Small Cap Value Report (Tues 11 Aug 2020) - ZTF, HAT, CDM, AMO, SOLI

Morning, it's Jack here.

Humans are funny aren’t they? I was reading last night about how ex-McDonald’s CEO Steve Easterbrook is being sued over alleged workplace relationships. It got me thinking about corporate governance. Even the biggest and most polished companies can get caught up in human mischief.

For years I paid lip service to corporate governance but it took a while to cotton on to its true importance. One day I made an investment in a small cap with an inexperienced and small corporate team. Communication with shareholders was non-existent and RNS statements were unreliable. Pretty quickly I began to worry that my investment might be misplaced - in time those fears were justified. Lesson learned.

It’s one of those hard to screen for, qualitative aspects of investment, but it is a very real consideration. Not all companies are focused on shareholder value.

Some companies that do seem genuinely concerned with this point include Games Workshop and Judges Scientific. There are more but those are the two that immediately spring to mind.

Some of the things I’ve started to look out for in spotting that type of company include:

• Founder-owners or long term management with significant shareholdings,
• Cash-generative companies with strong balance sheets,
• Management commentary that is considered and distinctive (too many statements feel phoned in or boilerplate), and
• A lack of equity dilution over time.

These help but they’re not foolproof. Given that it’s hard to screen for, I’m curious to hear any other suggestions of companies with good shareholder alignment. And what do you look for to identify those companies? Anyway, nearly 7am.

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Zotefoams (LON:ZTF)

Share price: 357p (before market opens)

No. shares: 49m

Market cap: £173.58m

Zotefoams (LON:ZTF) is a foam and insulation specialist. It was highly rated in the past but shares have come off a little:

I’m not familiar with the story here. My guess is this is due to some missed growth targets and a lack of cash generation.

If you head over to the group’s cash flow statement you can see it has had to raise debt and equity in the past two years.

Note the dividend payments too. I’m not a fan of companies that insist on paying dividends while funding operations externally, but ZTF is in an interesting niche and calls itself a ‘world leader’, so let’s take a look at today’s update.

Interim Results

Highlights:

• Group revenue down 18% to £34.6m, driven by:
  • 7% decline in High-Performance Products
  • 23% decline in Polyolefin Foams
  • 2% increase in MuCell Extrusion sales
• £6.0m (30 June 2019: £5.2m) cash generated from operations but capital expenditure of £7.4m (mainly related to a new facility in Poland),
• Operating profit down 38%, net income down 45%, and basic earnings per share down 48%
• Liquidity headroom of £18.8m,
• Net debt up 55% to £36.2m but within covenants (net borrowings to EBITDA ratio of 2.6x vs. bank covenant 4.0x),
• Interim dividend of 2.03p declared (30 June 2019: 2.03p), ‘reflecting the resilience of the H1 performance as well as the Board's confidence in future prospects’.

A lot of today’s reaction depends on what has already been priced in by the market, but these results don’t scream growth to me. In fact the increase in net debt is a bit of a red flag.

The group says H1 was ‘challenging in a number of markets’ and expects a ‘subdued but stable H2’. That sounds like a slog for a company on an historic PE ratio of just under 24x.

The group did remain profitable over the period though, which is better than a lot of companies out there. ZTF’s CEO, David Stirling, does add:

We expect the second six months of 2020 to deliver record sales, beating the previous best half year sales of £43.1m. Our expectations are based on relatively subdued but stable demand in most polyolefin foams markets other than PPE, where demand is very strong, and a much stronger second half for footwear products and T-FIT® technical insulation, continuing the momentum experienced late in the first half.

So strong growth momentum in T-FIT could drive a record H2, which sounds a bit more like the type of swagger you would hope for in a small cap world leader. The group has some registered trademarks as well (AZOTE®, ZOTEK®, ReZorce® and T-FIT®), which might allow it to generate above average returns in future.

In fact it is already generating decent returns:

I do wonder about the disconnect between earnings and free cash flow though.

During Q1 ZTF experienced a continuation of the lower level of demand in its western European and North American markets ‘that we witnessed during the latter part of 2019.’ It seems as though momentum has been faltering here despite many millions of pounds in investment.

Conclusion

For now, the lack of free cash flow and mixed trading momentum pre-COVID are enough to put me off. It seems as though ZTF might have enough about it to reclaim momentum with its trademarks and technology, but at current levels it feels like a lot of this is priced in.

A quick look at the Analyst Consensus chart shows downgrades were feeding through long before economies began locking down:

Regarding high levels of capex, the group says

The recent large capital expenditure programme has created ample capacity to support future growth and any economic recovery. As a result, capital expenditure across the business is now returning to much lower levels, more in line with depreciation.

FY19 depreciation was £5.8m compared to capex of £24.4m - so if the group can get the latter closer to the former then perhaps ZTF is on the cusp of free cash flow generation. Such a development could help rerate shares and support its financial position, particularly if broad-based trading momentum returned.

In the meantime there are some balance sheet concerns with net debt increasing by more than 50%. Given the historic lack of cash generation I would be concerned about the risk of a rights issue or placing while the company attempts to either revive broad-based trading momentum or wait for T-FIT growth to come through.

Shares trade at more than 2x sales. ZTF’s time may come, but I think there are probably better and safer growth opportunities out there for that kind of valuation.

H&T (LON:HAT)

Share price: 319p (+1.27%)

No. shares: 40m

Market cap: £125.57m

The share prices of H & T (LON:HAT) and Ramsdens Holdings (LON:RFX) both got hit during lockdown but their strong balance sheets, cash generative business models, and modest valuations limited the downside.

These pawnbrokers aren’t for everyone, but for those that focus on the quantitative there is plenty to appreciate, including high margins and returns on capital. It’s no surprise that HAT qualifies as a Super Stock, with broad-based factor strength:

The group’s valuation metrics are strong across the board versus the rest of the market, too.

HAT qualifies for two screens - one Bargain and one Growth, suggesting a blend of Value and Momentum. A quick look at the Recent History box lower down the StockReport shows some promising compound annual growth rates.

This is a promising starting point but lockdowns cast a shadow so I’d like to see more management commentary on HAT’s short-term prospects. Recent trading might not have been pretty, but the group’s valuation and cash generation provides some comfort.

Interim Statement

Highlights:

• Operating profit down 32.9% to £5.5m
• Profit before tax down 26.5% to £5.0m
• Net pledge book, including accrued interest, increased by 4.6% to £56.3m, but the Personal Loan book reduced 43.8% to £10.0m
• Net debt reduced to nothing (30 June 2019: £11.6m)
• Net assets up £19.3m to £126.9m
• Reduced interim dividend of 2.5p (2019 interim: 4.7p)

Stores were closed on the 24th of March but have since all reopened. During that time clearly revenue and profitability took a substantial hit but the group’s net debt reduction is impressive and maintaining the dividend (albeit reduced) is a good sign.

Group CEO John Nichols says:

"Pre lock-down the Group was well on track to deliver revenue growth and increased profitability, underpinned by our diversified income streams, increased footprint and investment in digital initiatives… The Group has a strong balance sheet, no debt and a good cash position. This will enable us to build back our pawnbroking book, a resilient secured asset in times of economic uncertainty, and deliver our long-term growth plans which remain intact.

Conclusion

I can see the attractions here: modest valuation, strong balance sheet and market position, double-digit returns and profitability, and strong, consistent annualised growth rates. HAT could be a good long term hold with a useful yield attached.

There may be some regulatory concerns. I’ve not read up on this point for a while, but it’s something I’d want to check before investing. H&T pawnbrokers has very good reviews on Trustpilot, which is a good start.

Directors appear to be net sellers in recent years. I’m not reading too much into that, but it would be nice to see either directors or the company buying shares given the mix of modest valuation multiples and historic growth rates. Perhaps further growth in HAT’s markets (and therefore share price upside) is limited?

I would guess there is plenty of scope for expansion into alternative forms of lending, as well as market consolidation opportunities going forwards. Broker estimates are buoyant.

All in all the above makes for a favourable impression - there could be good value here.

Codemasters (LON:CDM)

Share price: 412.00p (+9.28%)

No. shares: 151m

Market cap: £570.58m

(I hold)

This UK video game developer is too big for the SCVR really but I can see some chat about today’s results so I’ll quickly touch on the update on trading so far in FY21.

Codemasters Group (LON:CDM) shares are breaking all-time highs and are now above 400p, which is exciting.

Trading since the start of the year has been particularly strong and the Board now anticipates that Revenue and Adjusted EBITDA for the full year will be significantly ahead of current market expectations.

CDM specialises in racing games. Some may view this as a lack of diversification across game styles, but I view it as a deep technical expertise in a core, evergreen gaming genre. The engines used to create racing games are unique and highly optimised. CDM is one of the best in the business.

The group adds:

These revised expectations are driven by the particularly strong performance to date both of the annual instalment of its Formula One title, F1® 2020, and the continued strength of the Company's growing back catalogue of games. Fast & Furious Crossroads, which was released on 7 August 2020, has to date performed as anticipated, and the Board is pleased to report that levels of pre-orders from both retailers and consumers for the title launches scheduled for the remainder of the year also remain consistent with original expectations.

Conclusion

One thing I would point to with these companies is the accounting for software, development costs etc. These measures can require subjectivity and cash generation can be left wanting.

It’s not ideal, but the video games market represents a vast opportunity for many years to come, with exciting (and better) business models being established as the industry matures. We have some fantastic companies in this space listed on AIM and other indexes (including KWS, FDEV, TM17, and SUMO).

The high relative valuations may prove to be deceptive if those companies can execute and grow quickly, which I think is possible. Coupled with that you have unique gaming IP and proprietary software engines. It’s a promising space albeit one that can get hyped up and that comes with valuation risk.

That said, FY21 looks bright for CDM.

Amino Technologies (LON:AMO)

Share price: 132.50p (-3.28%)

No. shares: 76m

Market cap: £100.76m

This is strange - clearly there is an ongoing story here - but Amino Technologies (LON:AMO) has released an additional statement today saying it will provide an investor presentation on Thursday so that ‘its strategy, business model and performance are clearly understood.’

So presumably group strategy needed clarification. You can sign up to the Thursday presentation here.

So what does the group do then, I wonder? AMO calls itself ‘a new breed of Media Tech business, focused on enabling operators to meet the challenge of the rapidly converging worlds of broadcast and next-generation streaming services.’

It has two operating companies: Amino, with TV-centric solutions, and 24i, focused on streaming. ‘The two companies can combine their products and services to create an industry-leading eco-system to provide full end-to-end, yet highly modular, solutions,’ apparently.

I’ll need a little more time to really dig into this company and understand just how it adds value and makes money. If anyone can help out in the comments that would be appreciated. On that note, I’ll probably sign up for the presentation linked above.

Anyway, it’s an intriguing backdrop for this High Flyer (soon to be a Falling Star?), whose shares have fallen markedly so far this month.

On valuation grounds alone, AMO looks attractive with a forecast PEG of just 0.5 - but can these growth projections be trusted? The group’s historic profit figures are mixed.

Through it all, cash generation has proven more robust than earnings which could be a positive sign of underlying strength. On the whole though I’m concerned about the mixed historic results.

Half-year Report

Highlights:

• Revenue +10% to $38m
• Adjusted operating profit -11% to $4.2m; statutory operating profit -68% to $0.7m
• Adjusted basic earnings per share -21% to 4.88c; statutory basic EPS -69% to 0.92c
• Net cash down from $19.3m to $2.1m
• Interim dividend withheld

These are alarming results and a wide gap between adjusted and statutory figures always sets lights flashing.

The group is pushing forward with a ‘transformation to [a] software-led strategy’ that has driven a doubling in recurring revenue to $10m and is leading to a ‘higher quality of earnings’. It sounds like AMO has to pivot its business. Perhaps its old model was outdated?

This seems like a dangerous time to make such a shift, with net cash declining precipitously. In terms of current trading and outlook, the group says that ‘it is possible that new business wins in H2 2020 may be impacted by any further negative Covid-19 impacts on the global economy and potential knock on impact for our customers and our supply chain’.

Is this a benign acknowledgement of uncertain conditions, or is this management paving the way for a full year profit miss? I’m not sure about this one.

Conclusion

On the whole I’m happy to let this company get on with its transformation. There could well be teething pains as it shifts towards a more software and recurring revenue-based model. In the meantime, AMO’s net cash position has reduced dramatically.

Could a fundraise ultimately be on the cards? The group has been reasonably cash generative in the past, but there are also appear to be instances of shareholder dilution.

Perhaps shareholders will be fine. There are some positives. AMO qualifies for the R&D Breakthroughs screen and the share price does not appear expensive on a forecast earnings basis. Increasing recurring revenues and higher-quality earnings are fine things to aim for.

I'm not yet comfortable with the business model though - I need to understand it better. This transformation may be a big opportunity, but for now the signals are decidedly mixed. I don’t see any reason to get involved until there are concrete signs of the strategy bearing fruit.

Solid State (LON:SOLI)

Share price: 610.00p (+0.33%)

No. shares: 8.6m

Market cap: £52.03m

Solid State (LON:SOLI) is a high value-add manufacturer of technology for use in harsh environments. It specialises in hard-wearing computing, battery power solutions, communications systems, electronic components, and displays.

The group says it is a recognised industry leader in providing these complex, performance-critical products. Alongside these products, it gives a high level of service and technical support. You can see more on its individual products here.

It sounds interesting. The group is modestly valued at 13.7x forecast earnings, it generates double-digit returns on capital, and its operating margin is consistently between 5% and 8.5%.

It also looks quite financially safe, with solid liquidity ratios, cash generation, and net cash on the balance sheet.

The group’s shares are more or less unchanged on today’s update but there could be potential with this small cap Super Stock so I’m keen to take a look.

Highlights:

• trading since the last update on 8 June 2020 has continued to be ahead of management's expectations.
• Group revenues were down 4% year on year.
• Order intake in Q1 was down just under 15% year on year, although this appears to be improving - by the end of July 2020, order intake for the four month period had improved to down 7% like-for-like.
• The open order book at 31 July 2020 was 4% below the year end at £38.3m.
• As at the reporting date, SOLI had cash level at £3.2m alongside an unutilised revolving credit facility of £7.5m.

COVID-19 update

• All of the Group's four manufacturing sites remain open and fully operational.
• SOLI's supply chain is intact albeit with some interruption. Lead times on new orders are lengthening and freight costs from the Far East remain elevated. Could be something to keep an eye on.
• Some customers are operating at reduced levels. The group notes a ‘significant slow down’ in the oil & gas and civil aerospace sectors but the medical, food retail, security and defence sectors have been resilient.

So there has been some disruption here, although shares have recovered strongly.

Is this because of strong growth prospects going forwards, I wonder? The group says its pipeline of new product designs continues to increase.

Meanwhile it is keeping an eye out for potential acquisitions - so it possibly fits into that camp of survivors who can take advantage of market disruption.

Conclusion

I’m taking the strong relative strength as a signal that it could be worth digging deeper into this company and its trading prospects.

I’d like to know why the operating margin has come down in recent years. If SOLI can pull off revenue growth while bringing margins back up to previous levels, that could lead to an encouraging increase in profitability.

It’s a speculative Super Stock that qualifies for the Tiny Titans screen, which is one I do like to keep an eye on due to its strong performance over the years. SOLI’s trade has been reasonably resilient through the lockdown, which suggests that its products are important to customers.

There could be further disruption ahead but the group is looking to take advantage of this by possibly making selective acquisitions later in the year.

All in all, there could be something here but I want to learn more about its existing products and this pipeline of new product designs it talks about. It ticks a lot of boxes at first glance.