Small Cap Value Report (Mon 20 Feb 2023) - TEK, DARK, LIT

Good morning from Paul & Graham!

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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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Graham’s Reporting:

Tekcapital (LON:TEK)

Share price: 17p (-16%)

Market cap: £26m

We’ve only covered this investment company twice previously in the SCVR. Roland gave an overview of the company in 2021, and I gave it a quick comment in December 2022.

As noted by Roland, one of the main points of worry here is the dilution of existing shareholders:

It appears that this dilution has held back share price gains::

Today we learn that the company is selling 14 million new shares at 16p each (gross proceeds £2.25m). The latest share count is 151 million, so this is 9% dilution.

For dilution in the region of 10%, I want to see the proceeds having a material positive impact on the value of the company.

The company provides the following explanation:

The net proceeds of the Placing will primarily be used to accelerate the growth of the Company's portfolio companies…
Funds raised will be used as follows:
- £0.6m to build commercial inventory of MicroSalt Limited
- £1m to purchase autonomous shuttles for Guident's Remote Control Monitoring Centre clients and for fabrication and testing of their regenerative shock absorbers for prospective clients
- the remainder of the funds raised will primarily be for additional working capital.

So we do at least have specific purposes given for most of the funds raised.

My view

I’ve resisted taking a strong view on this share because its portfolio companies seem to be early-stage, VC-type of investments, and there are only 4 of them. An undiversified set of early-stage investments has a very wide set of potential outcomes!

However, one noteworthy feature of Tekcapital’s strategy is to IPO its companies while they are still young. This does improve the liquidity of the portfolio and reduce risk (by transferring that risk to other investors in the public markets!).

Portfolio companies:

Guident Corp - this has not yet IPO’d.

Microsalt - Zeus have been appointed to work on a proposed AIM IPO for this company in 2023.

Innovative Eyewear - this trades on the NASDAQ under the tickers LUCY and LUCYW (its warrants). Market cap is $17m.

Belluscura (LON:BELL) - Tekcapital still owns 12% of this one (it has reduced its stake). Market cap is £52m.

As you can see, Tekcapital does have access to cash by selling its BELL and LUCY shares. It should also soon have the ability to sell Microsalt shares.

If you check the most recent balance sheet (May 2022), Tekcapital’s cash balance was a paltry £1.1 million. My impression is that management here are happy to run on fumes, with the belief that they will be able to sell down their investments or raise fresh equity as needed.

It’s not a strategy that fills me to the brim with confidence. To me, it implies that Tekcapital has to sell investments or raise equity even when the pricing of these deals might not be advantageous to their shareholders.

For example, Tekcapital’s NAV per share was reported to be 51 cents (42p) at the last interim results. Tekcapital shares trade at a discount to that level, but the company is unable to prove that it’s undervalued by carrying out share buybacks. Instead, due to its lack of cash, it has to do the opposite and sell new shares at these low prices.

Also, for companies at such an early stage in their development, I would prefer to see a more diversified portfolio.

Therefore, I’m going to take a neutral stance on this company for now. With further evolution of its portfolio and development of its financial strength, I could take a more positive view.

Darktrace (LON:DARK)

Share price: 267p (+2%)

Market cap: £1.9b

This is outside our market cap range but thought it was worthy of attention. The cyber security firm Darktrace has appointed Ernst & Young to provide “an additional independent third-party review of its key financial processes and controls”.

This is in response to the short attack by Gabriel Grego’s Quintessential Capital Management that launched at the end of January.

The QCM short report included the following statement:

DT [Darktrace] has been consistently audited by Grant Thornton, an audit firm with an arguably less-than-stellar track record in detecting accounting fraud. Inter alia, we can mention Parmalat, Globo Plc (exposed by QCM) and Patisserie Valerie among complete accounting frauds audited by Grant Thornton, whose chief incredibly asserted that auditors “are not looking for fraud”.

Some familiar names in there for SCVR readers!

The short report also includes the following edited screenshot, depicting links between Darktrace management and Autonomy (a scandal from 2011/2012).

Even in the absence of a short report from Mr. Grego, I would be cautious when it comes to Darktrace shares. The cybersecurity space as a whole looks pricey to me, and Darktrace is no exception.

It’s a 2021 IPO, which is already a bad start as most of those IPOs were awful.

And it’s trading at a price to sales multiple of more than 5x! The ValueRank is only 7:

Interestingly, the short attack has failed to put a serious dent in the share price so far. The share price is actually higher now than it was a few weeks ago:

Even if the accusations from QCM don’t stand up to scrutiny, I still wouldn’t want to own Darktrace shares at anywhere near this valuation.

Litigation Capital Management (LON:LIT)

Share price: 68.4p (+3%)

Market cap: £81m

Continuing on the theme of auditors, here’s an update from Litigation Capital Management, the Australian (AIM-listed) dispute financing company.

In 2021, LCM funded a claim against the accountants at KPMG related to their audit work on Carillion from 2014 to 2016. Carillion subsequently collapsed, leaving a financial black hole where they used to be.

I remember covering Carillion a few times, here in the SCVR. In a strange coincidence, before their collapse, Carillion also hired Ernst & Young to assist with a review of their finances.

Anyway, the point of today’s update is that there has been a confidential settlement between the parties to this case, which LCM describes as a “successful outcome”.

Judging by the table in the update, it looks like the case produced a return of around 140% (not an annualised number). The LCM balance sheet did even better than that, thanks to the payment of a performance fee from LMC’s Global Alternative Returns Fund.

LCM say:

Carillion was the largest corporate collapse in the building and construction industry in UK history and we are pleased to have supported the underlying creditors who suffered financially from the collapse.

My view

I’ve just checked the most recent balance sheet, and found that LCM had equity of A$97.9m (£56m) as of June 2022.

If the company can generate consistently strong returns on cases such as these, and earn performance fees on 3rd-party funds to boot, then I would have absolutely no problem paying a substantial premium to book value for the shares.

This could be worth researching in greater detail. Knowledge of Manolete Partners (LON:MANO) and Burford Capital (LON:BUR) will help, as this sector has a number of interesting options for investors now.