Small Cap Value Report (Weds 8 June 2022) - FUL, NEXS, MRK, IGP, CPC

Good morning! Paul & Jack here.

Agenda - 

Paul's Section:

Fulham Shore (LON:FUL) - a decent, in line trading update for Apr & May. Acceleration of expansion into new sites, in prime locations, on attractive rents - so this is a good quality restaurant roll-out. Long-term, I think this share is likely to do well. Shorter term though, the valuation isn't a bargain. Since listing, the share price has basically gone sideways over 8 years.

Marks Electrical (LON:MRK) - as I expected, profit margins are falling from unrealistically high levels. Hence profit is flat, despite a 44% rise in revenues, for FY 3/2022 results. This seems a shrewdly managed business, lean on overheads, which is what's needed in a low margin, highly competitive sector. Too expensive for what it is.

Intercede (LON:IGP) (I hold) - a profit warning in April reset expectations downwards, so no surprises in today's results. Growth has stalled this year, but it's still profitable and has a sound balance sheet, with cash. We need to see growth resume, which could happen if contracts that were not signed by year end are signed in the new year. I've cooled a bit on this share, due to no growth. However, that's been reflected in a much lower share price already.

Jack's section:

Nexus Infrastructure (LON:NEXS) - a solid update, with a small hiccup in the energy transition business, but the company is confident of recovering gross margin in H2. Nexus is clearly working in some high growth areas and compares favourably to some more speculative alternatives, but the valuation is not particularly cheap and I wonder if near term pressures and investments might lead to a more attractive entry point some time in the future.

City Pub (LON:CPC) - an encouraging recovery in trading with good like-for-like progress, new site openings, and the prospect of the first uninterrupted summer’s trading in two years. Valuation has always been a concern for me though and I still struggle to see the upside, particularly after accounting for the recent increase in share count.

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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.

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Paul’s Section:

Fulham Shore (LON:FUL)

14.25p (pre market open)

Market cap £90m

Trading Update

Fulham Shore owns and operates "The Real Greek" ( www.therealgreek.com ) and "Franco Manca" ( www.francomanca.co.uk ) restaurants.  
The Board of The Fulham Shore PLC is pleased to provide an update on trading for the first two months of its financial year ending 26 March 2023.

April & May - trading in line with management expectations.

Tourists returning to London & many other cities.

Office areas - improving, but still behind pre-pandemic.

Cost inflation - mitigated by -

• Increased menu prices
• Negotiations on rent reviews (i.e. lower rents)
• Strong trading in suburban areas & shopping centres.

New sites - 10 opened in FY 3/2022, 3 more this YTD. 11 more set to open just in H1 this year - an accelerated pace of expansion (18 expected in total for FY 3/2023).

New openings: “continue to trade very well”

Key point - getting “historically low rental levels” on “prime new locations”, “not been seen for many years”.

Net cash of £3.6m (ignoring lease liabilities) at 6 June 2022 - looks fine.

Plenty of liquidity, with undrawn bank facilities of £16m

Outlook - “We continue to be very optimistic about the significant growth opportunities”

Diary date - 21 July for FY 3/2022 results.

My opinion - this looks a strong update in tough conditions.

I see FUL’s restaurant formats as likely to continue doing well, because Franco Manca in particular offers good value for money, plus an interesting & tasty product, very fast service too. It also has grown delivery & takeaway offerings well during the pandemic, so is a better business now than it was pre-pandemic.

At the moment, stock markets seem obsessed with the cost of living issues, but at some point sentiment is likely to turn more positive towards companies which are trading well despite headwinds, and have lucrative expansion underway (prime new sites on great deals from landlords).

The trouble is, investors can see that FUL has good formats being rolled out, and that attracts a premium valuation. Even now, after a recent c.30% fall in share price, FUL still looks expensive, on c.33 times forecast earnings.

The share price has gone nowhere since it moved to AIM in late 2014, despite the business growing considerably, and not many new shares having been issued.

So it’s a tricky one. I can see that this business is likely to be maybe double the current size in 3-5 years’ time, which is appealing. It’s a roll-out of proven, differentiated brands. The product is good. Conditions are perfect for expanding into prime new sites at cheap rents. Although as the economy improves, then rent reviews could hike those rents 5 years down the line.

Overall then, I’m neutral, leaning towards being slightly positive. In a future bull market, this share could be double the current price, I reckon. But it might take several years of waiting, and tolerating a reduced price in the meantime, if markets take another plunge at some stage.

If I already held, then today's update would reassure me to continue holding.

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Marks Electrical (LON:MRK)

93.5p (up 2% at 08:25)

Market cap £98m

Annual Results

Marks Electrical Group plc ("Marks Electrical" or "the Group"), a fast growing online electrical retailer, today announces its audited results for the year ended 31 March 2022 ("the year" or "FY22").

Strong revenue growth of 44% to £80.5m

Low gross margin of 19.8% (down from 21.3% LY) - as I would expect for an online business selling other companies’ products, in a highly competitive sector.

Advertising & marketing spend has risen a lot, to 5.0% of revenues, LY 2.9%

Adj EBITDA margin has fallen from 13.7% to 9.0%

Adj EBIT (operating profit) margin down from 12.2% to 7.9%

Adjustments look reasonable, being £2.7m of IPO costs (it floated on AIM in Nov 2021)

Adj EPS is 5.0p, down 1% on LY

PER of 18.7 looks too high to me.

Cashflow looks good, mainly due to adverse working capital movements last year partially reversing this year.

Small maiden divi of 0.67p. Given the lack of capex, and a sound balance sheet, better divis should be possible in future.

Outlook - strikes me as uninspiring -

Competitor pressure has increased in FY23, coupled with a challenging market backdrop, but despite this, the business has continued its momentum, gaining market share and focusing on leveraging its cost base to maintain a strong Adjusted EBITDA margin.  
Our disciplined approach to margin management, capital allocation and cash conversion demonstrated in FY22, provides us with solid foundations to deliver our strategic objectives in FY23.  

Continued positive trading momentum in the first months of FY23, with revenue growth exceeding 20% year on year

Disciplined approach to margin management, capital allocation and cash conversion demonstrated in FY22, provides the Group with solid foundations to deliver our financial targets and strategic objectives in the year ahead

Balance sheet - it’s a capital-light model, with hardly any fixed assets.

£3.9m cash, with no interest-bearing debt.

NAV & NTAV are both £9.4m

Looks fine to me, no issues here.

My opinion - as mentioned before here, I didn’t believe that MRK’s high operating margin relative to the sector made any sense, and probably wasn’t sustainable. Today’s results confirm that, with the operating margin down from 12.2% to 7.9%. I would expect that to fall further. Larger competitors can’t achieve that margin level, so how does MRK manage it, with less buying power?

It seems to me that MRK operates a lean cost model, which might work well whilst the company is relatively small. However, as it expands, I reckon it could become less efficient, as overheads mount, warehouses get bigger, product ranges expand, etc.

There are well-known headwinds too, including staff who are probably expecting a 9% pay rise, plus distribution costs rising (fuel costs especially), and continuing supply chain problems (particularly for electrical appliances, reliant on limited supply of chips).

Combine that with little to no pricing power, as customers just compare prices online and go for the cheapest option. There’s no customer loyalty to the retailers. AO.com has proven that focusing on superior customer service doesn’t work commercially. People want the lowest price, once they’ve decided on which product they like. In 5 years’ time you won’t remember if the delivery driver was pleasant or not, you just want the product to still be working, and the price the lowest!

I’d say MRK is a much better option than AO World (LON:AO.) , if you absolutely have to own an electrical retailer. But I’d want it on a PER of 10 or less - hence for me, I wouldn’t even consider buying above 50p per share (currently 92p).

MRK seems a shrewdly managed business though, run on a shoestring. So MRK is much more appealing to me, than the delusional management at AO, thinking they could take on the world with a high cost, high service model, which is inappropriate in this sector. But the price of MRK still includes an IPO premium I think, which is likely to wear off.  I can buy great businesses like Dunelm (LON:DNLM) or B&M European Value Retail SA (LON:BME) on a PER of 10. So why pay more for this?

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Intercede (LON:IGP) (I hold)

51p (up 10% at 09:47)

Market cap £29m

Final Results

Intercede, a leading cybersecurity company specialising in digital identities, derived credentials and access control to enable digital trust in a mobile world, today announces its preliminary results for the year ended 31 March 2022.

Intercede warned on profits in April, which I covered here. Contract signing delays resulted in anticipated profits for FY 3/2022 being largely wiped out. Or hopefully deferred into the current year, possibly? It did highlight though the dependence IGP has on some big, long-term customers (especially the US Govt), and that profits are unpredictable.

On a more positive level, overheads are now largely covered by recurring, high margin revenues.

I’m frustrated that the turnaround has not yet moved on to meaningful growth.

So there’s nothing exciting in the numbers, all as expected.

Balance sheet is strong now, with plenty of cash.

Profit after tax (fine for companies with tax credits each year) was £0.7m, half the prior year's level.

A rather disappointing year has already been reflected in a share price down almost two thirds from the peak, and £29m is hardly a demanding valuation.

Today’s commentary talks a lot more about acquisitions, which has been flagged in the past. I’ve got mixed feelings about that, in particular I don’t want to be diluted when the share price is low.

Outlook -

Moving forward, the Group has a great opportunity for growth with Intercede having established a strong market position in a rapidly expanding sector. Our differentiated offering sets us apart from competitors, in addition to a quality team and a strong financial position. We look forward to the future with confidence.

My opinion - I’ve cooled somewhat on Intercede shares, because the growth needed to re-rate this share hasn’t as yet been forthcoming. Hence I’ve trimmed my position size from large to medium, and recycled some money into Beeks Financial Cloud (LON:BKS) (I hold) where rapid organic growth is happening, but it’s much more expensive. But I'm happy to continue holding a reduced position for the long-term.

I remain of the view that IGP could re-rate significantly, once the growth starts to motor, but we don’t seem to be there yet.

Costs are mainly staff at IGP, who will need bigger pay rises this year, so a headwind there, as for all IT companies. Hence growth is needed, just to stand still.

The StockRank has fallen to a low 23 now, mainly reflecting poor momentum.

The share price is almost back to where it was 3 years ago, which I think seems harsh, given a lot of operational progress, and de-risking the balance sheet. The share count has risen from 48m to c.58m, reflecting conversion of loans into shares at c.68p from memory.

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Jack's section

Nexus Infrastructure (LON:NEXS)

Share price: 185p (unchanged)

Shares in issue: 45,481,904

Market cap: £84.1m

Interim results for the six months ended 31 March 2022

Nexus focuses on multi-utility solutions for residential developers, civil engineering, and has a fast-growing energy transition division focused on things like electric vehicle charging.

• Revenue +26.1% to £80.3m,
• Operating profit -26.7% to £1.1m,
• Group order book remains strong with a 6.6% increase since the year end to £306.7m (H1 2021: £301.6m)

The interim dividend is up 66% to 1.0 pence per share ‘reflecting confidence in the second half of the year’.

TriConnex continues to grow by attracting new customers with its multi-utility networks. This division designs, installs and connects energy, water, fibre networks and electric vehicle charging infrastructure on new residential properties. Customers are a mix of large, small and mid-sized residential developers.

Revenues have risen by 2.5% to £25.0m, with operating profit also up 2.5% to £2.4m and the order book up 3.4% to £197.4m.

eSmart Networks, the energy transition business (including electric vehicle charging, industrial electrification, and renewable infrastructure), is scaling up and is seeing ‘significant growth’ in its order book. Revenues are up 208% to £8.6m, although the operating loss has grown from £0.4m to £1.1m, with the order book up 72.1% to £21m.

The loss reflects £1.4m of growth investment as this business further establishes its position in the UK's energy transition markets. Total group operating profit was lower than anticipated though, due to a low margin contract which is now complete. Gross margin was 15.9% in the period and is expected to recover to c25% in H2.

Nexus continues to look for ways to crystallise shareholder value in this part of the business, which has so far resulted in a minority investment from a third party. I wonder if management had been hoping for more interest by now?

The civil engineering business Tamdown has grown its order book but the focus now moves to protecting margins. Revenues up 26.8% to £46.7m (H1 2021: £36.8m), operating profit of £1.1m (H1 2021: £0.3m), and order book of £88.4m (H1 2021: £98.5m).

Balance sheet

Net assets have increased by 8.5% to £32.7m and cash levels are stable if down slightly (cash down from £25.6m to £23.1m and net cash down from £13.7m to £12.5m). Since the period end, Nexus has eliminated group borrowings with the sale and leaseback of its head office, which has brought in another £2.9m and increasing net cash to £13.9m. The balance sheet looks fine.

Outlook

During the first half of the financial year the Group's performance reflected strong underlying trading across all businesses. Looking ahead, although there are currently signs of significant levels of input cost inflation across the industry, the Group is committed to taking the necessary mitigating actions to protect and maintain margins.

Nexus continues to be well positioned to support established and new customers with their Net Zero plans, which is in line with our strategy of enabling the UK's energy transition by delivering sustainable infrastructure including electric vehicle charging, industrial electrification and low carbon heating sources. TriConnex continues its strong performance, eSmart Networks continues to scale up and is expected to deliver significant revenue growth and deliver profits during the second half of the year in line with management expectations. Tamdown is on track to enhance profitability over the medium term.

Conclusion

Unlike some other more speculative energy transition companies, Nexus does have a track record of profitability - although it has been struggling to make progress on this front.

That is reflected in a share price that has not done too much since listing.

Still, Nexus is positioned in some promising growth markets and appears to be more established than other more speculative energy transition plays so as a thematic pick, it has some merit. eSmart is the most interesting opportunity, but I get the feeling that its strategic review has not really taken off in the manner management had hoped.

The group's order book is ahead year-on-year and has grown over the past six months. It is confident of meeting full year expectations. A reassuring, if unexciting update then. The one negative surprise is in eSmart, with the low margin contract.

Nexus is forecast to make 9.73p of earnings this financial year, increasing moderately to 10.7p the following year, so it’s still not cheap by any stretch in my view. It does strike me as more attractive than others in what is a hyped up and speculative part of the market, but I wonder if there is still significant investment to come. That could weigh on near term profits.

It has spent a lot on capex in the past.

It’s still too early for me. There are short to medium term inflationary pressures to navigate before realising the longer term opportunity, which makes me wonder if we might see a more attractive entry point in future.

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City Pub (LON:CPC)

Share price: 95.35p (+1.98%)

Shares in issue: 103,868,430

Market cap: £99m

AGM trading update

This is an owner and operator of 42 premium pubs across Southern England and Wales.

Trading is recovering. Like-for-like sales have continued to strengthen faster than predicted, with May 2022 5% ahead of May 2019.

Two new sites opened: The Oyster House in Mumbles and The Tivoli in Cambridge, with initial trading encouraging at both sites. A new all-day concept in Bury St Edmunds, Damson and Wilde, is expected to open next week. One other site, The Nest in Bath, is anticipated to open in August. Beyond that, some existing sites have been refurbished or had their capacity increased.

Cost inflation:

We continue to seek ways of mitigating the increased cost inflation facing the wider sector and have reviewed our cost base with renewed vigour, with particular focus on labour scheduling to maximise sales and efficiency. Control of energy usage and procurement remains a key focus from both environmental and cost perspectives and we continue to evaluate our menu offering to provide best value and experience for our customers, whilst delivering great food in a cost-effective way for the Group.

So recovering trade, but increasing costs.

The Jubilee Bank Holiday weekend was particularly strong, with LFL sales up in excess of 20% versus 2019. That’s a one-off event, but it could be the foundation for a strong summer.

Executive chairman Clive Watson comments:

We continue to see our sales growth reflecting the quality of our pubs and customer offering. With a strong foundation to build on, and momentum that has been created through investment in - and opening of - our development sites, we look forward to an uninterrupted Summer's trading for the first time in two years. Despite the macro economic headwinds, recent openings, tight cost control and a low net debt position leave us well positioned to continue to develop our business both organically and through selective high-quality acquisitions during the rest of the year as opportunities arise.

Conclusion

It’s great to hear operators looking forward to their first uninterrupted summer in two years. Watson himself is an experienced hand and City is a competent outfit, but I’ve never seen particularly good value in the share price.

It remains some way below its c170p IPO level established nearly five years ago now. Back then it had 34 pubs and a market cap touching £100m. Today it has 42 sites and approximately the same market cap.

And lockdowns led to a significant amount of equity dilution (which is why the market cap is broadly the same even though the share price is down).

Pubs are a great cultural institution, but they can struggle to generate durable earnings growth. The ones that do grow tend to have a ceiling in terms of how large they can become, plus the ever present prospect of hungry and ambitious competition to contend with.

City does have a good freehold estate, which provides security and could even see a valuation uplift, but it’s not enough to tempt me as I suspect there are companies with more upside potential out there.