Small Cap Value Report (Mon 7 Sept 2020) - SRC, UPGS, SLP, BLV, SPSY

A lot of the time, the findings that go into financial studies and the rest are actually based on quite short data sets in the grand scheme of things. Perhaps 200 years max of good data.

That means some of the investing truths we take for granted can rightly be called into question from time to time as conditions change.

One bit of news that caught my eye over the weekend was that Warren Buffett has apparently invested more than half a billion dollars into Barrick, one of the world’s largest gold miners, while selling down holdings in banks such as Wells Fargo, JP Morgan, and Goldman Sachs.

Here’s what Buffett (allegedly) said about gold in a speech at Harvard in 1998:

Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

It seems like that stance has changed slightly. Another quote that is tricky to attribute: ‘When the facts change, I change my mind - what do you do, sir?’

It reminds me of efficient versus adaptive markets. Efficient markets was an academic idea that implies it is impossible to ‘beat the market’ consistently on a risk-adjusted basis since market prices should only react to new information. Most subscribers will not recognise this description of the markets. EMH has had its day in the sun.

Adaptive markets is a more intuitive idea which acknowledges that unknown human variable, suggesting that conditions evolve as competition, adaptation and natural selection do their thing. Things change and some ‘fundamental’ financial truths actually have an expiry date. Think of how hard it can be to describe software and IT values using traditional price to book metrics, for example. The world has moved on from Benjamin Graham’s world of deep value.

It’s worth bearing in mind that one of Buffett’s first big investments, and Berkshire’s namesake, was an on-its-knees textile mill in 1962. The Omaha got in just as the world was changing and those old US textile mill economics no longer stacked up.

Thankfully he saw the writing on the wall and got into insurance instead and the rest is history. Decades later he would call Berkshire Hathaway the ‘dumbest’ stock he ever bought.

I won’t interpret Buffett’s move into gold - I’ll leave that to the man himself to explain in due course. There are probably already hundreds of articles online putting words into his mouth about it.

I just thought it was an interesting bit of news given last Friday’s preamble about potential changes in market dynamics. Once they are identified, they can run for months and years because the forces driving them are just so big.

Couple that with the long-held idea that the market can be slow to price in improving prospects, and you have some potentially lucrative themes to start investigating.

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Sigmaroc (LON:SRC)

Share price: 48p (pre-market open)

No. shares: 253.7m

Market cap: £121.8m

(I hold)

There’s a tsunami of RNS statements this morning. First up is Sigmaroc (LON:SRC) - I made an initial buy after doing some work on the company here. It’s a buy and build strategy in the construction sector, rolling up uniquely placed assets such as quarries and assembling them into local clusters (or ‘platforms’).

The theory goes that assembling assets previously neglected by larger global companies and pairing them up with complementary businesses should unlock further value. The management team seems experienced and has worked together before so I’m curious to see what can be achieved.

Interim results

Since the group is rapidly assembling new businesses that makes for a lot of adjustments and underlying figures in the accounts. It’s the nature of the beast right now unfortunately. Bear in mind, as well, that some particularly large and transformational acquisitions were made last year in the Benelux region, funded mostly through debt and equity.

Highlights:

• Underlying revenue +83% to £54.5m
• Underlying profit before tax +51.4% to £5.3m (non-underlying +126% to £3.5m)
• Underlying earnings per share +0.5% to 1.98p (non-underlying +54% to 1.17p)
• Cash and equivalents +380.5% to £17.3m
• Reduction in net leverage across the first six months of the year
• Option to acquire the remaining 60% of GD Harries exercised in August 2020, funded by SRC’s own cash reserves for £7.3m

These results are all stated before acquisition and reorganisation-related expenses. The difference between profit and EPS growth is a bit of a concern - if you fund acquisitions by issuing more shares, you need to make sure those acquisitions will be suitably EPS-enhancing. You can see the share count has been going up.

The last bullet point is significant though - GD Harries is one of Wales’s largest independent suppliers of aggregates operating out of six quarries. So that’s quite a significant asset now wholly owned by SRC.

Previously SRC had a 40% interest in GDH which was equity accounted. This means it provided minimal contribution to group results due to accounting standards but should now provide a meaningful contribution to the Group's results going forward.

Operating performance

Ronez (Jersey and Guernsey platform) - a strong start to the year before mixed fortunes post-lockdown, with Guernsey operations halted for a month but better fortunes in Jersey. ‘Near-normal’ trading was resumed by the end of June. The outlook for H2 is ‘promising’.

SigmaPPG was up 26% year-on-year in Q1. Sales fell in April but recovered in May and June.

Benelux - a similar pattern, with demand down in April but recovering in subsequent months. Sales for the 6 months to June 2020 were 10% higher than the six-month period to June 2019 - a good result. CdH is one of SRC’s biggest assets and there is promising growth potential here. Work can be done to get more favourable terms for aggregates production which presents and there is the potential to bring Bluestone to the UK market.

GDH faced some stronger challenges but remained largely operational.

Outlook

Trading for July and August saw ‘normal seasonal reductions in activity’ in SRC’s European operations. Aggregate demand for CDH is encouraging coming out of the summer holiday period as is the residential market order book for Bluestone. Visibility over Belgian commercial and public sector Bluestone demand is more limited and so demand patterns for the fourth quarter are more challenging to predict at this stage.

Ronez continues to see an encouraging rebound in Jersey, supported by a solid order book into Q4, but with a slower return of activity in Guernsey.

SigmaPPG performance remains strong with supply into a number of high-quality infrastructure projects.

The recovery in South Wales has continued with the order book now benefiting from some significant project work and the Group will look to begin implementing further efficiency initiatives in the business having acquired the outstanding 60% interest in GD Harries in August.

Here’s a key bit:

On the basis of no further significant impacts on the Group's markets as a result of the pandemic, the Board expects the recovery trends experienced through the third quarter to be maintained over the remainder of the year. As a result and with the benefit of the GD Harries acquisition, the Board expects 2020 financial performance to reflect further significant year on year progress which could be further accelerated by a continued recovery in end-market conditions in 2021.

Conclusion

The group sounds pretty optimistic about H2. Talk is cheap, but taking the team at its word, let’s assume that we have H1 underlying EPS of 1.83p and H2 underlying EPS of 2p. That would make for a FY20 PE ratio of 12.5x. I’m hoping 2p is conservative given the growth potential in SRC’s Benelux and South Wales assets - especially the latter now that SRC has 100% of GdH on its books.

I think that’s quite a modest valuation. The clear risks here are execution risk of a rapid acquisition and integration programme, as well as the correspondingly messy accounts. There’s not much you can expect management to do about the latter, but it can’t be ignored that there are a lot of adjustments and restructuring costs going on at SRC that are subjective in nature and have to be taken in good faith.

Given that the above results were achieved over lockdown I’m happy with this progress and feel like the share price is cheap. It's not clear to me right now just what level of EPS the group can turn in over the next six months but the longer term thesis is that management is assembling a profitable construction company of significant scale. There are a few moving parts though, so DYOR.

UP Global Sourcing (LON:UPGS)

Share price: 110p (+5%)

No. shares: 82.2m

Market cap: £86m

Up Global Sourcing Holdings (LON:UPGS) has been on the list for a while. Equity Development provides excellent coverage of this stock - I haven’t had the chance to read today’s report but you can find it here if you’re interested.

It’s an owner, manager, designer and developer of household appliance brands selling to over 300 retailers across 38 countries.

Some suggest there are few barriers to entry here, but you can’t fault the group’s recent operating track record and share price performance. I would imagine it’s a huge market for a sub-£100m company to expand into as well.

At the lockdown stock market nadir in March, UPGS shares hovered just above 30p. Today they are at 110p. That’s quite a turnaround.

What’s interesting is that even after trebling the group’s valuation metrics (and particularly the PEG ratio) are modest.

The group is proving impressively resilient thanks to its flexible, adaptive business model and canny management. I’m happy to see it passing the Tiny Titans screen, which identifies small cap momentum and has proven very successful in the past.

When Covid was restricted mainly to China, the UPGS share price was one of the first to be hit. The group’s operational resilience is to be commended and the market seems to be waking up to its continued strong execution.

There could be further to run here - the important thing to find out is the scale of the opportunity and to identify any possible barriers to entry in its business model.

Given its focus on providing mass-market goods to supermarkets, discounters, online channels, and international retailers, you’d have to think the addressable market is quite big. I imagine there’s plenty of scope for UPGS to grow from its current market cap of £86m if past performance is anything to go by.

A profitable, fast-growing enterprise with a rolling forecast PE ratio of just 11.8 - worth a closer look given the potential for both earnings growth and price multiple expansion.

Today’s trading update sounds like a slightly mixed bag but hopefully future years won’t involve global pandemics and entire economies locking down.

Trading update for the year to 31 July 2020

Highlights:

• Revenues down 6.1% to £115.7m
• UK and international online revenue up 47.2% to 14.5% of total sales (FY19: 9.2%)
• UPGS’ top two customers accounted for 26% of group revenue (FY19: 34.8%)
• Underlying PBT -2.7% to £8.2m
• Net bank debt down 73.7% to £3.8m due to dividend suspension and cash generation; dividend now reinstated
• FY21 order book ahead of this time last year

I would suggest these results are good given UPGS’s modest valuation and macro events this year. Perhaps though, after such a strong rerating rise that valuation of 11.8x is now fair?

Conclusion

Andy Gossage et al might well be quite a sharp retail outfit. What they are accomplishing at UPGS is no mean feat.

That said, it’s worth remembering that the group licenses rather than owns some of its biggest brands. This does introduce some risk but then again I wonder if this fact can get overstated as a negative sometimes.

Thinking about it some more, an 11.8x forecast rolling PE ratio with an attached PEG of just 0.6x does still represent good value to me. I wonder if perhaps UPGS is a higher quality and more resilient business than the market has previously given it credit for.

The group is very cash generative and boasts excellent returns on capital over the years - at what point do you admit there is a promising business here?

Online growth looks strong and there could be big potential here. In unlocking online, other businesses have reaped tremendous profits in recent years. One to take a closer look at, IMO.

Sylvania Platinum (LON:SLP)

Share price: 62p (-5.5%)

No. shares: 271.6mm

Market cap: £178.2m

(I hold)

A popular platinum, palladium, and rhodium miner with operations in the South African Bushveld complex here.

Sylvania Platinum (LON:SLP) is known for being cheap across conventional metrics. Today’s results look strong - but perhaps not as strong as brokers were anticipating, hence a c10% share price drop.

Part of the problem is probably the announced 1.6p dividend payment - considerably less than some were expecting. To this point, SLP makes an intriguing announcement about a possible ‘metal price windfall dividend’ to be expected in Q3 of FY21:

The Board is therefore considering the payment of a 'metal price windfall dividend'. This windfall dividend payment will be based on excess cashflow generated from palladium and rhodium prices achieved above long-term broker consensus prices for these metals for the 2020 calendar year. Actual production achieved, actual prices achieved and the actual ZAR exchange rate will all be taken into account as well as its share of royalties, corporate tax and dividend withholding tax.

I see a Liberum note calculating this payment could be as much as $10m.

This seems a strange way of managing investor expectations. It’s the first I’ve heard of it. Perhaps this possible windfall dividend could have been better flagged previously - presumably it’s something the board has been considering for a while.

That aside, It’s worth mentioning the share price has been very strong recently as well, so perhaps some profit taking is to be expected.

SLP has a very low cost base, extracting platinum group metals (PGMs) from chrome dumps rather than mining itself. It’s cost is $636/oz versus a basket price of $2,676/oz (based on spot prices).

It also has some exploration assets and, as noted, it’s very cheap:

There are some negatives as well though - namely ongoing operational disruption as a result of water and energy issues. Also, SLP’s fortunes are obviously tied to the spot price of the commodities it produces.

Annual financial report

There is also an investor presentation on the company’s site here.

Highlights:

• 69,026 PGM ounces produced for the year, 4% below the FY19 record of 72,090 ounces, with c10,000 ounces lost due to the impact of COVID-19. This means SLP was on course for another record year.
• Net revenue up 62% to $114.1m
• Net profit +125% to $41m
• Basic earnings per share +130% to 14.62 US cents - I make that about 11p and an FY20 PE ratio of 5.3x
• Net cash balance of $55.9m - about £42.2m of cash you can knock off the market cap
• A total of 14,937,795 shares repurchased in the year (c5.2% of FY19 weighted average shares in issue - a meaningful buyback programme)
• Cash dividend of 1.6p per share

Water constraints and power supply issues continue but progress is being made on these fronts.

Current depressed chrome market has led to production cuts at the host mine, hitting current arisings volumes at some operations ‘and this will continue into the foreseeable future’.

Exploration projects

There’s a $9.5m impairment charge on the Aurora exploration project.

This is because it’s no longer being linked to the Volspruit project, meaning economies of scale and infrastructure benefits are missed. Regarding Volspruit - a review of the previous feasibility study is ongoing, so we should expect an updated investment case here in due course.

The Grasvally project received a conditional cash offer in FY19 of ZAR115m (c£5.2m). This was thwarted by the chrome market downturn and other reasons, resulting in an option agreement with Forward Africa Mining to have 12 months to purchase the asset, so watch this space.

Conclusion

Comments on the depressed chrome market and subsequent production cuts should be investigated further. The Aurora exploration project is not ideal and I suspect the group’s strategy re. dividend payments could have been better communicated.

Beyond that, my impression is the PGM market is recovering along with other commodities and appears to be supported by favourable long term dynamics (such as demand for electric vehicles, which use PGMs). I'm long personally, but let's see. There are also a number of ongoing initiatives to bear in mind, all of them funded by SLP’s impressive free cash flow generation.

It is cheap and has navigated a tricky year with only a modest decrease in production and revenue despite being hit harder than most with shutdowns at its South Africa sites. Meanwhile, profit has shot up and it has a growing cash pile on the balance sheet.

SLP is generating pots of cash, buying back shares, investing in new projects, paying dividends, and has some asset optionality. The group has a profitable operational life of at least ten years, with scope to extend this. On the whole I think risk is to the upside but DYOR as always.

Belvoir (LON:BLV)

Share price: 157 (-0.3%)

No. shares: 35.1m

Market cap: £55.3m

So how’s the property and rental market? This is a big question as there’s a couple of interesting plays here.

On the one hand you have franchised real estate operations such as Belvoir (LON:BLV) ,TPFG , and WINK . All three are QARP plays, with sticky revenue, stable cash generation, and high returns on capital. They’re all quite small though, with BLV the largest at £55m.

And then you have the obvious high-yielding housebuilders - Persimmon et al. But also there are the much higher risk estate agents like Foxtons and Countrywide, which could be deep value recovery plays. High risk though.

It might pay to have a view on this market (even if that view ends up being to leave well alone).

We’ve got Belvoir’s first half results today.

Interim results

Highlights:

• Revenue +8% to £9.77m (2% organic, 6% from the acquisition of Lovelle network)
• Management Service Fees (MSF) -1% to £4.16m
• Financial Services revenue +7% to £4.25m
• Profit before tax +17% to £3.16m and basic EPS +16% to 7.3p
• COVID-19 impact on revenue ‘substantially mitigated’ by a reduction in operating expenses and government support
• Dividend reinstated with an interim divi of 3.4p (same as last year)
• An additional payment to shareholders to make up for suspended FY19 final dividend, with a further catch up payment expected later in the year

BLV has also entered into a ‘strategic alliance’ with The Nottingham Building Society, which will see The Nottingham hand over its estate agency and lettings activity to Belvoir.

These strike me as pretty resilient results and are testament to the strength of Belvoir’s franchise-led business model. Back in the middle of lockdown, with the property market totally frozen, who was expecting this type of turn out for a property franchise group? People forget quickly but it was a lot gloomier a couple of months ago.

Of course, there’s a valid argument that we’re not out of the woods yet but still BLV is to be congratulated on these results. Indeed, group CEO Dorian Gonsalves says:

Since our sector was 'unlocked' in May, both property sales and financial services activities have been at record-breaking levels for the Group in terms of instructions, sales agreed and written mortgages. These are expected to convert to sales fees and banked mortgage income during the remainder of the year.

… Given results are on track in H1, a promising start to H2, and a strong pipeline of agreed property sales and written mortgage business, the Board is confident of meeting management's pre-Covid expectations for the full year.

Conclusion

I’m more impressed by the business model as an investment proposition than I am enthused by UK house market prospects going forward. Every now and then I encounter a bad news piece about nasty landlords, etc. so possibly ethics might be a concern here? It’s all been quite anecdotal in my experience.

For now, I’m assuming that’s not an issue but perhaps others will disagree in the comments. What I can say with more certainty is that BLV’s performance during lockdown suggests you need to really throw the kitchen sink at these property franchise groups before you see an impact on profit.

The group is supported by sticky, recurring revenue and has a valuable layer between itself and the housing market in the form of its franchise network. Meanwhile the Financial Services division seems like a canny way to further monetize that network.

The first half of 2020 saw network lettings revenue basically the same as 2019. I think that signals business model strength and encouraging prospects assuming markets normalise. The group has observed ‘only a minimal increase in rent arrears’ and is expecting a ‘strong last quarter for sales fees and financial services income’.

It’s an impressive performance. Given the business model resilience and BLV’s quality characteristics, I think there could be longer term value here.

Spectra Systems (LON:SPSY)

Share price: 151 (+14.4%)

No. shares: 45.3m

Market cap: £62.3m

Spectra Systems (LON:SPSY) is a ‘leading provider of advanced technology solutions for banknote and product authentication’.

Interestingly, the group says that ‘discussions with central banks during H1 have reinforced our belief that worldwide demand for banknotes will be significantly higher this year than last year and that this will positively impact our earnings in H2 of this year.’

It’s a High Flyer with strong returns on capital. A closer look shows SPSY to be potentially attractive, with some niche tech that could have interesting applications and apparently strong demand from respected clients.

Interim results for the six months to 30 June

Highlights:

• Revenue +1.8% to $6.5m
• Adjusted earnings per share down from 4.8c to 4.6c
• Cash from operations +14.6% to $2.3m
• Special dividend +28.5% to 9c
• Net cash down slightly to $10.9m

These results at first seem sensible if unspectacular. Modest top line growth, EPS down but handily covered by cash, with a solid special dividend.

But hopefully there is a little more growth in store than what’s on show today. The company certainly sounds optimistic of its prospects and ‘expects to significantly exceed market expectations, in spite of the COVID-19 pandemic’.

So to me that sounds pretty exciting.

SPSY is busily executing a new central bank contract to enhance existing authentication sensors and has got continued research funding for future sensor technology development for a central bank.

In fact, reading through, there’s a lot of varied operational activity at this company - it’s quite impressive. I’ll just bullet point the rest:

• Strong sales of optical materials for K-cups - K-cups being those little containers of coffee that coffee machines puncture and then flow water through
• Launch of a new phosphor which outperforms and undercuts incumbents
• Covid-19 studies on Aeris banknote decontamination efficacy
• Four lottery contract renewals for the secure transactions group

All this activity suggests to me that SPSY has some valuable technical nous and can add value to multiple markets. The group seems to have a high quality roster of central bank clients, and that K-cup business could offer interesting growth potential.

Conclusion

The key takeaway is that the Company is on track to achieve record earnings for the full year and expects both revenue and earnings to significantly exceed market expectation.

This is definitely one to look at more closely - its security solutions clearly add value in a number of different areas, with many of these being potentially large markets. So the opportunity facing SPSY could be quite large. Perhaps there are further earnings surprises in store.

If the group expects to significantly exceed market expectations of 9.2p, let’s say 10p of earnings for FY20 (hopefully conservative). That would give a PE ratio of 15x. That’s very good for a high margin security company with top-tier customers and multiple promising growth prospects. We could see some quite handsome returns over the long term.

There’s a story at Spectra and I look forward to uncovering it in more detail at a later date. In the meantime there is a reassuring level of cash generation, net cash on the balance sheet, and a solid looking dividend yield.