Small Cap Value Report (Thu 5 May 2022) - QXT, RCH, BUMP, TRI, LUCE, SNWS

Good morning, it's Paul & Jack with you today.

Agenda -

Paul's section:

Reach (LON:RCH) - A confusing trading update, showing the revenue mix shifting more towards lower margin print revenues, with advertising & circulation down. Nothing is said about profitability, but Singers has lowered forecast profit by 6%. Higher paper costs, and lower advertising revenues are the main negatives. Looks very cheap now, might be worth a nibble?

Seraphine (LON:BUMP) - A third profit warning from BUMP, in less than a year of being listed. Putting aside the negative emotional reaction, I think this share is starting to look interesting in valuation terms. The new CFO is experienced, and should be rectifying sloppy financial & operational controls. High risk (I think it needs a placing), but possible high reward longer term? 

Luceco (LON:LUCE) - I take a look at yesterday's profit warning. Customer stockpiling last year, of high margin products, is unwinding this year. It surprises me that this has taken LUCE by surprise. FY 12/2022 forecast EPS is dropped considerably, by a third. Shares now look quite good value, on more realistic forecasts, assuming no further profit warnings occur, which is a big assumption right now!

Smiths News (LON:SNWS) - turnaround is proceeding as planned, at this cash generative, ultra low PER share. Highly attractive (and rising) divis of 8%+, covered over 3 times. What's the catch? it's in structural decline, like RCH, and cost-cutting can't go on forever. On balance though, I like it.

Jack's section:

Quixant (LON:QXT) - order intake is ‘significantly’ ahead of last year across both businesses and the group’s net cash position has allowed it to manage a difficult supply chain. There’s a 537bps spread, which is a bit of a shame as I think there are a few points here which flag the group up as an intriguing candidate.

Trifast (LON:TRI) - solid results, with Q4 revenue up by around 15%. The valuation has fallen and the shares are now back to their Covid lows, so there could now be more of an opportunity for patient investors. Challenges persist however and, while Trifast has so far been able to pass on costs, macro conditions are clearly weighing on the shares.

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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.

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Paul's section

Reach (LON:RCH)

160p (pre market open)

Market cap 503m

Trading Update

Reach plc ('the Group') is issuing a trading update for the 4-month period from 27 December 2021 to 24 April 2022 ('the period'), ahead of its 2022 Annual General Meeting today.

Cost inflation worse than expected, especially paper cost, since middle of March.

Action taken to “help offset” inflation - suggesting only partial recovery of higher costs.

Digital - lower growth than expected, due to reduced advertiser demand.

Cover prices raised.

Outlook - only talks about revenue, not profit -

We still anticipate broadly flat group revenue for the year, though with a higher mix of circulation revenues and lower digital contribution than previously expected as a result of more challenging trading conditions. The impact of further recent newsprint inflation is fully reflected in our cost expectations for the current financial year, with actions now underway to help mitigate the impact on operating profit.

"We're developing a more sustainable and profitable long-term future for the business, with delivery of the strategy progressing well, despite a more challenging economic backdrop. The effective collection and use of data are supporting the growth of our higher yielding digital products, which are becoming an increasing part of our revenue mix. We've taken swift action to address the impact of inflation on our cost base and the business remains strongly cash generative, supporting the investment in data and technology that is key to future growth."

The table below, for revenues in the first 4 months of FY 12/2022 shows almost all the revenue shortfall from lower circulation & advertising revenue being recouped from digital growth, and “printing and other”.

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Analyst update - many thanks to Singer’s analyst, Caspar Erskine, who clears the fog for us with an update note this morning.

He’s leaving revenue forecast unchanged at £615m, but trims profit expectations by 6%, reflecting a change in mix towards (presumably lower margin) printing & other revenues.

EPS is forecast at 32.5p, giving a PER of just 4.3, at 139p per share (correct as at 08:16 today).

That’s not as cheap as it sounds, given that large pension scheme payments have to come out of earnings (deficit recovery payments don’t go through the P&L a/c remember), and the business is in long-term structural decline.

That said, it is building up a digital business, although we’ve never been given enough information to ascertain how that might perform once print has gone.

My opinion - this strikes me as a badly worded trading update, because it ducks the issue of profitability - which is the key information investors need!

So a confusing update, which talks about higher cost inflation, and lower advertising revenues, is bound to be interpreted as a profit warning.

The share price is down 10% in early trades, at 139p as I type this. To my mind, that’s such an appealing valuation, that I’ll stick my neck out here and say it might be worth considering a small initial purchase. The share price has absolutely collapsed from last year’s high (like so many smaller caps), but at some point the valuation becomes so cheap that it’s worth putting some money to work - there are good divis here, over 5% too.

Downside risk is obviously the further contraction of advertising revenues, if the economy does go into recession, which is looking increasingly likely by the day. Or at least some parts of the economy might experience a downturn, as consumers increasingly seek out value for money, to offset rising inflation.

Or this could all be a relatively short-lived blip, nobody knows at this stage.

The stock market does seem totally fixated on the very short term, which means patient investors could be locking in some attractive buying prices right now.

Another way of looking at it, is that last year saw a speculative frenzy in this share, which has now scrubbed off.

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Seraphine (LON:BUMP)

30p (down 38%, at 09:11)

Market cap £16m

Profit warning number 3, from Seraphine, which sells maternity clothing, which listed in July 2021! That must be a new record?

Looking back through my notes here -

Profit warning 1 - reviewed here in Sept 2021 - seemed to be isolated problems with supply chain over the summer, and the share looked interesting at the time.

Profit warning 2 - covered here in Feb 2022 - much more serious, with wider supply & cost inflation problems. Shares crashed 60% to 50p, but I decided to steer clear over balance sheet worries & possible need for a fundraising. Also, terrible execution by management so soon after listing, cast a cloud over the shares’ credibility at any price.

Profit warning 3 - today - covered below, and has now taken the shares down to 30p, so it’s lost 90% of the initial float price of 295p, in July 2021. That’s so bad - no wonder many of us treat new floats with suspicion. It looks as if the City has killed the golden goose - by floating too many rubbish, and/or over-priced companies, in the pursuit of lucrative fees for themselves. Who would trust a new issue now?!

Or is it just a case of caveat emptor? If investors buy into an over-priced, over-promoted, but unproven company, with incompetent management, then that’s the risk they’ve willingly taken.

On to today’s news -

Year End Trading Update

Seraphine (LON:BUMP), an international digitally-led maternity and nursing wear brand, today announces a Trading Update for the year ended 3rd April 2022.

I’m looking for these 3 key things before I would consider investing -

• Trading to have stabilised or improved,
• Supply chain under control, and
• No need to raise more equity.

Seraphine blames external factors for a continued reduction in demand -

Since the trading update of 23rd February, market conditions have become significantly more challenging as a result of Russia's invasion of Ukraine, which began on 24th February, weakening consumer sentiment across Europe. This has been further impacted by the rising cost of living. Seraphine has not been immune to these sector-wide pressures.

As an aside, it’s interesting to note that Next (LON:NXT) (I hold) also reports today, and doesn’t mention any of these things. It just says trading continues to be in line with expectations.

Mind you, Next does report that Q1 store sales shot up (because they were closed last year), and online sales dropped against very strong prior year comparatives.

This is an interesting point, because the stock market seems to have assumed that online retailers have gone ex-growth, and massively written down their share prices. Whereas we could be about to see growth return, now the last (hopefully) lockdown from Q1 2021 is annualised, hence prior year comps normalise. Therefore, a contrarian might be looking for bargains in the online retail sector, from current bombed out levels. If growth does resume, then some online businesses could see a decent re-rating.

Revenue growth - at BUMP is actually quite good, at +33% (constant currency) for FY 3/2022. This is only slightly down on +37% (also CC).

International sales are unusually high, I see from the interim results that the UK was only 23% of sales, with the bulk coming from USA & Europe - giving much bigger potential upside for shareholders, if the business continues growing & can make reliable profits.

Cost inflation continues to be problematic, and some accounting cock-ups too, for good measure (but a new CFO, Lee Williams [ex-French Connection] has recently been appointed, to hopefully improve slack financial controls & budgeting) -

As previously announced, there has been a number of margin and costs challenges identified, with notable inflation in distribution costs and customer acquisition marketing costs, with cost of acquisition currently running 25% higher YoY. Furthermore, following a reconciliation of both the FY21 and FY22 accounts, additional one-off non-cash corrective items, including previously unreconciled customer refunds and stock adjustments, have been identified.

FY 3/2022 guidance -

As a result of these issues and the macro-economic headwinds, we now expect FY22 sales of circa £44.1m and Adjusted EBITDA (pre-IFRS16) of not less than £3m.

Forward guidance - shows slowing growth -

Given well reported sentiment issues affecting the industry, the Group believes it prudent to re-set market expectations for FY23 and now expects to deliver sales growth of 10-20% and an improvement in EBITDA (pre-IFRS16) margin to 8-9%.

My opinion - going back to my earlier list, does this update satisfy my requirements to invest?

• Trading to have stabilised or improved - I’d say yes to stabilised, even though guidance is reduced, the business is still growing at a decent pace, with continued growth expected, so in the context of a share price down 90% from listing in July 2021, I think current trading looks OK.
• Supply chain under control - not clear, from today’s update. The experienced new CFO should be making a difference, bringing more discipline into pricing, margins, etc. So the jury is out on this.
• No need to raise more equity - notable by its absence is the cash/debt position, and I remain of the view that BUMP is likely to come back to the market for more equity at some point. Holders have to hope that this is done when the figures are improving, and not an act of desperation at a deep discount.

Overall then, I see this share as high risk, due to the probable need for more equity funding - in a horrible bear market.

That said, if it manages to keep going without dilution, then this share could quite conceivably be a multibagger from just £16m market cap.

For that reason, I think this is starting to look interesting as a punt, and only for risk-tolerant investors/punters.

The business model looks good - niche products, in demand (high gross margin & strong revenue growth), with international appeal. So far, it seems to me the main problems have stemmed from a lack of financial & operational controls (so they were taken aback by supply problems & inflation). The new CFO is an old hand in the rag trade, and should be able to sort out forecasting & controls fairly quickly.

Hence I’m starting to think about the potential upside here, although the risk of a discounted placing is pushing me in the other direction. It might justify a small opening position possibly in my portfolio, I’ll have to give it some more thought.

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Luceco (LON:LUCE)

129p

Market cap £214m

Q1 2022 Trading Update

Luceco plc ("the Group" or "Luceco"), the manufacturer and distributor of wiring accessories, EV chargers, LED lighting, and portable power products, provides the following update on trading for the three months ended 31 March 2022 ('Q1 2022').

Background - the underlying problem with this share seems to be that investors assumed the bumper earnings in FY 12/2020 and FY 12/2021 was mainly structural growth, and applied a higher PER to peak earnings. Whereas in reality it seems to have been demand pulled forward by the pandemic - i.e. people doing up their homes, instead of spending on holidays/entertainment.

To be fair, the company has been saying for a while that tough comparatives would be difficult to beat.

On top of that, there’s been so much general momentum selling in small caps, that I think selling just feeds more selling, as people capitulate. I’m wondering if we’ve now reached, or could be near to, peak doom, and is this share now a buy, being a fundamentally decent company, down by about three-quarters from last year’s (admittedly overdone) high? Let’s find out!

Q1 2022 Trading Update

The Group has previously highlighted the challenge of repeating 2021's record results, which delivered Adjusted Operating Profit more than double pre-COVID 2019 levels, including a particularly strong H1 2021 performance.

Customer stockpiling last year is now unwinding this year -

Last year's unusually buoyant markets disrupted the normal function of global supply chains, leading to some customers ordering more product than it now appears they needed to meet demand. We expect that the reversal of this position this year will lead to a £15m shortfall in 2022 revenue compared to our previous expectations. The shortfall in 2022 Adjusted Operating Profit will be approximately £10m due to the lower revenues being in the Group's higher margin Wiring Accessories category.

Notwithstanding any future changes in market demand, profit progression in 2023 should be made easier by the temporary nature of the supply chain rebalancing expected in 2022.

A £10m profit reduction is a big number for Luceco. For context, last year’s PBT was £33.3m.

It does raise the question as to why LUCE didn’t seem to previously realise that customers were stockpiling in 2021? Investors don’t like negative surprises, especially when it’s something like this which should have been anticipated and baked into forecasts previously.

Cost inflation - this is very good news - there may be a time lag in passing on higher input costs, but LUCE is stating clearly that it can pass on higher costs fully. Not just mitigate, but fully pass on - that’s a key factor right now, and makes me lean towards being bullish.

Our estimate of the annual impact of input cost inflation remains at £25m, which will be fully offset by selling price increases. We will receive the full benefit of these increases in Q2 2022.

We are targeting Adjusted Gross Margin of 37% during H2 2022, representing the full pass through of input cost inflation. We are confident that the margin will improve thereafter as elevated input costs recede and our sales mix of Wiring Accessories normalises after destocking.

China/covid - no problems at the moment. Although it does highlight that LUCE is too dependent on China, which I dislike, given what happened recently with Russia is also likely at some point, when China decides to invade Taiwan. Maybe not an immediate worry, but it’s an important risk.

Outlook - this sounds fair -

The normalisation of customer inventory levels will hold back profits in 2022, which is disappointing, but I do not believe it diminishes either the progress we have made over recent years or our long-term potential. We emerge from the pandemic a better business with stronger positions in our existing markets and with significant growth potential in new markets such as EV charging. I remain excited by our long-term potential."

Forecasts - many thanks to Liberum’s analyst, Christian Hinderaker, for publishing an update with revised numbers.

FY 12/2022 was forecast at around 20p EPS, which is now revised down to 12.9p. Quite a steep fall, but that’s operational gearing working in reverse.

My feeling is that this now looks like a more realistic base number to use for valuation purposes. What PER to use? I think about 12-15 looks sensible, and takes into account that there was gross bank debt of £36.8m when last reported. This implies a valuation of 155-194p.

Therefore it seems to me that the current share price of 129p looks good value on fundamentals, assuming of course that we don’t see further profit warnings.

My opinion - given the pulling forward of demand into 2020 & 2021, especially customers stocking up, then we need to disregard peak earnings during the pandemic, and be careful not to anchor to what now turns out to have been an irrationally high share price.

That said, I reckon it might have now overshot on the downside.

Therefore I’m minded to maybe open a small position, of say ⅓ of a full position size, to dip my toe in the water, and possibly add to that position if the next update reassures. That way, any losses would be small, if the next update disappoints.

Or a perfectly reasonable alternative would be to sit in cash, and just wait, to avoid any losses at all. The trouble with that, is the danger of missing out on a big rally - which usually happens ahead of economic recovery, as investors anticipate recovery.

I put it on my list of possible buys in March 2022 at 200p, but held off thankfully due to worrying about whether peak 2021 performance could be maintained in 2022. It’s now much more reasonably priced at 129p, so appeals to me more, especially now that we have more realistic, lowered forecasts for 2022.

Your money, your choice!

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Smiths News (LON:SNWS)

36p

Market cap £91m

Half-year Report

Background - here's a turnaround we did spot early, at the SCVR! We’ve covered it a lot in the last few years, explaining how the simplified business was set to pay down debt, and resume divis. That’s exactly what’s happened, with a now very generous dividend yield.

The downside is that its business involves distributing newspapers & magazines, which is obviously in long-term structural decline. Although costs are also reduced on 3-yearly plans, thus preserving profitability & cashflow. How long it can keep stripping out costs is the only thing that worries me. Hence the low PER, very similar to Reach (LON:RCH) - due to investors giving a low earnings multiple to earnings which probably won’t be sustainable long-term.

Attempts at diversification at SNWS have previously been disastrously executed under previous management, so current management is understandably wary about repeating that mistake.

Higher inflation might even help SNWS, because publishers raising the cover prices helps offset volume declines, and SNWS contracts with publishers are priced on cover prices of the newspapers/magazines.

I had a couple of good chats/Q&A with the recently retired CFO, who described the business as a “reliable cashflow generator”, churning out about £10m cashflow each quarter. As debt is paid down, the upside flows to equity holders. Although the share price has shown little sign of that, given bearish market conditions.

Overall then, it’s best seen as a special situation - very cheap on PER, exceptionally good & growing dividends, but how long will the party last, given the structurally declining nature of the business? Plus of course the wild card - can anyone think up a lucrative additional use for the rapid overnight delivery network that SNWS operates? So I wonder if someone might bid for it?

Interim results - to save me typing it up, here’s the highlights table.

I note that -

Statutory results are similar to adjusted, so no issues there.

Low net margin - PBT is just under 3% of revenues, but the profits are dependable, because operational gearing is low.

Huge reduction in net bank debt - very encouraging, and this should continue to reduce finance charges through the P&L, benefiting EPS.

Note that the cashflow benefited from 2 one-off items, which made such a big dent in net debt, namely £8.1m pension scheme surplus received, and £6.5m deferred consideration for Tuffnells. So don’t expect net debt to fall so much in future.

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Balance sheet - isn’t good, but improving from retained earnings each half year. NAV is negative at £(38.7)m, NTAV is a little worse at £(40.7)m. I can’t remember the exact details, but I went through all this with the old CFO, and came away satisfied. Receivables are paid promptly by customers on Direct Debits, and that results in a favourable working capital cycle.

Note that the pension scheme is now closed off, with SNWS even receiving a cash surplus from it, so nothing to worry about there in future.

Outlook - sounds fine, and higher inflation looks under control -

Building on a good first half, underlying trading for the year to date is in line with market expectations. The net impact of inflationary pressure remains consistent with our planning assumptions, while the cost mitigation programme and continued favourable sales mix means the business is on track to meet the market's expectations for the full year.

Dividends - Stockopedia is showing a forward divi yield of 8.2%, which is consistent with the 1.4p interim divi, plus a slightly larger final divi combined. Amazingly, that level of divi payout is more than 3 times covered!

My opinion - the forward PER is an astonishing 3.7, together with a dividend yield of over 8%.

That makes this share remarkably cheap on valuation terms, but of course we don’t know how long that can be maintained. In the meantime though, the company could comfortably afford higher divi payouts still, as the bank restriction is currently at £10m p.a. maximum for divis, which implies up to 4.0p p.a. in divis, a yield of up to 11.1%.

I reckon higher inflation could be a help to this business, as it might end up causing revenue & profits to even rise, due to higher cover prices for newspapers & magazines. Costs are mostly semi-fixed, or variable.

On the downside, note that, despite rising cover prices, revenues have dropped from £1.6bn in 2016, to c.£1.0bn forecast for 2023. So structural decline is very real. I remember on a webinar, mgt said that costs are reduced in 3-year plans, including closing/amalgamating depots. However, mgt said they’re now close to the end of that ability to close depots whilst maintaining full geographic coverage. So I think the key question to ask management, is how much more scope is there to reduce costs, and when do they reach the point where profits cannot any longer be maintained? It may not be too far away, in which case the ultra-low PER is for a good reason - that profits can’t be maintained forever at the current level.

Overall though, the turnaround has worked out exactly as described a few years ago, and the share price remains stubbornly low. So I think there’s a strong case for buying to receive an 8%+ yield, with the possible speculative upside on the share price, of say banking a c.50% upside on the share price if you get lucky! But not a share I’d want to be holding when the cost-cutting can no longer be done to maintain the divis, at some point in the future.

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Jack’s section

Quixant (LON:QXT)

Share price: 149p (pre-open)

Shares in issue: 66,450,060

Market cap: £99m

AGM trading update

A quick update from Quixant this morning, which designs, develops and engineers computers and software for the wager-based gaming and sports betting industries. More recently, Quixant has acquired Densitron (the company that much of the founding management team comes from).

I had a chat with management last month (read the notes here) and came away with a favourable impression, noting it as a company worth monitoring.

Quixant Chair, Francis Small, comments on current trading:

The strong demand for our specialist technology outsource solutions in both Gaming and Densitron divisions has continued through the first four months of the year and year-to-date order intake has been significantly ahead of the same period in 2021 across both businesses…

The healthy trading year to date and order intake give us confidence that we will achieve full year market expectations for both revenue and profit.

Regarding supply chains:

• The group has been investing in stock to manage supply chain issues but, ‘given the strong relationships with suppliers’ these issues have so far been successfully managed anyway.
• Quixant continues to use its ‘strong cash position’ to manage future growth and mitigate supply chain issues.

We can see the group tends to keep a net cash position, which is a positive for risk management (as we are seeing now).

This reminds me of my call with the CEO, in which he said that Quixant had been a proactive and helpful partner during lockdowns as companies in Gaming struggled. That investment now seems to be bearing fruit and year to date revenues are well ahead of the same period in 2021 across both divisions despite the challenging global supply chain environment.

Conclusion

It’s been a poor market for many investors, with some fairly indiscriminate sell-offs among popular stocks. Quixant hasn’t fallen by as much as some others, but in my view the group’s trading performance, technology, customer and supplier relations, and strong balance sheet warrants a stronger share price.

On a 5 year view, the share price remains well off its previous highs, with no equity dilution to speak of.

The group should recover margins if supply chain issues and price rises begin to ease, and I think there are some genuine long term sustainable growth prospects here, so Quixant is higher up my list of stocks to look at in more detail.

Unfortunately, liquidity might be a bit of an issue given a 537bps spread.

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Trifast (LON:TRI)

Share price: 101.31p (-5.32%)

Shares in issue: 136,083,883

Market cap: £137.9m

Q4 trading update

Trifast specialises in the design, engineering, manufacture, and distribution of high-quality industrial fastenings to major global assembly industries.

It looks like the combination of supply chain lead times and inflation has brought the share price right back down to Covid lows.

Trading doesn’t sound too bad though.

Strong trading continued in Q4, contributing to year-on-year organic revenue growth at constant exchange rate (CER) of c.15% for FY2022 (organic growth at CER of c.9% against FY2020). As a result, the Group expects to report an overall trading performance for FY2022, in line with the Board's expectations.

Sales to distributors have remained ‘very high’ in Q4, although light vehicle sector volumes have continued to be volatile due to supply chain disruption. The group adds that it began to see this disruption spread into the health & home sector, with temporary factory closures across several of its Global OEMs operating in Europe.

Lockdowns are impacting trade in China but North America is strong. The Ukraine conflict is having an indirect impact insofar as it is causing further supply chain issues.

Regarding price increases and supply chains:

We have successfully concluded most of our phase one price increase programme negotiations. Although further inflationary cost increases have held back a full margin recovery, we are pleased to report that in March 2022 we recorded gross margins much closer to historic levels. We expect price increase negotiations to be an ongoing part of doing business in the current macroeconomic environment. With this in mind, we are already reaching out to our customer base to discuss a prompt pass-on of relevant additional costs, including increased energy and broader macro costs.

Supply chain challenges remain and although lead times are now stabilising across most of the world, these continue to stand at high levels. Considering this challenging backdrop and given our strong financial position, the business has continued to invest in inventory levels in the second half to ensure reliability of supply.

Project Atlas - seen as an important driver of future growth. Trifast is currently in a phased roll-out to its trading subsidiary, TR Fastenings, which is expected to complete by the end of calendar year 2022.

Conclusion

Unlike Quartix, Trifast has a net debt position which is currently moving higher as it invests in working capital. The group says its acquisition strategy ‘continues at pace’, so the increase has not derailed its plans but it’s still a point to be aware of and I would hope we see signs of net debt reduction in the near future.

The group itself comments:

Net debt (before IFRS16) at the period end was c.£25m, with this expected to reduce and drive historically high cash generation rates, as the macroeconomic environment settles.

One encouraging point is the group’s ability to pass on costs via selective price increases. This is now expected to be an ongoing process.

The initial round of price rises are done and by March gross margins returned much closer to historic levels. Management is in talks for further rises, which should recover margins by late summer.

It looks like a decent business now trading on a more modest valuation, but conditions are trickier than they were six months ago and this is set to continue. Trifast has so far been up to the challenge however.  At 10.7x forecast earnings there is potentially some upside, but that depends on the company continuing to manage pressures and for sentiment to improve in order to drive a bit of a rerating.