Small Cap Value Report (Thu 22 April 2021) - G4M, SOLI, TRI, SFR

Good morning, it's Paul & Jack here with the SCVR for Thursday. Sorry I forgot to put up the placeholder at 7am, so we're running a little late.

Timing - TBC

Agenda -

Paul:

Gear4music Holdings (LON:G4M) (I hold) - another positive trading update, and brokers upgrade forecasts again. I explain why this is one of my favourite "coffee can" (long term hold) investments.

Trifast (LON:TRI) - positive year end FY 03/2021 update. Lots of interesting detail. Looks a decent company, but as with so many things at the moment, recent share price rises mean the price looks up with events.

Jack:

Solid State (LON:SOLI) - full year results to be 'ahead of the recently upgraded consensus forecasts' for this maker of rugged technology parts. Shares currently at near all-time highs.

Severfield (LON:SFR) - full year results expected to be comfortably above management's previous expectations.

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Paul’s Section

Gear4music Holdings (LON:G4M)

(I hold)

835p (up 5% at 08:07) - mkt cap £175m

Year-End Trading Update

Gear4music (Holdings) plc ("Gear4music" or "the Group"), the largest UK based online retailer of musical instruments and music equipment, today announces a year-end trading update covering the 12 months to 31 March 2021.

To recap, this online business has been putting out a series of ahead of expectations updates over the last year. No doubt a beneficiary of lockdowns, but also a focus on margin improvement has seen a step change in profitability in the last year.

I reported on its last, and impressive, update here on 25 Feb 2021.

Today’s update - is another “ahead of expectations” update.

Two things strike me from the sales table below -

Firstly that Europe & RoW has now inched ahead of UK sales. Is the stock market really valuing this share as a European eCommerce business (and potentially global)? The market cap of £175m doesn’t strike me as aggressive at all, and there could be scope for a re-rating possibly, once people factor in that it’s growing into becoming a potentially global business.

Secondly, these numbers below are really quite small. £78.7m sales in the UK, and similar for Europe/RoW, must only be a smallish market share of large markets. Hence I see much more growth potential - a long runway for continued growth for many years to come, which is a key factor I look for with shares.

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Longer term growth (all organic, remember) is shown in the Stockopedia graphical history below. Bear in mind that the broker consensus forecasts shown (lighter blobs) are too low. We’ve already worked out last time, that FY 03/2021 was heading for over 50p EPS, usefully higher than the 40p shown here. Also, it seems extremely pessimistic to anticipate that EPS would more than halve to just 21p in FY 03/2022. So I expect forecasts to be raised considerably over time. Although we don’t really know to what extent lockdowns boosted the numbers, and how much was structural, permanent growth.

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EBITDA - the most recent forecast, helpfully provided by N+1 Singer, is for Adj EBITDA of £18.2m, or £16.7m pre IFRS 16.

Today, G4M says it traded ahead of expectations, and will deliver “not less than £19.0m” in EBITDA. Unfortunately it doesn’t state whether this is pre, or post IFRS 16. I’m assuming it’s post, so that means £19.0m actual, vs £18.2m forecast, so it’s a c.4% beat - not bad, coming right at the end of the financial year (FY 03/2021). The latest lockdown will have no doubt helped somewhat.

Revenues - actual of £157.5m, a slight beat against forecast of £157.0m

Gross margin - a revised strategy to go after better gross margins, rather than revenue growth at any price, has worked brilliantly. See the lovely progression in gross margin -

Gross margin improved by 360bps to 29.5% (FY20: 25.9%; FY19: 22.8%)

This may seem a low gross margin (compared with say fashion, which is over 50% usually), but bear in mind that G4M has higher average transaction value, of over £100. Also the returns rate is much lower than fashion eCommerce.

As the business grows, then its biggest controllable cost, digital marketing spend, gradually falls as a percentage of sales, providing operational gearing. This is why it’s so difficult for smaller competitors to keep up - they can’t keep up with the bigger, more efficient marketing spend of the bigger players, so I imagine consolidation in the sector could happen.

Net debt - seems to have been eliminated, moving into net cash. Impressive!

Net cash of £2.4m at 31 March 2021 (net debt at 31 March 2020 and 31 March 2019: £5.5m and £7.5m respectively)

Bank facility - a new £35m bank facility has been agreed with HSBC. This is intriguing, because it’s on a much larger scale than previous borrowings. It sounds as if the company’s ambitions are growing -

As part of the Group's ongoing strategy, the new enlarged banking facility will help us to accelerate our longer-term ambitions. As we lay the foundations in FY22 for the next stage of our growth journey, in addition to establishing new sales verticals, we will further strengthen our European distribution network, accelerate investment into our e-commerce platform, and consider acquisition opportunities as they arise.

Current trading - sounds encouraging, despite tougher comparatives now kicking in -

Whilst it is still very early in the new financial year, we are pleased with FY22 trading to date, relative to the exceptional period of trading during April FY21.

We also remain mindful of the ongoing global pandemic and operational challenges posed by Brexit, but are confident that we have appropriate plans in place to mitigate their effects.

Updated broker notes - thanks again to N+1 Singer, an updated note has just come through. It has upgraded FY 03/2021 by 6%, to 55.8p EPS - at 835p per share the PER is just 15 - surely that rating is too low? It depends whether this year has been a one-off, or is (at least in part) sustainable?

N+1 seems to be assuming that most of this year’s profit growth is due to lockdowns. They helped for sure, especially in Q1 as G4M comments today, but I reckon most of the growth this year might have been structural. If I’m right, then the forecast for FY 03/2022 could be way too low. Singers are pencilling in a crash in EPS from 54.6p to just 20.0p. Although it has annotated its own note (something I've not seen before), highlighting the the FY 03/2022 forecasts with the words “Conservative assumptions....” . Singers is going to re-appraise its forecasts in June. So my money is on a series of uplifts to the very low forecasts as this year progresses.

As I’ve been typing this, another broker update has come through from Progressive. It has a slightly lower EPS forecast for FY 03/2021, of 53.6p. For the new year FY 03/2022, it has 26.4p EPS. Are earnings really going to halve? I doubt it. Personally I think something in the 30-40p EPS range seems more realistic, but time will tell. Put that on a PER of 30, and I think this share is worth 900-1200p as things stand now, with future growth likely to take that higher.

Scuttlebutt - my family are professional musicians, so I pick their brains about G4M occasionally. In a recent discussion, they said that many musicians in the UK have experienced border delays & extra costs when buying things from the EU (e.g. market leader Thomann). Apparently the problem is that, with small imports, there are multiple shipments from many companies, in a single lorry. If any one of those parcels, or pallets, has got the paperwork wrong, then the whole lorry load is held up. So customers have had goods stuck in lorries for a week or two, causing general consternation.

My brother said that, as a result of this, when he is asked by schools, pupils, etc, where they should buy their musical instruments & accessories, he now suggests they buy everything from Gear4Music (he’s not working on commission from me, I hasten to add!). G4M’s speed of delivery (next day on most things), and excellent customer service, plus not having to worry about border delays, make it a no-brainer to buy everything from G4M now, according to my brother.

Border problems going the other way (exporting into the EU from the UK) isn’t a big problem for G4M, because it set up 2 distribution hubs in Germany & Sweden, well before Brexit. It can therefore import directly into the EU from the Far East, by-passing the UK completely, as well as sending bulk shipments from the UK. So G4M should be able to manage these issues better than UK companies with no EU physical presence.

This is set up very well, and has opened the doors for G4M to become a much larger company - I’m thinking in terms of this company being £500m+ revenues in a few years’ time.

My opinion - this is pretty much a perfect “coffee can” share (100 Baggers book by Christopher Mayer, a book that many of us find very interesting & thought-provoking). It ticks all the right boxes, e.g.

• Entrepreneurial management, with lots of skin in the game (founder Andrew Wass still owns 30%)
• Management are good capital allocators & safe hands
• High ROCE
• Long growth runway, in large markets (international)
• Self-funding growth, so no requirement to raise more equity
• Little to no debt, but opportunity to make acquisitions or otherwise accelerate growth using borrowing facilities

Those are all very attractive qualities. That you can buy this share on just 15 times earnings, seems crazy to me. But I’m basing that view on my assumption that the predicted slowdown on lockdowns ending could be largely offset by continuing structural growth. Plus of course remember that physical music re-starting (bands being able to meet up again, gigs resuming), means that many product categories should now see a resumption of growth which was limited by lockdown.

I wonder how many physical music shops are likely to survive, especially after the prolonged shutdowns? Also, no physical retailer can stock the huge number of product lines required to be a one-stop shop, that is only viable online.

Hence my opinion on G4M is that it’s a terrific, coffee can (hold forever) share, and looks good value to me. Today’s update further reinforces my high conviction levels on this share.

As always, I have absolutely no idea about, and don’t really care, what the short term share price does. I’m thinking this is a 5+ year hold, and should be a very much larger business by then.

It's interesting to see on the 3-year chart below, how the StockRank system began to move from red, into green, well before the big move up in share price. It must have spotted something, so a dramatic & sustained improvement in StockRank is worth investigating further, I'd say.

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Trifast (LON:TRI)

165p (up 2%, at 11:25) - mkt cap £223m

Trading Update

Leading international specialist in the design, engineering, manufacture, and distribution of high quality industrial and Category 'C' components principally to major global assembly industries …

issues the following unaudited Trading Update covering the Group's financial year ended 31 March 2021

"Our fastenings enable innovation today to build a better tomorrow"

When I think about it, I agree with Trifast that innovative fastenings build a better tomorrow. Or at least a tomorrow where my white goods hopefully won’t fall apart on a 1200 rpm spin.

Trifast’s update today is very similar to most companies reporting at the moment - i.e. a steady recovery in trading, and more-or-less back to normal.

Q4 (Jan-Mar 2021) even saw revenues up >7% on prior year.

Profitability -

As a result of this strong performance, we expect FY2021 to exit ahead of current market expectations on an underlying basis (before IFRS2 presentational changes, as noted below).

Other points -

• Global logistical challenges have continued to have an impact
• Short term margin impact expected from higher priced/shortages of steel - a common theme which does raise the possibility of cost-push inflation in the wider economy, as has been widely discussed by financial commentators
• Cost savings made
• Strong cash generation
• M&A opportunities increase
• Problems with delivery of “Project Atlas” business improvement measures - being reviewed for budget & timetable

Outlook - sounds quite positive to me -

Demand has returned to our traditional end markets and we are already actively working with new and existing customers across a number of new high growth markets, including Electric Vehicle & battery technology, 5G infrastructure and healthcare.

The Group's return to sustained growth since September 2020, in addition to a very strong pipeline and high activity levels across all our key sectors, means we are looking ahead with confidence although, we remain mindful of macro level headwinds including future possible pandemic related restrictions.

Broker update - many thanks to Finncap for a forecasts update note today. It’s predicting 6.2p adj EPS for FY 03/2021 - a PER of 26.6 times, and 7.3p for the new year just started FY 03/2022 - which drops the PER to a still rather punchy 22.6 times.

My opinion - it’s had a great run, but I can’t see why anyone would think it’s worth holding at this valuation, unless you believe it has loads more upside to smash the forecasts.

It’s an OK business, but I think there are probably better investing opportunities elsewhere.

It was interesting to hear Trifast mention growth markets like EVs, 5G, etc. This reminds me of the exposure Volex (LON:VLX) (I hold) has to those sectors, and is seeing strong growth there. I think VLX looks a better bet, as it's on a lower PER than TRI, but strikes me as a higher quality company with more obvious growth drivers.

Trifast's share count rose from 122m to 136m during the pandemic, dilution of 11%. We need to take that into account when looking at the chart. So 11% more shares in issue means that, when valuing the whole company, 200p on the chart before the fundraising is now the same valuation as 178p today. Taking that into account, the share price is now effectively back to its pre-covid level.

Note the high StockRank below - middle-ranking, but almost into the green - maybe it could move into the green zone when broker updates are fed into the system shortly?

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Jack’s section

Solid State (LON:SOLI)

Share price: 879p (+4.64%)

Shares in issue: 8,553,504

Market cap: £75.2m

Solid State (LON:SOLI) has spent much of the past few years as a high StockRank stock, so it’s nice to see the share price finally break out and today we see it at nearly all-time highs.

For pretty much as long as I’ve known it, this one’s been flagged as a Super Stock.

Solid State is a long-standing AIM constituent is a specialist design-in distributor to the electronics industry, manufacturing technology for use in harsh environments. The company has particular expertise in industrial and ‘ruggedised’ computing, along with battery power solutions, communications including antennas and secure radio systems, electronic components and displays.

The group's mantra is - 'Trusted technology for demanding applications' and it specialises in complex engineering challenges often requiring design-in support and component sourcing for computing, power, communications, electronic, electro-mechanical and opto-electronic products.

Established in 1971 and admitted to AIM in June 1996, Solid has made 12 acquisitions since 2002, and is worth considering for, among other things, its long track record of steady revenue growth:

And, while the shares are not as attractively priced as they were six months ago, they’re also not as expensive as a lot of other valuations you might encounter at the minute - particularly when compared to other stocks in the Machinery, Equipment & Components industrial group.

Trading update for the 12 months to 31 March 2021

Solid State expects to announce results ahead of the recently upgraded consensus forecasts, following a final month of trading that benefitted from demand pulled forward and a strong contribution ‘from the two businesses acquired at the end of February’.

These businesses are Active Silicon, acquired for an initial net consideration of just £2.7m on annual revenue of £5.5m (with up to £1m more to be paid in earn outs), and Willow Technologies, purchased for an initial net consideration of £5.5m with a further max earn out of £3.5m. This group has annual revenue of £10.3m.

So at first glance these look like canny opportunistic purchases made from a position of relative strength during the Covid disruption - exactly the kind of event prospective shareholders might be looking out for.

Solid says its new acquisitions have integrated well so far, and commercial synergies are increasingly being realised, ‘with exciting prospects being advanced’.

Since its update to the market on 22 February 2021 trading ‘has continued to be encouraging’, with stable order flow and strong invoiced sales in March, driven by component shortages and customer stocking to mitigate supply chain risks.

We’re seeing this sort of supply chain disruption across different industries as a result of Covid. The question is who’s benefiting and who is scrabbling around paying through the nose for vital parts.

It looks like Solid, for now, is in the former camp. The company comments:

Market conditions across the electronics industry are expected to be impacted by supply chain challenges and component shortages for several months, and customers have been encouraged to pay increased attention to forecasting and adequacy of forward order cover. The Board is pleased to report that we have seen particularly strong order intake post year end to start FY21/22, building confidence in the outlook for the current year.

The group is experiencing shortened customer order schedules and reduced visibility, though.

To this point, Solid State’s open order book on a like for like basis on 31 March 2021 was down year-on-year to £33.7m (31 March 2020: £39.9m) due to the shortened customer order cycles. Including acquisitions however, the order book is £41.3m.

Foreign exchange headwinds are also a factor, but the group notes that this has so far been mitigated by invoicing in the same currency as the supply chain cost. Freight costs are running at a premium to the historical average as well - again, something other operators have commented on.

At 31 March 2021 the group had net cash (excluding deferred and contingent considerations and IFRS16 lease obligations) of approximately £3.1m. A good sign given Solid spent a net £8.2m on acquisitions late in the year.

Conclusion

These are very encouraging results from Solid State and the new acquisitions sound promising.

On that note, yes the share price has been strong recently, but the company has just added around £16m of annual revenues at undemanding multiples, and organic trading is good on top of that.

The group has a long operating track record that gives potential investors good visibility over its past operations, and we can see that it generates consistently good profitability metrics. Although the chart looks like a downward trend, these are ROCE figures comfortably in the teens over time.

The rate of growth has perhaps been an issue in the past, but broker consensus is a Strong Buy and the forecasts are building in some good earnings momentum over the next year or two.

And Solid’s performance over Covid is to be commended - this year exceeds the prior year, which was itself a record. So even after a rerating in the share price, this one could have good longer term potential as a potential Quality compounder if it can maintain growth rates.

Severfield (LON:SFR)

Share price: 81.4p (+7.39%)

Shares in issue: 308,221,462

Market cap: £250.9m

£SEVR has been listed on the Main Market of the London Stock Exchange since 1995 and has a long and successful history of handling steelwork projects across multiple sectors, from the highly complex to basic structural work.

The company also has an established foothold in the developing Indian market with strong production capability.

This kind of company suffers from cyclicality, no matter how well run, and so the first consideration should be the group’s financial health. Severfield does tend to carry some debt but interest payments are typically well covered by earnings.

See interest payments over time and TTM interest cover below.

Revenue took a tumble back in 2013 though and this coincided with an increase in shares in issue. The group made a net loss of £23.1m in this year.

So reading between the lines, it looks like shareholders have had to bail Severfield out before, which is something to bear in mind. To Severfield’s credit more recently, it has maintained a net funds position throughout the pandemic, with plenty of cash headroom and has not needed support under any employee-related government schemes.

And, with the UK economy unlocking, the next couple of years could potentially be a good time for the wider construction sector.

Trading update

Severfield says trading is good and, based on a strong H2, expects to deliver a full year result which is comfortably above management's previous expectations.

The group is winning high-quality work, with a strong order book of £315m, ‘which supports trading throughout the 2022 financial year and beyond’, and has a pipeline of opportunities in the UK, Europe and India.

In the UK and Europe, Severfield's factories and sites are fully operational and the group has been trading at pre-pandemic levels since the beginning of Q2 of the 2021 financial year. The UK and Europe order book stood at £315m as at 1 April 2021 (1 November 2020: £287m).

A good H2 leaves the group well-positioned with a strong future workload for the 2022 financial year and beyond. 80% of this order book represents projects in the UK, with the remaining 20% representing projects for delivery in Europe and the Republic of Ireland.

Severfield’s Indian joint venture ('JSSL') has continued its recovery after a difficult first half, the company has maintained a largely break-even profit position in H2.

JSSL's order book as at 1 April 2021 was £104m (1 November 2020: £98m), with 90% of that representing higher margin commercial work. However, Severfield is mindful of the ‘evolving COVID-19 backdrop in India.’

Year-end net funds (on a pre-IFRS 16 basis) were c.£4m, representing cash of c.£25m offset by the outstanding acquisition loans for Harry Peers of £9m and DAM Structures of £12m.

Conclusion

Severfield has a long operating track record and proven expertise in managing complex projects. Its sector is inherently risky though, with volatile margins, potentially large and lumpy contracts, and counterparty risks. You only need one or two projects to fall through for the picture to change dramatically.

I would be mindful of the volatility that can be expected from this type of business model, but, interestingly, Stockopedia has Severfield as a Balanced RiskRating, so clearly my caution here is not borne out by the observed share price volatility.

Severfield says it is ‘well-placed to win work in the diverse range of market sectors and geographies in which we operate and across a wide client base, providing us with extra resilience and the ability to increase our market share in the future’. So perhaps it is building more resilience into its operations than it might have had in the past.

And then the more immediate picture, in the UK at least, could be promising, while Severfield’s recent acquisition of DAM Structures brings earlier construction project involvement and significantly strengthens its presence in the rail/transport sector.

Small Cap Cyclical Value has been a good spot to be in recently. Severfield fits that profile, so if you are looking to increase your exposure to this part of the market then this looks to be a well run outfit with some good trading momentum behind it.