Best Of The Best - a high quality growth stock for troubled times?

No doubt most investors are feeling bruised as a result of what is proving to be a pretty ferocious stock market drawdown. Even good companies are getting hammered.

Such conditions do provide long term opportunities, though, as Mr. Market presents us with new prices every day. Those good companies are just as high quality as they have ever been, it’s just now they are cheaper than they were a couple of months ago. Now more than ever it’s important to identify the best stocks to invest in because the odds are we will get chances to buy at good prices.

On first glance, Best Of The Best (LON:BOTB) shows some signs of having what it takes to be a long term winner. It has a clean balance sheet. Its revenue and profits have been growing consistently for years. It has a QM Rank of 98. It generates consistently strong returns on capital and chucks off cash, which is reinvested in growth opportunities or returned to shareholders. The founder still runs the company and owns nearly 50%.

These are promising early signs.

It looks like there will be significant disruption to certain parts of the economy as a result of measures to prevent the spread of Coronavirus. I imagine a lot of Leisure & Travel companies are registering some pretty steep like-for-like revenue drops right now, for example. Other companies will be less affected by these measures, and this is where there might be some opportunities.

The key driver of growth for BOTB is its evolution into a purely online host of weekly skill-based competitions. I think this could make it reasonably well insulated from the challenges other parts of the market are facing.

The story so far

Ever since 1999, car enthusiast and BOTB CEO and founder William Hindmarch has been busy building a cash generating machine - and, with a market cap of just £37m, I reckon there is still plenty for BOTB to aim for.

The group’s core business is in running car competitions. Once upon a time you would find them in airport terminals and shopping centers but the world has changed and now these competitions are online.

There is a lot to like about this company from a financial and shareholder perspective. A well run operation is one thing though. What makes BOTB interesting now is that it has a big expansion opportunity and is executing on it as we speak. Today, its addressable market is much larger than it was 20 years ago. As BOTB itself notes:

The Company continues to evolve away from being an operator of retail based car competitions, to a pure online operator. The scope and breadth of our competitions and other products will be further developed to target the much larger addressable market online, both in the UK and internationally, using all available marketing channels.

What’s more, as it moves online, the company cuts out rent and labour costs and marketing becomes more targeted. Social media and TV advertising are having a pronounced effect on revenue growth - and the more money BOTB makes, the more it can spend.

The data is a little patchy on the group’s progress here but I’ve cobbled together a table that shows everything appears to be moving in the right direction:

Over the past seven years, online revenue has grown at a compound annual growth rate of more than 33%. The trajectory is still strong: online sales have increased by more than 30% year-on-year in the past two years as well and are now almost all of BOTB’s business.

The evolution into a pure, higher margin online business appears to be a successful one. BOTB is growing sales, profits and marketing efficiency. An enlarged, predominantly in-house marketing team has invested in a multitude of channels, including Social Media, TV, Radio, PR and YouTube Influencers to acquire new players.

The enhanced insight into its customers that these new channels bring is paving the way for more tailored competitions, pricing and products. It also gives BOTB a better chance of building a relationship with people that might encourage them to participate in future competitions.

On top of this growth, the group operates with a reassuring sense of financial safety - no debt and strong cash generation. Meanwhile, the move to exit from shopping centres and airports has allowed it to shed costs, particularly rent and staff expenditure.

Nearly a decade of steadily increasing revenue and profits

This strategic shift is supported by some very encouraging figures. Revenue and gross profit have increased every year for the past nine years. Operating profit has increased every year for the past seven years and operating margins continue to improve.

We can see that BOTB has an impressive track record across key financial measures in the 2014-2019 period:

HY20: Interim results for the six months ended 31 October 2019

Back on the 30th of January, Paul wrote in the SCVR that he “like[d] everything about these figures” and it’s not hard to see why:

• Total revenue +6.7% to £7.6m
• Profit before tax +27.8% to £1.38m
• Earnings per share +37.3% to 12.4p
• Cash balances of c£4.3m
• A special dividend of 14p per share declared
• Encouraging sales momentum and FY earnings to be in excess of forecasts at the time

The update sparked another upgrade to broker EPS forecasts. These upgrades have been material: up from 12.4p in March 2019 to 22.7p in March 2020.

Sometimes when this is the case analysts can be slow to appropriately price in the near-term upside. It’s not something I’d bank on, but it is certainly nice to see the positive direction of travel.

Financially safe, cash generative and aligned management

BOTB has some encouraging quality characteristics. It is heartening to see a cash-rich balance sheet and management alignment with shareholders.

Trading at just 15 times forecast earnings despite high returns on capital and a better-than-expected half-year statement, this looks like a promising “QARP” candidate with a strong operating track record and ample room for future growth.

Strong balance sheet

The group has historically been financially prudent, with net cash on the balance sheet even after frequent special dividend payments in recent years.

The balance sheet is also quite clean. No pension fund, no debt, very few liabilities or intangibles that need to be checked out.

Solid liquid and strong cash generation

The group converts a high proportion of net income into free cash flow, which is good news for shareholders:

While some of this cash is reinvested back into the company, a lot of it is simply returned to shareholders.

Aligned management

It’s fair to say the board has skin in the game here - between them, they own about two-thirds of the company. The holdings as of 30 April 2019 were as follows:

This does have implications for the liquidity of this micro cap’s shares given its tiny free float. Nevertheless, I take it as a positive for shareholders that management holds such a big stake in BOTB.

Risks

As with any micro cap, there are risks to consider.

In the group’s FY19 accounts, BOTB registered a sizeable exceptional gain as a result of a tax dispute with HMRC. While this clearly worked out for BOTB, it does flag a degree of exposure to regulatory risk depending on whether you interpret BOTB’s competitions as skill or luck-based.

The group’s small size and tiny free float also make its shares quite illiquid, which can make buying and selling expensive. As BOTB is also now entirely online, it is prudent to acknowledge the potential for website and IT infrastructure disruption.

Conclusion

While the small size of BOTB both in terms of market cap and free float might put some off, I see a lot to like in this company.

It is run by its founder, who retains a large shareholding. This alignment with investors is reflected in the company’s generous dividends in recent years. BOTB earns superb returns on capital and the group’s shares have held up well in the recent market sell off.

This latter point is possibly as a result of its cash-generative online business model and debt free balance sheet making it one of the safer stocks from Coronavirus related disruption.

Over the past seven years, online revenue has grown at a compound annual growth rate of more than 33% and has increased by more than 30% year-on-year in the past two years. Operating margins have improved and profits are growing. Given this track record, a valuation of 15.1 times forecast earnings looks undemanding.

A key point now is how much you can trust forecast earnings in general, given the widespread disruption created by the spreading Coronavirus. This development will be potentially disastrous for a lot of companies, so caution is key. There is no rush to invest but I also think now is the time to be identifying opportunities.

BOTB is reasonably well insulated from this risk and it has strong quality characteristics. For that reason, I think it is worth monitoring to see if the market unduly discounts its growth prospects for the years ahead.