Small Cap Value Report (Thu 14 Dec 2023) - BEG, CPI, STEM, CURY, ENSI, MMAG

Good morning from Paul & Graham!

US interest rates - interesting news overnight, from the US central bank, indicating the likelihood of 3 interest rates cuts (of 0.25% each) in 2024, because inflation is now largely under control, albeit still above the arbitrary 2% target.  This helped power the Dow to a new all-time high. It seems like a different world to UK small caps! Although looking at some of the early risers this morning here in the UK, I can see quite a few are interest-rate sensitive, highly geared companies like Mobico (LON:MCG) and S4 Capital (LON:SFOR) - maybe we'll see a dash for trash, as investors worry less about high gearing? Who knows. 

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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 (usually) between £10m and £1bn. We usually 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.

What does our colour-coding mean? Will it guarantee instant, easy riches? Sadly not! Share prices move up or down for many reasons, and can often detach from the company fundamentals. So we're not making any predictions about what share prices will do.

Green (thumbs up) - means in our opinion, a company is well-financed (so low risk of dilution/insolvency), is trading well, and has a reasonably good outlook, with the shares reasonably priced. OR it's such deep value that we see a good chance of a turnaround, and think that the share price might have overshot on the downside.

Amber - means we don't have a strong view either way, and can see some positives, and some negatives. Often companies like this are good, but expensive.

Red (thumbs down) - means we see significant, or serious problems, so anyone looking at the share needs to be aware of the high risk. Sometimes risky shares can produce high returns, if they survive/recover. So again, we're not saying the share price will necessarily under-perform, we're just flagging the high risk.

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Summaries -

Begbies Traynor (LON:BEG) - up 2% to 115p (£182m) - Interim Results - Paul - AMBER

H1 results from earlier this week. If you accept the large adjustments, then this share looks good value. Nice outlook. Modest but OK balance sheet. The trouble is, I don't properly understand the adjustments, so can't form a firm view on this share. 

Capita (LON:CPI) - 20.75p (pre-market) £353m - 11-month Trading Update - Paul - AMBER/GREEN

This update seems to mainly be a recap on previously announced news, and strategy. Shares have been a disaster over the last 10 years, but I wonder if seeds have been sown for a potential recovery, at least in part? Worth a look I think.

SThree (LON:STEM) - up 1% to 422p (£569m) - FY23 Full Year Trading Update - Graham - GREEN

This full-year update is in line with expectations. Fees from Contract recruitment are up slightly while Permanent fees are allowed to keep falling, consistent with their strategic focus. Demand is volatile and 2023 is weaker than 2022, but I remain a fan of this recruiter.

Currys (LON:CURY) - up 11% to 50.2p (£569m) - Interim Results - Paul - AMBER/RED

Another loss-making H1, but it's expected to eke out a small FY profit, with guidance unchanged. The weak balance sheet, and very cash-hungry pension deficit are further reasons to avoid this share. I've moderated my view from red to AMBER/RED, due to the favourable pending disposal of its Greek operation. 

EnSilica (LON:ENSI) - down 24% to 35.5p (£27m) - Placing & New business update - Paul - AMBER/RED

My first look at this May 2022 float. Surprisingly, it has done a placing today, following a positive trading update just 2 weeks ago. Dilution is only 5-10% though, depending on whether warrants are exercised. I rummage through past accounts, and am a bit concerned about cash outflows. Doesn't look great at this stage, but it claims to have a massive sales pipeline.

Musicmagpie (LON:MMAG) - up 20% to 13.8p (£15m) - Full Year Pre-Close Trading Update - Graham - RED

The market has treated this update with relief: EBITDA in H2 was significantly higher than H1, and rental subscriber growth was impressive. However the big picture here continues to look ominous for shareholders and I would treat these shares with a great deal of caution.

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Paul's Section:

Begbies Traynor (LON:BEG)

115p (£182m) - Interim Results - Paul - AMBER

Begbies Traynor Group plc (the 'company' or the 'group'), the professional services consultancy, today announces its half year results for the six months ended 31 October 2023.

Background - BEG’s core business is an insolvency practitioner - the specialist profession who manage administrations and liquidations. Begbies has made some seemingly good acquisitions over the years. So I have a favourable impression of this group, which still has the owner's eye of Exec Chairman Ric Traynor, with his 17.5% shareholding.

The theory is that this share should be a safe haven in softer economic conditions, but that hasn’t always played out as expected, due to the distortions caused by 14 years of zero interest rates, pandemic policies, etc. With interest rates now much higher, and credit conditions generally being tight (especially for smaller businesses), then I think it’s reasonable to assume BEG should have plenty of work over the next few years.

Despite this favourable backdrop, BEG shares are on a lowish forward PER of 10.6x, which strikes me as having scope to increase - although this share never seems to hold onto any re-ratings, for reasons unknown.

Interim results - for the 6 months to 31 Oct 2023.

The headline reassures -

"Strong first half performance and confidence in full year outlook"

By far the biggest issue with these accounts is getting our heads around the adjustments - which is where most of the profit comes from - I’ve highlighted adj profit, and statutory profit below - bear in mind these numbers are only for a half year - I can’t be the only investor who sometimes forgets that, and works out all the numbers wrong, thinking a half year was a full year! - thankfully I always realise in time before hitting the publish button! 

Note that of the 13% revenue growth, an impressive 8% is organic - which should be enough to absorb higher salaries (I’m told that accountancy firms are doing a roaring trade generally, and hence pay is rising strongly).

Acquisitions - “trading well and in line with expectations”.

Outlook - this strikes me as upbeat, considering the modest forward PER -

4. Current range of analyst forecasts for adjusted PBT of £21.9m-£22.5m (as compiled by the group)

Balance sheet - there’s little asset backing, so this share is all about profit & cashflows.

NAV is ££80m, with £71m of that being goodwill & similar, so only £9m NTAV. I’ll add back deferred tax (usually relates to goodwill) of £7m, giving adj NTAV of £16m. That’s only 9% of the market cap.

Receivables is the stand-out large number, which is inherent with insolvency practitioners, as they typically run up a fees account, then get paid when assets are disposed of, which can take a long time.

Overall then, I don’t have any balance sheet concerns, but bear in mind there isn’t much asset value to fall back on, if trading were to go badly wrong.

Cashflow statement - oh dear, this is the part where it becomes difficult.

I’m ashamed to admit that I simply don’t understand this accounting treatment, despite having had a zoom with the CFO a while back, where he tried to explain it to both  Graham & I -

This same issue is the main area of adjustment in the P&L, as note 3 details -

So what is the real profit and cashflow? I don’t know, it’s completely confused me.

Paul’s opinion - given that I spent 3 years training as an auditor with Price Waterhouse, and then 8 years as a CFO, I can usually breeze through almost any small-mid cap accounts in a few minutes and understand them, despite all that being 20-30 years ago now. So we might have to allow for a bit of age-related brain fog, and advances in accounting standards, where I barely know my IFRS from my elbow these days!

To be fair, it’s not just me who is confused by the adjustments in BEG accounts. Graham and I had zoom with the CFO, and were nodding along sagely, but afterwards I asked him - did you understand any of that?! I think we agreed that we thought we sort of understood it at the time, but cannot now give a coherent explanation. So that means no, we didn’t understand it.

The CFO did say that he’d had so many identical enquiries from fund managers, that he had prepared a slide deck to explain it. Maybe he needs some new, simpler slides?!

Part of me says just accept the adjustments, and value the shares on the adjusted numbers. In which case, BEG shares look  attractively priced, particularly given the positive outlook for its core insolvency division.

However, given that I don’t really understand the adjustments, and they’re so material to profits, then I can’t go above AMBER again, which is Graham’s previous view too.

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Capita (LON:CPI)

20.75p (pre-market) £353m - 11-month Trading Update - Paul - AMBER/GREEN

I’m not sure why this large outsourcing group has issued another trading update since its last, in line with expectations update, which I reviewed here on 21 Nov 2023?

Today’s update doesn’t tell us how the group is trading versus expectations, but is more a summary of things they’ve already told us.

Here are the most important points -

“Positive operational performance across both divisions”

(but nothing said about profitability, just a slight increase in revenues of 2.1%, less than inflation. There’s a slowdown in growth from H1 to H2 2023)

Increase in contract wins.

Cost savings (mostly people) of £60m from Q1 2024 - as announced on 21 Nov 2023.

Medium term target to “more than double” operating profit margin from 2.9% (implies 6%+ which would be a great catalyst for a share price rise, if it can be achieved).

Disposals almost complete.

Main pension scheme in actuarial surplus of £53m at Mar 2023. £30m paid in 2023. £21m payable in 2024. After 2024, no further cash required by the pension scheme - this sounds excellent, and obviously is a major benefit to cashflow from 2025 onwards. Assuming nothing goes wrong with the subsequent scheme valuations.

Negative overall cashflow expected to reverse in future years.

Broker updates - we don’t have access to anything, so we’re at a disadvantage here. So we have to fall back on the broker consensus graph on the StockReport here - which doesn’t seem to show much enthusiasm for the turnaround from 5 analysts - are they lagging behind reality, or is the company over-PR-ing its trading updates, I wonder? -

Paul’s opinion - there seems to be plenty of potential here for a turnaround, and the share price looks as if it might be finding a floor.

The key with this type of business is only taking on work where it can generate a decent return. Instead CPI seems to have got embroiled in problematic contracts in the past, and who knows whether its extensive disposals have sold off the best stuff or not?

I dislike the balance sheet, but it’s a lot better than it was.

As you can see below, a horrible trend in EPS has driven the share price collapse in recent years -

Staggering shareholder value destruction here over 10 years -

We're buying the future, not the past. So as a potential turnaround, I particularly like the ending of substantial pension scheme deficit recovery payments in 2024. That. combined with deep cost cutting, and a target to get the operating margin up from 3% to 6%, could (if it happens) fuel a rebound in share price maybe?

Overall then, not the type of business I would want to invest in, but as a trade for a partial recovery in share price, it’s looking tempting. So I’ll stick at AMBER/GREEN - mildly positive, but with some reservations.

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Currys (LON:CURY)

Up 11% to 50.2p (£569m) - Interim Results - Paul - AMBER/RED

Currys actually uses the RNS title - “Solid performance in a tough environment” - instead of the more usual “Interim Results”, so I’ve changed it above to be more accurate.

As well as the heavily PR-d title, I think we also need to be cautious about share price movements on a big up day - small caps are up 2%, and mid caps 3%, on the back of the more dovish Fed stance re 2024. Hence big moves today might be somewhat exaggerated maybe, and may not stick?

I won’t spend much time on going through the figures, as they’re lacklustre - eg - 

H1 revenue £4.16bn (down 7%)

Ignore EBITDA, as it excludes a huge amount of rent costs.

Loss before tax £(46)m, H1 LY was £(548)m but that included a £511m goodwill write-off, so a £(37)m loss H1 LY.

Adj loss before tax was £(16)m.

There’s an H2 bias to trading, I recall.

Disposal of Greek subsidiary happened post H1 period end, this does indeed look a good price achieved, and should help strengthen the group balance sheet -

After period closed, agreed sale of Greece for an enterprise value of £175m and net proceeds of £156m, representing an attractive return for shareholders. Greece will be included in continuing operations until transaction completes

Outlook - sounds OK -

Balance sheet - is very weak still. NAV of £1,886m includes £2,569m of intangible assets, so NTAV is negative £(683)m. The main elements of this hole in the balance sheet are caused by £190m pension deficit, £230m deficit on the lease entries, and £129m of net borrowings. I suppose you could argue that these should be manageable things, and with the net borrowings about to be fully repaid by the Greek disposal, maybe I’ve been overly gloomy about this balance sheet in the past?

My main worry is still that the £2.52bn owed to trade creditors is gigantic, and could be dependent at least in part on trade credit insurance, which can be withdrawn at any time without notice.

However, there is £2.28bn of inventories + receivables, which supports most of the trade creditors.

So providing this state can be maintained indefinitely, then it might be just about OK?

Pension deficit - is a massive cash drain for the next few years -

Scheduled pension contributions will rise to £50m in 2024/25 and to £78m for the following three years before a final payment of £43m in 2028/29

Paul’s opinion - I think the pension deficit recovery payments are a deal-breaker for me. I was just starting to get a little more comfortable with the balance sheet until I came across the size of the pension deficit cash demands.

So as things stand, this business is operating to fuel the pension scheme. I see that brokers are forecasting a reintroduction of dividends, but that’s not sensible given its weak balance sheet.

Upside could come from a surge in consumer spending in 2024 and beyond, which is not as daft as it sounds, given that wages (and benefits/pensions) are set to rise way ahead of inflation from April 2024, plus the 2% NICs cut should kick in from Jan 2024, offsetting some of the stealth tax rises (such as frozen personal allowances). On c.£9bn revenues, and trading a little above breakeven currently, Currys could see a strong % increase in profits from such a low base. Offsetting that, will be a big increase in its own staff costs from April 2024, as everyone seeks to maintain their differentials above minimum wage. Lots to ponder there!

On balance, I think the Greek disposal reduces risk, so I’ll shift from red to AMBER/RED, to reflect that this really isn’t a very good business, operating on wafer-thin profit margins, with substantial fixed costs, totally dependent on trade creditors, and with a cash-hungry pension scheme. So why get involved?

Also despite the best efforts of the PR team, reality is that broker forecasts are still in a downtrend -

Long-term, this is a story of shareholder value destruction, which began long before the pandemic hit us. 

Although note the share count hasn't risen significantly in the last 5 years, so theoretically that suggests upside could be considerable, if trading were to substantially improve -

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EnSilica (LON:ENSI)

Down 24% to 35.5p (£27m) - Placing & New business update - Paul - AMBER/RED

This is our first look at Ensilica. It listed in May 2022, had a honeymoon period where it doubled, but has since come crashing down to a new low today.

EnSilica, a leading chip maker of mixed signal ASICs (Application Specific Integrated Circuits)...

Today announces it’s raising £1.56m in a 40p placing being done by Allenby.

Warrants are attached on a 1 for 1 basis, with an exercise price of 55p and a period of 18 months.

These are quite small numbers, so it’s about 3.9m new placing shares, plus 3.9m potential new shares from warrants (which would bring in £2.15m of fresh cash). Total dilution therefore up to 7.8m new shares, compared with 78.1m existing shares = 5% + 5% dilution, which isn’t a disaster by any means.

What’s the money for? There’s a nice story here -

It’s surprising that Ensilica has raised more money today, as just 2 weeks ago it issued an upbeat-sounding, in line with expectations trading update, that didn’t give an inkling that it needed more cash.

I’ve quickly reviewed its May 2023 accounts, with the cashflow statement being the most revealing - all its cashflow in both 5/2023 and 5/2022 came from tax credits. It then capitalised heavy development spending, having to plug the resulting cash shortfall with equity raises in both years. This year seems to be following a similar pattern.

Paul’s opinion - it’s never a good look for a fairly recent float to come back for more cash, especially when the share price is depressed. That said, the 5-10% dilution from today’s raise is not the end of the world.

From all the numbers to date, I’d say the jury is out on whether this is a decent business or not, it just hasn’t got enough of a financial track record for me to judge.

It would be useful to check out management - are they any good, what have they achieved in the past, etc?

The shareholder list is nearly all individuals (management maybe?), with Amati Global Investors holding 6.4% - they seem to crop up at a lot of more speculative micro caps that have been hammered in price over the last 2 years.

Anyway, we can keep an open mind about Ensilica - if a decent amount of the huge pipeline turns into sales & profits, then it could do well, who knows?

For now, I see it as AMBER/RED - so no strong opinion either way, but nothing much to convince me there’s a good business here based on its record to date.

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Graham’s Section:

SThree (LON:STEM)

Share price: 422p (+1%)

Market cap: £569m

SThree plc ("SThree" or the "Group"), the only global specialist talent partner focused on roles in Science, Technology, Engineering and Mathematics ('STEM'), today issues a trading update for the financial year ended 30 November 2023.

This is my favourite recruitment sector stock, and I always look forward to its updates. Today’s update is in line with expectations.

Key points:

• Net fees down 4% “against a record prior year performance and challenging global macroeconomic backdrop”.

• Contract fees up 1% and now 82% of total.

• Permanent fees down 22% and now 18% of total.

SThree has been shifting its business away from Permanent hiring and into Contract hiring for years, and the declining fees from Permanent recruitment have been a drag on total growth.

Average headcount in Permanent recruitment is down 17% year-on-year, so we should see reduced costs offsetting most of the reduced revenues.

Sectors: the Covid-boom in Life Sciences continues to retreat and Life Sciences fees are down 21% year-on-year. In contrast, Engineering is up 17%.

Order book is £184m, down 3%, but SThree argues that this is “sector-leading visibility with the equivalent of c. 4 months’ net fees”.

Net cash of £83m.

CEO comment: describes this as a “consistently robust performance”.

As we enter the start of the new financial year, we haven't yet seen an easing of the macro-economic environment, which continues to drive soft trading conditions. Our strategic focus, exposure to long-term megatrends, and progress to date delivering operational enhancements provide us with a strong platform for sustained growth. We remain excited by the opportunities ahead.

Graham’s view

In September, commenting on the Q3 update, I gave SThree credit for tightly managing its costs in a year with lower demand than the boom conditions of previous years.

I also pointed to the long-term trajectory of revenues, which remains encouraging despite the current hiccup:

Today’s full-year update confirms that Contract fees are approximately flat - as this is now effectively the company’s “core” activity, I think investors should be focusing on this now, rather than the aggregate revenue performance.

The company’s cash balance keeps rising (note that there is a 4% dividend yield here, too) and the share enjoys a StockRank of 98, also passing three bullish stock screens, including the Ben Graham Deep Value Checklist.

If I wanted to build a bear case here, I would start by pointing to the lack of recent top-line growth and the competitive nature of the recruitment sector. However, I’ve been following SThree for quite some time and have been consistently impressed by the quality of its results, which suggest to me that it’s a leader in the space. The focus on contract recruitment in STEM fields seems to be a winning strategy, and the cash balance provides comfort.

So I’m keeping my positive stance on these shares, as I struggle to find reasons to think that this valuation is overcooked:

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Musicmagpie (LON:MMAG)

Share price: 13.8p (+20%)

Market cap: £15m

Takeover possibilities are in the air here, although potential bidders Aurelius and BT have said they do not intend to make an offer for this reseller of refurbished phones, tables, games consoles, and laptops, and second-hand films, books, and box-sets.

The company said on 27th November that it “continues to seek potential buyers”.

Let’s see if today’s full-year trading update (for FY November 2023) offers any light at the end of the tunnel:

• Revenues £136.6m (2022: £143.3m)

• Gross margin 27.7% (2022: 26.2%) was prioritised over revenue growth.

• EBITDA £7.5m (2022: £6.5m)

At the interim results, adjusted EBITDA of £2.8m translated to a pre-tax loss of £3.2m, so I would assume there will be a full-year statutory loss.

Active rental subscribers are up 21% to 37,100 year-on-year, and rental revenues are up 57% to £8.3m. But this is just a fraction of MMAG’s total revenue base.

Estimates: there is no reference in today’s announcement to performance versus prior market expectations. Broker Shore Capital has withdrawn its forecasts, due to the company being in an offer period.

Previously (in August) it forecast revenues for this year of £140.6m, and an adjusted pre-tax loss of £2.2m

Net debt has reduced by £0.5m over the past six months to £13.1m.

Since the net debt position is nearly the same size as the company’s market cap, let’s focus on it for a moment:

Leverage at 30 November 2023, being EBITDA to net debt, was 1.7x (31 May 2023: 2.0x). Net debt is mitigated by future contracted rental revenue of £3.6m and Rental assets on the balance sheet with a net book value of £7.7m. It also continues to be supported by the £30m committed RCF facility provided by HSBC and Natwest, due for renewal in July 2026.

So let’s make a few points on this.

Firstly, the leverage multiple of 1.7x would usually be considered moderate. However, for a company that struggles to turn a profit, we need stricter criteria and so I do not consider this to be a comfortable position.

The company points to rental assets on its balance sheet of £7.7m. In isolation, that’s a reasonable argument but look at the entire balance sheet and it’s less reassuring: as of May 2023, the company had tangible net assets of only £3m. So it could not sell its rental assets to balance out its debt position. Firstly, because the rental assets are only £7.7m and the net debt is £13.1m. Secondly, because it’s very close to having negative tangible book value. So liquidation would be a risky strategy.

CEO comment:

We are pleased with the performance of the Group in the second half of the year, and are delighted that our focus on profits and cash has delivered significant EBITDA growth. Our strategy of proactively managing the number of active Rental subscribers has also helped in this regard and will support our short-term objectives on profits and cash into 2024, bolstered by an enhanced Buy Now Pay Later offering. I remain confident in the business and our ability to navigate the difficult external market conditions, especially given the outstanding level of trust that consumers continue to have in our brand, as demonstrated by our excellent 4.4* Trustpilot rating based on over 277,000 reviews.

Graham’s view

Share price gains today suggest that shareholders are pleasantly surprised with the update: H2 EBITDA is up significantly vs. H1 EBITDA.

However, I’m going to continue the negative stance on this one that Paul has suggested in his recent coverage. Reasons for this include:

• Lack of profitability.

• The combination of unprofitability and financial leverage.

• No real balance sheet support.

• The attempted sale of the company - is this a search for a bailout?

Looking at the historic financials, I see that the company was briefly profitable in 2020, just prior to the 2021 IPO. It’s difficult to blame investors for being wary of any fresh IPOs, given what they’ve experienced over the past two years with all of these 2021 IPOs:

Of course you can never tell what will happen in an attempted sale, and perhaps Music Magpie will find the buyer it is looking for, at a premium to the current share price.

Price to sales is only about 0.1x. If somebody thinks that this can be turned into a sustainable business, who knows what they might be willing to pay for it? But another strategy for possible buyers might be to let the company continue on its current course, and hope to start discussions with the bank at a later date.