Small Cap Value Report (Fri 9 Oct 2020) - SGC, TET, GFIN, MARS

Good morning,

It's Jack here with Friday's SCVR. Any suggestions or talking points just drop by with a comment while we wait for the RNS statements to come through.

Some interesting tidbits from either end of the Quality spectrum this morning: on the one hand, renowned quality investor Lindsell Train has opened a position in Experian, the world’s largest credit data company.

With a forecast PE ratio of 35.8x and a forecast PEG of 3.1x, it’s one I’ve consistently pushed to the back of the research pile for being ‘too expensive’. But in the long term, quality shines through so perhaps I’ve been too dismissive of this valuation in the past.

It’s the third new position at Lindsell Train this year following FeverTree (edit: and PZ Cussons - thanks iwright7!).

And then, further down the scale, we have news that shareholders are revolting over Restaurant Group’s CEO pay plans. After years of underperformance as a result of price gouging and tired brands, this group actually emerged with some credit following its clear-eyed appraisals of lockdown and some useful models of the potential impact.

It has also used this period to fit a couple of years’ worth of turnaround into a couple of months - but it’s obviously not out of the woods yet. It’s a much riskier bet with a potentially higher payoff than either of Lindsell Train’s picks. A totally different and much riskier proposition.

If society normalises on a 1-2 year view then RTN might be left to pick up the pieces after a ‘grand reset’ in the Leisure sector. But the downside risks are much greater too.

It could be a bumpy ride over the next few months with a few big variables: not just the scale of any increase in COVID cases, but the government and economic reaction to those rises, as well as potential news flow around Brexit developments.

I do note that Bank of England governor Andrew Bailey said last week that risks to the UK economic outlook remain ‘very much to the downside’. Meanwhile in the stock market volatility clusters - what happened in March can happen again - so we’d do well to keep our wits about us when making investments in this environment. But as Dale Winton would say, 'you have to be in it to win it'.

With the weather cooling and the days growing slightly darker, it would be great to hear how others are positioning themselves for the winter ahead - even if your strategy continues to be ‘make no changes at all’.

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Stagecoach (LON:SGC)

Share price: 41.94p (pre-market open)

Shares in issue: 550,778,551

Market cap: £231m

Stagecoach (LON:SGC) is not normally a small cap, but these are not normal times. Back in the beginning of 2020 this was nearly a £1bn company (£900m) with annual revenue approaching £2bn. But when was the last time you voluntarily hopped on the bus?

It shouldn’t come as a surprise that transport stocks are still reeling:

If you take the FY20 figures, SGC trades at:

• 0.16x sales
• 3.6x free cash flow
• 6.6x earnings

That’s a big leap in the current environment though. These are not companies I want to go near owing to low operating margins and capital intensiveness (having to spend a lot of cash on maintenance of its transport assets).

That said, with such a steep drop in share prices there could always be contrarian value on offer.

Trading Update

SGC continues to withhold FY21 guidance.

It reports a ‘substantial fall’ in regional bus demand for public transport in the wake of the pandemic, although demand has been ‘steadily recovering’ since April with commercial revenues returning to around 50-60% of prior year levels.

SGC will continue to receive COVID-19 Bus Services Support Grant Restart payments with an eight week notice period. This, it says, will be enough to remain EBITDA positive and avoid significant operating losses.

London bus demand has been much more robust and the group continues to unwind its former train operating companies.

Conclusion

SGC says it has adjusted liquidity of £605.6m. For as long as government support continues then it should be ok. But is that much of an investment case?

The group also mentions its pension deficit and an upcoming triennial valuation for the main fund. It expects the deficit valuation to reduce from its current £404.1m to somewhere between £150m-£200m.

That’s all well and good but in this market I’m not looking at transport companies with net debt, pension deficits, and poor share price momentum.

There really might be some contrarian value here but, with no real edge into this sector or company, I’ll gladly sacrifice a bit of the upside for more certain signs of a sustainable recovery in public transport. I do think some of these stocks will come good, but picking the winners will seem much easier in a couple of years with the benefit of hindsight!

Treatt (LON:TET)

Share price: 592p (+0.34%)

Shares in issue: 59,608,089

Market cap: £352.9m

Speaking of high quality, superficially expensive stocks, here’s one mid cap the Lindsell Train bunch would presumably be all over.

Treatt (LON:TET) is a global independent ingredients manufacturer and supplier to the flavour, fragrance and consumer goods industries. It’s got a diverse and internationally-recognised product portfolio ranging from natural ingredients to synthetics and ‘impactful aroma chemicals’ - so it makes things smell good.

This seems to be a useful niche facing some big, global markets and, sure enough, TET has managed to consistently grow revenue over the past five years or so.

At the same time, operating margins have held steady at a useful 11% with returns on capital ranging between 12-20%.

You also can’t fault the group’s Financial Health scores or liquidity metrics, so it looks like a Quality Rank of 85 is well deserved.

The only issue is around valuation, with a trailing twelve month PE ratio of 35x and a PEG of more than 4x.

Trading Statement for the year ended 30 September

It looks like a resilient FY20 performance for TET, with profit before tax in line with pre-COVID expectations (c£14m) - that’s probably what you’d hope for given the premium relative valuation. That would put the company at about 14x PBT.

Revenue for the full year is expected to be down 3% due to a substantial reduction in orange oil raw material input costs. Excluding this, revenue would have increased by 4%.

The citrus category (which makes up 50% of group revenue) was down 10% but gross profit was up ‘as the business continues to transition away from traded and minimally processed products to more added-value customer solutions’. That could be a useful way to enhance margins in future.

Non-citrus revenue was up in a number of categories, with underlying growth in Tea looking particularly strong, up 47% in H1 before on-trade site closures brought it back down in H2.

In other news, new product launches have been reduced due to COVID-19 although the group is making inroads into the alcoholic seltzer market and its ongoing work into natural coffee extracts ‘represents a significant growth opportunity for the business’.

TET is also now three-quarters of the way through a substantial capital investment programme in the UK and US, with a new UK facility to come online in Spring 2021 and its expanded US facility fully operational.

Conclusion

These are the type of results you might expect from a high quality operator that has consistently impressed the market. TET has finished the year with net cash of £1m despite ongoing capital investment for future growth, which is testament to its resilience.

It looks expensive across relative valuation measures, but the best companies often do - and then they just keep growing.

TET is using its expertise and product knowledge to diversity its revenues and find big new markets. That’s an encouraging sign heading into FY21.

The group gives useful contextual information in its update too - the alcoholic seltzer market was valued at $4.4bn in 2019 and is expected to grow at a compound annual growth rate (CAGR) of 16.2% from 2020 to 2027. That’s just one of the markets TET can supply its products to. The group also has its sights set on the cold brew coffee market, for example.

Meanwhile TET’s core business continues to be in demand with growth tailwinds and strong margins. Recent capital investment in the UK and US should also increase production capacity. It has proven its ability to generate strong margins and returns on that capital.

This looks like a great company with promising long term growth potential.

My question is whether the valuation prices this in but then we’re back to the ‘Lindsell Train buys Experian’ point above. You usually have to pay up for quality and long term growth.

Needless to say on a c15-year view TET has trounced the market.

And given the size of the markets TET is targeting, I don’t see why this can’t continue to grow into a bigger company on a ten year view.

Gfinity (LON:GFIN)

Share price: 4.1p (+22.6%)

Shares in issue: 763,795,860

Market cap: £31m

Gfinity (LON:GFIN) is an interesting company. It’s always talked a good game about exposure to the massive, growing eSports market - but the fact of the matter is it has consistently lost cash and diluted shareholders over the past few years.

Management and business models have both changed in that time. Meanwhile, the share price has tanked.

I’m wary of this stock given the track record of losses and shareholder dilution. Stockopedia classifies it as a Highly Speculative Micro Cap Momentum Trap (!) so there’s a warning for you.

That said, it’s up 23% today on the announcement of a strategic review. I remain open to the idea that GFIN can prove itself as a viable high-growth business, so let’s take a look at what’s changed.

Strategic review

The group says that considerable corporate and strategic development post-COVID has left it ‘exceptionally well positioned’. It is now focused on three key areas:

• JV's and partnerships with an initial focus on virtual motorsports;
• Expanding the Company's own community franchise; and
• Using its tech platforms and production know-how to build communities for others.

It’s a move away from delivery of physical eSports events. I did actually visit one of these events a few years ago and it was fun, but not really at the level of the huge arena-style events you might imagine. It also seemed like a potentially cash-hungry endeavour.

So a move away from single-handedly developing that business and re-focusing on other avenues could be a step in the right direction.

GFIN is now targeting profitability by the end of Q1 2021 calendar year.

There’s a frenzy of activity in the update but precious little in terms of trading figures.

Digital media

• Launched Gfinity Digital Media in July 2020 which generated over £130,000 of revenues in September 2020;
• New sites launched;
• Partnered with YaLLa Esports to expand its RealGaming101 offering into the Middle East-North Africa (MENA);
• Gfinity Plus, the ‘reward-based product’ driving increased engagement across the sites; and
• On track to deliver target revenues from digital media for this financial year of approximately £2m.

Joint Ventures and Partnerships

• Partnered with BT Sport to deliver a series of celebrity led gaming entertainment shows;
• Partnered with ViacomCBS to deliver Street Fighter experiential event at Vidcon London 2020; and
• Entered into a five-year agreement with Abu Dhabi Motorsport Management to design, develop and deliver a esports racing championship (ERC), to be jointly owned by Gfinity and ADMM.

Building communities for others

• Continued partnerships with brands including: F1 Esports Series; EA Sports; ePremier League; Activision Blizzard and the Forza Racing Championship;
• Chosen to deliver the new F1 Esports Virtual Grand Prix series extended into 2020 and 2021, and the 2022 qualifying events;
• Selected by premier cricket broadcaster Willow TV (owned by the Times Group) to design and deliver "The eCricket Challenge", in partnership with Betway;
• Appointed to operate the inaugural and follow on ePremier League ("ePL") Invitational tournaments; and
• Partnered with BT Sport to co-produce a new entertainment based competitive gaming series, "The BT Sport FIFA Challenge".

Given the track record I’m waiting for more concrete signs that these developments can translate into shareholder profits, or at least materially reduced losses.

What’s probably grabbed people’s attention is the following extract:

The Board believes that the Company can continue on its current pathway towards profitability it believes, at this point in time, that it is important to all its stakeholders to ensure that it has explored all strategic options to capitalise on the potential market opportunity and to deliver shareholder value, including options for making acquisitions, forming partnerships, separating the activities of the Group or a potential sale of the Company.

As of yet, no interested parties have come forward but it’s early days.

Conclusion

A lot has changed at GFIN since I followed it in any detail so I don’t want to attribute previous false dawns to the current management team.

That said, this is a strong price reaction to a company effectively hanging up a ‘For Sale’ sign.

GFIN has a lot going on and eSports is a great space to be in for some operators. Others will pour their heart into building the infrastructure only to see their timing is wrong, they run out of cash, and other players swoop in to reap the profits.

There is value in this market, but where does that value ultimately accrue? I would suggest that it goes to the owners of intellectual property - the games makers - but perhaps others disagree.

I certainly don’t know for sure but I’m still not tempted here. There are plenty of signs suggesting it might be better to wait for more tangible signs of profitability and cash generation. On that note GFIN is targeting profitability by the end of Q1 2021, so let’s see if it can make that happen.

Marston’s (LON:MARS)

Share price: 49.5p (+19.2%)

Shares in issue: 634,100,000

Market cap: £314m

The CMA has cleared the proposed joint venture between brewing companies Carlsberg and Marston's (LON:MARS) .

This was originally announced back in May and led to a sharp rerating as Marston’s showed it has more than just a pub estate with some debt attached.

It also has a pretty useful brewing and distribution business. Marston's is merging its operations here with Carlsberg's to create an enlarged distribution business. The pub operator will keep a 40% stake and equity upside, as well as receiving £239m in cash.

There should be some material and straightforward synergies resulting from the combined scale of the enlarged distribution business.

Here’s the presentation pack from back in May if you’d like a refresher. It’s a good operator but a lot of people worry about the debt, even backed as it is by freehold property.

The Competition and Markets Authority (CMA) has cleared the deal following its investigation, concluding that:

In relation to their role as brewers, the CMA found that Carlsberg and Marston’s have different areas of focus, meaning competition between the 2 businesses is generally limited at present, with Carlsberg largely focusing on the production of lager and Marston’s focusing on ale. They also face several competitors in all of the product categories where they are both active.

Conclusion

MARS shares have drifted back quite a lot since the original joint venture announcement. I didn’t consider the CMA a big threat to the deal so perhaps the fall was just on general anti-Leisure sentiment in the short term.

I’m also surprised the shares are up by quite so much today. This is good news, but also known news.

The deal will now complete at the end of the month at about £380m above book value and will result in MARS owning 40% of an enlarged distribution business as well as receiving a cash windfall of £239m - the majority of its market cap - resulting in a useful upgrade to net asset value per share (barring any drastic property write-downs).

Say what you want about the treacherous trading environment, but this at least looks like a canny bit of business.

Before COVID, management had just begun to acknowledge the perception that MARS had too much debt and was committed to debt reduction in the medium term.

It’s probably paid out too much in dividends in the past given the level of free cash flow generation:

It would do well to re-base the dividend in my view, so that it could re-direct cash into higher return activities. Perhaps this is that chance. Even just share buybacks could be better if its stock trades at a fraction of net asset value (once COVID is well and truly behind us of course).

A tightening of restrictions in the north is a concern, and also a reminder of just how changeable the situation is right now.

I wouldn’t get involved in this sector at all if you can’t handle short-term, news-based share price volatility. Shares fell gradually after the initial announcement back in May. It’s not hard to envisage something similar happening again.

But at some point there could also be a sharp rerating. In the longer term, I have one eye on MARS as a good pub operator, brewer, and distributor with a clear path to shareholder value via debt reduction should conditions show signs of normalising over the next year or so. Just my take - I don’t hold right now, so DYOR as always.