Small Cap Value Report (Thu 19 Aug 2021) - CLX, RBN, MCB, CGS

Good morning, it's Paul & Jack here today, with the SCVR for Thursday.

Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to cover 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 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.

Agenda -

Paul's Section:

To follow

Jack's Section:

Calnex Solutions (LON:CLX) - another 'in line' update from one of 2020's more intriguing IPOs. The shares trade on a premium valuation, but this is a well-managed, growing company with a strong market position and positive longer term prospects.

Robinson (LON:RBN) - tricky conditions here, with cost inflation and variable customer demand. It's capex heavy as well, and I wonder if payments to shareholders might be better to reduce operational costs and pay down debt post-acquisition. There are signs of value as well, and the company has been running for a long time, so it should have the nous to navigate tougher markets. Illiquid shares though - that will rule it out for a lot of investors.

Mcbride (LON:MCB) - more warnings on cost inflation, this time including a shortage of heavy goods vehicles. McBride has a fair amount of debt and has a lot going on with its Compass strategy. It's a fairly capital intensive business at the best of times, so if profits fall and the low margins take a hit things can get risky here.

Castings (LON:CGS) - a good, safe company with an excellent dividend track record that has been operating steadily for a long time although profit has been on a declining trend for years now. Conditions are tough, due to widely reported supply chain disruption and cost inflation.

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Jack’s section

Calnex Solutions (LON:CLX)

Share price: 119.97p (+5.24%)

Shares in issue: 87,500,000

Market cap: £105m

This growing company creates test and measurement instrumentation and solutions. These products are then used to validate the performance of critical telecoms network infrastructure.

They are essential products for Calnex’s customers, and the group has good standing in its market, as well as insight into its customers’ needs. This global network informs the group’s ongoing R&D efforts and strengthens its market position.

We took a closer look at it here as one of 2020’s more notable IPOs. It seems like a good company, certainly one worth taking a little further.

The valuation is quite high, but so are the growth rates.

Meanwhile, profitability metrics are strong over time, with a ROCE in the high teens to mid-thirties, growing free cash flow per share, and a Quality Rank of 94.

Nevertheless, after a strong early rerating, the shares have trended back down after hitting a high of 130p.

AGM statement

Calnex has continued to achieve strong trading and good order levels in the first quarter of FY22, in line with expectations.

The group draws attention to a positive response to its Paragon-Neo enhancements, with customers placing ‘encouraging’ levels of pre-orders ahead of launch later this year. This is the group’s Lab Sync platform which ​​allows network managers to test that their systems against enhanced timing standards.

Calnex says:

This new functionality will support testing on the very high speed 400G interface and the new PAM4 interface format. This is a key technology development which is expected to be widely adopted, as organisations upgrade their network infrastructure to cope with the increasing amount of data as a result of the increase in cloud computing and evolution to 5G.

Additional recent product developments include the enhancement of its Field Sync platform with the unique ability to test 5G Networks alongside the 3G and 4G support already available. This must make the platform a lot more valuable to telecoms operators increasingly focused on new 5G networks.

The group has not experienced any impact on production from the widely reported semiconductor shortage but ‘continues to monitor the situation closely’.

Calnex has also received a Gold standard accreditation from Investors in People. This has nothing to do with profits but it does reinforce the impression that there is a good company here. You would hope that happy workers will translate into a motivated workforce and lively R&D departments and product pipelines.

Conclusion

I’ll summarise with bullet points:

• Calnex looks like a well run, growing, profitable, cash generative company, with strong quality metrics, that invests for future growth,
• It is superficially expensive based on multiples,
• But it has a strong market position selling essential testing products to network operators, who in turn help inform the group’s R&D and product pipeline,
• This market is evolving, with drivers including the internet of things (IoT), 5G, and cloud computing, all of which present business opportunities, and
• The group’s founder and CEO remains its largest shareholder (21%).

So I think there’s a good long term investment case here. The shares have more than doubled since IPO and trading remains in line, so there is the valuation to consider.

With nothing in here to suggest an upgrade, that means the company is on course for earnings per share of around 3.8p, which is less than that achieved in the prior year, and keeps the group on that lofty PE rating of more than 30x.

That aside, having so far sidestepped any supply chain issues and with encouraging pre-orders of new products, this is a reassuring update from a company that looks to have robust longer term prospects.

Robinson (LON:RBN)

Share price: 109.99p (-10.21%)

Shares in issue: 16,753,445

Market cap: £18.4m

Robinson is a small manufacturer specialising in custom packaging with technical and value-added solutions for food and consumer products based in Derbyshire. It was formerly a family business with origins dating back to 1839, and the Robinsons remain major shareholders

After years of operations, the enterprise has grown to include three plants in the UK, two in Poland, and a recently acquired plant in Denmark (Schela Plast).

The main activity is in injection and blow moulded plastic packaging and rigid paperboard luxury packaging, operating within the food and beverage, homecare, personal care and beauty, and luxury gift sectors. FMCG customers include McBride, Procter & Gamble, Reckitt Benckiser, SC Johnson and Unilever.

Schela Plast similarly specialises in the design and manufacture of plastic blow moulded containers, serving a number of the major FMCG brands in Denmark and neighbouring countries.

Robinson also has a substantial property portfolio with development potential. The group is currently looking to dispose of some of these properties to fund further investments. This could release hidden value if the sites can be sold for above the reported cost.

It’s a small, illiquid company though so it might not be an appropriate investment for most investors. The market cap is less than £20m and it looks like you can only pick up scraps on the market.

The shares do look good value on the face of it.

But current market conditions are presenting issues and today we have a warning, with shares down 10%. That suggests some of these forecasts might get downgraded.

Interim results

The interim results we report today reflect the very challenging circumstances we are continuing to experience in 2021 across materials price inflation, customer demand and the ongoing uncertainty resulting from the Covid-19 pandemic.

Highlights:

• Revenue +19% to £21.2m (+3% excluding Schela Plast acquisition in February),
• Gross margin down from 23.6% to 16.7%,
• Operating profit before amortisation down from £1.6m to £0.1,
• Loss before tax of £0.6m (2020: PBT of £1.1m),
• Interim dividend of 2.5p,
• Net debt of £13.7m, up from £6.6m in December 2020, after net capex of £2m, £1.4m for the Schela Plast acquisition, and net debt acquired of £3.5m.

That’s quite a fall in gross margin, with most of the damage coming in the form of higher resin prices. These have now stabilised and even fell slightly in July, but the group does not expect a significant reduction this year.

This lack of supply and sharp uptick in prices was flagged back in March and Robinson now says:

Since 1 January the market price of resins used in the Group have increased on average by 60% and we have experienced substantial challenge to secure raw materials in a market where resin unavailability has caused some competitors to shut down production lines.

This has been partially mitigated with some price increases but not enough to prevent a first half loss. Over the medium-term the group is protected from resin price movements through contractual arrangements with most customers, but there’s a three month lag before prices can be changed.

Furthermore, the group is seeing price inflation in other areas including secondary packaging and transport ‘which will continue to impact on the second half of the year’.

And the group is getting no help from the demand side - lower-than-normal levels of demand in the third quarter across its markets due to the ongoing uncertainty across FMCG supply networks and a varying pace of recovery following the pandemic. This is expected to continue for the second half.

In response, management is accelerating plans to improve operations for additional cost savings and profitability. The chairman adds:

We expect full year operating profit before amortisation of intangible assets to be in the region of £2.0m (2020: £2.7m). We remain committed in the medium term to delivering above-market profitable growth and our target of 6-8% of adjusted operating margin.

Stockopedia has £2.3m of profit before tax pencilled in for FY21E, so this will presumably have to come down.

Given the prevailing conditions, that 2.5p interim dividend seems quite generous. Perhaps it would be better to use that cash to pay down debt, or reinvest into those operational improvements. I imagine the shareholders here like their dividends.

On this point, the group says:

Despite the short-term market challenges we face, the Board has confidence in the medium term prospects for the business and therefore announces an interim dividend of 2.5p per share to be paid on 8 October 2021 to shareholders on the register at 10 September 2021 (record date). The ordinary shares ex-dividend date is 9 September 2021. The current intention of the Board is to pay a total dividend of 5.5p (2020: 8.5p including the 3.0p deferred 2019 final dividend) per share for the year ended 31 December 2021.

That would be a 5% yield.

Property

This is what makes the company interesting beyond the current market conditions.

Work has continued on the potential disposals announced in March and completion is expected in the second half of 2021, for a gross value of £3.4m for two plots of land with a book value of less than £1m. There’s plant, property and equipment of £24.356m on the balance sheet, up from £19.893m in the prior period.

Robinson expects further sales to be achieved in the latter part of 2021 or early 2022.

Net debt

Net debt has increased to £13.7m (31/12/2020: £6.6m) following the acquisition of Schela Plast and the resin price impact on profitability and working capital. In addition, deferred consideration of £2.3m is payable to the former owners of Schela Plast in 2022, provided for in Trade and Other Payables.

Robinson has total credit facilities of £22.6m, so there is headroom.

This is a fairly capital intensive business though and net capex in the first half year was £2.0m (2020: £2.1m) including new production equipment now installed in Schela Plast to service a major FMCG brand owner. Again, the mix of tough and uncertain market conditions, higher net debt, payments to shareholders, and high capex makes me slightly uneasy.

Conclusion

Ronibson is forecast to make £51.1m of revenue in FY21. At the halfway point it had generated £21.2m so it will need to perform better to match that target. Assuming it does, the forecast £2.3m of net profit implies a 4.5% profit margin, which seems reasonable under more stable conditions given the 6-8% adjusted operating margin target.

For now it looks like that profit figure will not be met though.

This is shaping up to be an unusually tricky year for the group, but it has been running for a long time and when that is the case, it strikes me as more likely than not that the company can ride out the tougher periods.

If we assume the group can hit its FY21E revenue forecast and grow at the CAGR of 5% thereafter, that would get us to £65m of revenue in five years’ time and £3.9m-£5.2m of operating profit. Given the market cap of £18.4m, those numbers are worth considering, particularly in light of upcoming property disposals.

But then there are the current market conditions - an uncomfortable position, with apparently widespread cost inflation at a time of variable demand, alongside higher net debt, high capex, and maintained dividend payments.

You might argue that the latter two points signal confidence in the group’s medium term prospects but, as a shareholder, I’m not sure I’d want to be receiving a dividend at present. Given the habitual capex spend, I’d much rather see cash being used to lower the net debt.

It’s an illiquid stock as well, so any holders looking to sell might weigh down the share price for a little while. There could be value in this company but in light of present conditions this update makes it one to monitor in case of further share price declines or better news flow that improves the risk:reward, in my view.

Mcbride (LON:MCB)

Share price: 77.57p (-8.53%)

Shares in issue: 174,200,661

Market cap: £135.1m

This is a ‘picture tells a thousand words’ kind of share price chart, characterised by sharp lurches both upwards and downwards and an overall lack of progression over time.

Perhaps the answer lies in the fact that it manufactures goods for private label. Who has the power in that relationship?

I would assume not McBride. Nor can I imagine much pricing power against supermarkets. If conditions worsen, as appears to be the case now, it would be a tough task getting these private label owners - often low margin themselves - to pay much more if there are viable manufacturing alternatives around.

It’s a low margin enterprise, which makes sense, and the ROE of 19.7% is flattered by a big slab of debt, meaning gearing is high. So it doesn’t immediately present itself as an attractive investment.

Trading update

On 14 July 2021, as a result of both the uncertainty surrounding the volatile input cost environment and the success and timing of pricing actions, the Board indicated that, at that time, it would not be offering guidance on the outlook for financial year 2022.

The raw material environment remains extremely challenging both in terms of exceptional price increases and supply availability. This is in keeping with Robinson’s update above.

More recently, and in line with the general trading environment experienced by others, McBride has also started to experience distribution challenges, particularly in the UK and Germany as a result of the shortage of Heavy Goods Vehicle (HGV) drivers. This is affecting both transport availability and cost.

Margin recovery

The group continues to discuss margin recovery actions with its customers, mostly across liquids categories. McBride's approach has been to seek a variable pricing surcharge to sales contracts, based upon certain key commodity prices.

The board's view on input costs for the new financial year remains in line with prior estimates. In terms of customer pricing, although discussions have resulted in agreement for price increases, the effective start dates for price increases are later than targeted.

Guidance

The first half of FY22 is now expected to see EBITA at approximately break-even, with profits heavily weighted towards the second half of the year. McBride hopes to see the business exiting the year with run-rate profit levels in line with the average of the last few years.

That means adjusted profit before tax for financial year 2022 to be 55% - 65% lower than current market consensus (of £19.7m) for full year 2021, and for net debt at 30 June 2022 to be 5%-10% higher than full year 2021 consensus (of £121.5m).

A further update will be provided at the group's preliminary results presentation for the year ended 30 June 2021 on 7 September 2021.

Conclusion

Although actions are being taken to recover margins, falling profits and increasing net debts does not sound promising. The group’s relatively modest valuation to begin with means shares are down 8.53% so far today, but I wouldn’t be feeling particularly comfortable as a shareholder.

It’s not the only company warning on supply chain issues, but the group’s financial position makes this a more serious threat for McBride. It’s an uncertain position for an indebted company to find itself in. There’s not much room for manoeuvre.

Furthermore, McBride has been through several strategy resets over the years. Financial position, business model, repeated changes to strategy - all adds up to a lack of progress over the years.

The group continues to work on its Compass strategy, which aims to deliver €1bn of annual revenues in the next five years. Perhaps it can accomplish that, but what of margins? If existing customers ordered greater volumes, they would presumably expect discounts.

And before that, it feels like there’s quite a lot of work to do here to get the company in shape, even in more benign markets.

Castings (LON:CGS)

Share price: 369.5p (-4.77%)

Shares in issue: 43,632,068

Market cap: £161.2m

Another negative move in what is proving to be a tough day at the office for investors (I note Calnex is now also down).

Castings has three operating sites:

• Castings
• WM Lee
• CNC Speedwell

The business started as a black country foundry business based in Walsall in the 19th century. It floated on the Birmingham stock market back in 1960, acquired William Lee in 1991, and bought CNC Speedwell (a machining facility) in 1996. Prior to this it was normal for foundries to purchase from machinists so this looks to have been an important acquisition.

In 2009 the group opened a major new production facility at the William Lee site for larger castings and today it is a highly invested iron foundry and machining group, with around 1,100 current employees and turnover typically between £110m-£160m.

It works by designing pieces which are then produced in small batches in its foundries and machined and assembled in its machine shops. From there, the products are delivered to customers.

Europe has become an increasingly important market here and is now the bulk of revenue by geography (70%) but America also presents a small growing market. Heavy truck is the biggest customer segment (71%), with some notable clients including Caterpillar. Other business comes from cars, agriculture, rail, and wind power.

The business specialises in making small batches of parts with high-tech equipment. This USP has allowed the group to invest heavily in its business and retain a strong balance sheet. Whether or not that capital is being deployed profitably is another question - there’s a deterioration in ROCE prior to Covid.

There is scope for M&A but the group seems to move cautiously.

AGM statement

A brief update to the market.

The group painted a mixed picture back in June - commercial vehicle customers (70% of group revenues) were forecasting increased volumes for H2 but were also suffering from the semiconductor shortage.

Output during the first quarter of the financial year was in line with recent (pre-Covid) years. However, the reported supply chain issues have forced OEMs to reduce truck build rates to below their order intake levels.

This has hit Castings’ sales in the last two weeks of June and that’s continued into the second quarter. The group has maintained high production levels to increase stocks so that it can supply the higher anticipated demand but no doubt there’s an underlying trend of disruption.

Raw material prices have also continued to rise. There’s a time-lag in sales price increase so this is still negatively impacting margins.

Conclusion

While Castings is also relatively low margin like McBride, a key differentiator (business model and sector being the obvious ones) is the group’s balance sheet strength. A net cash position over time compared to an uncomfortable level of indebtedness.

This makes it a much different investment proposition. Debt can be good in that it magnifies the impact of profitability on equity. But when times are bad, it can prove disastrous.

Although Castings is facing similar pressures, it looks far better equipped to manage its way through tricky market conditions. This is a sensibly run operation that takes care of its estate. Investments in automation technologies should improve productivity and profitability, but there’s been a lack of meaningful revenue growth over time, while net income has fallen over that period.

The forecast dividend yield is a respectable 4.02% and the dividend track record is excellent. That might be the primary attraction here, a good income stock.

But until the group arrests its slide in margins and returns on capital I suspect there are better opportunities out there for those that focus on total returns. It seems like a good business but there’s not any numbers in this update so it’s hard to really quantify what’s going on. The near term outlook does not sound appealing.