Small Cap Value Report (Thu 25 Feb 2021) - G4M, RCDO, MACF

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

Agenda -

Gear4music Holdings (LON:G4M) - yet another increase in guidance for FY 03/2021 - this share looks cheap at 725p, expect a decent rise today.

Macfarlane (LON:MACF) - resilient results from 2020. Big increase in divis, and net debt paid off. Looks good value to me.

Ricardo (LON:RCDO) - improving conditions and reinstated dividend from this engineering consultancy (this section by JAck)

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Gear4music Holdings (LON:G4M)

(I hold)

725p - mkt cap £152m

Trading Update

Gear4music (Holdings) plc ("Gear4music" or "the Group"), the largest UK based online retailer of musical instruments and music equipment, today announces the following trading update.

This is the latest in a long line of above expectations trading updates.

We are pleased to report that Group trading performance in the 2021 calendar year to date [Paul: FY 03/2021] continues to be strong. Both our UK and European Operations have performed well post Brexit, helping to drive revenue growth and support margins that have exceeded our previous expectations.

The Board now expects EBITDA for the 12 months ending 31 March 2021 ("FY21") will be not less than £18.2m, up from the guidance provided on 14 January 2021 of not less than £16.5m.

That’s a useful increase in forecast EBITDA, especially coming near the end of the financial year. G4M seems to be going from strength to strength.

Forecasts - I can’t see any updated broker notes yet, but using a previous note from N+1 Singer, I can manually update it to adj PBT of £13.1m, or 50p EPS.

That means the PER is only 14.5 - clearly the wrong price. It should be on a PER of 20-30 in my view, implying a share price of 1000-1500p - good upside from 725p currently.

My opinion - I think broker forecasts here look way too cautious. The assumption seems to be that G4M has had a one-off boost from lockdown. That’s probably true to some extent, but bear in mind that once lockdown lifts, then live music should return with a vengeance. That means customers wanting to buy new equipment. Therefore some categories such as speakers, might see a boom, even if others fall back a bit.

I really can’t see EPS falling from 50p FY 03/2021 to 27.73p next year (current broker consensus). Hence upgrades to next year’s forecasts seem inevitable.

In my view G4M is a high quality growth company, that is a core part of my long-term portfolio. I can’t see any reason why the share price is below 1000p, so it’s a really good buying opportunity in my view at 725p. Although it’s likely to be marked up before trading begins shortly (I’m writing this at 07:31).

G4M has also impressed for its foresight in opening distribution hubs in Germany & Sweden some time before Brexit. Therefore it can service the important EU markets from within, an important logistical advantage over other UK-based competitors.

Shareholders who backed the company’s strategy change in 2019, to focus more on increasing gross margin ahead of revenue growth, have been richly rewarded.

This share ticks the box for having an entrepreneurial owner/manager with lots of skin in the game (Founder, Andrew Wass still owns 30% of the shares), and he’s built a terrific team, that are really delivering the goods. I’m giving this factor a lot more emphasis in my stock picks these days, as it really does seem to be closely correlated with investment success.

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EDIT - I’ve had a look at the new note on G4M from Progressive, which came through after I’d written the above. It ties in with my figures, with 50.9p EPS. They’re not changing subsequent years due to uncertainty, which seems unnecessarily cautious to me. Are earnings really going to almost halve to 26.4p in FY 03/2022? That seems highly unlikely to me, but only time will tell. If that gloomy scenario does play out, then the share price is probably high enough for now.

Fund manager Stephen English was brilliant in the latest Mello Monday on 22 Feb 2021. He made a point which in particular stuck in my mind. He said that, for the best companies, analyst forecasts for later years are nearly always far too conservative. That provides an opportunity. I’d add to that my observation that, coming out of a recession (as we are effectively now), analysts also tend to be far too cautious. For some reason, they don’t seem to like factoring in the operational gearing, and strong revenue growth, which usually accompanies an economic recovery. Conversely, when the economy is doing well, they extrapolate out current growth rates forever, with no slowdowns. Too optimistic in the good times, too gloomy is the bad times. Hence why forecast numbers should never be taken as gospel. They're just a starting point, and I frequently adjust them for my own purposes.

My feeling is that G4M was already growing strongly before covid, and in the long-term is likely to be a very much larger, and more profitable company than it is now. The growth runway is massive too - large markets, and global, since it sells almost completely online. All the ingredients seem in place for a long-term major success. So why play around the edges, going in & out of the shares, trying to time the market? I think it’s just a buy & hold forever type of share.

Book recommendation

I’ve been strongly influenced by a superb book that I’m reading at the moment, recommended by a reader, sorry I’ve forgotten who, or I would have mentioned you. It’s called 100 Baggers, by Christopher Mayer, and although I’ve only read 8 chapters so far, have found it full of brilliant insights. Without spoiling the book for you, which I highly recommend, his key point is that history shows that 100-bagger shares are often entrepreneurial, high growth businesses (with a very long growth runway ahead of them), have a high ROE, and great management (who hold lots of shares personally). Investors who have 100-baggers are the ones who buy, and then do nothing. Just buy & hold for 10+ years. It's also a very easy strategy to follow!

He recommends having at least some of your portfolio in a "coffee can" portfolio - which in 20th century America was used by people to store their valuables, in a coffee can. After their death, relatives would apparently find the deceased person's coffee can, containing some long-forgotten stock certificates, one or two of which would be massive multibaggers.

It strikes me that G4M almost perfectly fits the bill for a potential 100 bagger (from its original float price, maybe not from today’s price!). Hence I've put it in the "coffee can" part of my portfolio, along with Boohoo (LON:BOO) and Volex (LON:VLX) . These are shares I don't intend selling ever, unless something serious goes wrong with the fundamental case. But even then, Mayer suggests you should look through bad news, and even be prepared to absorb drawdowns of as much as 50-80% which occur with most 100-baggers.

Just imagine if I'd put my Asos shares in a coffee can years ago! I bought 500,000 Asos shares at about 4p (the all-time low), and sold them a few months later, thinking I'd been terribly clever, more than doubling my money, a profit of £25k, selling at 9p. Those shares would now be worth £29m.

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Macro thoughts - City centres & offices

I suppose we’re all wondering how quickly people will return to city centres, once lockdown restrictions are removed. Particularly once bars & restaurants are open again. Personally, I’m not too bothered about going shopping in town centres again, but have a long list of friends & city contacts that I’m looking forward to meeting up with again, over long lunches.

Everyone’s different though. When we last discussed this here, several readers pointed out that many women in particular see shopping as a social occasion, to meet up with friends, do some shopping, have a nice lunch, etc.. Therefore we could see people flocking back into city centres, particularly at the weekends. When people are denied access to something they enjoy, it becomes more desirable. Hence I can see why holidays, and city centre shopping & hospitality could see boom times over the summer & maybe beyond.

What about offices though? Has work from home (WFH) changed things forever? Do companies actually need offices any more? Again, everyone has their own view on this, but we’re starting to see some interesting newspaper articles covering what companies are actually going to do. The link above is from the Guardian, reporting that HSBC is planning to slash about 40% of its global office space, and Lloyds Bank 20%. Those are seriously large numbers. Who's going to fill that vacant office space?

The Guardian questions whether this is more about cost-cutting than changing work practices, and also questions the reported figure surveyed of 77% bank employees who want to continue working from home for 3 or more days per week.

Personally I question whether employees really do work as efficiently from home, as they do in an office? I’ve worked from home, on my own, for 19 years now. I find you get into increasingly bizarre working practices, of working in intense bursts, at weird times of the day or night. It’s very difficult to work consistently throughout the day. In some ways that makes me more efficient, working very efficiently with no distractions, when I’m focused on something. Or being 0% efficient, when I’m asleep on the sofa after lunch, or any other time when I feel tired! Can people with kids really get much work done, once they're home from school?

All of which makes me feel that we simply don’t know what’s going to happen in future. Although I have seen enough evidence to convince me that flexible working seems the most likely outcome - people going into the office for some of the time, when it’s necessary, and working from home the rest of the time. That makes hot-desking more likely, and companies needing less office space overall. Which is very bad news for commercial landlords, and commercial property developers. Hence I’m completely avoiding investments in those sectors, regardless of what their figures look like. There could be a risk of buying into value traps, in both those sectors - things that look superficially cheap, but where profits and net asset values could be in a long-term down-trend.

I think it also puts a question mark over retailers & hospitality. Will the weekend trade be enough in future to compensate for probably slower mid-week trade, with fewer people around? It could be. I remember the CEO (I hold) of Revolution Bars (LON:RBG) telling me that “We make our money on Fri & Sat nights”. Hence why the business was so focused on those periods, and it didn’t really matter that they were almost empty during the week. I also remember being asked to help a nightclub owner in 2008-9 who was at his wit's end, by thinking up ways to get people into the site during the week, and the day. He said forget it, it's cheaper to be closed. It's all about maximising the peaks on Fri & Sat. He was right! He became very successful once the economy recovered, with the key element being finding up & coming DJs, then promoting the hell out of their party nights on social media. People came for the music, not anything else. So my ideas (which included ballroom dancing during the weekdays!) were rightly consigned to the ideas dustbin, along with my credibility! Lesson - don't get a former fashion retail FD to advise on how to run a nightclub!!

It will be fascinating to see how all this pans out. I don’t know the answers, but one thing I’m pretty sure about, is that we’re likely to have a bonanza over the summer, with so many households having hoarded cash over the last year. Holidays, hospitality, and maybe retail, look set to be sectors which should see the release of pent-up demand. That’s also why I think fears of a recession, and permanently high unemployment are probably also wide of the mark. The stock market is fairly buoyant, which is telling us that recovery is more likely than a lasting recession. I’m seeing that almost every day in trading updates too - they’re mostly doing better than base case scenarios from last year.

A wave of optimism is at last sweeping the nation, and the stock market.

Should we be selling online retailers? Definitely not, in my view. I think a lot of business has shifted permanently online. There's also evidence to back up this view. If you look back at what happened last summer, when we did re-open for a while, before the second wave covid struck, I recall that a lot of shops didn't actually re-open. Footfall was too low, and many smaller shops remained closed. Footfall was well down in the larger shops.

If you look back at Boohoo (LON:BOO) (I hold) trading updates last year, the group's very strong sales growth during lockdown actually continued unabated despite physical competitors at least partially re-opening over the summer. This is evidence that a lot of retail spending has possibly permanently shifted online. Plus of course the Arcadia shops, and many others, have disappeared altogether, now being online only and owned by Asos and BooHoo mostly.

How much of a danger is an online sales tax? Reader comments have persuaded me that there is an argument for this, mainly to replace lost business rates taxation for the Government. A figure of 3% is mooted. I can't see that doing much damage to online retailers. They'll just put up their prices by 3%. That's not likely to put much of a dent in sales or profit growth, in my opinion, although it's clearly not helpful. It might actually be a long-term help, in driving out some weaker online competition - remember that many online retailers are not profitable, e.g. BooHoo's local competitors MissGuided came very close to going bust a couple of years ago, and has still only recovered to barely breakeven, apparently. The competitive advantage that online retailers have in saving on business rates, is offset by the nightmare of having to deal with 40-50% customer returns, and the necessity for heavy digital marketing spend, to draw customers in. So I remain of the view that a lot of the critical comments, supporting an online sales tax, haven't really thought through the whole business model. Above all High Streets just need lower rents! (and lower business rates, to be fair).

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Macfarlane (LON:MACF)

94p (up 10%, at 12:35) - mkt cap £148m

To get up to speed, here are my notes from the interim results published on 28 Aug 2020, for the 6 months to 30 June 2020. It’s a neat summary, covering the main points, even if I do say so myself! The short version is that I was generally happy with the numbers, but couldn’t see a lot of upside to the share price (about the same as it is now). Also the pension scheme was sucking £3m p.a. In deficit recovery payments in cash, out of the business. I feel the actual cash drain is far more important than the accounting deficit (which often under-states the scale of the problem). More on that below.

Final Results - for FY 12/2020 - published today. The market likes the numbers, with a share price up 10% today.

EPS 6.45p (up 5.9% on LY) - that’s usefully ahead of the c.6p which I estimated back at the time of the interims (haven’t got access to any broker notes, unfortunately).

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Clearly that’s a solid performance for 2020 in the circumstances.

Adjustments - note that Macfarlane seems to present its numbers without any adjustments, or underlying figures. I see that it is amortising £2.5m p.a. of acquisition-related intangibles through the P&L. Most companies would adjust this out, and show underlying profit of £15.5m, instead of the £13.0m shown above. That’s a 19% improvement, if we manually adjust out the goodwill amortisation.

Applying the same adjustment to EPS, means adjusted EPS would be 7.7p, thus reducing the PER to 12.2 times, as opposed to a PER of 14.6 as reported.

I hope my numbers are correct, I’ve checked back through the 2019 Annual Report (see note 10) and think I’m correct. In other words, if you adjust MACF’s figures to make them comparable with how other companies report profit, then it’s 19% cheaper than it looks on the reported numbers.

Dividend - a big increase. Dividends normalising is a key investing theme at the moment, which I very much like. We can anticipate which companies are likely to be able to resume decent dividends quite easily, by spotting companies that;

• have been trading resiliently in 2020, and
• have sound balance sheets, and
• have previously paid out good divis.

I think at the moment, this manual approach is more important than screening for high yields, because that can throw up a lot of anomalies in unusual times like these. I think it makes more sense to screen on historic yields, than rely on often incorrect or outdated analyst forecast yields, at the moment. The forecast numbers should gradually sort themselves out over time, as companies reinstate guidance, and analysts then have more to base their forecasts on.

Net debt - I’m impressed with this. At the interims, net debt was £0.8m, but had been boosted by £5.4m Govt support & deferral schemes, which it indicated at the time had been repaid in H2.

Therefore, the year end net debt being only £0.5m, means that cashflow has been generated sufficient to cover repayment of Govt support in full - impressive.

Pension deficit - big news here. I tend to ignore accounting deficits, as they’re often wildly different to reality. It’s the actuarial deficit that matters. In this case, the deficit recovery repayments have dropped dramatically, which is great news for shareholders -

The triennial valuation of the pension scheme on 1 May 2020 has now been concluded and the Group has agreed with the Scheme's Trustees to reduce contributions from £3.1m to £1.3m per annum with effect from 1 May 2021. The recovery period for deficit contributions now runs until April 2024.

Bank facilities - look ample, and relatively long-term compared with most other companies I look at - indicating that the bank is comfortable lending to MACF, as they should be - it’s a stable & resilient business -

The Group's bank facility of £30.0m with Lloyds Banking Group has been extended until December 2025 and accommodates normal working capital requirements as well as supporting acquisition funding.

Balance sheet - looks OK. NTAV is about £19.2m, which seems adequate. With net debt reduced a lot, and the pension scheme drawing out less in cash recovery payments, then I think there’s scope here for more acquisitions, and increased divis. No risk of dilution.

Outlook - this seems reassuring -

2021 has started well despite the ongoing impact of Covid-19. There are still significant uncertainties about the duration of disruption caused by lockdowns and the consequential impact on demand levels which means that 2021 will be another challenging year. However the Board is confident that, given the resilience seen in 2020, the strength of our business model and the commitment of our people, Macfarlane Group will progress in 2021 and is well positioned to benefit when the UK economy begins to recover.

Cashflow statement - looks strikingly cash generative, but do remember that IFRS 16 has messed things up. So ensure you take into account the £6.7m “repayment of leases” which is in the wrong place thanks to IFRS 16, down at the bottom in “financing activities”. Hence all the numbers above that line are over-stating real world cashflow. Not MACF’s fault, it’s the damage done by IFRS 16, which needs to be eliminated from accounts to give a meaningful view.

Hence we need to re-work the cashflow numbers to manually move the £6.7m lease repayments up the cashflow statement, out of financing activities, and instead put it higher up as a deduction from operating cashflow.

Even when you make this amendment, the cash generation is still very impressive.

My opinion - I question why MACF has a manufacturing division, as it is now barely operating above breakeven. How does it add value? Does it have turnaround potential? Thankfully the main packaging division, is strongly profitable.

Overall, this share gets a thumbs up from me. It looks a decent, resilient business, and is attractively priced, especially when you adjust out the goodwill amortisation charge, which is what other companies generally do.

Cash generation is good, it’s paid down the net debt, the pension scheme is now much less of a cash drain, the balance sheet looks fine, and divis are being restored to pre-covid levels.

It’s not going to set your portfolio on fire, but as a sensible value share, to hold long-term, I think this could be a good entry point.

The share price oscillated sideways for the last 3 years. That doesn't necessarily mean it will do the same thing for the next 3 years though.

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Jack's section

Ricardo (LON:RCDO)

Share price: 467p (-1.06%)

Shares in issue: 62,218,280

Market cap: £290.6m

Ricardo (LON:RCDO) is a global strategic engineering and environmental consultancy that specialises in the transport, energy and scarce resources sectors.

Its work encompasses a broad spread of sectors including passenger cars, commercial vehicles, rail, defence, motorsport, energy and environment. Within these sectors, the group covers a wide range of assignments including strategy development, cost reduction, safety management, regulatory compliance and environmental impact assessments.

The past year has been rough for such companies but note Ricardo was underperforming the market before Covid. So that’s something to look into.

The share price has recovered partially since we last covered it in November 2020, from around 350p to today’s 472p. Back then, the group had just RNSd an update and a proposed placing.

In January Ricardo released an ‘in-line’ half year update (Management succession plan and trading update - January 25th) and today we get the more detailed results for that period. Dave Shemmans, the CEO for the past 15 years, is leaving but this was flagged previously.

Interim results

Highlights:

• Order intake, revenue and operating profit have all increased on the six months to June 2020, but remain lower year-on-year;
• Revenue down 15% year-on-year to £164.7m;
• Underlying profit before tax down 69% to £5m; statutory loss before tax of -£2.1m;
• Automotive market is improving slowly; good performance in Energy & Environment and Rail; Performance Products in line with management expectations;
• Share placing completed, raising £28m, ‘to reset the capital structure of the group’; net debt of £50.4m
• Interim dividend of 1.75p declared.

CEO Shemmans comments:

Whilst the economic outlook continues to remain uncertain, we have a robust order book, good pipeline of opportunities and our diversified business platform offers leading edge capabilities to support the global environmental agenda. We remain cautiously optimistic about the economic recovery and for further progress of the business as we deliver on our strategy.

The net debt improvement reflects £28.2m of proceeds, net of fees, from the share placing in November 2020, and a strong working capital performance. Excluding the placing, restructuring costs and acquisition-related payments, the group generated a net cash inflow of c.£3.0m in the half (and the whole of the 2020 calendar year).

Order intake of £181.1m represents a decline of 13% on HY 2019/20, however it is a 13% increase on the six months to 30 June 2020, indicating that order volumes are recovering from the impact of COVID-19.

Conclusion

Management is keen to impress a sense of sequential improvement, with conditions recovering and a positive trading trajectory.

Whilst the economic outlook continues to remain uncertain, the company continues to trade and looks well placed for a global recovery with its strategic focus on the Net Zero agenda.

It could be one to watch. Yes, Ricardo has made a loss for the period, but given what companies have endured over the past year or so, a small loss in that context is not so bad. And before Covid, Ricardo was busily building a solid track record of top line growth.

Although brokers have been nudging down earnings estimates, they all rate RCDO as either a buy or a strong buy and expect revenue to more or less recover to FY19 levels by FY22. That’s no substitute for your own research, but the forecast PEG of 0.8x does suggest the stock offers value if it can hit targets.

Not one I have a strong view on but it could be worth a closer look for those interested in this kind of recovery play. The reinstated dividend is cause for cautious optimism.