being passed on to some customers.
• China - lockdowns have resulted in the loss of some higher margin revenues.

Any positives? The order book is still up by 25% year-on-year.

In addition: revenue growth is still “strong”, all categories are growing except Tea, the new manufacturing site is still promising to deliver the expected efficiencies, and the company is exploring ways to limit FX volatility.

My view

There has been a lot to digest in this update. My first instinct is to say that if so many things can go wrong in just three months, it raises questions about the quality of the business. The best businesses don’t suddenly suffer from lots of issues beyond their control.

On the other hand, we shouldn’t forget that Treatt has an excellent long-term record and a profit warning like this is historically rare.

Furthermore, these really are unusual times and many other companies have struggled in an environment where China is imposing lockdowns, inflation is at a multi-decade high, currencies are moving in strange and unusual ways, and there is negative economic growth in the US for six months (even if this is not officially a “recession”).

Overall, therefore, I’m going to retain my positive view on Treatt and would argue that this is just a blip in the long-term story of the company.

Whether it’s worth buying at this moment in time is another question.

As noted by readers in the comments, the de-rating today has not necessarily resulted in any compression of the current-year earnings multiple: the earnings forecast for the year is down by 35% and the share price is down by less than that.

My personal view is that the problems disclosed today are temporary in nature and will be resolved over time: long-term contracts will expire allowing price increases to be passed on to more customers, lockdowns in China won’t last forever, and the US will get out of its economic slump. I don’t see any evidence of Treatt’s competitive position having deteriorated.

So if you liked Treatt before (like me), I don’t think today’s profit warning makes a huge difference. Profits are temporarily lower, and so is the share price. Over time, both should make a recovery - but the timing is anyone’s guess.