Small Cap Value Report (Mon 21 Mar 2022) - STEM, SPSY, BBB

Good morning, it's Paul & Jack here with Monday's SCVR.

Agenda -

Jack's section:

Sthree (LON:STEM) - strong Q1 trading and ongoing investment in headcount. Conditions are positive and that might not last forever, but there’s nothing in today’s update to seriously dent sentiment. In the meantime, STEM has a differentiated strategy, a good balance sheet, and opportunities to drive further growth.

Spectra Systems (LON:SPSY) - strong full year results and multiple growth opportunities going forward. Given the group’s increasing earnings per share and dividend payments over the years, I think the share price probably deserves to be higher. The shares are illiquid and neglected, so perhaps a more engaged investor relations function would help.

Bigblu Broadband (LON:BBB) - an interesting micro cap situation, but one with very poor share price liquidity and an ongoing lack of sustainable cash generation. The company has changed significantly over the past couple of years, so it could be that it’s now a different proposition but, given the lack of liquidity and poor track record over the past five years, I’d need to spend more time on it to really get comfortable with the outlook.

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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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Jack’s section

Sthree (LON:STEM)

Share price: 412.5p (pre-open)

Shares in issue: 133,632,112

Market cap: £551.2m

Q1 trading update for the three months to 28 February 2022

SThree is a global pure-play specialist staffing business focused on roles in Science, Technology, Engineering and Mathematics ('STEM').

Operationally, things have been going well, which you wouldn’t necessarily expect from looking at the share price chart.

This is a good company though, with a positive outlook and reasonable valuation, so it’s worth spending a bit of time on.

• Group net fees for the quarter up 29% year-on-year at constant currency,
• Strong YoY growth in all five core markets: Germany up 24%, USA up 27%, Netherlands up 45%, UK up 29% and Japan up 78%
• Momentum across key sectors: Technology up 30%, Life Sciences up 23% and Engineering up 31%
• Robust balance sheet, with £41m net cash as at 28 February 2022 (28 February 2021: £57m).

The year-on-year decrease in cash is driven by growth in the number of contractors and timing of performance bonuses. The headcount has increased by 2% since Q4 2021 and SThree aims to grow headcount by c. 10% in FY22E.

All geographies and sectors are performing well, with Contract and Permanent YoY net fees up 32% and 18% respectively. Contract now represents 77% of group net fees, up from 75%, and the contractor order book is up 42% YoY (Q4 2021: up 43% YoY).

SThree does say:

As expected, we have seen some normalisation of productivity as new hires come on board although it remains well above historic levels, with Q1 productivity up 19% YoY (FY 2021: up 31%).

It presumably takes time to get new hires up to speed.

Timo Lehne, Interim Chief Executive, commented:

The strong momentum of FY 2021 has continued into the first quarter of FY 2022, in line with the Board's expectations, with robust performances across all our core markets and sectors. In addition, the previously guided investment in our people, talent acquisition and infrastructure to drive long-term sustainable growth is progressing and will gather pace through 2022.

Conclusion

SThree has a strong balance sheet and continues to invest in line with its strategy of focusing on specific niches within sectors and markets where it can gain market share. Investment in talent acquisition remains a priority for the business, and trading is good.

Recruiters are generally doing well at the minute though, so for how long that lasts, and how well the company can lap tougher comps, are questions to consider. Maintaining the present growth rates will become progressively trickier.

But along with Robert Walters (LON:RWA) , SThree presents itself as one of the better picks in the sector and the recent share price drop suggests now could be a good time to take a closer look.

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Spectra Systems (LON:SPSY)

Share price: 147p (+5%)

Shares in issue: 45,320,439

Market cap: £66.6m

Results for the 12 months to 31 December 2021

The Spectra Systems share price remains something of an oddity, possibly reflecting a degree of uncertainty around this small cap. Its profitability figures are top drawer, and the group is expanding successfully while maintaining balance sheet strength and paying out a more than 5% dividend yield.

There’s a real lack of liquidity in the share price though, which might further put investors off. This also puts a slight question mark over the group’s decision to buy back 500,000 shares in the year. It’s more a positive than a negative of course, but managing the liquidity of the shares is also a valid concern for a listed enterprise.

For all the growth in earnings per share over the past few years, the actual share price performance must be frustrating for holders.

• Revenue +13% to $16.6m,
• Adjusted EBITDA +8% to $6.9m,
• Net income up slightly from $5.1m to $5.2m and adjusted earnings per share +1% to 12 cents,
• Cash from operations +45% to $8.1m.

The thing that jumps out here is the difference between revenue and net income growth. This is due to an increase in tax rate, from 5.6% to 14.8%. Operating profit (EBIT) increased by 10.9%.

Spectra is as busy as it has ever been. In the past year it has executed a contract with its central bank customer relating to the a sensor development program, which has expanded to include the capability to detect exotic counterfeit notes. The group’s agreement for the supply of banknote security materials with this customer has also been extended for another five years.

Our two-decade long relationship with a major world central bank continues to provide new revenues from the introduction of more advanced products. This central bank customer has invested US$8.8MM for the development of these new capabilities which are expected to result in sensor sales of approximately US$50MM from 2024-2026. In addition, we expect a ten-year service agreement worth over US$8MM to line up with the delivery of the first advanced sensors in 2024.

I believe that shareholders should view this spending by our long-standing customer as both a testament to our capabilities for producing cutting edge products, as well as the stability of banknote production by reserve central banks, where the "store of value" is as much a driver for banknote production as every day transactions.

It’s interesting to note that final sentence, given that the rise of cashless transactions is often seen as a big headwind for the business.

Spectra has also attracted a new customer for its materials in K-cups, ‘more than doubling the sales of this product over 2020 levels’. It has also obtained a new customer for its TruBrandTM product in addition to current tobacco related sales in China.

Banknotes - established a vertical integration of polymer banknote substrate manufacturing to produce ready for printing substrates, and commenced a polymer print trial with a Middle Eastern central bank.

The efficacy of the AerisTM banknote cleaning process for deactivating Covid has been validated, with third party testing results showing the deactivation of Covid to below detectable limits. Spectra has also patented its new Banknote Disinfection System and introduced the product to the market with one Asian central bank requesting a price quotation.

Additionally, the group has been selected by one of the largest US lotteries to provide internal control software, expanded this business into Canada with a new contract award, and renewed a long-term US lottery customer contract.

Outlook

The group notes several short and long-term opportunities, which I’ll just quote as there’s a lot. Short-term is expected in the 2022-2024 period and includes:

• Fulfillment of new, larger than typical pre-Covid-19 orders for covert materials to a long-standing central bank customer during 2022;
• Additional sensor development funding;
• Completion of the development of the new generation of sensors for a long-standing central bank customer with US$6.2MM of revenue still to be recognized through 2023;
• Increased sales of TruBrandTM related products to reach the level of several million dollars per annum in both tobacco and other opportunities such as tax stamps and government documents;
• Increase the K-cup business to the US$1MM per annum level and beyond;
• First sales of the newest patent pending phosphour product;
• Sale of its first banknote cleaning or decontamination system to central banks;
• Qualification with a central bank of our FusionTM machine-readable polymer substrate;
• Expansion of gaming software business in Canada and other non-USA customers; and
• Supply of quality control equipment to a central bank.

Long-term opportunities are expected in the 2024-2028 time frame and include:

• A supply agreement for its polymer substrate technology (FusionTM) with a major central bank; and
• Supply of upgraded sensors worth up to US$50MM to a central bank customer.

Conclusion

The curious case of Spectra Systems continues - multiple growth opportunities, a strong balance sheet, progress across all business lines, good returns to shareholders, and yet the share price either flatlines or falls. Perhaps the Spectra Systems management team needs to get out there to explain and de-mystify the company to investors.

There’s certainly a lot of different products, technologies, and business segments at play here, and that’s before we’ve even touched on the group’s more recent strategy of investing in early-stage businesses such as Solaris BioSciences (which looks to have made an increased loss this year).

That’s presently a small part of the whole though. Spectra’s core business is underpinned by its contracts with a major G7 central bank that have spanned two decades. That’s also perhaps a significant risk, should that partnership come to an end for some reason.

It’s worth investigating that possibility in more detail but the duration of the relationship so far is notable, and I continue to view the Spectra share price as slightly anomalous given the growth prospects and dividend track record.

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Bigblu Broadband (LON:BBB)

Share price: 50.5p (+5.21%)

Shares in issue: 58,365,678

Market cap: £29.5m

Final results for the year to 30 November 2021

This is a provider of alternative super-fast and ultra-fast broadband services throughout Australasia and the Nordics, which supports consumers and businesses unserved or underserved by fibre.

To provide some context, 2021 was an important year for the group due to the disposal of its majority interest in Quickline (the UK fixed wireless business) to Northleaf. The Disposal valued BBB's shareholding in Quickline at up to £48.6m, representing a return of up to 5.8x the cost of its investment over a three-year period.

The Group received £31.1 million in cash on completion, with up to a further £10.1 million payable as deferred contingent consideration that is subject to certain performance conditions being met by no later than 31 March 2022, or in certain circumstances, 31 May 2022.

So there could be another £10.1m of cash to come soon, if performance conditions are met. However:

As disclosed when the Disposal was announced, the deferred contingent consideration is dependent on achieving certain roll-out and subsidy milestones. Whilst progress is being made in scaling up the organisation in terms of people and systems, the continued global shortage of microchips affecting the supply of 5G radio equipment means that the milestones required to deliver the maximum amount due for the deferred contingent consideration are unlikely to be met in full, partially reducing the amount payable

The cash brought in from disposals has been used to completely pay down debt and return capital to shareholders.

The Board believes that BBB is firmly on the front foot with a strong balance sheet and remains focused on maximising and delivering shareholder value from each of the Company's remaining businesses; Australasian operations (Skymesh Pty Limited) based in Brisbane and the Nordics operations based in Oslo (Bigblu Norge AS) (the "Continuing Group").

Moving on to the key FY21 results, we have:

• Total revenue +15.8% to £27.1m and like-for-like revenue growth +15.3%,
• Adjusted EBITDA +11.1% to £4.6m,
• Adjusted profit after tax increased from £1.1m to £2.5m (with reported profit before tax of £27m including the disposal of Quickline),
• Adjusted earnings per share increased from 1.9p to 4.3p,
• Net cash down from £7.4m to £5.2m after full debt repayment of £8.4m and return of capital of £26.1m.

Total customers as at 30 November - 59k (FY20: 57k). Strong organic growth in customer numbers in Australia offset by continued pressure on customer numbers in the Nordics due to exceptional churn relating to the phased demounting of loss-making sites.

Australasia

SkyMesh is the leading Australian satellite broadband service provider, with 50k customers (up from 46k). Total revenues were £21.8m, with adjusted EBITDA of £4.0m.

Having been named Best Satellite NBNCo Provider in 2019, 2020 and again in 2021, SkyMesh continues to secure over 50% market share of net new satellite adds under the NBNCo scheme as demand continues to grow for the Sky Muster Plus product. SkyMesh is seeing growth in the business sector subsequent to the release of a new business focused product by NBNCo and this momentum will continue into 2022.

Partnerships or acquisitions are also being targeted. SkyMesh recently signed an agreement with Kacific to provide services into New Zealand and acquired assets and customers from Clear Networks after the period end.

Nordics

Bigblu Norge's infrastructure upgrade has been completed and unprofitable sites have been dismounted. A distribution agreement with Telenor has been entered to provide next generation ultrafast broadband via wireless 5G, although this is running six months behind due to equipment shortages.

This part of BBB used to deliver strong EBITDA and cash flows but has more recently faced high levels of customer churn due to increased fibre competition and low broadband speeds.

The challenges experienced in the Nordic region in the period saw a reduction in both revenue and adjusted EBITDA. Total revenue from the Nordics for the year ended 30 November 2021 was £4.6m and adjusted EBITDA was £1.9m.

Conclusion

BigBlu is changing shape fast and recent disposals have strengthened the balance sheet, while focusing operations on two potential growth markets. It could be a recipe for success, but I'm mindful of past losses.

The share price performance has been static over the past few years, obscuring the significant changes in capital profile and operating structure.

The Nordics business still needs fixing, but progress is being made. Investments and upgrades have improved technology, speeds, and throughput. Meanwhile, the customer base appears to have stabilised and provides ‘a good foundation for the launch of the next generation satellites over the next years’.

The Australasia segment seems to be in good shape. SkyMesh has a strong market position and is growing, there is expansion into New Zealand, and the acquisition of Clear Networks increases focus on the business market and expansion into the fixed wireless market.

It’s potentially a company of interest, and I do note the improving StockRank, but it’s also an illiquid micro cap with a history of losses and cash burn. It could do well from here, but I don’t want to get swept up in the management commentary without acknowledging the poor past performance and the fact that the company has so far struggled to generate cash.

This year sees a net cash outflow from operations of £1.6m with capex spend of just over £6m.