Small Cap Value Report (12 June 2020) - IQE, AIR, WAND, GAW

Good morning!

The FTSE is back around 6000 after a rough session yesterday (down 250 points, or 4%) and more weakness this morning. This comes after the Federal Reserve indicated that the US economy would shrink by 6.5% this year, before returning to growth in 2021.

According to the ONS today, the UK economy contracted by a massive 20% in April, so that the overall economic contraction from lockdown is now c. 25%. It is hard to find comparisons in history for such a sharp and deep fall.

The VIX, the Fear Index which I keep a close eye on, continued its rebound and climbed by 50% to 40 yesterday. Fear remains elevated (for good reasons, I guess).

But there are strange discrepancies. Some of what I'd consider the most speculative stocks remain ebullient - Tesla ($TSLA) at $970 (market cap $180 billion), for example, but there are plenty of others, where confidence is high.

You have a bankrupt company like Hertz ($HTZ) whose market cap reached $700 million a few days ago (now lower). Hertz has even applied to issue $1 billion in new equity, which it could use to settle some of its debts. Many of the recent buyers of Hertz stock may be about to learn their first painful lesson in the stock market.

So it's a weird market - you have a terrible recession (depression?) on both sides of the Atlantic, you have lots of extremely scared investors hedging their market risk and buying up portfolio insurance, but you also have nosebleed valuations for some of the most speculative tech stocks and even for bankrupt companies. I suppose nobody ever said that any of this would make sense.

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Some companies I've noticed today:

• IQE (LON:IQE)
• Air Partner (LON:AIR)
• WANdisco (LON:WAND)
• Games Workshop (LON:GAW)

Finished at 2pm.

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IQE

• Share price: 48.69p (+23%)
• No. of shares: 796.5 million
• Market cap: £375 million

Trading Statement

This manufacturer of semiconductor wafers fell all the way to 20p during the March crash. Wow! I've had an eye on it since 180p, a few years ago.

I'm obviously not the company's biggest fan - see February for my most recent comments, where I noted its arguably excessive/inappropriate remuneration policies.

The share price is up today despite IQE insisting that it can't give guidance for the full year. But there are encouraging snippets of positivity in the update:

• no disruption caused by the pandemic.
• Q1 revenue "slightly ahead of internal expectations" (this had already been disclosed).
• Q2 strong so far (this is new).
• H1 revenues to be up 27% to £85 million.
• H1 to be cash generative with "low single digit adjusted operating profit".

For some time now, I've been arguing that IQE is a capital-intensive manufacturer, possibly with some customer concentration risk, which is unlikely to deserve a rich valuation.

Bulls have argued that its lack of free cash flow has been due to investments in capacity which will eventually pay off at some point in the future. Perhaps that future is finally approaching? Perhaps it is here?

IQE says capex has now reduced:

IQE expects to be cash generative in H1 2020 due to current trading performance, a reduction in capital expenditure following the completion of the infrastructure phase of the Group’s expansion in Massachusetts USA, Hsinchu Taiwan, and the Newport Mega Foundry in South Wales, coupled with cost control measures and working capital management

Net debt was £16 million at year-end and IQE says that this figure has now reduced.

Outlook

The overall smartphone market will be smaller this year than last year, due to the international recession, and IQE expects some "inventory adjustment" in H2 (sounds painful).

Against that, the company expects growth opportunities in 3D Sensing, 5G and in products for the US military.

My view

Today's rally is a sigh of relief from the market, that the awful 2019 for IQE isn't being followed up by an awful 2020 (despite the macro conditions).

People don't tend to change their mind on this one, and I am probably going to be slow to change mine. For a company with equity of £270 million (tangible equity £150 million) at the last count, I think it needs a certain level of profitability to justify itself.

The track record isn't stellar, but perhaps "low single digit adjusted operating profit" in H1 could be the start of a turnaround?

I will acknowledge that most of the air has already been taken out of the valuation. It's not at the egregious multiple to book value that it was at several years ago. And perhaps some level of optimism is justified, now that the big capex programmes have finished.

But given the patchy track record, the excessive LTIP schemes, and the uncertain demand from its smartphone customers (made more uncertain by economic depression), I'm stuck in a cautious mode when it comes to this one.

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Air Partner

• Share price: 76.74p (+1%)
• No. of shares: 53.5 million (pre-Placing)
• Market cap: £41 million (pre-Placing)

Proposed Placing of Ordinary Shares

Retail Offer via PrimaryBid.com

Result of Placing of Ordinary Shares

Well done to Air Partner for including retail investors in this process via PrimaryBid.

And well done to it for fixing its balance sheet, without any hint of distress and without massively diluting its existing shareholders (many of whom will have taken part in the placing, I presume).

Last month, I wrote that AIR's balance sheet "could be stronger", but I expected various self-help measures to improve it. I didn't expect it to go down the placing route, but here we are.

Last week, in a further update which now looks like the signal that the company wanted to raise, it said:

there are undoubtedly challenging times still ahead and we continue to monitor the situation extremely closely, while prudently managing costs tightly across the Group to preserve cash and maintain our working capital.

While H1 (Feb-July) was going extremely well, the company was still using £11.5 million of its £14.5 million in debt facilities as of the end of May. And visibility after June was limited - the company does well when there is strong demand for private chartered flights, but the surge of Covid-19 evacuations and repatriations is ending. AIR will need its other services to take up the slack in July.

Replacing a big chunk of debt (caused by an acquisition last year) with equity will keep the wolf from management's door, and allow them to act more aggressively:

the Directors believe it is prudent to strengthen the Company's balance sheet, enabling the repayment of the debt taken on at the time of the acquisition of Redline Worldwide Limited in December 2019 and enabling the Company to capitalise on new opportunities arising from COVID-19 that will help drive organic growth...

My view

It's not a sector that I personally would choose to invest in, but on balance I continue to lean in a positive direction when it comes to this share - the risks might be sufficiently priced in.

An expected underlying PBT of £7.5 million in (H1) the first four months of the financial year, shows what can happen in the busy times. Hopefully, performance will continue to be reasonable in the possibly more quiet times ahead.

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WANdisco

• Share price: 666p (-10%)
• No. of shares: 48.2 million (pre-Placing)
• Market cap: £321 million (pre-Placing)

Preliminary Unaudited Results

Proposed Placing of New Ordinary Shares

Result of Placing

Paul dropped coverage of this data company back in 2018, describing it as "jam tomorrow, loss-making, and hugely expensive". What has changed?

Last night, it reported a revenue decline and increased losses for FY December 2019. Surely a bit late to be announcing these results, in June?

What it calls its "cash overheads" were almost double the revenue figure.

• revenue $16.2 million
• adjusted EBITDA loss $11.7 million
• operating loss $28.3 million

Operational and strategic highlights - like Paul, I can't claim to be able to value this company. It claims that its cloud data services enable machine learning and artificial intelligence - two themes which tend to make it very easy to raise money in this market.

For what it's worth, here are some things WANdisco achieved in 2019:

• product is "deeply embedded within Microsoft's Azure Cloud".
• new services launched providing cloud migration and analytics.
• Partnered with Amazon Web Services.
• $5 million in Chinese contracts.
• Raised $34 million last year.

Fundraise - $25 million has been raised (gross) at 650p, after the cash balance fell to $12 million by the end of May.

Cash was $23 million at the end of December, so the burn was more than $2 million per month.

My view

The deal gives WANdisco the headroom to continue burning cash at this rate for another year.

Hopefully this doesn't turn out to be another jam-tomorrow AIM stock which ultimately leads to nothing for its shareholders. The forecast on the StockReport shows another big loss penciled in for 2020.

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Games Workshop

• Share price: 7845p (+10%)
• No. of shares: 32.7 million
• Market cap: £2.6 billion

Trading Statement

Please note that I have a long position in GAW.

This games manufacturer (and brand owner, retailer, etc.) is clearly far too big for this report.

But seeing as I own shares in it, and I think several of you do, too, let's check out the update.

The main points are that the factory is working "in a limited capacity", the warehouses are operational, over three hundred stores are open, and trade/online sales orders are being processed.

There are still over 200 stores which need to re-open, as local restrictions are lifted.

Financial impact of lockdown was huge in the company's Q4 (March to May). At one point, it had almost completely ceased trading.

The good news is that "our recovery since re-opening has been better than expected".

GAW is famous for under-promising and over-delivering. So let's not read too much into this snippet, shall we?

On April 28th, GAW said the PBT result for the year would be "no less than £70 million".

It today says the result will be "no less than £85 million" on sales of £270 million.

For context, sales last year were £257 million, and PBT was £81 million.

To get increased sales and profits in FY May 2020, despite shutting down almost completely at one point, is a remarkable result, in my view.

The result has been helped by the pure profit of royalties, which increased from £11.4 million to £16 million.

There is no guidance:

In relation to the future performance of the Group, the board feels that it is too early to know what the continuing impact of COVID-19 is likely to be.

My view

I bought a few of these last year, thinking that they were probably overpriced, but worried that I'd miss my chance if the company continued to perform outrageously well.

They have now become possibly even more overpriced. So I guess I was right?

It's a fantastic company - an IP owner, with a unique franchise, and has generated amazing profit growth from incremental sales and royalty income. Quality metrics are outstanding.

I can't defend the valuation, so I'm not going to try. But I am happier owning a few shares in it, rather than not being involved at all. If it ever becomes "cheap" some day, I hope that I'll have the conviction to back up the truck!

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That will do it for this report. Have a great weekend everyone. And Happy Birthday to Paul!

Cheers

Graham