Small Cap Value Report (Thurs 24 Feb 2022) - MACF, RCDO, INCH, VIC

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

There's a free Mello Investment Trusts and Funds event from 1pm today and Edmund Shing will be on the panel later - his contributions to the site are greatly appreciated, so I'll be tuning in to see what he has to say. Given all the developments, it could be a good opportunity to meet up and discuss with fellow investors. More detail in David's post. Here's the link to register.

Agenda -

Jack's section:

Macfarlane (LON:MACF) - I hold - strong growth ahead of market expectations, external pressures well-managed, and the valuation remains modest on an adjusted EPS basis. Macfarlane has grown profitably for a long time now, and the business is quite resilient. These good results will likely be lost amid the noise this morning, but all the more reason to put it on the watchlist in my opinion.

Ricardo (LON:RCDO) - looks potentially interesting, with a new CEO and a more sustainable strategy becoming clearer. There has not been a huge deal of equity dilution since the share price fall, so a successful turnaround could lead to good upside. A capital markets event is planned for the Spring, so that will be a good opportunity to get a better grasp of the group’s plans and prospects.

Inchcape (LON:INCH) - too large for the SCVR usually, but worth a look given the potential readacross for smaller peers given recent exceptional market conditions in the used car market.

Victorian Plumbing (LON:VIC) - looks like a mild profit warning, with higher costs leading to lower than expected margins. This is a recent IPO and has lost nearly 80% of its market cap in less than a year. Given that the past couple of years have been boosted by lockdowns, I’m unsure what the longer term growth prospects are like here so I don’t see the need to jump in.

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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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Macfarlane (LON:MACF)

Share price: 123.23p (-1.02%)

Shares in issue: 157,812,000

Market cap: £194.5m

(I hold)

Final results for the year to 31 December 2021

Highlights from continuing operations:

• Revenue +26% to £264.5m,
• Operating profit +47% to £20.1m,
• Profit before tax +50% to £18.7m,
• Including discontinued operations, diluted earnings per share is up 23.1% to 7.98p,
• Diluted earnings per share from continuing operations +40.4% to 8.62p,
• Net cash inflow of £23.8m (2020: £23.3m),
• Continued improvement in pension scheme, from deficit of £1.5m to a surplus of £8.3m,
• Full year dividend +25% to 3.2p.

These are good results regardless of how the shares fare today, so for those that are not running for the hills this morning, Macfarlane is one to watch on any fall in share price. Management strikes me as highly competent here, very experienced, and they’ve been managing external pressures (both Covid and post-Covid) well so far.

Packaging Distribution achieved strong growth in sales and an improvement in revenue (+19% to £239.5m) operating profit before amortisation (+19% to £2.6m) versus 2020. Gross margin has held up well despite input price pressures, holding steady at 32.4% (2020: 32.5%).

Business in Europe is growing:

During 2021 we made steady progress in extending our service into Europe to support a number of our pan-European customers. Through the Group's subsidiary company, based in the Netherlands, sales exited 2021 on an annual run-rate of c£5m with sales in 2021 of £2.3m (2020: £1.1m).

Macfarlane notes continued sales growth in the year thanks to the structural shift to e-commerce retail, a good performance in Medical, and a recovery in certain industrial sectors, and the GWP and Carters acquisitions. The strong profit performance is encouraging given well-flagged inflationary pressures on input costs and supply shortages of various materials.

Demand from the aerospace, high street retail and hospitality sectors has not yet recovered to pre-pandemic levels but, given how well the company is currently doing, I would actually view that as a positive, as existing demand will at some point be bolstered by recoveries here.

Our customers increasingly see the benefits of transacting with us online and this has resulted in a growth in activity through our website: shop.macfarlanepackaging.com and through our Simplicit-e electronic trading platform. In 2021, 44% of our customers managed their transactions with us online.

Manufacturing Operations delivered an ‘encouraging’ recovery versus 2020 in both sales and operating profit before amortisation. GWP is performing ahead of expectations. Year-on-year progress is distorted by the discontinued Labels business and GWP, but the net result is operating profit before amortisation of £3.7m compared to a small loss of £329k in the prior year.

Acquisitions - small, bolt on acquisitions are a core part of Macfarlane’s strategy. Again, management has proven over many years that they know their market and how to purchase sensibly. GWP and Carters Packaging were bought in February and March of 2021 and have performed well, according to the group.

The sale of its Labels business is complete, hence the continued and discontinued operations in today’s results. Labels generated a loss before tax of £0.9m after charging a goodwill impairment of £1m and costs of disposal of £0.3m.

This is probably a good move - if you look at Macfarlane’s progress over the past decade, it’s all about Packaging Distribution. Meanwhile, Manufacturing Operations complements that growth division and could grow itself (management presumably hopes so, having recently purchased GWP and added it to this division). Labels always seemed something of an outlier.

Outlook - 2022 will see ongoing inflationary pressure on input prices, continuing supply constraints on most raw materials and operating costs increasing due to staffing pressures.

However, despite these challenges, trading in the early months has been encouraging and the Board is confident that, given the effectiveness of our strategy, the resilience of our business model and the experience and commitment of our people, Macfarlane Group will continue to deliver further growth in 2022.

Balance sheet - there is a net debt position, c32.5m including leases, but the improving pension scheme is a big positive and the group is cash generative (with free cash flow well ahead of net profits).

Conclusion

I agree with Shore Capital that a 150p share price is warranted, although I still think that would be conservative and will personally be adding on any significant pullback. DYOR of course, that’s just my own position.

Macfarlane has proven itself as a resilient business, growing profitably over the longer term and handling Covid and resulting supply chain and input price pressures well. No risky change in strategy is required to continue to do so in future. Labels will bring in c£6.3m which can be redeployed into the remaining two divisions.

I think Macfarlane is well placed to grow, as it has done over the past few years, by growing organically and making small, high-quality acquisitions. Revenue growth resulting from structural drivers such as ecommerce should enable a degree of operational gearing, which has also been the case recently looking at the group’s operating margins.

Obviously there’s an elephant in the room today. Not the best time to herald positive results, but that could lead to an attractive entry point for anyone that has been considering this share.

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Ricardo (LON:RCDO)

Share price: 434p (-2.91%)

Shares in issue: 62,218,280

Market cap: £270m

Interim results for the six months to 31 December 2021

Whenever I see a chart like this, the first thing I do is to check for signs of material equity dilution.

It’s not often talked about, but share price history is a flawed reflection of value as shares in issue are not represented. So buybacks and equity dilution can go unnoticed, and events such as steep share price drops can coincide with discounted equity placings, which make it virtually impossible to regain previous highs.

That’s not the case here though, with shares in issue from 2018 up from 54m to 62m, which is an increase but hardly disastrous.

Highlights:

• Order intake +16% to £210.6m, with accelerating environmental trends across all segments,
• Order book down slightly, from £318.2m to £315.5m,
• Revenue +13% to £185.5m,
• Underlying operating profit +42% to £10.5m,
• Underlying cash conversion of 162% and net debt down to £38.5m,
• Interim dividend of 2.91p.

Underlying operating profit margin is still quite low, although it’s up from 4.5% to 5.7%. Underlying basic earnings per share is up 56% to 10.6p. Statutory results are notably different to the underlying figures given.

Here’s the note connecting them:

In terms of segments, Energy and environment (EE) saw revenue grow from £26.6m to £30.9m, with underlying operating profit up from £3.8m to £4.3m. Rail revenue was down slightly from £38.5m to £37.4m although underlying operating profit improved from £3.5m to £3.8m.

Automotive & Industrial (A&I) revenue rose from £50.1m to £54.2m and operating loss reduced from -£3.4m to -£1.7m. Defense revenue increased from £13.9m to £21.5m and operating profit rose from £1.7m to £2.8m. Performance Products (PP) revenue grew from £35.6m to £41.5m, with operating profit steady at £3.9m.

There is seasonality here, with H2 typically stronger than H1.

There’s a capital markets event planned for late Spring, where the group will set out its plans for future growth.

£6.1m has been invested into research and development before government grant income of £1.2m. Development costs capitalised were £3.5m, the same as H1 last year, reflecting investments in software and technology.

Capital expenditure on property, plant and equipment was £2.6m (HY 2020/21: £2.2m), reflecting targeted investment in business operations such as a hydrogen and electrical test capability A&I EMEA.

Pension scheme - The fair value of the scheme's assets at the end of the period was £162.8m (FY 2020/21: £156.2m) and the pre-tax surplus increased to £9.6m from £6.8m at 30 June 2021. Ricardo paid £2.1m of cash contributions into the scheme during the period (HY 2020/21: £2.3m).

From November 2021, following completion of the 2020 triennial valuation negotiations with the scheme Trustees, the level of deficit funding contributions reduced from £4.6m per annum to £1.8m per annum through to November 2023.

That will be a useful cash boost for the company going forward.

Balance sheet - looks fine. £115.2m of goodwill and intangibles making up 29% of total assets, so NTAV of £69m. The current ratio is around 2x, with £56.8m of cash against £99.6m of current liabilities.

Outlook

Our strong order intake is particularly encouraging and is driven by increasing demand for services in respect of energy transition, climate change and decarbonisation. We have also seen strong cash generation in the first half that will create opportunity to invest in our key target segments to deliver sustainable growth.

The Group enters the second half of the year with a good level of orders and pipeline of opportunities and solid momentum in all segments. As we enter our seasonally stronger second half, whilst some economic uncertainty remains, we are cautiously optimistic to deliver on our full year expectations for revenue and underlying PBT. Following strong net debt improvement in the first half we would expect a further small improvement by year-end.

Conclusion

I can see how Ricardo’s ESG and sustainable energy expertise could see continued growth into the future. And, importantly, there has been no material permanent equity dilution over the past few years, so it is possible for the shares to rerate from here if the company does well.

I’m neutral for now, but it looks interesting. Debt has reduced over the past year or two and the StockRank has improved considerably. With a new CEO in charge, I’ll be watching out for that capital markets day as this looks like a solid turnaround prospect. The reduced pension contributions will be an additional boost.

It does seem like the strategy is becoming better articulated now, with a focus on existing strengths such as EE coupled with efficiency improvements. Sustained momentum should improve margins and cash generation, which can then be used to shore up the balance sheet.

Ricardo did once have double digit operating margins.

As the largest but lowest margin division, the recovery of A&I will be important to watch out for. It’s currently loss-making but profits are H2 weighted and the £76.7m of orders is encouraging. Moving on from Covid would clearly help.

There’s quite a lot going on here, across five different operating segments, so it will take some time to dig into, but enough to warrant further research at these levels in my opinion.

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Inchcape (LON:INCH)

Share price: 768.5p (-7.63%)

Shares in issue: 381,662,261

Market cap: £2.93bn

Final results for the year to 31 December 2021

We’re venturing out of SCVR territory here, but Inchcape is a car retailer so it could have some useful readacross for smaller peers given the exceptional second hand car market conditions that have been boosting sector profitability recently.

Highlights:

• Group like-for-like revenue +21% to £7.6bn,
• Profit before tax more than doubled from £128m to £296m, thanks in part to high vehicle gross margins,
• Free cash flow of £289m, up from £177m,
• Net cash up from £266m to £379m following c£80m of share buybacks,
• Proposed final divided of 16.1p and new £100m buyback programme announced.

Outlook

The Group's strong performance in 2021 was supported by robust consumer demand and high vehicle gross margins (particularly in Retail), largely due to vehicle supply shortages. Looking ahead, our 2022 performance to date has seen a continuation of the trends experienced last year, although there is ongoing uncertainty relating to vehicle supply and the impact of the pandemic.

The group adapted operationally to Covid conditions and it’s good to see this therefore had less of an impact in FY21. Global supply-chain issues did have a more pronounced impact in H2, however.

Importantly though, the demand for vehicles and aftersales remained strong throughout the period, which created a supply-demand imbalance, and led to higher gross margins and profitability.

I won’t go into company-specific deal here, it’s more the industry outlook commentary I’m interested in. There’s not much of it in the statement, but the gist is that trends have so far continued into the new year.

This will normalise at some point, and it’s worth noting that Inchcape shares are down by more than the wider market today which suggests an element of ‘it’s better to journey than to arrive’ going on, but the dynamic remains in place for now.

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Victorian Plumbing (LON:VIC)

Share price: 75.6p (-7.8%)

Shares in issue: 325,062,985

Market cap: £245.7m

Victorian Plumbing says it has ‘continued to trade in line’ with the dynamic set out in its full year results announced on 9 December 2021.

This is what the company said back then:

We experienced more subdued market conditions during the summer months following the easing of restrictions, before customer demand improved somewhat during September. Through the first two months of FY22, whilst consumers have continued to spend more on leisure and less on big ticket material homeware purchases, demand and revenue have been broadly the same as last year and 41% ahead of FY20.

The adaptability of our supply chain and investment in-stock inventory means we are currently operating from a position of strength relative to others. Given the popularity of our own brand offering, we are able to absorb most of the current supply chain pressures. However, as we look to balance revenue growth with profitability in the short-term, gross margins may move closer to those achieved in FY20.

Today the group updates the market

As we look to the second half of the financial year, we note that the comparative period performance for revenue eases and so we expect to return to having modest year-on-year growth through H2 2022. There are however ongoing inflationary cost pressures that we face. We are acutely aware that our customers are also managing inflationary pressures and will adopt a careful approach to price rises, which means we are choosing to temporarily absorb some additional costs. We therefore expect both gross profit margin and adjusted EBITDA margin to be slightly lower than previously anticipated.

I wouldn’t say that’s ‘in line’ with anything, seeing as it results in lower than expected margins.

Revenue for the four months ended 31 January 2022 was down 3% year-on-year, but up 38% on the same period two years ago, whilst marketing spend has now started to normalise. The group is confident of its ability to take market share in the long term.

Conclusion

This is an unfortunately timed IPO. The Value Rank is picking up though, now at 60.

It's an online bathroom retailer and the lack of trading data as a listed company makes Victorian Plumbing’s prospects hard to gauge. Online businesses across the board fared well over lockdown-impacted periods, so I’m unsure as to the longer term prospects here under more normal conditions.

Revenue growth has slowed year-on-year but is up 38% on a two-year view. So that’s a 17.5% annualised. But, given the IPO price of c330p less than a year ago based on what have transpired to be unsustainable growth rates, I think it’s fair to remain skeptical here. No wonder IPOs get a bad name. It’s really not in the UK market’s long term interests to have such a poor track record in this regard.

Meanwhile, costs are rising with limited ability to pass them on by the sounds of it. When consumer confidence takes a knock, I suspect people are more likely to skip Victorian’s bathroom products than everyday treats. If you look on the group’s website, there’s a 60% clearance sale on.

I haven’t read the admission document here, so I could be missing something and there’s always the chance this will end up being an excellent contrarian pick. The shares have lost nearly 80% of their value in less than a year, so there will be a floor somewhere. But this is not a forgiving market right now, and it’s up to the company to rebuild trust which has presumably been badly impacted.