Small Cap Value Report (Fri 19 Aug 2022) - JOUL, HSW, VLX

Good morning! It's just Paul here, with it being Friday. I have to finish by 11am today, due to being required to take Mum to Newbury for her 85th birthday lunch. My brother particularly likes this restaurant, but it's a 75 minute drive away, so the food had better be very good! Update: sorry I have to leave it there for today, but got 3 companies done anyway. Have a lovely weekend! I'll have a look at your comments this evening, so do flag up anything interesting that I could come back to next week.  Today's report is now finished.

I should give a special mention to "our Graham" (80's reference!) who has diligently worked Mon-Thu this week in really difficult circumstances, with terrible internet in a holiday cottage, a crying baby, and a family wedding. Yet he's managed to cope with that, and produce sterling output here, so thanks Graham!

Weekly summary podcast - click here (Sat 20 August).

Agenda

Paul's Section:

Hostelworld (LON:HSW) - my notes are below from the webinar yesterday on IMC. There was a lot of information & commentary via a slide deck, but I only jotted down a few points that seemed most important. I'd be more interested in this share, if it were not for the expensive, risky debt. There's a capital markets day in November, so maybe that will be a  precursor to a placing, to clear the debt problem? Management come across as knowing what they're doing, so I'm less bearish about this share, although still dislike the balance sheet structure.  

Joules (LON:JOUL) (I hold) - another profit warning, as trading has continued to deteriorate over the last few weeks. I estimate this could lead to an H1 loss of about £7m. Bank remains supportive, and discussions with Next continue about a strategic investment. I think my patience with Joules has run out, and am considering whether or not to sell up. There's likely to be a nasty fall at the open today I'm afraid, so the damage is already done unfortunately.

Volex (LON:VLX) - the share price has been strong in recent months, bouncing almost 50% from the lows. Today's reassuring, even upbeat update seems to underpin that share price (partial) recovery, so I reckon it's looking safer now we know it wasn't just a bear market rally. Forward PER is modest, at 13.3. I think the risk of a profit warning seems quite low, due to favourable tailwinds in all Volex's main product sectors (e.g. EVs). It's got pricing power. More acquisitions are in the pipeline, and maybe it might be able to snap up some bargains in more difficult macro conditions? Thumbs up from me. 

---

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 (no Graham today, as it’s Friday):

Hostelworld (LON:HSW) 

My notes from InvestorMeetCompany webinar yesterday

I reviewed this online booking portal for hostels here on 10 August, when it reported rather poor interim results. My impression was negative, mainly due to the expensive debt structure (with a US based investment company, and payroll taxes deferred to the Irish Govt). Also, the market cap seems to already factor in recovery in travel, so what's the attraction of paying up-front for a recovery that's only partially happened? Particularly when many other travel sector shares are looking much cheaper right now.

On 10 August, a member here jvb68438 posted an interesting more bullish view of HSW in the reader comments here (note that you can get a link to any specific reader comment by clicking on the icon that looks like a pair of spectacles, which also then allows you to post that comment on Twitter, etc) .

So I decided to watch yesterday afternoon's webinar from HSW, to get a more bullish view of the company, to weigh up against my more bearish view. We try to keep an open mind here at the SCVR. I didn't take detailed notes, but jotted down what seemed to me the key points from this H1 results webinar -

There were 3 presenters, the CEO (ex-Expedia) who is softly spoken, but seems to know his stuff, and seems strikingly positive about the outlook for this business (but I suppose that's part of his job!). Also the CFO Caroline Sherry sounded on top of the numbers. The third person on the webinar (operations guy, I think) didn't talk until near the end, but I missed his name. Hostelworld is based in Dublin.

Some revenue is deferred, only being recognised once the cancellation period has passed. Since the business was effectively re-started from almost nothing in lockdowns, H1 this year required this balance sheet provision to be re-built. That's a one-off, and it suppresses the reported figures, but won't happen again (we hope).

Very highly geared to travel sector recovery.

Expect to be EBITDA positive in H2.

Expect to be very highly cash generative in future (as to be fair, it was pre-pandemic, and paid big divis, but lacked growth, so was more of a value share pre-pandemic)

Young customers, who typically don't have mortgages or children, full employment, so not as impacted by cost of living crisis as other age groups.

Operating costs (excl. marketing) are lower than pre-pandemic, due to cost-cutting in pandemic - leaner business now.

Forex hit in H1 due to strong dollar.

Social platforms - this bit was really interesting. CEO explained how its app has been developed to encourage travellers staying in hostels via HSW to socialise - a key aspect of hostels, where 60% of travellers are solo, and want to mingle with their own younger age group. So features on the app allow chat, and organising group activities, conversation starters by being linked to people staying in the same hostel, leaving feedback, etc. Other companies can also advertise via this social platform, targeting people for drinks/meal promotions, live gigs, etc. It looks well thought-out, and I'd be interested to find out what the competition is doing in this social area. Could be good for repeat business, as it's clearly an added value service. Although I wonder how many people in a hostel would have necessarily booked through HSW, it may not be that many?

Capital Markets Day planned for November - I wonder if this means a fundraising is on the cards, to clear down the substantial debt owed to the US lender, which is 9%+ base rate cost, and the Irish Govt payroll tax arrears (CFO says they are currently negotiating a payment plan to repay in instalments, and there's no interest cost at present). So to plan for some dilution, I think would be sensible.

Cohorts graph (of customers) was interesting, showing long lifetime value, and repeat business of each cohort. Obviously dwindles a lot over the years, but is still quite a significant base.

Customer payback period on marketing costs is 30-90 days.

Current trading shows that customer behaviour is mathematically very predictable, with gradual return to near pre-pandemic levels, for the various cohorts (year groups) of previous customers, very much as expected. This enables very predictable budgeting.

Marketing costs - 60% of revenues this year (i.e. incredibly high!), reducing to 50-55% (still very high!) in 2023. 

My opinion - my reservations about high valuation, and weak balance sheet with expensive debt remain. However, I think the business seems fundamentally pretty good, and it sounds like considerable improvements have been made during the pandemic. Can it get back to being a profitable, cash generative business? Yes, I think so, and we were given a lot of evidence to back up the idea that previous customers are returning as expected. Although the big challenge for online businesses right now, is getting value for money from online marketing, which is now very expensive. Spending 60% of revenues on marketing, suggests to me that this is a key, and problematic, issue. In the past HSW struggled to generate revenue or profit growth, it was starting to struggle pre-pandemic remember. So I'd need a lot of convincing that it's a growth company. 

---

Joules (LON:JOUL)  (I hold)

44p (before market open) - update: 30p (down 32% at 09:02)

Market cap £49m - update: £33m at 09:02

Trading & Business Update (another profit warning)

Joules, the premium British lifestyle group, provides a trading and business update in respect of the period since the end of its financial year to 31 May 2022.

Profit warning -

As a result of the recent softness in trading and the current weak consumer sentiment set out above, the Board expects a significant loss in the first half, followed by an improved performance in the second half as the benefits of business simplification begin to be realised. In light of this, the Board currently expects the Group to deliver a full year loss before tax, and before adjusting items, significantly below current market expectations.

Key points -

Trading has “softened materially” in the last 5 weeks.

Hot weather has impacted core categories (e.g. coats, knitwear, wellies).

Cost of living crisis.

Retail sales down 8% in financial YTD (June, July, August to date)

Wholesaling for Joules brand doing well - up 10% vs LY

Garden Trading “significantly impacted” (no figures provided) by slowdown in home & garden market.

Retail margins (presumably they mean gross margin?) down c.6% points down on LY - due to discounting required to shift stock.

Expecting a “partial recovery” in margin, as full price Autumn/Winter ranges come in.

“Good progress” to simplify business & improve profitability.

Liquidity/covenants - is under pressure -

Net debt £21.1m (end July)

Headroom £11.4m (end July) + £5m additional headroom (until Nov 2022) since agreed with bank.

Managing cash carefully, expects sufficient liquidity, including repayment of £5m extra by Nov 2022 - so no immediate crisis by the sound of it.

Covenant waiver needed - in “positive discussions” with the bank on this, and medium term funding needs.

There are options here though, with bank debt. Remember that JOUL owns its Head Office freehold, in the books at £18m cost (but maybe not worth that much now?), and it also owns a wholesale receivables book (which could be used for a non-recourse lending facility from the bank) of typically £9-12m. Hence the bank does have security over most of the debt. That’s probably why they’re not panicking (yet).

Discussions with Next (LON:NXT) over strategic investment continue - announced previously on 7 August. “...no certainty that these discussions will lead to any agreement”.

Diary date - for FY 5/2022 will be in late Oct 2022. That’s very late. Last year's results were out in early August 2021. I imagine going concern disclosures are likely to be an issue.

Forecasts - nothing has come through on my email yet, so I’ve worked out my own figures, as follows.

H1 LY was £127.9m revenues, and a £2.6m PBT.

Of that, £99.8m revenues for the retail division, at 54.6% gross margin = £54.5m gross margin.

Reducing revenues by 8%, and margin by 6% (as guided today), lowers gross margin to £44.6m - that’s a £9.9m shortfall.

If we ignore costs & the wholesale division, assuming it will all net off (which is probably being too optimistic), then H1 PBT his year would become a loss of at least £(7.3)m.

The actual loss in H1 could be worse, as there will be considerable increases in costs compared with H1 LY, due to wage rises, and the resumption of business rates. Set against that, the company has been cost-cutting more recently, so that could mitigate things.

There’s also much higher energy costs to contend with.

UPDATE at 09:20 - many thanks to Liberum for an update note that has just come through via Research Tree. It has reduced forecast for FY 5/2023 from £3.4m PBT, to a loss of £(7.0)m, so a drop of £10.4m. That's almost identical to my estimate of a shortfall in profit of £9.9m in H1. This implies that Liberum probably haven't made any changes to the H2 element of its forecast. 

Liberum does point out a potential positive, that Joules's supply chain fell apart in Autumn/Winter last year, resulting in very poor customer service (remember all the negative reviews on TrustPilot that we discussed here last year - on reflection that was the canary in the mine, as some of you said at the time, to be fair), and gaps in the product ranges as stock was stuck on the high seas. This year should be better in this respect, as supply chains have eased.

End of update.

 My opinion - my patience has run out here, and I’ve decided to probably sell up, but am still thinking about it.

On the plus side, the bank is being supportive, and I very much doubt it is likely to pull the plug, but it is likely to insist on an equity fundraise. If that comes from Next, great - a strategic investment of the mooted £15m for 25% (as reported by Sky News, what would be do without them!), and the expertise of Next to sort out Joules’s lousy supply chain & logistics management, plus an implied financial guarantee from the sector behemoth, would straighten out the problems and remove risk, I imagine. So expect significant dilution either way, hopefully not ruinous, but we don't know, that depends on lots of things.

Joules is a lovely brand, but it clearly can’t sell the product at full price, which tells me it does not have pricing power - a key deficiency in an inflationary world. Customers now know they can just wait for the discounts to roll in, as products they like probably won’t sell out at full price. That’s a tough thing to eradicate once it’s established, and it devalues the brand. It’s better to start off with somewhat lower prices, and not hold constant sales discounts, and secure better prices from suppliers, which might mean Joules needs to drop some of the nice product detailing (which costs more in production). Whether Tom Joules, still a 22% shareholder, will allow that, is another matter. Maybe it’s time for him to go?

There’s turnaround potential here, so it’s not a complete basket case, but unfortunately I got it wrong by not realising how badly trading was deteriorating.

Expect another plunge in share price today, I’m afraid, which is likely to wipe out a good chunk of the recent recovery.

Bulls need to hope that the Next deal gets signed soon, and that the new CEO can take bold and prompt action to sort out the issues within the business.

This 3-year chart is before today's likely 30-50% fall in share price (my guess at 07:57) -

.

---

Volex (LON:VLX) (I hold)

304p (down 3% at 09:48)

Market cap £482m

AGM Statement (trading update)

Barely a day goes by without a profit warning right now. Often it’s companies where you think, well that was all pretty obvious, why didn’t they manage down broker forecasts earlier? Instead of acting surprised that costs have gone up, and customers are drawing in their horns?!

The trouble is, we’re also getting bombshell announcements from plenty of good companies that we thought were high quality, reflected in high PERs, who suddenly surprise us with profit warnings where the CFO seems to have also not budgeted for increased costs, e.g. Treatt (LON:TET) springs to mind.

It seems almost a lottery right now, apart from the people who always seem to be wise after the event!

With Volex, I couldn’t see many risks, although as mentioned before, I did wonder whether it might have be buoyed up by customers building inventories to prevent supply chain problems? We saw how with both Luceco (LON:LUCE) and Supreme (LON:SUP) a sudden & unexpected de-stocking by customers, whacked their profits (and share prices). Could the same happen to Volex?

Turkey (the country) risk (80% inflation rate now, apparently) was dismissed by VLX management on a previous webinar, saying that currency devaluation was going at a similar pace as local cost escalation (which is what happens when hyper-inflation gets embedded, in a self-fuelling cycle), thus offsetting local inflation, and keeping Volex’s Turkish factory competitive.

I see Turkey is advertising on UK TV, for holidaymakers, and it does look tempting, I’ve never been but apparently Turkey is meant to be a beautiful country. So that’s going on the list of places I’d like to visit once my portfolio recovers.

The price of copper has been a red herring, as explained by management several times, they have contractual terms which allow re-pricing (with a time lag) to pass on higher input costs.

Anyway, moving on, we get a Q1 update from Volex today -

Volex plc (AIM: VLX), the global manufacturer supplying power products and integrated manufacturing services, today issues a trading update for the three months ended 30 June 2022 ahead of the Company's Annual General Meeting, being held today at 4:00pm BST.

This sounds reassuring -

Strong start to FY2023 and continued progress across the business

Q1 performance is strong, in line with mgt exps, and the new 5-year growth plan.

Revenue - organic growth of +4.9%

Positive customer demand.

Managing “challenging” supply chain.

Higher inventories (as mentioned in June’s update) continuing to ensure timely deliveries to customers - I think this is fine, and a good thing to do when supply chains are under pressure, making Volex a reliable supplier, and maybe able to gain market share in future as a result?

Acquisitions - are being integrated well, and there’s a strong pipeline of further deals.

Product categories - Electric Vehicles continues growing. Consumer electricals also growing, and increased market share. Medical - robust demand, and revenues up despite availability problems for components. Industrial - core demand remains strong. Growth in future from replacement cycle of high speed next generation cables (data centres, etc). All sounds good, with no sting in the tail from anything.

Outlook - sounds good to me -

Overall, whilst still early in the year, the encouraging trends in the first quarter mean the Board expects to deliver full year underlying operating profit in line with current market expectations1.

1 Latest company compiled view of market expectations shows an underlying operating profit consensus of $62.8 million with a range of $62.3 million to $64.0 million.

It’s so helpful when companies provide a footnote, thank you, and why can’t everyone do this? It’s because apparently some brokers don’t let their clients do it! Telling them (which is obviously untrue) that they’re not allowed to say what market expectations are. Suggestion - change brokers, if they stand in the way of clear communications with investors.

No such issues here, with Singers being one of the best brokers for getting information across to us.

My opinion - I’m long-term bullish on Volex, because Nat Rothschild seems to have done a cracking job of restructuring & transforming this group both organically, and through acquisitions. It’s got a good spread of businesses in different niches.

So far, so good, today’s update sounds very good to me, given the macro picture. As noted before, Volex has some positive industry tailwinds in its EV, medical, and data centre markets. So I’m hopeful the underlying growth there could offset tougher macro conditions. Plus of course, rising selling prices generates revenue growth even if volumes remain static or fall slightly.

We have forecasts confirmed today, which means this valuation data should be something we can rely on - in particular a forward PER of 13.3 looks attractive to me, for what seems a resilient, and growing business.

Thumbs up from me.