Small Cap Value Report (Fri 7 Sep 2018) - BKS, G4M, SOM

Good morning!

I finished yesterday's report at about 6pm, so here is the link, in case you are interested in the completed sections on Frontier Developments (LON:FDEV) and McBride (LON:MCB) - both of which I think look quite interesting.

Apologies but I didn't get round to looking at EI (LON:EIG) . This is because the whole afternoon was spent planning & carrying out my latest Director interview, which I thought was a better use of my time.

Somero interview today

The interview audio file is here. Many thanks to readers here, who submitted some excellent questions a few days ago. I tried to name-check you in the call!

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Beeks Financial Cloud (LON:BKS)

Share price: 103.5p (up 1.5% today, at 11:00)
No. shares: 50.7m
Market cap: £52.5m

(at the time of writing, I hold a long position in this share)

Results presentation video

Our friends Tamzin and Tim, at PIWorld, published a very interesting new video yesterday. It's the results presentation from Beeks. The CEO and FD talk through the presentation slides, then answer Q&A.

What particularly impressed me, is that some of the audience questions are quite searching. Management answered them honestly, and were happy for the video to go out as is. That gives me a lot of confidence. I'm sure that lesser companies would want the difficult questions edited out of the video, which does nobody any favours in the long run.

Other interesting points from this video;

• Beeks has a stronger moat than I realised - the CEO said it took 5-6 years of blood sweat & tears to create its network of connections to over 200 financial exchanges worldwide - so not something that could be quickly or cheaply replicated
• Strong organic growth, and rising gross margins expected - this should give a nicely leveraged benefit to profits. I wonder if forecasts might be too cautious?
• In the past, there was little to no sales effort - growth came from inbound sales enquiries, often referred by the exchanges themselves. This is remarkable in itself. However, Beeks is now building a proper outward looking sales force. This could turbocharge growth, I hope
• Despite a revenue miss (but margin beat) in recent results, the monthly run rate of revenue growth in Q4 had recovered strongly. There's a slide which explains this. There was a glitch mid-year basically, which has now been resolved. So the revenue miss is not important
• No competition with a self-service portal, so Beeks really does have a lovely market opportunity
• This video once again reinforces just what a high quality management team Beeks has - unusual for a £50m market cap company. I've come round to the view that successful small caps investing is mainly about backing great management, who also have a good business plan. Poring over the historic figures, and obsessing about valuation, is actually less important (although it still needs to be done). So in the case of Beeks, I accept that the shares are not cheap, but am prepared to overlook that, as my focus is on the longer term growth opportunity. The growth is not just hope/hype, it's actually happening - that's absolutely key

Anyway, see what you make of it, and I'd love to hear your comments on Beeks, as it's a fascinating company in my view. It's one of my larger long positions now, so obviously am talking my own book here. I intend holding this share for years, so very much an investment, not a trade. This could be a multi-bagger, looking say 5 years ahead, in my view, providing the growth rate is sustained.

A final comment on PIWorld - I reckon this company is in a class of its own, in terms of quality video content. They're picky about which companies they will work for, because PIWorld are capable investors themselves, hence are genuine about wanting to produce quality content for other private investors. We need more of this kind of thing, rather than the many companies which will promote any old rubbish for a fee!

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Gear4Music (LON:G4M)

Share price: 590p (down 4% today, at 09:40)
No. shares: 20.9m
Market cap: £123.3m

(at the time of writing, I hold a long position in this share)

Trading update & change of year end

Gear4music (Holdings) plc ("Gear4music" or "the Group"), the largest UK based online retailer of musical instruments and music equipment, today announces a trading update for the six months to 31 August 2018 and its decision to change its accounting reference date from 28 February to 31 March.

Year end change - this can often be a red flag. However, in this case it looks absolutely fine to me, not an issue. The reasons given are sensible, and it's only extending the year end by one month anyway;

This will result in a reporting cycle that is more compatible with the Group's seasonal trading pattern and will avoid timetable conflicts with attendance at trade events that are important to the Group.

Trading update - covering the 6 months to 31 Aug 2018.

I see this as a bit mixed, but positive overall. This is my interpretation;

Positive

• H1 revenues up 36% (all organic) to £42.5m - ahead of management expectations
• Well-positioned for H2 - the seasonally stronger half, as it includes Christmas
• European growth expected to accelerate in H2 as inventories improve (new buyers recruited)

Negative

• Pressure on gross margins due to competition
• Slower than expected build-up of inventories at European distribution hubs

Overall - this looks fine to me;

We are confident that strong sales growth alongside a controlled overhead cost base will compensate for short term gross margin compromise.

The Board expects EBITDA for the full financial year to be in line with our expectation.

I don't like the current fashion for quoting EBITDA as the main performance measure. I prefer adjusted profit before tax as my main performance measure, providing adjustments are reasonable.

Note that G4M capitalised £1.7m of development expenditure (for its websites) into intangible assets last year (up from £1.5m prior year). In itself, this is a perfectly reasonable accounting treatment, but it renders EBITDA meaningless and inflated in terms of real world performance.

My opinion - the company's strategy is (correctly, in my view), to aggressively grow its market share. As in so many sectors, there is a transition underway from physical stores, to online. That makes sense, because music shops cannot possibly stock the enormous ranges required (over 30,000 products).

I think it's a mistake to value fast-growing eCommerce businesses on a PER basis. That's because the profits come later. For now, the emphasis is on heavy marketing spending, to grow as fast as possible.

Once G4M has grown from a c.£100m revenues business, to a c.£500m revenues business (which I think is possible over say 5-10 years), then it will be a lot more profitable. Why? Mainly because the largest cost is marketing spending. This is currently running at 8.3% of revenues.

When the business is much larger, then marketing spending should increase in absolute terms, but reduce as a percentage of revenues. This should increase the operating profit margin from low single digits, to middle to high single digits. Economies of scale in purchasing & distribution costs should also play a part in improving profit margins in future.

For now though, G4M is in the market share land grab phase. Investors who understand this, and are patient, should be well rewarded in the long term, in my view.

Threats to G4M include: the dominant European online retailer of musical equipment, Thomann. This has a different business model, of centralisation, whereas G4M reckons there is room in the market for both Thomann, and their own model of opening smaller distribution centre/ showrooms in Europe. The other threat is Amazon. Although musical instruments is quite a niche area, where the margins are already low, and inventories are large, and can be slow-moving, across many thousands of product lines. So it's difficult to imagine Amazon would see this as a good market to attack.

Overall, I'm happy to continue holding this one, for the long term. I reduced my G4M position size considerably some time ago, to free up funds for my next eCommerce position, Sosandar (LON:SOS) (which is now my largest personal long position). So even though I still like G4M very much, my perception is that a more rapid % share price appreciation was likely at SOS. So far, so good.

 Below is the 3-year share price chart. As you can see, it had a spectacular rise, but has since dropped below both 50 & 200 day moving averages. This has probably triggered the exit of momentum traders. Who knows how long that downtrend will last, nor how significant momentum traders are in the overall scheme of things?

Share prices of smaller, less liquid stocks like this, can go all over the place, on very little volume. There can be pent-up buyers and sellers, who are simply not able to deal at all, in the size they want. Therefore I think the short term share price movements are of little consequence to the long term investor. The short term share price on small caps can actually be quite artificial, as liquidity is so limited. It's the smallest trades that end up setting the price, bizarrely enough. Those resulting price anomalies provide the buying & selling opportunities for us, if we get our research right.

The share price looks about right to me, in the short term. It's the longer term potential that interests me more.

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That's it for today & the week. It's been a pleasure (hard work mind!) to report to you this week on many companies. Thanks for all your comments too.

Best wishes, Paul.