Small Cap Value Report (Fri 3 Sep 2021) - CMCX, ECEL, JSG, PPH

Good morning, it's Paul & Roland here with the SCVR for Friday.

I'm writing this from an AirBnB apartment in Bormla, near Valletta in Malta. I've got good aircon & wifi, so can write these reports from anywhere like that. Hence I thought why not grab a fortnight in the sun? Malta recognises England's NHS vaccine proof app, so it was very straightforward to get here, no additional testing required, and just a couple of forms to fill in online.

Agenda -

Paul's Section:

Eurocell (LON:ECEL) - really good interim results, I'm impressed! Dividends are resuming, the balance sheet is strong, and it gives a positive outlook statement. Valuation looks reasonable too. The main question is how to value it? Where are we in the earnings cycle? That's the key question.

Roland's Section:

Cmc Markets (LON:CMCX) - Shares in this financial trading firm crashed yesterday when it revealed a slump in client activity. This could be a temporary slump, if volatility picks up again.

Johnson Service (LON:JSG) - A strong recovery seems to be underway at this textile rentals group, but the shares already seem priced for a return to normal. Not sure there’s much value here.

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Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to cover 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 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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Paul's Section

Eurocell (LON:ECEL)

267p (yesterday’s close) - mkt cap £298m

Half-year Report

Eurocell plc is a market leading, vertically integrated UK manufacturer, distributor and recycler of innovative window, door and roofline PVC building products

HALF YEAR REPORT FOR THE SIX MONTHS ENDED 30 JUNE 2021

Strong first half, a further increase in full year expectations and reinstating dividend payments

I’m not terribly familiar with this company, so as always the first port of call is the Stockopedia graphical history -

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What I can glean from the above graphs is -

Graphs 1 & 2 - a history of rising revenues, but flattish profits, indicates falling margins - usually caused by competitive pressures

Graphs 2 & 3 - a collapse in profits in FY 12/2020 no doubt caused by the pandemic, but forecasts (lighter coloured blobs) showing a full recovery is on the cards in 2021 & 2022

Graph 4 - ignore the spike up in PER recently, as that’s due to one-off plunge in profits (hence higher PER) during the pandemic. What the previous numbers show us, is that in recent years (pre-pandemic) this share traded on a lowish PER between about 7-14. That’s because of the sector it operates in, being cyclical and not very attractive. Hence it’s a warning not to chase the share price up above a PER in maybe the very low teens, in future. If you do, then you’ll probably be over-paying!

Graph 5 - dividends - this needs to be read in conjunction with current forecasts, which are for dividends resuming after a hiatus caused by the pandemic. Although note that the trend for the divi yield was downwards, well before the pandemic hit, which is a potential warning sign that business might have been suffering from other underlying problems perhaps?

Interim results - I really like the way the highlights table has been presented, giving us just the right amount of information, without overloading us!

As you can see below, Eurocell shows us the three relevant half-year results: this year, last year (pandemic), and the year before that (pre-pandemic).

I’ve highlighted the main numbers I focus on. As you can see, H1 2021 (Jan-Jun) has not only fully recouped to 2019 levels, but is well above them - suggesting that the company may have benefited from strong demand returning, and some catching up of previously lost sales due to pent-up demand -

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This explains why the share price has recovered to previous highs, which looks fully justified in my opinion.

We know that households have seen “forced saving” in the last 18 months, due to the pandemic, and that many households have been splashing out on big ticket items (e.g. used cars, which have shot up in price by an unprecedented amount), and home improvements.

How long that remains the case, we don’t know.

For that reason, I think it’s probably safest to value Eurocell on a return to previous levels of profitability, rather than assuming boom times will continue forever, much as I’ve done with the car dealerships (i.e. ignoring current year earnings as a one-off). That’s a prudent way to look at it, others may want to take a more aggressive approach, that’s up to you.

Cost inflation - a key issue at present, with many companies reporting big price rises for raw materials (and wages), as well as supply difficulties/delays. Eurocell reassures in this regard, and seems to be passing on price rises to customers successfully, which is all that matters -

- c.5% from selling price increases and a surcharge implemented to mitigate raw material price inflation

· Surcharge successfully recovering higher raw material costs, but dilutive to gross margin percentage

Supply chain - in a similar vein, this reassures -

Although high demand has put sector supply chains under pressure, to date we have secured most of the raw materials we require, and we are mitigating cost inflation with selling price increases, a surcharge and through our market-leading recycling plants.

Dividends reinstated - a 3.2p interim divi will be paid on 8 Oct. I can’t see any reason why the company wouldn’t return to historic dividend payments.

Current trading/outlook - sounds really good -

"Trading performance in July and August has continued to be robust. With the industry close to capacity and lead times growing, we are becoming more confident that these market conditions will continue for the foreseeable future. Reflecting these factors, and notwithstanding very tight supply chains, labour and transport availability, the Board is now again raising its expectations for the full year."

Balance sheet - I’m very happy with this, it’s robust. No concerns at all.

Valuation - I can’t find any updated broker forecasts, but looking at the previous consensus of 18.3p EPS for FY 12/2021, it’s probably safe to assume it should achieve 20p. At a share price of 267p, that gives a reasonable PER of 13.4 - far from expensive, but fairly typical of how shares in this sector tend to be valued.

My opinion - this would have been a terrific share to buy in the bust last March, but like so many other shares, it’s now recovered, and re-rated to reflect the current boom times - all that Govt stimulus funded by money-printing has certainly worked. Although the worry is obviously that economies seem to be over-heating, with supply constraints being seen across the board, leading to higher inflation. How all this pans out longer term - no idea! Nobody knows. Historically though, when demand is booming, and inflationary pressures come through, then it’s best not to chase up cyclical shares onto too high a rating, because sooner or later boom conditions fizzle out, or burst, earnings fall, and you end up holding something you thought was cheap, but now on a PER of 25 or more, not 13 as it was when earnings peaked, as an example.

However if you think boom times are likely to continue, then this share could continue to do well. The company certainly seems to be executing well, and has a good solid balance sheet. Dividends are returning, so for now anyway, things look good.

The long term chart, since it listed, it not great, although there have been divis on top. Based on previous chart highs at this level, I wonder how much more upside there is likely to be? Who knows!

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Pphe Hotel (LON:PPH)

1480p - mkt cap £630m

Interim Results

Historically this share has been fantastic for investors, see the long-term chart below. Obviously that’s been heavily punctuated by the pandemic, as you would expect from a hotels group.

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As with all “re-opening” type shares, there are several key question to focus on, which I think are these -

• How is current trading recovering? (and outlook?)
• Is it still solvent and what dilution risk is there (i.e. does balance sheet need repair from an equity raise?)
• Is the valuation attractive - i.e. is there good upside or not from the current valuation once trading has returned to pre-pandemic level?

It’s clear now that the market overshot on the upside with re-opening shares earlier this year, and many have given up a fair bit of the gains. Could there be opportunities again, now that it appears that vaccinations may have allowed things to at least begin to return to normal?

Obviously if you think that covid could yet mutate & shut everything down again, then you’d probably be more inclined to avoid, or even short re-opening shares, rather than buy them!

Personally I think it’s too risky to short individual shares in a booming market, where takeover bids are coming thick & fast from cashed up private equity bidders.

Interim results - the context is obviously disruption to trade from lockdown in Q1, so I’m expecting profitability to be poor, but hopefully improving in Q2 on re-opening -

PPHE Hotel Group, the international hospitality real estate group which develops, owns and operates hotels and resorts, announces its unaudited interim results for the six months ended 30 June 2021 (the "Period").

Improving demand during the second quarter

Further significant progress

This hints at rising labour costs, a known sector problem -

Multiple actions taken to attract and retain talent in a highly competitive labour market

Revenues - just £5.4m in Q1 and £20.4m in Q2, so £25.8m in H1 as a whole

EBITDA loss in Q1 was £(10.1)m, and Q2 improved to £(3.9)m

EPRA NAV (what the shares are supposedly worth based on current property valuations) is £20.85p per share, well above £14.85p current share price. There always is fair sized discount though, so the question is whether that discount is enough? It would be important to research how disposal prices of hotel companies compare with their reported EPRA NAV Do any readers know?

Bookings are coming from staycationers -

Liquidity - sounds fine, with £178m in cash, and an undrawn £60m borrowing facility.

Recovery seems to be continuing into H2 -

"Post period end, we have seen the increasing trend for leisure demand continue, while the number of enquiries for meetings and events in the UK is at the highest level since the pandemic started. In Croatia we have reported a strong July and August performance, with revenues at approximately 90% of those generated during the same period in 2019."

Balance sheet - there is a very large amount of bank debt, so properly digging into that (terms, covenants, expiry, etc) is key.

Also I note the huge “non-controlling interest” of £166m - i.e. net assets on PPHE’s balance sheet which are effectively owned by third parties, not PPHE’s shareholders.

My opinion - at this point, I’m going to admit defeat! This group is way too complex for me to properly analyse, and I’m not going to give a half-baked view on something that would probably take a whole weekend to research in depth, and understand all the moving parts.

For me, the discount to EPRA NAV isn’t large enough to justify investing the considerable time & effort to properly understand everything.

I’d be interested in reader comments from any subscribers, who’ve done more work on this share, to hear your views.

For me though, it goes into the “too difficult” tray. Sorry about that.

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Cmc Markets (LON:CMCX)

Share price: 305p (-27% at Thursday’s close)

Shares in issue: 291m

Market cap: £888m

Trading update

Online financial trading firms such as were among the big winners last year, thanks to market volatility (and perhaps lockdown boredom). But those conditions have reversed over the summer - it’s been quite calm in the markets but more lively in the real world.

These conditions provided the context for Thursday’s profit warning from spread betting/CFD trading firm CMC Markets. This is of interest to me, as rival firm Ig Group (LON:IGG) is one of the larger holdings in my personal portfolio.

CMCX shares fell by nearly 30% yesterday, after the company said that trading activity among both new and existing clients has slowed. The company’s non-leveraged (stockbroking) business has also seen a reduction in activity.

As a result, the board now expects net operating income (revenue) for the current year to be between £250m-£280m.

That’s around 20% below previous consensus forecasts of £333m and 35% below last year’s record figure of £410m.

Rising costs: This slump in expectations appears to have been made worse by a reduction in the proportion of client income retained after hedging costs. CMC says that client income retention in H1 has been “tracking moderately below the targeted 80%”.

This is a measure of the proportion of spreads, financing charges and commission payments that CMC retains after hedging client positions.

Last year, client income retention hit an astonishing 104%. The company attributed to the success of its new TARDIS risk management system, which automates and internalises much of the hedging needed to offset client positions.

TARDIS does not seem to be working quite so well in these more stagnant market conditions, although the company says it does expect retention to improve assuming that the mix of asset class trading reverts to historical norms.

The company says that operating costs will be higher this year, mainly due to recruitment to support the growing stockbroking business.

My view: Although trading activity was already expected to soften this year, yesterday’s warning is a sharp downgrade to previous guidance from the firm. In CMC’s Q1 trading update on 29 July, the company said it remained “confident in achieving net operating income in excess of £330m for FY 2022”.

Six weeks later, and the picture has changed. This suggests to me that August may have been a very poor month indeed.

This may just be a temporary setback. Leveraged traders look for opportunities to capitalise on moving prices. The company says that client assets remain “near record levels”, suggesting that traders have not withdrawn their money from CMC’s platforms. If we get a burst of volatility in the autumn, I wouldn’t be surprised to see the company’s guidance trend upwards again.

However, as things stand, we have to assume that profits this year will be significantly lower than previously expected.

Updated broker forecasts don’t seem to have filtered through to Stockopedia’s data provider quite yet. But if CMC Market’s operating margin reverts to its historical average of c.30%, then I estimate full-year operating profit could be around £85m.

That would give the stock an EBIT/EV yield of around 11%. I’d see that as a potentially attractive valuation.

I’m generally cautious about buying immediately after a profit warning. As Stockopedia’s research has shown, profit warnings are very often followed by a longer period of poor performance.

However, in this case I wouldn’t be so worried. CMC Markets is one of the better players in this sector, in my view. Even before the pandemic, the company’s TARDIS system appeared to have improved the profitability of its hedging activities. At current levels, I suspect the shares may be worth considering.

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Johnson Service (LON:JSG)

Share price: 144p (unch)

Shares in issue: 445m

Market cap: £641m

Interim results (1 Sept)

There’s not much news today, so Paul and I are circling back to a couple of results from earlier this week.

Johnson Service Group provides “textile rental” - rented workwear for industrial and manufacturing clients, and linen for the hotel and restaurant trades (‘HORECA’).

While workwear demand remained “fairly robust” during the various lockdown periods, the HORECA business was virtually shut down at these times.

This week’s half-year results give us the first real chance to see how well the business is recovering as things return to normal.

Let’s start with a look at the financial highlights from the first half of 2021, to get a flavour for how the business is performing. As I’ve done before this week, I’ll compare these numbers to H1 2019 to get an idea of what normality should look like.

• Revenue: £99.7m (H1 2020: £114.8m, H1 2019: £167.1m)
• Adjusted pre-tax loss: £11.2m (H1 2020: £12.6m, H1 2019 profit of £20.1m)
• Net debt ex-IFRS 16: £8.8m (December 2020: net cash of £6.6m)
• No dividend

Trading during the first half of this year appears to have been below H1 2020 levels, with a similar loss to H1 2020. Some additional cash appears to have been drawn down from the group’s credit line. I suspect this was to fund working capital outflows as the company restocks inventory.

However, trading does seem to be returning to normal. Management says that HORECA volumes climbed rapidly from mid-April to reach over 70% in June and more than 80% in August. Sites in some tourist areas are said to be back to 2019 levels, thanks to the staycation boom. I think we can expect a much stronger H2 performance.

Outlook: Indeed, barring any new restrictions, CEO Peter Egan says that he expects full-year results to be “towards the higher end of current market expectations”.

According to Stockopedia, consensus forecasts for 2021 earnings have edged higher this week, following these results:

Forecasts are for earnings of 1.2p per share in 2021, rising to 8.9p in 2022. These estimates put JSG on a 2021 P/E of 122, falling to a more normal P/E of 16 in 2022.

This valuation suggests to me that the shares are already priced for a return to normal trading. I’m not sure how much near-term upside is likely.

Balance sheet: JSG’s net financial debt of £8.8m is modest because the company raised £82.7m in an equity placing last year. CEO Egan describes the balance sheet as strong, but I’m not sure I completely agree.

JSG’s tangible net assets are just 27p per share, by my calculations. This is reflected in Stockopedia’s valuation graphic:

Much of the group’s £251m net asset value is made up of £131m of goodwill from historic acquisitions, so it’s not something the company would easily monetise or borrow against.

JSG also relies on negative working capital to fund its operations. This means that customers pay the company before it pays its own suppliers. This is not a problem, as long as business levels stay stable. However, as we saw last year, a fall in activity levels can result in a cash crunch as the group is forced to fund its payables from debt or cash reserves.

I don’t think Johnson Service Group really has a strong balance sheet. But with the benefit of last year’s fundraising and a £175m credit line, the situation looks comfortable enough to me for now.

My view: JSG has delivered steady growth in the past, aided by acquisitions. Until 2020, both profit margins and returns on capital were in double digits and reasonably stable:

I don’t think this is a bad business. I expect profitability to recover to be broadly in line with historic levels.

However, after factoring in the dilution from last year’s 20% equity placing, my sums suggest the shares are now trading broadly in line with December 2019 levels.

Given the backdrop of rising labour costs and JSG’s ongoing recovery, I think the shares are probably fully priced at current levels.