Small Cap Value Report (Thurs 4 March 2021) - K3C, FRAN, AIEA

Morning, it's Jack here starting off Thursday's SCVR. Do leave a comment if anything catches your eye.

So yesterday was The Budget: the furlough scheme has been extended until September; fuel has been frozen again and the stamp duty holiday has also been extended. Meanwhile, corporation tax will increase from 19% to 25% from April 2023 for companies earning more than £250,000 a year.

Pension tax relief, annual and lifetime allowances, IHT rates and CGT remain unchanged for private investors. Mortgage guarantees up to 95% looks like it could inflate house prices even further (and the ratio of house prices to average earnings is already stretched).

There’s also much-needed help for the hospitality and arts sectors.

Longer term, there’s no getting away from the debt that COVID has created. We’ll need to address that with tax rises, spending cuts and borrowing at some point but politicians and central banks are adept at kicking the can down the road. Rising rates would be a real concern.

In the short term though, things are looking up. The Office for Budget Responsibility (OBR) forecasts a ‘swifter and more sustained recovery’ than what was expected last November and is penciling in economic growth of 4% in 2021 and 7.3% in 2022.

Another interesting tidbit: the government is looking to modernise listing rules to allow dual class share structures and reduce free float requirements. If accepted, these changes might encourage more firms to list in London. It already feels like we’re seeing quite a few IPOs at the moment, so maybe that will become more of a trend?

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K3 Capital (LON:K3C)

Share price: 277p (+3.75%)

Shares in issue: 68,624,309

Market cap: £190.1m

K3 Capital (LON:K3C) is a professional services firm providing advisory services to SMEs. The company was incorporated in 2007, is headquartered in Bolton, and employs around 450 staff across 18 UK offices (with another three overseas).

It tends to advise on M&A, tax, and financial recovery matters across a collection of subsidiaries including KBS Corporate, Quantuma, Knightsbridge, and Randd.

The group floated in 2017 with the intention of diversifying revenue streams by acquiring complementary professional services businesses.

Two target segments were promptly identified: specialist tax reclaim and business restructuring / insolvency. One £30.5m fundraise later and the group acquired both Randd (a research and development tax reclaim specialist), and Quantuma (a business advisory firm specialising in corporate finance, pension advisory, forensic accounting and investigations, and restructuring and insolvency).

Trading update

Following a ‘robust’ first half, K3 is now trading ahead of expectations in the second half and it expects revenue for the year ended 31 May to be significantly ahead of consensus market expectations, with Adjusted EBITDA of no less than £12m.

It’s worth bearing in mind that those expectations have been nudged down over the year though.

Adjusted EBITDA is taken before acquisition related costs and share based payments.

In FY20, EBITDA was £6.8m and in 2019 it was £5m, so that’s a promising growth trajectory (with a couple of acquisitions thrown in for added rocket fuel)

All business divisions have performed well, with a particularly strong performance by KBS, driven by a large volume of transactions. The recent acquisitions of inTax and Aspect Plus, as well as lateral hires, have also already made positive contributions in the period.

What’s more, the group expects to see continued strong performance for the remainder of the financial year.

John Rigby, K3's CEO, commented,

The Group's excellent performance during the global pandemic is testament to the resilience and determination of our teams. This trading performance also provides further validation of our strategy, with the Group's diversified revenue streams providing us better visibility than ever before on future trading. Whilst all divisions have performed well, we are particularly pleased with the large volume of transactions, across our M&A division, in line with our ongoing 'bigger and better' strategy.

Conclusion

Not a company I’ve looked at before, but the tone sounds very encouraging with broad-based growth across K3’s operating divisions. It’s just an update, so it’s light on actual figures. You can find the half year report from the 16th of February here.

Brokers are expecting some good top line growth over the next couple of years.

The share price has recovered quite well in recent months, but the forecast PEG of 0.8x suggests this is a company on the move.

The update sounds positive to me and I can see plenty of demand for K3’s services once the various Covid-related initiatives are withdrawn and businesses are left to deal with the repercussions of repeated lockdowns.

It’s good to see the group’s CEO, John Rigby, is one of K3’s major shareholders as well. So there are certainly some points of interest here. A clear growth strategy, robust trading across divisions, and management alignment with shareholders.

I wonder if operating results might be volatile, but the group has so far driven impressive growth over the past few years. Worth a closer look.

Franchise Brands (LON:FRAN)

Share price: 106.44p (+4.87%)

Shares in issue: 95,758,470

Market cap: £101.9m

Franchise Brands (LON:FRAN) is an interesting one, with a mix of savvy institutional and private investors making up its major shareholders. They’ve been net buyers recently, and so have directors.

The group’s franchises have some great names like ‘ChipsAway’ and ‘Barking Mad’.

And franchise models, when they take root, can be fantastically cash generative. Clearly that’s the case here, although at 40.4x TTM free cash flow, you are paying up for those attractive cash flow characteristics.

Since being admitted to AIM in August 2016, the group has developed a resilient portfolio of brands and has generated compound annual growth in adjusted EBITDA of 47%, with 59% compound growth in dividends.

Acquisitions to date are:

2016 – Barking Mad for £0.9m,

2017 – Metro Rod for £28m,

2019 – Willow Pumps for £12.5m.

In April 2020 the group raised £14m (£13.6m net of expenses) via an equity placing from new and existing investors to ensure financial security through lockdowns. But now this strengthened balance sheet can be used to expand the business ‘and take advantage of the considerable opportunities we see in the recovery.’

The company is actually presenting at the upcoming Mello event, so that might be worth tuning in for.

Final Results

Financial highlights:

• Revenue +12% to £49.3m including the first full year contribution from Willow Pumps.
• Adjusted EBITDA +28% to £6.6m.
• Adjusted profit before tax increased by 19% to £4.8m; statutory PBT +12% to £3.7m
• Adjusted EPS +0.2% to 4.35p and basic EPS down by 11% to 3.09p due to ‘COVID-19 non-recurring items.’
• Net cash of £4.9m at 31 December 2020 (2019: Net debt £11.1m).
• Final dividend of 0.80p per share proposed (2019: 0.65p per share), giving a 16% increase in the total dividend for the year to 1.1p per share (2017: 0.95p per share).

Non-recurring costs were £707,000 in the period. There was another £393k in amortization of acquired intangibles and £205k in share based payments. Together these make up the bulk of the difference between adjusted and statutory figures.

That values the shares at 23.3x adjusted earnings and 32.8x statutory earnings, with a dividend yield of 1.08%. On the pricey side but this is a growth stock and revenue has compounded at some 58.9% over the past six years.

That rate is slowing now but Franchise is aiming to expand organically and by acquisition with the target of achieving run-rate revenues of £100m and adjusted EBITDA of £15m by the end of 2023. That’s quite ambitious, and it’s nice to see some explicit targets.

This will be achieved through organic growth and complementary acquisitions largely funded from existing facilities.

Franchise presents a familiar pattern of trading: a strong Q1, resilient performance and cost reduction measures through lockdowns, followed by a robust recovery in H2.

What’s more, trading has started strongly in 2021, with resilient sales in the B2B division and robust recruitment in the B2C division.

Going into a little more detail, the B2B division comprises Metro Rod, Metro Plumb, and Willow Pumps. It provides a "Water In. Waste Out." range of drainage, plumbing and pumps services to commercial and domestic customers across the whole of the UK. Most of these services have been designated by the Government as essential and continued to operate throughout the lockdowns.

Metro Rod and Metro Plumb full year system sales were down just 2% against 2019 but a higher management service fee due to a favourable service mix drove a 24% increase in Metro Rod adjusted EBITDA. Metro Plumb system sales exceeded £5m in the year and grew by 3% on a like-for-like basis.

Willow Pumps, which was acquired in October 2019, saw sales down 23% but gross profit declined by only 4% for the full year.

The B2C division comprises ChipsAway, Ovenclean and Barking Mad. It followed a similar trajectory and ChipsAway, which contributes 88% of the division's EBITDA, quickly re-established pre-lockdown levels of activity.

Ovenclean also recovered quickly from early summer onwards, however, Barking Mad continued to suffer very low demand as people were unable to take holidays that generated demand for dog boarding.

Conclusion

All in all, these results are better than might have been expected in a year of multiple disruptions. Franchise saw strong trading in the first quarter, it was quick to cut costs back in Spring 2020, and trading recovered well in the second half.

Now it is investing in automation and believes that this will increase sales, improve corporate and franchisee efficiency, and reduce costs. It sounds like a potentially high return initiative.

Since acquiring Metro Rod and Metro Plumb in 2017, management has been busy developing and improving the systems. Its new works management system ‘Vision’ is now live and paves the way for more advanced customer facing functionality.

That sounds like an important step, delivered on time and on budget, which now allows management to step up investment by £1.5m over the next three years and accelerate the digital transformation of its business.

I’ve a positive impression of these results and the accompanying management commentary. Valuation is a concern, but Franchise has set out some ambitious growth targets. On that last point, the group continues ‘to search for additional franchise businesses of scale that could create a third division of the Group.’

Franchise is emerging with a stronger balance sheet and some good trading momentum. The sticking point here is valuation.

I’ve a positive impression of management execution and trading momentum. If you know the management team and believe in its ability to execute, then this could be a good opportunity. It looks fairly priced to me but it’s possible I’m downplaying the growth potential.

Airea (LON:AIEA)

Share price: 29.9p (+6.79%)

Shares in issue: 41,354,353

Market cap: £12.4m

Airea (LON:AIEA) is a design-led specialist flooring company. It’s tiny, with a market cap of £12m and an enterprise value of around £10m so liquidity is a factor here. But this part of the market can provide good opportunities for the more patient and risk tolerant investor.

The StockRanks tell a story: Airea is a neglected Value play with non-existent momentum and no broker coverage.

Its origins stretch back to 1880, but the Airea of today arguably begins with its first move into floor coverings through the acquisition of Burmatex in 1984. In 2007 the original spinning business left the group, and the new name of Airea was adopted.

Burmatex® enjoys a strong and growing brand position in the commercial flooring market, where it offers a wide range of eco friendly flooring solutions to the contract, commercial and leisure sectors. Products adhere to strict industry standards making them a durable solution within schools, offices, hospitals and the like.

The company also has a direct sales force in Poland, and a network of agents and distributors covering all major international markets.

It’s a simple strategy: develop products that sell, exploit the strength of its combined manufacturing and distribution platforms, and deliver robust cash flows to support ongoing investment.

And those cash flows do look resilient, with free cash flow per share regularly exceeding earnings per share:

It looks like a solid enterprise with limited downside at the current valuation, and with scope for earnings growth over the medium term. It’s a very neglected stock, though, so it could test holders’ patience.

Final Results

Airea has remained open for business throughout the year, although trading has been impacted.

Highlights:

• Revenue -24% to £14.6m due to Covid pandemic affecting demand, with exports particularly affected,
• Operating profit before valuation gain fell 68% to £0.7m,
• Increased year-end cash balance from £3.0m to £6.6m (£3.9m excluding CBILS loan of £2.75m),
• Underlying gross profit margins (revenue less cost of sales) increased year on year,
• Three new product launches during the year,
• Investment property value up from £3.6m to £3.7m,
• Operating cash flows before movements in working capital and other payables were £1.5m (2019: £2.7m); capital expenditure of £0.2m.

Trading in the first quarter was strong before the Covid-19 pandemic changed the game for everyone.

At this point, management prioritised cash and working capital preservation, but the group continued to develop new products as well.

Product launches were pushed back to the fourth quarter and into early 2021. The benefits of these launches have yet to be felt but feedback from customers ‘has been extremely positive and bodes well for their success in 2021 and beyond.’

Measures taken to navigate lockdowns include:

• A six-year CBILS loan of £2.75m with no fees, interest or repayments for the initial 12-month period,
• Capital repayment holiday for 6 months on existing long-term loan,
• Extended overdraft from £0.5m to £1.0m,
• Q1 2020 VAT payment deferred until 2021, and
• Furloughed employees throughout the year.

Airea has £5.5m of net PPE on the balance sheet and the value of its investment property increased from £3.6m to £3.7m. Useful numbers given the size of the enterprise.

But it also has a pension scheme deficit, which has increased slightly to £1.8m from £1.5m. This warrants further investigation. Thankfully, Airea puts its principal risks front and centre - an appealing characteristic when compared to some other listed companies.

Regarding the scheme, Airea notes the actuarial deficit and that further increases may require the group to increase the amount of cash contributions payable to the scheme.

Following the triennial funding valuation of the group's pension scheme as at 1st July 2017, a revised deficit recovery plan was agreed. Under the plan, the company makes annual contributions of £0.4m to allow a gradual reduction in investment risk.

The next triennial funding valuation will be drawn up to 1st July 2020 and completed within the permitted 15-month period. So we should be hearing news on that later in the year.

The post Brexit transition export trading conditions are also a short-term risk to the group.

Conclusion

Compared to some of the other valuations seen today, Airea does stand out as offering attractive value and a possible margin of safety given the cash generation.

For really big returns, you need both sustainable earnings growth and a low valuation, so you can get the combination of earnings growth and multiple expansion.

Barring the TTM PE ratio, Airea appears to have the ‘low valuation’ angle ticked.

This could be an attractive recovery play, particularly when you compare its languishing share price to the likes of Headlam. Note this divergence stretches back to before Covid though, so there could be company-specific factors to take into account:

Additionally, management warns that, while continued investment provides ‘significant opportunities for profitable growth’, the Covid-19 pandemic and nationwide lockdowns continue to suppress market activity on a global basis. This is expected to continue.

So there’s no obvious pick up in trade yet, but the company remains cash generative and profitable. On a longer term view, assuming the pension deficit situation does not dramatically worsen, I’d expect the shares to recover.

There’s also potential earnings growth in the form of ongoing product development, so worth keeping tabs on but I imagine patience is required and the opportunity cost of holding those shares should be taken into account.