Small Cap Value Report (Monday 26th April 2021) - TSTL, LOK, MIND, STAF

Good morning, it's Jack and Paul here with the SCVR for Monday.

First item on the agenda is Mello - David Stredder and co. continue to offer an invaluable service to private investors with these events and you can catch Ed speaking tonight about the first quarter performance Stockopedia's Stock Picking Challenge 2021. Here's a link to the event so do check it out.

I've just had a quick look and my performance year-to-date is +15.9% - not bad, but the market has had a strong start. We have a mini competition in the office and the current leader is way out in front with 76.7% so plenty of work to do! There are some pretty chunky Q1 gains on the leaderboard.

Edit: Paul has just posted a fantastic progress update on his ZANE fundraising initiative in the comments below (see here). If this was a company I'm pretty sure it would be trading ahead of expectations so thank you to everybody that donated!

Paul:

Tristel (LON:TSTL) - 30% profit miss from this highly rated disinfectant products provider

Staffline (LON:STAF) - shares have nearly trebled over the past six months and trading momentum is encouraging, but significant balance sheet risks remain

Jack:

Lokn Store (LON:LOK) - good trading momentum and store pipeline from growing self-storage business in a resilient part of the market

Mind Gym (LON:MIND) - recovering trading momentum and revenue ahead of revised expectations (but still down year-on-year) at behavioural science specialist

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Paul's section

Tristel (LON:TSTL)

670p (pre market open) - mkt cap £315m

I last reported on Tristel here in Feb 2021, on publication of its interim results. It’s a nice little company, but the valuation was looking very stretched then, yet it’s gone up by another 10% since (like most other shares in this bull market). That was despite a wobbly outlook statement with the interim results.

Tristel has a 30 June 2021 year end, so today we’re getting a Q3 update.

Tristel plc (AIM: TSTL), the manufacturer of infection prevention and contamination control products utilising proprietary chlorine dioxide chemistry, provides the following trading update.

Profit warning - today we are given reduced guidance for FY 06/2021, of revenues c.£31m, and profit before tax of c.£5m.

Reason for profit warning - the pandemic has held back health services from their usual activities, which has reduced demand for Tristel’s medical devices disinfecting products. Growth in surface disinfecting has not compensated enough.

I remember when covid struck, Tristel was seen as a potential winner, since it makes disinfecting products, but that has not turned out to be correct.

Broker update - many thanks to Finncap for giving updated forecasts. We’re looking at EPS of 8.8p for FY 06/2021, a hefty reduction of 30% on previous forecast, quite a nasty miss.

Recovery is forecast for next year, rising to 10.5p.

Valuation - this share is now priced at a PER of 64 times, based on next year’s earnings, recovering by 19% compared with this year. That strikes me as a crazily high valuation.

What on earth is the share price doing anywhere near 670p? That valuation seems detached from reality to me. Halve it, and the share would still look quite pricey.

I suppose bulls must be looking through the current soft year, and pricing in a stronger than forecast recovery next year, and pricing in winning approvals & gaining new sales in USA. How does it make sense to pay up-front for all that, when there’s no certainty it will happen?

Outlook -

Looking out to next financial year, we expect demand conditions in the UK to improve significantly. However, in these uncertain times we believe that we must take a cautious approach. Whilst our global revenues continue to diversify away from the UK, our home market remains our largest exposure to one healthcare system….

We remain very confident that sales and profits growth will resume next year and the investments that we have made in people, systems and new market registrations will lay the foundation stones for strong growth in the years ahead.

My opinion - as you’ve probably gathered, I cannot understand why the share price of Tristel is so high. There’s more detail in the update today, but I’ve just focused on the key points. It’s a 30% profit miss, and the shares are very expensive. Hence a sharp correction looks overdue.

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Staffline (LON:STAF)

77p (up 11%, at 09:30) - mkt cap £53m

Here are my notes from the FY 12/2020 trading update from Staffline, published in Feb 2021. In a nutshell, the business is recovering gradually, but has an extremely weak balance sheet. It is being propped up with £42.9m VAT arrears (repayable in instalments from Mar 2021 to Mar 2022 - effectively a taxpayer loan), and has been open about the need for an equity placing to repair its balance sheet.

Despite this, the share price has tripled in the last 6 months. Strange though it may seem, in a roaring bull market like this, it’s often the riskiest shares that go up the most. There is a good argument for relaxing balance sheet standards in a bull market, but that’s up to each individual to decide. Personally I prefer to limit myself to good risk:reward situations, and accept that I might miss out on spectacular % gains on more risky punts. Each to their own!

Anyway, on to today’s update -

Trading update

Staffline, the recruitment and training group, is pleased to provide the following trading update for the year ended 31 December 2020 and the three months ended 31 March 2021.

It firms up on the numbers for FY 12/2020, which was a year obviously disrupted by the pandemic, financial problems due to its weak balance sheet, and cost-savings implemented in a restructuring.

In the year ended 31 December 2020, Staffline generated revenues of c. £928m1 (20192: restated £1,063m) delivering a c. 66% increase in underlying operating profit3 to c. £4.8m (2019: restated £2.9m) for continuing operations, which was ahead of expectations.

Note that most revenue is pass-through - i.e. the wages of the temporary workers that are supplied by Staffline to its clients. Hence it’s really a much smaller business than a near-£1bn revenues line suggests. Wafer thin profit margin too.

Refinancing - is pending. A significant equity fundraising is very necessary here, so expect significant dilution for existing shareholders. That introduces risk & uncertainty, and of course it also means an apparently cheap valuation now, may not turn out to be cheap after all, once the finances have been repaired with more equity.

The broker reckons c.£40m fundraising is likely. That won’t even turn the NTAV positive. I think c.£60m is needed if they want to properly repair the balance sheet. Quite big numbers for a £53m mkt cap company.

Although, given that the share price has been rising strongly, you could argue that this is becoming less of an issue - i.e. the higher price that the inevitable placing occurs at, then the less dilution there will be. Hence things do seem to be moving in the right direction.

As noted in the 1 February 2021 trading update, the Board continues to evaluate its options in relation to the Group's finances.

Current trading - sounds positive -

The Board is pleased to confirm that the momentum achieved in the second half of 2020 has continued into 2021, and the Group has made a strong start to the year.

As a result, both revenues and underlying operating profit are ahead of expectations with all three businesses ahead of budget, resulting in an underlying operating profit for the Group for the quarter.

Despite the hard national lockdown in the Republic of Ireland, Staffline Ireland also reported very positive momentum across the quarter.

Whilst that sounds good, the table underneath shows an u/l operating profit of only £1.4m for Q1. Although I imagine that should improve as 2021 progresses, with more sectors opening up.

Broker forecasts - many thanks to Liberum for publishing an update note today. This shows forecast EPS of;

2020: 0.9p, PER of 86
2021: 2.3p, PER of 33
2022: 4.6p, PER of 16.7

Those forecasts make sense, given the V-shaped economic recovery, and re-opening, and pre-covid results. Although bear in mind things were going quite badly wrong at Staffline before covid struck.

The way I look at the EPS forecasts, personally I would halve the above numbers, to allow for a substantial equity placing to fix the balance sheet. That would then double the forecast PERs above - making this share look rather expensive, unless it can smash the forecasts.

Net debt - as before, top marks to the company and its advisers for being transparent about the large overdue VAT bill. This is the latest -

Pre-IFRS 16 average net debt (which includes the deferred VAT creditor) reduced by £14.5m to £54.9 million as a result of initiatives implemented to generate additional cashflow. The Group has benefited from a £46.5m Covid-19 VAT deferral, which will be repaid in eight equal instalments of c. £5.8m from June 2021 to January 2022. The first instalment will be reduced by a c. £4.1m corporation tax refund.

Clearly then the clock is ticking, and it needs to get the equity fundraising done fairly soon, in the next few months. I’d put money on there already being a fundraising being worked on, in the background, but that’s educated guesswork.

The major shareholder list is dominated by 2 investors that own about half the company. I have heard speculation that HRnet might launch a bid for the whole company? They bought a stake with very unfortunate timing, just before the share price collapsed. I checked out HRnet’s finances at the time, and concluded it could afford to launch a bid for the rest of Staffline, so that’s a distinct possibility.

Outlook - sounds confident, which is handy when you need to raise a lot of fresh equity -

Whilst there continues to be ongoing uncertainty relating to the pandemic, given the strength of Staffline's results in the first quarter of 2021 and the momentum being seen across the Group's core markets, the Board's confidence in the outlook for the year has increased. As a result and subject to no further unforeseen lockdown restrictions, the Board is confident that results for the current financial year are likely to be ahead of expectations.

My opinion - Staffline is recovering nicely, as I would expect given the economic recovery underway. So things are clearly going in the right direction.

Set against that, is the awful balance sheet, that needs serious repair from a big placing to get things back on track, and provide the funding to repay HMRC for the large VAT arrears.

Thank goodness for taxpayer support, because in previous recessions when such support was not available, this company would very likely have gone bust.

The wild card is that a major shareholder could bid for the whole lot, but at what price? (if at all).

Personally, I like certainty (or as near we can ever get), whereas this share looks to have too many unknowns, and once you factor in dilution from a placing, then the valuation doesn’t actually look appealing at all. Unless you think it can smash future years’ forecasts.

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The share count has already almost tripled in the last 3 years. It could easily double again from the next placing, meaning perhaps 5-6 times as many shares in issue as before the problems started in early 2019. Therefore, the share price probably won’t ever get back to previous highs, or anywhere near.

Well done to anyone who’s tripled their money in the last 6 months, albeit by taking on a lot of risk, holding shares in a company that has an insolvent balance sheet & needs to do a big fundraising - risky stuff, but it’s paid off.

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Jack’s section

Lokn Store (LON:LOK)

Share price: 619.9p (+4.54%)

Shares in issue: 29,548,312

Market cap: £183.2m

Lokn Store (LON:LOK) is a supplier of low cost, secure storage space on flexible terms for household and business use.

Self storage is an attractive part of the real estate market - the Club recently bought a stake in Safestore Holdings (LON:SAFE) (pitch here) - it is experiencing structural growth in demand, with tailwinds including urbanisation, pandemic-related decluttering, and general lifestyle changes.

As Edmund Shing notes in his excellent Market Musings posts:

While there are many things that affect real estate performance, self-storage is influenced by the transition and trauma business. The industry often plays a role as people go through difficult life events. As a result, it is one of the most recession-resistant asset classes.

Lokn Store itself opened its first self storage centre in Horsham, Sussex in February 1995, listed on AIM in 2000, and has grown consistently over the last 25 years. Today it operates 36 branded self storage centres in the UK (mainly in the South-East of England in large towns and cities).

We can see that steady growth in revenue performance over time.

While the forecast earnings multiple of 41.1x looks pricey, Lokn Store continues to grow, the outlook is encouraging, and its balance sheet is strong.

As of FY20, LOK had £199m of net plant, property, and equipment, about £13m of cash and total debt (including capital lease obligations) of £63.2m.

Interim results

Highlights

• Group revenue +13.9% to £10.21m,
• Group adjusted EBITDA profit £5.5m up 17.3% (31.1.2020: £4.7m),
• Profit before tax +27% to £2.928m,
• Diluted earnings per share +37.8% to 7.76p,
• Interim dividend +8.25% to 4.33p,
• Adjusted net asset value (NAV) +6.8% to £5.68

So LOK shares currently trade at around 1.09x NAV - a premium is justified given the company’s sites are seeing ‘unprecedented growth in occupied space’, which is driving a robust trading performance. Healthy cash flow generation allows the group to increase its dividend.

Balance sheet

Remains prudent given the freehold asset base, with cash of £11.3m and net debt (excluding lease liabilities) of £42.6m (31.7.2020: £38.3m). The asset backing makes for enviably cheap debt costing just 1.55%. The group has great liquidity ratios.

And the loan to value (LTV) ratio, which measures the debt of the business expressed as a percentage of total property assets, is just 20.4% - up slightly from 19.3% last year, but still very comfortable given that other property-based companies often have LTVs of 60%+.

Trading and pipeline

Has been very encouraging. Occupied space is up 24.7% since January 2020 and occupancy has jumped from 67.1% to 81.6%. This is helping margins. Store EBITDA Margins increased from 55.8% to 58.5% and store management fees reached £0.74m (+87.5% on the six months to December 2020).

Lokn Store’s pipeline consists of 13 sites, equivalent to 38% of new space over the coming years. Two new stores have been opened post-balance sheet date and another two have been acquired, with a total of four stores being built.

Commenting on the Group's results, Andrew Jacobs Chairman of Lok'nStore Group said,

We continue to build our pipeline of prominent Landmark storage centres tapping in to deep latent demand for storage in the U.K and our store team members have worked tirelessly to provide great service to our customers. As a result, we have achieved an unprecedented growth in occupied space of 24.7% in the period and this has driven strong growth of revenue and profits.

Conclusion

The first half results are very good and trading since the period end has remained strong. Occupancy gains imply pricing and margin opportunities over the second half and beyond, and the new store pipeline will add 38% more trading space over the coming years.

This looks good to me as a long term, quality buy and hold stock. The only quibble is over the high earnings multiple. It does seem like this has been appreciating in recent years, although dividend growth has kept track.

But on that note it does look like you get what you pay for. The track record of steady growth is hard to beat.

Andrew Jacobs, the founder and executive chairman, remains LOK’s biggest shareholder and directors have been buying recently at current levels.

Lokn Store may be classed as a Falling Star, but I would suggest that this is a higher quality company than the Quality Rank of 60 indicates.

The Rank is held back by low returns on capital, which is unsurprising given the nature of Lokn Store’s business. I would actually consider its freehold asset base (which weighs down returns on capital) as an attraction.

Self-storage is a good defensive growth choice with lower yields but attractive growth prospects. LOK has a very sensible and boring sounding strategy for shareholder value creation (which is good):

• Steadily increase cash available for distribution (CAD) per share, ‘enabling a predictable growth of the dividend from a strong asset base with conservative levels of debt’,
• Fill existing stores and improve pricing,
• Acquire more sites to build new landmark stores, and
• Increase the number of stores it manages for third parties,

So it knows what it wants to do in the years ahead and I’m sure the management team is more than capable of executing.

It’s a resilient business model, a strong balance sheet, and a proven and highly experienced management team.

Are you overpaying at current levels? It depends on the time horizon, in my view.

In the very short term it is hard to argue this stock is cheap. But if you have a longer time horizon then Lokn Store has a great chance of growing into a bigger company in the years ahead.

Mind Gym (LON:MIND)

Share price: 135p (+3.85%)

Shares in issue: 99,791,784

Market cap: £134.7m

We last reported on Mind Gym (LON:MIND) last October on the back of a 22% share price drop to 77p and a 40% fall in revenue. The shares recovered almost immediately after that initial shock:

Mind Gym uses psychology and behavioural science ‘to transform how people think, feel and behave and so improve the performance of companies’. It’s an interesting idea, in that it presumably helps to create the type of elusive but highly desirable positive workplace culture that investors look for.

The group operates in three global markets: business transformation, human capital management and learning & development.

Looking at some of its programmes is quite fun. The ‘Personal dynamo’ accelerator promises to help you ‘regain your mojo’, which could be useful as we continue to wake up from the hibernation of lockdowns.

But has Mind Gym’s trading and outlook kept pace with the share price? A lot of stocks have rerated in this bull market, some for no real reason.

Mind Gym does have a high Quality Rank of 97, however, and sometimes this type of stock is worth holding onto through share price volatility.

Full year trading update

Highlights:

• FY revenue to be £39.4m, down 18% year-on-year (down 16% in constant currency), but ahead of previous expectations of -20% to -30%,
• Stronger than expected H2 revenues, up 3% versus the comparative period last year (up 6% in constant currency), compared to H1 decrease of 39%,
• ‘Digitally-enabled’ revenues (think Zoom sessions) increased by 102% to £30.5m, representing 77% of total revenue compared to 32% last year,
• Adjusted PBT is expected to be within the range of breakeven and £0.5m,
• Cash at bank of £16.8m, ahead of expectations (for £9m - £11m), ‘in part due to increased pre-payments by clients and a continued improvement in working capital management’.

So clearly there has been an improved trajectory in H2 and full year revenue will be ahead of revised expectations. H2 is expected to at least recoup the H1 loss of £1.3m and the group intends to reinstate guidance in its full-year results on 11 June 2021.

Conclusion

So it looks like growth is returning sooner than anticipated.

The co-founders own upwards of 60% of the group’s shares between them (see Major Shareholders), although this does make for a small free float of 31%. Liquidity will be an issue for some, as the company has a spread of 769bps and it looks like you can only reliably pick up stock in c£2.5k increments.

There are points of interest here, though. The high Quality Rank, good profitability metrics, a net cash position, and a lack of shareholder dilution to name a few. Add that to the large founder-management stakes and there are a few indicators that this company is aligned with shareholders.

There were also some notable director buys in October 2020 at 90p.

A quick look at some Glassdoor reviews show a rating of 3.7 out of 5. Maybe you’d expect more from a company that specialises in workplace psychology and behavioural science. Recurring feedback seems to be along the lines of ‘inspirational bosses but a heavy workload’.

Back in June 2020 Staff were made to accept reduced hours, salary cuts, and some furloughing. Obviously this was an extremely difficult environment for many businesses.

The growth CAGRs in the Financial Summary are notably good, with many in the high double digits and some in triple digits. So if H1 of 2020 was just a wobble then perhaps taking a longer term view, this could be an attractive entry price.

If you assume the company gets back to its FY20 level of 5.3p of normalised EPS in FY22 (which is, incidentally, much higher than the broker forecast of 1.19p), then shares would trade on 25.5x forecast earnings. If you take the normalised EPS CAGR of 30.3% and use that as the PEG growth rate, you begin to see a forecast PEG of less than one.

At these levels, a lot of the investment case revolves around the group’s future growth potential. Are the programmes good? Can it really turn you into a personal dynamo? And is there anything stopping competition from offering similar services for less?

It’s worth researching in greater detail as the total addressable market is probably very big, but we must also bear in mind the share price has recovered quite strongly.