Small Cap Value Report (Thu 6 Oct 2022) - MOTR, VIC, CMCX, ECK, FAN, STEM

Good morning from Paul & Graham!

Agenda - 

Paul's Section:

SThree (LON:STEM) - I've lined up another of my CEO audio interviews today. These are only occasional, when I approach companies that I think look good, and are trading well, and reasonably priced. We've covered STEM positively here all this year, as it has issued repeated ahead of expectations updates. So I thought it would be interesting to talk to management and learn a bit more about the company. I'm recording it at 15:00, so it should be published here at about 16:00, and will come up automatically on my podcast channel. Here is my audio interview with STEM, I hope you find it interesting.

Motorpoint (LON:MOTR) - quite a nasty profit warning, with broker forecasts slashed by 50-60% this morning. The company tries to explain it as being about "investments" for growth, but I suspect the market is about to take a dim view of this update (am writing this just before the market opens). With profits now largely disappearing, and not much asset backing, it's a lot harder to feel bullish about this share in the short term.

Victorian Plumbing (LON:VIC) - one of many bombed out eCommerce shares. Today's update sounds encouraging, being ahead of (lowered) expectations. I like the balance sheet, with a cash pile of about a third of the market cap. Also a low PER. I do have some reservations, but this share now looks attractively priced, and fairly low risk due to its sound finances, in my view.

Graham's Section:

CMC Markets (LON:CMCX) (£624m) - a nice trading update from CMC. It’s looking to grow profits by 30% over the next three years, from the FY 2022 level. The FY 2021 results are considered a one-off event, boosted by Covid, and FY 2022 is considered to be more representative of normal performance from now on. The market apparently disagrees, however, and has put CMC on some very cheap valuation ratios. If volatility collapsed back to 2018 levels, then I agree that profitability would suffer but I don’t consider that to be very likely and I appreciate the counter-cyclical characteristics of these shares. I also welcome CMC’s move into traditional stockbroking. I like these shares - two thumbs up from me.

Eckoh (LON:ECK) (£128m) [no section below] - the “global provider of customer engagement security solutions” provides an H1 trading update. Orders are up >50% over last year at £17m, in line with expectations. The company provides payment technology, phone systems (“interactive voice response”) and other customer engagement services. According to a note published by Singer today, the revenue forecast for FY March 2023 is £40m, and then £43.2m in FY March 2024. The adjusted EPS forecast is 2p for both FY 2023 and FY 2024. This puts the shares on a current earnings multiple of >20x, which perhaps can be justified on the basis of the growth figures. However, Eckoh made an acquisition in December 2021 (Syntec - annual revenues c. £7m) and so the true level of underlying organic growth is unclear. I note that the company has a net cash position and has developed a good track record of dividend payments since 2016. I take a neutral stance on this share, pending better information on organic vs. acquisition-led growth. [no section below]

Volution (LON:FAN) (£678m) (+12%) [no section below] - this is a “leading international designer and manufacturer of energy efficient indoor air quality solutions”. FY July 2022 results are impressive: revenues up 12.9% to £308m, adjusted PBT up 14.5% to £61m, and actual PBT up 57% to £47m. The company clearly outlines where its revenue growth comes from: inorganic growth is higher than organic growth, and currency fluctuations have a negative impact. All regions are doing well: UK, Europe and Australasia, and with improved non-UK diversification. This is another company developing a nice dividend track record.

Comparing notes to when I last mentioned this stock a few years ago, there continue to be huge year-on-year differences in the “adjustments” applied to its earnings: sometimes they are enormous, while sometimes (like this year) they are less severe. Net debt rises to £85.8m after acquisition spending, but the outlook sounds fine: the new year has “started well, delivering revenue and profit ahead of the same period last year”. I haven’t got a strong view on this one but it’s superficially inexpensive relative to earnings and maybe deserves to recover a higher rating (it was trading as high as 550p in 2021, but has fallen in sympathy with the rest of the small-cap market).  [no section below]

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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:

Motorpoint (LON:MOTR)

178p (pre market open)

Market cap £161m

Half Year Trading Update (profit warning)

Motorpoint Group PLC, the UK's leading independent omnichannel vehicle retailer, provides an update on its trading performance for the six months ended 30 September 2022 ("H1 FY23").

Strong revenue growth, up c.30% to £785m (due to new branch openings, higher spec cars being sold, and price inflation).

Sharp slowdown in volumes of cars sold in Sept, after positive growth over the summer.

Profit warning, which I suspect the market is likely to take a dim view of (am writing this at 07:36), despite the company trying to convince us that higher costs are “investments” -

Accordingly, as a result of the investments during H1 FY23, coupled with the costs of maintaining market leading finance rates at 8.9% (9.9% from 1 October 2022), Profit before Taxation ("PBT") for the period is c.£3m. This PBT is significantly lower than H1 FY22 (£13.5m) and reflects the increased strategic investment (c.£4m) and interest costs (c.£1m) in H1 FY23 and compares against record margins experienced in H1 FY22.

Outlook -

… macro factors will continue to challenge financial performance in FY23, the extent of which is difficult to predict. In this environment the Group will carefully manage its cost base, align its consumer financing rates with borrowing costs, and continue to build technology and digital capabilities which increase automation, data-led decision making and customer self-service, thereby enhancing the agility of the Group to proactively manage its cost base. Further, the Group will continue to invest in important strategic capabilities but only to the extent that it remains profitable and cash generative, and maintains a strong balance sheet…

As has been previously highlighted, the impact of rising inflation, interest rates, consumer uncertainty and worldwide vehicle supply chain challenges are significantly affecting the used car market. Whilst it is prudent to remain cautious given these short term headwinds, the Group will continue to invest now for the longer term in a weakening competitor landscape, whilst also delivering appropriate levels of profitability and cash generation.

Liquidity - sounds OK, but this will need a bit more scrutiny from me when the interim numbers are published -

The Company's balanced approach to investment, profit and cash is demonstrated by the Group growing cash balances during the first half and the absence of any structural debt. At period end, the Group had a net cash position of c.£4.5m (31 March 2022: £7.8m) and stocking finance headroom of c.£70m. The strength of the balance sheet will provide further firepower to continue the planned strategic investment.

Balance sheet - the business model for MOTR is different to conventional car dealerships. So it only sells secondhand (nearly new) cars, and doesn’t do the franchising selling (or servicing) for new cars.

Whereas conventional car dealers tend to have masses of freehold property and strong balance sheets, MOTR does not. Its last reported NTAV was only £38.8m, which is a fraction of Vertu Motors (LON:VTU) which we covered here yesterday. Therefore MOTR shares don’t have that bulletproof asset backing of VTU, making them higher risk.

My opinion - this is a big disappointment. Earnings forecasts for FY 3/2023 and FY 3/2024 have been heavily slashed, to just under 6p for both years, being 50-60% falls. This seriously undermines the investment case, and I’m sorry to say that a big drop in share price looks likely today.

The trouble seems to be that MOTR was egged on to grow more aggressively by American shareholders, but that’s now clobbered profitability. UK investors tend to focus on profit based valuation of shares, and don’t like it when profits are slashed to chase growth, especially in bear markets.

So unfortunately I think this share is likely to join the growing ranks of investments which have gone wrong in the short term, but which hopefully might recover long-term.

Solvency shouldn’t be a problem, providing the key lenders (there’s a lot of stocking loans for the inventories) remain co-operative.

EDIT: I'm surprised it's only down c.12% in early trades to 156p. That strikes me as a selling opportunity, given the size of the downgrades.

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Victorian Plumbing (LON:VIC)

37.8p (up 6% at 08:31)

Market cap £123m

Full Year Trading Update

Victorian Plumbing Group plc (AIM: VIC), the UK's leading online specialist bathroom retailer, today provides an update on trading for the year ended 30 September 2022 ("FY22").

The financial year finished positively with revenue, earnings, and cash flow all ahead of consensus market expectations.

Revenue for FY 9/2022 was flat vs last year, but showed an improving trend in H2.

Revenue up 78% on pre-covid year FY 9/2019.

It claims to be the no.1 bathroom retailer in the UK.

Gross margin improved in H2 vs H1 (but no figures provided).

Cash - this is impressive, considering the market cap is only £123m -

Victorian Plumbing continues to be highly cash generative and we will start the new financial year with in excess of £43m of net cash.

Outlook - fairly vague -

Whilst the operating and economic environment is challenging, as a highly cash generative business with a strong balance sheet and growing momentum through 2022 we enter the new financial year with confidence in our plans for further progress.

Is the balance sheet actually strong? (I always get suspicious when companies trumpet a strong balance sheet, because they’re often deluding themselves). In this case, actually yes it is. NTAV was last reported at £32m. Doesn’t sound that much, but bear in mind being an eCommerce business, it has hardly any fixed assets, and hardly any receivables. Therefore it doesn’t need much NTAV to be in a healthy position. There was no interest-bearing debt, and cash was £33.7m at end March 2022. Net cash is now £43m, so it’s in a very healthy position.

Is it really a “highly cash generative business”? It was during the pandemic, with £24.4m of operating cashflow (after tax) for FY 9/2021. However, the latest interim figures to Mar 2022 show that cashflow dried up to only £3.2m on the same basis in H1.

So the jury is out on whether it actually is highly cash generative any more - doesn’t look like it is, based on the interim numbers.

Marketing costs - management might be referring to cash generation before marketing spend - which is very high. VIC spends an extraordinary amount on marketing, £40.2m in the 6 months to end Mar 2022. That’s 30% of revenues, and it didn’t generate any revenue growth at all - revenues actually fell 5% on H1 LY.

This is my main concern with VIC - the business seems to have to spend colossal amounts on marketing, just to stand still. This implies poor customer lifetime value, and that many sales are just one-offs. Wouldn’t it make more sense to slash prices by say 10-20%, so that customers come back of their own accord, and spend less on marketing, because you wouldn’t need to - the lower prices would attract customers? Maybe that’s too simplistic?

Valuation - i can’t find any broker notes unfortunately, which hampers things.

If we use the Stockopedia numbers - see below that forecast EPS has dropped a lot from original expectations, but it’s still profitable, and today we’re told that it’s beaten the market consensus numbers (but there’s no footnote to confirm what consensus figures actually are - a glaring omission, it really should be standard practice to always include a footnote, as many companies are now doing).

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This graph from Stockopedia shows 3.3p EPS forecast for FY 9/2022, which would put us on a current year PER of 11.5, which looks good value, especially considering about a third of the market cap is represented by the company’s own cash pile.

My opinion - despite my reservations, this share is now looking cheap.

The upside potential for eCommerce shares, is that some structural growth might return at some stage, replacing the boom & bust cycle that we’ve seen in the last 2-3 years due to the pandemic.  Also venture-capital backed new entrants are likely to be less of a competitive threat these days.

That could trigger a nice re-rating for some eCommerce shares.

VIC looks low risk (due to the cash pile), is still profitable, and looks modestly valued. That’s assuming the company is able to increase earnings in future - which can’t necessarily be taken for granted, hence why I've ignored forecasts for next year.

Overall though, it gets a thumbs up from me. It seems strange finding eCommerce businesses that are now priced as value shares, after so many years of them attracting sky high valuations as growth companies.

2021 certainly wasn't a vintage year for IPOs, was it?! Most have turned out to be corked, or just over-priced vinegar to begin with!

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Graham’s Section:

CMC Markets (LON:CMCX)

Share price: 222.5p (pre-market)

Market cap: £624m

This trading platform provider was previously outside of our £700m market cap limit.

In April 2021, its share price reached a high around 540p:

Maybe we need to adjust our market cap limit, depending on whether we are in a bull market or a bear market!

CMC is a competitor to IG group (LON:IGG) which is the third-largest holding in my personal portfolio. So I guess that makes me slightly biased against CMC.

Today we get an H1 2023 trading update. Key points:

• Net operating income +21% to £153m
• Leveraged net trading revenue +27% to £128m
• Non-leveraged net trading revenue minus 14% to £21m

They have launched a new platform for UK customers: CMC Invest, “with the aim of supporting customers throughout their entire investment journey”. They offer ISAs and SIPPs in addition to ordinary investment accounts.

They are a few years late to the party. IG’s share dealing has been around for a while now. I always thought it made sense that spread betting providers should provide investment services: they already have the apps, the trading technology and the customer service infrastructure. All they need to do is let clients access the physical shares (which the spread betting provider is already taking positions in, to hedge clients’ positions).

Even if they are a bit late with this product, compared to IG, I still think it’s the right move by CMC. Note that investment accounts are far less profitable than leveraged trading accounts, but they have more sticking power (leveraged traders have a tendency to lose money and give up within a few years).

Let’s dig into the specifics of this trading update:

• Client leveraged AUM finished H1 at £530m, slightly below the £560m record at which it started the period.
• Client numbers are “moderately lower”, but there is an “overall increase in activity”.
• Similarly, the Australian stockbroking business saw a “modest reduction” in assets under administration, but “activity remains elevated versus pre-pandemic levels”.

Medium-term plans: In FY 2022, net operating income was £282m. CMC is looking to grow this by 30% over the next three years.

(FY 2021’s net operating income was £410m. This was driven by the extreme Covid-related volatility and is not expected to repeat).

Currency exposures: GBP weakness will have the net effect of boosting results due to CMC’s non-GBP revenues.

CEO comment:

We closed the first six months with a pickup in market volatility and client trading volumes driving an improvement in operating income versus last year…

We are on a fast track to diversification, using our existing platform technology to win B2B and B2C non-leveraged business. Our strategic growth plans are on track and set to deliver significant new business expansion as we introduce new products across our retail, institutional and stockbroking businesses. We look forward to updating you more in our H1 results on 16 November 2022."

My view

I view this as a high-quality business that is likely to be undervalued at current levels:

However, please bear in mind that I feel the same way about IG group (LON:IGG) which is a large position for me. IG also appears to be “cheap”:

The market doesn’t seem particularly interested in either of these shares right now. Perhaps there is a feeling that Covid artificially boosted their profitability (which it did), and that activity levels are still artificially high.

Remember that these were much smaller businesses a few years ago. See the rapid progression in CMC’s revenues and operating profits:

So there appears to be sheer disbelief in the rapid gains in profitability, especially after the post-Covid drop in their performances. A suspicion that current profitability is unsustainable.

On top of that, investors in this sector have had to navigate some major regulatory issues in recent years, and that experience tends to have a lingering effect on sentiment.

Personally, I’m happy to own IGG and I’d consider adding CMC at current levels.

The major risk is perhaps that volatility dies down, and trading activity levels die down with it.

Here is a 5-year chart of the VIX (volatility index):

This chart helps to prove that volatility is still at much higher levels than it was pre-Covid. If it did go back to the low levels of 2018/2019, then yes, I would expect the profitability of the spread betting companies to suffer.

But personally, I don’t expect that to happen, and in any case I like to have a volatility hedge in my portfolio. Volatility tends to be highest when markets are going down and I like to own some companies that will thrive in that environment.

So while IGG and CMCX shares aren’t for everyone, they remain an important part of my personal investment strategy.