Small Cap Value Report (Tue 17 Nov 2020) - EZJ, SAGA, BOO, IGP, G4M, TUNE, EYE, SCPA, CRW

Good morning, it's Paul here with the SCVR for Tuesday.

Timings - update at 14:07, I've been working since 7am, so am having a break for now. Will come back later to finish off.
Update at 16:10 - I'm back at my desk, so finish time now likely to be 6-7pm, as there's lots to cover still. Update at 18:24 - that's me done, today's report is now finished.

Many thanks for all the thumbs ups for yesterday's report. People seem to like it when I do a personal portfolio review, maybe I should do those more often? Remember I only covered my top 10 holdings yesterday, to focus on the main conviction longs I hold. There are about another 18 holdings, making up the remaining 23% of my portfolio not included in the top 10 positions. Maybe we'll have a look at those on a quiet day.

Easyjet (LON:EZJ) - interesting comment from its CEO a moment ago on CNBC. He said that lockdowns are increasing pent-up demand. It seems to me that 2021 could be a bonanza year for travel companies, once they're allowed to start operating freely again. The elderly could be widely vaccinated by the spring or summer, and many of them love cruising. This is a key reason why I'm so keen on Saga (LON:SAGA) shares ( hold), as mentioned yesterday, as it has clear multibagger potential, once its 2 brand new cruise ships can begin generating cash again. The current market cap doesn't make any sense to me.

Boohoo (LON:BOO) - I hold - Last night Sky news reported that BooHoo has made the first of two heavyweight NED appointments, to improve its ESG (environmental, social, and governance) credentials. This was confirmed on the RNS today. Hopefully this might be the start of a comeback for the shares, since it's clear that BOO is serious about making changes being demanded by journalists, and I imagine some institutional shareholders in private.

Judith MacKenzie was recently interviewed in a MelloMonday session, and she emphasised just how important ESG is to fund managers now. That must be why the share price fell so far, on re-hashed news about its supply chain, and the auditor resigning because of reputational worries (nothing to do with the accounts, as it had repeatedly signed off clean audit reports).

ESG - This ESG issue could present us with more opportunities. It might lead to fund managers bunching into the same stocks (and them becoming over-valued as a result), but avoiding some good companies on ESG concerns. The most entrepreneurial companies, which perform best, often have dominant founder/CEOs who flout governance guidance/rules. If those shares are going to become cheaper, as fund managers avoid them, then that sounds rather interesting to me. I suppose the key issue is for us to assess whether ESG breaches are serious, or just part of a company still being entrepreneurial?

Improving trends - it's interesting how almost all of the companies I am reporting on here, are now reporting business steadily improving this year, and looking like it's gradually returning to normal. Not in every sector, but in most. For this reason, I think the strong market recovery in recent weeks is justified, despite worsening pandemic numbers on the news every night. Most businesses seem to have found work-arounds, and the second lockdown is not as severe as the first. Also, bear in mind that the stock market has very little of its total market cap in those most vulnerable sectors, so I think the pain is mostly being felt by private companies, and small businesses, not so much for listed companies.

Agenda - there are lots of interesting announcements today from companies I like, so it should be a busy day;

Intercede (LON:IGP) - contract win (I hold)

Gear4music Holdings (LON:G4M) - Interim results

Focusrite (LON:TUNE) - Final results

Scapa (LON:SCPA) - Interim results

Eagle Eye Solutions (LON:EYE) - AGM statement

Craneware (LON:CRW) - AGM statement

That's all I can do in one day. Sorry I ran out of time, so didn't get round to looking at DOTD or SYS1.

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Intercede (LON:IGP)

Share price: 92p (up c.3% at 08:22)
No. shares: 50.5m
Market cap: £46.5m

(I hold)

Contract win - follow on purchase order

Intercede is a cybersecurity company specialising in digital identities, credential management and secure mobility. Headquartered in the UK, with offices in the US, we believe in a connected world in which people and technology are free to exchange information securely, and complex insecure passwords become a thing of the past.

This contract relates to the project from Guidepoint, which includes Intercede software as part of a package. I delved into this impressive contract win with the Department of State, in the USA, here on 30 July. Things must be going well, because a follow-on order of considerable size has been received;

Further to the contract win that was announced on 30 July 2020 and the receipt of an initial progress order that was announced on 20 August 2020, Intercede, the leading specialist in digital identity, credential management and secure mobility, is pleased to announce the receipt of a follow-on purchase order totaling $2.8m. The order includes software licenses and associated development, professional services and support & maintenance; the majority of which will be recognised in the current financial year ending 31 March 2021...

That sounds great, but before we get too excited, it was already included in the current year forecasts.

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Gear4music Holdings (LON:G4M)

Share price: 715p (up 5%, at 08:59)
No. shares: 20.95m
Market cap: £149.8m

Interim results

Gear4music (Holdings) plc, ("Gear4music" or "the Group") (LSE: G4M), the largest UK based online retailer of musical instruments and music equipment, today announces its unaudited financial results for the six months ended 30 September 2020 ("the Period").

There are two musical equipment companies, both reporting sparkling numbers & outlooks today, G4M, and TUNE. As Patrick Leahy comments below, the big question is how much of this year’s superb performance has been driven by covid/lockdowns, and how much is sustainable? We don’t know yet.

Here are my notes from the half year trading update provided on 22 Oct, where full year expectations were raised again.

Remember that G4M’s strategy this year has been to seek margin improvement ahead of revenue growth. The good news is that it’s delivering both, which combined have given a very strong increase of 61% in gross profit, and a move from breakeven last H1, to strong profits this H1, also helped by efficiency gains on overheads.

Current trading - excellent;

Very strong trading patterns have continued into November

Bear in mind that we have renewed lockdown for physical retailers in England, plus Black Friday coming up, Fri 27 Nov, according to Google. I reckon this should mean that eCommerce companies should see a bonanza, giving another boost imminently to G4M, and all the other eCommerce leaders, like Asos, BooHoo (I hold), and many others.

Retailers which have not integrated their online warehouses and physical stores, could end up with serious over-stocking problems in their stores once lockdown ends. There should be plenty of bargains in the January sales for consumers. Plus maybe a lot of insolvencies in January to come?

These numbers for H1 look really good, especially as it’s normally the seasonally softer half. Although bear in mind that Q1 (lockdown) was stronger still, at +68% revenue growth. So Q2 looks to have slowed somewhat from that very rapid growth previously;

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Outlook - the key part says;

I am pleased to report that trading into November continues to be very strong, and we are well positioned for what we expect to be a busy peak trading period ahead of us. We therefore expect that results for the financial year will now be ahead of the recently upgraded consensus market expectations. The Board remains focussed on prioritising profitable growth and continues to look forward with confidence over the medium term."

As last time, it’s a pity they don’t provide a footnote to save us time, giving the figures for consensus forecasts. Plenty of companies are doing that now, and it’s a simple thing to help investors.

Labour costs - a point that stands out, is that labour costs have reduced from 9.4% of sales, to 7.8% of sales. So the business is becoming more efficient as it grows.

The same is true of marketing spend, down from 8.0% to 5.3% of sales. This was always the bull case for this share - that as it reached scale, profitability would come through, from reducing costs as a % of sales, and improved gross margins. That’s exactly what is happening, so it’s good to see a plan come to fruition.

Balance sheet - no issues here, it looks OK to me. NAV: £26.6m, less £9.6m intangibles, gives £17.0m NTAV That’s fine, since being an online retailer, G4M is paid in cash by its customers (i.e. little to no receivables). Hence as it grows, that doesn’t put a strain on working capital.

Net debt of £5.7m looks fine.

Cashflow - again looks OK to me. Note that it capitalises c.£2.8m p.a. in development spend, so EBITDA is meaningless.

My opinion - I remain very positive on this company. As readers have commented, forecasts for this year look too low. It has achieved 23.6p EPS in H1, and H2 is usually stronger. Although seasonality this year could be different, due to the lockdown boost in Q1, maybe?

Is it possible that the company might achieve 40-50p EPS this financial year? Who knows, but I think that’s within the realm of the possible.

The ridiculous bid/offer spread of 700/730p are not the real prices. I just checked with my broker, and there are 5k shares available on the bid and offer, at 711.5p/722.5p. So a real world spread of 11p, not the 30p quoted on price feeds. Why on earth do the market makers do this? It’s madness, because people see a 30p spread, and it puts them off buying or selling. So why don’t they just publish the real prices, with the actual 11p spread, which would help everyone including them, by generating more market activity!? What a ridiculous system.

Anyway, my view remains positive on G4M. Even though covid/lockdown has undoubtedly boosted this year’s numbers, I think the shift to online purchasing is probably permanent. Physical stores can’t compete, with more likely to disappear each year. They also can’t hold such a huge range (over 50k lines), nor have the scale to do own brand stuff cheaply, as G4M does.

I think the strong share price for G4M looks justified by its superb performance this year.

EDIT: the house broker has upgraded FY 03/2021 to 33.7p, a PER of 21.2, but the narrative in the note suggests the outturn could be higher still. Next year's forecast of 20.0p is clearly irrelevant now, so I'm ignoring that. Could be good upside here still, I reckon. End of edit.

It’s now recovered rapidly, to not far off the previous highs;

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Focusrite (LON:TUNE)

Share price: 936p (up 2.4% at 10:22)
No. shares: 58.1m
Market cap: £543.8m

Final Results

Another music equipment company, benefiting from the trends mentioned above. Although note that TUNE has also seen some reduced demand from covid/lockdown, e.g. from one of its smaller subsidiaries that does speakers for large events, or meetings.

Focusrite plc (AIM: TUNE), the global music and audio products company, announces Final Results for the year ended 31 August 2020.

As you can see below, the adjusted numbers show very strong revenue and profit growth. The organic revenue growth appears to be about 21.5% (highly impressive!), which I’ve calculated from a table shown in the commentary. The rest of the growth has come from acquisitions.

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The adjustments of £15.1m are so large (statutory profit is actually down from £13.0m to £7.0m), then we need to take a close look at note 5 which says;

Note 5 gives the detail on adjustments to profits;

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This looks fairly reasonable. The two highlighted items at the bottom total £13.2m, which is all related to goodwill/similar type charges, which is fine by me, I ignore those completely anyway.

As with all acquisitive groups, we have to take it on trust that only genuine one-off costs end up in the adjustments section. There is a risk at all such acquisitive groups, that these could become soft codes, for other costs to be booked to.

Assuming everything is alright on the accounting front (I have no reason to suspect otherwise, just to be clear), then these numbers looks really strong.

Profit before tax margin is very good, at 17% - indicating strong pricing power.

Adj diluted EPS rose over 53% to 32.8p - a fantastic result. This gives a PER of 28.5 - which looks fine to me, considering such strong earnings growth was achieved, and assuming growth continues.

Balance sheet - only has about £9m of NTAV, but that’s fine considering it has hardly any fixed assets (only £4.1m, if we ignore intangibles). The business is highly profitable & cash generative, which it is spending on acquisitions. So far, so good!

Cashflow statement - looks very impressive, but it has been helped somewhat by favourable working capital movements, which might unwind next year, as they often do.

Note it has capitalised £5.6m in “purchases of intangible assets” which sounds like development spend. Nothing wrong in that, but you need to adjust for it when looking at EBITDA, which would be inflated. The development spend also helps reduce the tax charge, due to R&D enhanced relief as noted in the commentary, which is helpful.

Outlook - the usual warnings are made about covid & brexit uncertainty, which is standard stuff we see in all company results at the moment.

I particularly like the comments about new product pipeline, and more acquisitions coming (although they need to be careful not to over-pay)

Since the year end, demand for most of our Group products has remained high and revenue is substantially ahead of the level achieved in the similar, pre-COVID-19, period of the prior year, helped by the acquisition of Martin Audio...

...We look forward to another year of product innovation with many new products and solutions coming to market across all three of our business groups.

My opinion - this looks a terrific group, and I’m highly impressed with the numbers published today. The outlook also sounds encouraging.

The highish valuation looks perfectly justified to me. Well done to the company, and shareholders!

I could see this share going higher longer term, once it’s taken a breather for people to bank some profits maybe?

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Eagle Eye Solutions (LON:EYE)

Share price: 402p (down <1%, at 13:22)
No. shares: 25.75m
Market cap: £103.5m

AGM Statement

Eagle Eye, a leading SaaS technology company that creates digital connections enabling personalised, real-time marketing through coupons, loyalty, apps, subscriptions and gift services, is pleased to provide the following update ahead of the Company's Annual General Meeting ("AGM"), to be held at 12:00 p.m. today.

It starts off by summarising previously announced contract wins with Woolworths in Australia, and the coffee subscription offering from Pret;

… positive start to the financial year ...underpinning the Group's continued growth.

The company’s year end is 30 June 2021, hence Q1 is July, Aug, Sept 2020. This is all self-explanatory;

While COVID-19 has continued to impact revenue growth, the Group nonetheless delivered revenue growth for Q1 FY21 of 11% on the prior year. The ongoing strategic management of the cost base and investment in line with revenue has resulted in a substantial increase in adjusted EBITDA profit for Q1 FY21, comfortably in line with management expectations.

The Group continues to benefit from high levels of recurring revenue and extremely low levels of customer churn.

Cash management continues to be strong, with the full headroom within the Group's £5 million banking facility with Barclays available at the end of Q1 FY21, ahead of management expectations and sufficient to support the Group's existing growth plans.

Q1 revenues growth of 11% looks slower than the 18% revenue growth in the consensus forecast figure shown on the StockReport.

Aus/NZ progress is to be used as a springboard for wider expansion in Asia, so “investment” will increase, i.e. more overheads.

USA sales pipeline is good;

The Board is encouraged by the increasing number of sales opportunities entering our pipeline, both through our direct marketing activities and via our partners in the US.

It mentioned being in phase 3 of an 8-stage implementation for one customer. This reinforces that these are complex, and time-consuming contracts to implement, as discussed in a previous SCVR. That concerns me a bit, because it seems to cap the amount of growth the company can achieve each year, and the danger is that decent profits might be pushed out each year, as more revenue sucks in more discretionary spending, maybe?

A cautionary note on lockdown;

However, with new lockdown restrictions recently introduced the Board anticipates this segment of the customer base and revenue will continue to be impacted for some time. Likewise, whilst the Group has a growing number of opportunities domestically and internationally, the Board anticipates that new customer discussions may continue to be protracted in the current environment.

Outlook - this seems to be saying that the Q1 growth shortfall should be recouped later this year;

… This provides an expanding opportunity and is expected to drive accelerated growth in the remainder of the year, in line with management expectations. The Group will continue to invest in its people, product development, sales and marketing, and in new geographies in line with customer demand, whilst carefully managing the business and cost-base, to capitalise on this momentum.

My opinion - there’s a lot I like about Eagle Eye. Clearly an excellent product, which has been sold to major retailers around the world, with low customer churn & high recurring revenues. That sounds great.

But, it doesn’t make any money! Nor is it forecast to in the current, or next year. This does make me question the valuation, which has now gone over £100m, after a spectacular year for the shares.

Do profits matter, when you could see this as a land grab for market share, and to become a dominant global business in digital vouchers, etc.? We’ve seen with many (particularly American) tech companies, they’ve expanded relentlessly, and not even tried to make profits in the short term, and have subsequently become very valuable businesses once they have achieved market dominance. That is a perfectly reasonable argument for EYE to just target breakeven at worst, but prioritise growth instead.

I can see the merit in both bull and bear arguments, so will say that I’m neutral.

This type of business could possibly have considerable value to an acquirer perhaps, as a backdoor way into many large organisations, for their client relationships, cross-selling of other services, etc. Or for another IT business to bolt on EYE, and accelerate its sales growth as part of a larger organisation. So a takeover bid wouldn't surprise me.

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Scapa (LON:SCPA)

Share price: 162p (up 7%, at 16:26)
No. shares: 187.8m
Market cap: £304.2m

Interim Results

Scapa Group plc (AIM: SCPA), the diversified Healthcare and Industrial company focused on bringing best-in-class innovation, design and manufacturing solutions to its customers, today announces its unaudited financial results for the six-month period ended 30 September 2020.

The opening summary says;

First half results ahead of COVID-19 plan

Revenue and profitability expected to continue to improve in the second half

That’s great, but on my first skim of the numbers before 8am this morning, I did wonder if the results/outlook are good enough to justify the big recent rise in share price? Or whether subconsciously, I’m annoyed with myself for panic selling when it dipped below 100p a few months ago, despite being bullish on the fundamentals?! I’m sure most investors know that feeling. It’s really important to root out and destroy all such emotions, as it could cloud my judgement and lead to a second error, of missing a good buying opportunity now, possibly.

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Results that include the first, more severe covid lockdown, are of limited value. All I want to see is that the company didn’t generate horrendous losses. That seems to be OK here;

Trading profit1 of £5.5m (2019: £14.2m) impacted by reduced volumes but offset by targeted cost savings and government subsidies

My next checklist item is that liquidity is OK, which it is here;

Adjusted net debt2 reduced to £21.8m (31 March 2020: £54.4m) due to reduction of working capital and net proceeds from the equity placement in May 2020 of £31.6m

Bear in mind that receivables & inventories are likely to go up again as business recovers, so future net debt might rise, but it doesn’t look a problem at this sort of level, given the size of the business.

Finally, my third checklist item is that trading is improving, and heading back towards pre-covid levels;

· Return to pre-COVID-19 demand levels in Industrial and encouraging progress in Healthcare are driving momentum

· Whilst uncertainty remains given the recent global resurgence of COVID-19 infections, revenue in both divisions in H2 is expected to exceed H1, with earnings benefitting from additional volumes and cost improvement programmes already implemented

· As a result of this momentum, we continue to track ahead of our COVID plan

There is a fly in the ointment with Scapa that it lost a lucrative contract with ConvaTec, which is subject to a highly material legal claim by Scapa against ConvaTec. I’m reluctant to buy this share when such a big legal action is underway. If it goes in Scapa’s favour, it would be fantastic, but there’s no guarantee it will.

Valuation - where might future earnings be heading? Without the ConvaTec contract, who knows? Maybe 10-15p future EPS? Although remember the share count has gone up from c.155m shares to 188m, due to the placing, a rise of 21% - quite significant. Therefore I should reduce my estimated future EPS range by a similar figure, taking it down to c.8-12p.

What PER to use? It’s quite a good business, with a sound balance sheet, so I think 15 is reasonable. That gives me a target share price of 120-180p. With the price currently 162p, then it doesn’t look there’s much potential upside here, using my valuation method.

Broker forecast for next year (the lighter coloured line below) is in the same ballpark as my estimate, which reinforces my figures;

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Therefore the main upside for this share, is if you think it can not only recover to pre-covid levels of profits, but beat them. How feasible is that? Not sure.

Balance sheet & cashflow statement - I’ve quickly reviewed both, and they look OK to me.

My opinion - I liked this share more on a valuation basis, when it was sub-120p. Now it’s risen to c.160p, a rise that I feel was justified, it’s probably sitting at around what I consider to be a fair valuation. Hence not enough upside to get me interested in buying back in.

Upside could come from future earnings beating expectations, and/or the market deciding that a higher PER is justified. Or a takeover bid maybe? Or a favourable outcome in the big legal case.

I just see better alternatives elsewhere - e.g. Volex (LON:VLX) (I hold) which looks cheaper on a PER basis, and is growing profits rapidly, paying divis, and making great acquisitions. So why choose Scapa instead of that?

The StockRank is similar to my view - a reasonably good company, but all a bit grey. I want bright green!

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Craneware (LON:CRW)

Share price: 2150p (up 12% at market close)
No. shares: 26.83m
Market cap: £576.8m

AGM Statement

Craneware (AIM: CRW.L), the market leader in Value Cycle software solutions for the US healthcare market, is pleased to provide an update on trading ahead of its Annual General Meeting taking place at 10am today.

Trading update for FY 06/2021 to date -

The first four months of this fiscal year saw a return to strong sales growth, considerably ahead of the equivalent period of the prior year. Results are ahead of management expectations for this stage in the year and, we expect revenues and adjusted EBITDA for the Interim period to 31 December 2020 to be ahead of the equivalent period in the prior year, building the foundation for a return to double-digit growth in the future….

We continue to see substantial new opportunities entering the sales pipeline and the Board is confident in the continued strong performance of the business.

Checking my notes here from Sept 2020, I was concerned that the business looked expensive on a PER basis, and might have gone ex-growth. Today’s update addresses the growth concern, with good growth returning apparently. That’s pleasing, because growth has been lacklustre for the past 3 years.

My opinion - it’s a pity, as I was starting to get slightly interested in this company when it had fallen to about 1600p, but the recent surge to 2150p takes it well out of my range, in terms of valuation.

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That's me done for today! See you tomorrow.

Best wishes, Paul.