Small Cap Value Report (Thu 25 May 2023) - HEAD, SUS, LSL, CHRT, BOOT

Good morning from Paul and Graham!

Charity challenge - Our friend Damian Cannon, who many investors will know as the presenter of the StockSlam evenings, and all round lovely chap,  is doing a truly remarkable challenge for a very worthwhile charity. He's going to run up to the top of a city skyscraper, then cross to the gherkin on a zip wire! I feel bilious even thinking about it. Anyway, if you can bung his charity, Tommy's, which helps research and support re miscarriages, a few quid, I know he'd be very grateful. Link here to his donating page.

I thoroughly enjoyed Mello Chiswick, and was one of the last to leave when they closed the bar at nearly midnight. It was terrific to meet up with lots of investor friends, and meet new ones, many/most being Stockopedia subscribers. What struck me is how everyone has their own distinctive approach, and many of the people I spoke to are obviously very shrewd indeed. So overall I had some fascinating chats with some lovely people! I do hope physical investor events continue, as it would be such a shame to lose everything to online.

Talking of which, Mello has an online only third day today, starting at 1pm, with some very interesting speakers that I'm looking forward to hearing from. I find there's always at least one key point from almost every investor talk that gives me an insight, so I lap up these type of things, and podcasts.

I did my quarterly catch-up on Monday with Paul Hill, which you might find of interest. I think 1 (Watkin Jones), maybe 2 (Portmeirion?) of the companies mentioned issued profit warnings the next day, which must be a new record! Very difficult markets at the moment, for sure.

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Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to review 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 are analysing the company fundamentals, not trying to predict market sentiment.

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.

What does our colour-coding mean? Will it guarantee instant, easy riches? Sadly not! Share prices move up or down for many reasons, and can often detach from the company fundamentals. So we're not making any predictions about what share prices will do.

Green - means in our opinion, a company is well-financed (so low risk of dilution/insolvency), is trading well, and has a reasonably good outlook, with the shares reasonably priced.

Amber - means we don't have a strong view either way, and can see some positives, and some negatives. Often companies like this are good, but expensive.

Red - means we see significant, or serious problems, so anyone looking at the share needs to be aware of the high risk.

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Summaries of main sections

Headlam (LON:HEAD) - down 10% to 236p (£181m) - AGM TU (profit warning?) - Paul - AMBER

A frustratingly vague update, that sounds like it might be a profit warning. Shares look cheap now, taking a medium-term view, but weak consumer demand sounds like it's hurting margins in the short term. I'm also worried about possible damage from growing competitor Likewise (LON:LIKE)

S&U (LON:SUS) - £25.23 (-1%) (£306m) - AGM TU - Graham - GREEN

There’s no explicit reference to expectations in today’s update and nothing new on Research Tree yet. However, collections in car finance are ahead of budget and management promises steady lending growth over next two years. I remain a fan of this company.

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Quick comments

LSL Property Services (LON:LSL)

Down 3% to 270p (£281m) - AGM TU - Paul - AMBER

Significant progress made in restructuring. “Very challenging market conditions”. Recently announced to convert its estate agents offices into franchises, with 143 out of 183 branches done, remainder to follow soon. Franchising - simpler to manage, and higher margins.

Outlook - “some early signs of improved trading”, and expecting an H2 weighting in 2023. Overall, confirms in line with (considerably reduced) expectations for 2023 still.

Paul’s opinion - a quick skim of the StockReport doesn’t show anything of appeal to me, in terms of value or growth, so why get involved?

Cohort (LON:CHRT)

Unch at 503p (£209m) - FY 4/2023 TU - Paul - AMBER

Describes itself vaguely as “the independent technology group”. It is actually a group of 6 companies focused mainly on the military sector.

Long-term performance was excellent, being a multibagger between 2011-2020, although shares have been drifting gently down since.

Today’s update says trading for FY 4/2023 has been “slightly ahead of expectations…”

Net funds of £15m. Order intake up. Big closing order book of £325m, is well over 2 years’ revenue, giving good visibility: 84% of FY 4/2024 revenues already secured.

Outlook - it mentions that war in Ukraine, and Taiwan tensions, is driving higher defence spending, and higher demand for CHRT. Confirms in line with expectations for FY 4/2024.

Paul’s opinion - Cohort looks quite interesting.Over the last 6 years, this share has typically commanded a PER in the high teens or above. It’s now only priced at 14x FY 4/2024 forecasts (confirmed today), which looks attractive value compared with previously. The financial track record below looks attractive, particularly as the lighter (forecast) blobs have been confirmed today. Overall, this looks a nice quality business, at a reasonable price, albeit with some contract lumpiness risk.

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Henry Boot (LON:BOOT)

Up 2% to 239p (£320m) - AGM TU - Paul - GREEN

An interesting land development, and construction group. Its detailed AGM update today is worth a look, and surprisingly upbeat. A few snippets -

• Good start to 2023, trading in line with exps (although these have been lowered).
• Housebuilders are buying land again, selectively.
• House buyers returning to the market.
• Planning permission delays ongoing - frustrating but also supports value of sites with PP.
• BuildToRent sector is seeing strong demand, and investors looking to fund schemes again.

Paul’s opinion - I don’t know this company very well, but it looks interesting, with a nice mix of activities. Stockopedia shows it’s trading at a significant discount to NTAV. Other housebuilders have bounced a lot, whereas this hasn’t. So there might be an opportunity here for subscribers to research in more detail yourselves? Although the latest news this week on inflation & interest rates might dampen the sector perhaps? On my initial review, I see this favourably, so it's a thumbs up from me, GREEN.

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Paul’s Section:

Headlam (LON:HEAD)

Down 10% to 236p (at 08:28)

Market cap £181m

Trading Update (AGM)

Headlam (LSE: HEAD), the UK's leading floorcoverings distributor, is releasing the following trading update for the first four months of the year ahead of its Annual General Meeting being held later today.

Company’s headline -

Revenue growth despite suppressed residential volumes

This is a frustrating, and I think badly constructed trading update. Mainly because it’s too vague, and doesn’t say if the company is trading in line (or below, or above) market expectations. It really needs to be compulsory for companies to clearly state this. So much confusion is caused when companies don’t make it clear how they are trading vs market expectations, which is the whole point of trading updates!

By missing out that key information, investors tend to just assume the worst, and that a profit warning is being slipped out on the quiet, often via broker updates. As you can see, brokers have already cut forecasts considerably -

Remember that the graph above is as of close of play last night, so it won’t yet reflect the likely downgrades that today’s vague update is likely to trigger.

Headlam doesn’t get any broker notes out to private investors through Research Tree, because it uses brokers who restrict their output to paying clients (Peel Hunt & Panmure Gordon). Panmures used to put out some notes on RT, but seem to have stopped unfortunately.

So unfortunately we’ll only have the share price today to indicate to us how much the brokers (who have privileged access to the company) have privately downgraded their estimates by. What an unsatisfactory situation. The regulators need to look at this I think, as it’s obviously unfair to have brokers privately reducing forecasts, but only informing a select few investors no doubt after having been given a steer by the company privately. As a CEO once told me, "Broker forecasts are the company's forecasts!" Everyone just pretends that they're independently set.

Summarising the detail of the trading update (profit warning?) today -

(this is for 4 months to end April 2023)

Revenue up 3.4% vs 2022.

Claims market share gains (based on independent research).

Gross margin reduced (no figures provided).

Residential market weak, offset by stronger commercial, trade counters, & larger clients.

Mitigating actions taken, eg price rises, cost cutting, and pushing own label products - benefits to come in H2 mostly.

Overall performance - nothing stated, which is ridiculous. Just a vague comment that -

...overall profit performance remains dependent on consumer sentiment in the residential market.

Paul’s opinion - this is a highly unsatisfactory and vague update. I’ve got no choice than to interpret it as a veiled profit warning. Gross margins being down suggests to me that HEAD is facing competitive pressure, probably from the rapidly growing Likewise (LON:LIKE) which is run by the former boss of HEAD. LIKE did £122m revenues in 2022, which has got to be coming from somewhere, so it seems likely to me that LIKE must be chipping away at HEAD’s sales, which they’re protecting by accepting a lower margin. I could be wrong, but that seems an obvious interpretation. The trouble is, that's not a temporary thing, it's a structural problem - an ambitious competitor growing fast.

Which makes me wonder if HEAD will be able to return to its pre-covid normality of making c.40p EPS each year, and paying out generous divis from that? HEAD should be able to continue paying good divis though, as it has such a lovely strong balance sheet. Note that the StockReport shows a very good  price to tangible book of 1.03 - so the market cap is almost fully supported by tangible assets, a lot of which is freehold property. Hence why HEAD is a safe share to hold, even in a downturn.

Consumer demand is linked to the housing market, as people often replace carpets when they move into a new home. Although people also replace carpets in their existing homes when they wear out, especially if they can’t afford to move. So it can work both ways.

As with many small caps, I think HEAD shares look cheap, if you look beyond current subdued trading conditions. At some point the downtrend is likely to turn, and become an up-trend. I’ve no idea when of course. It might be a time to be looking at charts to help get some guidance on that, although we’re also seeing plenty of false dawns, where charts bottom out & start to break out upwards, only to fizzle out and fall back down again after a while. There’s no clear trend I can determine at the moment.

I’ve just looked at the share price at 08:28, and see it’s down 10% to 236p, not too bad considering. I’d like to own some HEAD shares, but don’t feel in a rush to get involved, after today’s disappointingly vague update. So I’ll give a neutral opinion at this stage, AMBER.

As you can see below, the share price (1-yar chart) had already been anticipating softer trading. It's probably at a level where value investors will be sniffing around. Sooner or later there's likely to be a nice recovery, so I think this is worth adding to our watch lists. High StockRank too from Stockopedia.

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Graham’s Section

A big thanks to David for a thoroughly enjoyable Mello conference, with some very interesting companies presenting, and it continues today in online format!

S&U (LON:SUS)

Share price: £25.40

Market cap:£309m

Today brings an AGM statement from this family-run car finance and property lender.

At first it sounds like they are reporting more of the usual high growth that they always seem to report, albeit with a bigger drag than usual from interest costs:

Profit before tax for the period is £0.3m ahead of the same period last year, despite a rise in Group borrowing costs of nearly £3m for the period versus the same period last year. This is the result of interest rates which have significantly risen since early 2022 and a net receivables book which has now reached £418m (25 May 2022: £340m).

But actually this is a departure from the norm, as the receivables book has finally taken a break from its fast pace of growth seen in recent years. Group net receivables had already reached £421m at year-end (January 2023), so we have at last seen a decline in this important measure of the company’s size.

In the company’s words, “commercial prudence and preparations for the new Consumer Duty framework due in July, have seen a hiatus in the rapid growth of the Group's motor net receivables. Hence, in the latest quarter these grew by £1.5m against £14.5m in the last quarter of 2022/23.”

The most important thing from my perspective is that S&U maintains a high rate of collections. So long as this continues to be the case, I wouldn’t quibble with management about their rate of growth.

In any case, the growth in lending has been remarkable here in recent years, so a short-term pause is hardly a huge cause for concern? With both difficult economic winds to face, and the imminent implementation of the FCA’s new Consumer Duty, a more cautious approach may be perfectly reasonable in the short-term!

Financing: S&U has been hitting against the upper limits of its borrowing facilities as it grows the business, but we do get more positive news on this front today. Given the strength of both of their divisions, the company says it is “justified” to open new medium-term funding facilities. This gives them extra headroom of £70m and brings total funding facilities to £280m. This will enable them to fund the “steady and sustainable” growth they are looking for over the next two years. Current gearing is 79%.

Car finance: collections in the first c. four months of the new financial year are “above budget” at 94%. S&U is looking for this division to return to growth over the rest of the financial year, helped by “an increase in transaction sizes to higher scoring customers”.

Property bridging: this new division is finally starting to experience defaults, with 10 of its 140 loans currently in default. However, all of these are expected to be recovered by the end of June.

My view

Shareholders have plenty to ponder here but I think most of it is positive. It feels like the moment of truth for the bridging loans - now that a chunk of them are late, we find out how prepared the company was for this to happen!

Car finance continues to motor on (pun intended) with a fine collection rate.

The outlook for the next two years, with £100m of total headroom in lending facilities, suggests to me a moderate rate of growth in the receivables book of something in the region of 10% p.a. annualised. “Steady and sustainable growth”, in the words of the company.

The valuation has ticked higher in recent months but to me this is still within the range where sensible investors may find it interesting as a possible candidate:

The researchers at Edison (paid by the company) forecast return on equity of 14%+, while Stockopedia calculates ROE of 15.6%. With this level of return and to my eyes a moderate level of risk given continued high rates of collections in car finance, the valuation metrics on offer here are still quite attractive to me.

The company is taking a more aggressive stance than it did before re: gearing, so I think we do have to accept that risk levels are elevated compared to where they were previously. But I remain positive on this.