Small Cap Value Report (Mon 16 Jan 2023) - KLR, AMS, RWA, SHI, MRK, GHT, SUP, STCM, TPT, QTX, BDEV, JSG, CREO, IQE, QXT, AT., MPAC

Good morning from Graham & Paul. Today's mammoth report is now complete!

To start you off today, I spent some time over the weekend catching up on 11 company announcements we missed in last week's SCVRs. These are all short sections below.

Podcast transcript - here's the written version of this weekend's podcast. The audio version is here, and on podcast platforms. No mystery shares this week, but dozens of shares discussed, and lots of macro news/views too.

Graham's 2023 watch list

We thought that it would be a nice idea for Graham to write up his watchlist ideas for 2023 small caps, like I did the weekend before last. So he's been working on this today, and Graham's article is now published here.

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Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to review 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 are analysing the company fundamentals, not trying to predict market sentiment.

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.

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Paul's Section:

Today's news 

Iqe (LON:IQE) (49p [down 18% at 09:47] - mkt cap £395m) - it’s down a lot today, but in reality this has only reversed a spike up that happened in the last 10 days, in this somewhat frenzied market - reinforcing the point I made in my weekend podcast, that big rises at the moment look indiscriminate, and don’t necessarily mean a company is trading well. So it’s dangerous buying into price rises right now, unless you’ve got the safety of a positive recent trading update. I’m thinking that unusual spikes up might be good opportunities to top slice some profits, and thereby have a war chest for buying any unreasonable dips. But each to their own, and market timing is very difficult to get consistently right - some people have a flair for it, but most of us don’t.

Trading update for FY 12/2022 today. Revenue c.£166m, short of £173m forecast shown on StockReport. Hit by “small number of doubtful debts”, and one contract seeing slippage into Q1 of 2023. Reported 8% revenue gain all comes from favourable forex, growth is flat at constant currency.

Vague about profitability, saying it’s “largely resilient to the challenging macro environment”.

Outlook for 2023 - expects some destocking by customers in H1. Confident in strategy to diversify & longer term growth targets. Excited by pipeline.

My opinion - I’m not keen on this update. It’s all rather vague, dodges telling us what profitability has been, and the outlook sounds soft for 2023. The valuation looks inflated to me, for a capital-intensive business that doesn’t seem to make any meaningful profits any more. Bulls need to be sure that a big increase in profits is in the pipeline, otherwise why on earth are you valuing this company at almost £400m? Very poor free cashflow historically too - with capex exceeding operating cashflow most years.

Quixant (LON:QXT) (172p [up 3% at 09:34] - mkt cap £114m) - FY 12/2022 trading update. Strong demand, positive trading in Q4. Revenues $120m (up 38% vs LY) - a new record, and ahead of expectations of $115m. Adj PBT - forecast is $10.1m expecting to beat this slightly. Supply chain issues continuing, but partial recovery in gross margins as component prices stabilised. Net cash of $12.9m, up slightly over last 6 months. Inventories being reduced. Outlook - strong order book, good visibility, should see further revenue growth in 2023. Macro headwinds, but resilient end markets and “strategic positioning”.

My opinion - a confident-sounding update, and note that broker forecasts have been rising in stages for the last 6 months. Valuation looks about right, at 15x forecast earnings, with a modest 1.4% dividend (scope to increase that, I think). Could be upside on the shares, if it’s able to return to pre-covid peak EPS of about 20p (note that it reports in US dollars, so you need to convert into sterling, to avoid overpaying accidentally!). No dilution during the pandemic, with share count stable at 66-67m shares for years. Overall, I’ll give this a thumbs up, although it doesn’t madly excite me.

Ashtead Technology Holdings (LON:AT.) (330p [down 1% at 11:14] - mkt cap £264m) - I don’t know anything about this share, but Roland covered it here in Sept 2022. It sounds interesting, and is a rare case of a 2021 float that’s actually done well! Broker consensus forecasts have been steadily rising over the last year. Services to global offshore energy sector looks a nice place to be, with the proliferation of wind farms an ongoing theme.

Trading update today says - strong trading continued in Q4 of FY 12/2022. FY revenues up 30% on LY, to £72.5m. Slight benefit from acquisitions, but organic growth was the bulk at +28% (6% of which is from favourable forex). Strong pricing & utilisation have enhanced gross margins. Profit guidance: EBITDA “modestly ahead” of market consensus (they forgot to include a footnote specifying the figure), and EBITA (ie adj operating profit) “comfortably ahead” of mkt exps. Sounds good, in the context of mkt exps that have been rising, so to beat a raised number is a lot more impressive than meeting/beating a lowered forecast number, as with plenty of other companies right now.

Outlook - nothing specific, just “continued progress” expected, and a positive tone. No cautionary words.

My opinion - a new share for me, so I’ve only done the quickest desktop review, but I like what I see. Forecast for FY 12/2022 shows a big rise in profits, and a strong operating margin - suggesting in-demand niche services, with pricing power. Forward PER of 15 seems reasonable, and cheap if this rate of growth can be sustained. The last balance sheet was OK, but isn’t strong, at just £18m NTAV, with some debt. So I hope the company prioritises debt reduction/elimination rather than divis.

Overall, thumbs up from me - looks worthy of further research.

MPAC (LON:MPAC) (270p [up 5% at 11:17] - mkt cap £55m) - FY 12/2022 trading update, is in line with market expectations (but no footnote), with an “encouraging outlook” for 2023. Says H2 improved on H1 (good, as H1 was weak), with supply chain issues & costs sounding well managed in H2, giving improved margins & profits in H2. Order intake rose “significantly” in H2, although Dec 2022 order book of £69m is down on £78m a year earlier. Increasing pipeline it says (no numbers). Higher year end net debt (no figure provided) due to working capital increases, expecting to “largely unwind” in H1 2023.

My opinion - no strong view either way. The profit warning mid-year was a big one, with profit forecasts slashed, and the growth story unravelling. As supply chains normalise, and maybe some pent-up demand might come through, I could see this share doing OK in future, but that depends on lots of unknown factors, so it’s just educated guesswork really, as with most shares! No divis here I see for a long time. Strange balance sheet, showing a large pension surplus, that needs careful scrutiny. This share looks primed to rise, if it’s able to report good trading updates in 2023, and it looks well set up for that - because last year’s soft H1 is this year’s easy comparative to beat.

Backlog items from last week

Keller (LON:KLR) (750p - £546m mkt cap) - I’ve only looked at this large contracting business once before, here in June 2022, and was quite impressed with its value characteristics (low PER, good divis, and sound balance sheet).

FY 12/2022 update last week disclosed that it has discovered fraud at its Australian unit, Austral. The profit impact on its H1 results is said to be c.£6m (it reported total profit of £50m for H1). So significant, but not massive. Trading in the rest of the group has been strong, and FY 12/2022 adj operating profit guidance is now slightly below £109m, little changed from previous consensus of £111m.

Expectations for 2023 are unchanged. Year end net debt as expected at 1.3x EBITDA (no figure provided). Final divi raised 5%, total for the year now 37.7p, a nice yield of 5.0%.

Outlook comments sound upbeat, with talk of a substantial order book, and confidence in prospects.

My opinion - news of this internal fraud has knocked about 10% off the share price, which looks about right given the likely impact on results. Liberum’s revised forecasts are little changed, and the share looks to be priced attractively on a low PER of 7.5, and a 5% yield. It seems cash hungry, with net debt rising a lot, seemingly being sucked into working capital. Needs more work on balance sheet & cashflow analysis, but looks superficially cheap on a PER/yield basis.

Advanced Medical Solutions (LON:AMS) (254p - mkt cap £551m) - FY 12/2022 trading update last week. Both revenues & profits are In line with market expectations. Confident of meeting 2023 market expectations. Talks about “particularly significant” progress with regulatory approvals, new products, and hopes to expand in the USA.

My opinion - shares look fully valued as things stand, with a forward PER of 24x, which seems a lot given that EPS hasn’t gone anywhere for the last 5 years. It’s a high margin, quality business, sitting on a decent cash pile on its strong balance sheet. The key area would be to assess growth potential for new & existing products. Could be worth doing more investigation.

Robert Walters (LON:RWA) (500p - mkt cap £374m) - FY 12/2022 update last week says conditions became more difficult in Q4, but still showing growth over LY, and profits expected to hit a new record - but “slightly below current market expectations”. Net cash very healthy, at £96.4m.

My opinion - together with SThree (LON:STEM) this is one of my favourite staffing groups. It’s modestly rated on a fwd PER of 9.5, lovely divi yield of 4.9%, and a bulletproof balance sheet.

On the downside earnings forecasts are now starting to drop, so it’s probably seen peak earnings for now. So 2023 could be a bumpy ride, but I don’t see much risk to the divis, which are 2.4x covered. Fine for long-term holders I think, but more nervous short-term traders might be a bit nervous about the outlook as economies slow. So, as with lots of things, how you view it depends on your investing timeframe. It’s a quality business though, and reasonably priced, so I like it still.

SIG (LON:SHI) (35p - mkt cap £414m) - large & complicated. Turnaround plan seems to be working, with an in line update for FY 12/2022. Guidance: revenues £2.74bn, underlying operating profit c.£80m (almost double 2021). Took a £5m hit from insolvency of one of its largest customers, Avonside. Net bank debt is £159m (up by £30m in the year). Leverage is 1.8x on pre-IFRS 16 basis, which doesn’t look worrying (debt did previously worry me). The bank debt is almost entirely a E300m 2026 bond, costing 5.25%. Covenants would need checking.

My opinion - looking at the historic performance, this doesn’t look a very good business at all. Performance now seems to be improving, with broker forecasts improving in the last year. So maybe the turnaround could generate decent results? Might be worth doing more research work to understand what’s happening here. £2.7bn revenues is a lot, so each 1% gross margin improvement is £27m extra on the bottom line. It generated nice free cashflow, pre-pandemic.

Marks Electrical (LON:MRK) (98p - mkt cap £103m) - this share has risen 75% from the low in Oct 2022. Update last week was for the 9 months to Dec 2022. Impressive revenue growth of +22% vs LY. “On track to achieve its full year targets”. It all sounds bullish, but is light on details. Broker profit forecasts have been in a gentle downtrend trend, quietly lowered by c.16% to 4.6p over the last year - managing expectations downwards very skilfully!

My opinion - I admire the entrepreneurial, penny-pinching style of management here - essential in such a low margin, competitive sector. Nearly 19x forward earnings is too high for me. So I suspect the current bull run might have got a bit ahead of itself. There again, larger competitor AO World ran to a ludicrous over-valuation, and remained over-priced for years, before coming back down to earth with a bump. As the new kid on the block, with a better, more efficient business model than AO, maybe MRK could also get into a bull run where people don’t worry much about the valuation? The fact that it’s generating decent sales growth, in a time of challenged consumer disposable income, is impressive. So I can see some merit in this share. Let’s see how things pan out longer term. Maybe tempting to bank some profits after such a good recent run, so there’s ammunition to buy on any dips?

Gresham Technologies (LON:GHT) (180p - mkt cap £150m) - this software company is looking interesting. Strong Q4 performance. Figures slightly ahead of previously upgraded guidance.

New FY 12/2022 guidance: revenue up 31% to £48.6m (includes an acquisition, organic growth is still good, at 16% up). Cash EBITDA (a good figure, as it deducts capitalised development spend) of £4.3m (up 76% vs LY). Good recurring revenues (annualised £28.0m at year end). Cash of £6.3m, and no debt. Figures have benefitted from forex gains (not clear how much). Great visibility - over £42m of FY 12/2023 revenues already under contract. Confident outlook.

My opinion - I think this looks like a breakthrough year in 2022, with Gresham finally delivering a decent level of profitability, after years or erratic performance and limited profitability even in good years. Recurring revenue contracts with some large banks, could be very good business. Intriguing, and worth further investigation, if you understand software companies.

Supreme (LON:SUP) (115p - mkt cap £134m) - trading update last week says its “in line with current market expectations” for FY 3/2023. Strong Q3 (Oct-Dec), with revenue & gross profit up 30% vs Q3 LY. Vaping products are selling well. Lighting division recovering. Batteries division “consistent performance”. Confident outlook for FY 3/2024.

My opinion - looks interesting, on a forward PER of 10.3. This update glosses over the reality that forecasts are now much lower than they were a year ago! As a reminder, it issued a profit warning which I reported on here in July 2022, when orders for the lighting division suddenly dried up. There’s also the ethical consideration of supplying vaping products, which get people addicted to nicotine. On the numbers alone though, it’s looking decent value, and I like the history & approach of entrepreneurial management (57% shareholder). Could be a recovery stock for 2023 maybe, providing no more banana skins are hit.

Steppe Cement (LON:STCM) (44p - mkt cap £96m) - what a bizarre company, selling cement in Kazakhstan. I’ve never looked at it before, because I normally avoid AIM-listed companies that operate abroad, as so many have turned out to be dodgy in the past. However, I will consider overseas companies on AIM if they’ve been listed for a long time, and pay divis. STCM passes those two tests, having been listed here since 2005, and having paid patchy divis since 2014 - the eye-opening one is a whacking great 5.0p interim divi paid very recently (2 Dec 2022). The full year forecast divis are 7.0p, a yield of almost 15%. If that’s sustainable, then it would surely drag the share price higher in future? The history shows a share price that has oscillated sideways for the last 10 years, so what has changed to make things better, and cause a big dividend to have just been paid? See 2 big Director buys on 12 Oct 2022. The last balance sheet looks solid.

My opinion - only for adventurous investors, but the numbers do look intriguing.

Topps Tiles (LON:TPT) (50p - mkt cap £98m) - trading update for Q1 (Oct-Dec 2022) from last week. Everything is in line with expectations (profit, balance sheet, and cashflow, but no figures provided).

LFL sales were up 5.1% (total sales up 10.2% thanks to an acquisition). Expecting more of an H2 weighting to profits this year than usual - reasons given are higher gas expense in H2 expected, timing of accruals (???), and benefit of supply chain costs easing in H2.

Gaining market share.

My opinion - looks reasonably priced, at 12x expected EPS of c.4.2p. I’m intrigued by the expectation of improved profitability in H2, which could have nice read across for other companies.

Quartix Technologies (LON:QTX) (275p - mkt cap £133m) - trading update for FY 12/2022 issued last week - in line with expectations for 9.7p adj EPS (PER of 28x). However, forecasts for FY 12/2023 are guided down to 9.0p (previously 11.1p). Prices are falling (4.7%) not rising, and customer churn is another headwind at 12.8% (increased). So my concern is that Quartix has to generate a lot of new business, just to stand still. This is maybe why EPS has actually fallen over the last 7 years. Which, as I always point out, does raise a big question mark over why the shares are on a growth company rating of 31x 2023 forecast earnings? Balance sheet - negligible asset backing, with NTAV of £2.6m at June 2022 - it has minimal fixed assets, so doesn’t need asset backing, and pays out profit/cashflows in divis historically - a nice business model, I’m not criticising it, just reporting the facts.

France doing well, expanding. Other European countries (aside from main UK market) very small, but growing strongly. USA is a concern, with hardly any growth, and operational problems, and a review of the US expansion plan.

Accounting policy change will boost profit by c.£0.4m.

My opinion - I like the company and management, but just cannot see how the valuation makes any sense, given where things are. Shares still look far too expensive, especially after a profit downgrade for 2023. There needs to be some seriously positive newsflow, to justify the existing price, let alone take it any higher.

Barratt Developments (LON:BDEV) (455p - mkt cap £4.53bn) - trading update for H1 (6m to Dec 2022). “Strong operating performance” in H1 due to big opening order book. But “marked slowdown”, due to known factors (economic & political turmoil, higher mortgage rates, reduced consumer confidence). “Strong net cash position” of £965m, so no danger to the business from a downturn, in my view. Some stats -

Net reservation rate has fallen heavily in the last 12 weeks, to 0.3 (from 0.69 LY).

Forward order book at 31 Dec 2022: £2.54bn (LY: £3.79bn). In terms of number of houses, this is 10,511 now, vs 14,818 LY - a huge drop.

Full year completions could be between 16,000 to 17,475 houses, depending on whether or not usual spring seasonal uplift occurs.

These factors will “undoubtedly impact trading in the second half”.

Construction activity is being slowed down, to reflect slowing orders.

Average selling price up 14.6% in H1 vs H1 LY, to £330k.

Retrenching on land acquisitions, with 3,293 plots no longer proceeding. Strict financial hurdles on new sites. Running down land bank now (not replacing all the land used) in FY 6/2023.

My opinion - it’s quite stark to see how much the forward order book has shrunk, so obviously there’s going to be a big drop in future profits (after a time lag). Therefore we’ve definitely seen peak earnings for a while. The big question is, how much will house prices actually fall by? Nobody really knows, we’ll just have to see what happens. Mortgage rates are coming down, I’ve just checked the latest deals, and with a 20% deposit you can get a 3-year discounted rate of 3.29% with Loughborough B Soc. Or a 4.53% 5-year fixed rate, with Yorkshire B. Soc. These are well down on the recent spike up in mortgage rates. I spoke to an estate agent last week, who told me that buyers are holding off, and waiting until Feb/Mar, to see where mortgage rates settle. So it seems to me that this could just be a temporary phenomenon, but we don’t know for sure either way. Other opinions are equally valid, because we’re all guessing.

Profit forecasts for housebuilders have dropped a lot already, as have share prices. They’re underpinned by bulletproof balance sheets too, with net cash. Barratt has already bounced +40% from its recent low of 325p, and is now 455p. But it’s now trading at par with NTAV, so is hardly over-priced. It all depends what the future holds. I’m inclined to sit tight with my personal position in MJ GLEESON (LON:GLE)

Johnson Service (LON:JSG) (102p - mkt cap £447m) - update for FY 12/2022 last week reassures, with performance in line with expectations. Net bank debt modest at £14m. Share buyback ongoing. Energy - almost two thirds of usage for 2023 is now fixed in price (don’t know at what level). Cost inflation a “challenge” but actions taken to mitigate it. Nothing said about outlook for 2023.

My opinion - profitability looks to have recovered back to pre-covid levels, but EPS less so - since the share count has risen from 372m in 2019, to 439m now, 18% more shares to spread earnings over. PER is about 14, which looks about right to me. Forecasts for 2023 have come down a fair bit, now at 7.1p EPS. Bulls must be hopeful that it’s going to beat expectations in 2023 and beyond, because on current earnings forecasts the valuation doesn’t excite me.

Creo Medical (LON:CREO) (23p - mkt cap £41m) - this looks extremely high risk. It’s burned through a lot of cash, and is now running out. Cash was £26m at June 2022, now down to only £13m, implying it’s going to need a fresh fundraise in H1 2023 - good luck with that, as the market seems to have little appetite to pour fresh money into jam tomorrow companies right now. I’d steer well clear of this, no matter how exciting the story is, it’s uninvestable until a refinancing has been done - not just a top-up either, but a proper refinancing to take it through to profitability. Although it does say the heavy development spend & launch phase is “coming to an end”. Company confirms it needs more cash -

“the Board is considering a number of options to ensure that the Group is sufficiently funded to meet its stated growth ambitions.”