Small Cap Value Report (Mon 27 April 2020) - Lockdown uncertainty, PCF, LOK, OTMP, STAF, QTX,

Morning!

I'm sure some of you are sick of talking about Covid/the lockdown, but unfortunately it is still the only major story and is unavoidable.

I'll try to keep this brief with a recap of the latest news:

• Boris Johnson sends a pro-lockdown message in a speech this morning
• Italy restarts manufacturing and construction from next Monday, with retail opening on May 18
• Some of the most draconian rules in Spain are relaxed
• Late last week, it emerged that 21% of New Yorkers have antibodies to the virus
• Wuhan in China reports zero new infections

I remain stunned by the economic and social damage which people are willing to tolerate in the name of combating the spread of the virus.

Boris Johnson says that he won't "throw away all the effort and sacrifice" made so far. Despite rumours last night, he provided no guidance in terms of when or how the lockdown might be ended.

As noted by Daniel Hannan, we are in a wartime mentality where prior costs will be justified by future costs.

The terrifying scale of the damage to the US economy was confirmed last week, with another 4.4 million Americans losing their jobs. That brings the total to 26.5 million since the lockdown policy began in most states.

The US unemployment rate (which will show up officially later) is now estimated to be over 20%. That's the highest level since 1934, the aftermath of the Great Depression.

For countries which persist with lockdown, I don't see why unemployment can't go to 30%, 40%, who knows? I expect it to exceed the Great Depression, unless lockdown ends soon.

The numbers in the UK and Ireland would already be the same or worse than the US, but for governments choosing to pay salaries to keep people officially employed.

In Ireland, for example, I think that around 48% of the total workforce is currently either unemployed, furloughed or getting temporary income support from the government, i.e. out of work for one reason or another.

Of the remaining workforce, I think that around a quarter of them are public sector workers.

To take my mind off things, and do something useful, I spent five hours yesterday turning the soil and removing rocks from the garden of my new house.

Quite appropriate really, given that the global economy is heading back to the Stone Age. Perhaps I'll be able to grow some vegetables?

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Markets - the FTSE is up 100 points today, at 5850.

I remain long the FTSE, because I still think that on a long-term view, equities are a better place to be than cash and most other asset classes. I expect oil, banks and pharma to perform ok from their current low levels.

However, I am also afraid that we will need to brace ourselves for Great Depression-style economics. By this I mean: many millions of unemployed, government finances out of control, printing presses at full steam, currencies in a race to the bottom. Hopefully the new Depression isn't followed by the same sort of thing which followed the last one.

I still expect lockdowns to gradually be lifted in Europe over the next month or two, but there is great uncertainty over the exact timing. Governments may persist with "social distancing" for some time to come.

There is a big question mark around the pace of future economic recovery. 

Last week, I posted on my Twitter a survey by CBS News, showing that a massive 71% of US respondents would not be comfortable going to a bar or restaurant, even if lockdown restrictions were lifted.

85% wouldn't want to get on an airplane, and 87% wouldn't want to go to a large event.

It's only one data point and may not be worth much on its own, but I do think we need to be very careful about travel and leisure stocks, and other companies using physical venues where people might be afraid (e.g. gyms).

To follow up on my recent airline commentary, I note that Richard Branson is desperately looking for new investors in Virgin Atlantic.

For the foreseeable future, travel and leisure stocks will need to battle against:

• the economic ruin which has taken away the disposable income for millions of unemployed
• the fear (whether rational or not) that some people will have of catching the virus in public venues, months or even years after lockdown
• new habits formed, e.g. working remotely, using a home gym, and drinking at home (hopefully not all at the same time)

There will be some winners from this crisis - e.g. some tech stocks - but mostly losers.

Tread carefully!

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Building a list of small-caps to look at today:

• PCF (LON:PCF)
• Lokn Store (LON:LOK)
• Onthemarket (LON:OTMP)
• Staffline (LON:STAF)
• Quartix Holdings (LON:QTX)

Finished at 4.30pm. Didn't cover TRAK or MIND.

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PCF (LON:PCF)

• Share price: 20.5p (-13%)
• No. of shares: 250 million
• Market cap: £51 million

Trading Update

This is an online-only challenger bank. I owned shares in it until January of this year, when I had a clear-out of my portfolio.

Without any physical locations, it has an easier time in the current work-from-home conditions.

Half-Year ending March 2020 - limited impact on the results from Covid-19, since the crisis started too late in the period.

Furlough - some staff are furloughed and get their salaries topped up to 100%.

Trading was in line with expections until Covid-19. The reasons I was attracted to PCF were playing out: very fast growth in the lending portfolio (it raced up to £400 million) and most of that being to high-quality borrowers.

Things then fell off a cliff in April:

New business originations were 26% down against target in March and with a limited pipeline, are trending to be 65% down on target in April. The broadcast, entertainment and transport sectors have seen the sharpest decline. Approximately 25% of our customers have made forbearance requests which represents 32% of our portfolio by value.

That 32% number is very scary. Maybe I have been complacent in my view of the safety of the banks in the FTSE Index?

No guidance is given for H2.

My view

Checking the last results statement, net assets were £59 million. It has paid a £1m dividend since then.

In prior circumstances, this balance sheet would be enough to withstand any conceivable shock.

Paul H in the comments (#14) puts forward an arbitrary guess as to how much of PCF's portfolio might ultimately turn into non-performing loans. His guess is 30% of these seeking forbearance, so around 10% of the entire £400 million portfolio.

Unfortunately, I don't feel able to even make a stab at guessing this.

The 25% of customers seeking forbearance, representing 32% of portfolio value, must include some high-value business customers. We can assume that companies don't ask for forbearance unless they are really struggling.

What would get them out of their struggle? An end to lockdown plus economic recovery. How likely is that to happen in the next few months - not very?

Segments

PCF owns Azule, a lender to the media/entertainment sector - not a great sector right now.

The core PCF business also lends heavily to the transport sector (buses and coaches), and many other types of commercial vehicle.

The used vehicle market is currently in the dumps, so I would say that the resale value of these vehicles is at risk of collapsing. If the current owners of buses and coaches can't make any money using these vehicles, why would somebody else want to buy them?

The financing of plant and machinery might do better, for those factories which haven't shut down or which will open again soon.

Conclusion

While I do rate very highly the management team at PCF, I feel relieved not to be a shareholder currently, as I am unable to quantify the hit which its balance sheet might be about to take.

Previous assumptions about credit quality are no longer valid. Such is the scale of the changes brought about by lockdown. PCF says the interim results will include "a revised outlook for impairment modelling".

If the lockdown ends soon, then we can expect most individual and business customers to gradually return to financial health, over some period of time.

But the longer that lockdown persists, the greater will be the number of customers who default or who simply cease trading - and the lower will be the value of their assets in liquidation.

For example, I can't rule out the possibility that 20% of PCF's portfolio goes bad, and only 50% of the value is recovered from those loans. This would wipe out most of PCF's balance sheet equity. 

I'm not saying that this is the most likely outcome, but I have to accept that there is some non-negligible probability of it happening.

The extent and duration of lockdown is the one critical input we need, to value this and many other stocks whose fortunes depend on the strength of the economy. Without that input, valuation is not currently possible.

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Lokn Store (LON:LOK)

• Share price: 575p (+7.5%)
• No. of shares: 29.6 million
• Market cap: £170 million

Interim Results

This self-storage company presents good results for FY January 2020, revenue +5.3% and adjusted EBITDA +6.4%.

Let's skip ahead to the section on Covid-19:

• customers include the NHS, GP surgeries, home support services, government departments
• other customers in storage, logistics and transport sectors are still operational (they are considered essential services by the government)
• customers still have access to storage during reduced opening hours, following social distancing guidelines

The business doesn't seem too badly hit yet:

We have seen some new business customers move in, but this has been modestly outweighed by some businesses directly affected by the closures choosing to move out.  We do expect trading to soften as move-ins have tailed off but this will only impact our numbers in the fourth quarter of our financial year.  

Occupancy is up and pricing is level. The general trend in self-storage is for both of these to increase - this is a highly successful part of the property market.

Cash is currently £14 million, and there were undrawn facilities of £32 million at the period-end, i.e. plenty of headroom.

The debt load appears manageable, with limited gearing, and the hit to income and growth from the crisis appears manageable. LTV is a low 17.2%, and interest cover is 7x.

Dividend - a great sign of confidence here. LOK is paying an increased interim dividend of 4p.

My view - it's doing absolutely fine, which is reflected in the share price.

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On the Market (OTMP)

New agent contract alongside welcome shares

This RNS pretty well encapsulates the main problem I've been highlighting at this share for a long time - the risk of ongoing heavy dilution, as it gifts shares to its customers.

The mentality of a "mutual" (being run for the benefit of its customers) lives on here:

• £1,000 value of new shares to each estate agent office that signs up, or £2,500 if they list exclusively for 12 months (this assume a £1 share price, which is not accurate).
• Listing is free until 1 September 2020, and future payments from agents (until mid-2022) will be receive compensation in the form of new shares
• Agents who don't list on both Zoopla and Rightmove (in which I have a long position) will also get discounted prices.

For example, a one-office sales and lettings firm in Whitley Bay, listing on a one other portal basis, will pay £314 per month. But, in addition to receiving £1,000 of welcome shares, it will also receive £94* of shares for every paying month up to 31 August 2022. 

My view

This strengthens my previous view that OTMP shareholders will be diluted to smithereens over time.

If estate agents wish to own a property portal, I invite them to buy shares in Rightmove (LON:RMV).

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Staffline (STAF)

• Share price: 30.69p (+7%)
• No. of shares: 69 million
• Market cap: £21 million

Company update

Lots of board changes at this blue-collar staffing group. There's a new Executive Chair and a new Chair of the Audit Committee.

Key points:

• Trading is negatively affected by the pandemic. Growth in food sector not enough to compensate for "the temporary shutdown of the majority of other clients".
• the trading and education business is impacted, too. Not quantified.

Financing:

The Board expects to agree and implement a revised financing structure in respect of its main banking facilities ahead of the publication of the Company's annual results for the year ended 31 December 2019 as good progress has been made.

Those annual results for 2019 are due to be published "during June 2020".

Outlook - no formal guidance, but both divisions are "cautiously optimistic about achieving a positive result on an underlying EBITA basis".

My view

I would be unwilling to touch this with a ten-foot barge pole.

Remember that Staffline had an accounting horror show not that long ago, and was fired as a client by PWC. I gave an overview of its problems in February.

2019 results won't be published until the last minute, in June, if we are lucky. An important red flag.

The current market cap might be cheap, but I cannot trust its numbers.

And the balance sheet is terrible. Net debt at year-end is uspposed to be around £50 - £55 million.

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Quartix (QTX)

• Share price: 270p (+7%)
• No. of shares: 48 million
• Market cap: £129 million

Trading Statement

This high-quality telematics company reports a likely 60% decline in new installations for the month of April.

Because of upfront costs with new installations that are expensed immediately, the lower number of installations paradoxically means that the result for H1 won't be too bad:

The Board therefore believes that the COVID-19 pandemic is unlikely to have a material impact on profit and cashflow in the first half of 2020, although there is likely to be some reduction in revenue compared to its previous expectations.

Net cash is £8.5 million - pretty good. That would pay nearly a year of historical operating expenses, without needing to borrow.

H2 2020/FY 2021 - no guidance. On the basis of scenario planning, it thinks "it is unlikely that it will need to draw upon the substantial cash reserves it has on the balance sheet (subject to the usual monthly fluctuations)".

My view - a classy company and on the basis of its track record, I'm inclined to trust that it will be ok this year and next year.

Growth will slow down in the short-term, so you have to decide if you're happy to pay an above-average earnings multiple. It's your typical High Flyer, showing excellent quality (95) and momentum (22), but less value (22).

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I've run out of steam for today, thanks as always for your interesting comments and feedback.

Paul will be with you tomorrow.

Cheers!

Graham