Small Cap Value Report - Tuesday 11 October 2022 - BKS, IGP, IOM, QUIZ, RCH, SUR

Good morning from Paul & Graham!

Today's report is now finished, as we've covered 6 companies, and don't want to overwhelm you. However, we've not forgotten about several other items, which we'll cover tomorrow.

Agenda 

Paul's Section:

Beeks Financial Cloud (LON:BKS) (I hold) - written up last night, I review the contract wins announcement (helpful but not massive), and more importantly, the FY 6/2022 results. This share is all about very rapid organic growth (revenues up 57%), mostly recurring. It's modestly profitable, but share option costs consume most of the underlying profits. Balance sheet is strong, after a £15m fundraise in April 2022. Outlook comments confirm confidence in achieving FY 6/2023 market expectations, although additional growth beyond that might take time to nail the contracts. Overall, I like it a lot for the potential, and think that the current valuation seems about right.

Intercede (LON:IGP) - also from yesterday, there's an interesting acquisition - a tiny business called Authlogics, which is said to have specialist IP which will enable IGP to increase its addressable market by tenfold, filling a gap in the product suite. Sounds very interesting! Also there's a positive-sounding trading update, with H1 in line with mgt exps, but well over half the full year forecast revenues are now in the bag, so looks like a beat against forecasts could be in the pipeline for FY 3/2023. Cash has continued rising, hitting £10m. All looks most encouraging. [I don't hold this share any more, by the way, but am keeping it on my watch list as something I'd like to return to].

Quiz (LON:QUIZ) - a smashing trading update from yesterday. This share looks incredibly cheap, largely backed by net cash, and trading encouragingly well, with its multi-channel glamorous but cheap product offering, which achieves high gross margins. Online is growing nicely, in fact all channels are, but growth has slowed in recent months, as I would expect. Broker forecasts have been raised several times. The shares look stunningly cheap to me, pity I wasn't able to hang on to mine. They tend to drift back down gradually, after spikes up in price, so probably no immediate rush to buy back in. 

Graham's Section:

iomart (LON:IOM) (£161m) - a profit warning here as the current financial year is likely to come in “at the lower end of the Board’s original expectations”. A cloud computing and IT managed services provider, this business has seen some good revenue growth over the years, and expects revenue growth in H2. The difficulty is with margins and profitability: they don’t seem to keep up with revenue growth. I believe this reflects the nature of the business: high labour intensity and limited pricing power. However, I’m no longer bearish on the stock as it has been drifting lower for five years and, I believe, reached a point where profitability and cash generation can start to support it.

Reach (LON:RCH) (£240m) - this share has been an unpleasant rollercoaster for investors and the news today isn’t great: revenue trends in Q3 are only “broadly as anticipated”. The underlying revenue trend is a slow decline: excluding September, Q3’s trend was minus 0.5%. The company appears highly profitable but the market seems to think that by 2027, there won’t be much left of value. 2027 is the year when the very large payments to the company’s pension scheme are currently scheduled to cease. The UK 10-year yield is currently almost 4.5%, versus just 1.1% a year ago, i.e. the pension scheme should be able to generate much higher returns now than it did previously. So I’m wondering if we might get some good news from this scheme in the years ahead, assuming that they survive the drawdown in asset values?

Sureserve (LON:SUR) (£128m) (-4%) [no section below] - this is a “Social Housing Energy Services Group”, formerly known as Lakehouse. Today it reports that FY September 2022 is in line with expectations, on the back of “solid operational performance”. The order book is up 16% year-on-year to £585m, and the company reports a net cash balance of £23m. Two of its subsidiaries are currently up for sale. This one gets a huge StockRank of 93, i.e. it’s a Super Stock, and it also passes two bullish screens. The operating margin is 5% - 6%, reflecting that it’s a contractor that provides building services. I am open to listening to any arguments as to why this particular contractor will have an advantage in this highly competitive, low-margin, accident-prone sector. [no section below]

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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.

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Paul’s Section:

Beeks Financial Cloud (LON:BKS) (I hold)

148p (down 5% at 09:33)

Market cap £96m

There were two announcements  yesterday, firstly -

Private Cloud Contract Wins

Beeks Financial Cloud Group plc (AIM: BKS), a cloud computing and connectivity provider for financial markets, is pleased to announce the signing of two multi-year Private Cloud contracts with global Asset Management firms. The contracts, worth c.$2 million in aggregate over three years, were secured via a partner for deployments across US, APAC and EMEA.

Quite small contracts on an annual basis, but nice to have -

The contracts help to further underpin the Group's FY23 expectations.

It’s a June year end, so the current year is FY 6/2023.

The CEO sounds upbeat about the outlook -

"We continue to see positive sales momentum across our range of cloud computing offerings and are delighted that our partnerships go from strength to strength, supporting our direct sales activities. A substantial pipeline continues to build across our Private Cloud, Proximity Cloud and Exchange Cloud offerings, and we are confident in our ability to further increase our market share of the growing cloud computing market."

Moving on to the more important announcement -

Final Results

Beeks Financial Cloud Group plc (AIM: BKS), a cloud computing and connectivity provider for financial markets, is pleased to announce its final results for the year ended 30 June 2022.

Revenues up 57% to £18.3m

Annualised recurring revenues hit £19.3m at year end (+40% on LY) - a useful metric, which effectively gives us the base line for next year (FY 6/2023) revenues, before any new contract wins. Hence the broker forecast (Progressive) for £24.5m revenues (+34% forecast growth) in FY 6/2023 doesn’t look demanding, given the remarkable growth rate last year of +57%, and £19.3m of it is already in the bag from recurring revenues.

Underlying EBITDA is up 52% to £6.3m, but to my mind, this is not a useful measure, given that capex has been heavy, so we can’t just ignore capex and depreciation (£3.2m).

Underlying PBT is up 28% to £2.06m, but statutory PBT is much lower, at £0.66m in the commentary, but only £66k further down in a reconciliation. So it looks like the £0.66m could be a typo, and should say £0.066m? The main difference is the £1.66m share based payments, which consumes 81% of the underlying profit. Hmmmm.

Balance sheet - has been transformed for the better with a £15m fundraise (at 165p per share) in April 2022. NAV is very sound now, at £30.8m, less intangibles of £6.7m = NTAV £24.1m, which is plenty for the size of company. Although it does need sound finances, as the business model involves up-front capex, to drive expansion in revenues.

Net cash is fine, at £7.9m.

I was a bit concerned that physical capex of £9.6m (source: cashflow statement) looked heavy, but note 10 shows this included a £3.0m freehold property purchase, and £2.0m addition to leasehold assets (right of use assets). Excluding these as one-offs and discretionary investments, then what I would see as regular capex (mainly computer equipment) was £5.2m - that’s OK I think.

Intangibles - £2.6m of internal development costs were capitalised, partly offset by £0.4m of grant funding received. This by-passes EBITDA remember, hence why I don’t regard EBITDA as a meaningful measure here (as with many IT companies that are capitalising some of their payroll costs into intangible assets). Personally I think it’s best to adjust the accounts to expense all development spending, because it’s never-ending, and is just part of the normal operating costs of any IT business. Without dev spend, the business would gradually wither away.

Note that inventories went from nothing LY, to £1.8m this time. This was due to forward purchasing of computer equipment, so that supply chain bottlenecks of IT equipment would not prevent new contracts going live. Seems very sensible, and I recall the company previously mentioning this as being a planned strategy.

Note that of the £5.6m receivables, only £1.0m is trade receivables, very low because customers tend to pay up-front, or monthly recurring revenues. Although there is a further £2.3m contract assets (see note 13) which is effectively receivables which have not yet been billed. It's all fine basically, I just like to check everything.

Remuneration for Directors could arguably be seen as too low, with the highest paid Director on £109k, which does of course flatter profits, compared with if they were paid full market salaries.

Although a reader has flagged the £1.66m share options charge this year seems out of kilter with profitability (i.e. seemingly too generous maybe?)

Corporation tax - is favourable, due to the super deductions on capex (a new Govt scheme to incentivise investment), which has resulted in a negative tax charge of £760k (also helped by deferred tax adjustments). This flatters EPS, so be aware of that when calculating the PER.

Outlook - the all-important part, especially for growth companies.

This section reads positively to me - in particular (my summary) -

Good reputation established & big name reference clients. That should drive future growth.

“...considerable opportunity” re cloud - sector tailwind.

Strong product offerings.

“...confident in achieving results for FY23 in line with market expectations…”

“... with the potential for considerable additional growth given the size of the pipeline for Exchange Cloud. These types of discussions however will naturally take time to flow through into contracts and revenues”.

I suspect that last bit about taking time for contracts, might have spooked a few people. But the way I read it, that part refers to “additional growth”, over and above the current market forecasts. Therefore it doesn’t sound like a concern, or a profit warning. The existing forecasts look achievable, and management confirm they are confident of achieving them, so panic over I think.

Continuing spend on product development, and sales & marketing. I see this as code for - don’t expect exponential profits, because the company is still in the rapid growth phase, which involves additional costs to make it happen - e.g. headcount has risen from 73 to 89 this year under review.

Broker forecasts - slightly tweaked, but nothing significant. See Research Tree, where Canaccord (many thanks) and Progressive (commissioned) have useful notes available.

Valuation - as mentioned before, this is tricky. I see BKS as having a unique growth opportunity, so personally I’m comfortable with a market cap around £100m currently. That feels about right to me.

Conceptually, I see it as similar to Eagle Eye Solutions (LON:EYE) - different activities, but a similar model of building recurring revenues, sticky clients, quite rapid organic growth, in a specialist niche, and EYE is valued at £150m currently. In comparison, BKS looks priced about right.

I don’t find PER useful for valuation with very high organic growth companies, because just a few years’ strong growth can utterly transform profitability. Although costs often also tend to rise rapidly too.

My opinion - Beeks strikes me as unique, and I could see this becoming a much larger business in time. It’s got a big market opportunity, and the growth rate has really accelerated in the last year, as you can see from the Stockopedia graphs -

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For now, I think Beeks shares look priced about right. It’s the longer term upside which does get me excited.

My interview with Beeks - I’m delighted the CEO has agreed to my request for an interview this Thursday, and thanks for your ideas for questions in the reader comments yesterday. My interviews tend to be typically 30 minutes, and overview in nature. So there isn’t really scope to get stuck into minor details. Hopefully though it should be useful in us learning more about the company.

Also note that Beeks is doing an IMC webinar at 13:00 this Thursday, 13 October. I’m doing my interview immediately afterwards, so I’ll watch the webinar first, and make sure I don’t duplicate the questions! Should be interesting.

By the way, it’s fine to post bearish views on Beeks (or any company), if you feel that way, if you explain your reasoning with facts & figures, and don't become abusive. I fully understand that BKS won’t appeal to value investors right now, as it’s a rapid growth company, work in progress essentially. So we’re more than happy to hear contrarian opinions, indeed we want to hear opposing views, then we all make better decisions I think, if we consider the downside too. So do post away! There’s no groupthink here - maybe we’ve fallen into that trap in the past, but we learn from our mistakes hopefully.

Looking at the chart below, since BKS listed 5 years ago, all the gains were really made in the first few months, and since then it's zig-zagged around, but largely flat overall. That's despite the business having made great strides in that time. The share count has risen from 49m back in 2016, to 65m now - remarkably little dilution for a growth company, which has almost all happened in the most recent £15m fundraise.  I think it shows the benefit of having the founder as a major shareholder, still with 38% of the company - the "owner's eye" as they say, reluctant to dilute without good reason.

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Intercede (LON:IGP)

54.5p (up 43% yesterday)

Market cap £32m

Acquisition

This is a very small business acquired, called Authlogics Ltd (founded in 2015), but the rationale sounds sensible - it has valuable IP, but lacks the funding to sell it.

I’ve looked at Authlogics last accounts filed at Companies House, for its FY 6/2021, and it’s really, really tiny! 4 people, and fixed assets of £1,385, which looks like a desk, a couple of laptops, and a stapler! I’m being silly there, but you get the gist. Its balance sheet looks stretched, with £(635)k negative NTAV, with funding propped up with related party loans, and what looks like a big up-front payment from a customer (reflected in a big jump in deferred income).

This is not to disparage Authlogics at all, but more to say it’s clear that the company looks too small, and doesn’t have the funding, to go it alone. Hence an acquisition, with an earn-out, by Intercede could make sense.

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Authlogics looks to have traded around breakeven for FY 6/2021. The smallest companies don’t need to file a P&L, but you can compare the change in net assets or liabilities year-on-year, which tells you (providing share capital hasn’t gone up) what the after-tax profit/loss is. In this case, it made a profit after tax of £7,554 in FY 6/2021. This is confirmed in the RNS from Intercede.

Intercede is paying £2.5m for it, so the IP must be good. Of that, £0.5m looks to be paying off Authlogics’ debt. Plus there’s another potential £3m of staged earn-out payments. I like earn-outs, as they are usually structured to be self-funding, and to keep the key people motivated in the acquired business.

As outsiders, I don’t think we can judge yet if this is a good deal or not, we have to just take it on trust. I see IGP management as safe hands, so they wouldn’t be doing the deal unless it made sense, and it’s easily funded from existing cash, so no apparent risk.

This is the most striking sentence in the acquisition announcement -

This enlarges our addressable market more than 10-fold, and these markets are predicated to grow significantly over the next three years.

Trading Update

Intercede is a cybersecurity company specialising in digital identities, derived credentials and access control, enabling digital trust in a mobile world.

Intercede revenues for the six months ended 30 September 2022 totalling £6.1m are approximately 23% higher than last year on a constant currency basis and 24% higher on a reported basis (2021: £4.9m on a reported basis). This is in line with management expectations.

The Group had cash reserves of £10.0m as at 30 September 2022 compared to £7.8m as at 31 March 2022 reflecting positive operating cash flow and continued tight cost control as budgeted for FY23.

Following payment of approximately £2.0m initial consideration, after net debt and working capital adjustments, relating to the acquisition of Authlogics Ltd announced today, the Group had cash reserves of £7.9m and has no debt.

My opinion - thanks to Finncap for an update note yesterday. This has £11.1m revenue pencilled in. So with £6.1m of that in the bag from H1, that only leaves £5.0m to be achieved in H2. Therefore it’s looking as if IGP is more likely than not to be heading for a full year beat at the revenue line. With a largely fixed cost base, profitability is highly operationally geared, so the £0.1m adj PBT forecast for FY 3/2023 could be beaten. Although bear in mind that staff costs are rising quite heavily at IT companies.

This all looks pleasing, and interesting. I’m not currently holding IGP, but I still like the company. A strong current trading update shows that progress is being made, and this small acquisition sounds intriguing.

The StockRank looks very mean, considering IGP is profitable again now, and has repaired its balance sheet, which is now strong.
It's interesting to see that 6-months of share price losses were erased yesterday. So there's obviously pent-up buying interest, with people wanting to see evidence of good trading, before rushing in at once.

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Quiz (LON:QUIZ)

10.4p

Market cap £13m

Trading Update

QUIZ, the omni-channel fashion brand, announces a Trading Update for the period from 1 April 2022 to 30 September 2022 ("the Period").

Positive trading across all channels

H1 revenues £49.4m, up 37% vs H1 LY, and “marginally ahead” of what mgt was expecting.

Growth rate “moderated” in Aug & Sept, which it blames on consumer confidence declining.

Gross margin has improved (but no figures provided) - demonstrating ability to pass on higher prices, which I think is impressive. It's been very high in the past.

All sales channels are up, and I think the online growth is particularly impressive, as plenty of other fashion retailers are struggling to achieve any online growth against tough 2021 comps (pandemic boosted) -

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UK stores - LFL revenues now “consistently higher” than pre-pandemic. That’s good, but they need to be higher, to absorb cost increases like wages & utilities.

Stores are trading well in the UK, benefiting from the restructuring in 2020, which lowered rents, and I think nearly all the stores are now on turnover rents (which are marvellous, they work a treat, because rents flex up & down with revenues, largely de-risking most sites).

Concessions (which are stores within a larger store, e.g. Dept Stores) - QUIZ has 62 sites in the UK, nothing said about trading, but says they are “flexible and low-cost route to market”.

Online - good growth, and average transaction value has risen, but returns rate has worsened (something that other online fashion companies are also moaning about).

International - is the Ireland stores/concessions, plus franchise revenues elsewhere. Confident in further growth opportunities.

Cash - good grief, it’s got £9.2m cash in the bank! (the market cap is only £13m). Plus an unused £3.5m bank facility (expires June 2023, but it’s not really needed now I’d say).

Outlook - this is reassuring I think -

The Group's full year results to 31 March 2023 which will, as always, be in part dependent on trading during the key Christmas period, are expected to be in line with market expectations.

The Board is pleased with the strong growth recorded across all channels during the Period which supports the Group's omni-channel business model. It remains confident that the brand will continue to increase its appeal and looks forward to achieving continued profitable revenue growth.

Valuation - it’s a pity that QUIZ didn’t provide a footnote to explain what market expectations are, which is best practice these days, so a bit of an obvious omission. This is not helped by the lack of broker research available to us (nothing on Research Tree).

However, the Stockopedia data provider has picked up on one broker forecast, and as you can see, it’s in a nicely rising trend, not something we’re seeing with many other (if any!) retailers -

My opinion - this is going really well. I think the share price seems woefully inadequate, and in more normal markets would probably be double (or more) the current valuation.

In tight consumer conditions, I think it’s generally best to avoid the middle market, and instead focus on value, or top end retailers. QUIZ offers “glamorous looks at value prices” - I think that’s ideal for current conditions.

Lack of physical competition is also a bonus, as QUIZ is one of the few High Street retailers still going, with so many competitors having disappeared. Its shops are all (or nearly all) on cheap turnover rents, so it has an enduring competitive advantage there, and can just walk away (from short leases) if the landlord wants to raise the rent on expiry.

There’s been no dilution since it listed in 2017, with the share count remaining static at 124m.

The founding family seem intent on rebuilding the business, and I’m told are highly committed workaholics! Surely if they intended to take it private on the cheap, they would have done it by now?

There doesn’t seem any stock market interest in the shares right now, but weighing up all the facts & figures, I think this share is as close as we can get right now, to a no-brainer. But you might have to be patient. What a pity I wasn’t able to hang on to my previously big holding here. Spilt milk and all that.

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Note the almost perfect StockRank too - so the house computers agree that QUIZ looks good.

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Graham’s Section:

iomart (LON:IOM)

Share price: 146.7p (-7%)

Market cap: £161m

This is a cloud computing and IT managed services group, rarely covered in the SCVR (the last time was in 2017).

Over the years, I’ve developed a sceptical attitude to IT managed services. My heuristic process is to classify it with recruitment companies and others that I consider to be “people businesses”.

This is a category that I’ve gradually stopped investing in, as I came to the conclusion that (in general, there are rare exceptions) they had trouble building and maintaining long-term competitive advantages.

Iomart’s share price trajectory over the past five years has been unpleasant, so I’m relieved that I was writing sceptically about it all those years ago:

There was a point when any business which had the word “cloud” attached to it could receive a premium rating.

But that bubble is now a shadow of its former self. The NASDAQ, for example, is currently down by 34% versus the peak it reached last November.

Let’s dig into Iomart’s H1 trading update:

• “Performed well… with strong cash conversion, improved customer renewal levels, and continued momentum across all strategic areas, including the completion of our first acquisition…”
• Customer renewals plus recurring revenue provide visibility over full year financial targets.
• Revenue ahead of prior period (£52.5m vs. £51.9m), adjusted EBITDA lower (£17.8m vs. £19.6m), adjusted PBT lower (£7.3m vs. £9.1m).
• Lower profitability “reflects both the revenue mix in the period and our continued investment in the skills and capabilities of our workforce”.

This reference to investing in the workforce - as a drag on profitability - is indicative that this is a labour intensive type of business.

Acquisition - there is a £10.5m acquisition that “allows Iomart to broaden our market and customer reach whilst enhancing our product expertise within the data management service layer.” Another £4m is payable in deferred consideration.

Outlook - Iomart can “flex pricing” in response to energy costs and the inflationary environment.

H2 should be better than H1 but:

“...in the face of potential economic headwinds, it is not expected that margins will fully recover and that profit for the full year is therefore likely to be at the lower end of the Board’s original expectations”.

My view

Despite the profit warning and my negative attitude towards this sector, I’m actually going to take a more positive view on this share than I did five years ago.

Why? Valuation:

It turns out that if you have a weak share price for five years, but you broadly maintain your profitability, you can end up offering decent value!

Profits have been just about maintained over the years, despite rising revenues:

Indeed, the company announces today that H2 revenues will again be higher than H1, but that margins won’t recover. It looks like we can’t expect much margin improvement here in the long run. But given the lower valuation, maybe there will be some value investors who spot an opportunity at current levels..

The Stockopedia computers have noticed something. IOM shares pass the free cash flow screen, as the company has been generating very decent cash returns.

Last year it did exceptionally well: £35m was generated from operations, while only £10m was spent due to lower capex and no M&A.

The company is carrying some net debt (£41m in March 2022). If it keeps up the good cash conversion, this shouldn’t be a problem.

So I’m no longer bearish on this stock. I wouldn’t go so far as to say I’m bullish, but I think there’s enough here to justify this market cap.

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Reach (LON:RCH)

Share price: 75.9p (-1.5%)

Market cap: £240m

This share saw some optimism post-Covid, but then drifted lower once again:

Let’s see what the newspaper group formerly known as Trinity Mirror has to say in its Q3 update.

“Improved year on year group revenue trajectory versus Q2 driven by both print and digital”

This is a reference to the second derivative of revenue. The first derivative (in the table above) is not overly flattering.

Q3 and September revenue performance distorted by impact of the passing of HM The Queen which benefited circulation but significantly reduced advertising due to the blackout during national mourning

We can use the July & August column in the table to see a “normal” trading performance, i.e. print revenue down 2.8%, digital revenue +5.9% and total revenue down 0.5%.

Inflation - there has been “more stability in the cost of newsprint during the period”. Measures have been taken to offset the inflationary pressure.

Outlook

Although the unusual period of trading during September impacted revenue and profit, underlying revenue trends during Q3 were broadly as anticipated heading into Q4, historically the strongest period for advertising. We expect circulation revenue to be supported by increased cover prices, while advertising revenue should benefit from seasonally stronger yields, particularly around Black Friday and Christmas and from the football World Cup which starts in November.

My view

Paul has already done the donkey work here, in July, of going through the pension scheme disclosures. According to Paul, the annual payments due to the pension scheme, from 2022 to 2027, are £52m p.a.

Here are some very rough-and-ready ideas that might help someone to come up with a valuation for Reach.

Take the c. £90m in net profit that the company appears to be making currently. Deduct £52m. Use the result (£38m) as current profitability for shareholders, and apply a multiple to this figure. Under this approach, we are pessimistically assuming that the payments to the pension scheme last forever.

For example, suppose we applied a 7.5x PE since we believe that Reach is a low-quality business with a poor long-term outlook, and we only want to pay a single-digit multiple.

That gives a valuation of £285m.

On the recent interim balance sheet, current assets matched current liabilities so we could assume they don’t require any adjustments to the valuation.

However, there are long-term provisions of £40m so let’s deduct them from the £285m valuation.

This gives £245m, i.e. about the same as the current market cap.

The good news is that the payments to the pension scheme will end, some day.

The other point is that changes to inflation and interest rates can have strange effects on pension schemes.

For one thing, my understanding is that most defined benefit pension schemes, even if they are indexed to inflation, have a cap, e.g. 5%. This means that when inflation is higher than 5%, the pensioners are poorer in real terms because their payments can only rise at the rate of 5%. But it limits the risk to the pension scheme, of having to match runaway inflation.

The other point is that with higher interest rates, pension schemes can earn vastly higher returns on new investments (e.g. when reinvesting portfolio income or deploying fresh money from company contributions). This is of course offset by lower asset values, but in the long run it is excellent news for pension schemes. The era of low interest rates is, after all, what probably made defined benefit pension schemes unsustainable in the first place.

Therefore, while I can’t say this with certainty, I think there’s a possibility that the pension scheme here could prove to be less expensive than feared.

This share has never appealed to me in the past but as a risky gamble, I’m starting to get interested.