Small Cap Value Report (Weds 11 Nov 2020) - ZOO, MKS, WATR, RCDO, RNO, MCS

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

I'm starting this report early, on Tuesday evening, with some catch up sections from my backlog.

Agenda -

Zoo Digital (LON:ZOO) - Interim results from yesterday (Paul, done)

Marks And Spencer (LON:MKS) - interesting interim results webinar (Paul holds a long position) - (Paul, done)

Water Intelligence (LON:WATR) - interesting news on a new product (Paul, done)

Ricardo (LON:RCDO) - trading update and share placing (Jack, done)

Renold (LON:RNO) - Half year results (Paul holds a long position) - (Paul, done)

Mccarthy & Stone (LON:MCS) - Trading update (Paul, done)

.

Timing - today's report is now finished.

.

---

Zoo Digital (LON:ZOO)

Share price: 53.5p (down 3.6%, at market close)
No. shares: 74.6m
Market cap: £39.9m

Interim Results

ZOO Digital Group plc (LON: ZOO), a world-leading provider of cloud-based localisation and digital media services to the global entertainment industry, today announces its unaudited financial results for the six months ended 30 September 2020 ("H1 FY21").

I’ve been following this company for several years now, and it never seems to manage to live up to the expectations created. As you can see from the graphs below, at times it’s been valued at a high PER, despite lumpy and overall rather unimpressive profits, and it doesn't pay any divis;

.

.

I covered the trading update from ZOO here on 23 Sept 2020 where it indicated H1 (to 30 Sept 2020) should deliver double digit revenue growth. Nothing was said about profitability.

Interim results today;

• H1 revenue growth of 15%, to $16.4m, consistent with the last trading update
• Lower gross profit though, due to increased costs
• Loss before tax of $(710)k vs. $374k profit in H1 LY - not very impressive
• Balance sheet - quite weak, with NTAV negative, at $(2.0)m. Receivables look rather high at $9.2m

Outlook comments seem quite positive, especially the bits I’ve applied the wonky highlighter to below;

.

My opinion - I‘ve not seen anything in these interim results to make me want to buy this share.

To be fair to ZOO, the TV/film sector has been struggling this year, due to social distancing, which has led to a marked slowdown in production of new programmes. Therefore the figures for H1 from ZOO are not representative of what it might be able to achieve in future.

I’ll keep an open mind about the future, but there’s not enough in this announcement to get me interested at the moment.

The StockRank algorithms don't rate it either;
.

.

---

Marks And Spencer (LON:MKS)

Share price: 120p
No. shares: 1,953.4m
Market cap: £2,344m

(I hold)

Just a quick mention, but I've just enjoyed watching a very interesting interim results webinar here. Highly recommended, it's really thorough.

MKS has been trying to turn itself around for a long time, with repeated restructuring programmes. It feels to me, as if this time it could be the real deal - Chairman Archie Norman is well respected, and a few things jump out at me from this webinar, so here are the key points from my notes;

• High performing food business, with LFL sales up 6.6% in H1, once things likes cafes are stripped out (as they were forced to close)
• Full M&S food range now available on Ocado, doing well apparently, profitable
• Plenty of liquidity: £1.4bn cash & undrawn facilities - "far better" than anticipated
• Costs cut & layers of management removed
• Supply chain being "radically reshaped" & costs removed
• M&S is now the UK's #2 clothing retailer online - surprising
• Relaunch of Sparks loyalty scheme, with 1.5m app downloads
• Targeting >40% of total sales online, within 3 years
• Digital transformation, lots of credible stuff to back this up

My opinion - I think M&S could be beginning a genuine resurgence. As mentioned last week, I've dipped my toe in with a starter size position at something like 96p. Lucky timing, because then the positive Pfizer covid news came out. So it's important not to delude oneself that lucky timing was anything more than just luck. It's now about 118p, due to that indiscriminate vaccine bounce.

The mkt cap of MKS is about £2.3bn now, yet I reckon it's by far the best brand on the High Street. How many other food retailers make you feel special, and warm/fuzzy, even privileged, as you walk in? Maybe just Waitrose, but none of the others do. I think the MKS brand is incredibly valuable, potentially multiples of the £2.3bn market cap.

Debt is fine, at £1.4bn (excluding leases), with loads of headroom.

The challenge is obviously how they turn around the clothing/home part of the business, which lost its way many years ago, and has never really recovered?

I'll keep monitoring MKS, and for the time being am only dipping my toe in the water, with a small position (about 1% of my portfolio). I really do think it could be a recovery story, not a terminal decline story. Time will tell!

Pretty awful chart, so there's a lot to do.

.

.

---

Water Intelligence (LON:WATR)

Share price: 490p (up 2% yesterday)
No. shares: 17.6m
Market cap: £86.2m

Initiation of Sales of Sewer Diagnostic Product

Water Intelligence plc (AIM: WATR.L) ("Water Intelligence" or "Group"), a leading multinational provider of precision, minimally-invasive leak detection and remediation solutions for both potable and non-potable water is pleased to announce the initiation of sales from Orca^TM, its proprietary sewer diagnostic product. Such initiation of sales has been delivered on schedule, as guided by the 3Q Trading Update previously released...

This sounds rather interesting -

Orca has been in development at the Group's UK-based, Water Intelligence International subsidiary (WII). The proprietary product uses acoustic technology to identify sewer blockages in municipal pipes more effectively than any competitive solution.

WII has paid engagements starting with 4 large municipal customers in the UK. The Group expects that such engagements will lead to a broader rollout in 2021 in the United States, Canada and Australia within a subset of the Group's 140+ locations.

It would be good to get some third party confirmation of what this product is like, and what potential it might have. No financial details are provided today.

Directorspeak -

Commenting on the Group's performance, Executive Chairman, Dr. Patrick DeSouza remarked: "We are pleased with the initiation of commercial sales of Orca. The product is timely and will add to the growth of our Water Intelligence International subsidiary. Such sales, combined with our recent insurance customer wins, will reinforce our growth trajectory for the remainder of 2020 and 2021.

My opinion - every time I report on this company, I moan about the high valuation. However, the company keeps throwing more red meat to shareholders, with a succession of positive-sounding announcements.

It's looking quite interesting. If this Orca product takes off, then the addressable market must be very large, globally. What other competitive products are there, I wonder? If WATR has something genuinely ground-breaking, then things could be good. Its not for me to say, I'm just flagging up the share as something that readers might want to look into in more detail.

.

.

---

** This section written by Jack **

Ricardo (LON:RCDO)

Share price: 340p (-7.4%)

Shares in issue: 53,406,250

Market cap: £181.6m

(Jack writing)

A hat-trick of RNS statements from Ricardo (LON:RCDO) this morning: a trading update, a proposed share placing, and a linked PrimaryBid offer.

This environmental and engineering consultancy specialises in the transport, energy and scarce resources sectors. While those areas are hopefully poised to recover in the months and years ahead, 2020 has been a hard year so far. The same can be said for Ricardo’s share price.

Mind you, this has been another defining week and market sentiment has totally flipped - for now, at least - on the back of Pfizer’s vaccine announcement. So perhaps this type of beaten up share will be viewed more favourably by the market in the weeks ahead.

Trading update

This is for the first quarter's trading to 30 September 2020. Half year results are expected in February 2021.

In the quarter to 30 September 2020, overall order intake was strong at £105.2m, up 19% year-on-year (note that comparable was before COVID disruption) and an improvement on the £70m of orders received in the quarter ended 30 June 2020.

All segments delivered an increase in order intake except for Performance Products. Running through those business units in a little more detail, we have:

• Energy & Environment orders up 29% to £11.7m.
• Rail orders up 40% at £26.9m.
• Defense orders up 141% to £14.2m.
• Performance Products down 42% with received orders of £13.2m.
• A&I up 27% with an order intake to £39.2m.

The group continues to experience challenging conditions in Automotive & Industrial (A&I) EMEA and expects the order intake to remain at a low level over the next few months.

Consequently it’s guiding towards more of an H2 weighting in full-year results - this can be (but isn’t always) an early warning sign. Per the group:

Historically operating profit phasing has typically been 40% H1 and 60% H2 and in FY21, as we emerge from the impact of COVID 19, we expect this to be approximately 25% H1 and 75% H2.

So at least the company is sticking its neck out and giving some guidance, rather than pinning hopes on poorly-defined H2 recovery.

Dave Shemmans, Chief Executive Officer, commented:

The economic outlook continues to be uncertain and we approach the year ahead with a degree of caution, with our non-Automotive businesses providing some resilience against continuing challenges in the Automotive segment. Nevertheless, we have established a firm and diversified platform for our business and looking forward I remain confident of the prospects for the Group.

Proposed placing

Mixed orders aside, Ricardo anticipates a small net cash outflow in addition to the payment of £5.2m of earnout costs in relation to previous acquisitions and approximately £3m of redundancy costs. It’s burning cash and net debt has increased. That’s why it is placing shares.

Up to 7,981,809 new ordinary shares at a price of 333p, with directors subscribing to 29,128 (c£97,000). There’s an additional offer of up to 801,093 shares to retail investors on Primary Bid. So gross proceeds of around £29m representing 16.5% of existing share capital.

This is driven by the Automotive EMEA business, which continues to receive a lower than required level of workable orders.

Per the group:

The Fundraise is intended to reset the capital structure of the Group, reducing leverage to achieve an appropriate level of balance sheet efficiency and resilience. The net proceeds will be used to pay down drawn debt facilities, resulting in increased headroom, lower net debt and lower adjusted leverage, and providing greater flexibility to invest in growth projects and meet working capital requirements.

Conclusion

This looks like an interesting company but I’m not tempted.

There’s a slight mismatch between the tone of the trading update, which sounds reasonably resilient, and the placing, which, reading between the lines, sounds much more distressed.

Given that, perhaps I am more sceptical about the H2 weighting. Obviously I hope the company prospers but I don’t see why I need to risk my capital to make that happen. You can see the net debt spiking up this past year.

Directors are participating but have been heavy sellers in the past. I’m quite happy to leave this one for now and potentially revisit once we are well and truly past this COVID disruption. The outlook for its problem division, Automotive and Performance Products, continues to look uncertain.

In fairness its other divisions appear to be performing strongly and there could be longer term potential here if trading recovers - but right now seems a particularly intriguing time elsewhere in the market.

Is there a changing of the guard taking place, with a rotation from lockdown beneficiaries to beaten down recovery stocks? Or have the past few days been a false dawn? There might be more immediate reratings out there.

.

---

Renold (LON:RNO)

Share price: 12.2p (up 12%, at 12:22)
No. shares: 225.4m
Market cap: £27.5m

(Paul holds a long position)

Half year report

I bought a small opening size position in this one back in June 2020, as it looked an interesting potential turnaround, and management were indicating that a dilutive fundraising could be avoided. The thorn in the side is a humongous pension scheme, in deficit, draining cash out of the company, a long-term problem, particularly in times of ultra low interest rates.

I often like to make a small initial investment into something, then monitor it closely, and either gradually increase, or cull the position over time, as my knowledge of the company increases, and news comes out to either weaken or strengthen my conviction about the company.

Renold, a leading international supplier of industrial chains and related power transmission products, today announces its unaudited interim results for the half year ended 30 September 2020 (the 'period').

Resilient performance…strong cash generation…significant net debt reduction

The summary points above are accurate, so I’ve included them.

Clearly this has been a period (April-Sept 2020) when covid/lockdown has had a major impact on many/most companies. So I’m not expecting great numbers. These do however indeed look resilient;

.

.

Revenues are down about 16%, which I would normally expect to have a much larger, operationally geared impact on profits. However, in this case you can see that profitability has been fairly resilient (down 25%). This is due to restructuring & cost-cutting done before covid, fortuitously. See also how H.O. costs are down about 10%.

These figures are only for 6 months remember, so if we look at adj EPS of 1.1p for H1, and double it to approximate to a full year (ignoring seasonality), and 2.2p, with a share price of only 12.2p that’s a PER of just 5.5 - quick ring the broker & get a buy order in! Not so fast, because of course there’s a catch - a huge pension deficit.

The Group has a number of defined benefit pension schemes (accounted for in accordance with IAS 19R 'Employee benefits'). During the period agreement was reached with the UK pension trustee to defer contributions (£2.8m) to the UK pension scheme. This delays agreed contributions, now payable between April 2022 and April 2027, but maintains the consistent cash requirements of the Group's schemes.
Cash pension costs are sustainable, having remained consistent at approximately £5m for several years, and are expected to remain broadly stable over the longer term.
The Group's retirement benefit obligations increased from £97.6m (£80.2m net of deferred tax) at 31 March 2020 to £115.6m (£94.7m net of deferred tax) at 30 September 2020.

Continuing declines in corporate bond yields, which determine discount rates, have increased the deficits in the key UK and German schemes. In the UK, discount rates falling to 1.55% (31 March 2020: 2.4%) and the CPI inflation assumption increasing to 2.2% (31 March 2020: 2.0%) has the effect of increasing the present value of future liabilities by £29.2m.
Strong asset returns helped to mitigate the impact of change in the financial assumptions, with the net UK deficit increasing by £16.0m to £84.0m.

These are massive numbers for a company with a market cap of only £27.5m.

We’ve discussed pension deficits here quite a lot recently, and it cropped up in discussions of Reach (LON:RCH) . My worry is that, as in this case, good investment returns are not enough to offset the problem of low bond yields inflating the liabilities. An interesting angle on this, is if policymakers could be persuaded to allow pension schemes to reduce their liabilities by coming up with an alternative way of discounting them?

The nightmare scenario would be if investment returns crash the assets values, e.g. another collapse like we saw in March, without a rebound. Where pension schemes are a material factor, it really is vital to understand the situation properly, by reading all the disclosures at the back of annual reports, e.g. to see what the pension scheme assets are invested in, and how risky those investments might be. Sometimes risk has been mitigated by the trustees, by taking out insurance policies, or other hedging.

How to adjust the valuation? Personally I’m mostly concerned about the cash outflows. We’re told that these are c.£5m p.a., and likely to continue at that level. Hence I would adjust earnings down by that amount, then put the shares on a more normal PER. Or work out a reduced PER, on the basis of how much is being absorbed by the pension scheme?

Or, you could look at free cashflow, and adjust that for the pension cash payments maybe, then put the shares on a multiple of cashflows?

Net debt & cashflow - there’s an impressive reduction in net debt;

Strong cash generation resulting in a £10.2m reduction in net debt to £26.4m (31 March 2020: £36.6m); with net debt to adjusted EBITDA ratio of 1.2x (31 March 2020: 1.5x)

That’s a huge reduction in net debt, over just 6 months. Looking through the numbers, the main factors for this are: very strong EBITDA (bear in mind there is a large depreciation charge), low capex (restructuring done last year), favourable working capital movements from decline in business (inventories & receivables down), deferral of pension payment, and a tax rebate.

I think this big debt reduction, and cash generating ability (even in a downturn) augurs well for the future, in that the company probably won’t need a fresh equity raise, when it can demonstrate the ability to pay down debt fairly quickly without it.

However, there is a warning in the going concern note, that a downside scenario could trigger a covenant breach (and hence maybe an equity raise);

However, the most severe downside case indicates the potential for a covenant breach during the test period, indicating a material uncertainty related to events or conditions which may cast significant doubt over the Group's ability to continue as a going concern in the event that, following a covenant breach, lenders elected to trigger a repayment of outstanding debt….

Balance sheet - is dominated by the huge pension deficit of £115.6m. However, if we park that to one side as being a manageable long-term creditor, costing £5m p.a. to service, then things start to look more manageable.

The working capital position looks fine, with a big surplus of current assets over current liabilities, but a fair bit of long-term debt.

Overall, I’d like to see net debt come down some more, to make me fully comfortable with the balance sheet.

Dividends - none for the moment, but will be kept under review. As a small shareholder, I don’t want divis, I’d much rather see the company retain cash, and reduce its debt, and thereby reduce my investment risk. Divis can come at a later date, once the balance sheet is more robust.

Outlook - not madly exciting, recovery sounds slow;

The trends exiting the period suggest that order intake should continue to improve slowly, albeit this is likely to be at levels below the prior year in the near term. The immediate outlook varies by both geography and sector, and is difficult to forecast, however, Renold benefits from its geographic, customer and sector diversity. The tight focus on cost and cash management in the first half has created a strong platform from which the Group can manage through short-term disruption, whilst retaining the ability to invest in support of our strategy as markets recover.

My opinion - I’m happy to continue holding, and might top up my existing position. This share can be very illiquid. I remember when I needed to sell some when a margin call hit me, my broker could only shift 5,000 shares, for about £500! And that pushed the price down, which made my margin call bigger! For that reason, I probably shouldn’t be using margin for something this small & illiquid, hence why I’m reluctant to increase my position size. As mentioned earlier this week, it’s vital to be able to exit from positions where you’re using margin. Most readers are probably more sensible, and wouldn’t use margin on this type of thing, or at all.

Taking everything into account (including the pension deficit), I reckon this share looks cheap. It’s whether you can live with the pension problems or not, that is the deciding factor.

The 5-year chart below shows that Mr Market hasn't given the company much credit for its turaround restructurin last year, which could be an opportunity maybe?

.

.

---

Mccarthy & Stone (LON:MCS)

Share price: 116.7p (up 0.5%, at 15:14)
No. shares: 537.8m
Market cap: £627.6m

Trading Statement

I mentioned this retirement housing developer yesterday, casting doubt on whether the 115p cash takeover offer from Lone Star Real Estate would gain enough shareholder support to proceed, or whether a higher-priced offer might crop up, or the offer lapse.

Today we have a trading update.

McCarthy & Stone, (the 'Group') the UK's leading developer and manager of retirement communities, is today issuing a trading update for the financial year ended 31 October 2020 ('2020'). All comparatives are for the 14 months financial year ended 31 October 2019 ('2019') unless otherwise stated.

To summarise the main points;

Completions are well down on last year:

Total completions of 832 units (2019: 2,402) … and generated full year revenue of c.£197m (2019: £725m).

Operating loss in line with the Board’s expectations, but we’re not given any figures on profitability

Modest net debt, it’s a low geared balance sheet. That might have attracted the bidder, who could be planning to fund the bid partially by loading it up with cheap debt maybe?

Net debt of c.£63m (2019: net cash £25m) with a continuing focus on cautious cash flow and investment management … which provides £137m headroom versus bank facilities in place of £200m

Current trading -

Current trading increasingly affected by rising COVID-19 infection rates and Government lockdown measures

"However, with national COVID-19 infection rates rising and lockdown measures in place, the retirement housing market is expected to remain difficult. As a result, the Group will continue to cautiously and actively manage cash flow balancing investment in land and development to support future sales with the need to preserve headroom in order to enable the Group to navigate the short-term risks. It is against this backdrop that the Board believes the 115p cash offer from Lone Star Real Estate Fund represents fair value reflecting both the future opportunities and risks facing the business."

My opinion - personally I was happy to grab the profit, and sell out at c.115p when the bid was announced. A friend emailed me to point out that the offer price is below NAV. Working out the figures, last reported NAV was £695.1m at the recent interims. Deduct £4.3m intangibles, gives NTAV of £690.8m. Divide that by 537.8m shares in issue, and that gives NTAV (sometimes called P/TBV) of 128.4p per share.

I wonder if major shareholders might be angling for a premium to NTAV? Maybe the bidder might need to raise the price to say 130p+ to get more support from institutions? So far only one, holding c.17%, has publicly given an irrevocable undertaking to support the 115p takeover bid.

.

---

All done for today! See you tomorrow.

Best wishes, Paul.