Small Cap Value Report (Wed 18 July 2018) - MPAC, CALL, HEAD, RDL

Good morning!

Today we have in line with expectations updates from Hotel Chocolat (LON:HOTC), Premier Foods (LON:PFD), DX (Group) (LON:DX.), Strix (LON:KETL), Bloomsbury Publishing (LON:BMY) and Team17 (LON:TM17).

So I intend to focus on MPAC (LON:MPAC), which issued a profit warning, and on Headlam (LON:HEAD). Paul has also written a section on Cloudcall (LON:CALL).

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MPAC (LON:MPAC)

• Share price: 145p (-34%)
• No. of shares: 20 million
• Market cap: £29 million
  

Half-Year Trading Update

I have previously described this as "a pension fund with a small operating business attached".

It traded under the name "Molins" and was traditionally associated with the tobacco industry, but sold its tobacco division in August last year.

What is left is a packaging machinery business focused on the pharma, healthcare and food & beverage markets.

Today's news

"...the business climate has softened considerably as the year progressed, attributable in part to general economic as well as Brexit related uncertainty, leading to customers deferring machinery investment decisions. The Board believes these contracts will be delivered in future financial years."

Many small-cap investors will be familiar with this type of profit warning. Decisions on contracts get delayed sometimes, it goes with the territory.

It's still a disappointment of course. A longer sales cycle ultimately means lower earnings for MPAC and makes it a less valuable company.

Blaming economic and Brexit-related uncertainty is a bit harder to stomach. Given how many companies have reported that H1 was in line with expectations, it suggests that most companies are not finding conditions as difficult as MPAC is.

The UK manufacturing PMI has been softer than it was last year, but it remains north of 50. This means that most manufacturing companies are continuing to report an improvement in conditions.

Source: TradingEconomics.com

The final point I would make is that only 14% of MPAC's sales are to UK-based customers (according to the 2017 annual report), while 24% are to Europe (excluding the UK). Most of the company's sales are to either the Americas or to Asia Pacific. The US economy is extremely strong right now.

So while I accept that capex spending is cyclical, I think we need to take the idea of "economic uncertainty" being to blame for this profit warning with a large grain of salt.

Alternative explanations might be that the packaging niche in which MPAC operates is struggling, or that specific problems at MPAC are causing it to struggle.

The next named problem in today's announcement is much more tangible. Two legacy projects are running late and their cost overruns are eating into MPAC's profits for the current year.

Again, this is standard fare: contracts which don't work out as planned. This is why contract-driven businesses need to be on modest valuations. We need to allow for the occasional mishap!

Updated numbers

Revenue will be in line with expectations, but "the closing order book will be lower as a result of market softening and profits are currently expected to be around £1.2m below current market expectations."

Equity Development have cut their 2018 EBIT forecast for MPAC by £1.3 million to £1.5 million. Their note is available online.

My view

There are two elephants in the room with MPAC.

The first is the cash pile. This is forecast to end 2018 at £24 million.

Normally, if I saw a profitable company with £24 million of cash and a £29 million market cap, I would want to buy the stock.

But the other elephant in the room is much larger. It's a £400 million UK pension scheme.

The accountants valued this scheme at December 2017 as follows:

• Assets £415 million
• Liabilities £397 million
• Net surplus £18 million

The actuaries valued the scheme at June 2015 as follows:

• Deficit of £70 million (funding level of 83%)

An updated actuarial view on this would be helpful. The June 2018 valuation will be completed in H2 2019.

I was tempted to buy MPAC shares when I saw the announcement first thing this morning, but I had to remind myself that it's largely a bet on the performance of the pension fund. Marginal variations in the long-term value of its assets or liabilities will have a bigger effect on shareholders than marginal variations in the performance of its packaging business.

In general, pension funds benefit from higher interest rates (it means that future liabilities are worth less today, and that the future return on pension fund assets will be higher).

UK rates have not improved since June 2015. So that is one reason for caution in relation to the next actuarial valuation.

If I expected that UK rates would have a substantial increase, or had some other reason to expect the actuarial deficit to go away, then I would be a lot more interested in these shares.

Example calculation: If you add the together MPAC's latest market cap, the £70 million  UK pension deficit from 2015, and subtract the £24 million of forecast year-end cash pile, you get an enterprise value of £75 million.

Based on payments made into the UK pension fund since 2015, we might reduce our estimate of MPAC's enterprise value to £65 million. That's the implied market estimate (using 2015 pension assumptions) for the value of the operating business.

If MPAC achieves its EBIT forecast of c. £3 million next year, that's not terrible value. But it's not a screaming buy either. And we are also punting on the pension fund.

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The next section is written by Paul Scott, who owns CALL shares.

Cloudcall (LON:CALL)

• Share price: 134.5p (+2%)
• No. of shares: 24 million
• Market cap: £32 million

Half-year trading update

Somewhat belatedly, here are my comments, in response to reader requests above, on the Cloudcall (LON:CALL) trading update yesterday. I hold a long position in CALL shares.

Firstly, it was clearly a profit warning, but a fairly mild one. The 2 brokers which report on CALL (both make their research available to subscribers of Research Tree) both put out updates, reducing 2018 revenue forecasts from c.£9.5m to c.£9.0m. 

One broker reduces its 2018 EBITDA loss from £2.4m to £3.1m, and the other reduces from a £1.9m EBITDA loss, to a £2.9m loss, so quite a significant drop in forecasts at the EBITDA level.

What's gone wrong? The company says it's all down to timing of recruiting & training new sales people, which has taken longer than expected. It says there's not a problem with customer demand, they just didn't have the internal resource to bolt on new customers at the pace required.

The brokers clearly believe that explanation, as they have not reduced revenues forecasts for 2019. The company also talks about expecting a strong H2 in 2018, as the new recruits kick in.

If it all pans out as the company suggests, then the current share price weakness should prove temporary. The trouble is that the company has proven somewhat accident-prone in the past (repeatedly missing targets, especially on cash burn), so investors are wise to take the company's outlook comments with a degree of scepticism. That doesn't make it a bad company, but I'm just pointing out that it tends to be overly optimistic, and then disappoints a bit. But that's within an overall picture of strongly growing revenues (which have risen organically from £3.3m just 3 years ago, to forecast c.£9m this year - that's very impressive growth).

Organic growth - is still very impressive, as noted above. The market tends to put a significant premium on the price of any company delivering over, say 20% organic growth at the top line. CALL is still well above that, at +31% Y-on-Y revenues growth in H1 of 2018. That's still a very impressive growth rate, albeit below the previous forecast of c.39%. I don't think the company should be punished too hard for this.

I like to look at not just year-on-year growth, but also sequential half year growth. This has been;

H1 2017  £3.2m

H2 2017  £3.7m (up 15.6% on previous half year)

H1 2018  £4.1m  (up 10.8% on previous half year)

So there's been a slowing there, but still good growth.

Note also that the company has sticky, recurring revenues - because its product is excellent (I use it myself). Cashflow is hence highly predictable, with customer receipts coming in regular as clockwork each month. Customer retention levels are high, because people find the product so useful. That's key for building a SaaS business. Gross margins are also very high - again a key point.

Will it need more cash? Almost certainly, yes in my view. Does that matter? Not at all, in my view. There is no reason for shareholders to worry about another fundraising, because the company is well beyond the blue sky stage, when fundraisings are uncertain & can be done at deep discounts if investors are nervous. CloudCall's business model is now proven, and if it needs say another £3m to push it over the line into profitability, then that would only be about 10% dilution, and I reckon Instis would be queuing up to participate.

Evidence for this is that the last placing raised £5.7m in late 2017, and was priced at 143.5p, only a 5.3% discount to the then share price of 151.5p.

The only circumstances in which CALL would struggle to raise more equity, would be if the whole market turns bearish, and/or if CALL's revenue growth grinds to a halt. If that happens, then we'd be looking at a much lower share price, for sure. But that hasn't happened, hence why I think worries about another placing are wide of the mark. It's not a worry to me at all, for the reasons given.

Note that the company has a track record of repeatedly stating that it will not need to raise more cash, and then going on to raise more cash! So the reassurances given in the latest update that it has adequate cash resources, and worthless in my view, given the history. But it doesn't actually matter either way.

Is this a buying opportunity? That's obviously up to each individual to decide for themselves. I see this as a "good" profit warning - i.e. temporary, fixable problems, with the business model & growth story intact, just slightly blunted in H1.

The share price recently peaked at 193p. So being able to buy at 135p today, seems an attractive proposition to me. I can understand emotions kicking in, and some investors' patience wearing thin, but taking a longer term view, this share could be worth substantially more, once you factor in a few more years' strong growth, and the eventual move into profit.

Tech shares like this are not really valued on profits at the moment. The market is instead placing more emphasis on growth, with strong organic growth (combined with lots of operational gearing here, from high gross margin) should attract a premium rating.

There are plenty of private equity buyers around, willing to pay eye-watering valuations for growth tech companies. I would welcome a takeover bid for CloudCall, providing the premium is sufficiently large. It doesn't sit well in the stock market, where people are too focused on short term performance. Whereas, the better option for a growth company is to set aside short term profitability, and instead "go for it" in terms of growth, which might mean incurring heavy losses in the short term.

For stock market investors, CloudCall has been frustrating, in that the runway to profitability seems to be extended each year, by a year! The company is increasing its costs to take advantage of growth potential (and extending the features of its product), but with the time-lag inherent with that type of spending, it results in administrative costs relentlessly increasing, and absorbing the benefits of increased sales/gross margin. Hence why I don't think CALL should be listed on the stock market - it would be better off as a private company, and able to press on with faster, but more cash-consuming growth in the short term.

Overall, I think that for investors who are prepared to be patient, then we should do well out of this one in the long-term. The current market cap is extremely low for a SaaS business that's not far off profitability. Just look at the valuation of LoopUp (LON:LOOP) to see what can be achieved in this sector.

Regards, Paul.

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Next section written by Graham.

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Headlam (LON:HEAD)

• Share price: 456.25p (-1%)
• No. of shares: 84.3 million
• Market cap: £385 million

Pre-close trading update

This is an H1 update for "Europe's largest distributor of floorcoverings".

Paul last covered it in May (link), when the company issued what he described as a "mild profit warning".

This also feels like a mild warning. Note the phrasing used:

Subject to no further downturn in market conditions and the Company experiencing the usual weighting of trading to the traditionally stronger second half of the year, the Board is currently confident of delivering expectations for 2018.

It's similar phrasing compared to what the company said in May.

Like-for-like (LfL) UK revenue is down 5.5% in H1. This is a small improvement compared to the 6.3% reduction reported for the first four months of the year.

It's crucial to focus on LFLs, as Headlam has made three acquisitions so far in 2018. These are described as "infill acquisitions", i.e. not too big.

My view

This is another cheap stock in the household goods / retail sector. There are quite a few of these knocking about at the minute.

Checking the archives, I see that I wrote positively about it last August, with the share price at 575p.

I gave it points then for the clarity of its presentations, its long-running dividend track record, and its lack of acquisition activity.

However, since then, it has been surprisingly active in acquisitions. In December 2017, it purchased a Dutch company for up to £35 million, to diversify into ceramics and broaden its capabilities in other types of hard surface.

This reduces my interest in the stock, as I like to keep things simple by looking for companies with organic growth, whenever possible. Or if there is no organic growth, then I want a cheap valuation. I don't want growth by acquisition instead.

Other aspects of the stock remain attractive. It qualifies for the Stocko screens "Best Dividends" and "Dividend Achievers". Cash generation has typically been excellent.

This has been a rare example of a distribution company that has succeeded, for reasons Paul may have figured out back in March (in a nutshell, that independent retailers don't have the space to store all of the floorcoverings needed for customer orders).

So I retain a positive overall view of Headlam.

I wonder if it's really wise to go hunting for acquisitions, though, when business is tough? I know from my own career experience that acquisitions are incredibly distracting, and take up a great deal of management time. I'd worry that management may have too much on their plate, dealing with a tough environment and also trying to bed in a bunch of subsidiaries.

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Ranger Direct Lending Fund (LON:RDL)

Please note that I currently own RDL shares.

Holding(s) in Company - this is a stock I classify within the "fixed income" part of my portfolio, as it is mostly invested in loan assets and is not using much leverage.

It's a special situation as the fund is headed for wind-down after a shareholder activist battle won by Oaktree (the firm created by Howard Marks) and LIM Advisors.

There was a little bit of news yesterday I thought I would mention: LIM has increased its stake from 10% to 12%. 

LIM now has Board representation, and I take it as a positive sign that it is increasing its stake. I reckon that LIM is probably more knowledgeable when it comes to RDL than whoever is selling. We shall see!

I think the NAV is at least 871p at latest exchange rates, using end of April data. I am looking for this discount to close, for the bulk of fund assets to generate a reasonable return until they mature, and for wind-down expenses to be low.

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Calling it a day there. Cheers!

Graham