Small Cap Value Report (Fri 10 July 2020) - AAZ, GYM, RTN, LIT, MRL, SRT

Good morning, it’s Jack here - Paul asked earlier this week if I could step in today as he has business in London. Any particular requests just send them over.

Reaction to Rishi Sunak's mini-budget appears to be mixed to mildly positive (probably good in the circumstances) especially in the Hospitality and Leisure industry, with a VAT cut from 20% to 5% on accommodation, visitor attractions, cinemas, and other Leisure destinations. How much of this is held onto by operators, and how much is passed onto customers I wonder? There's not much of a precedent.

One big hurdle that remains for many businesses is rent - there is considerable rent debt out there and government support here is probably also needed...

A quick note before we start: It’s great to see passion in the forums but at times things can boil over. At the end of the day, we’re all private investors trying to make money. We have far more in common than that which divides us.

Nobody at HQ wants to have to moderate the community but we will do if it’s needed. There are a couple of issues we continue to discuss privately with some subscribers and we hope to find a way forward on these fronts.

We want to maintain a delicate but important balance:

• On the one hand, diverse opinions are what make stock markets. It is important to have a wide range of valid and considered views; but
• On the other hand every comment posted informs the culture of this community at Stockopedia.

And so we must bear in mind the culture that we want to build. In this venture we are all stakeholders. I remember when I started investing how important the supportive Stockopedia community and the daily SCVR was in igniting that passion.

There’s a lot of cheap, disposable hate on the internet but what makes Stockopedia a great place to hang out is the fact that it is a fundamentally positive environment - whether or not you agree with the person on the other side of the screen from you.

Anyway, that’s me off the soapbox. Before we get on with today’s news I’ve also got some notes on everyone’s favourite shiny metal...

Going for gold

The bull case for gold is pretty established so I won’t trot it out again. Suffice to say mid to long-term prospects look encouraging and relative strength in this part of the market is particularly strong.

Related note: Jim Mellon has just bought 18,426,963 shares in Condor Gold (LON:CNR) , taking his total shareholding to 15.7% of the c£48m gold miner.

In picking Anglo Asian Mining (LON:AAZ) for my own portfolio I’ve skilfully avoided most of the upside so far but I'm quite happy to hold it. A friend on Twitter was kind enough to get me onto a chat with management earlier in the week so I thought I would relay some points from that discussion below.

• COVID is actually getting a bit worse in Azerbaijan but operations are working fine and people are able to isolate. Quarterly production has been undisrupted
• Spread - AAZ can’t even talk to the market makers, so not much to be done here.
• The group is getting some institutional interest now. 2-3 fund managers are on the share register. Perhaps institutional investors are looking for dividend-paying gold miners?
• Hardman’s forecast of a forecast 10.5c dividend (c5.9% yield) - this is not picked up by Reuters as the broker does not forecast dividend per share (it just works out forecast yield from projected free cash flow). Board and management owns 40% of the company so it is reasonable to expect this kind of dividend, although it hasn’t been discussed by the board.

That’s all I’ve got - I joined the meeting late as I scrambled for last minute Zoom passwords etc., but overall I got the impression of a solidly run mining venture with plenty of scope for life of mine extensions and dividend payments into the future. Any further upside in the gold price would also be a positive tailwind for shares, so quite encouraging on the whole.

We have some news flow now - some RNS that catch my eye at first glance:

• Litigation Capital Management market update
• SRT Marine Systems trading update
• Restaurant Group update on banking facilities and reopening
• The Gym Group re-opening update plan
• Senior PLC - post-close market update
• Impact Healthcare - Rent, Dividend and Business Update
• International Personal Finance - Trading Update
• Genedrive trading update

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Gym Group (LON:GYM)

Share price: 149.8p

No. of shares: 165,878,544

Market cap: £248.49m

Re-Opening Plan Update

Obviously it’s been a tough time for these businesses. Gym (LON:GYM) 's share price has halved with not much in the way of recovery. And why should it recover? Brokers are forecasting a swing to loss for the year, albeit with a decent recovery into the following year.

To recap the developments so far:

• Gyms were closed on 20 March 2020,
• In the first few days after closing there were a significant number of cancellations, but this rate subsequently slowed considerably. As at 9 July 2020 GYM had 692,000 members (vs 870,000 on 18 March 2020) - a 20% drop,
• On the re-opening date of each gym, members' monthly direct debits will automatically re-start; prior to the opening date all members will be offered the opportunity to continue the 'free freeze' option

And now gyms are finally preparing to open their doors once more. Gym Group plans to open 160 sites across England on the 25th of July, with 13 sites in Scotland and 3 in Wales to follow as soon as local restrictions are lifted. The group’s own research suggests 92% of members are keen to return.

Things will be different though - sites will initially operate 6am-10pm on weekdays and 8am-8pm on weekends, to make room for ‘new operating protocols’ but the group expects to return to 24/7 more widely within the next few months.

GYM’s #safewithus initiative will ensure gyms operate in a Covid-secure way. In brief, there are six principles:

• Shield - preventing infected people from entering the gym via temperate checks for colleagues, stay-at-home precautions for those with symptoms, and the ability for gymgoers to freeze membership for free.
• Prevent - clean surfaces, contactless entry, hand sanitisers, enhanced cleaning regimes.
• Limit - reduce social interactions, reduce the number of people in the gym to one member per 100 sq ft and encouraging people to go at less busy times (potentially tricky, but possibly easier with so many people now working from home)
• Reduce - wider spacing of equipment, new layouts, best-in-class ventilation
• Educate - train colleagues and ingrain best practice.

My view

This one is important on a personal level as over lockdown I have rediscovered chocolate and appear to have developed a bit of a pot belly.

It’s truly heartening to see businesses announce re-opening plans. Simply put, we need to find ways of living our lives even if COVID-19 remains on some level. The economic risks and the psychological hit to swathes of people become more important as time passes.

A lot of these measures will hit margins - and on the other side, how will demand hold up? GYM says 92% would like to come back but I haven’t seen the details of any studies or surveys.

Let’s assume, simply, that the recovery is sustained despite society opening up once more, and 2021 sees a normalisation in trade to about 90% of 2019 levels. That would make for about £138m of revenue and 5.8p of earnings per share.

That would put GYM’s shares on a 2021 forecast PE of about 26 times, with a forecast price to sales of 1.8x. The latest broker forecasts suggest 6.5p of earnings per share in 2021 so my assumption doesn’t look far off.

When the model is up and running like a well-maintained treadmill, it’s a highly cash generative model with attractive box economics, a solid roll out strategy, and healthy market demand. But, at this level, I feel like there are probably better risk:reward propositions out there.

To invest in a gym group, I would want a strong margin of safety and to feel like the risk of life never returning to normal (or at least a second wave of disruption) is reflected in the share price.

I don’t feel that’s the case at present, so I’m not tempted - although I wish holders well and it’s certainly not hard to imagine the share prices recovering to the 300p mark if everything goes well.

Restaurant Group (LON:GYM)

Share price: 56.15p (+4.95%)

No. of shares: 589,795,475

Market cap: £315.54m

Talking of risk:reward in Leisure stocks, Restaurant (LON:RTN) does strike me as one company that has a lot of downside priced in. It’s a risky bet, for sure, but the valuation makes it more tempting.

Running the same figures for RTN (90% 2019 revenue and normalised EPS) and assuming that is where the company gets to in FY21 would give us a valuation of about 0.34 sales and a normalised PE of about 3.6x.

There’s a lot going on at this group though. It is mired in a turnaround after years of mismanagement and muddled strategy, so assuming 90% of FY19 figures might well be too much of a stretch. Brokers are certainly being much more conservative:

That FY21 EPS estimate of 5.9p would make for a forecast PE multiple of 9.4. This kind of company is hard to value and this is reflected in recent share price action:

When the market can’t gauge price, that can signal an opportunity though.

Over the past three months RTN has been down 30%, up 30%, and right now it is back to where it was at the start of that period. Who knows what the real value is - but if it can get back to anything like 2016 levels, that makes it a tenbagger.

I don’t think that’s likely anytime soon, but it does mean there is plenty of scope for a rerating if things go well in the years ahead, in my view.

Anyway, the company has updated on its banking facilities and reopening plans. There is probably some useful readacross here. Running through the key points:

• RTN has accessed £50m from the Government CLBILS scheme, supported by Lloyds Banking Group,
• It has extended the term of the current RCF facility by six months to 30 June 2022,
• The group has a covenant waiver for December 2020 with covenants next tested at the end of June 2021; and there is
• A reduction in commitments under the RCF of £40m.

The net effect is an additional £10m added to the group’s overall debt facilities.

Having been a long time bear on this company, what started to thaw my opinion this year was management’s actions during the lockdown and the depth of communication with the market throughout this painful process. Bear in mind this is a much-changed line-up from the team that led this company into the ground back in 2015/16.

More research is needed, but it looks to me like RTN is actually using the current circumstances to strengthen its hand (having committed to ditching some underperforming sites and brands, and after shoring up its balance sheet).

When companies show signs of change, it pays to keep an open mind so that’s what I’m doing for now. With the share price back down in the 50s, it might be worth another look.

In terms of its reopening agenda, the group aims to have:

• 25% of the total estate operational by the end of July;
• 60% by the end of August; and
• 90% by the end of September, with the reopening phasing varying by division.
• The remaining 10% of the estate is not expected to open this calendar year reflecting locations where footfall is anticipated to remain considerably weak (primarily in some airport locations).

Not one I’m about to jump into without a lot more research as a special situation, and not for the risk averse, but I do think at 50-60p RTN is worth a closer look.

Litigation Capital Management (LON:LIT)

Share price: 62.75p (-2.11%)

No. of shares: 104,580,899

Market cap: £62.75m

My overall feeling with litigation financing is that ‘I know enough to know what I don’t know’.

I believe I’m butchering a Socrates quote there, but at least it shows I’m in good company. The thing that ultimately turned me off this business model is the cash flow statements. Burford Capital’s cash flow statement was characterised by non-existent operating cash flows, lumpy investing cash flows, and frequent fundraisings. The Litigation Capital Management (LON:LIT) cash flow statement shows more of the same.

There could well be a totally acceptable explanation for this operating profile. All I know is it’s far outside my circle of competence. Happy to flag this one up so more informed investors can give their 2p on these results though.

Market update

People love to talk in the world of litigation funding.

Sifting through this word mire, we have the following highlights:

• 9-year portfolio ROIC of 134% and cumulative portfolio IRR of 78%,
• Accelerated growth in commitments from the LCM Global Alternative Returns Fund, which now stands at $106m or 47% of $150m since fund launch in March 2020,
• Increased applications and investments in the quarter reflecting the counter-cyclical nature of the industry
• COVID-19-related delays on court proceedings, particularly in Australia, although the effect on earnings will be minimal thanks to cost controls

I’d summarise two important points with the following quotes from the statement. One:

With regards to LCM's existing investments, the immediate effect of COVID-19 has predominantly been felt in Australia where the Company's longest-running and most advanced investments are located. In relation to disputes which are approaching a final adjudication, the Australian courts have struggled with effective implementation of digital hearings, resulting in longer hearings as courts and practitioners grapple with new technology.

LIT points out this is deferred not lost revenue.

Two:

COVID-19 has led to the global financial markets experiencing high volatility, and there is a strong correlation historically that dispute levels rise during such periods of instability. As outlined, LCM is already observing the levels of insolvency events increase and corporates looking for alternatives to disputes spending and is well-positioned to respond to the resulting increase in applications accordingly.

So there is a degree of counter-cyclicality to consider with litigation financing. A useful characteristic. The group’s shares are well off their peak of c110p and below the IPO price of c64p in 2019.

Take 10% off the FY20 revenue forecast in light of today’s announcement and that still gives a doubling of revenue year-on-year to c£70m. There could be value here, and it looks like a big market - just not one that I know well.

Marlowe (LON:MRL)

Share price: 526p (0.38%)

No. of shares: 46,045,559

Market cap: £241.28m

Fwyburd and Ben1 have flagged this one - the recent share price looks interesting, and note the Shareholder Activity box. The community’s buying so let’s have a look.

Marlowe (LON:MRL) is a leader in providing an end-to-end approach on safety and regulatory compliance services for businesses so that they can get on with the day job.

The strategy for growth is clearly defined: build leading positions across existing sectors via organic and acquisition-led growth. If this is a fragmented market ripe for consolidation, that could be a promising and large niche.

The group’s final results came out on Wednesday. Here are the highlights:

• Revenue +44% to £185.4m
• Operating profit +55% to £14.7m
• Profit before tax +54% to £13.6m
• Basic EPS +30% to 24.3p
• Net debt up from £20.1m to £32.3m (pre-IFRS 16)

It looks good. Those are the adjusted results though. Statutory results show much lower profit figures (operating profit down from £2.6m to £2.1m; profit before tax down from £2m to £0.5m, basic EPS down from 3.8p to -0.8p).

So understanding the significant adjustments is important. Here’s the reconciliation:

These restructuring costs are as a result of integrating acquired companies, with Clearwater a particular culprit, incurring a £4.2m charge. Management is realising synergies here and says ‘that towards the end of the financial year, the business's operating margin was improving to be more in line with the Group's wider Water activities.’

The bulk of restructuring costs come from duplicated staff roles, redundancy costs, and IT integration costs, with the bulk of the hit incurred in the 12 months post-acquisition. Seems reasonable to me.

Amortisation costs are up due to an increase in the carrying value of intangible assets. Looking at the balance sheet, intangible assets are up 37.5% to £123.2m. That’s 59% of total assets. Something worth keeping an eye on.

The intangibles include goodwill from acquisitions. This year:

• MRL paid £3.3m for Clearwater, but it was loss-making and the price reflects £7.8m of goodwill,
• Aquatreat was acquired for c£0.4m including £0.1m of GW, loss-making,
• Quantum was bought for £7.8m and includes £4.5m of GW, profitable,
• FSE Fire Safety Systems for £2.8m, £1.8m of GW, profitable,
• Law At Work for £4m, £8.8m of GW, profitable,
• Eurosafe for £2.4m, £1.5m of GW, profitable,
• Managed Occupational Health, £2.5m, £2.1m of GW, profitable
• Solve HR, £0.3m, £0.3m of GW, profitable.

A lot of these acquisitions have contingent or deferred payments to come, so the above is a very brief run through. That’s c£24m spent on acquisitions, probably more given upcoming payments. Not inconsiderable for a c£241m company. How well these businesses are integrated and the price paid will be important drivers of returns for MRL.

It explains the increase in net debt. Given the buying spree free cash flow is lumpy:

FY17 and 18 show good cash generation so perhaps if the company was to cease acquisitions, we would see quite a cash generative operation emerge? Meanwhile, broker forecasts have been reasonably resilient through lockdown so that’s optimistic:

Marlowe expects to be able to return to pre-COVID levels over the summer given that a lot of its services are required as a matter of regulation.

The forecast PE is 20.9x - not cheap but it comes down to how big the opportunity is for MRL. It looks like a big, defensive, potentially fragmented market and clearly investors are anticipating substantial market share gains.

The group’s annual reports give the following re. total addressable market:

That looks like plenty of headroom to me, given current annual revenue of c£180m. It sounds like there are potential barriers to entry given the regulatory nature of these services as well.

Overall the group comments:

Given the defensive nature of our business model, we expect to see growth in line with our pre COVID-19 expectations as restrictions are lifted. COVID-19 is no longer having a significant impact on our operations and we expect to deliver further good progress in the current year.

I’ll leave it there for now, but Marlowe’s an interesting proposition with headroom for growth if it can successfully integrate acquisitions and identify further consolidation opportunities. I do wonder about the growing intangibles on its balance sheet though, so that’s worth keeping an eye on. Understanding more about management’s track record around acquisitions would be telling.

SRT Marine Systems (LON:SRT)

Share price: 36.5p (+23.7%)

No. of shares: 164,251,939

Market cap: £48.45m

Quite the share price jump today for this marine technology business. Srt Marine Systems (LON:SRT) provides maritime monitoring services and surveillance systems for a variety of clients, from port owners to vessel operators, and even national defence agencies.

It sounds interesting - but the StockRanks hate it:

You can see why - a lot of the damage comes from an abysmal F-Score of 1, with poor cash generation to boot.

This is visible in the group’s increasing net debt position towards the bottom of the Financial Summary. It looks potentially like a lumpy revenue, large contract business, albeit in an interesting niche.

Trading update

SRT’s Philippines fisheries management system project has recommenced, with a significant cash payment having been received this week. The revised plan is to accelerate implementation to make up for time lost due to a 5 month pause. Contract negotiations have also recommenced in the Middle East, with resulting projects to begin in the coming months.

This sounds good:

Furthermore, our transceivers business has performed better than expected in the current circumstances, achieving gross sales during the first financial quarter 2% ahead of the same quarter for the previous financial year.

Playing catch up, it looks like a couple of contracts were delayed and you can see the share price more or less halved back in February/March:

If SRT can recover back to its highs of 56p heading into 2020, that’s still c50% upside from here.

Jumping back to the half year report of November 2019 we can get some more colour on this company.

Revenue was up 9.8% to £3.5m and the group has an increased active new systems pipeline of some £580m. That sounds massive for a sub-£50m company. Half year loss before tax was £2.7m though, and SRT had a net debt position of c£12.6m. Given the company’s historically poor cash generation that does make me wary.

Shares in issue have been going up.

The group has two divisions: Transceivers and Systems. Looks like Transceivers is much larger (source: September 2019 Investor Presentation):

Systems is lumpy though, so this might not be representative. The above pie chart represents £3.5m of HY revenue but SRT also said that ‘subsequent to the period end… we have received a further £4.9m as scheduled from a systems customer’.

Cash expenditure in the first half nearly doubled from £2.8m to £4.2m, in part driven by a doubling of product development investment to £1.4m. A new range of products - the B900 series - began shipping in January of this year.

Product development looks promising. Back in November SRT said:

This development program, which commenced in 2018, will yield further innovative AIS related products during 2020 and 2021 for both our OEM and em-trak sub-divisions… that are affordable and desirable to the mass leisure and commercial marine markets. We therefore see many exciting growth opportunities for our transceivers business for the second half and beyond.

The historic financials look grim, and the net debt on the balance sheet looks scary. But then the company seems to occupy a trusted position in an interesting niche, with a potentially strong pipeline of new products and systems. The latest update signals improving trading momentum.

SRT has strengthened its finances in recent months with £5.3m raising of £2.8m in equity and a £2.5m interest-free loan under the Coronavirus Business Interruption Loan Scheme.

Interesting company, but is it a good investment? It’s too risky for me. One to watch if it can turn product development into increasing revenue, but it’s also got bargepole potential.

I’ll take a break here - the sun appears to have made a welcome return...