Small Cap Value Report (Thu 23 April 2020) - LGRS, SDI, G4M

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

I finished off yesterday's report last night, with a new section on BooHoo, which is here. What a fantastic business that is. Although on current trading, the company should have just given the figures, instead of ambiguous narrative. Numbers in a table is always the best way of conveying information. If vague or ambiguous language is used, then my conclusion is that the PR is probably trying to hide something unfavourable from us.

Estimated timings - I should have a decent amount up by the 1pm email deadline, but intend continuing until about 3pm. Update at 15:09 - oh dear, I've only managed to get through 3 of the 9 companies I wanted to cover today. I'll keep going until whenever. Today's report is now finished. Most of the companies I didn't get round to looking at are now in tomorrow's report here.

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Loungers (LON:LGRS)

Share price: 95p (up 23% today)
No. shares: 92.5m + 9.25m new shares = 101.8m
Market cap: £96.7m

Extension of bank facilities and placing

Loungers - the operator of 167 café/bar/restaurants across England and Wales under the Lounge and Cosy Club brands - today provides an update on the actions it is taking in response to the Covid-19 crisis.

This RNS came out after market close last night. It joins the rapidly growing list of companies which need to refinance, because nobody thought of the possibility of a pandemic. The business models of entire sectors were completely wrong, for decades, with a huge risk lying dormant, we just didn't realise it. Once Covid-19 is over, I wonder how long it will be for this lesson to be forgotten again? 5-10 years, at a guess!

Loungers floated in April 2019. I reviewed the IPO document in quite a bit of detail in a video here. Although I made a mistake, in miscalculating the debt, therefore my main conclusion of it being over-geared, was (partially) wrong. Doh! Although the main purpose of the video was to demonstrate how you don't need to spend half a day wading through an admission document, but can actually skip a lot of it, and focus on the most important bits, in about an hour. Time well spent, if you're about to buy thousands of pounds-worth of shares in any company. Admission documents are usually on the investor relations section of AIM companies' websites, so I try to always have a look at them, even if they're a few years old. There could well be important disclosures in them, that shed light on the business, in a way which is never done again.

Actions taken - by Loungers, in response to Covid-19, sound very similar to what Revolution Bars (LON:RBG) (in which I have a long position) recently reported, namely;

• 99% of staff furloughed under Govt scheme
• All capex & "non-discretionary" spending paused. Surely they mean discretionary, not non-discretionary? That looks like a typo to me
• Negotiating with landlords & other creditors
• VAT & business rates deferral schemes being used
• Directors taking a 20% pay cut, and 30% pay deferral whilst sites are closed

Cash burn - weekly cash burn (on full rents) has reduced to only £480k. That is 20% more than Revolution Bars recently reported for its weekly cash burn of £0.4m. Loungers turnover is about 21% more than Rev Bars, so the cash burn figures are almost exactly in line with each other.

Bank facilities - increased bank borrowings are partially linked to an equity raise being undertaken - sensible risk-sharing to my mind;

As at 17 April 2020, the Company had £4.1m of cash on its balance sheet, undrawn facilities of £3.0m and net debt of £35.4m.

Loungers is pleased to announce that its current lending banks, Santander and Bank of Ireland, have agreed to provide an incremental £15.0m revolving credit facility for an 18 month period (the "New Facilities").

£10.0m of the New Facilities can be drawn immediately and a further £5.0m can be drawn conditional upon the Company raising equity funding of at least that amount.

Covenant tests at 12 July 2020 and 4 October 2020 have been waived and subsequent quarterly tests to 3 October 2021 have been re-set.

That sounds comprehensive, and should buy the company time to get through this lockdown.

I particularly like this very clear statement on how the company is now set up to survive even an extended lockdown. All companies need to issue this kind of statement, so that investors can correctly assess risk;

The Board believes that the net proceeds of the Placing, having utilised both of the above authorities, and when combined with the New Facilities, will provide the Company with sufficient capital to best manage through the Covid-19 crisis, particularly in the event of a protracted period before the Government allows hospitality businesses to re-open, and to subsequently recommence its roll-out.

Assuming completion of the Placing, the Board estimates that the Company will have available funds of approximately £31.0m which, if the Company's sites remained closed and including a forecast working capital unwind of £9.0m, would equate to approximately 46 weeks' liquidity at the cash burn rate set out above.

When will lockdown end? - this is the crucial question. Nobody knows, is the only answer right now. I see the Chief Medical Officer is talking about lockdown being required until the end of 2020. That's pie in the sky in my view, because the economic pain would be far too severe to tolerate such a draconian measure. Remember, the economy is people, not just numbers on a spreadsheet or on a bank statement. We're talking about extended lockdown ruining the lives of millions of people. It's just not an option.

The solution is obviously a vaccine, and/or drugs to treat the condition, and make it survivable for everyone. If such a breakthrough were to be announced, then shares like Loungers would probably double, or more, instantly, as business would return to normal quite quickly.

For what it's worth, which is not much because it's only one person's opinion (subject to change as the facts change), then my view is we're probably going to see lockdown eased in phases, quite soon (May/June maybe?). The reason being that the UK Govt seems to be bending with the wind, and just following what other European countries are doing. Macron is today reported to be mooting allowing France's cafe/bar/restaurants to re-open in May. That would be unusually early, and is very positive for UK cafe/bar/restaurants, which would probably be allowed to re-open once that is happening in other countries.

The nightmare scenario is that cafe/bar/restaurants are allowed to re-open, and a second wave of Covid-19 sweeps through the population all over again. Apparently that's what happened with Spanish Flu, a hundred years ago. In that case, I think many hospitality and retail sector businesses that survived the first wave, would close their doors for the last time.

It's all up in the air. If we don't get a vaccine or other effective drug treatment, then I think herd immunity (whilst protecting the vulnerable properly) would be the only viable option. Statistically, the risk to life from Covid-19 for fit & healthy, normal weight, working age people, is tiny. At some point, Govt policy will need to reflect that reality. Although every death is a tragedy for family & friends. We just had another death in my family last night, rest in peace Jack. He was 83, with dementia. Covid-19 has worked its way through his care home, and killed about half the clients there already. Nature/God is certainly demonstrating well its ruthless and brutal side, by mercilessly killing off the old and vulnerable.

Bottom line, is that investors in the hospitality sector are taking a considerable risk. If I'm wrong that lockdown could be eased for bars by this summer, then my largest position (in Revolution Bars) could go disastrously wrong. That's a risk I've weighed up, and accept, since I think the upside is much larger than the downside. Time will tell if buying a big stake there was a stroke of genius, or an act of madness!

Loungers has given itself more headroom than Rev Bars, because it's raised enough equity/debt to survive well into 2021. Whereas Rev Bars only increased bank facilities until Aug/Sept, so is on more of a tightrope.

Result of placing - another RNS out this morning.

Number of new shares: 9,250,000 (10% dilution of existing holders - perfectly reasonable in the circumstances)
Price: 90p (this is a very strong result -a premium of 16.1%)
Proceeds: £8.3m gross, £8.1m net of fees

Brokers: Peel Hunt & Liberum (who have done several other successful fundraises lately, they seem to be the dream team!)

Directors: are subscribing for 822,787 shares, a healthy 8.9% of the total being issued. Lion Capital (former VC owner) is subscribing for 3m shares. Therefore related parties in total are taking up about 41% of the new shares. Perhaps this is why they managed to get a premium price for the placing - because only a small amount of new shares are being issued to outsiders, and the insiders are motivated to protect the value of their existing shareholdings, hence going for a premium price for the placing. That's my theory anyway!

My opinion - the sector expert I consult on the hospitality sector, has always told me that Loungers are very good operators, better than most of the competition, hence worth backing.

Today's fundraising has dramatically reduced the risk for investors, hence I would certainly consider buying some shares in this company, if I didn't already have far too much exposure to the sector. I see this as a lower risk way of doubling or tripling our money, if Covid-19 is defeated, and normal business can resume. It now has headroom well into 2021, which I imagine should be sufficient. We can't hide away from this virus forever. At some point life has to return to normal, and we have to live with the risk.

The main problem with Loungers shares, is that liquidity is terrible. It barely trades anything most days. This is the problem with brokers that float companies shares to institutions - there's no after-market. The City needs to address this issue with new floats. There has to be some mechanism to distribute shares to private investors, thereby creating a liquid after-market. Otherwise, what's the point in acquiring a listing?

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Sdi (LON:SDI)

Share price: 60.5p (up 7% today)
No. shares: 97.5m
Market cap: £59.0m

Covid-19 update

SDI Group plc, the AIM quoted Group focused on the design and manufacture of scientific and technology products for use in digital imaging and sensing control applications, is pleased to announce an update on trading for the year ending 30 April 2020, and on the impact of COVID-19 on SDI's operations.

Summary of general points;

• Continuing to operate from its 8 UK sites
• Reduced costs & using Govt schemes where appropriate. 19% of staff furloughed - so they must be expecting a reduction in orders/output
• Conserving cash

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Expected results for FY 04/2020 -

The Group continues to expect to meet market profit expectations for the year ending 30 April 2020, with sales of around £24 million.

A broker update note today gives EPS of 3.6p, for a PER of 16.8 - but that's likely to be peak earnings for some time, hence doesn't look cheap to me.

Cash & liquidity - this doesn't sound very safe to me, with bank facilities almost fully drawn down, hence not a lot of headroom if things turn really ugly -

SDI has a strong balance sheet with current cash in excess of £4.5m, unused debt facilities of £0.6m and bank debt of £8.9m. The Group has a good long-term relationship with its bank and has agreed, as a precautionary measure, a capital repayment holiday of three months of its revolving credit facility. The Group has also taken advantage of the UK Government's scheme allowing a temporary VAT payment deferral.

Current trading - not great, but not disastrous either at this stage -

...However due to COVID-19 SDI withdraws market guidance for the year to 30 April 2021. There has been some disruption to supply and some slow-down in orders, but SDI currently has all factories in operation and has so far remained both profitable and cash generative. At least four of our production units are providing their customers with components for medical and scientific products used in the fight against COVID-19.

Balance sheet - it's not strong, it's just OK.

When last reported as at 31 Oct 2019, NTAV was modest, at £1.7m.

In my view, management should take advantage of the share price strength, and do a placing of about 10% dilution, which probably wouldn't upset anyone, and would raise almost £6m to strengthen the balance sheet. That's simple, but sensible advice to the company. I don't charge any fees! Good quality companies like this, are not having any trouble raising fresh equity at the moment, and it could avert a future crisis if Covid-19 pans out worse than expected.

My opinion - given the uncertainty, withdrawal of guidance, and not much headroom in terms of liquidity, I'm quite surprised the share price has remained so resilient.

In the current, potentially dire circumstances, I think this looks over-priced for the time being. Am happy to look at it again, once the dust has settled. By looking through Covid-19 and pricing things for recovery, I think the market is possibly under-estimating the economic damage that is starting to occur. But everyone has their own opinion on that, and obviously alternative views are equally valid. I cannot see the sense in paying a fairly full price for a business at peak earnings, when a potentially very severe recession is just starting.

Don't get me wrong, it's a nice little group of businesses, and seems well managed. I'm just questioning the valuation, given how uncertain the outlook seems.

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Gear4Music

Share price: 275p (up 10% today)
No. shares: 20.95m
Market cap: £57.6m

(at the time of writing, I hold a long position in this share)

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 2020.

As you can see below, G4M has fully recovered from the recent indiscriminate sell-off. Another reminder (after BOO yesterday) that some online businesses are coming into their own in the lockdown, with conventional competition stifled. Maybe Covid-19 might be accelerating previous trends, towards more commerce being done online, more people working from home, less travel, more video-conferencing, etc.? Or will things return to previous norms, once this crisis is over? Answers on a postcard please!

As you can see from the 2-year chart below, the company disappointed previously, as its operating margin fell to essentially nothing, as it chased market share. The strategy was more recently revised, to improve margins, and accept a lower growth rate. That now seems to be working.

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We've been inundated with reassuring trading updates from G4M this year. Today's update gives us more data, for FY 03/2020.

Key points -

• Revenues up only 9% to £120.3m - much slower growth than in the past, but that's as planned, to chase margin, not revenues
• Gross margin improved by 310bps to 25.9% (FY19: 22.8%) - this is the stand out number. It's still a very low gross margin, but remember that the average transaction value is quite high, so gross margin in £ terms for each order is quite good
• EBITDA not less than £7.0m (FY19: £2.3m) - a whacking great increase in EBITDA. Before we get too excited, bear in mind that this £7.0m EBITDA only translates into adj PBT of £2.4m. It's still a cracking improvement though

Covid-19 - operational challenges. But, this bit sounds very encouraging;

I am extremely grateful for the extraordinary hard work and commitment our teams have demonstrated, which has allowed us to successfully satisfy the high demand we have encountered since late March, as an increasing number of people recognise the benefits that playing musical instruments can bring during these difficult times.

My opinion - things seem to be firmly back on track at G4M, very pleasing.

Sad though it is, I imagine that many independent music equipment retailers that were just about surviving, may not re-open once the lockdown is lifted. Therefore online is the beneficiary.

Overall, I think with forecasts beaten for FY 03/2020, and a strong outlook, given the current crisis, then G4M is starting to look appealing again. I'll probably be adding to my existing small position on down days. Management has renewed credibility, now that it has executed very well on the plan to increase margins.

I think this is likely to be a much bigger & more profitable business in 5-10 years' time. That's what investing is all about really isn't it?

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That's it for today. Please see tomorrow's report for additional companies that I had originally planned to put in this report.

Best wishes, Paul.