Small Cap Value Report (Thu 15 Oct 2020) - VLX, CER, MARS, BOWL, NCYT, FUL

Good morning, it's Jack here with the placeholder for Thursday's SCVR.

Many thanks for the >200 thumbs ups for Paul yesterday, and such an interesting & vigorous reader discussion. We shouldn't shy away from interesting discussions, everyone wants to express themselves, within reasonable bounds, good thing too!

A brief but eye-catching update from Volex today, so that's the first stop - as always, the early comments are greatly appreciated.

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Volex (LON:VLX)

Share price: 209.4p (8.5%)

Shares in issue: 152,250,802

Market cap: £318.8m

(I hold)

Volex (LON:VLX) is a supplier of integrated manufacturing services and power products to companies around the world. These are wiring solutions of varying complexity that can be found in hospitals, data centres, and many other locations.

A few years ago the company was loss-making, focusing on cheap commodity-like products where others had the economic edge. Since then it has been revitalised by a renewed focus on higher margin activities. It’s an old, respected company with a lot of history so this is good to see.

Helmed by CFO Darren Morris, COO John Molloy, and executive chairman and Nat Rothschild (who also owns 25% of the company’s stock), VLX is a few years into an established and increasingly successful turnaround.

Management is focusing on more vertical integration and higher margin markets and it looks to be working, with shares up nearly 8% so far on today’s brief ‘ahead of expectations’ update.

Thing is, even after recent share price strength the stock looks cheap on some measures, with a PEG of 0.5 and trading at less than 1x revenue. It also qualifies for the Charles Kirkpatrick Bargain Screen.

Trading update

VLX says that performance has continued to improve since the last update at the AGM on 30 July, and the board now expects revenue and profitability to be above current market expectations for both the half and full year.

Some detail:

• H1 revenue is expected to be at least $200m, which represents a 2.2% increase on the same period last year,
• Underlying operating profit is expected to be at least $20m, which is up 25.8% year-on-year, and
• Net cash excluding lease liabilities is around $31m, and
• The forward order book is strong.

Nat Rothschild, the 25% owner, comments:

Our geographic and customer diversification continues to provide the business with a high degree of visibility at this time while ongoing demand for consumer electronics remains strong and the global shift to electric vehicles gathers pace… Given the robust performance in the first half of the year, coupled with our strong forward order book position, the board expects to see a strong performance for the year as a whole that will be above current market expectations.

Conclusion

VLX seems to be doing all the right things operationally and is reaping the financial benefits during what has obviously a tricky operating period for most companies.

The valuation continues to be undemanding, so I’m happy to hold.

Meanwhile as the company continues to execute on its proven turnaround strategy, there is scope for further margin expansion. That would lead to higher cash flows which could then be ploughed back into strategic M&A and other growth opportunities.

It’s an impressive update and VLX’s shares are comfortably at five-year highs. When you get companies that generate a high level of sales already, and are focusing on expanding margins while growing those sales at the same time, that can all translate into sustained share price strength.

The StockRank has been in the 90s for years now, too.

Cerillion (LON:CER)

Share price: 319.5p

Shares in issue: 29,513,474

Market cap: £94.3m

Cerillion (LON:CER) is on my radar as one of a couple of ‘expensive’ software and tech companies that might well be worth the apparent premium.

Dotdigital (LON:DOTD) is another one, as well as a couple of the video games makers. My criteria are something like:

• Profitable and cash generative,
• Growing, and with sustained high margins, and
• Facing a large market opportunity.

Preferably with clear signs of management-shareholder alignment. Ticking those boxes can justify a relatively ‘expensive’ valuation, in my view.

I’m sure there are many other promising candidates out there so weigh in if you’ve got one and I’ll add it to my small but growing list…

Cerillion was founded by CEO Louis Hall back in 1999 and was a management buyout of Logica’s customer care and billing division. Since then, the company has carved out a niche for itself as a builder of reliable CRM and billing systems for global telecom companies.

It seems high quality not just quantitatively, with a Quality Rank of 92 and double digit operating margins and returns on capital, but qualitatively given its solid list of long customer relationships.

It also turns out that CRM system revenue is sticky as they are mission-critical and take a long time to replace - typically three years or more, with significant reputational risk attached. So very much ‘better the devil you know’ type situation - CER would presumably have to do quite a lot wrong before customers went looking for alternatives.

Trading update for the year to 30 September

Another very short update - but, again, encouraging.

H2 trading has continued to be strong, helped in part by CER signing its largest ever contract in mid-September which took the group’s order book to a record high.

Management now expects revenue and adjusted EBITDA for the financial year to be slightly ahead of current market expectations. Net cash is expected to be significantly ahead of market expectations at approximately £7.7m.

The new business pipeline remains strong, ‘with opportunities across all regions’, and the CER says COVID-19 has not affected business to any significant degree.

Conclusion

Here is a company quite clearly with the wind in its sails. There are plenty of skilled contrarian investors but I must admit I find it less psychologically bruising to look for companies that are already trading strongly and surpassing expectations. Cerillion is one such example.

The group’s founder and CEO owns more than 30% of the company and has been at the helm since the buyout back in 1999 - so there’s a great sense of continuity and shareholder stewardship here.

That also comes across in the company’s prudent financial position. CER guides towards a net cash position of £7.7m and it scores well on Stockopedia’s Financial Health scores.

The director dealings page shows some large sells and no buys, but that’s not a deal breaker if there are valid reasons for wanting to realise what I imagine are quite significant share price gains.

That aside, CER ticks a lot of boxes at first glance.

I don’t have any market data to hand but I imaging the CRM and billing systems market for telcos is quite large, with plenty of scope to expand into adjacent markets if required. I suspect the management team has quite a deep understanding of its market.

It’s cash generative and dividend-paying. The only possible blot in the copybook is a dip in profitability a few years back.

Understanding more about what happened here would be my next stop. It throws off the longer term compound growth rates, but I note the three year growth rates are looking very healthy:

Certainly worth a closer look assuming the total addressable market is large enough to justify a couple of years’ growth baked into the valuation, in my opinion.

Marstons (LON:MARS)

Share price: 41.7p (-7.1%)

Shares in issue: 634,100,000

Market cap: £264.4m

Just a couple of days ago the Marston's (LON:MARS) share price spiked on confirmation that their distribution tie up with Carlsberg could go ahead. I’m not sure why that was such a positive surprise to the market and the shares have come right back down again.

I continue to be an interested observer for now. There could be long term value, but a lot of the short term share price action is driven by more macro COVID commentary, and the body language in that regard suggests a tricky winter with potentially volatile share prices for businesses directly affected by lockdowns and related measures.

At some point the newsflow will change direction and it will become more obvious who will win in this sector. For now, though, the technicals look poor with the relative strength index in no man’s land and the share price well below the 50 and 200-day moving averages.

For what it’s worth I think Marstons is a good operator and I expect to see its pubs operating in a post-COVID world. I just think the ride between now and then could be quite bumpy.

Year-end trading update

Financial highlights:

• Group sales -30% to £821m,
• Total pub sales -34% to £515m, reflecting the closing of pubs for the 15 weeks from 20 March through to 4 July,
• Marston’s beer company sales -22% to £306m,
• Off-trade volumes +23% but on-trade volumes -11%

MARS says 99% of pubs have reopened since 4 July. Of course, that could change as we navigate a tricky winter, but you can only play the ball you’ve been bowled.

The group breaks down like-for-like trading at its managed and franchised estate:

I actually think 10% down in the weeks since reopening is quite a good result, all things considered. It looks like Eat Out to Help Out provided a material boost in August though.

Indeed, MARS goes on to say these trading figures represent ‘outperformance of approximately 7% relative to the UK pub sector (CGA Peach Tracker) over the 13-week period’ thanks to its balanced estate of pubs and limited exposure to the bombed out central London market.

So, things were recovering at MARS - but then we got hit with this Monday’s three-tier lockdown announcement from Boris et al.

On this important point, the group comments:

The introduction of these further restrictions and guidance affecting pubs is hugely disappointing in view of a lack of clear evidence tying pubs to the recent increase in infection levels, and our own data which suggests that pubs are effective in minimising risks...

Inevitably, and regrettably, recent restrictions will impact jobs… because of the recent additional restrictions, we have reluctantly concluded that around 2,150 pub-based roles currently subject to furlough are going to be impacted. Furthermore, we have initiated a full review of overhead costs which will be concluded by the end of December.

Net debt and liquidity

Net debt and liquidity - obviously an important bit for a pub company these days.

The ongoing question for most operators in this space continues to be: how long can you hold your breath. My view is that larger, asset-backed operators like MARS are better placed to raise funds and cut costs.

The group’s joint venture with Carlsberg will obviously help here, bringing in a useful £230m of cash that will be used to reduce bank debt.

Putting this windfall to one side, the group’s cash management has been quite impressive. Net debt as at 3 October had actually fallen to £1,329m - £70m lower year-on-year and £50m lower than at the end of March. This has been helped by MARS’ ongoing disposal programme as well as government support in the form of furloughs and deferred VAT and Duty payments.

That’s still over £1bn of debt, but it’s worth remembering that the tie up with Carlsberg values the Beer Company well ahead of book value and MARS has nearly £2.5bn of plant, property, and equipment on the balance sheet.

In all, by the year end MARS had £90m of headroom against a £360m bank facility and does not expect to use the additional £70m facility secured in May (which is due to expire in November).

Conclusion

MARS has traded ahead of expectations in the timeframe it has been given. It has worked out a joint venture with Carlsberg that hints at undervalued assets. It has brought net debt down ahead of expectations during a period that included 15 weeks of pub closures, despite not raising any equity. This is a credible result.

But it’s a big stock market, with many sectors either insulated from this year’s remarkable events or even outright benefitting from them - so with that in mind, I totally understand those that decide to just pass on this entire sector. It’s a very rational tactical investment decision to make.

Short term uncertainty is undeniable and share price volatility is to be expected - but on a longer term view I believe MARS and other good operators will be around long after we have got to grips with the current pandemic. For now though, this stock is only for those that can handle the volatility.

Hollywood Bowl (LON:BOWL)

Share price: 128.5p

Shares in issue: 157,500,000

Market cap: £202.4m

Trading update for the year ended 30 September

This ten-pin bowling operator seems to have fared better than other companies forced to close sites for part of the year. It expects to ‘deliver a marginal profit for the year’ despite sites being closed for some five months of the year. The group guides towards FY20 revenue of £79.5m, which is down 38.7% on last year. Net debt currently stands at £8.9m.

Even though Hollywood Bowl (LON:BOWL) revenue was up 9% like-for-like pre-COVID they are -32% since reopening. That’s actually worse that MARS has managed, with its pubs down 10% since reopening. Meanwhile, fellow bowling operator Ten Entertainment (LON:TEG) has reported -17% since reopening - so I’m not sure why BOWL lags these two quite so much.

Conclusion

I won’t spend long here - I've just seen an RNS from Novacyt so I want to move onto that.

In normal conditions, BOWL looks like a high-quality, high-return, and cash-generative roll out with attractive economics.

These are obviously not normal conditions though and FY revenue of less than £80m is below revised consensus expectations. As things stand I’d be looking for a cheaper entry price if I were to put my cash here rather than in another, safer part of the market. I do think the group’s scale and its high margins (when sites are open) could be enough to ultimately see it through though.

Novacyt (LON:NCYT)

Share price: 853.5p (+2.8%)

Shares in issue: 70,626,248

Market cap: £602.8m

(I hold)

Novacyt Sa (LON:NCYT) has shot to investors’ attention over the past few weeks and months with some massive contract announcements and a substantial rerating.

Such a rapid rerating can attract low-conviction holders who are then shaken out of their positions for a loss. Volatility can go both ways, after all.

This did happen to a degree, although the shakeout wasn’t nearly as bad as it could have been with shares dropping by about 10% after hitting the new all-time high of 880p.

The overall year-to-date share price strength is, of course, stellar, with one-year relative strength an incredible +14,441%.

Keelan wrote an excellent pitch for NCYT to get it into the Investment Club - have a read here if you haven’t already as he goes into great detail.

This is an exceptional situation with a hard-to-quantify but potentially massive short-term COVID-19 market opportunity followed by the execution risk of turning that demand spike into a sustainable mid-cap diagnostics company.

News today is an early sign of how NCYT plans to spend its incoming cash.

Acquisition of IT-IS International

Ever since 17 September, NCYT has had a new strategy in response to its transformed financial position. It is aiming to make strategic acquisitions to create a more vertically-integrated clinical diagnostics specialist.

This sounds sensible, but efficient capital allocation is a famously tricky task and management actually often struggles with it. There are a couple of ways to deploy capital, including: dividends, buybacks, capital expenditure, and mergers & acquisitions.

The latter is often the most value destructive according to some studies, and it is also what NCYT is doubling down on. So there is substantial execution risk here and a lot of NCYT’s future prospects depend on management’s ability to properly deploy its capital. That can often be a totally different skill set to develop. It’s just something to bear in mind - but a first glance at NCYT’s first acquisition does look promising.

NCYT has acquired the entire share capital of IT-IS International, the profitable instrument development and manufacturing company that is the exclusive manufacturer of NCYT’s q16 and q32 PCR instruments for £10.1m (£6.5m net, excluding a possible £1.9m earn-out).

IT-IS has been developing and manufacturing PCR devices in collaboration with NCYT since 2014. It is located in Stokesley near Middlesbrough and was founded by Benjamin Webster, Roderic Fuerst and James Howell in 2004 and has established a reputation for high quality mobile PCR products, which are sold in more than 50 countries worldwide.

Highlights:

• Secures key IP for NCYT’s q16 and q32 PCR instruments for near-term COVID-19 testing,
• Expands NYCT’s instrument manufacturing capabilities,
• It’s immediately earnings accretive: IT-IS generated £3.9m of revenue and £0.8m of net profit in FY19, with revenue increasing to £5m for FY20 and an increased gross margin leading to £2.9m of gross profit.
• Strengthens NCYT’s longer-term position in rapid near-patient testing.

Terms:

• £10.1m in cash to be paid upfront but IT-IS has £3.6m of cash already, so it’s a net cash consideration of £6.5m
• There’s an earn-out of up to £1.9m in cash payable to directors of IT-IS over the next two years

Conclusion

This seems a very sensible and earnings accretive first acquisition from NCYT. It has worked with IT-IS for more than five years and the move critically gives NCYT more control over manufacturing instruments to meet testing demand, particularly over the winter period.

It does suggest that management might be able to make smart acquisitions, as this adds value in better positioning NCYT to test for other infectious diseases on a longer term view.

It also strengthens NCYT’s IP portfolio and expands its core capabilities, whilst maintaining attractive margins. IT-IS has clocked up £5m of revenue and £2.9m of gross profit for FY20 and business is growing - on that note, a net consideration of £6.5m really doesn’t seem much to pay.

What’s more, this barely dents NCYT’s growing cash pile so I don’t see how there can be much downside to this acquisition.

In fact it could prove to be a bargain in time, if IT-IS’s manufacturing ability enables NCYT to capitalise on a longer term shift towards decentralised testing.

That said, I think it will be further news of trading and contract wins or larger acquisitions that really drives the share price. The bull case puts forward a second act at Novacyt: one of continued positive trading and contract wins, the release of broker notes, and institutional buying. Let's see if that happens.

It’s still all to play for and I’m sure we’ll be hearing more from this company in the coming weeks.

Fulham Shore (LON:FUL)

Share price: 7.1p

Shares in issue: 609,617,181

Market cap: £43.3m

(I hold)

A bit late in the day now but I’m a long-time shareholder here and rate the management team highly.

Fulham Shore (LON:FUL) is one of the better and more experienced operators in the casual dining game.

Its site economics at Franco Manca are excellent thanks to a combination of low-cost ingredients (pizza is one of the highest-margin food types), dealing directly with food suppliers, occupying smaller and cheaper sites, and the high volume of customers.

I would class its low cost-base as an almost structural advantage against more expensive, debt-saddled incumbent operators that have expanded too far. It’s played havoc with Pizza Express, for example, effortlessly undercutting it on prices by a substantial margin.

The Real Greek is pretty useful too, but the estate is more heavily weighted towards Franco Manca restaurants.

Stock here is illiquid and tightly held, so it might not be for everyone. In fact the trading figures - delayed for the year to 29 March - are basically ancient history given all that’s happened.

The chairman’s statement though is a terrific piece of writing, well worth a read. There are so many quotable bits I’m tempted to just paste the whole thing, but I’ve singled out a couple of highlights:

On an over-saturated pre-COVID casual dining market:

We believe that the restaurant market in the UK was heading for a correction well before the Coronavirus outbreak.

There were too many restaurant businesses with owners and managers convinced they could swim like Mark Spitz, but which were actually being kept afloat by some badly made rubber rings and various leaky flotation devices. They were driven to expand by historically cheap debt, supposed high exit multiples on sale of the businesses and run by management teams who had never experienced either a downturn in the UK economy or an oversupply in the restaurant sector.

On an observed structural trend towards smaller regional markets:

Before the onset of the coronavirus the busiest UK restaurants were those in the West End of London and metropolitan areas such as central Manchester... Since 4 July 2020 this situation has completely reversed. We believe this will remain the case for the foreseeable future.

Some of our regional and suburban restaurants are currently breaking trading records on a weekly basis. This is unprecedented in my 47 years in the restaurant industry. Fulham Shore's estate is well positioned to benefit from these structural changes.

On the experienced management team’s ability to directly source ingredients from suppliers:

Purchasing directly from our growers and producers cuts out one, two or even three wholesalers, agents and middlemen. This enables us to pass on these savings to our customers in the form of more affordable menu prices. This results in the high numbers of customers visiting our restaurants per week and means that our turnover per site continues to be strong.

This is the future - high quality ingredients combined with low prices, delivering high turnover per site.

On falling rents:

Landlords prior to COVID-19 were facing falling retail and restaurant demand for their sites, due to the continued shift to online shopping, the contraction of some large restaurant chains, and the challenging economic backdrop over the past three years.

The bottom has now truly fallen out of their world… The tribulations of distressed UK businesses and their landlords has resulted in the Group being offered more new sites than we can possibly view. These are ex retail shops, ex ground floor offices, ex chain restaurants, plus new build sites which were some years in the planning, but now have no tenants. We feel the longer we wait for even the best of these sites the lower the rents we can achieve. We believe this situation may last at least 5 years.

Writing like this makes reading RNS statements far more enjoyable! There are interesting tidbits here that might have useful read-across for some investors, particularly that last point on property and rents.

Anyway the report’s already a little long now, so I’ll leave it there for today. Good afternoon all.