Small Cap Value Report (Weds 9 Sept 2020) - SOM, WIN, QUIZ

Good morning, it's Paul here with the SCVR for Weds.

I wrote yesterday's report in two parts, covering Scs (LON:SCS) (I hold) , Ten Entertainment (LON:TEG) (I hold), and Luceco (LON:LUCE) in the morning. Incidentally, I think all 3 are good investments, worthy of a closer look. I'm particularly interested in looking for companies that are securely financed, and should be able to comfortably beat broker forecasts for 2021, and then resume generous dividend payments. In particular, the broker forecasts for ScS look ridiculously low next to very strong trading reported since re-opening. We know people are spending on revamping their homes, and by my calculations, buying ScS now could lock in a future dividend yield of almost 10%, if former levels of divi payouts resume. And it's loaded up with cash, and no debt. What's not to like?!

I see Headlam (LON:HEAD) in a similar way - very securely financed, with tons of freeholds, and with trading recovering, it should be able to pay out big divis again. Why the market hasn't priced in this yet, I have no idea. Unfortunately, both ScS and HEAD can be difficult to buy, due to lack of liquidity. Hence I've only managed to take small positions so far, and am hoping they drift down again, so I can buy more.

The second part of yesterday's SCVR I wrote in the afternoon, and covered;

Alumasc (LON:ALU) - quite good, but very large pension deficit,
Flowtech Fluidpower (LON:FLO) - primed for an H2 recovery but overall it's not performed well in 7 years as a listed company,
Gaming Realms (LON:GMR) - speculative, but for me the market cap is too high, although I like the growth and impressive clients,
Michelmersh Brick Holdings (LON:MBH) - solid performance in H1 considering the covid impact, looks a decent company, priced about right in my view.

Here's the link for yesterday's full report, to get you started today.

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Today's agenda;

Somero Enterprises Inc (LON:SOM) - interim results

Wincanton (LON:WIN) - trading update

Quiz (LON:QUIZ) - Retail store portfolio & trading update

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Covid - my latest thoughts

Obviously I'm writing about this from an investment perspective, and not being a medical expert. Although as the excellent Superforecasting book points out, a diligent amateur is perfectly capable of sifting through a lot of information, and coming to sensible conclusions, if that information comes from reliable sources. Hence generally why I like to drill down to source information if possible, rather than relying on (sometimes incorrect, or sensationalised) output from journalists.

As investors we need to have some kind of view on this issue. It's a perfectly valid view to say "don't know". In fact that's the only honest view, at least in terms of timing of covid receding and then being eliminated altogether. I can't stand it when people post comments, saying with apparent complete certainty, that this or that will happen, then something else will happen. When they're actually just guessing what the future might hold! Superforecasting has taught me to be highly sceptical of all commentators who hold their own views with complete certainty (because they're so often wrong), although it's easy to slip into that myself sometimes, so I'm sure you will give me a well deserved kick if I do it too!

Positive things - these developments encourage me that investors should probably be planning for an end to covid as a major issue impacting company earnings & hence share valuations;

• Death rate is now very low, due to older/vulnerable people being better protected, and medical treatments being so much better
• The UK Government has consistently played down potential vaccines in the past, but this has changed - Matt Hancock very recently said that the Oxford Uni/Astrazeneca vaccine should be ready quite soon (probably within the typical 6-month time horizon that equity investors tend to think about when valuing shares). EDIT - although my attention is drawn to an article today, saying that a potential safety issue has caused the trials to be paused. End of edit.
• Testing - numerous tests seem to be under development, with talk of some giving results very quickly. Once manufactured in large quantities, this opens up the potential for mass testing at events or travel hubs, so that people can once again safely travel or go to gigs/sporting events, comfortable that everybody there has just tested negatively. This clearly needs tests to be highly accurate. People are itching to go back to normal, and this could be the key to making that happen.

Negative things - is just one issue really - that covid keeps popping up again when restrictions are eased. The blame seems to be being put on young people partying & ignoring social distancing rules. I've seen this widely, in Bournemouth, with drunk youngsters hugging & kissing, completely ignoring social distancing rules in pubs & on the street. There again, I don't think it's fair to demonise all young people, as many are being very sensible & thoughtful. My niece visited recently, and was extremely concerned about possibly being an asymptomatic carrier, and she didn't want to go into Granny's flat Instead we had a Pimms on the lawn outside! So I do think there are plenty of very thoughtful young people, who should be praised & thanked for their actions.

The BBC is reporting that the Govt is due to make an announcement later today, to apparently impose much tighter restrictions on gatherings in England from 14 Sept, limiting them to 6 people. That makes me wonder how bars & restaurants can continue trading, and what the logic is for allowing that, but not other gatherings?

Picking our spot - probably the most important point. We now have detailed knowledge of how much covid has impacted different sectors & companies. So, if you're terrified of a second wave, and sceptical about vaccines and mass testing happening any time soon, then just don't buy any shares in non-food retail, hospitality, travel, or anything else that has been badly affected by covid.

If, like me, you think covid could be under control within the next 6 months, then these sectors might provide some interesting upside. I highlighted Ten Entertainment (LON:TEG) yesterday, which said it's already reached breakeven since re-opening. Providing there is no major, national lockdown again, then it should be fine. The shares are still bombed out, with potentially good upside once covid has gone.

There are many other companies reporting now, which have survived H1 2020 remarkably well. I'm finding such companies almost every day, and reporting on them here. Although it's vital they disclose how much benefit in £ terms they received from furlough, and other schemes. We need full disclosure of this information. Also bear in mind that restraining discretionary spending (like bonuses, marketing, etc) is only temporary. So costs are likely to rise again, and that means companies will need to increase sales a lot, in order to cover future increased costs.

I reserve the right to change my mind on all of the above, if circumstances change.

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Somero Enterprises Inc (LON:SOM)

Share price: 240p (up 16% at 08:43)
No. shares: 56.4m
Market cap: £135.4m

(I hold)

Interim Results

The market clearly likes these figures, as SOM shares are up 16% at the time of writing.

It's a USA-headquartered maker of laser-guided concrete laying & levelling equipment which has been listed on the UK stock market since 2006.

H1 figures are much better than I was expecting.

Checking my notes to see what SOM said previously;

5 June 2020 trading update (my notes here) - said revenues are 25% below original expectations for the year, due to covid impact. $5m in annualised cost savings made. Remains profitable & cash generative, but no figures given.

14 July 2020 trading update (my notes here) - reiterates that revenues 25% below full year expectations, which implies $67.5m. No guidance given.

Hence there was a bit of an information vacuum until this morning.

H1 figures - key numbers;

H1 revenue $35.3m, only down 9% - this is much better than I expected, as previously they said full year revenues would be down 25%, thus implying H1 would be worse than this, and H2 recovering from covid. So -9% in H1 is really very positive (EDIT: note that H1 figures last year were soft due to bad weather)

Full year guidance has risen from $67.5m when last reported on 14 July, to $75m guided today for revenues. That implies only a 12% uplift from H1 to H2 in revenues, which seems very modest considering the H1 covid disruption. What's the betting that this latest guidance is too cautious? That looks a strong probability to me.

Profitability - I don't like EBITDA, and have no idea why the company gives prominence to this, but it's $8.7m in H1 2020 (LY: $11.2m). That's a very good performance during covid.

Real profit before tax in H1 is $7,465k (LY H1: $10,454k) - a very creditable performance.

Balance sheet - is great, very strong. It includes $28.9m net cash. Note how SOM piles up cash from its operations, and pays it out in divis, including special divis sometimes.

Dividends - a strong message here, very strong actually. The previously deferred dividend of 20.7 US cents is now being paid after all. Plus a 4 US cents interim divi. And a $1m share buyback will recommence. That's a total of $15m being paid out in divis/buybacks. Clearly management is very confident, so the outlook must be good.

Full year guidance is now reinstated - revenues of $75m, adj EBITDA of $19m, net cash of $20m (after paying out divis/buyback) - again this shows confidence, as this management tend to be cautious. I reckon they'll probably beat those numbers.

Broker forecast - many thanks to Finncap for resuming forecast for FY 12/2020, which is based on the guidance from SOM, which is probably conservative. This is for 23.8 US cents EPS, or 18.4p - personally, I'm not valuing shares on 2020 earnings, as it's been an aberration of a year.

My opinion - I think SOM should get back to say 30-40 US cents EPS in 2021, which is 23-31p range. As a cash generative business with a strong balance sheet, I think a PER of 20 is justified, so to me this share is worth 460-620p. That's way above the current price of 250p, hence I think this looks a good buying opportunity.

The only flaw in my argument is that SOM has historically been valued by the market on a low PER, of only about 13 typically (from memory). I think that's crazy, this is a really good quality company, and in a permanently low interest rates environment, it should be re-rated towards a PER of 20 in my opinion. The narrative also provides clues about expansion in the pipeline - e.g. new product lines which are broadening the total market, and already contributing to sales. Plus the enlarged headquarters facility is increasing capacity considerably. So the market might wake up to the growth potential here at some point, and re-rate it.

It's just proven highly resilient during the covid crisis, which suggests to me that not only is the company well-run, but also that its products have remained in demand, despite all the disruption. That's telling me that growth is likely now that things are settling down at least somewhat. It also tells me that the cyclicality is nowhere near as bad as investors seem to think. Another reason why it deserves to re-rate. Investors seemed to fixate on the savage drop in business in 2008-9, and see this as a constant risk. Whereas in reality, I think that was a one-off, when credit was withdrawn as banks imploded. This is not likely to happen again, because policymakers now know to flood the system with liquidity to prevent it happening again. Which is precisely what they have done in 2020 in response to covid. That is the new normal, so why discount SOM for a threat that isn't likely to happen again?

Overall, this share looks terrific value to me, taking a long-term view. It's rare to find such a quality company at such a modest price. So an unequivocal thumbs up from me. As usual, please do your own research, as I might have missed something.

Results webinar is on Monday coming, 14 Sept 2020 at 3:30 pm. Signup link here, with our friends at PIWorld. Tamzin is such a class act, superb at hosting & interviewing management teams - professional, unflappable, and very knowledgeable, being an accomplished investor herself.

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Wincanton (LON:WIN)

Share price: 200p (up 11% at 10:44)
No. shares: 124.5m
Market cap: £249.0m

Trading Update

Wincanton plc, the largest British third-party logistics company, today announces an update on its trading performance in the period since its AGM Trading Update on 22 July 2020.

Today we get a positive update, concluding;

Given the combination of Wincanton's improved trading performance, cost intervention measures and the recovering economy, the Board expects results for the current year to be materially ahead of market expectations. This continues to assume no further COVID-19 impact that severely affects the business.

Materially usually means at least 10%.

For context it's worth a recap on my notes from the last, positive update on 22 July 2020 here. That was "significantly ahead", although forecasts had been reduced far too much beforehand.

Balance sheet - this is the main weakness of this share, it has a terrible balance sheet. Management repeatedly state that their balance sheet is strong. IT ISN'T, it's EXTREMELY WEAK. That's why the PER is low. I explain the balance sheet problems here.

Management continue to pretend that the balance sheet is strong, when anyone numerate can see that it very patently is not;

The balance sheet remains healthy, with strong cash collection and a robust working capital position.

What they should say, is that the balance sheet is weak, but that doesn't matter because they operate with negative working capital - i.e. customers pay up-front. That is the truth. It really puts me off this share, that management are trying to pull the wool over our eyes on this issue.

The auditors agreed with me - there was a "material uncertainty" going concern note in the last published accounts. Even if that issue is since resolved, its not what happens at companies with a "healthy" balance sheet, is it? This is fair comment, backed up by facts.

Everything else in this update today sounds very positive, including;

The Group has seen a continued improvement in profitability in July and August, with a particularly strong performance in Digital and eFulfilment.... Performance across the rest of the Group is encouraging, supported by changes to the cost base implemented earlier in the year in the face of challenging external conditions.

There's no doubt this is an excellent business, just with a ropey balance sheet. It's up to investors to decide what importance you attach to that issue. But do bear in mind the pension scheme is sucking out a massive £17.8m p.a. in deficit recovery payments, and the deficit is (bizarrely) shown as an asset on the balance sheet.

My opinion - the company is doing well, but the balance sheet is a deal-breaker for me, mainly because so much cash is being consumed by servicing the pension fund deficit. Zero interest rates forever probably means that deficit is not likely to go away for some time. This share might go up because buyers of the shares may not be aware of the balance sheet problems, who knows?

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Quiz (LON:QUIZ)

Share price: 8.0p (up 7% at 11:55)
No. shares: 124.2m
Market cap: £9.9m

Retail store portfolio & trading update

QUIZ, the omni-channel fashion brand, announces an update on its retail store portfolio and current trading during the period between 1 April 2020 to 31 August 2020 ("the Period").

This is a complicated special situation, which requires knowledge of how pre-pack administrations work, to form an informed view. Can I just ask that readers first recap on my explanation of this here on 14 Aug 2020, to save me having to recap the basics.

By way of background, I was seconded to the corporate restructuring & insolvency dept of PWC for much of 1990-93 in a junior role, but then later in 2001-2 I played a key role with my CEO, buying out a retail chain (about 20 shops) of administration. So I've got some relevant experience in this area.

The short version is that a pre-pack administration involves the operating business being put into an insolvency process which ultimately becomes a liquidation some time later. Unsecured creditors usually receive little to nothing. The assets only of the operating business are immediately sold to the (usually) previous owner, at a knockdown price, and the liabilities such as lease commitments, and trade creditors become bad debts. Special rules apply to employees (TUPE) and preferential creditors.

The phoenix company then has a flying start, because it only takes on the profitable shops, and is able to renegotiate all the leases from scratch. Thus greatly reducing rent payments, and turning a loss-making, failed company into a profitable company with fewer stores. Also, the inventories are bought for pence in the pound, and suppliers find that retention of title claims are difficult to prove and action, and often too late (the stock has been sold by the time it is established who owned it).

Quiz was not viable as it stood, due to covid and other factors, so management did a pre-pack admin. This should be seen as a new business, re-starting from just the locations it wants, with each site renegotiated with the landlord, plus of course no business rates at the moment. This should result in a decently profitable business, with a competitive advantage (lower rents).

What does it say today?

Cash - this is the most important point, by far. My main worry is that QUIZ could run out of cash. When last reported, net cash on 13 Aug 2020 was £5.7m. Today it says that yesterday 8 Sept 2020, it had £6.1m "cash available", and an undrawn £3.5m short term bank facility due to expire on 31 Oct 2020, which it intends to renew. So cash has actually gone up a little in the last month or so, and is about two thirds of the market cap.

Admittedly, we can't make full sense of this without seeing other current assets & liabilities, but it's a strong indicator that the business is not apparently in any danger of going bust.

Sales figures - these are massively down, but as mentioned above, this is a closure & re-start situation. Therefore I would expect the short term figures to look awful. They won't have been paying rent or rates on a lot of sites since re-opening and re-negotiating, hence why the short term numbers don't matter that much, and hence why cash has gone up, not down.

Also bear in mind that QUIZ's niche is special occasion wear (weddings, events), which is the worst place to be right now. Although those things are likely to come back in due course.

So terrible sales figures and gross margins down 600bps due to discounting.

Current trading - in a pre-pack admin, it's all about getting the business back on track, and you expect to see dire sales figures in the transitional period. I'm pleased to see the online offering is getting back on track after a very poorphase;

Sales have steadily improved in the Period with August revenues being 11% lower than the previous year which reflected the benefit of increasing the ranges of casual product.

I recently tested out the Quiz menswear product, and was generally pleased. Although the website does not seem to be able to distinguish between male & female customers. So I was slightly irritated but also saw the funny side of an email from Quiz which congratulated me for being a "Quiz Queen" after I signed up for unlimited annual free deliveries (no sniggering at the back please!)

My blue floral shirt from Quiz was a great success - even the cabin crew admired it as I boarded my recent flight from Warsaw to London.

Stores have mostly re-opened (on cheaper rents remember);

Whilst sales generated in UK standalone stores and concessions remain below levels generated in the previous year, the Group is encouraged by the consistent improvement in like-for-like sales in recent weeks.

My opinion - there's a lot more detail in the update today, which you can read for yourself if interested.

This is the most important thing, and it confirms that most sites are now on short leases, with turnover rents. This means they should all be profitable. Loss-making sites have been jettisoned. This is what matters;

Prior to the Restructuring, the Group operated 75 standalone stores in the United Kingdom. As at 9 September 2020, the Group has so far reopened 48 stores and anticipates reopening a total of approximately 60 stores in the United Kingdom.

Rental terms for the reopened stores are consistent with those targeted by the Group.

They provide a flexible cost base going forward with rents payable predominantly based upon revenues generated rather than previous higher fixed rental arrangements. The average lease length on these stores is 24 months.

This should provide the basis for a profitable business going forwards. Time will tell.

EDIT - so what is QUIZ worth then? That's the tricky bit, nobody knows. It's run by experienced rag traders, and the founders seem to own about half the business, so they must be reputation-bound to turn things around, having bagged close to £100m in the IPO a few years ago. The pre-pack means that the liabilities are gone, and the rents are now cheap turnover rents. It should turn into a nicely profitable business - that's what happened last time.

Being devil's advocate here, the downside risks to me seem these;

They completely lose the plot in terms of product (I did look at the website recently, and ask myself, who is the customer?

Management/family decide to shaft external shareholders, and buy it back for tuppence ha'penny. I'd be really surprised and disgusted if this were to happen. In this sector people put a lot emphasis on reputation, relationships & trustworthiness. I've seen situations where retailers that go bust do deals with suppliers to quietly pay 50p per garment post-administration, to make it up to longstanding suppliers. I met the management of QUIZ when it did the IPO, and I hope they will do the right thing.

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Time for a rest now, I'll look at ANP tomorrow.

Best wishes, Paul.