Small Cap Value Report (Mon 16 Aug 2021) - MWE, AVON, TEK

Morning all, it's Paul & Roland here, with the SCVR for Monday. Welcome back Roland!

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.

Agenda -

Paul's Section:

Avon Protection (LON:AVON) - profit warning from Friday seems temporary/fixable supply problems, rather than a lack of demand. So might be worth a closer look? Probably priced about right.

Roland's Section:

Mti Wireless Edge (LON:MWE) - this radio technology group has reported a strong set of figures today. It’s an overseas AIM stock, but it’s ticking quite a few boxes for me.

Tekcapital (LON:TEK) - This Oxford-based intellectual property specialist has released record results today. There’s a history of dilution, but profitability appears to be impressive.

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Paul’s section

Avon Protection (LON:AVON)

2132p (down 28% on Friday) - mkt cap £661m

Shareholders here have had a rough time since AVON shares peaked at about 4635p in Dec 2020, having more than halved since then - opposite to the general market, which has done well over that period. It’s dropped back into our under £700m market cap territory here at the SCVR. As there’s not much news today, this profit warning from last Friday looks more interesting to cover.

Trading Update

Avon Protection plc ("Avon") today provides the following trading update for its current financial year ending 30 September 2021 ("FY21").

Positives -

• “Good commercial progress” in H2
• Order intake over 10 months to 31 July 2021 up 13%, at $221m
• Order book currently up 21% on LY, at $146m - this includes the the benefit of an acquisition called Team Wendy, bought in Nov 2020 for $130m

Negatives -

• “Delays in receipt of orders” - e.g. $16m order delayed due to “procurement bottlenecks”
• “Supply chain disruption” - e.g. extended lead times in obtaining components has delayed shipment of a $6m order
• “Tight labour market” in US
• Build up of inventories and receivables, with poor cash conversion of 50% (i.e. only half of profits turning into cashflow) - expected to unwind in FY 09/2022
• These problems are said to be temporary, and covid-related
• Revised revenue guidance - $245m-260m

EBITDA guidance -

The result of the lower revenue expectations, combined with an adverse mix effect and an overhead base that is fixed in the short term, means that adjusted EBITDA margin guidance is expected to reduce to between 17% - 18% for FY21, before recovering thereafter.

Outlook -

The Board is confident that the delayed orders will be received over the coming months, but expects supply chain disruption and a tight U.S. labour market to persist into next year. As a result, the Board believes it is prudent to take this into account and reduce FY22 revenue expectations to $320m - $340m, whilst maintaining current guidance for FY23…

These issues will be resolved over the coming months, but as they are affecting both our customers and suppliers simultaneously the situation has significantly limited our operating agility in the short term.

We remain as confident as ever about the medium-term prospects of Avon Protection, underpinned by a record order book, a growing and visible contract pipeline and world leading businesses and technologies. We will carry significant momentum into next year, which will also benefit from a strong ramp-up in the Ballistics business, and remain well set for growth in FY22 and beyond."

Broker updates - I can’t find any updated forecasts, expect them to feed through into consensus numbers shortly.

Since FY 09/2021 has been impacted by these various delays, then I’m inclined to value the shares on FY 09/2022 forecasts. That runs the risk of over-valuing the share, as it does say that supply problems are expected to continue into 2022.

We’ve got 121p EPS as consensus forecast for FY 09/2022, so at 2132p per share the PER is 17.6 - seems reasonable.

My opinion - if we have to endure profit warnings, then the best type are like this - temporary supply disruptions, whilst demand remains strong.

It’s brought the valuation of the company down to what seems about right to me - goodness knows why it reached over double the current level last year?

Last Interim results - I’ve had a very quick skim of the numbers, and spotted two noteworthy points - a hefty $96m pension deficit, and that capitalised development spend looks very high. Apart from the pension deficit, the rest of the balance sheet looks OK.

Overall, I don’t know much about this company, so don’t have an opinion either way on it. Although I’m leaning towards thinking the 28% drop on Friday, on problems that should be temporary, could be more of a buying, than selling opportunity? It’s not cheap enough to tempt me in though.

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Roland’s section

Mti Wireless Edge (LON:MWE)

76.5p (pre-open)

Market cap: £68m

Interim results

Mti Wireless Edge (LON:MWE) is an Israel-based company that specialises in radio technology - primarily antennas for mobile and other types of network. Here’s an example of a recent military contract win.

MTI also has a division which sells wireless control systems for irrigation.

Today’s interim results appear to confirm the attractive qualities of the business and show further progress.

Investor seminar: MTI Wireless Edge is hosting an investor seminar on the Investor Meet Company platform at 10am today. I’ve found the IMC platform easy to use and an excellent way to get some additional insight into a company’s operations and its management team. I plan to dial in later and will try to add in a comment here if anything interesting arises.

I’ve become interested in this business recently because it’s appeared on a number of my screens, thanks to its solid balance sheet, attractive profitability and good cash generation. MTI shares have also performed well this year - the stock is not so obviously cheap as it might have been a few months ago:

I should probably point out that this is an AIM-listed overseas stock, so might be considered slightly higher risk than some UK firms. However, MTI has been listed in the UK since 2006 and benefits from owner management. The group also has a track record of dividend payments. So I wouldn’t rule it out automatically on the basis of its overseas status.

Let’s take a look at today’s numbers.

“Another positive trading period”

Today’s interim results strike a positive tone, which appears to be supported by a strong set of numbers. Here are the financial highlights:

• Revenue +9% to $21.3m
• Operating profit +14% to $2.2m
• Earnings per share +14% to 1.89 US cents
• Cash flow from operation +52% to $3.1m
• Net cash +28% to $9.7m (versus June 2020)
• Annual dividend +25% to 2.5 cents per share (paid 31 March - MTI only pays a single dividend each year)

The company’s financial results are refreshingly free from adjustments - nice to see.

MTI’s business is divided into three operating divisions, all of which made progress during the first half of the year. The accounts include a full segmental breakdown of revenue, profit and assets, which again is nice to see. Some larger businesses do not provide this level of visibility.

Antenna: This business makes radio antennas for 5G mobile applications, including network backhaul, vehicle, marine and military use. A recent contract win will see the company develop a new range of space antennas. Management says this is a new market “and one perhaps which the Company can expand into”.

The Antenna business generated 27% of revenue but just 12% of operating profit during the half year. Segmental margins were low, at just 4.3%.

This manufacturing operation does not appear to be as profitable as some of the group’s other divisions, but presumably it does benefit from intellectual property assets.

Sales growth during the first half is said to have been in line with the company’s internal targets.

MTI Summit Electronics: This is MTI’s consulting and distribution business. It sells products from approximately 40 international radio/microwave component suppliers to Israeli customers.

MTI Summit generated 40% of revenue and 42% of operating profit during the half year, with a solid 10% margin.

The business serves defence and commercial customers, but my feeling is that the main market is defence. MTI Summit also has a satellite office in Russia.

Commentary on trading is fairly general, but management reports “new orders from a number of significant military customers”.

Mottech: This business sells wireless systems to manage irrigation and water distribution for agriculture and other markets. Mottech’s products combine Motorola hardware with the company’s proprietary management software.

Mottech is expanding in Canada and Australia and also appears to have a significant client base in France - its Tethys system is installed in vineyards covering more than 6,000 hectares.

2021 is said to have been “another good trading period”. Somewhat surprisingly (to me), this is the most profitable part of the group.

Mottech generated 33% of revenue but 45% of operating profit during the first half of the year. The operating margin for this business was a healthy 13%.

My view

I like what I’ve seen of this business. Today’s numbers suggest to me that the steady growth seen in recent years is continuing:

I’m also encouraged by the attractive profitability of this business - note the steady progression of return on capital employed:

The balance sheet has consistently shown net cash in recent years, too.

Valuation: Consensus forecasts in Stockopedia show the shares trading on 33 times 2021 forecast earnings, falling to 30 times 2022 forecast earnings. Annualising today’s figures would give earnings of 3.6 cents per share for 2021, versus 3.2 currently shown on the StockReport.

Interestingly, I’ve seen forecasts elsewhere suggesting a figure of c. 4.5 cents per share for 2021, so I’m not sure whether the Stockopedia numbers are fully up to date.

Today’s management commentary doesn’t mention any upgrade to expectations, so I’m guessing that the outlook for earnings is broadly unchanged. That seems to be supported by the share price reaction -- the stock is flat in early trading.

In this case, I’m inclined to value the business based on its trailing 12-month earnings yield and dividend yield, rather than P/E.

• Earnings yield: 4.8%
• Dividend yield: 2.4%

These ratios suggest to me that the stock is fully priced, but not especially expensive, if growth can be maintained.

I remain interested and may consider operating a starter position - subject to further research - at this level.

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Tekcapital (LON:TEK)

24.5p (+1% at 08:50)

Market cap £31.7m

Interim results

This Oxford-based firm specialises in working with universities to commercialise intellectual property. It’s a new stock for me, but looks potentially interesting - so thanks to the subscribers who suggested it in the comments.

TekCapital highlights a number of its portfolio companies in the results. I’m not familiar with any of them but they appear to cover a wide range of sectors:

• Medical devices (Belluscura)
• Bluetooth sunglasses (Lucyd)
• Air traffic control software for drones (Guident)
• Reduced salt crisps (Salarius/SaltMe!)

I note that Lucyd sunglasses have had mixed reviews online - e.g. here. The lack of audio privacy seems a big downside to me, but otherwise I can see this could be an attractive product.

I’d imagine that anyone considering an investment in Tekcapital would want to spend some time gaining a much more in-depth understanding of the company’s asset portfolio. That’s outside the scope of this report, so I’ll concentrate on reviewing the numbers for now.

“Record results for the period”

Today’s interim results are modestly headlined “record results for the period”. This is certainly true, as far as I can see. But I think we should probably mentally caveat this with a reminder that half-yearly profits from Tekcapital’s operations can be quite lumpy. Here’s a snapshot of the pre-tax profit since 2016 to show what I mean:

However, on an annual basis there is a much cleaner progression, so I’m encouraged by today’s numbers:

Let’s take a look at today’s interim results, which cover the six months to 31 May 2021.

Financial highlights

• Net assets +56% to $51.1m
• NAV per share +11% to $0.39 (note the impact of dilution)
• Revenue $14.5m (H1 2020 $2.9m)
• Pre-tax profit $13.9m (H1 2020 $1.9m)
• Completed a placing of 38m new shares at 10p to raise $5.3m gross in March 2021.
• Cash position of $2.5m at 31 May 2021.

There are a couple of points I think are worth highlighting from these numbers.

Revenue: Reported revenue for the half year of $14.5m is a substantial increase from the $2.9m reported during the same period last year. However, most of this increase came from a $13.8m unrealised revaluation gain on Tekcapital’s assets.

Around $9m of this reported increase came from the IPO of medical device firm Belluscura (LON:BELL), which floated on AIM in May. This holding was booked at $2m in November but valued at $10.8m when Belluscura floated at 45p.

Belluscura shares have since doubled from the IPO price of 45p, suggesting that Tekcapital’s holding (if it hasn’t sold any shares), could be worth more than $20m today.

However, although Belluscura’s market cap has soared to £100m, this business does not appear to have any material revenue or profits. I’d want to do further research to understand the valuation here.

Returning to Tekcapital, the group says that revenue from services (i.e. actual billings) rose from $557,684 in H1 2020 to $715,753 in H1 2021. That’s a healthy 28% increase, but still a fairly small amount.

Pre-tax profit: In a similar way, Tekcapital’s pre-tax profit of $13.9m is almost entirely driven by the unrealised revaluation gain on assets. Excluding this non-cash item, my sums suggest an operating loss of $823k for the half year.

Net asset value vs NAV per share: Despite rising headline revenue, it’s clear that this business is still in cash-burn mode. This is reflected in the share count, which has risen from 30m in 2015 to 130m today.

The dilution suffered by shareholders is reflected in NAV per share, which only rose by 11% despite the 56% rise in reported net asset value.

Incidentally, the latest fundraise saw 38m new shares issued at 10p in March. Congratulations to buyers then, who have already enjoyed a 150% return.

However, longer-term shareholders have not done so well. At 24.5p as I write, the shares are worth less than they were five years ago:

Until Tekcapital can realise some material income or capital gains from its assets, I would suggest that there’s a continued risk of further dilution.

Cash burn in 2020 was $2.3m. Today’s figures show this outflow increased to $3.1m during the six months to 31 May 2021.

Insider shareholdings

Chairman and serial entrepreneur Clifford Gross retains a fairly modest 6.6% shareholding, according to Stockopedia. Tekcapital’s second-largest shareholder is well-known UK investor Nigel Wray:

My view

Tekcapital appears to be making steady progress with its strategy of commercialising university discoveries. However, group’s reported profits appear to be entirely derived from unrealised valuation gains, often on unlisted early-stage businesses.

For me, this is too speculative to be of interest. I’m wary of attributing too much value to unrealised valuation gains when they aren’t backed by cash flow or even revenue.

I can see that Tekcapital could have significant potential, but I’m also concerned about the risk of further dilution for shareholders. I don’t feel able to value this stock, so I’ll watch with interest but won’t get involved.