Small Cap Value Report (Thu 9 June 2022) - SPE, XPD, WATR

Good morning! Paul & Jack here.

Agenda -

Jack's section:

Sopheon (LON:SPE) - decent results but low current and forecast earnings are weighing on the share price. This results from an ongoing shift to recurring revenues, well flagged by management but still requiring a degree of faith and patience from investors. There are signs of quality here, and other valuation metrics (beside forecast PE) look more attractive, so there’s enough to warrant a closer look. But, depending on how the market chooses to value the shares, there is also scope for a further derating. I think it’s finely balanced.

Xpediator (LON:XPD) - seems to be managing the impact of the Ukraine conflict, which is more of a risk here due to the markets it operates in. Inflation is also a concern though and, while there’s potential for a rerating if things go well, business is low margin, there are risks, and the share price is illiquid.

Water Intelligence (LON:WATR) - audited FY21 results out. Revenue up 44% so the growth continues and the share price has moderated, meaning the shares trade on a more attractive forecast PER than they have done in the past. Still expensive though, and I wonder if in the current market there are more attractive opportunities out there.

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Explanatory notes -

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Jack's section

Sopheon (LON:SPE)

Share price: 579p (+3.79%)

Shares in issue: 10,553,325

Market cap: £61.1m

AGM statement

This is an international provider of software for enterprise innovation management solutions. It’s a falling star now, but one with a Quality Rank of 96 and strong financial health measures. So there’s minimal danger of bankruptcy but plenty of scope for a further derating if people look solely at near term earnings.

The current poor level of profitability results from the group’s​ transition from a traditional perpetual software license business to a higher-quality recurring revenue business.

But recurring revenue can lead to higher quality earnings and operational leverage, so there’s a potentially valuable prize at the end of the road. By year end, 90 percent of the new customer pipeline by value was SaaS focused.

Strategic progress made and results are ahead of management expectations

Both recognized revenues and annual recurring revenues ("ARR") for the year to 31 December 2021 grew by approximately 15% to $34.4m and $20.7m respectively. A new CEO, Greg Coticchia, was appointed in the year and additional senior hires were made in key marketing, sales, and product areas.

Sopheon continues to spend on R&D, with a focus on cloud solutions, and I see it qualifies for an R&D related guru screen.

Acquisitions - At year end Sopheon completed the acquisition of ROI Blueprints, which is already playing a material role in both existing and new customer opportunities. Solverboard was acquired in May 2022, and should accelerate the SaaS strategy. It looks like Solverboard is quite early-stage, so the jury's out here.

Solverboard brings the innovation and product needs of professionals together so that they can focus on addressing front-end innovation challenges, by helping companies dynamically find, align, test and deliver the best innovation and product ideas from employees and customers.

Current trading

Since the start of the year (financial year to 31 December 2022), Sopheon has closed six new customer wins compared to ten in the whole of 2021. ARR has risen to $21.7m compared to $19m a year ago, and gross retention has held above 98% on a year-to-date basis.

Confidence in our full year performance is sustained by a sales pipeline that includes several major extensions with existing customers, alongside a growing list of new prospects. Net cash at the end of May stood at $25m compared to $23m at this time last year, underlining our cash generative nature and our ability to execute.

Conclusion

The ongoing source of frustration, uncertainty, and potential opportunity is the strategic shift to SaaS and the manner in which it affects revenue and profits. A lower share of one-off revenue contributions from perpetual and consulting sales year to date means that FY visibility for recognizable 2022 revenue is currently at $28m, a similar level last year.

That doesn’t sound exciting given the valuation, but it is a dynamic that has been repeatedly flagged by management. The question is whether or not we can see through this transition period to a more attractive end state.

Sopheon maintains a net cash position, now at $25m despite two acquisitions, and remains healthily cash generative.

The 98% gross retention figure is a positive, signalling a good product fit with customers, so if the group can generate genuine organic growth with a recurring revenue model, then that sounds like a promising mix. Underlying momentum is decent given the acquisitions and the six customer wins so far this year.

There’s a problem in valuing the group’s shares though, given the shifting strategy. Brokers forecast FY23 EPS of 11.9p - an improvement on recent results but that would still value the shares at 47x forecast earnings. So you really need to believe that the shift to SaaS will lead to much higher profits in the medium term.

The group is generating free cash flow far in excess of earnings per share at the moment though, and other metrics such as EV/EBITDA paint a more favourable picture, so perhaps it is worth spending more time on this one to look beyond near term earnings.

I think there are signs of a good business here and if you can get comfortable with the low level of current earnings, future profitability might look very different. One attraction of the SaaS model is that it should provide attractive operating leverage as incremental sales add more to profits. So on that basis I think it’s worth spending a bit more time on at current levels, although clearly the market is uncertain as to whether or not this will materialise.

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Xpediator (LON:XPD)

Share price: 36.59p (+4.26%)

Shares in issue: 141,688,425

Market cap: £51.8m

AGM statement

I recall looking at Xpediator when it was first becoming obvious there was lockdown-related supply chain disruption and freight cost inflation. It stood to reason back then that logistics companies could stand to benefit in such an environment, but that doesn’t seem to have happened here.

You can almost see the build up in expectations and the resulting disappointment in the share price chart. Also note the precipitous drop in StockRank heading into May of this year.

Following a strong initial start to trading in the year, particularly from the Group's CEE operations, the Company has continued to trade well despite the effect of Russia's invasion of Ukraine, the impact from which, to date, has been largely offset with increased volumes in other markets.

Xpediator’s strength is in its pan-European operations and CEE focus, so the Ukraine invasion is a bigger risk here than for other companies.

The Group is in a good position, and with its asset light base, it is shielded from some energy and other inflationary cost pressures, but not all.

Conclusion

Brokers are forecasting an uptick in earnings per share but past performance has been patchy, which makes me cautious.

The valuation is starting to look cheap at 8.6x forecast earnings, but this is a very low margin business facing into an inflationary environment.

I can see that the group has expertise in the Central and Eastern Europe region, which might be enough to differentiate it from some other listed logistics peers, and it has traded well in the past. But ultimately I find it hard to get excited about this part of the market. If things go well then there is scope for a rerating at some point, but there are also risks and the share price is illiquid, so I’m happy to leave this for others.

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Water Intelligence (LON:WATR)

Share price: 746p (+5.07%)

Shares in issue: 17,361,188

Market cap: £129.5m

Audited results for the year to 31 December 2021

This is a multinational provider of precision, minimally-invasive leak detection, an area set to grow in importance globally.

Despite Covid-19 disruptions, we delivered across the board in both 2020 and 2021 to deliver on our mission of building a world-class multinational growth company in an important space - water infrastructure.

There’s plenty to like about Water Intelligence - increasingly important market, strong growth track record, and double digit returns on capital. But the valuation remains fairly high even after a near halving of the share price in recent months.

A forecast PER of c28x is more reasonable than it has been in the past, if not cheap.

On 7th February the group released an FY21 Trading Update which showed revenues +44% to $54.5m, confirmed again today, with organic growth of +19% in corporate-owned locations helped by franchise reacquisitions and M&A.

Adjusted FY results (not including one-time gain) in line with February trading update with revenues +44%, Adjusted EBITDA +48% and EPS +29%

• Revenue +44% to $54.5m,
• Adjusted EBITDA +48% to $10.3m,
• Adjusted PBT +36% to $6.9m,
• Adjusted EPS +29% to 30.2 cents.

So that’s about 24p of earnings per share, 31.1x FY21 earnings.

Outlook:

Confident in further corporate development through 2022; well placed to navigate inflationary challenges in order to be in line with market expectations for 2022 with a strong Q1 already reported

On 30th May, Water Intelligence released a strong Q1 trading update with sales growth of +44% to $16.5m driven by same store corporate sales growing +26%, while Adjusted EBITDA advanced +26% to $3.0m.

Conclusion

Following the placing last year and extension of its banking facilities, Water has resources to continue franchise reacquisition and pursue other M&A opportunities. The group's shares have derated but there is a strong operational track record and potential upside to forecasts.

That should be a given though, seeing as forecast growth is not set to match previous results. Perhaps these are undercooked but, considering valuations elsewhere, I would want to see more anticipated growth for a c28x forecast PER.

It’s still a company worth keeping tabs on though, given the level of growth it has achieved in the past.