Small Cap Value Report (Fri 10 Feb 2023) - MEX, ZYT

Good morning from Paul!

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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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Agenda

There's nothing of interest today in company news. Thank goodness, as I must admit to being a bit tired out, after the crazy avalanche of news in the first 6 weeks of the year, so it's pleasant to be taking things at a more gentle pace this week! Also great to be seeing so many strong recoveries in small cap share prices, although I'm still wondering if these will stick, or whether we should be banking some profits?

I might call it there for today's report, and go for a nice long walk & listen to some podcasts. Then I need to update my summary & watchlist spreadsheets, and prepare for tomorrow's small caps podcast.

Sections below -

Tortilla Mexican Grill (LON:MEX) - notes below from my company visit to its Head Office yesterday. Cautious thumbs up from me.

Zytronic (LON:ZYT) - a quick review of its trading update earlier this week. Thumbs up from me.

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Company Visit - Tortilla Mexican Grill (LON:MEX)

I can’t remember the last time I visited a company, it was so long ago, pre-covid. These days, almost all contact I have with companies is on zoom-type calls. Yes, it’s more efficient for everyone, but lacks the human element of a face-to-face meeting, and seeing people in their own environment, interacting with colleagues, etc.

So I was delighted when the PR company for casual dining chain Tortilla contacted me, to ask if I’d like to meet management at their central london Head Office, yesterday afternoon.

I met the affable CFO, Andy Naylor, and did a Q&A for about 45 minutes, covering lots of topics. Here are the main points I took away with me (not verbatim, this is roughly what I remember being said, so may not be exactly right on everything) -

Rapid growth in site numbers, reached 82 most recently. What’s the total market size? We’re expanding outside of London now, so think there’s room for at least 300 sites. In London people are more familiar with Mexican-themed food (with several competitors). Outside London, less so, and it takes maybe 18-24 months for business to build in new sites.

Your balance sheet shows a deficit of about £5m on the IFRS 16 asset/liabilities, which suggests you have some loss-making sites. Are these problem leases? No, not really, there are only 2 loss-making sites, and they’re not losing very much, and we think they can be made profitable over time. We’re not keen on IFRS 16 (nor am I!) and it isn’t something that we use to run the business. It’s just a year end audit matter.

Deals on new sites - were very generous throughout the pandemic, could be reverse premiums (cash from landlords) of up to £250k per site. Typical capex is £400k per site, so that made a very good impact, and return on capital employed is incredible on those sites, under 1 year payback. But higher interest rates have impacted landlords’ willingness to offer such generous deals, and reverse premiums are now typically c.£100k. Long rent-free deals are still available. Expansion is self-funded, from EBITDA.

EBITDA isn’t really profit though! Charlie Munger described EBITDA as bulls@#t earnings I think, and quipped that the tooth fairy doesn’t pay for capex! That’s true, but EBITDA is a good approximation to cashflows. After the float in Autumn 2021, we were guiding about £7m EBITDA, but were hit with several headwinds - most noticeably £2m additional cost of meat, caused by the Ukraine war, prices just suddenly went up 40%. We shopped around, but it was the same everywhere. That sort of increase can’t be passed on to customers in one go, and our focus is on offering everyday value for money, e.g. to students (we do well in university towns). Also energy costs went through the roof. We weren’t hedged (a mistake, in hindsight), but that’s now peaked, and we’re benefitting from falling costs, whereas some other competitors are locked into higher deals. In future we’ll be hedging more.

Managing the lunchtime rush is the difficult bit - very condensed selling, with queues, then it goes quiet again. We're looking at ways to use technology (e.g. self-ordering/payment at kiosks) to increase throughput at busy times. But smaller sites can be difficult to fit in self-service machines.

Head office team seems very small - it’s just maybe a dozen people, for accounts, IT, and marketing. The office is the 1st floor of a small office building in Fitzrovia. There is also a central procurement depot in North London, which supplies stores with ingredients ready-prepared. Other than that, stores are managed locally, and overseen by a team of Area Managers out on the road (typically c.10 sites each). That's getting more efficient as the store estate grows, so bunching together site visits becomes easier.

My opinion - I think the IPO in 2021 looked over-priced at 181p, and the share price of 117p is now well below. That’s partly because expectations were lowered from £7m EBITDA to £4m due to cost inflation, and the cost-of-living crisis. But the way I see things, is that MEX remains profitable, just (currently around breakeven really, once depreciation is taken into account), which isn’t bad when they’ve been hit with both unforeseen higher costs, and reduced demand. So I think the way to look at this share is as a recovery situation, once the consumer is spending more freely, and maybe costs are falling, or maybe just not rising any more (they’ve seen inflation moderate more recently). Another round of price rises to customers is to be implemented shortly, and the company hopes to rebuild margins gradually.

There will also be a roll-out of more sites nationally, and MEX has demonstrated it can handle a fairly rapid pace of growth in site numbers.

Overall then, I think this share could be a good one for our watchlists. At £45m market cap, I don’t see it as particularly cheap, as I’m not inclined to value shares on a multiple of EBITDA. I prefer proper profits. Also, the balance sheet is a little thin, so I’d prefer to see that strengthened over time from reinvested profits. So the dividend-paying potential is limited at the moment.

Near the start of my investing career, roll-outs of retail/hospitality chains was quite a lucrative area. If you spotted an early stage, successful format, then you could buy the shares, wait 2-3 years, and make good money, as they grew, and re-rated at the same time. Turbulence from online competition, and then covid, has taken away those opportunities. However, newer chains, which are opening sites on newly competitive rents, and don’t have historical baggage of loss-making over-rented sites, could rejuvenate this investing theme perhaps? I've mystery shopped Tortilla about 5 times, and been happy with the quality/taste, and value for money. So I think this is likely to be a successful chain, in a niche that it has largely to itself at the moment - outside of London, there are not many other Mexican-themed burrito restaurants.

So this one gets a cautious thumbs up from me.

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Zytronic (LON:ZYT)

132p (down c.12% yesterday)

Market cap £13m

AGM Trading Update & Board Changes

Zytronic, a leading specialist manufacturer of touch sensors…

The current financial year is FY 9/2023, so this update covers the 4 months to Jan 2023.

It’s a bit lacklustre, hence the share price dropping c.12% yesterday.

What surprised me was the comments that supply chain issues are still having a significant impact, with shortages of components causing it to pay more for unofficial supplies, and cannibalising finished goods for the components, which sounds a bit extreme, and would presumably involve extra labour costs (and maybe having to write off other inventories?). It’s not good anyway.

Monthly order intake similar to H2 last year. That’s not good, as H2 LY was only £4.9m order intake, suggesting that the current revenue run rate could be as little as £10m annualised.

Pipeline - sounds more encouraging, with £61m in lifetime value of contracts, although that’s multi-year, and not all of it will actually turn into contracts. I prefer firm orders, to numbers on pipeline of potential opportunities.

Although this all sounds rather negative, the good thing about Zytronic is it has a proven ability to operate around breakeven, even in very slow years. In good years, it has been highly profitable. Plus of course there’s pots of cash in the bank, relative to the size of the company.

Net cash is now £6.8m, just over half the market cap. It’s genuinely surplus cash too, if you look at the last balance sheet, net current assets was £9.8m, with no significant long-term liabilities.

So this share tends to attract value investors, who like the strong asset backing, and you’re getting the business thrown in for very little extra - a nice combination I think, for patient investors.

Outlook - a stronger H2 expected, although it cautions that pay rises for staff are likely to be more than budgeted.

My opinion - this is an interesting little value share. You have the comfort of strong asset backing, supporting most of the share price. Then you get upside from a possible recovery of the business, on top of that.

So a thumbs up from me, as a value share. Note also the consistently high StockRank.

It's interesting to note a permanent de-rating of this share from the 5-year chart below. That came about because, as it turned out, the company had a number of key products that reached end of life, with repeat orders drying up. That's the sort of thing that only insiders really know about. We always think we understand companies we invest in, but the reality is that outside shareholders usually haven't got a clue about the inner workings of any companies we invest in.

The number of shares in issue has fallen from 16m to only 10m, following large buybacks. So theoretically, if orders recovered to previous levels of profitability, this share could not just recover to 500p, but go considerably higher. So there's an opportunity here, we just don't know whether that positive scenario will play out, or not.

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