Small Cap Value Report (Tue 25 Feb 2020) - RCDO, DOTD, CALL, HOTC, DLAR, SNX, IDP

Good morning, it's Paul here, with Tuesday's SCVR. See the header above for the announcements I'll be covering today - quite an interesting list, of companies that I mostly like, which is good.

Timings - I'm taking things at a leisurely pace today, so aiming to finish by 3pm.

I see that futures made an attempt to rally overnight, but they're not really getting anywhere near recovering the big sell-off yesterday (Dow down over 1,000 points at one stage). Finally coronavirus is having a significant impact. I'm mystified why it took so long, when this threat has been building steadily for several weeks now.

Travel companies and others with China supply chains got whacked yesterday in particular. Although I saw signs of some panic selling, in that other stocks seemed to get sold off too. The big problem with small caps, is the lack of liquidity. It only takes a handful of small trades to really whack some of the shares I follow.

I need to go through my own portfolio again, and work out if any of my shares are likely to be hit by China supply chain issues. I think it's worth asking companies how much they import from China. Non-food retailers like Dunelm (LON:DNLM) could be hit hard, as I reckon a lot of their stuff must come from China. They probably won't feel the impact for a few weeks, but it's probably coming. The share price already given up that big (and unjustified) spike up to over 1400p, with it now down to 1214p. It's a lovely business though, so if it does tank on supply chain issues, I'll be a buyer at some point.

China is such a large part of the global economy now, that it could impact many, even most, areas. For example, I asked management of Sosandar (LON:SOS) (in which I have a long position) if they have exposure to China, and the reassuring answer was no, only a small element of supplies are sourced from there. However, then I remembered that a lot of the world's fabrics are made in China. Therefore, there could be problems for garment manufacturers all over the world, if supplies of fabric are interrupted.

In a way, it shouldn't affect valuations much, because this virus is temporary, and business will recover. Yet it is affecting share prices of companies that indicate they have exposure to China. Even when that was obvious, and already known. It doesn't make sense to me, the market is supposed to discount risk in advance, not stumble blindly into it. Although in many cases, shares are only giving up the gains made in the autumn rally, when practically everything went up. So not many bargains around - yet.

Also, there could be rich pickings for short sellers maybe, where the market has not yet adequately discounted China-related problems at some companies. Being complacent really isn't working very well as a strategy, at the moment.

There's likely to be a powerful rally at some stage, when a vaccine is announced. Buying opportunities may therefore not be as protracted as we might think, and short positions are correspondingly risky. Markets have a habit of doing things we don't expect!

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Let's start with a faller than mentions Coronavirus in its update today. Obviously I'm prioritising this issue.

Ricardo (LON:RCDO)

Share price: 650p (down 14.5%, at 10:08)
No. shares: 53.4m
Market cap: £347.1m

Interim results

Interim Report for the six months ended 31 December 2019

There's no header explaining what the company does, which is a surprising omission. A little intro is useful, when we have so many companies to look at. Ah here we are, there's a description lower down;

Ricardo is a global engineering, technical, environmental and strategic consultancy business. We also manufacture and assemble low-volume, high-quality and high-performance products and develop advanced virtual engineering tools for conventional and electrified powertrains as well as for complex physical systems.

Our ambition is to be the world's pre-eminent organisation focused on the design, development and application of solutions to meet the challenges within the markets of Transport & Security, Energy, and Scarce Natural Resources & Waste. Our mission is to create a world fit for the future, and we will achieve this through the activities of our portfolio of businesses, each of them underpinned by our talented team of professionals.

That doesn't strike me as very focused. It's got 6 divisions, which seems crazy for a relatively small group. How can it make sense to have such a sprawl in activities? Still, they're all profitable, so maybe it's not such a big deal? It must stretch management rather thin though.

Profitability - underlying profit was £18.0m, up 8% - but driven entirely by acquisitions (organic profit is down 1%) - but well done to the company for making this disclosure so clear, rather than trying to gloss over it.

interim results look OK, and are in line with management expectations, so I don't need to go through the detailed figures. Note that the adjustments are large - underlying operating profit is £18.0m, whereas reported operating profit is 43% lower, at £10.3m

Outlook - It's the outlook which has obviously rattled investors. There are 2 issues, coronavirus, and the general slowdown in the automotive sector.

Coronavirus - this is surprising, in that it says Chinese offices remain closed. Whereas other companies have been telling us that factories have been re-starting.

The outbreak of Coronavirus resulted in the closure of our and the majority of our customers' Chinese sites since the Chinese New Year holiday and travel restrictions on our staff. Our Shanghai, Hangzhou and Hong Kong offices opened on 24 February, but our Beijing, Chongqing and Changchun offices remain closed.

This has resulted in a slowdown in both order intake and the progress of ongoing projects, due to the inefficiencies created through customer staff and our own staff having to work from home.

The financial impact is material (i.e. at least 10% profit impact)

Although it is not possible at this time to fully assess the potential impact on the current financial year, we do expect the impact to be material. Our operations in China accounted for 8% of the Group's revenue in the first half of the year.

8% of revenue doesn't sound much, so it's a little surprising that the impact on group profit is expected to be material. I suppose reduced revenue on a fixed cost base, would have an operationally geared impact on the bottom line.

Wider sector problems are explained here;

As we start the second half of the year, we have seen increased headwinds in the automotive sector which we anticipate will lead to suppressed order intake in our US, EMEA and China Automotive businesses.

The Coronavirus outbreak at the start of H2 has already had an operationally disruptive impact on our Automotive and Rail operations in China and we anticipate continuing disruption to client engagement, project delivery and business development in the coming months in mainland China and surrounding countries. Based on the issues highlighted above we are anticipating material impact to our forecast second half profits and thus full year.

It would have been helpful if the company had put out some guidance. They could have said, say 10-15% lower profit compared with existing forecast, instead of leaving it vague. Liberum comes to our aid, with an update today, which is very helpful, many thanks. The impact is larger than I expected, with full year forecast profit reduced by 25%. I would say that is significantly lower, rather than materially lower. Isn't it ridiculous, having to interpret words, instead of just getting the numbers directly from the company. How come some companies give direct guidance, and others don't? There's no consistency, it drives me mad! Still, being British, I wouldn't be happy unless there was something to moan about.

We now have a FY 06/2020 revised forecast of 44.9p adj EPS (down 16% on last year's actual result) - a PER of 14.5 based on 650p share price now. That's fairly cheap, given that it's based on a year which is disrupted. Although we don't know what the split is, between the wider general slowdown, and coronavirus.

At some point the market should look ahead to a recovery in earnings next year, and that could be a catalyst for a recovery in the share price. Although next year's forecast is also cut by 20% to 51.9p adj EPS - a PER of only 12.5 - looking cheap.

Balance sheet - looks a little thin, due to acquisitions piling up intangible assets at the top. Although NTAV looks OK, at £38.4m.

Receivables look too high - I would want to see this reduce, and turn into cash on a more timely basis. Maybe car makers exploit Ricardo for cashflow? Or it might be offering extended payment terms to win business?

Debt looks too high, with £104.7m borrowings in long-term creditors. Net debt is more sensible, at £73.8m - but still quite high, given that profit is falling.

My opinion - this looks a good collection of businesses.

I have no way of knowing whether this profit warning will be the last, or might be followed with another one. Automotive is really not a good sector to get involved with at the moment, although Ricardo also sells into other sectors.

Maybe one for the watchlist?

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Dotdigital (LON:DOTD)

Share price: 109.5p (up 2% at 11:01)
No. shares: 297.9m
Market cap: £326.2m

Interim results

dotdigital Group plc (AIM: DOTD), the leading 'SaaS' provider of an omnichannel marketing automation and customer engagement platform, announces its Half Year results for the six months ended 31 December 2019 ("H1 2020").

I've learned a new word today from DOTD, "martech" - presumably a combination of marketing, and technology. 2 syllables instead of 7, does save time I suppose, and keeps people on their toes in meetings, having to maintain a calm exterior, whilst trying to work out what it means.

This is great - prominent links are provided in the results statement, to a slide deck presentation, here.

Here's a short results video, courtesy of our friends at PIWorld:

Another neat feature, is that DOTB publishes broker consensus figures on its investor relations website - together with the other helpful links, this is clearly an investor-friendly company. I'm impressed!

It's good to see group photos of the staff wearing DOTD branded shirts (lots of young men with beards!) on slide 3 - that's a nice touch, after all, it's not all about management.

Stand-out points;

90% of revenue is recurring - which helps to justify the rich valuation. Although having said that, is a PER of 27 really that high, for a growth business with pots of cash on the balance sheet? Maybe not.

Revenue growth of +14.5% vs H1 LY, but only +3.1% vs H2 LY - not so good. As revenues are presumably monthly recurring, then I would have expected sequential half year revenue growth to be stronger than this

Very high, and increased, gross margin - so gross profit has gone up 15.8% to £20.6m

Big improvement in operating profit, up 40% to £6.56m. However, it's only up 3.5% sequentially on H2 LY - maybe there is some seasonality to the results, but that would be unusual for a recurring revenues business

Adjusted basic EPS is 2.0p, double that to 4.0p to annualise it, and we're almost exactly on broker consensus forecast for FY 06/2020 of 4.04p. With some more growth in H2, it could beat forecast.

Outlook - all sounds fine;

Expenditure on 'martech' has seen year-on-year growth of 22%, with a combined value of $65.9bn for the UK and North America alone in 2019⁴. With the trend expected to continue, we believe we have the right platform in place from which to scale and a clear strategy that is focused on generating results.

The Board is confident in a successful outcome for the year in line with market expectations and sustained future growth.¹

Consensus adjusted EBITDA for continuing operations as at 21 January 2020, for the year ending 30 June 2020, is approx. £17.0 million. EBITDA means earnings before interest, tax, depreciation, amortisation, and before restructuring, other non-recurring costs and certain non-cash items.

I don't know why they've quoted market expectations in EBITDA, when EPS is the usual benchmark. EBITDA doesn't work for software companies, because it ignores development spend.

Balance sheet - very strong indeed. There's no debt, and a cash pile of £22.6m. That gives scope to do more acquisitions. The strong profits and cashflow mean that conceivably the business could even spend all of that cash, and gear up a bit. So there's potential for acquisitions up to say £40m-ish, without needing to dilute shareholders at all.

Cashflow statement - note that development spending capitalised consumes a decent chunk of cashflows - almost half of the £6.1m net cashflow from operations was spent on development spend of £2.84m. So actually, it's not as cash generative as I originally thought.

Dividends - are modest at only 0.8% yield, which is strange considering it has a large & growing cash pile. Why not pay out more to shareholders? Although that can backfire, as investors may then de-rate the share to a lower PER, perceiving it to be a mature business?

My opinion - lovely figures, but I am concerned that the top line growth rate doesn't look good when you compare it to H2 of LY. Maybe UK & Europe growth has stalled?

I think I'd want faster growth, to induce me to pay a PER of 27 times. That said, this is a nice sector, and it's a good quality business.

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Cloudcall (LON:CALL)

(I have a long position in this share)

I mentioned recently, a couple of times, that American investors are buying & disclosing major shareholdings. An RNS today says that Goudy Park Capital LP (based in USA) has increased from 3.65% to 5.32% - not significant in itself, but it is an ongoing pattern of interest in the company from across the pond. They value tech growth companies much more aggressively than we do on AIM, which could mean we end up with a good outcome here. I hope so anyway, we've waited long enough!

It's interesting though, that CALL is seen by a lot of UK investors as damaged goods, given the repeated fundraisings & missed forecasts. Whereas new shareholders in America probably see it very much more positively - as a high growth, high gross margin, recurring revenues business that arguably should be valued much more highly.

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(work in progress)