Small Cap Value Report (Fri 27 Sep 2019) - FTSE/Interest Rates, ESC, SONG, EQLS

Good morning!

Sorry for the late start today.

• Escape Hunt (LON:ESC)
• Hipgnosis Songs Fund (LON:SONG)
• Equals (LON:EQLS)

---

Personal Note (feel free to skip)

This is irrelevant, but I think it's worth saying that this has been my busiest month, probably ever. The stream of work assignments been extraordinary. Finding a spare 10 minutes has sometimes felt impossible.

I knew that September was going to be like this, several months back, and tried to prepare for it, but it was always going to be hectic, because of the things I had agreed to do.

Thankfully, I have learned my lesson and will not allow my calendar to get so crowded ever again.

Anyway, there are still a few more days and a few more assignments to get through, so I'm still run off my feet. But from next month, I am going to have more time and am going to have to be more careful with my time, too. Thanks for your patience.

---

FTSE/Interest Rates

Many of you will have noticed that the FTSE is up 350 points, or about 5%, compared to a month ago.

I was thinking about doing some more FTSE trades a few days ago, but the pricing wasn't quite right. If I had pressed the button, I'd be sitting on nice profits already. It turns out that there are BOE bankers who are inclined towards loosening again:

If growth is weak for a while, below potential, spare capacity rises and down the road inflation undershoots.

"Our remit encourages us to steer against that,

His remarks bashed the pound and boosted the FTSE, as you'd expect.

As Peter Schiff would say, Western central bankers are in the monetary equivalent of a "roach motel" (a place where you can check in, but you can't check out). Large parts of our economies and especially our governments are now accustomed to low interest rates, they like low interest rates and they can't imagine suffering high interest rates. Borrowers have more clout than lenders, and going "back to normal" is not something that many people really want to do.

Indeed, low interest rates are "The New Normal". Someone who graduated from university in 2010 has never known anything but low interest rates during their entire professional career. If they've been working full-time for the best part of a decade, they might have reached a senior position in a bank, investment company or government body by now.

Each year that passes, the ranks of these organisations become filled with more and more people who don't know what normal interest rates are. Unless they've read some economic history and take a contrarian stance, they probably don't see any point in interest rates going back to normal.

Meanwhile, the UK is close to falling into a technical recession, and if that happens then it will be one more reason for the BOE not to raise interest rates. Indeed, it might soon wish to cut them again from the current 0.75% level.

In short, there is no reason to think that things are going back to normal any time soon. The investment implications of this aren't very pleasant but equities, property and precious metals are where I continue to focus my efforts. Bonds are mostly a waste of time for anyone who is looking to build wealth.

There is an argument that can be made for holding cash until things become better value, for investors who are good at timing their entry. I do this a little bit by opportunistically placing bets on the FTSE, but I mostly outsource this job to Warren Buffett ($BRK.B) and Jonathan Lander (VLE). Being fully invested in managers who aren't fully invested is what works for me - what works for you?

---

Escape Hunt (LON:ESC)

• Share price: 50p (-5%)
• No. of shares: 27 million
• Market cap: £13.5 million

Unaudited Half Yearly Results

This has been listed since 2017. It runs hundreds of escape rooms, the increasingly popular live puzzle venues.

Having studied this company some time ago, I came to the conclusion that I liked what they do, but the investment merits weren't proven (see initial coverage in March 2018, and then a follow-up in September 2018).

Today's results show excellent revenue growth (from £800k to £2.2 million) but adjusted EBITDA is only marginally better, at minus £1.2 million, using the old accounting method.

The new IFRS 16 rule makes EBITDA better for companies with leases. So on an IFRS 16 basis, ESC's H1 EBITDA loss is "only" £1.06 million (but this completely ignores the cost of leases).

Numbers aren't good whichever way you look at it!

Outlook

This is in line with expectations. H2 has started "well", with a new revenue record in August, and with benefits to come from new marketing to corporates.

Also, annualised savings of "circa £450k" are coming through, thanks to the end of some expenses while the company was in transition (it was originally headquartered in Bangkok!).

Quote:

Given the early stage nature of the business and number of initiatives being pursued, both in the UK and abroad, it is difficult to predict the exact timing when things come to fruition, but overall we are confident that during the remainder of the year, we will see continued progress in line with expectations.

My view

It's just too speculative for me, I'm afraid. It might succeed, it might not. Who can tell?

The cash outflow from operations and investments was over £2 million during the six month period, and only a £4 million equity raise prevented the cash balance from going to zero.

While I do think that escape rooms are here to stay, are they good investments? Much like pubs and restaurants, I suspect that the answer is no, in most cases.

The StockRank is 3 (out of 100, not out of 5). While I wish the company well, I cannot see any reason to invest.

---

Hipgnosis Songs Fund (LON:SONG)

• Share price: 107.25p (-0.2%)
• No. of shares: 389 million
• Market cap: £418 million

Initial placing and offer of C shares

This is targeting a step-change in funds under management, with another £300 million sought.

The funds will be used "to acquire attractive Catalogues containing proven hit Songs from well-known songwriters, artists and producers which are in line with the Company's Investment Policy..."

Hipgnosis has exclusivity agreements to acquire 9 catalogues "with an aggregate purchase price in the region of £300 million", so it knows what it wants to spend the money on.

In total, it has £1 billion of songs it is interested to buy.

The C shares which it issues will eventually convert to ordinary shares, when 80% of their proceeds have been invested.

Prospective investors will need to take into account the technical rules around conversion:

On the relevant Calculation Time, the net assets attributable to the Ordinary Shares then in issue, the net assets attributable to the C Shares issued pursuant to the Initial Issue and the resultant Conversion Ratio will be calculated.

My view

I'm starting to wonder if songs might be getting more expensive, thanks to the existence of Hipgnosis? I wonder how big is the market for these catalogues. If you inject several hundreds of millions of pounds into it, is there a risk that you might move the prices, a bit like PSG or Manchester City making footballers more expensive for everyone eles?

That said, even if SONG finds that it pays a full price for these music catalogues, it could still get an acceptable return (and one that isn't correlated with the performance of other shares).

It currently pays dividends of 1.25p per quarter. Some blue-chip investment funds are involved and probably because they also think that this share could prove to be a useful source of income.

---

Equals (LON:EQLS)

• Share price: 90p (-1.6%)
• No. of shares: 178 million
• Market cap: £160 million

Replacement: interim results

I've been meaning to catch up on this one. It's an international payments company with strong revenue growth but I also noticed quite a lot of cash burn. It was previously known as FairFX. You can browse its investor relations website here.

These interim results show revenue up by 21%. Pre-tax profit, however, only increases by 15% (on an adjusted basis).

Scrolling down to the financial review, I see that operating expenses increased by 33%, or by 22% excluding "one-off" costs.

So there is no operational leverage yet, I'm afraid. Opex is growing faster than revenue.

Outlook is in line with expectations.

According to Stocko, the company is set to produce net income of £10.9 million this year, rising to £13.7 million next year.

As usual, there is a lot going on at Equals: a new relationship with Citi Commercial Bank (for settlement and clearance), an online credit offering in partnership with iwoca, and the integration of Hermex FX.

Cash flow

The cash flow picture for H1 is complicated: there were large increases in receivables (draining cash) and an acquisition, offset by equity issuance. In August, the company has raised more money again, so hopefully it isn't going to run out again soon!

My view

This is a tricky one - it's working hard to grow and is very active through all sorts of channels, but what's the competitive advantage? I don't know. It's a very complicated picture, especially in terms of cash flow.

Readers will remember that Earthport (EPO), another cross-border payments company, was acquired earlier this year by Visa. Its financials were always very ugly, but Visa saw value in what it had created.

Unlike Earthport, Equals/FairFX does offer some evidence of value creation in its financials. Maybe the logical outcome is that it too will get acquired before too long, by a much larger company. if it succeeds in developing something of real value?

---

That's it for the week, thanks everyone for your comments and feedback.

Cheers

Graham