Small Cap Value Report (Tues 10 Aug 2021) - SUS, ZTF, BKS

Morning all, Jack here with Tuesday's SCVR.

Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to cover 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 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) - don't blame us if you buy something that doesn't work out. 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.

Agenda -

Jack's section:

S&u (LON:SUS) - positive outlook from this family-owned finance company that seems ably run for the long term.

Zotefoams (LON:ZTF) - the company has spent a lot of money building up its operations and the products, apparently, are world-leading so now is the time for management to execute and prove to the market that a growth multiple is deserved. Some cost pressures are set against a positive near term outlook.

Beeks Financial Cloud (LON:BKS) - brief in line update from this provider of low latency solutions for financial markets. The group is in investment mode, with negative free cash flows, so the question is whether this investment is being spent wisely to build a larger and more profitable business down the line.

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Jack’s section

S&u (LON:SUS)

Share price: 2,820p (pre-open)

Shares in issue: 12,145,260

Market cap: £342.5m

(I hold)

S&U is a holding company for two subsidiaries: Advantage Finance and Aspen Bridging. The former is a non-prime used car finance established in 1999 and the latter focuses on loans for the short term residential and refurbishment markets. Aspen was only launched in 2017 and has yet to reach meaningful scale, but management is optimistic of its future contribution to the group.

Fittingly, the post that first brought this onto my radar is called ‘Credit Where Credit is Due’ (penned by Lewis Robinson, formerly Expecting Value, who you can find on Twitter here). The post is worth reading but notes a share price of £17.60 compared to today’s £28 or so.

Nevertheless, it is the long term merits of the investment case that stand out here and make this a useful ‘buy and hold’ candidate in my view, regardless of short term share price moves:

• Family ownership and management alignment with shareholders - run by the Coombs family since S&U Stores inception back in 1938 (see Major Shareholders)
• An underlying trend of steady revenue progression

• High margins and sensible returns on capital over time,

• A solid small cap dividend track record, with the current forecast yield at 3.7%,
• Habitual financial strength,
• Distinctive and characterful management commentary,
• And a low share count with no signs of dilution over the past five years.

Having been trading for the best part of a century, the group has emerged from lockdowns intact with no permanent damage to shareholder value. It seems like a company that protects its owners. And Advantage’s headquarters are in Grimsby, which shows a healthy independence from the London rush.

If you want to get a better sense of the management you can watch this recent investormeetcompany video, complete with reassuring references to Warren Buffett.

It’s also possible that, having navigated the lockdowns, S&U’s businesses might benefit from a reopening UK economy.

Trading update

S&U continues to trade well, ahead of expectations in terms of profitability, collections and book debt quality… The result is a good half year's performance and a sound basis for further progress.

This has been reflected in strong Advantage motor finance applications and for Aspen in the strength of the residential property market. Both are constrained by a lack of supply but the group believes this will gradually correct as the economic recovery gathers pace.

Advantage continues to increase to nearer normal levels of new business but continued cautious underwriting and a lack of supply mean transaction numbers come in slightly under an ambitious budget. This has been more than offset by collections, with related bad debt attrition and impairment more benign than anticipated.

As a result, net receivables are stable versus the previous year-end, risk adjusted yield is ahead of budget, and operational cost is well within budget.

The result will be a significant increase in Advantage's half year profit, comfortably beating budget.

A number of initiatives are in train to drive further improvements including refinements to the scope and range of the customer offering; simpler online payments for customers; new arrangements to boost dealership capability, and social media marketing work.

Management also flags its work on ‘what will be a significant opportunity in the financing of hybrid and electric used cars’.

Aspen, the property bridging business, has continued the encouraging trends reported in May. Net receivables are now at just under £58m against £18.5m a year ago, and book quality and repayments continue to be good.

The net receivables growth has been due to Aspen's successful offer of Government backed CBILS loans to larger and more established developer customers. The original CBILS scheme is being wound down but Aspen hopes that the contacts it has made will lead to further business beyond this.

Financial health is robust, with an increase in funding facilities in the first quarter to £180m and current borrowings of £116m.

Anthony Coombs, S&U chairman, comments:

As Britain gradually emerges from the effects of Covid, S&U is demonstrating by its debt quality, collections performance, customer service and product improvements, the inherent strength and potential future profitability of the Group. The challenge now is to grasp these opportunities for new growth. I am confident that we will do so.

Conclusion

There’s not too much detail in this trading update, but the direction is positive.

At 14.7x forecast earnings, the group’s shares are not as cheap as they have been recently, but neither are they obviously expensive. Management commentary, a PEG of 0.6, and a positive broker consensus suggests plenty of scope to justify or exceed the current rating in time.

This strikes me as a company managed for the long term, with deep expertise at the top level and a team that is focused on generating sustainable capital appreciation and income for shareholders. I believe that’s what Stockopedia’s high Quality Rank is picking up from the financial data.

This comes across more clearly when you look at the dividend track record, so I’m happy to hold here, hopefully for a long time.

Zotefoams (LON:ZTF)

Share price: 443.48p (-0.12%)

Shares in issue: 48,621,234

Market cap: £215.6m

Zotefoams is a popular small cap - a promising company with differentiated cellular materials products that have market-leading potential and a diverse range of use cases.

Key markets include footwear, where it has an exclusive agreement to supply Nike, product protection and transportation (aviation and aerospace), automotive, rail, and building and construction. These are the big ones, but ZTF’s products are also supplied to medical, industrial and other markets.

The group is headquartered in Croydon but has additional manufacturing sites in Kentucky, USA and Brzeg, Poland (foam manufacture), Oklahoma, USA (foam products manufacture and conversion), Massachusetts, USA (MuCell Extrusion) and Jiangsu Province, China (T-FIT). So it has built up a substantial operational base.

The hard work goes alongside rising revenue.

But this top line growth is being funded by high levels of capex. This should change soon with the completion of the Poland factory.

One point that has concerned me before is declining levels of returns on capital, although this metric can lag investment - so if everything goes very well with the capital expenditures, there could be a period of reducing costs, increasing profits, and improving ROCE.

The share price often commands a premium multiple, so you would invest based on the group’s growth prospects rather than a rerating.

Interim results

Highlights:

• Revenue +39% to £48.2m (+14% on FY19); +46% at constant currency,
• Operational leverage offset by gross margin pressures,
• Profit before tax +49% to £4m; constant currency PBT +93% to £5.2m,
• Basic earnings per share +46% to 6.52p,
• Cash generated from operations down 6% to £5.6m,
• Period-end net debt/EBITDA down from 2.1x to 1.9x,
• Interim dividend of 2.1p, up from 2.03p ‘reflecting strong growth and positive outlook’

The growth rates do seem encouraging here. These are set against a disrupted 2020, but we do see evidence of revenue growth on 2019 figures as well.

High-Performance Products (HPP) sales were up 66% to £19.6m, Polyolefin foams sales rose 24% to £27.3m, and MuCell Extrusion LLC (MEL) sales increased 50% to £1.3m.

Meanwhile, the Poland plant has been commissioned albeit with ‘expected low utilisation’.

Then we have the gross margin pressures: ‘significant’ supply chain pressures particularly in polyolefin raw materials and freight, and the reversal of FY20 short-term cost savings. A bout of inflation could be a good test for the pricing power of these world-leading products.

So far, in the first half, gross margins have fallen from 34.8% to 28.9%. This has more than offset operational gearing.

On this point, the group comments:

Gross margin, benefitting from strong sales and better mix, is expected to remain steady despite cost inflation, predominantly in polyolefin raw materials, the price of which increased sharply during the first six months and is now, we believe, at its peak. We anticipate these raw material price levels and operational disruption to freight to persist for the remainder of this year before seeing a return towards more normal conditions early in 2022.

The footwear business has performed extremely well and accounted for 34% of group sales (HY 2020: 19%). Demand in most other markets also showed strong growth against the prior period, although aviation fell year-on-year from 12% of group sales to 3%.

Polyolefin Foams - represents 57% of group revenue (down from 64%). Volumes increased here but the average selling price fell and segment profit declined from £2m to £1.3m for a margin of just 5%. The Poland plant had some impact on margins but most of the damage was done by price inflation. The group combatted this with its own price increases from 1 May, along with freight and specialty materials surcharges. As conditions normalise, Zotefoams hopes to maintain the higher price points but remove the surcharges.

High-Performance Products ("HPP") - 41% of revenue with continued strong momentum in footwear. The use cases are quite broad: footwear, the aviation market, and cleanrooms in pharma, biotech, and semiconductor manufacturing. Zotefoams continues to invest in sales here so hopefully more growth is to come.

Segment profit margin in HPP was a much healthier 20% for £3.9m (HY 2020: £2.8m). Supply chain and logistics costs, including unplanned Brexit freight costs of £0.4m, negatively impacted margins. So there could be room for further margin expansion as it moves past that, and particularly as the group builds up T-FIT insulation ‘which has attractive underlying margin potential’.

MuCell Extrusion LLC ("MEL") - just 3% of revenue. Zotefoams is investing in ReZorce, a barrier materials product that should make cartons and pouches more easily recyclable. The opportunity is in ‘an industry currently worth multiple billions of pounds’. For now the segment reports a loss after amortisation of £0.1m (down from a £0.7m loss).

Capital expenditure in the period was £3.4m (HY 2020: £7.4m) and the group confirms the end its recent capacity expansion programme, with a return to more normalised levels of investment in future.

Commenting on the results and the outlook, David Stirling, Group CEO, said:

In the second six months of 2021 we expect further positive momentum in sales, with a strong order book underpinned by improving economic conditions. Product mix is anticipated to be slightly more favourable, with good growth in HPP products and recent sales price rises in polyolefin foams. FX headwinds are expected to continue.

Conclusion

There’s a lot going on at Zotefoams and many millions of pounds have been invested to facilitate the manufacture and distribution of what the group says are world class products. It’s now approaching the point where it will have to definitively prove the market demand for those products and justify its high multiples.

The group points to strong demand in Polyolefin Foams in the first half, which should continue. HPP has a strong order book for footwear in particular, while MEL is expected to remain at similar levels. And then we have today’s results, which certainly show impressive year-on-year growth: revenue and profits up 46% and 93% on a constant currency basis respectively.

The shares are not especially cheap but there’s no doubting management’s ambition here.

And with capex set to normalise, perhaps the next five years for Zotefoam will look very different from a cash generation and net debt perspective, assuming cash expenses fall, sales rise, and margins increase. That’s a possibility though, not a guarantee.

The scale and duration of negative free cash flows has put me off in the past, but what’s important is how the cash is being spent, ie. is this maintenance or growth capex? It sounds as though there has been a lot of the latter going on, which will not persist.

So perhaps the share price has moderated while the group has gone about laying the foundations for future growth. If you take that as the starting hypothesis, then it’s probably worth spending more time investigating the products as the upside potential could be significant.

It looks like a promising business that has worked hard to get itself into a position to grow, but the shares are fairly pricey, so you do need to buy into that vision. For now, I’m not familiar enough with the situation or the management.

Investormeetcompany strikes again with a presentation later today, so that could be a good opportunity to gauge the potential here.

Beeks Financial Cloud (LON:BKS)

Share price: 123.4p (+0.33%)

Shares in issue: 56,051,149

Market cap: £69.2m

Beeks has been a fairly volatile ride since listing in 2018 with various periods of buying and selling.

It’s a cloud computing and connectivity provider offering low latency solutions for financial markets.

There are certain superficial parallels with Zotefoams insofar as this is a growth company with upwards trending revenue but consistently negative free cash flow.

Again, the key question here is whether that capex per share is growth or maintenance capex. This is not something companies have to split out and it can be difficult for shareholders - the owners of the company, lest we forget - to determine.

In this instance, given where Beeks is in its lifecycle, I’m assuming that a good deal of this capex spend is for ramping up operations and that a mature Beeks will be free cash flow positive.

Trading update

Beeks expects to announce results in line with market expectations, meaning year-on-year growth in both revenue and underlying EBITDA. There’s a growing pipeline of opportunities and the group continues to ‘successfully expand’ its relationships with existing Tier 1 customers.

It’s a pretty insubstantial ‘in-line’ update so no surprise that the share price has barely reacted.

Perhaps the main reason for the announcement to the market is the launch of Proximity Cloud, with multiple proof of concepts commencing. This is a high-performance, dedicated and client-owned trading environment, fully optimised for low latency trading conditions and built with security and compliance at the forefront.

Beeks raised cash back in April to fund the project. £5m gross through the issuance of 4,347,827 shares at 115p. Group founder and CEO Gordon McArthur also sold 434,783 shares, taking his holding in the enlarged group down to 48.2%. Paul covered it here.

Conclusion

It’s a brief update that’s unlikely to change views on Beeks one way or the other. And there’s no quoted figures re. what the market expectations are. The assumption should be that everybody is time poor so in the interests of clarity it would be a big help to attach concrete numbers as to what these expectations are.

Taking Progressive Equity’s figures, they’ve got FY21 forecasts of £12m of revenue, £3.83m of adjusted EBITDA, and 2.72p of adjusted earnings per share growing to 3.86p in FY22. That’s a PE ratio of 45.4x falling to 32x.

That’s too rich for my liking, but there is a growth story here so it’s an interesting company to keep tabs on. If the group is forgoing earnings now to build out a bigger company, then perhaps you can justify it.

Early stage expansion costs can mask profitability while paving the way for longer term value creation. Sometimes it’s better to just breakeven if the extra money is being spent in the right way and a materially larger company is being built. It seems as though a lot of upfront investment is required at Beeks - the group has spent a lot of money building out its datacentre infrastructure and it’s possible that more of this will be needed. Seven new datacentres were opened in FY20, all of which had reached operating cost breakeven by the end of December.

Back in April 2020 it also acquired loss-making Velocimetrics (revenue of £1.16m and LBITDA of £0.18m) for a total consideration capped at £4.55m. We’ll have to see if that acquisition proves astute.

The above might translate into an attractively profitable business further down the line but it makes these opportunities trickier to value. You need greater conviction in the opportunity and the management, as the historic profitability and cash generation just isn’t there to fall back on. Retaining the founder and major shareholder as group CEO does suggest that there could be a longer term vision though.

On balance it’s not one I’m sufficiently familiar with so I'm happy to leave it, but recently Paul described it as a ‘coffee can’ stock so the bulls are out there.