Small Cap Value Report (Fri 25 Feb 2022) - STU, TGP, BEG

Good morning, Paul & Jack here with the small cap value report (SCVR) for Friday. Today's report is now finished. 

Market uncertainty over Ukraine was removed last night, as the Russians invaded. I am sure we can all agree that the scenes on TV were upsetting, but we're not here to discuss issues like this, these reports (and the comments you leave) are focused on the small caps end of the UK market. So hopefully we can try a little harder to keep comments on topic. Nobody is interested in hearing some half-baked views on WWII for example, which uselessly cluttered up the comments the other day! I did a degree in International Relations, so you can imagine it's quite difficult for me to bite my tongue and not respond, but there are plenty of other places on the internet to broadcast your views to people who don't give a damn about them!  ;-)  Let's stick to shares, and markets here please.

Market conditions - obviously things are very difficult at the moment, especially in small caps. In some sectors I can see why share prices have fallen sharply - it may be the case that smaller companies suffer from inflationary pressures more badly than larger companies. If you can't raise selling prices easily, then facing big increases in raw materials, and higher wage demands, can crush profitability. I didn't get round to writing up a section on it, but Mcbride (LON:MCB) recently reported "rapid and massive input cost inflation" - wording which leaves us in no doubt that cost inflation & the ability to pass it on, is the biggest issue that investors need to think about. There are likely to be lots of profit warnings from companies which make products at low margins. The good news is we can just avoid those type of companies & sectors.

Pricing power - arguably, retailers are in a good position, in that they can set their own selling prices,  in real time. But the problem is, customers shop around, and as Next (LON:NXT) said, it can put through price rises, but doesn't yet know what the customer reaction will be. Demand can be quite elastic (i.e. an increase in prices can have a larger, negative impact on volumes, in the clothing sector, from my experience). This is where the strength of the brand, and the uniqueness of product becomes more important. At the higher end, customers already paying hefty prices, are not likely to baulk much at a price that's say 5% higher. Joules (LON:JOUL) (I hold) and Superdry (LON:SDRY) spring to mind as brands that are design-led, not price-led, who might do OK in an inflationary environment, if they get their product designs right, and can improve supply chains.

Historic reaction to crises - Just one example, I remember in 2003, when the US + allies invaded Iraq. The stock market had been in a deep depression after the market euphoria bubble burst in March 2000. There followed a 3-year bear market, that was unrelenting, and valuations got crushed. The build up to the Iraq War from about Sept 2002 to Mar 2003 saw confidence remain on the floor. However, as soon as the war actually began, a major bull market started, which ran for years until the financial crisis hit in 2008. Many shares became multibaggers from their 2003 lows. 

When prices are irrationally low, that's presenting you with the best buying opportunities, if you pick the right companies. So it will be interesting to see if the same pattern plays out again. The US market rallied strongly last night, so fingers crossed we might see some buying interest in the UK too. I think this is such a good time to put cash to work, selectively. I know lots of investor friends who are sitting on the sidelines in cash right now. So there's arguably a wall of money waiting to come back into the market, because nobody wants to hold cash long-term, given that its buying power is dissipating by c.7% p.a. from inflation.

It's important to remember, that when prices are falling (sometimes irrationally) and valuations get cheap, that's a great time to be buying, not selling! But it depends on each share individually. If you think a profit warning could be looming, then selling could be the best thing to do for that particular share. Anyway, everyone has to decide these things for themselves. A lot of investors think they can time the exact bottom of the market, so they hold back. This then leads to surprisingly powerful rallies, as everyone dives in at once, when they think a turning point has been reached. So there's something to be said for making small initial buys, and then having some powder dry to build up a position as confidence returns.

We're also likely to see more takeover bids in a market that is in parts, looking cheap. If you sit on the sidelines in cash, you won't get any takeover bids.

As it turns out though, cash has been a very good place to be in the last 6 months or so, well done to those of you who anticipated this. I never imagined conditions in small caps would get this bad, but there we go - we have been discussing the various economic risks (e.g. higher inflation, pricing power, and higher interest rates) for a long time. Working out how that translates into share prices is the tough bit. Sometimes the markets ignore risks, other times they go the other way and over-react on the downside.

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Agenda

Paul’s Section:

Studio Retail - an absolutely scandalous situation. It shouldn’t be legal, but it is. The company was put into Administration due to a small working capital shortfall, with major shareholders (unknown to us) apparently refusing to support it in a placing. Administrators appointed yesterday, and today Frasers (LON:FRAS) (the biggest shareholder) has bought the business from the Administrator! A total stitch-up.

Tekmar (LON:TGP) - poor results for 18m ended 30 Sept 2021, but positive outlook from the strong order book. A £4m fundraising is also announced, very well supported (albeit tiny) at 45p/share, a premium.  Could be worth a closer look, due to the positive momentum in order intake - suggesting that financial performance should improve.

Begbies Traynor (LON:BEG) (I hold) - the Q3 trading update issued yesterday seems to show a slight softening of trading, but still within full year market expectations. Ending of the rent moratorium in March 2022 is likely to trigger a big upsurge in  new business. Therefore the valuation currently looks highly attractive, for a counter-cyclical business set for a bonanza of work from April onwards.

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Studio Retail (shares cancelled)

This is a scandal in my opinion.

The first sign of any solvency problems was on 31 Jan 2022, when the company indicated in a trading update that it had a £25m working capital shortfall. As mentioned in that day’s SCVR, I lost confidence in management, and decided to sell. A lucky escape. It would have been perfectly rational to take a more positive view, imagining that a £25m working capital shortfall would be solved with a placing - which would have been the normal outcome. Although selling would also make a lot of sense whenever you think a placing is on the cards, especially after 2 profit warnings, as the risk of heavy dilution is too great.

Then, just a fortnight later, the shares were suspended, and the bombshell news was announced that STU intended to appoint administrators.

Administrators were appointed yesterday.

Today the operating business (not in administration) has been sold to the largest shareholder, Mike Ashley’s Frasers (LON:FRAS)

How on earth is this legal?! It is though, I’m not suggesting anything worse than sharp practice.

How can an Administrator appointed yesterday, fully assess the situation, in under 24 hours? The reason usually given, is that the bidder was the only credible option, and Administrators usually want to sell off the operating business as soon as possible, so as not to incur potential liabilities itself.

Consideration for the sale of the operating business is nothing, to the holding company (in administration). Therefore shareholders are wiped out, so this is a zero I’m afraid. Sorry to anyone who got caught on this.

The consideration for the Transaction comprised the release of the Company from its liabilities to its secured creditors under its revolving credit facilities and ancillary facilities. The Transaction resulted in a cash payment by FG to the Company's secured lenders in the amount of approximately £26.8 million.

What can we learn from this? Off the top of my head -

Run for the hills if Mike Ashley turns up as a major shareholder at any company which might run into cashflow problems.

The current insolvency laws allow legalised theft of companies from their shareholders, if financial distress emerges. This is a known problem, that has been discussed for years, and it’s fair to say there are pros & cons under the current system (e.g. rapid sale of operating businesses does protect jobs & allows companies to recover, but shareholders, and often (but apparently not in this case) unsecured creditors, are stuffed).

Weak management clearly rolled over at STU, when they should have fought back with a deeply discounted equity raise, at say 10p, and just told Ashley & Schroders to back the fundraise, or be massively diluted. This could & should have been done. So I’ll keep a note of the Directors names at STU, and never back anything else they’re involved with.

Major shareholders are a big potential threat to small investors. So I need to review my own portfolio, and make sure I’m happy that the major shareholders can be relied upon to act ethically. How on earth do we measure that? By reputation, and previous actions.

With interest rates rising, bank debt is now becoming much more dangerous. In a zero interest rate environment, banks are usually happy to wait to be repaid, because the debt is not increasing. However, when interest rates were high (e.g. in the late 1980s & early 1990s), a typical base rate of 13% meant that problem debts snowballed fast, and many viable (but overly indebted) companies saw the banks pull the rug out from underneath them. So we need to be careful about investing in companies with a lot of bank debt. Many investors have learned very bad habits in recent years - imagining that bank debt isn’t a threat. It is, it’s a potentially terminal threat, now that rates look set to rise.

Thinking more about STU itself, the business model was always questionable, so the wisest thing would have been to avoid the shares altogether. Although to be fair, nobody foresaw the stitch up coming.

Schroders and other institutions need to explain why they wrote off their investments, instead of supporting a relatively small placing?

Why were shareholders not informed that the company was in serious financial trouble?

Anyway, that’s it, game over for small shareholders. Mike Ashley's FRSA has just gone from 29% shareholder, to 100% shareholder, at a cost of £26.8m, paid to the banks. Small shareholders have paid the heaviest price, with shares now worth zero.

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Tekmar (LON:TGP)

43p (up 3% at 09:18) - mkt cap £22m (before placing)

Final Results

For the 18 month period to 30 Sept 2021 - quite late reporting.

This is a very brief review, as we’re short of time this morning, and the company is tiny, with little liquidity in its shares.

Results are poor, with an adj EBITDA loss of £(2.1)m, which translates into an operating loss of £(5.4)m.

That’s damaged the balance sheet, hence Takmar also announces a placing/open offer today, to strengthen its balance sheet somewhat.

Very encouragingly, the placing is priced at a premium, at 45p, not something I would expect in current bearish market conditions for small caps. So that’s encouraging, and means shareholders don’t have to worry as much about solvency, but that comes at a price - dilution.

Receivables look too high, and see note 6 which explains that some trade receivables are overdue. I think they need to break down the over 30 days late figure, as that could be seriously overdue, or only mildly overdue. Very often, late payment by customers is a sign of trouble - disputed invoices, or customer solvency risk.

What’s interesting about this share, on the bullish side, is that the order book has reached a new record (since listing) at £20.3m (end Dec 2021). The commentary contains interesting talk of recent landmark contract wins, re wind farms.

So it looks like the investment case here could be positive, on the outlook, for improved financials.

My opinion - neutral, as I haven’t looked into it closely for a while. However, on the basis of a well-supported placing, and positive outlook from a strong order book, this share could be quite interesting. Worth a closer look, I’d say.

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Begbies Traynor (LON:BEG) (I hold)

108p (up 4% at 09:42) - mkt cap £165m

Q3 Trading Update

Begbies Traynor Group plc (the "group"), the business recovery, financial advisory and property services consultancy, today issues a trading update for its third quarter ended 31 January 2022.

This strikes me as an OK trading update -

Trading performance in Q3 has been broadly in line with the first half year, which leaves the full year anticipated to be within the range of market expectations* and significantly ahead of last year.   
* current range of analyst forecasts for adjusted PBT of £17.0m-£18.5m (consensus £17.5m) - as compiled by the group

Other comments -

Liquidations increased, but administrations “remain much lower than pre-pandemic levels.”

I don’t really care about the split between liquidations/administrations, the key point is that the division overall is trading in line with expectations.

I think some people may have interpreted this following bit as negative, but it’s actually very obvious, given that the rent moratorium (which is keeping many small businesses going, as landlords can’t evict them) is expected to end on 31 March 2022. This is likely to be a major driver of new administrations from companies which face eviction due to rent arrears, and finally throw in the towel -

A return to more normal activity levels in this marketplace is now more likely to benefit our new financial year rather than the current year.

Since BEG has a 30 April year end, then this is what I would expect.

Property division is also performing in line with expectations.

Strong liquidity, with plenty of headroom, but no figures provided.

Outlook -

"We have performed well in Q3, benefiting from the integration of our recent acquisitions and our broad range of complementary services which provide a strong platform for growth. Although insolvency numbers are inexorably rising, the market is still awaiting a rise in the larger and more complex instructions that may result from the current economic headwinds and the removal of the final Government financial support measures in March."

My opinion - given the likely imminent surge in corporate insolvencies, BEG looks an ideal counter-cyclical share to have in our portfolios.

The fact that recent market wobbles have reduced its price from recent peaks of c.150p, to 108p now, I think provides a cracking buying opportunity, if you like the company (which not everyone will). As always, that view may turn out to be right or wrong, nobody can be certain either way, as the future is inherently uncertain.

It sounds like there’s been a little softness in recent months, and I note that broker forecasts have been slightly trimmed in the last 2 months. So not everything is perfect, but the main bull case for this share in unchanged - that’s it’s likely to get a tsunami of new work from early April 2022 onwards, as the rent moratorium ends. Rising inflation, and rising interest rates, are likely to further stimulate demand for BEG services.

Hence to my mind, the attractions of this share are greater than ever, and the forward PER of around 11-12 looks highly attractive in current circumstances.

Also note that BEG has done a series of successful acquisitions, which have added significant value - note how EPS has soared. It’s an owner-managed business, so new share issuance is only ever done to fund attractively-priced acquisitions.

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