Small Cap Value Report (Mon 14 June 2021) - TED, ESKN, SAGA

Good morning, it's Jack here with the placeholder for the first of this week's SCVRs.

If you have any suggestions or requests on what to cover just leave a comment and explain a little as to why you think the stock might be of interest to the community.

Agenda:

Ted Baker (LON:TED) - final results - the shares have rerated but trading is mixed and there is still a lot of execution risk here.

Esken (LON:ESKN) - Ettyl transactions for Stobart Air (SA) and Carlisle Airport fall through. SA to cease trading but residual obligations remain. Possible strategic funding could change the situation but this remains high risk. More detail is expected from the company later this month.

Saga (LON:SAGA) - Holding statement. Travel cash burn at lower end of guidance, insurance is ok (and benefitting from lower loss ratios), financial position is stable, ships remain ready to capitalise on pent-up demand once restrictions lift. 'Outstanding' customer loyalty so far.

Quick note - we said last week we would create a disclaimer for these posts. For now, just a friendly reminder that we don’t recommend any stocks. We aim to cover notable trading updates of the day and offer our opinions on them as possible candidates for further research if they pique your interest. We tend to stick to companies that have news out on the day.

A central assumption is that readers then DYOR (do your own research) and discuss in the comments below. The comments, incidentally, add just as much value as the blog post itself!

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Ted Baker (LON:TED)

Share price: 165.6p (-0.48%)

Shares in issue: 184,608,786

Market cap: £305.7m

Ted Baker (LON:TED) is one of the more dramatic turnaround situations on the market right now.

A flurry of bad news marked a calamitous fall in the share price, with a deeply discounted share placing at the nadir locking in the value destruction and equity dilution for shareholders at the time.

The share price fell by nearly three quarters in 2019 alone.

You can also see though that the price does appear to have been firming up recently, with the buyers beginning to outweigh sellers. Turnarounds can languish for a long time, but when they do turn, the rerating can be substantial.

2019 was a bad year. A brief recap:

• February 2019 - TED revises down expectations, including a £5m writedown of stock,
• July 2019 - trading conditions ‘extremely difficult’ with ‘elevated levels of promotional activity’ in the sector,
• October 2019 - unexpected H1 2020 loss announced, dividend cut by more than 50%,
• December 2019 - New CFO. Stock overvalued by as much as £25m. Trading behind expectations and a more cautious outlook. CEO and chairman resign.

2020 saw pre-tax losses nearly quadruple, while revenue halved and margins declined as the retailer tried to shift marked down stock. Some 38 tonnes of ‘terminal stock’ was sent to charity.

There was then Covid to contend with, and the equity placing at a low price.

The truth is though that the share price fall began in earnest back in 2018. Ted Baker’s clothes were pricey and its leased store estate was expensive. There were fundamental problems.

New management is focused now on the turnaround but fashion is fiercely competitive. With the likes of Joules (LON:JOUL) going from strength to strength, is there room for a resurgence?

It’s possible. Ted Baker was a strong brand with global potential. And the group now looks different to the Ted Baker of a few short years ago.

But there’s a long way to go and the situation is still risky, in my opinion.

Final results

Highlights:

• Revenue -44% to £352m; online revenue +22%,
• Gross margin down 140 bps,
• Underlying pre-tax loss of £59.2m, down from an underlying pre-tax profit of £4.8m in FY20,
• Loss before tax up from £77.6m to £107.7m,
• Basic loss per share has improved from 153p to 56.2p,
• No final dividend to be paid,
• Free cash flow of £24.2m.

Underlying items are quite chunky and include £45.3m of impairments, £11.4m of restructuring costs, and £6m of changes in inventory estimates. Total non-underlying items total £48.6m, down from £82.4m.

The group’s online capabilities lag its competitors and Ted has paid the price for this over the lockdowns. Ecommerce is up 22% but that figure could have been much higher if Ted had the appropriate digital platform in place.

Progress here has not been enough to compensate for the disruption faced in the group’s core business.

Free cash flow is more encouraging at £24.2m thanks to tight working capital management.

The Chinese JV is delivering strong growth and could be important going forward. China is a huge market. It’s the largest eCommerce market in the world and is larger than the next ten markets combined. But it’s a tough nut to crack and the joint venture is still small, with revenue of £2.9m.

Payroll has delivered £31m of annualised savings after cutting some 953 jobs late last year. The group has also generated £8m of savings in rental negotiations, meaning Ted paid £35.8m in lease payments in the year. Four underperforming stores have been closed.

Cash management has been good. Ted ends the year with £66.7m of net cash compared to £127.1m of net debt in the prior year, although the vast majority of this swing comes from the £168.9m of net proceeds from the equity raise and sale of its Ugly Brown Building (UBB). The group has liquidity headroom of £199m.

Current trading

Q1 trading continues to be disrupted. Trading days are lower than in FY21. Metro city centre and travel locations are significantly weaker than out-of-town and regional locations and the online growth rate is reduced due to a ‘heavily promotional’ FY21.

Store revenue is down 41% in the 12 weeks to 24 April 2021 and Online is up just 4%. Wholesale is down 25% and Licensing is up 7%.

The group does note a c250bps improvement in gross margin and improving momentum in Wholesale and Licensing.

Retail stores in the UK have opened slightly ahead of the scenario given to the market back in February, but the situation in Europe and Canada has worsened.

Conclusion

It’s still early on in the turnaround and a lot of execution risk remains. Investment is required in order to catch up with a lot of large, cash generative, and well invested competitors.

Leading retailers have not been sitting still waiting for Ted to fix its financial issues and rejoin the race. They have been investing millions of pounds increasing their own competitive barriers and market shares.

The group is aiming for medium-term revenue growth of c5% and an EBITDA margin of 7-10%, with free cash flow generation after capex of at least £30m by FY23.

Really quick numbers here, but if you assume FY22 revenue is the forecast £473m which then grows at 5% for five years, that comes to FY28 revenue of £603.7m. Apply a 7% EBITDA margin and you get FY28 EBITDA of £42.3m.

Today’s enterprise value of £407m means the group trades at more than 10x EV / FY28 EBITDA. Remember the share count has ballooned from 55m in FY20 to 184m today. Burberry (LON:BRBY) which is in much better shape trades on a trailing twelve month (TTM) EV/EBITDA of 11.3x.

Given the scale of the task ahead of the management team, the risk compared to the potential reward does not look attractive to me. A lot is being priced in. The shares have turned positive so far this morning though, so clearly others disagree.

Fashion, more than other sectors, is faddy and formerly cool brands can quickly lose their shine and enter a terminal decline. Due to this, bankruptcy risk is higher here and so investors must be particularly careful when weighing up the pros and cons.

Management says Q1 Digital is ‘in growth’ and leaves it at that, implying this is positive. But it is up by just 4%. What other retailers right now are happy with 4% growth in eCommerce?

To me, that 4% suggests Ted is not keeping pace in the key battleground of the future. I’m also surprised that just four stores have been closed in the period. I imagine more must follow.

It doesn’t mean the shares are uninvestable, but it does mean that my interpretation of the current situation is significantly less positive than that of the management team, which makes me cautious. It's high risk.

If management does very well and steadies the ship, the global clothing market is huge, of course. Here are the estimated sizes of some clothing markets (from the company):

• UK - £39bn
• North America - £204bn
• Germany - £47bn
• China - £233bn
• India - £44bn
• Middle East - 23bn

So winning just a sliver of these markets could still represent very good upside for more risk-tolerant investors. But I wonder if the scale and difficulty of management’s task is fully appreciated.

I’ve no doubt the team is pulling out all the stops. Ted Baker is a dramatically different business after its placing, financially speaking. Regional and out of town locations are showing early signs of recovery. I wish holders all the best and, as noted above, when turnarounds do come good the rerating can be lucrative.

Toscafund is an active investor and owns nearly 26% of the company, so there's the possibility of further shake ups and more aggressive value creation strategies down the line.

But I remain wary. There’s a lot to do here - Ted needs to cut costs, but it also needs to invest more than its peers in order to catch up in terms of competitiveness. Meanwhile revenue is falling, so it's a tricky balance going forward.

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Esken (LON:ESKN)

Share price: 25.25p (-18.55%)

Shares in issue: 630,926,123

Market cap: £159.3m

Esken (LON:ESKN) was previously known as Stobart Group. Today the group’s businesses consist of aviation services and energy.

Aviation has two main assets: London Southend Airport and Stobart Aviation Services (SA), but today the group announces that SA will cease trading. Esken also owns Carlisle Lake District Airport.

Stobart Energy is the UK’s number one supplier of biomass fuel. It supplies around 1.7million tonnes of fuel to dedicated biomass plants across the UK. It earns a ‘gate fee’ for receiving waste wood from construction site operators and the like, stores this waste wood in its sites across the UK, and then processes it into biomass fuel for supply to biomass plants based on long-term contracts.

A quick look at the Financial Summary shows us that Esken has been struggling for some time. The dividend was halted in FY20. It has only been profitable in two of the past five years. It has not been cash generative at the free cash flow level in any of those years.

And net debt increased alarmingly.

Shares in issue have now almost doubled over the past year as well, from 388m in FY20 to 631m today.

Revenue is set to fall considerably in FY21, from £170m to £56.1m, and it’s clear the company is changing shape quite drastically. A core part of its value creation strategy is the disposal of a ‘portfolio of non-core assets’.

Esken has recently exited Stobart Rail & Civils. It has a further portfolio of infrastructure assets that had a net asset value of £40m as at 31 August 2020. Esken aims to sell those assets through to the end of 2023.

So the question is how valuable and sustainable the streamlined company will be going forward, and the nature of the risks to shareholders as it attempts this transition. I’d suggest those risks are significant, particularly in the current Covid disrupted environment.

The shares are down heavily today and this is clearly at the riskier end of the spectrum (more on that below) - that’s glaringly obvious from the StockReport when you consider the Quality Rank of 9, the low Piotroski and Altman financial health scores, and the sea of red in the Financial Summary box.

Trading statement

Catching up on the situation here, a company called Ettyl offered to acquire Stobart Air (SA) and Carlisle Lake District Airport (CLDA) in April 2021. Now Esken says that Ettyl is unable to conclude the transactions and the deal has fallen through. The group adds:

In the absence of any alternative purchasers or sources of funding for the SA business within the timescales required, Esken has advised the Board of SA that it will not continue to provide financial support to the business going forward. As a result of this the Board of SA has terminated its franchise agreement with Aer Lingus, will cease trading and is taking steps to appoint a liquidator.

This is the reason for the fall in share price.

The board has agreed that it will continue to fund the lease obligations on the 8 ATR aircraft through to termination of the leases in April 2023 under the terms of its pre-existing guarantee.

Esken will take immediate steps to seek sublease arrangements for the aircraft with alternative operators to mitigate the impact.

The group also remains responsible for certain obligations to Aer Lingus under the franchise agreement which are now payable.

This is going to have a significant impact on cash outflow for the group over the next couple of years.

It’s unfortunate that Covid struck during this delicate transition and has delivered a fatal blow to SA.

Esken will retain the ownership of CLDA rather than it being sold for £15m (reflected in the cash impact above) ‘but will actively explore strategic options for the use of this asset’ including potential alternative commercial opportunities for the airport.

Strategic Update

The impact of the pandemic has been both greater and over a longer period than anticipated at the time of the capital raise in June 2020.

This strikes me as odd. I wouldn’t say that we are presently in a particularly surprising situation with Covid. We had the first full lockdown, a second wave later in the year, a gradual reopening of the economy so far in the first half of 2021, and vaccine roll outs at pace.

Fair enough there were any number of potential outcomes and the future is unknowable, but nevertheless it seems to me as though the current situation would fall within the bounds of a thorough emergency scenario analysis performed in the early days of the pandemic.

There might be a bit of hindsight bias in there, and perhaps it’s a harsh critique (modelling for Covid is an unenviable task), but ultimately top level management is paid well to get the big decisions right and protect the company’s stakeholders.

The board has subsequently reviewed the group strategy and its medium-term funding requirements. Esken says:

This concluded that the Group holds two attractive businesses which can generate significant value for shareholders as markets recover post COVID-19. The key strategic objective will therefore be to drive shareholder value from these assets with any decision on the realisation of value being deferred until the businesses recover fully from the pandemic and become mature cash generative business units.

The group expects Stobart Energy to return to pre COVID-19 run rate levels in the current financial year.

Aviation’s prime asset is London Southend Airport ('LSA') which, prior to the pandemic, offered passenger services to over 40 destinations to a market of c.8m people living within one hour travel time to the Airport.

There’s value in that asset assuming it can be appropriately funded, and the fundamental long term drivers remain sound. The Airport is well placed to capitalise on accelerated airfreight growth and movements.

Strategic Partnership for LSA

Over the last nine months Esken has been in discussions with a strategic financial partner in relation to the development of LSA.

This partner has significant investment experience in the airport sector globally.

Esken is now in the final stages of agreeing the documentation for the strategic funding transaction ‘which would release significant liquidity into the group while underpinning the funding requirement of the Airport in the medium term’.

This transaction must be approved by shareholders and further details will be announced at the full year results anticipated by the end of June. There are no guarantees that this will go ahead.

No detail is given on the character of this partner, and I’m mindful that the recent proposed transaction with Ettyl ultimately fell through.

Funding and liquidity

Esken raised £100m by way of a capital raise in June 2020 together with additional bank facilities of £40m.

The group's bank facilities totalling £120m expire at the end of January 2022. Esken is in talks with its banks regarding the repayment of these facilities as well as its medium term funding requirements.

Esken must be able to repay the facilities by the due date and it’s possible that waivers will be required here. The group has currently drawn £10m and additional conditions kick in beyond £15m.

The LSA strategic funding proposal would, if completed, enable Esken to repay the outstanding bank facilities and would go some way towards derisking the business.

It’s also likely that ‘a modest equity issue on an accelerated basis’ can be expected.

Trading

The Energy Division is operating at expected levels and the availability of waste wood from the construction industry has returned to pre-COVID-19 levels. All plants are fully operational.

The LSA recovery in Aviation is much slower, however there has been a return to low levels of passenger flying. Quite when unrestricted commercial flights resume again is a big unknown.

The business’ Global Logistics Operation which has now returned to similar levels to last year.

Conclusion

The financial status of Esken and its viability as an enterprise is at risk. It might be that the company finds a way through and becomes a promising special situation, but for now I view it as uninvestable and will await further news on the proposed strategic investment in the upcoming results (due before the end of June).

This is of central importance and could change the investment case.

But at present this is not so much an investment as a bet on funding. There’s nothing wrong with that if you are under no illusions and are equipped to handle the share price volatility and possible loss of capital, but it’s still worth calling a spade a spade.

The company is keen to repeatedly point out that none of its potential funding solutions are guaranteed.

If it can sort out funding, then there is a path to value here with the proposed disposal of non-core assets and renewed focus on London Southend Airport and the Energy business. But many things can go wrong along the way (as highlighted by the failure of the Ettyl transactions).

Again we find a high risk turnaround situation, and again we find Toscafund at the head of the major shareholders list. There will be a real drive here to realise value one way or another.

Given the financial concerns and remaining residual obligations, there’s too much uncertainty here for me. There could be good upside if it all pans out but things could also deteriorate quite quickly.

With a more detailed update coming before the end of the month it makes a lot of sense to hold off for now and wait until we have that additional information on funding.

Esken needs to get cash from somewhere and a lot rests on this potential LSA funding deal. Let’s hope it can get it over the line.

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Saga (LON:SAGA)

Share price: 407.8p (-0.63%)

Shares in issue: 140,102,227

Market cap: £575m

Saga (LON:SAGA) is a widely followed stock here - it’s one of Paul’s bigger holdings, so there’s always the chance he will revisit this later in the week.

For those that don’t know, Saga is a UK specialist in products and services for people over 50. It has two big cruise ships on standby and an insurance business as well. Debt levels remain a consideration, but the group has almost as much again in plant, property, and equipment assets and it has taken steps to ensure liquidity. Cash burn also appears to be in hand.

The share price has been steadily rising here and the market has been slow to adjust to Saga’s bolstered finances, earnings growth potential assuming restrictions ease, and the fact that it has some degree of diversification via its insurance business.

AGM trading update

Highlights:

• Insurance business expected to be ‘broadly flat’ over the first half,
• Travel business due to restart from 27 June 2021, subject to government restrictions.
• Continued debt reduction; Net debt to EBITDA (excluding Cruise) of 2.9x as at 31 May 2021, within the current covenant in short-term bank debt of 4.75x.
• Liquidity position remains strong, with total available cash of £78m at 31 May 2021.
• Progress against strategic priorities: Improved colleague engagement;
• Significant focus on customer experience; improvements to the digital journey; launch of customer experience strategy, GDPR re-consent programme and future operations plan.
• Launch of motor mid-term adjustment changes, giving customers more options when making a change to their policy.

Liquidity and Net Debt

Saga retains a ‘resilient’ liquidity position due to actions taken in 2020/21 to preserve cash and increase financial flexibility.

At 31 May 2021, it had cash of £78m, excluding £23m within the Saga Tour CAA ring fenced group, in addition to an undrawn £100m revolving credit facility (RCF).

That’s slightly higher than at 31 January 2021 due to Retail Broking trading EBITDA and positive working capital movements, offset by only cash support provided to Tours, capital expenditure, pension and interest payments.

Cruise cashflows are modestly positive for the year to date as a result of the collection of final balances on June and July departures.

Net debt, excluding the two cruise ships at 31 May 2021 was £246m and the ratio of net debt to EBITDA was 2.9x, slightly higher than at 31 January 2021 due to an expected reduction in reserve releases but well within covenants.

Total debt at 31 May was £757m, largely in line with 31 January 2021.

For now, Saga’s financial position probably remains the most important factor here. It looks like the group has enough cash to continue operating in the current environment as it waits for travelling restrictions to ease up, hopefully soon.

Insurance - The Retail Broking business faces ‘challenging conditions’ with continued premium deflation across the market. However May showed early indications of improvement and policies are expected to be broadly flat over the first half. Travel policies continue to be impacted by COVID-19 with total sales in the year to date 5% below the prior year but Underwriting has continued to experience reduced motor claims frequency, in line with the wider market.

Travel business - Cruise load factors are solid at 77% and 48% for 2021/22 and 2022/23 and per diems ahead of expectations. ‘Outstanding’ customer loyalty. The cash burn rate for the year to date at the lower end of the guidance of £7m-£9m per month.

The timing of the full easing of government restrictions and the implications of that for the travel sector remain uncertain.

Strategy and trading

Most of the strategy is already known by now and the company is steadily realising its priorities of colleague & customer satisfaction and digital & brand transformation.

Saga adds:

In order to continue to drive simplicity and efficiency within the business, a plan has been launched for future operations. This will create a step change in the service we are able to offer our customers, allowing us to deliver exceptional experiences every day. From a colleague perspective, we have developed a future working strategy through our Big Conversation which has allowed us to get the views of hundreds of colleagues on how we best collaborate and work together in the future.

The board is ‘encouraged’ by the first four months of the year.

Conclusion

Paul has covered Saga extensively in the SCVRs. If you want to scan his output just head over to the StockReport, click on Discussions and have a look through his comments.

There’s not much new in today’s update and the investment case remains unchanged. The financial position is stable and cash burn in travel is at the lower end of guidance.

Nothing on the stock market is risk free, but Saga continues to look like one of the more attractive reopening trades given the still muted share price reaction and the proactive steps the company has taken to ensure financial safety and operational improvement. Others seem to have too much priced in or are too risky.

In Travel, the resumption of sailing for both ships and restarting Tours remains the priority, whilst in Insurance Saga aims to deliver consistent performance across its balanced scorecard.

Having both Travel and Insurance helps to diversify revenue and earnings. So it’s probably in a more comfortable position than peers that exclusively run cruise ships and nothing else.

There’s likely to be pent up demand in the near future and longer term there should be opportunities for sustainable growth if well managed. The returning CEO Sir Roger de Haan has a deep understanding of the company and is its largest shareholder. So that gives some comfort.

Travel businesses are due to restart from 27 June 2021, subject to government restrictions. There is always the risk that leisure travel is restricted further. Let’s hope not, but it can’t be ruled out yet.