Small Cap Value Report (Wed 20 Oct 2021) - SRC, SYS1, AOM

Good morning, it's Paul & Jack here with the SCVR for Wednesday.

Agenda -

Jack's section:

Sigmaroc (LON:SRC) - rising costs are being managed at the local level and SigmaRoc's assets have a degree of pricing power, so inflation is being reported but the group is well placed to pass on costs. Demand is strong, and the recent Nordkalk acquisition could continue to drive revenue and earnings growth.

System1 (LON:SYS1) - interesting situation here from the company formerly known as BrainJuicer. It's transitioning away from large advertising consulting contracts towards a more scalable digital product suite that should allow it to build up its proprietary data. Digital is now around 45% of revenue. There's a real lack of liquidity though, and the share price can be volatile.

Activeops (LON:AOM) - a newer SaaS software listing focusing on Management Process Automation. It helps large organisations manage complex back office functions. There are some classic SaaS characteristics here: recurring revenue, strong cash generation, high margins, a net cash position, and a large addressable market - but you would need to get comfortable with the valuation.

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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 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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Jack’s section

Sigmaroc (LON:SRC)

Share price: 103.9p (+2.36%)

Shares in issue: 637,915,750

Market cap: £662.8m

SigmaRoc is a fast-growing, acquisitive construction materials company that buys and integrates quarry sites around Europe. The market is innately fragmented with high barriers to entry due to the high price to mass ratio of its products. These materials cost a lot to transport, so the nearest quarry can typically sell at a price that operators further afield will struggle to match. Location and quality of product are key factors.

Shares have essentially doubled over the past couple of years, and now far exceed pre-Covid levels. With widely reported construction materials price inflation, this may be deserved - but SigmaRoc is presumably facing its own cost pressures (drivers, for example), so it’s a complex picture.

Despite the strong share price, the group trades on a reasonable 16.3x forecast earnings with a forecast PEG of 1.0x. That suggests fair value assuming the company can continue as it has done in the past.

Shares in issue are increasing at pace, from 117m in 2017 to nearly 638m today, so the company needs to make sure that acquisitions are sufficiently earnings enhancing at the per-share level. On that note, brokers expect normalised EPS to increase from 3.75p in FY20 to 5.5p and 6.4p in FY21 and FY22 respectively.

Q3 trading update

The strong trading performance seen during H1 has continued through the third quarter, during which the group generated revenues of £73m. That would be £292m on an annualised basis, which is comfortably ahead of the FY21 forecast of £245m (although FY22 pencils in a sharp increase to some £435m).

Demand in Q3 for precast products in the UK and aggregates, concrete and dimension stone in the Benelux market continued the positive trend seen in the first half of the year. In Jersey, planning permission has been granted to allow a large extension to the Ronez quarry, and in South Wales margins are continuing to improve as a result of the ongoing review of efficiencies.

There is sustained demand across SigmaRoc’s geographical and product markets, although the ‘challenging’ supply chain situation requires ‘effective management’.

The net result is a performance in line with management's expectations.

The Nordkalk acquisition was completed on 31 August 2021 and the business is trading as expected.

Outlook - increases in energy costs and the availability of haulage and transport are ongoing challenges, particularly in the UK. SigmaRoc is combating this with the strategic fixing of certain hydrocarbon costs, production and efficiency optimisation, selective price increases, the sourcing of additional haulage, and now investment in its own heavy goods vehicles and drivers.

That said, the group says its outlook remains positive, with current levels of demand expected to continue into the fourth quarter.

Max Vermorken, CEO commented:

The third quarter has delivered solid results, building on our momentum from the first half of the year. We have delivered a transformational acquisition with Nordkalk and this is already beginning to deliver significant earnings growth and cash generation. The Group is well positioned to continue its strong performance and to develop future opportunities.

Conclusion

There’s not much in the way of numbers here but many companies don’t even report a Q3 update.

Supply chain and inflationary pressures are being managed effectively, with the benefit of the group's diversified platform model enabling local market-specific plans to be implemented. The reported issues are affecting lots of companies and, although SRC’s shares are currently resting at around the 100p mark, the management team has proven its ambition and ability to successfully integrate a certain kind of asset.

The pressing issue is the spectre of inflation. SigmaRoc should be able to pass that on, at least to a degree. We are seeing inflation reported by operators closer to the customer, with builders charging more. Construction cost inflation is at its highest level for a generation, so it’s a big deal at the moment.

For now, these issues look like they’re being successfully managed at the local level for SRC. The group is assembling an increasingly diversified platform of construction materials businesses and its well-located asset base suggests a decent degree of pricing power.

The situation must be monitored, but all in all, SigmaRoc continues to come across as a competent and ambitious operator that can continue to consolidate in the sector.

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System1 (LON:SYS1)

Share price: 282.44p (+12.98%)

Shares in issue: 12,898,296

Market cap: £36.5m

(I hold)

There’s an interesting situation at System1, although the company is very small and shares are illiquid. It’s a micro cap, about £36m in size with an 800bps spread. Buying and selling at scale is difficult.

But the StockRanks are high here at 97 (with a Quality Rank of 98), and rising consistently from the Covid crash back in March 2020.

The group used to be BrainJuicer but has since rebranded and is now focused on transforming revenue away from large consulting contracts and towards a far more scalable digital product. This is promising as it would lead to more resilient revenue and a growing bank of proprietary advertising data that SYS1 could leverage and use to differentiate itself from the competition.

That’s the key dynamic: the successful transition from consulting to digital revenue. This is happening at pace, and the latest update confirms an acceleration of this important trend.

Trading update

The first half saw a marked increase in sales of automated data products including Test Your Ad. Data products represented 45% of revenue in Q2, growing from 28% in Q1. That’s an encouraging jump.

Data Revenue in Q2 exceeded Q1 despite a quarter-on-quarter reduction in total group revenue. Perhaps to be expected given the ongoing shift here, with consulting revenue in decline as it builds up the digital product.

In total, H1 Revenue grew 22% year-on-year to £12.3m.

Adjusted operating costs grew as System1 invests in automated products, technology and business development, up by 10% over the comparable period to £9.0m.

Adjusted pre-tax profits are expected to be £1.3m in H1, approximately £0.9m higher than in the comparable period. Statutory pre-tax profits are expected to be £1.3m compared with a loss of £0.4m in the first half of last financial year.

There are quite a few listed adjustments.

‘Adjusted operating costs exclude impairment, interest, share based payments, bonuses, severance costs and government support related to the Covid pandemic.’

We’ll be able to check back on those adjustments in the interim report at the end of November.

Period end net cash increased from £6.5m at the end of March to £7.3m. The company will soon announce a share buyback programme over an extended period, ‘in order to enhance shareholder returns and to satisfy obligations in relation to employee share schemes’.

We have been delighted by the continuing adoption by both new and existing customers of System1's repeatable, fast-turnaround and scalable data products as they displace the historic large bespoke consultancy projects that dominated the Group's activity until H2 last year. We believe that the growth in data revenues signals tangible progress towards our strategic goals, and that these revenues will in due course more than offset the reduction in bespoke consultancy projects as more customers switch to using our automated data products.

The company will announce its interim results on 30 November 2021.

Conclusion

The faith required from investors is slowly being replaced by concrete numbers. In fact, slowly is the wrong word as things are moving at pace here. A more SaaS-style model built on scalable digital products could command a higher valuation in time. It has already won some promising partners here including Itv (LON:ITV) .

From a valuation perspective, a net cash position of £7.3m reduces the enterprise value and gives the group optionality. It’s a strong position from which it can drive investment and innovation.

Note there has been no equity dilution since its previous highs of c£10. Indeed, the company is about to initiate buybacks so the share count should actually reduce. This is encouraging as the group’s founder and executive president, John Kearon, remains System1’s largest shareholder (see major shareholders), so it all suggests a degree of alignment and share price appreciation as a management priority.

It’s still risky due to the nature of the strategic shift and change in product, plus the lack of liquidity. The share price is volatile and it really is hard to sell in any great volume, so if you build a position then the chances are that you’re strapped in for the ride. At present I have a small holding, to see how things progress.

Management has said before it wants to build a £1bn market cap company. I would suggest that there is still a lot to prove in the business model, so I wouldn’t attach too much weight to that for now, but a sense of ambition and urgency is important.

A positive update, all in all. Every new RNS confirming a continuation or acceleration of the digital shift goes some way to de-risking the proposition, although the lack of liquidity here is an important consideration.

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Activeops (LON:AOM)

Share price: 180p (+2.86%)

Shares in issue: 71,320,680

Market cap: £128.4m

We haven’t commented on this company yet, so it’s always useful to put a marker down for future reference. Activeops calls itself ‘a leader in Management Process Automation (MPA)’. It provides a SaaS platform to large enterprises with complex back office functions (often large amounts of clerical or administrative work).

The company helps with the type of business functions people take for granted, for example credit card payments, cheque clearing systems, and other essential tasks.

It has about 165 people in seven offices around the world servicing 80 enterprise clients including insurance and banks. These are ‘too big to fail’ organisations. From this base, Activeops has built up a track record of mid-teens growth over many years and it hopes to sustain this rate.

There’s a large addressable market of around £750m in annual recurring revenue and a further £70m of opportunities with the customers it already has contracts with, according to the company. The pandemic has crystallised the need for more precise structure control - organisations must now cope with more flexible working models and so the way people are being managed must evolve with that shift.

Trading update

Strong win and upsell performance drives revenue growth

The group expects to report revenue growth of approximately 22% (H1 FY21: £9.4m), in line with board expectations, and a stronger than expected profit performance, of approximately breakeven at the adjusted EBITDA level, reflecting reduced travel costs.

Activeops has exited the period with an Annual Recurring Revenue (ARR) of £19.8m, up from £18.3m in FY21. Customer retention is in line with historical rates and new customer wins or contract extensions were reported across all target regions and sectors.

The group also launched Collector in the period, a component which uses task mining technology to automate the counting and aggregation of completed work, providing an accurate picture of productivity whilst reducing the time spent on data collection. Over 20 new hires across the Technology, Product and Sales teams were made in the period.

ActiveOps will announce its results for the six months ended 30 September 2021 on 25 November 2021.

Richard Jeffery, Chief Executive of ActiveOps, commented,

The six months to 30 September 2021 has been a period of positive achievement for ActiveOps, as workforce management solutions move further into the mainstream. We have secured new customers and expanded existing customer engagements, while investing in our team and our offering to ensure we have the products and structure to execute on our growth plans. I look forward to the full year with confidence as our market-leading offering continues to resonate with our growing global blue-chip customer base.

Conclusion

There are some clear positive business model characteristics here, along with solid trading momentum and an attractive market opportunity (which has been strengthened by post-Covid working habits). But let’s not forget the company is loss-making and this is forecast to continue for now.

Such a high margin, cash generative business with recurring revenue will benefit from operational leverage however, if growth is maintained. Around 80 large corporate customers are billed for SaaS and training annually in advance of the service, giving favourable cash generation. The SaaS margins are between 80-85%. So the profit profile could change quite quickly.

As with a lot of other software companies out there, Activeops has a net cash balance sheet with no debt.

The valuation is not cheap though, given ARR of £19.8m and a market cap of more than £125m.

You might argue it is fairly valued given the attractive business model and growth prospects, but it does need to continue to grow from here - which it might well do. There’s a big opportunity to expand over the next few years ‘as demand for workforce management solutions continues to increase in response to the ubiquitous move towards hybrid working’.

On balance, this is an intriguing opportunity and management comes across well, so it’s probably worth looking at more closely. It’s not yet favoured by the StockRanks, although there has been an improvement over the course of its listing and there are some solid institutional names on the shareholder list, including BlackRock, Canaccord, Schroders, and Gresham.