Small Cap Value Report (Weds 21 Sept 2022) - ZOO, MOON, TEG, FDEV, ABDP, WAND, COG

Good morning from Paul & Graham!

Agenda -

Paul's Section:

Moonpig (LON:MOON) - from yesterday. It's trading in line with previous guidance. Interesting that it doesn't seem to be having a problem with input cost inflation. The company reckons greetings cards are proven to be resilient in previous downturns, but personally I have my doubts. On closer inspection, and following a large acquisition, the balance sheet now looks over-stretched. I think MOON could have taken on too much bank debt, and overpaid for the acquisition, at the worst point in the cycle (as we go into a likely recession). 

Ten Entertainment (LON:TEG) - impressive interim results. Liberum raises forecast profit for FY 12/2022 and the new forecasts don't look challenging, so I suspect it might out-perform again. Everything looks fine in the numbers, and the PER seems low - providing the "new baseline" of higher sales is maintained. The risk is that we're still seeing an element of pent-up demand, that could subside as consumer incomes are squeezed. On balance, I'm leaning towards a positive view of this share.

WANdisco (LON:WAND) - certainly not a value share, but the strongly rising share price, and a series of big contract wins with the same key customer, does suggest that something interesting might (at long last) be starting here. Continued heavy losses are forecast though.

Cambridge Cognition Holdings (LON:COG) [no section below] - I had a quick look at COG (I hold) shares yesterday, but didn't think there was anything much to say about them. P&L is a bit disappointing, with higher revenues absorbed into higher costs. Balance sheet look fine, as it gets paid cash up-front (at least in part). Order intake & outlook sound good. Probably priced about right for now, but a nice longer-term growth stock, with a strong moat.  [no section below].

Graham's Section:

Zoo Digital (LON:ZOO) (£125m) (+11%) [no section below] - we covered this company’s results in July, and I suggested that Zoo finally, at last, had grown into its valuation. Today’s AGM statement and trading update confirm that the company continues to grow at a fantastic pace: H1 revenues +89% to at least $51 million (vs. H1 last year) which also represents growth of 17% sequentially (vs. H2 last year). The company expects “a significant increase in EBITDA, benefitting from operational gearing as the business scales”, with “a substantial improvement in our cash position”.

I’ve found this company’s public emphasis of EBITDA very frustrating over the years, as its EBITDA has typically not translated into net income and cash profits. However, with the help of operational leverage, it may have finally turned a corner and reached a point where the cash profits become meaningful - so that it might be able to start funding its growth plans without diluting shareholders. Or, even sending money back to shareholders for once! This share provides exposure to the secular trends of increased content streaming and the internationalisation of media consumption. Despite my long-term scepticism, I now think it’s easy to come up with bullish arguments for it, from this valuation. [no section below]

Frontier Developments (LON:FDEV) (£483m) - this video game designer and publisher releases full-year results. The numbers are tarnished by a significant impairment charge, as development work done on an existing title failed to translate into profitability. The future prospects continue to look interesting, however: the company has recently released a flagship Formula 1 game to good reviews. It has already successfully published Jurassic World Evolution 2 and a 3rd-party Warhammer game. Valuation isn’t cheap by any means but if it hits targets over the next two years it will start to look much better value.

Ab Dynamics (LON:ABDP) (£291m) (+4.9%) [no section below] - this company provides testing and simulation products to the transport industry (mostly car manufacturers). Today’s update is ahead of expectations: FY August 2022 is expected to see revenues of c. £80m, up +22% against last year, with healthy profitability thanks to a “robust margin performance”. A positive book to bill ratio gives the company good momentum as it heads into FY 2023. Additionally, the company today announces the £19m acquisition of a Norfolk-based provider of products for car simulation (testing driver assistance systems, autonomy, etc.). Max consideration is £32m, subject to performance.

My view: The rationale for the acquisition makes sense - good synergies with ABDP’s existing offering - and the company can afford the purchase, thanks to a strong cash balance. Overall, ABDP has a fine track record of profitability and it appears to be getting back on track after a couple of difficult years during Covid. Unfortunately, the shares are never cheap and the PE ratio remains in the high 20s or even low 30s. For this reason, I have a neutral view on the stock. The car industry in general is struggling: Ford shares dropped by 12% yesterday after it announced huge increases in costs and parts shortages. As an alternative to the car manufacturers, a company like ADBP might be a nice way to invest in the industry but without the same exposure to raw material price increases and supply chain problems.  [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:

Moonpig (LON:MOON)

185p (down 8% yesterday)

Market cap £633m

Trading Update (AGM)

Moonpig Group plc (the "Group"), the leading online greeting card and gifting platform in the UK and the Netherlands… provides an update on its performance for the current financial year (commencing 1 May 2022) to date.

So that’s FY 4/2023 in the terminology we use here. I wish everyone would refer to financial years like this (including the month), as it saves having to check what it is, if companies refer to 2023, or 2022/3, which they usually seem to. Moonpig refers to FY23.

Overall, this is reassuring, although it doesn’t actually say what the guidance is! -

Overall trading performance is in line with our expectations and hence we reiterate existing guidance for the full financial year.

Other points -

Focused on greetings cards sales, which are proven to be “resilient across the cycle”

Average order is up (no figures)

Margins resilient (no figures)

Costs - very interesting, unusual, and  positive - “... absence of any significant pressure from input cost inflation.”

Seasonality - is returning to pre-covid levels.

H2 weighting expected, with H2 forecast at 58-60% of full year revenues (worth bearing in mind when the interim results come out).

BuyaGift acquisition (announced in May 22, completed in July 22) - is a sizeable deal, at £124m (cash)

Guidance - a glaring omission from this latest update. I’ve had to waste time rummaging through previous RNSs to find it - this is from the FY 4/2022 results, published in late June 2022 - guidance for FY 4/2023 is -

• Revenue £350m
• Revenue growth expected to be mid-teens underlying, in medium term (that looks too ambitious to me, given the slowing economy)
• Margins expected to be resilient in short & medium term.
• Buyagift acquisition will raise margins further
• Adj EBITDA guidance is 25-26% (that’s nice, but EBITDA isn’t real profit)

My opinion - it’s good that Moonpig is trading in line. Although on closer inspection, I have 2 concerns with this share -

1. EBITDA is not profit, or cash generation. If you inspect the last full year accounts, operating cashflow of £64m is then reduced by 3 real world outgoings, namely £9m tax, £8m capitalised development spend, and £9m interest (incl. leases). So free cashflow on that basis (a much more meaningful number, surely) is £38m.
2. Debt - net debt was £84m at last year end of 4/2022. After that, a £124m acquisition was paid from cash. So that means net debt is probably nearer £200m now - about 6 years’ worth of free cashflow. That looks worryingly high to me, given that the economy now seems to be slowing.

Overall then, I suspect Moonpig might have chosen a very bad time to further gear up an already geared balance sheet. It looks like they might have overpaid for the Buyagift acquisition.

Other concerns are Royal Mail strikes, which Moonpig is emailing customers to say it might disrupt deliveries - not good for time-sensitive items like birthday cards/presents. Also, from the last 2 years's accounts, the company seems overly generous with share based payments to management. In a bear market, I can't be the only investor who winces with annoyance at Directors loading up with free or cheap shares, particularly when (as is often the case) the amounts look excessive, and share price performance is weak.

Personally, I only want to be holding shares in companies with really solid finances at the moment, due to the economic uncertainty. Moonpig is a nicely cash generative business, but nowhere near as much as the EBITDA numbers suggest. At some point, who knows when, banks might start to realise that measuring gearing on EBITDA is actually quite foolish, because companies cannot (long-term anyway) just stop paying interest, tax, and doing capex. Therefore why would we value companies on a multiple of EBITDA? It can make sense in some sectors, but for many other companies it doesn’t make sense at all - I would include Moonpig in that.

So with net debt probably now approaching £200m, and a balance sheet that’s now heavily negative NTAV, I think Moonpig is looking financially stretched, especially if people cut back on sending expensive cards & presents in the coming economic slowdown.

If none of that bothers you, and you only look at earnings, then MOON looks quite good value, on a forward PER of just over 13.

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Ten Entertainment (LON:TEG)

199p (up 5% at 08:12)

Market cap £135m

Half Year Results

Ten Entertainment Group plc ("Ten Entertainment" or "The Group"), a leading UK based operator of 48 bowling and family entertainment centres, today announces its half-year results for the 26 weeks to 26 June 2022. H1 19 has been used in some selected comparisons because it is the last H1 that traded for a full 26-week period.

Value for money entertainment driving sustainable growth in sales and profit

The company’s headline above, and repeated use of the phrase “new baseline” in the commentary today, is for me (and the market, judging from the low earnings multiple) the big question mark.

If TEG really has reset its baseline at sales 30% higher than 2019, then the shares are cheap. If however (as seems more likely to me), it is still enjoying a post-pandemic boost, and sales might slip back somewhat in future, then the shares are not necessarily cheap - it could be enjoying unsustainably high profits. That’s something you have to judge for yourself.

For now anyway, the figures are very good, e.g. -

H1 revenues of £63.2m

Adj PBT £15.7m - a very good profit margin of 24.8%

Adj EPS in H1 was 20.2p

In the past, pre pandemic, I see from the Stockopedia half year table, that there wasn’t any noticeable H1:H2 seasonal bias. Therefore, does this mean EPS in FY 12/2022 could be heading for double the H1 number, implying c.40p EPS?

Liberum (many thanks) has updated us today, saying that it’s factoring in some cost headwinds (e.g. business rates relief ending, wage rises, etc) for H2, hence it today increases forecast adj EPS by 8% to 30.0p for FY 12/2022 (on an IAS 17 basis).

My hunch is that the forecasts are probably still too low, given the strength of H1 trading, so the downside risk of a profit warning strikes me as low. In line, or better, looks more likely for the next trading update.

Good cashflows are enabling new sites to be built, and refurbs of existing sites, including enhancing them with new karaoke rooms.

The Liberum note also provides interesting background on TEG’s focus on value for money – it hasn’t raised prices for the bowling games since 2019. This means customers see bowling as an affordable treat, and it may prove resilient in a consumer downturn. Possibly, we’ll have to wait and see.

H2 trading has also been resilient, basically flat against strong comps from last year, on an LFL basis (+0.5%). That’s pretty good, considering the exceptionally hot weather this summer, when I imagine people would have not particularly wanted to go bowling, when sunbathing & beaches are a big alternative draw.

Energy costs - no need for TEG shareholders to worry, as they’re fixed to Sept 2024, at 2020 prices.

Dividends - 3p interim divi, and a forecast 6p final divi, so 9p total, a healthy (and rising) yield of 4.5%

Balance sheet - looks fine to me. I wish TEG would split out bank borrowings, and lease liabilities into separate lines. It’s such a bad presentational own goal, combining them. Nearly all the “debt” is actually lease liabilities, which of course are actually just future operating costs, which will be paid from future revenues & profit, so really shouldn’t be on the balance sheet at all. Net bank debt is negligible, at just £0.7m - so this is a very securely funded business, with very little dilution risk, even in a recession.

My opinion - this is a very interesting company, and indeed sector. So far anyway, it looks as if demand for bowling remains strong, and as an affordable treat, maybe that could continue? Refurbished sites, and widening the range of entertainment on offer, could be driving sustained higher sales. Or it could reflect an element of pent-up demand - now that we can get out & enjoy experiences again, after 2 years of restrictions, people are bound to relish the newly recovered freedom. Will that, longer-term, subside though? That’s the big question.

Overall, I think TEG shares look very interesting. The business is humming along nicely, generating plenty of cashflow, which is enabling it to self-fund refurbs and new sites, and now divis too.

As regards demand, we still have full employment, and households now know their energy bills are capped. So I can’t see why demand would collapse, for what is an affordable leisure activity.

On balance then, this share looks good value to me, and I’d be tempted to have a dabble at the 200p level, maybe holding back some cash to top up, if it takes another lurch down.

Note that, positively, the share count has only risen from 65m to about 68m in the last 6 years. A lot of profit & EPS growth has occurred over that time, so this looks a fundamentally good sector to invest in. Although increasing competition might, over time, reduce the high profit margins, possibly?

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WANdisco (LON:WAND)

429p (up 6% at 09:32)

Market cap £293m

This share is about as far as you can get from a value share! Its track record is dire - minimal revenues, heavy losses year after year, repeated fundraises as it misses forecasts, etc.

However, it’s one of those shares, where in the back of my mind, I think this could get interesting, if demand takes off. Could we be at that kind of tipping point this year? The last fundraising was done at a good price, and the chart has been doing something very strange - going up! Although there have been several false dawns before.

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Record Contract, and Outlook Update

A “top ten global communications company” seems to have become of key importance, with another big contract won with the same customer. This one customer has now signed contracts worth $39.3m in 2022 with WAND. That must include the latest one, WAND’s biggest ever contract, of $25m. It doesn’t state over what period these contracts extend. If it were say 5 years, then that’s about $8m revenues per year, not a huge amount given that WAND tends to report losses of $20-40m year after year. However, if it’s the long-awaited start of properly commercialising WAND’s software into potentially huge markets, then this could get a lot more interesting. The £300m market cap already anticipates a much brighter future.

Overall -

Following this latest contract and our robust pipeline, we expect bookings for FY2022 to be significantly ahead of current market expectations."

That’s good, but do remember there’a big difference between bookings, and revenues (which tend to be much lower).

My opinion - Edison’s updated note this morning still forecasts heavy losses, but they’re hoping that up-front monies from contract wins might render another fundraising unnecessary. Although Edison’s own forecast shows WAND running out of cash again by end 2023. There again, with the share price soaring, and a market cap of £293m, I’d say raising some more cash now would be a smart move for relatively little dilution.

It’s impossible for me to judge WAND’s prospects, but just thought I’d flag up these material contract wins to anyone who likes speculative tech stocks!

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Graham’s Section:

Frontier Developments (LON:FDEV)

Share price: 1,228p (+3%)

Market cap: £484m

Frontier Developments plc (AIM: FDEV, 'Frontier', the 'Company', or the 'Group'), a leading developer and publisher of video games based in Cambridge, UK, publishes its full-year results for the 12 months to 31 May 2022 ('FY22').

I covered this one in June, thinking that its risk/reward prospects for shareholders had improved considerably in recent years, for two simple reasons:

1. The share price had come back to earth so that, overall, it had made little progress since 2017-2018.
2. The company had grown revenues and profits considerably over that time.

The tricky feature of FDEV, however, is the lack of diversification. There are a handful of important titles and a few new releases each year or two, and they determine the financial fate of the company.

Results

FY May 2022 was a good year. Jurassic World Evolution 2 was well-received and the revenue result of £114m is in line with expectations which had previously been raised.

Operating profit is less impressive at just £1.5m, and it relates to the dangers of companies who capitalise development work. Sometimes, they realise that this work isn’t going to result in the profits they were hoping for, and you get large impairment charges. FDEV suffered a £7.4m impairment charge.

So if you are willing to give them the benefit of the doubt for the rest of their development spending, you could write up their operating profit result for the year to £8.9m.

The company also provides an alternative measurement of “cash profits”: adjusted EBITDA with all game development expenses expensed as they are incurred, instead of capitalised. This measure comes in at £6.7m.

As you can see, profits can be a matter of opinion and in the case of FDEV, there are at least three different numbers you can use for FY 2022. In coming up with a range of valuations for the stock, I’d be inclined to use the actual operating profit result (£1.5m) but I’d also allow for the possibility that future results will be impairment-free. In which case, the £8.9m number I came up with is more relevant.

Game list

Jurassic World Evolution 2 has been a hit with £60m of revenue in its first ten months after release.

Planet Zoo is still selling strongly with expansion packs helping it to generate almost as much revenue in FY 2022 as it did in FY 2021.

Elite Dangerous has missed expectations (resulting in the impairment charge) and the company also continues to sell copies of Planet Coaster.

F1 Manager 2022 was released in August and received a score of 8/10 from IGN.

Then there are the games which FDEV publishes but does not create. Among these is a Games Workshop (LON:GAW) title: Warhammer 40,000: Chaos Gate - Daemonhunters. This is the most successful 3rd-party game ever published by FDEV.

Outlook

There has been a “pleasing start” to FY 2023, and the Board is “confident” that it can deliver on analyst expectations for the year. Initial sales of F1 Manager are “strong, as expected”.

And they remain positive on the prospects after this year:

Over the medium term, the Board expects Frontier to continue to grow revenue by around 20% on average per annum, with any annual growth rate variability largely driven by the timing and scale of new releases in each year.

The CEO and Founder is stepping back to become President, but he says that he “will still be actively involved, retaining oversight and involvement in strategic direction and key external relationships”. It’s worth noting that he’s a 33% shareholder, i.e. he has fantastic alignment with external shareholders.

My view

As I said before, I’ve grown to like this company more over time, both as a company and as an investment.

As a company, it has delivered some excellent games, branched out into new genres, become a successful publisher, and lengthened the lifespan of its existing titles with lots of fresh downloadable content. Diversification is still far below what could be achieved, but it has certainly improved.

As an investment, the market for small-caps has become more discerning (i.e. cheaper) and the nosebleed valuation this stock enjoyed in 2020-2021 has been eliminated.

It still only gets a ValueRank of 10, but it at least has the possibility of giving investors a proper earnings yield this year or next year. According to forecasts, net income should come in at £17m this year (FY May 2023), with further improvements next year.

Overall I view this as a weak buy: the valuation still requires the company to achieve a lot in the next two years. In particular, it requires the Formula 1 game to be a big success, and it requires a long stream of paid-for expansion packs from existing titles. However, despite the stretched valuation, I have now come around to the view that FDEV has done enough to justify its premium rating.