Small Cap Value Report (Mon 7 Feb 2022) - LOK, K3C

7th Feb '22 by Paul Scott

44 comments 10609 reads

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

If you'd like to catch up on last week's news, we recorded another podcast last Friday - it's only 20 minutes long so do give it a listen.

In other news, there's a bumper Mello event tonight with presentations from the likes of Centralnic (LON:CNIC) , Rbg Holdings (LON:RBGP) , and Belvoir (LON:BLV) . David's got more details in his post here.

Agenda -

Jack's section

Lok'n Store (LON:LOK) - good results, H1 revenue up 34.1% (driven by price and occupancy increases). 12-strong new store pipeline with plenty of opportunities beyond that. It’s smaller than some of its peers and so could offer superior growth. There have been repeated forecast EPS upgrades here, but the stock continues to look pricey, so you’d need to get comfortable with a c30x forecast PER.

K3 Capital (LON:K3C) - in line update, with record revenue and profits across all three divisions. Profit is strongly up, but big differences in adjusted and non-adjusted results by way of remuneration and amortisation of intangibles. Cash from operations is down, too, and the balance sheet carries a lot of intangibles now, so there are a couple of avenues to investigate, but the operational performance is strong.

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.

Jack’s section

Lok'n Store (LON:LOK)

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dhannaway58156

7th Feb '22

That's an interesting question. I'd value a freehold based on land plus how much it would cost to replace it.

I can't say much for land but construction costs have gone parabolic over the last year hence new buildings of all types are much more expensive or cut back to the bare bones.

Without knowing anything about their assets I would imagine that any re-rating would be justified to some extent.

I look for example at house prices which blew up about 23% in my local area last year. Is this justified? Yes because it costs that much more to build them. Will it be next year? I'm not sure but I do know that those who bought at the top will be very reluctant to sell them for less than they paid. The other thing is that new houses and houses in general are scarce so I'd imagine these prices could be stickier than some may think. Even if say rebar/ concrete do revert to prepandemic levels say.

Epsilon

"Do you think that such steep recent revaluations of assets, by c36% in one year, presumably industrial buildings, can be justified?"

The size of the revaluations in part reflects the conservative nature of accounting at Lok'n Store (LON:LOK) . New sites are initially valued at cost & later subject to independent (re)valuation. As rmillearee points out, a subsequent open market sale at a 22% premium to a 2021 valuation suggests that the independent valuation is also conservative.

ridavies

On a relatively quiet day, I picked up o the appointment of a new CEO at Taylor Wimpey (LON:TW.) (I hold). The Governor of the Bank of England rather clumsily put out a statement explaining a simple economic truth, that if the majority of the British workforce chase inflation in pay demands, then this will mean a longer period for inflation to come back into control AND is likely to cause a rise in unemployment. He was not surprisingly slammed since he is paid something over £600k plus pension emoluments, and this was related to how many times this was related to the median income,

I looked at the remuneration package for the new CEO of Taylor Wimpey (LON:TW.) and related that to the Governor of the Bank of England, a position with far more responsibility and effect on the British economy than the CEO of just another British house builder. Her package is HUGE.
Jennie's remuneration package comprises a salary of £750,00; Pension in line with the rate applying to the majority of the workforce, of 10% of salary
Then there is a bonus opportunity of 150% of salary (earned in respect of FY22) and on top of that a Performance Share Plan (PSP) award for 2022 of 200% of salary, (subject
to the same performance conditions as applied to the 2022 PSP award for the
Group Finance Director - SO WHAT?)

'Full details will be set out in the Directors' Remuneration Report in the 2021
Annual Report and Accounts.' So its fully transparent, and that makes everything all right, does it?

Why all the 'incentives'? Can the CEO have that much effect on the company's performance that her ADDITIONAL performance is rewarded to the tune of 350%???

What part of her working week and her performance is her SALARY related to?

I remain staggered by the way in which the chiefs of British (and other) industries reward themselves, and are supported by Remuneration Committees of appointed Independent Directors and the big shareholders (who by the way are managing our money invested through them). The Persimmon CEO bonus fiasco where effectively his bonus was magnified by a chance Government First Time Buyer support package was the worst in recent years, but is clearly far from the only one. They keep on coming.

It really does make me sick.

Robert W

K3 Capital (LON:K3C) Can anyone point me to a definition of "deemed remuneration" - I am trying to understand if the adjustments are reasonable.

Harry Hindsight

One also wonders how much time spend in the mud, wind, rain, COLD, cement, scaffolds, trenches, portaloo, site cafe or separately dealing with complaints from shoddy workmanship in customer 'care' departments.

mojomogoz

They covered in their last IMC presentation so if you listen to when CFO presents you will get explanation (I need to go back and brush up myself). It relates to the earnouts they have for acquired businesses so its a form contingent liability recognition. They were advised of the need to recognise it as a remuneration expense within admin expense rather than an acquisition exceptional (if I recall correctly)...and overall that deflates operating earnings and creates a bit of reporting complexity through balance sheet and cash flow. This is my on the hoof explanation which I wouldn't rely on as needs checked

Doug2b

I think the fact it exists suggests its a given that it CAN be justified.

This is certainly not my approach.

Since 2014, retained profits are relatively small and yet the tangible asset line, which will mostly be the storage sites, has increased massively by about 5 fold. That is a big increase in 7 to 8 years, some new sites will have been opened, but the turnover increase is about 50% during that time, allow for that and the revaluation is nearer around 3x to 3.5x for the equivalent property space.

Can't go much further with this but those numbers do not add up, the revaluations look excessive to me. In my experience, revaluations are a highly oppotunistic area of the accounts. Without these revaluations, the net tangible equity of the business would be falling, which would put off a lot of investors.

Effortless Cool

Interesting. Digging a bit deeper, it seems that RBC Capital Markets also initiated coverage of Water Intelligence (LON:WATR) ahead of the last fund-raising. I can't access it, however, and I also can't find anything to indicate that it has been updated since September last year.

Thus, it is likely I was unfair in calling the Stockopedia consensus figures wrong, they just likely include RBC CM forecasts that are lower than those of the other two brokers and, probably, out of date. I note that Stockopedia say that there are three brokers contributing to their consensus.

RBC CM must be the source of the 2023 figures then, so your 2023 estimate on Sharepad is based on one broker, not three, and likely out of date.

Just shows how important it is to validate data for these small caps.

I'm updating my model to incorporate today's trading update and will post my projections on the Water Intelligence (LON:WATR) thread in due course. I have consistently been more accurate than the brokers in the past.

rmillaree

I think my point was that the fact it exists simply means that accounting rules allow it- it was really meant as a tongue in cheek response.

It does strike me as being a fairly simple business model they buy land earn a bit and can sell on that land later - I guess over time they have massively benefited from the fact that their services are more desirable than they used to be and that probably help the revaluations. Must admit I don’t know how the uplift has arisen without doing further research - not sure if they have benefited from any planning permissions I know that can sometimes be a game changer ref land values.

BnB

I follow your reasoning and appreciate your work on this. But whatever the forecasts, we still have to address the obstinately high valuation at a time of faltering (to say the least) enthusiasm for longer duration assets. I’ll look out for your thoughts on the dedicated thread - which was a great piece of work that I wish I had been aware of when you originally posted it. Thanks again

GrahamF

Yes. Funny (not) how the remuneration committees of these companies seem to think that the top executives need to be incentivised to this massive degree on top of their already huge salaries but the rest of the staff don’t also need such lucrative schemes.

What I am saying is I don’t believe it, the asset values are very unlikely to have gone up by the amount stated in the accounts.

8th Feb '22

Some things are true whether you believe them or not Doug2b.

Lok'n Store (LON:LOK) is effectively a quasi property company. And property companies make both profits through the P/L and capital gains through the B/S.

Lok'n Store (LON:LOK) has two quoted competitors: Safestore Holdings (LON:SAFE) and Big Yellow (LON:BYG) .

Using data from Morningstar, here's the four year comparison:

Lok'n Store (LON:LOK) has achieved he fastest profit growth, maybe not surprising given it is the smallest of the three companies.

As for Total Equity growth, the numbers are similar - the experience of Lok'n Store (LON:LOK) is not unique,

Thank you.

Adrian Dayman

Anyone explain what this chart and the two blue lines means? thanks.

TheHitman

We're currently in Feb (far right of bottom axis), showing the FY22 (dark blue) and FY23 (light blue) earnings per share forecasts from brokers. The graph shows how the EPS broker forecasts for FY22 and FY23 have moved over the past 12 months. In this case, for both years, they have been rising, e.g. in Jan-22 the EPS for FY23 was 32p and in Feb-22 the forecasts have been increased to around 36p. Hope that makes sense?

jonno

13th Feb '22

Evening Mojomogoz

I have just listened to the IMC presentation as I have only just got back to the UK and the internet was largely unavailable during my travels. I have a reasonable holding in £K3C. The company is growing quickly, in part by acquisition, which is part of its stated strategy. This tends to make the accounts more complex. it is therefore not always easy to get a handle on the numbers.

A concern for me is how the company will fund future acquisitions. As a general rule I am not in favour of the over issuance of equity. Hopefully K3 Capital (LON:K3C) will therefore use debt and cash flow, although much will depend on the size and attractiveness of any potential targets. I was a little surprised that this subject was not raised with John Rigby in the Q and A.

As you appear to be one of the more knowledgeable members of the Stockopedia community on the company, do you have any thoughts or concerns?

Notwithstanding the above John Rigby, CEO and Anthony Ford, Vice Chairman and founder of the company hold 18% or so of the shares, which is reassuring.

All the best

14th Feb '22

Hello jonno, I was going to write up something on K3 Capital (LON:K3C) but not got round to it so a quick view:

I view K3C to be under appreciated in terms of model and management and priced like a typically somewhat cyclical services business rather than as an innovative growth platform. I believe there’s a long runway to growth and that K3C has a potential ‘category killer’ model for many professional services areas. There is upside in both growth and rating.

Clearly they seem to have been very successful with both acquisition and organic growth - tick! However...

...they have acquired quickly and there are hints of a little indigestion as in restructuring division they've invested significantly in expectation of an uptick in business and in tax there has been a slowdown in growth of randd acquisition as a result of HMRC change to checking regime and covid linked workflow hiatus. I don't see either as problem or indicative of structural problem but it does mean revenue growth is lower than could be (still good) and, importantly, short term cash flow from operations is lower. And that feeds into the acquisition question...

...they are definitely going to acquire more. There presentation suggests they will acquire £5m of ebitda this calendar year. The cost of that depends on how they do it and whether its accumulating some small bolt ons into current divisions or a bigger bite added to one of current divisions or a new division altogether. Rolling up a few small pieces is likely less pull on cash flows, whereas a bigger bite particularly if imminent is a bigger draw on cash.

I don't know which way they are going. The way I heard it is that they have some small bolt ons imminent but they haven't found the bigger piece yet...but tbc that's entirely speculation by me and maybe the price is down recently as they're out doing a book build and that sort of info leaks out among bigger players.

Looking at Quantuma acquisition that was c.£4.5m ebitda acquired at c.£20m cash and c.£6m equity vendor placing (roughly from memory) with further earn out over following 3 years. Take those numbers as a base - can K3C afford it now without raising excess equity beyond the vendor placing element? Yes they can. They've got £9m cash and £3m dividend going out, so net £6m. Then they have £15 credit llne. Throw in that there should be some unwind/normalisation of working capital build up too and that this is a very cash generative business on a normal running basis and they can afford to buy their £5m ebitda (which I don't doubt will be accretive to earnings).

But, how much will and should they stretch the balance sheet?

I need to look in more detail. Add up the cash flows that will be associated with the earn outs too. If they acquire a £5m ebitda business now they they will raise equity finance imo. I'd hope they wouldn't do the whole c.£20m cash component and display some ability to use retained cash and/or debt. Note so far they have raised the full cash amount.

IMO the option with K3C is between good and excellent value. They are the latter if they show conservatism in terms of equity raise. The high dividend payment is a negative IMO

My guess is they will beat current fy22 revenue target by £5m and maybe a decent chunk more depending how restructuring and tax claims pick up. My guess is that M&A makes up at least half that £5m and that is good margin so down to bottom line too. There's scope for higher beat.

I have given my feedback to K3C's broker and plan to get in touch with company once I've looked a bit more closely if I have questions.

I have bought in the pull back, as I had before the results. I see somewhere between decent and very good upside. I'm hoping for excellent and long term hold.

(Got to go now and will add more if I've missed it)

15th Feb '22

Many thanks for your analysis Mojomogoz.

I like K3 Capital (LON:K3C), but hope that John Rigby and his team demonstrate patience and prudence in their acquisition strategy and don't over gear the balance sheet. I have added a small amount to my existing holding as I have done selectively with other shares in my portfolio, during the current turmoil in UK small caps.

As mentioned previously management hold a good percentage of the equity and have more to lose than most, if they execute poorly. This provides some comfort but of course is no guarantee

I would be interested to learn of any feedback from the company in due course if you are in a position to share.

In the meantime keep well.

Clarification:

Revenue has clearly grown, I mean profit has stumbled a bit relative to trajectory that could be hoped for out of randd and Quantuma based on a simple extrapolation. Revenue growth from randd stalled and that comes with slice of high profit forgone and Quantuma had profit suppressed due to investment ahead of expected growth.

My negative re dividends is that such a high guaranteed payout could be construed as a form of disinvestment by management...and it doesn't make sense to me that capital is raised for an acquisition strategy whilst dividends are paid! This is partly big insiders liking their dividend bonus no doubt and the UK obsession with dividends...K3C say its driven by the latter (longstanding dividend investors who are holders), but I think there's a significant element of insider cash out too.

I'd be happier if K3C held all cash for acquisition. That said, the UK market doesn't reward this sort of strategy in the shorter term though longer term the compounding will be higher by doing so and ultimately the value of shares higher.

Small Cap Value Report (Mon 7 Feb 2022) - LOK, K3C

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