Small Cap Value Report (Mon 10 Aug 2020) - FGP, IDEA, MCL, SDRY, ORPH

Good morning, it's Jack here with today's SCVR.

It’s a strange time right now, isn’t it? We’re unfreezing parts of the economy but progress depends upon the data we get back concerning new COVID cases, R rates and the rest.

I don’t know about you but I’m happy to see businesses reopening, as much for peoples’ psychological wellbeing as for stimulating the economy. But it’s a calculated risk.

I’ve visited a couple of restaurants and bars, giving my custom, tipping, and talking to the site owners and managers where I can. It has clearly been a tremendously stressful period for thousands of small business owners.

That said, It’s not over yet. All around the world the pandemic rages on - with places as varied as Australia, Brazil, and America all continuing to grapple with rising cases. I’ve taken three taxi rides recently, always with a mask. In two of them the driver wasn’t wearing one. At the hairdressers, the barber told me I didn’t need to wear one for the haircut.

Each of these interactions is a small risk. Multiply them nationwide then we surely have to expect a degree of increasing cases as we slowly reopen.

With things so finely balanced I’m curious to know if others out there have started returning to bars, restaurants, etc. or if you think it’s still too risky. Everybody has their own take on how to play it right now.

One thing a restaurant owner did tell me over the weekend is that the Eat Out To Help Out scheme has had a noticeable impact - so the government at least is genuinely trying to get people out and about again.

Anyway, RNSs are beginning to come out so let’s see if there are any interesting announcements.

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Firstgroup (LON:FGP)

Share price: 38.8p (before market opens)

No. shares: 1,220m

Market cap: £473.53m

Understandably, investors continue to be wary of transport groups. Firstgroup (LON:FGP) and peers have seen no recovery in share price since March. While First is marked as a Value Trap, Go Ahead Group is awarded Contrarian status.

So is there a contrarian opportunity with these stocks or are the risks just too high?

Today Firstgroup updates the market with this Statement re further government funding for bus industry, so let’s take a quick look.

Key points:

• There is funding round of £218.4m from the Department for Transport (‘DfT’) to support the provision of vital services by regional bus operators in England
• Rolling funding of up to £27.3m per week will be available thereafter, ‘until such time as it is no longer needed.’
• First Bus operations across England have increased operated mileage from c.40% to almost 90% of pre-pandemic levels, with passenger volumes increasing from c.10% to c.40% since the low point.
• The Group also welcomes the Scottish government’s announcement of additional expenditure of up to £68m to extend to 8 November the similar funding scheme it has in place for Scotland’s bus operators.

Conclusion

With a market cap of £473.5m, we’re hardly in ‘too big to fail’ territory are we? But it does sound like the government is committed to keeping private bus companies afloat during this period. While many probably don’t fancy the idea of getting on a bus anytime soon, for others they must still be an essential service.

Companies like FGP have a role to play in restarting local economies, getting people back to work, and getting children back to school later in the year. How big will the revenue hit be from a more structural shift towards working from home, online shopping and the rest? That is something to consider.

Note the disconnect between operated mileage recovery (90%) and passenger volumes (40%).

FGP has a big balance sheet for a c£350m company: more than £4bn in gross debt, a net pension deficit, more than £800m of cash, and more than £4bn of net plant, property and equipment.

At just 0.06 TTM sales, there could be value on offer for the risk tolerant, but it’s not one for me. The share price momentum is negative, the group’s financial scores are weak and its liquidity metrics are further flags, with a current ratio of just 0.75x.

Go back four or so years ago and FGP looked ‘cheap’ at c115p. Today the shares are a shade under 40p. Value Trap indeed. The poor returns on capital figures show bus companies can be a great way to lose money.

The risk/reward has changed radically in recent times. The shares could bounce on valuation alone, but I remain cautious given past disappointments and a risky balance sheet.

FGP has had activist interest in the past and it seems like it could still be an opportunity for a large, active shareholder to unlock value given the leverage, assets, and low valuation. Coast Capital and others have found it hard to make progress here though, so I wouldn’t hold my breath.

Edit: Go-ahead (LON:GOG) has issued a similar update regarding the government funding with broadly the same comment. It appears to back up FGP’s assertion that bus passenger numbers are at around 40% of what they were the same time last year, with the group CEO saying:

As communities return to work, services reopen and people begin travelling again, we are seeing customers returning to public transport. However, passenger numbers are still below 50% of pre-COVID levels across our networks. While social distancing is in place and sections of society remain closed, we welcome the Government's continued support to keeping these critical services running.

Ideagen (LON:IDEA)

Share price: 181.88p (+3.34%)

No. shares: 227m

Market cap: £398.85m

The Ideagen (LON:IDEA) share price has marched ever higher over the past five years or so - clearly its strategic mix or acquisitive and organic growth is working. It’s a tricky formula to get right, but when it works returns can be excellent.

This ‘leading supplier of Information Management software’ has been on my radar after a particularly colourful exchange at a Mello event a couple of years back. The team is overseeing double digit annualised growth rates.

I’d like to know more about the background and track records of the management team. Experienced players can pull off this sort of acquisitive strategy over the long term, but it can also often end in tears.

For now my starting position is that management is probably capable given the group’s share price performance and growth rates, but this is something I would certainly like to investigate further before investing.

Today IDEA reports a trading update with an acquisition thrown in for good measure. Perhaps the fact that the company is acquiring at such a time can be seen as a sign of strength.

Acquisition:

• IDEA has acquired the entire issued share capital of Qualsys, a fast-growing supplier of Electronic Quality Management Software ("EQMS") for a net consideration of £15.6m
• Qualsys EQMS is used by over 150 customers including Diageo, Unilever, Honeywell, BT, FujiChem and IQE
• Qualsys' current Annualised Recurring Revenue (ARR) book is approximately £2.9m, an increase of 38% p.a. over the last 3 years. Total run rate revenue is £3.5m.
• This means the target is valued at c5.4x ARR or c4.5x run rate revenue, which strikes me as slightly expensive
• However, ARR is expected to grow to a minimum of £7m by the end of the Group's next financial year (April 2022) - a big step up. That’s a lot of growth. I wonder if this increase will be generated by cross-selling to IDEA’s existing client network? If so, that is a useful way to immediately increase the value of acquisitions.
• This is expected to be ‘modestly earnings enhancing’ in the current financial year.

David Hornsby, Chairman of Ideagen commented:

"We are pleased that trading so far this year has been in line with our expectations and that we today announce the acquisition of Qualsys. Qualsys has a resilient business model, a quality customer base, outstanding technology and a strong team. Qualsys V7 will be an important product for Ideagen as we integrate the software into our cloud platform and accelerate the ARR growth through our proven and established sales engine."

Trading update

The group says Q1 trading has been ‘robust’, with continued demand for its products from both new and existing customers. Notable contract awards include KPMG, GSK, Medtronics and Bank of Montreal.

Aviation remains suppressed but stable and Manufacturing is seeing an improving pipeline.

Customer retention and net cash generated from operations have not been materially affected by COVID-19 and the board expects to continue to perform in line with market expectations over the coming months. All in all, quite reassuring.

Conclusion

There are some encouraging points here but my concern for now is valuation.

Price to book you can probably ignore for a high growth software company. On a sales and free cash flow basis though, there’s no doubt this is pricey.

IDEA provides software and services to organisations in highly regulated industries such as aviation, banking and finance and life science. It has a broad geographical spread of clients. It appears to provide good value with software products that help clients reduce costs, improve operational efficiency, strengthen compliance and oversight and anticipate and manage risk.

The management team seems to be executing a rapid growth strategy. If this continues then IDEA could potentially become much larger. Directors are net sellers at the moment but the shareholder list seems to show some canny institutional investors like Liontrust are on board. Presumably they see a larger opportunity.

Looking quickly at IDEA’s executive team there could be a good mix of management experience and alignment with shareholders. Chairman David Hornsby has been involved at the top level since 2009 and retains a c4.5% holding in the company.

If the market opportunity here is sufficiently large and the management team can continue to execute on acquisitions, today’s share price might prove to be worth paying. I don’t have a developed view on that right now, but earnings and share price momentum have been encouraging so there’s certainly a case for taking a further look.

The group touches on its ‘proven and established sales engine’. If it can acquire companies and immediately boost their revenues then that could be a winning long term strategy. It’s an interesting one, but I need to understand the business model a little better to understand why IDEA might have an edge over competition.

In its recent interim presentation, IDEA cites a £2.5bn market opportunity. Presumably that is on a revenue basis. If so, the group’s forecast 2020 revenue of £56m suggests plenty of runway for growth.

Morses Club (LON:MCL)

Share price: 55.72p (+9.25%)

No. shares: 131m

Market cap: £66.93m

Everything I’ve seen so far about Morses Club (LON:MCL) suggests its COVID lockdown fall is overdone. I can’t see why this company’s shares shouldn’t be worth upwards of 100p again in future.

Morses Club is the second largest home collect credit and business in the UK. It is also a specialist lender in the non-standard market.

Typical customers are generally the lowest paid customers in the UK, predominantly females in their 40s or 50s with annual income around the £12,000 mark mainly made up of a mixture of benefits and part-time working.

There is a wide range of investors out there and some might have ethical concerns around investing in this space. A quick look at Trustpilot does suggest Morses is reputable.

The group had to close down its lending operations during lockdown but it has used this as an opportunity to greatly increase activity in its online portal (from 78,000 customers to 110,000 - well over 50% of the customer base). The group is now lending to new customers once more and collections have been strong.

This isn’t the kind of company I typically look at but the quantitative attractions of its shares are undeniable, trading at just 3.7x free cash flow and 4.5x forecast earnings.

Recent news concerning the suspension of a banking partner to Morses’ U Account subsidiary does raise the spectre of reputational and ethical risk, although as I understand it this issue was resolved within a matter of days with no business impact.

Trading and 2020 Results Update

• Collections in the HCC division for July increased to 98% of normal historic expectations when measured against expected terms, an increase from 91% at the end of June, and are anticipated to reach pre-Covid levels by the end of August 2020.
• Cash in July has improved slightly to 82.3% of the level achieved in 2019. Sales were 80.9% of the levels for the same period in 2019 again an improving trend whilst customer satisfaction has been maintained at 97% or above.
• Continued growth in the online customer portal, which now has over 110,000 customers registered compared with c. 78,000 at the end of FY20
• The audit process for the Company's FY20 results continues as the results will include the impact of Covid-19 on the impairment of the closing loan book as at 29 February 2020. Morses Club will update the market on the announcement date for its full year results in due course.

Conclusion

This isn’t my area but I can see the attractions here. Morses shares are cheap at less than 5x forecast earnings. The group has strong liquidity metrics, its business model generates high returns on capital and it is consistently cash generative:

As the number two player in the market, and with scope to make opportunistic acquisitions as weaker competitors exit, Morses could be well placed to bounce back and recover to pre-COVID levels.

It has been trading profitably throughout the period although sales and collections are down like-for-like. The trajectory is improving though and Morses is running at 98% of where it would otherwise have expected to be by now (up from 91% a couple of weeks ago).

Buying shares at 56p that generate free cash flow of 13.7p is a neat trick, although there is a question mark over the potential Covid-19 related impairment of the loan book.

That said, from what I’ve seen given the resilient lockdown trading and stellar annualised growth rates (with 5y revenue, operating profit, and EPS growth all above +40% pa) I think the mark down in share price has probably been overdone.

Superdry (LON:SDRY)

Share price: 142.00p (+20.44%)

No. shares: 82m

Market cap: £96.7m

I’ve been occasionally checking back in on both Superdry (LON:SDRY) and Ted Baker in recent months - two retail giants whose share prices both languish at absolute fractions of previous highs and annual revenue. Either one could be a high risk contrarian opportunity. They’re probably worth either multiples of current prices or nothing at all. Turnarounds are risky, so I'm being very cautious.

Today SDRY’s shares are up 20% on the back of a trading update and new financing facilities. If you think the brand could recover then a 20% jump to 142p will be peanuts in the grand scheme of things.

New financing facility and trading

Financing facility:

• SDRY has agreed a new £70m Asset Backed Lending Facility with existing lenders, extending the term until January 2023.
• The new facility is subject to a number of financial covenants and the borrowing base will vary throughout the year ‘dependent on the level of the Company's eligible inventory and receivables’.
• As at 6 August, SDRY had £57.8m net cash on the Balance Sheet (vs £39.8m net cash as reported on 7 May and vs £2.1m on 6 August 2019).
• Total creditor position at the end of Q1 was up net £3.1m year on year, with the deferred payment of property related costs and taxes broadly offset by the delayed intake of stock into the business.

Q1 trading update:

• Current trading in Q1 has been better than initial expectations, however disruption from Covid-19 continues to ‘materially’ impact year-on-year performance.
• Total Group Revenue for the period is down 24.1% year on year, with c95% of stores now re-opened and store like-for-likes down 32.3%.
• Wholesale is down 31.0% year on year although Ecommerce is up 93.2% in Q1, normalising in recent weeks as stores re-open.

As of the groups Q4 FY20 update, SDRY had the following revenue split:

• Retail - 43% (£373.7m)
• Wholesale - 38% (£335m)
• Online - 19% (£163m)

Conclusion

With the group’s co-founder and major shareholder Julian Dunkerton back at the helm as CEO, SDRY could be one to watch. If it can recover to anywhere near its previous levels of profitability, shares would be worth many multiples of the current price.

That is a big ‘if’ though, and forgoing some of the early upside in order to monitor progress and wait for the company to derisk a bit is a pretty valid option - no need to dive in on little information.

The shares are down almost 90% over the past five years, so a genuine recovery would suggest shares have plenty further to run if Dunkerton can turn the ship around.

Put in the context of that 5y performance, today’s share price action is negligible.

The recent drop in profitability is obviously alarming, and broker forecasts suggest there could be more bumps to come given the future net loss estimates.

SDRY needs to revitalise its brand and reshape its trading base. Online is growing but should be larger. This funding should help but there is plenty more to do.

Perhaps the current environment is an opportunity for SDRY to renegotiate some of its less profitable sites. But at what cost to its existing shareholders? SDRY wouldn’t be the first High Street CVA in recent times. The end game presumably is to refocus away from expensive retail sites to wholesale and online sales.

The picture continues to be mixed, and significant risks remain. No harm in sitting this one out but at the same time, it is worth keeping on top of developments here just because of the scale of the potential upside.

Open Orphan (LON:ORPH)

Share price: 14.61p (+8.83%)

No. shares: 666m

Market cap: £89.36m

Major New Contract Win

This is a Highly Speculative Healthcare Momentum Trap that is burning cash. It has recently diluted its shareholder base, it has a poor F-Score, a Quality Rank of 8 and a Financial Summary soaked in red. These are all flags I try to avoid, but shares are up c9% today on a new contract win.

Even great companies can have very risky financial profiles early on so you might always hit upon the real deal in this space. Open Orphan (LON:ORPH) needs to pull something out of the bag if it is to avoid diluting shareholders further but the community has been buying and the share price has been rising - so maybe there is something worth investigating here.

ORPH has announced a new contract, valued at £4m, with a top 3 global pharmaceutical company ‘to be the sponsor of and provide a respiratory syncytial virus (RSV) human challenge study trial’ and says this deal will generate ‘significant cash flow’ - so maybe it takes the pressure off existing shareholders to fund operations.

In fact trading momentum in general seems strong.

Conclusion

The transformational opportunity appears to be to do with COVID (see here). Possibly a crowded trade and it’s not an area I have an edge in. I’d like to see more signs of profitable, cash generative growth before getting involved.

It could be that ORPH is right at this inflection point but I’ll leave that for others to decide. DYOR.

I’ve had a quick look around and can see others expect this to grow quickly. Brokers are forecasting a stepchange in profitability in FY21 - so if you believe that, then there could be an opportunity.

These are quite big forecast jumps in revenue.

Possibly worth flagging for others but not one I’ve looked at before and it seems quite high risk, with further equity dilution very possible if anything gets delayed. For that reason I'm on the sidelines here.

Still, signs of some good trading momentum and management talks about a healthy pipeline going forwards so good luck to holders!