Small Cap Value Report (Tue 13 June 2023) - CMCX, TAM, IOM, DRV, VNET

Good morning from Paul and Roland! (Graham's on holiday this week)

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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.

What does our colour-coding mean? Will it guarantee instant, easy riches? Sadly not! Share prices move up or down for many reasons, and can often detach from the company fundamentals. So we're not making any predictions about what share prices will do.

Green - means in our opinion, a company is well-financed (so low risk of dilution/insolvency), is trading well, and has a reasonably good outlook, with the shares reasonably priced.

Amber - means we don't have a strong view either way, and can see some positives, and some negatives. Often companies like this are good, but expensive.

Red - means we see significant, or serious problems, so anyone looking at the share needs to be aware of the high risk.

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Summaries of main sections

CMC Markets (LON:CMCX)

Down 5% at 160p (£449m) - FY23 results, in line - Roland - GREEN

A solid set of numbers from this financial trading group, reflecting the impact of reduced market volatility and increased investment in IT and headcount. I think the fundamentals of this business remain strong and suspect the shares offer good value at present. (more detail below)

Tatton Asset Management (LON:TAM)

Up 1% at 460p (£276m) - FY23 results, in line - Roland - GREEN

A strong set of numbers for this asset manager and IFA support services business. Continued AUM growth in last year’s more difficult market suggests the group has a well-targeted offering and good distribution. My view remains positive.

iomart (LON:IOM) 

Up 1% to 166p (£187m) - Final Results - Paul - AMBER

In line results for FY 3/2023 are out today, so I have a good rummage below. This looks a fairly decent company, with nice recurring revenues, and good cash generation - funding decent divis and acquisitions. I've moved from green to amber, because the valuation has shot up in the last 2 months, from when we flagged it as a bargain here at 121p in April.

Driver (LON:DRV)

Up 1% to 32.7p (£18m) - Interim Results - Paul - AMBER

There's lots to like here - very good balance sheet with £5m net cash, divis of c.5%, improved H1 results, continued turnaround potential, an I'd say Driver could be a takeover bid target. So I would have gone green, but the weak outlook comments have put me off for now, suggesting a profit warning and reduced forecasts are in the pipeline probably.

Quick Comments only

Vianet (LON:VNET)

Up 1% to 85p (£25m) - Final Results - Paul - RED

Care is needed with these numbers, as I’ve mentioned before, the company is a heavy capitaliser of development costs (£1.7m this year, £2.0m last year), which means that EBITDA and operating profit numbers are meaningless, and don’t reflect reality.

I suggest reading the cashflow statement, rather than the P&L, because it makes starkly clear that Vianet has not generated any cash this year, or last year. It was all spent on development spending, which is just payroll, so I regard that as an ongoing operating cost.

Balance sheet is adequate, with c.£3m NTAV. A smallish debt position seems OK.

Cenkos (many thanks) slashes EPS forecast today from 5.3p to just 1.86p for FY 3/2024.

Paul’s opinion - the recent rise looks unjustified, and the current year forecast PER is now 46x, which looks way too high. It’s not a very good business in my view, and the share price looks well overvalued. Sorry if that upsets anyone, but it's what the numbers are telling me.

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Paul’s Section:

Driver (LON:DRV)

Up 1% to 32.7p (£18m) - Interim Results - Paul - AMBER

This is a global construction consultancy, that (from looking at its website) seems to be focused on dispute resolution/prevention.

The company had some problems, with an onerous contract I seem to recall, and was a possible turnaround share. I’ve not looked at it for about a year, so let’s see what the latest results are like.

H1 revenue down 1% at £24.2m, so close to a £50m annualised run rate - which seems quite good for a company only valued at £18m.

Profit is low though, at only £508k (or £710k if you ignore the share options charge), but this is a useful improvement of 378% on H1 2022.

Big reduction in headcount after restructuring in the M.East and Asia.

Outlook - sounds like a profit warning to me -

While the second half of the year for Driver has been shown historically to be strong. April was slower than expected owing to the timing of the Easter weekend and a succession of public holidays, which affected utilisation. The Board is currently considering its policy on forward guidance, which will reflect the short-term revenue visibility.

Balance sheet - is excellent, with NTAV of £12.7m, including £5.3m of cash (no bank debt). This is a very comfortable position, and nicely protects downside risk - even if it generates more losses in future, I don’t see any risk of dilution, or insolvency, providing nothing gigantic goes wrong.

Segmental performance - note 5 is interesting, showing that the Europe & Americas business is quite good, generating 79% of total group revenues, and a nice profit of £2.9m. Whereas M.East and Asia are very small, and making small losses. Which makes me wonder why don’t they sell, or close the small divisions, and focus on the main profit generator? Although this argument falls over when you consider the large £2.2m of central, unallocated costs, which gobbles up most of the divisional profit.

As mentioned before, I don’t understand why this company is stock market listed. It could probably eliminate maybe £500k pa in costs if it went private, which would materially improve profitability.

Paul’s opinion - potentially interesting as a turnaround, although the wobbly outlook statement today suggests to me that another profit warning is gestating. For that reason I’ll watch from the sidelines for now.

I really like the excellent balance sheet, which supports most of the market cap, giving lovely downside risk protection for investors, and leaves management free of funding issues, hence able to focus on turning the business around.

At this stage it’s difficult to see much immediate upside though, other than the potential for a takeover bid, which looks high to me. Consultancy companies often seem to attract bids, often quite highly priced.

Overall then, I quite like risk:reward here. I would have gone green, had it not been for the weak outlook comments today, so it has to be AMBER for now.

I almost forgot, the divis are quite generous, with a yield of about 5%, nice to be paid whilst you wait for a takeover bid or a turnaround.

The long-term chart is sobering -

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iomart (LON:IOM)

Up 1% to 166p (£187m) - Final Results - Paul - AMBER

My notes from reviewing its trading update on 14 April 2023 are useful as a quick way to get up to speed. I liked the value on offer at 121p, with a PER of only 11.2, a good yield of 4.6%, and a decent outlook. Also lower energy costs should help profits considerably, as the £7m cost headwind of FY 3/2023 should be reversing now, at least partially. Downsides were the lack of tangible asset backing (only £4m), and worries over the dominance of Amazon in cloud computing.

The share price has risen strongly in the last 2 months, so is it still good value?

iomart (AIM: IOM), the cloud computing company, is pleased to report its final results for the year ended 31 March 2023 (FY2023).

Strong increase in revenue and positive M&A activity

Some key numbers -

Revenue up 12% to £115.6m (a very impressive 92% is recurring)

Half the revenue growth came from an acquisition (Concepta)

Another (small) acquisition was done recently, post year-end.

Adj profit before tax (PBT) down 13% to £14.8m - a healthy margin of 12.8%

Adj diluted EPS down 9% to 10.9p - giving a PER of 15.2x - not such a bargain as last time I reviewed it.

I’m ignoring EBITDA as a nonsense number, because it ignores capex (£8.9m), depreciation (£16.5m), amortisation (£6.4m), finance costs (£2.9m), lease costs (£4.9m), development spending £(£1.9m), so you can see what a ridiculous number it is!

The company says these results are in line with market expectations, with this footnote providing some clarity -

Market expectations based on known sell-side analyst estimates for the full year ended 31 March 2023, established in or around 11 October 2022

Cost headwinds are mentioned, particularly energy, staff costs, and finance charges.

Sales pipeline improvement noted in H1 converting into stronger order booking levels in H2

Energy costs - I wonder if hedging might now be a negative, given that wholesale energy costs have fallen so much?

The data centre sector has had to navigate the significant challenges in the energy markets and during the year the Group's electricity costs increased by approximately £7 million. iomart's robust business model and customer arrangements have ensured this additional energy cost has been appropriately passed through to the customer base. While electricity costs remain high, the energy markets appear less volatile as we enter the new financial year. We have a proactive hedging strategy in place for the next two years and expect this matter to be less of a distraction for our team and customers going forward.

Net debt of £39.8m looks alarmingly high, but they’ve included lease liabilities in the headline number, which is a presentational own-goal. I had to search through the results to discover that of this, £19.2m is lease liabilities, so net bank debt is a much more acceptable £20.6m.

Outlook - is in line, but only for the first 2 months (April & May 2023). I would have preferred a more clear comment about FY 3/2024 expectations -

Balance sheet - is dominated by £113m intangibles, mostly from acquisitions, but also quite hefty £65m fixed assets (PPE) - although £20.6m of this is leases, which I would much prefer to be shown separately on the face of the balance sheet. Note there is a handy £6.9m freehold property asset, which I like. Data centre equipment and computers are £37m.

NAV is £120.6m, with NTAV being only £7.6m - so there’s little asset backing.

Overall though, for the type of business, I think the balance sheet stacks up OK (note there aren't any inventories, as it's a services business, which helps), but I wouldn’t want to see it increasing bank debt in the current macro uncertainty.

Broker note - thanks to Finncap for making its update note available to us. It confirms results are as expected. For FY 3/2024, it’s estimating adj PBT rising from £14.8m to £16.0m, but flat EPS at 10.9p. The culprit is higher corporation tax, and a slight increase in shares issued, which together absorb all the increased profits. The 6% hike in corporation tax is an important negative factor which is detrimental for company valuations, and it's curtailing earnings growth - negative, but it could also mean future earnings growth might be better, once this one-off factor has washed through the figures.

Paul’s opinion - this looks a fairly decent company, nothing special, so I can’t see why anyone would particularly focus on investing here, when we have so many other options? The PER is now 15.2x, which seems up with events now. I liked this share when it was cheaper in April, when I went GREEN on it. However, now the price has risen from 121p then, to 166p now, I think it’s going to have to be AMBER now, as the price looks up with events for the time being.

The key area to research in more detail, would be the services it offers, customer relationships, competitive landscape, and ultimately whether profits are likely to grow, or contract. Same as with any company really! At least it's genuinely cash generative, and has nice recurring revenues, so it can pay decent divis, and self-fund modest acquisitions. I also like that the founder has plenty of skin in the game, holding 15.7%, which is a very good vote of confidence in the company, and the new management. since he retired a couple of years ago it seems.

Long-term, this has been quite a rollercoaster ride! Note the high StockRank -

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Roland’s Section:

CMC Markets (LON:CMCX)

Share price: 160p (-5% at 08.30)

Market cap: £475m

Final results

Net operating income a new record high outside of the pandemic period, in line with guidance

This financial trading group is run by founder-CEO Lord Peter Cruddas, who has a 59% shareholding. CMC has looked like a possible value play to me for a while, after a series of downgrades.

I have an interest in this sector as I’m a shareholder of CMC’s larger rival, IG group (LON:IGG)

Today’s results are in line with guidance, but flag up a big increase in costs and an uncertain near-term outlook.

Let’s take a look.

Financial highlights: CMC’s claim to have achieved “new record” net operating income “outside of the pandemic period” seems slightly disingenuous to me. I think it only serves to highlight the operating leverage that’s inherent in the business model.

When leveraged trading activity rises thanks to volatile markets, profits tend to soar. But the reverse is also true, and that’s what we’ve seen over the last year.

I’ve pasted in the financial summary from today’s results as I think it highlights some interesting trends:

Net operating income rose by 2% to £288.4m. For context, this figure peaked at £409.8m in the (pandemic) year ended March 2021.

Net operating income represents revenue less commissions and levies. But CMC does not hedge all of its clients’ leveraged trading positions and takes some risk exposure itself.

These “risk management gains or losses” are reflected in trading net revenue, which rose by just 1% to £233.1m last year. This figure peaked at £349m in FY21.

Revenue from CMC’s non-leveraged stockbroking business was down, but this was offset by a sharp rise in interest income to £13m. CMC earns interest on its own funds (FY23: £310m) and on segregated client cash, which totalled £549m at the end of March.

However, a 26% increase in operating expenses to £217m (excluding bonuses) meant that pre-tax profit for the year fell by 43%. This sharp rise in spending represents additional headcount and investment in IT as the group develops new services and infrastructure.

Operationally, we can see that active client numbers fell by 9%, but revenue per active client rose by 11% to £3,968. To me, this suggests CMC’s lower-value pandemic clients are thinning out, but its higher-quality long-term clients are remaining active.

Profitability: last year’s slump in profits has had a big impact on CMC’s reported profit metrics. I calculate an operating margin of 17.5% and a return on capital employed of 14.2% from today’s accounts. Both are well below the recent average from this business, according to Stockopedia metrics:

Balance sheet/cash: CMC’s balance sheet looks in good shape to me. The company ended the year with £326.8m of capital, giving a coverage ratio of 369% of its Own Funds Requirement (OFR) of £88.6m.

Dividend: a final dividend of 3.9p per share gives a full-year payout of 7.4p (FY22: 12.38p per share). Although this is a cut, the FY23 payout appears to be ahead of consensus estimates of 6.5p per share.

Outlook: I think this is probably why the shares are down 5% in early trading.

CMC warns that “quiet market conditions” so far in the company’s Q1 have resulted in “client trading activity being down 15-20%”. This is expected to “negatively impact Q1 2024 net operating income”.

The company doesn’t mention full-year guidance at all. My guess is that it’s too soon to be sure if full-year forecasts will need to be cut. Market conditions can change quickly.

For what it’s worth, the company maintains its guidance for “underlying 30% net operating income growth from 2022 to 2025”.

My view:

I’m slightly biased towards this sector as I’ve found it a good way to hedge market volatility. When most of my stocks are crashing, I can usually be sure that IG (and CMC) will be enjoying bumper trading conditions.

During the pandemic, operating profit tripled from previous highs and the shares topped 500p – they’re 160p today.

The picture is more subdued at the moment, but I still think the fundamentals of this business are attractive.

I’m also encouraged by the speed and ambition of CMC’s expansion into stockbroking and institutional offerings. CMC now earns more from non-leveraged trading than larger IG.

The company is now in the process of launching a new retail investing platform in Singapore and an expanded institutional offering in Dubai.

Heavy IT investment should also pay off in the future, according to the company. CMC says its new API (effectively a standardised interface to connect into CMC’s core systems) will allow for easy bolt-on additions of new products and markets.

I know from past experience in IT that a good API can be a powerful tool, but I don’t have any insight into how good CMC’s technology is versus that of its peers.

I’m tempted to give an amber view here in recognition of the uncertain near-term outlook. But on balance, I don’t see this as a big concern – profit volatility is an inherent part of the business model.

My view remains that CMC is in sound financial health and offers good value at current levels, so I’m going to award a green view.

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Tatton Asset Management (LON:TAM)

Share price: 460p (+1%)

Market cap: £276m

Final results

“It is fitting that in this 10th anniversary year, we have raised the bar further, delivering our best performance to date with record net inflows of £1.8bn, AUM/AUI of £13.9bn and involvement in lending through Paradigm of £14.5bn.”

I’ve admired the progress of this asset manager and IFA services provider since its flotation on AIM. I have previously owned the shares, but I don’t currently have any position.

Given the pressure on most asset managers over the last year, we might have expected a slowdown for Tatton. But today’s results seem to suggest that its business model is still performing well, with growth across all key metrics.

Financial highlights: Tatton provides a range of support services for IFAs and also runs its own asset management arm, providing a logical and complementary set of services.

Last year showed continued top line growth and stable margins:

• Revenue up by 10% to £32.3m

• Adjusted operating profit up by 12.9% to £16.4m

• Adj. operating margin: 50.7% (FY22: 49.5%)

• Adjusted eps up by 10.7% to 20.6p

• Full-year dividend of 14.5p (+16% vs FY22: 123.5p)

• Net cash of £26.5m (FY22: £21.7m)

This strong performance reflects a positive operational performance:

• Assets under management up 12.3% to £12.7bn

• AUM at June 2023 c.£13.2bn

• Organic net inflows of £1.8bn, an increase of 15.8% on opening AUM

• Acquisition of 50% of 8AM Global Limited added “assets under influence” of £1.136bn

• Number of IFA firms served rose by 16.5% to 869, with the number of client accounts up 19.2% to 107,010

• Paradigm Mortgages business generated a 10.3% in completions to £14.5bn

Outlook: there’s no specific financial guidance for the year ahead, but CEO Paul Hogarth says he remains “optimistic about the group’s prospects”.

Broker Singer has a new note today (available on Research Tree) which leaves FY24 earnings forecasts unchanged.

Consensus forecasts on Stockopedia suggest earnings could rise by 4% to 20.9p per share, putting the stock on a P/E of 22.

Roland’s view: although Tatton looks pricey compared to many asset managers, I think its high margins and continued growth may justify a stronger rating.

As with CMC, this business benefits from founder management – the CEO remains its largest shareholder:

Stockopedia classifies Tatton as a high flyer and I would agree with this view. If performance disappoints, the shares could re-rate sharply. But if the company can continue expanding, then the shares could still be fairly priced at current levels.

On balance, I remain impressed by the company’s good progress and execution. I think Tatton is well positioned in the market and could continue to do well. My view remains green.