Small Cap Value Report (Thu 11 Nov 2021) - PMP, VLX, TED, BOTB, GMS

Good morning! It's Paul & Jack here with the SCVR for Thursday.

Agenda -

Paul's Section:

Best Of The Best (LON:BOTB) (I hold) - after a chaotic year, with earnings estimates down by two thirds, this online supercar competition company seems to be stabilising. An in line update today, so it looks like we're over the worst. I conclude that the shares seem attractively priced now, but not everyone will agree, given the unpredictability of earnings, and new, well-funded competition.

Gulf Marine Services (LON:GMS) (I hold) - 2 contract extensions, at increased charge out rates (no figures provided, probably commercially sensitive). The problem is massive bank debt, but everything seems lined up now for debt to reduce quite fast, with its 13 vessels in high demand.

Jack's Section:

Portmeirion (LON:PMP) - good update, with full year revenue now expected to be 5% ahead of current expectations. More guidance on margins would be appreciated given the pressures. However, the shares continue to look reasonably valued, the turnaround is going in the right direction, and the group scores a consistently high Quality Rank.

Volex (LON:VLX) - strong revenue growth of around 44% as the company pushes through price increases to negate rising costs. In the long term, there is scope to continue growing both organically and acquisitively, but the current conditions are tricky and the group is moving fast with acquisitions, so the shorter term risks are worth bearing in mind.

Ted Baker (LON:TED) - some positives in this update but I'm still not convinced that the recovery is as entrenched as the share price suggests. There's a key trading period coming up, and I'd rather see how the company performs there before making a judgement on its ability to recapture its former glory.

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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.

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Paul’s Section

Best Of The Best (LON:BOTB) (I hold)

655p (up 5% at 11:25) - mkt cap £62m

Trading Update (for H1)

Best of the Best PLC (LSE: BOTB), the provider of online competitions to win cars and other prizes provides an update on trading for the six months ended 31 October 2021.

Here’s the text in full (with my bolding of key points) -

The Company reports that financial performance for the period is in line with the market guidance issued on 13 August 2021. Customer acquisition costs have stabilised, albeit at the higher levels previously reported.

Engagement from the enlarged player base has also normalised, with average order values and frequency similar to pre-pandemic levels.

Trading for the period has, therefore, been consistent with management's revised expectations. The Board remains confident about the prospects for the business, both in the second half of the financial year and beyond.

We remain focused on our growth strategy and will update shareholders with further details upon release of the Company's Interim Results in January 2022.

Valuation - the share price collapse at BOTB occurred because earnings expectations have crashed by about two thirds, as you can see from the broker consensus chart below -

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It’s now clear that BOTB experienced a one-off boost from lockdowns, with profit and EPS forecasts looking to be back on a long-term upward trend. So I think we could still see BOTB as a growth business, once the one-off pandemic boost is stripped out.

Although looking at the revenue line below, that looks more of a step-change, and has only fallen slightly from the peak. So the problem seems to be mainly due to higher customer acquisition costs -

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How to value it? That’s the difficult bit. I would have thought a PER of say 15-20 is realistic. That arrives at the following valuations -

FY 04/2022 forecast 53.3p, at PER of 15-20 = 800-1066p

FY 04/2023 forecast 64.1p, at PER of 15-20 = 962-1282p

In that context, the current price of 655p looks too low.

However, an alternative view is that earnings have been so volatile, that some investors might only be willing to use a lower PER to value the company. Given the earnings volatility in the last year, and the extreme operational gearing, then this is a reasonable view too.

There’s increased competition, in particular from Omaze, and many me-too smaller car competitions. Some of them use a more transparent model than BOTB, e.g. publishing the total number of tickets to be sold, thus making the odds clearer.

My opinion - the big lesson I’ve learned from BOTB is the importance of operational gearing. Extra revenues drop through almost fully to the bottom line at BOTB - great when sales are rising, but awful when sales drop. Although as mentioned above, the revenues line hasn’t actually dropped very much from peak levels.

Another lesson is that online businesses can be hit with increased cost of customer acquisition, which seems to be the main problem BOTB has experienced. Although as we saw recently from Sosandar (LON:SOS) (I hold), marketing strategies can be tweaked to focus on the most cost-effective way to acquire customers - SOS has greatly reduced its customer acquisition cost, and is trading very well. Maybe BOTB might be able to improve the cost-effectiveness of its marketing strategy, rather than being a price-taker of higher cost online ads? It’s also a reminder of the pricing power that Facebook (now called Meta) and Google have, in online advertising. Hence there’s potential risk for all online businesses, if unexpected and large increases in online marketing costs occur.

A third risk is that, like many other sectors, BOTB is facing new competition that is apparently backed by private equity or venture capital funds. These operate by different rules. Instead of being self-funding like BOTB has been, some new entrants may have pots of cash that they can throw at marketing, incurring heavy short term losses. The idea being that many such businesses will fail, but the odd one could become a massive success. It does feel like unfair competition though.

We’re seeing well-funded new entrants in other areas too, like online selling of secondhand cars. New entrants which all seem to operate at heavy losses, and are burning through cash piles on big marketing budgets. After this boom has ended, people may look back and say, “What on earth were we thinking?”, chasing loss-making companies like Cazoo up to a valuation currently of over £5bn. That's exactly what happened when the original dotcom boom & bust happened in 1998-2000. Or larger US rival Carvana, currently worth £37bn, despite never having made a profit. Things are pretty crazy right now in some areas, but the trouble is that existing businesses are facing very well-funded new competitors, and I think that is a risk for BOTB.

Many investors were drawn to BOTB by the incredibly high quality measures, like ROCE, ROE, etc. However, we didn't think enough about whether the business model was sustainable at those levels. High returns attracts competition, a risk we maybe need to think about more in future?

On balance, I think BOTB does look attractively priced now. With hindsight it clearly overshot on the upside, but has now probably overshot on the downside too.

Also remember BOTB pays out surplus cashflows in special divis, so we get paid to wait. Hence overall, looking at it with fresh eyes, BOTB seems reasonably attractive at 655p per share. Although given the wild volatility in earnings and share price, I can understand why investors may be reluctant to get involved here, which could limit the upside for the time being perhaps?

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Gulf Marine Services (LON:GMS) (I hold)

6.4p (up 8%, at 12:41) - mkt cap £65m

Contract

I mention this because it’s close to being a trading update.

See the archive here for my fairly recent discovery of this interesting, albeit quite high risk special situation.

Here’s the short version: GMS owns a fleet of 13 specialist support vessels for oil/offshore wind sector. It’s got an awful track record, and a balance sheet groaning with way too much bank debt. Rise in oil price now means these vessels are back in demand, with daily hire rates rising, and utilisation high. The company should now be highly cash generative, which is forecast to bring down debt to manageable levels in 2022. The benefit of this should flow through to the bombed out shares, giving considerable (albeit still risky - something could go wrong) upside.

What I particularly like about this special situation, is that everything is already in place for the turnaround to happen. Hence we are set up for positive newsflow on contracts, cash generation, and debt reduction. You can work out the figures easily, as EBITDA is massive, maintenance capex is low, etc. Vessels are rented out on contracts of several years, some of which are now renewing, but at higher daily charge out rates - flowing straight through to higher profitability.

Today’s news is 2 contract extensions, at higher daily hire rates. Hence a continuation of existing contracts (no downtime to move the ships), one contract is to end 2022, the other to end 2023. Hence good visibility of cashflows.

Market is tightening, which should be very good indeed for GMS’s profits/cashflows -

"The two contract extensions, on improved rates, signal that the market for our vessels, particularly in MENA continues to tighten and that clients are taking action to ensure they have vessel availability to support their ongoing operations.

Today’s update is light on specifics (no figures given), but I imagine contract details are probably confidential (and commercially sensitive).

Confident outlook -

These awards further increase our confidence that the financial performance of the Company will continue to improve in 2022 and beyond."

My opinion - it’s early days, but so far the newsflow is panning out as I hoped. The sector tailwinds made this easy to anticipate.

Management explained the situation well in a recent webinar, and seem to have a grip on things. They’ve already done one successful renegotiation of the bank facilities, and it should be possible to normalise the banking arrangements by end 2022. We hope, but that’s not certain.

GMS is one for special situation investors, as there’s quite high risk, if something were to go wrong with the banking relationship. Although with the company now spewing out cash like nobody’s business, enabling it to pay down debt quite fast, why would the bank get difficult at this stage?

I like this share - rising cashflows, on a fixed cost base, should transform its financial position. GMS could be a very good performer, if things keep moving in the right direction.

This share has been an absolute dog in the past, but has now transformed into a highly cash generative business. Hence why it's of interest to me.

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Jack’s section

Portmeirion (LON:PMP)

Share price: 685p (+0.74%)

Shares in issue: 13,985,442

Market cap: £95.8m

Portmeirion designs, manufactures and distributes homewares under the Portmeirion, Spode, Royal Worcester, Pimpernel, Wax Lyrical and Nambé brands. They’re well regarded brands, but margins took a hit recently so the company is in turnaround mode.

Trading update

Since our interim results announcement in September 2021, we have continued to see strong sales of our brands across all key markets and have healthy order books for the remainder of the year, including the important Christmas trading period. We therefore now expect sales to be at least £95 million, approximately 5% above current FY21 consensus market expectations.

The group is still experiencing cost inflation and supply chain disruption. Together, these ‘will limit, in the immediate short term, the upside on profit from our higher sales in FY21.’ Portmeirion does add though that it thinks this disruption should be short-term in nature.

Mike Raybould, Chief Executive commented:

We are delighted to see the strong levels of demand for our brands around the world. Our focused strategy is transforming our business and our growth is being driven by our ongoing development of online channels, new product launches and expanding international markets. Whilst there are undoubtedly short-term cost and margin pressures within global supply chains, we are managing any current impact on the business and we are confident in our expectation that we can grow our operating margins over the next three years.

Conclusion

A short update but it looks like the strategy here is working well, with online proving to be a valuable new revenue stream. Portmeirion has said before that it’s only in the early stages here, so there should be more progress to come.

Shares have recovered well from Covid but remain well below their previous levels. There has been a degree of equity dilution, around 15% or so over Covid, which is manageable. Others have suffered worse.

What’s more, the valuation remains fairly modest at 12.5x forecast earnings (helped by a significant forecast increase in FY22 earnings), so there’s runway for a further rerating despite the High Flyer status. Sales are now expected to be c5% ahead for the current year, but it would have been good to get some more guidance on margins given the pressures faced by the group.

FY21 EPS estimates look a little low, with a big rise expected in FY22. I wonder if, given the trading momentum, the company might beat the current year estimates.

It’s already got a good H1 in the bag. H2 is more important, so it's positive to hear the sales beat. That plus the habitually strong Quality Rank means the shares are still well worth a look in my view, with scope for further steady progress. It’s not hard to envisage another 25%-30% added onto the share price over the next year or so should wider market conditions remain stable, although I wonder how much upside remains beyond that.

The company still has to navigate cost inflation, labour shortages, and supply chain issues of course (which it so far appears to be doing).

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Volex (LON:VLX)

Share price: 411p (-8.05%)

Shares in issue: 158,718,709

Market cap: £652.3m

Volex is a global supplier of integrated manufacturing services and power products, serving blue-chip customers from an increasingly flexible and global operating base. The group is very acquisitive, which means there is scope for continued inorganic growth, but such a strategy obviously brings acquisition risk.

And it’s a difficult time in the market. Some customers are experiencing extended component lead times and Volex continues to pass through rising costs. There’s a lot for management to deal with right now.

The group’s key markets include:

Electric vehicles - The automotive industry is experiencing a period of rapid change. The company anticipates increasing competition here and is investing in its manufacturing capabilities to ensure it remains one of the lowest cost producers.

Consumer electricals - Power cords and related products are sold to the manufacturers of a broad range of electrical and electronic devices and appliances (PCs, power tools, etc.)

Medical - Here, the group’s products are used in smaller medical devices for patient monitoring and treatment.

Complex industrial technology - This segment includes a wide range of equipment and customer solutions, including building control, smart metering, laser technology, vehicle telematics, telecommunications, industrial automation and robotics.

Half year results

Highlights:

• Revenue +44.5% to $292.7m,
• Underlying operating profit +31.3% to $27.3m,
• Underlying profit before tax +21.5% to $25.4m,
• Basic earnings per share +7.8% to 11 cents,
• Interim dividend per share +9.1% to 1.2p,
• Net debt before lease liabilities of $21.8m (H1 2020: $32m of net cash).

Not for the first time, there is a notable difference between adjusted and statutory profit. The main culprit here is just over $5m of amortisation of acquired intangibles, related to acquired customer relationships and order backlogs. You can see the additional items here, in note 3.

You might argue that Volex is a little too easy with its adjustments. It’s unclear from this update, for example, how much of the share-based payments charges are ongoing incentives for senior management versus one-off awards granted to the management teams of acquired companies.

What’s clearer is the strong revenue growth of 44.5%, ‘reflecting high levels of customer demand in all sectors’. Operating profit has gone up by less (but still +31.3%) as the group manages cost pressures and extended lead times.

It’s been busy acquiring, with three North American businesses entering the fold. Two of these came after the period-end.

Electric vehicles sales have grown some 210% year-on-year to $45.3m due to Volex’s strong position in grid-cords and expansion into other products. The prior year was impacted by Covid. Demand in Q1 of the current financial year was very strong but tapered slightly in Q2 as customer production suffered from component shortages.

Consumer Electricals sales were up 74% year-on-year to $127.4m, including positive impact from the acquisition of DE-KA. Medical revenue grew by 15% to $62m, with signs of improvement in the sector following Covid disruption. Complex Industrial Technology saw a slight reduction in year-on-year revenue to $58.1m following high levels of demand for data centre products in the first half of FY2021.

In terms of geography, North America contributed 41.4% of revenue and grew by 30.5% to $121.2m, with Europe contributing 34.5% and growing by 124.7% to $100.7m, while Asia made up 24.1% and grew by 9.4% to $70.7m.

Regarding cost increases:

We look to pass on higher component and commodity costs to our customers through contractual mechanisms and regular repricing. We have experienced increased freight and copper costs during the period. These have been passed on to customers, increasing revenue but not the absolute margins on individual products. This results in slightly lower gross margins as a percentage of revenue. There is also a small time lag in passing through such cost increases, which has an adverse impact on margins when prices are rising. This becomes a positive impact when prices are falling. There was an adverse impact on gross margin from these effects of 1.5%.

During the first half of the year, inventory has increased significantly to support the growth of the business and as a direct result of increases in lead times in the global supply chain, as well as longer shipping times between production facilities and customers.

Operating cash flow before working capital was $30m. The increase in inventories cost $20.4m, and an increase in receivables was $13.4m. That’s set against a $15m increase in payables, so you can see the cash impact as the company manages its position amid global pressures. The result after accounting for tax and some other lines is a net CFO figure of $7.3m.

The net debt position has increased and will rise by a further $35m after the acquisitions of Irvine, Prodamex, and TC. This will total $56.8m compared to $27.3m of underlying six month operating profit, which is manageable but still something to keep an eye on given the conditions.

Conclusion

The revenue growth is good here, but there’s an impact on its balance sheet and cash flows as it balances a highly acquisitive strategy with a tricky global environment.

The strong forward order book sees Volex on course to deliver on its full-year consensus market expectations, however global component shortages and shipping issues are a risk. The growing pipeline of acquisition opportunities must be carefully balanced against the group’s capacity to make such acquisitions, particularly at a time of heightened global costs and disruption.

Still, inorganic growth is a key part of the strategy and the group aims to grow revenue by 10% p.a. through the purchase of accretive and cash generative businesses. Six businesses have been acquired over the last 3 years for $140m with an additional three announced since August 2021. I think some shareholders would understand if the group reduced this rate given the current volatile conditions, but it doesn’t look like that is in the company’s plans.

Nevertheless, Volex describes its longer-term prospects as ‘excellent’. Managing such an acquisitive strategy must be difficult and time consuming, so I think the next six months or so is a period of heightened risk, although the longer term investment case remains intact.

As long as Volex can ride out the current pressures and continue to pass on costs, there’s scope for continued growth in the long term. But for now, at around 22x forecast earnings and some challenges to navigate, the shares look up with events in my view. There's a presentation today at 11:30 on investormeetco, which should be a good opportunity to hear more from the team.

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Ted Baker (LON:TED)

Share price: 139.2p (+1.83%)

Shares in issue: 184,608,786

Market cap: £257m

Interim results

• Revenue +17.6% to £199.3m,
• Reported loss before tax has improved from -£86.4m to -£25.3m,
• Basic EPS has gone from -64.1p to -10.1p,
• Net cash has declined from £60.7m to £12.7m.

While there are some year-on-year improvements here, the two-year performance is negative and the steep decline in net cash is alarming. Net cash flow for the period was an outflow of £38.3m (2020: inflow of £7.7m).

Ted does say this reflects the normal operating cycle of the business, as it brings stock in for sale during H2 ahead of Black Friday and Christmas. Still, that’s a hefty cash burn within the context of an extensive turnaround.

Ted Baker has significantly diluted its shareholders in order to raise cash over the past few years so the big risk is continued dilution. I remember in response to the most recent placing, a broker said the group’s balance sheet had been ‘fixed’, which I think downplays the financial risk.

That’s not to say the company and refreshed management team isn’t working hard. The transformation plan is on track, sales are improving sequentially, and the group is recovering its premium positioning. There’s little negative impact from supply chain disruption and inflation and the group has a ‘basket of mitigation strategies’.

Ted Baker has upgraded its target to achieve a net cash position, with this target to be achieved by the end of the current financial year. No guidance is given but Ted Baker is ‘comfortable with market consensus’.

Current trading and outlook

Q3 trading has been impacted by ongoing Covid restrictions and subdued footfall into physical retail. However, the group has seen further sequential improvement in trends during the period, with further progress in trading margin as a result of reduced promotions.

Balance sheet

Net tangible asset value of £102m looks better than it has done in the past, but it’s the rate of reduction in net cash that is the concern. This is a retailer though, and the group reassures that this is in keeping with normal trading patterns ahead of key periods.

Conclusion

Ted Baker can turn around. It’s more the risk:reward as I see it that has not seemed all that attractive. Often, it feels as though the risk has been understated while the return potential has been diluted.

But some have a different perception of the risk profile and there are plenty of investors banking on a successful recovery. It’s still too early for me but Ted Baker was until recently a valuable brand, and if it can recapture that prestige then of course there is upside potential.

The losses are still substantial, however, and the year-on-year reduction in net loss is flattered by a non-cash £45.8m impairment charge in FY20. On an underlying basis, net losses have improved from -£38.4m to -£27.1m.

There’s a sequential improvement in trading and it’s possible that that risk:reward trade off is improving now but I do worry that a sustained recovery is being taken for granted. The reduction in net cash is a concern, but the group does say this is partially due to investment in stock ahead of an important trading period.

Given the depth of the turnaround that is required here, I’d rather wait until after this key trading period is over and there is more concrete evidence of success.