Small Cap Value Report (Mon 28 June 2021) - NAPS, COG, LOOK, ESC, CPC

Morning, its Paul and Jack here with today’s SCVR.

Agenda

Paul:

Cambridge Cognition Holdings (LON:COG) - new contract win for cognitive testing group, with Finn Cap raising its price target to 175p.

Lookers (LON:LOOK) - strong current trading as with other car dealers, but delay to audited results is a concern.

City Pub (LON:CPC) - looks to be a well managed pubco with lots of freehold assets. As with others covered today though, dilution limits potential upside.

Jack:

Napster (LON:NAPS) - heavily loss-making MelodyVR changes its name to Napster (acquired in December 2020) but doesn't yet give any financial data on the Napster business. This plus track record of heavy losses and equity dilution makes it an extremely risky and speculative investment.

Escape Hunt (LON:ESC) - encouraging post-lockdown trading momentum with organic growth opportunities. Shareholders have been heavily diluted here in the past, though.

Disclaimer -

A friendly reminder that we don’t recommend any stocks. We aim to cover notable trading updates & results 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, and market caps up to about £700m. We avoid the smallest, blue sky type companies, and a few specialist sectors (e.g. resources, pharma/biotech).

A central assumption is that readers then DYOR (do your own research) and discuss in the comments below. The comments, incidentally, sometimes add just as much value as the articles. We welcome all rational views, whether bull or bear!

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Paul’s Section

Cambridge Cognition Holdings (LON:COG)

(I hold)

144p (up 7%, at 08:05) - mkt cap £46m

New £2.2m contract

I only mention contract wins if they’re significant financially. Often companies trot out contract win announcements to ramp the share price, and conveniently forget to mention that they have no material impact on forecasts because they were already baked in.

COG has had clever technology & an extensive track record in cognitive testing for a long time, but it never seemed to establish a consistent growth track record, with too many contracts turning out to be one-offs.

It seems to me that, in the last year, things have significantly improved, which is why I’m taking a close interest in the company. What’s changed?

• The newish CEO, Matthew Stork, is much more commercially focused than his predecessors, and is delivering good results now.
• The order book shot up last year, meaning that revenues for 2021 were largely underpinned with signed contracts, not just hope.
• More contract wins are being announced at a decent clip, with each one the forecasts become easier to beat.
• Breakeven achieved in Q4 2020, and with the large order book, should now be profitable in 2021 and in future.
• The pandemic has triggered an industry shift in the right direction for COG - pushing pharmaceutical companies towards doing clinical trials virtually, using COG’s software, as opposed to being done in person.

As you can see from the chart below, this progress has already been rewarded with a strong share price rise. Although the market cap is still only £46m, which strikes me as quite modest for a company with proven, high margin services, that are taking off (as evidenced by all the new contract wins).

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Contract win today - it’s described as a “large, at home cognitive testing contract…” for a “virtual clinical trial”. It seems such an obvious improvement to do clinical trials through software, with patients being asked to perform tests at home, through a smartphone or iPad. This new trend plays right into COG’s strengths. There’s not much competition either, because the know-how has been accumulated over many years. COG works with the big name pharmaceutical companies, who stick with what works - so repeat business is rolling in.

There’s a lot I like about this business model - e.g. high margins, barriers to entry, repeat business with major clients.

Today’s contract details -

£2.2m revenue (for context, revenue in FY 12/2020 was £6.7m)

Spread over 3 years, starting in H2 of this year

In the “growing field of virtual clinical trials”

Broker update - many thanks for Finncap for a brief update today.

Forecasts remain unchanged, but it notes that 2021 forecast revenues are now in the bag, and there’s scope for upgrades.

I’m not sure why the broker is being so cautious, when there seems obvious scope to upgrade now. I’m not sure why analysts are being so timid at the moment, often leaving unrealistically low forecasts standing, despite positive newsflow. Finncap does however raise its target price to 175p. Personally I’m hoping for a lot more than that, but am taking a long-term view.

My opinion - in bull markets, speculative small caps often reach astonishingly high valuations, before ultimately crashing back down to reality. My memoires of 1998-2000 are still quite vivid, with many similarities in today’s market (especially in USA) with pockets of speculative frenzy very clear.

Given that market backdrop, I don’t see £46m as a stretched valuation at all for COG. If these contracts keep rolling in, then an operationally geared profit upside could be highly significant. Obviously that’s dependent on more contracts being won, which can’t be guaranteed.

Given the positive fundamentals & newsflow, I reckon this share continues to look attractive, which is why I hold it personally, and have increased my position size this year.

Expect further broker upgrades later this year.

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Lookers (LON:LOOK)

Delay to audited accounts

The way this announcement is worded, it sounds pretty harmless. Although Lookers has a poor history when it comes to accounting problems, which makes me wary -

Procedures in relation to the Group's 2020 Annual Report & Accounts are almost complete and we are not aware of any material issues. However, the Board and the Group's new auditors, BDO LLP, require slightly more time to conclude the audit process.

If you’re going to delay publication of the accounts (which sometimes spooks investors), then combining it with a strong trading update is a smart move!

Trading Update -

Full year 2021 outlook significantly ahead of current expectations

Lookers plc, one of the leading UK motor retail and aftersales service groups, today provides an update for the current financial year to date, reporting strong momentum in trading and a significant upgrade to its full year 2021 expectations*.

*Management compiled analyst consensus for underlying profit before tax for the full year ended 31 December 2021 is currently circa £40m.

Many thanks for the footnote. It’s handy when EPS is mentioned too, as that saves time in working out the valuation, but never mind.

Key points from the commentary today -

• Strong trading has continued into May & June 2021
• Robust customer demand
• “Ongoing out-performance of the UK retail new car market”
• Used car margins strong
• Self-help initiatives & omni-channel offering are good
• H2 outlook - uncertainty re covid, and supply restrictions - tightening in recent weeks
• Strong H1 should mean FY 12/2021 will be “significantly ahead of current expectations”
• Net cash of £18m

My opinion - we’ve heard from both Vertu Motors (LON:VTU) (I hold) and Marshall Motor Holdings (LON:MMH) recently, that business is booming. LOOK says very similar things today. All 3 have also flagged H2 uncertainty, particularly supply restrictions (a knock-on effect of the global shortage of semiconductors).

I was worried about renewal of the bank facilities, but since it’s moved into net cash, that doesn’t sound like it should cause too many problems.

Personally, I try to avoid shares where there have been accounting irregularities of any kind. We can buy dirt-cheap car dealers that are able to correctly do the books (and on time). So why take the unnecessary risk of buying a share with those additional problems?

I suppose there is an argument that buying beaten down stocks which should recover, can be lucrative (but risky).

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City Pub (LON:CPC)

128.5p (up 1% at 09:57) - mkt cap £134m

AGM Trading Update

This is a mostly freehold property based pubs group.

Business since re-opening is described as “encouraging”, at 10% down on 2019 comparatives. Not bad considering there have been social distancing measures in place, due to be removed on 19 July.

Cost base reduced.

Trading profitably at current level.

Social distancing & lack of large bookings have been a headwind (e.g. people reluctant to watch football at the pubs under social distancing rules)

Outlook - positive once restrictions removed in July. Assuming of course that they don’t bring back restrictions yet again in the autumn.

My opinion - it looks as if there’s been a significant increase in the share count. Checking back, CPC raised £22m by issuing 44m new shares at the start of the pandemic, in March 2020, at just 50p per share. This resulted in the share count rising from 59.7m to 103.8m, which is quite a lot of dilution. That’s a big headwind for the share price now, at 128.5p, because future profits have to be spread over so many more shares.

It’s nice buying a pubco that owns the freeholds for most of its sites, with not much bank debt funding it. That’s a far more secure base than having leases, where you have little control over where the rent is set - hence open-ended potential liabilities, and less secure tenure.

CPC is also selectively expanding, and has 4 development sites.

Looking at the chart, and taking into account the increased share count, I’m struggling to see where the upside is going to come from?

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Jack’s section

Napster (LON:NAPS)

Share price: 1.86p (-0.38%)

Shares in issue: 2,760,945,548

Market cap: £51.4m

Napster (LON:NAPS) used to be a really big name in the US software scene a couple of decades ago, a pioneer in MP3 music files and with 80m registered users at one point. Let’s be clear: the current incarnation is a far cry from those days.

In truth, what we are dealing with here is not the renegade, revolutionary digital download pioneer but the residual strength of its brand post-liquidiation. Napster was hugely influential - in fact you can argue that it paved the way for the likes of Spotify, which used the P2P architecture in its earliest days of building its streaming service.

But here we find Napster listed on AIM and with a StockRank of zero.

Here’s a brief catch up on what’s happened.

• Napster was founded in 1999 by Shawn Fanning and Sean Parker as a peer-to-peer file sharing service emphasising digital audio MP3 files,
• It proved hugely popular but soon ran into copyright infringement issues and ceased operations before being acquired by Roxio, where it became an online music store,
• It merged with Rhapsody from Best Buy on December 1, 2011, valuing it at $121m,
• In 2020, MelodyVR (creates immersive live music experiences that you watch through VR headsets or phones) acquired Rhapsody for $70m in a cash and share reverse takeover.

MelodyVR said at the time of the reverse takeover:

MelodyVR’s acquisition of Napster will result in the development of the first ever music entertainment platform which combines immersive visual content and music streaming… For music fans today, live and recorded music are intrinsically linked. We are as keen to see our favourite artists perform live as we are to listen to their albums. Our purchase of Napster, one of the music industry’s original disruptors, is born out of our wish to deliver the world’s foremost music experience, available seamlessly across audio and visual media and in turn presenting a truly next generation music service.

An interesting tale, but with Napster now so far removed from how it made its name, is this anything more than a stock market curio?

The rate of equity dilution here has been breathtaking, with a 5Y CAGR of 125% - at that rate, barring incredible growth, you can expect to get diluted into oblivion in short order. The chart below doesn’t capture the present shares in issue: now nearly double FY19 at 2.76bn.

And there are other clear risk signals. Weak F and Z scores, lack of cash generation, and growing net losses. So it’s extremely risky.

Full year results

Highlights:

• Revenue up from £195k to £987.7k,
• Gross loss widened from £1.6m to £4.6m, with cost of sales up from £1.8m to £5.6m,
• Operating loss up from £15.9m to £26m,
• Net loss after R&D tax credits up from £15m to £22.4m,
• Net cash outflow from operations of £28.26m and net cash outflow from investments of £1.22m.

If you’re hoping to actually look at the trading figures, you’ll have to scroll quite far down here. That’s rarely a good sign. In this instance, historical results probably don’t reflect the enlarged business post-Napster but there are still vitally important matters for investors to consider such as cash burn and balance sheet strength.

Given the group’s track record for dilution these should be prominently and clearly communicated at the top of the update, in my view.

With the reverse acquisition of Napster being completed on 29 December 2020, Napster felt it would be more appropriate to prepare these financial statements excluding the Napster business. That means the results solely reflect the activities of MelodyVR.

This gives us no visibility on the current trading profile of the enlarged group. Who knows, the acquired Napster business could also be heavily loss-making. The group must have done its due diligence on this acquisition and so presumably it would have been possible to present pro-forma results.

Napster says subscriber growth will be at its core - initially focussing on relationships with both existing and new telco partners including SingTel, Telefonica, NOS, and six others.

To date about £4.8m of annualised OPEX savings of c.£4.8m have been secured. Existing losses are significantly larger than that though.

Napster has a term loan from Davis Capital (representing its largest shareholder) and a convertible loan facility from Swiss Investment firm Nice & Green. In total, the group has c$40m of aggregate funding ‘to fund our operations over the near term as we work towards the launch of our new Napster platform’.

During the course of 2021 the group expects to invest some $27m (including internal resourcing) in the development of its cloud-based platform which is intended to launch during Q4 2021 across mobile, web and TV.

It will also launch a marketing and PR campaign to establish the new Napster brand identity and preview the new platform.

Conclusion

It seems like there is still a lot of heavy lifting required before Napster is anywhere near its final state and a sustainable business model looks to be some way off.

As a Board we are aware of the amount of capital we have had to invest in our technology and people over the last 5 years.

That’s the crux of the matter. Napster could be building something of value, but investors have had to have very deep pockets so far and this could remain the case.

For now, this looks the very definition of a story stock. There could be some good intrinsic value in the acquired business but we can’t say because MelodyVR has not published any relevant information.

The track record of shareholder dilution makes me wary of trying to catch an inflection point. If the idea does work, I’d much rather forego some of the upside and wait for concrete signs in the financial data that this strategy is sticking and no further dilution will be required.

Yes, the MelodyVR business has been busy over lockdown, but all this activity has led to revenue of less than £1m and a near-trebling in cost of sales to £4.6m.

The woeful track record so far and the fact that these results shine no light on the actual nature of the Napster of today that investors would be buying into makes these shares uninvestable for now, in my opinion.

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Escape Hunt (LON:ESC)

Share price: 39.3p (+0.77%)

Shares in issue: 88,620,091

Market cap: £35.8m

Speaking of extreme shareholder dilution, Escape Hunt (LON:ESC) is another case in point. Fair enough nobody could see Covid coming, but this company’s issues began before the pandemic with a delayed rollout and missed operational milestones.

Then came equity placings after a substantial decline in share price. Current shares in issue now stand at 88m, having IPOd with about 17m back in 2017. It continues to make me wary.

Trading sounds good on the face of it here though, so it’s entirely possible that the company is now hitting its stride.

Trading update

Highlights:

• Revenue +47% in the five-week period compared to the same period in FY19,
• Like-for-like revenue across its eight established UK owner-operated sites +87% (again, on FY19 not Covid-disrupted FY20),
• Five new owner-operated sites opened in the UK in the past 12 months, performance so far ‘extremely encouraging’,
• Work commenced at proposed site in the Lakeside shopping centre and imminent exchange of contracts at a site in Milton Keynes,
• Paris and Brussels own sites were only able to reopen in June, but Dubai is performing well,
• Franchise estate performing in line with board’s expectations. Australia strong but Europe more disrupted by the pandemic,
• Further progress has been made in the US with partner Proprietors Capital Holdings ('PCH'), although completion of master site in Houston has been delayed,

The company's UK owner-operated sites re-opened on 17 May 2021.

Escape Hunt says it is benefitting from initiatives implemented during 2020 to improve site level margins. This is good as cash burn has been a real issue in the past.

The group has also benefitted from the temporary reduced VAT rate which is expected to run until 30 September 2021. As a result, estimated EBITDA at site level for the five weeks to 20 June 2021 was 310% of the site level EBITDA in the same five weeks in 2019. On a like-for-like basis, site level EBITDA from the company's eight established sites was 189% of the equivalent site level EBITDA in 2019.

Conclusion

Cash burn has been an issue in the past here, with delays to the roll out proving costly. Those interested would want to check that more closely, given the degree of dilution so far. In FY20 the group spent a total of £3.5m in the year.

That’s exactly Escape Hunt’s reported cash balance at the end of May 2021. The cash balance at the end of May 2021 was £2.5m. In addition, the company has access to a £1m convertible loan note facility. This facility remains undrawn.

So if revenue continues to grow, newer sites do well, and the group manages its costs, perhaps it has enough cash on hand to meet that all important inflection point into break even. The improved cost management and site level profitability is food for thought.

But if there are any snags along the way then another placing is possible, although at the current share price that would be more tolerable. It does seem as though the trend is improving - which was always the plan - but probably a year or two behind schedule.

There is potential upside in its remote play and corporate initiatives, as well as scope to expand its international franchise network. The US has been delayed but this could prove in time to be a fruitful partnership.

The management tone sounds upbeat and the like-for-likes versus 2019 are strong. I do think there is a market for escape rooms and it sounds as if the company could be turning a corner with some good initial post-lockdown trading momentum.

The degree of unplanned equity dilution overseen by current management (a portion of which predates Covid) still makes me cautious, however.