Weekly Commentary 17/05/21: Aaaaaaaaaaaark

Markets sold off last week, with the FTSE 100 down -2.3%, S&P 500 -2.8% and Nasdaq 100 -4.5%. The best performing index was Brazil’s Bovespa, which was still up less than 1%. Despite the sell-off being attributed to inflation, the UK 10Y bond yield at 0.86% and US 10Y bond yield at 1.64% remained steady. Similarly, the Brent Crude composite oil price was actually down -2% to $66, even with rising tensions in the Middle East.

Cathie Wood’s Ark Innovation ETF is down -36% in the last 3 months. The concern is not the concentrated holdings in the likes of Tesla (10.3%) Teladoc (6.2%) Roku (5.6%) Square (4.5%). I, and probably most other amateurs, run a portfolio with much higher concentration. Tesla might be overvalued, but the stock is liquid and she’ll be able to sell if she has to. Instead, the risk is that there’s a long tail of illiquid stocks; for instance, the WSJ mentions Intellia Therapeutics which ARKK funds own 16.5%.

That risk is similar to what happened to Neil Woodford. Ostensibly ETFs are a better structure than Open Ended Investment Companies (OIECs) that Woodford managed. ETF promoters point to the arbitrage mechanism that allows market makers (Authorised Participants) to create and redeem shares in the ETF, to mirror inflows and outflows into the fund. However, I’m not convinced by this argument because an OEIC fund manager also creates and redeems new shares in their OEIC, and this didn’t help Neil Woodford when his outflows became too large. Last week, some of ARKK’s smaller holdings fell steeply following disappointing Q1 earnings, for example, 10x Genomics -21% and Fastly -27% (hat tip to Rhomboid on Twitter).

A few years ago I came across an academic article – Inefficiencies in the Pricing of Exchange-Traded Funds – arguing that there were hidden costs in ETFs. The headline charges might be lower than traditional OIECs, but ETF prices could deviate significantly from the value of the underlying holdings. This made sense to me, because I’d long wondered why investment banks are so keen to promote ETFs, despite their lower headline costs. It’s similar to “commission-free” foreign exchange at the airport, which profits from wide bid-offer spreads.

Cathie Wood said last week that some of the market opportunities she sees are “pretty incredible”. She also believes that rather than the expensive tech stocks that she holds in her fund, it is the commodities sector that is due a sell-off. In early March I suggested that when the tech sell-off came, all the hot money that had flowed into ARKK was not going to sit in a bank earning 0.1%. Instead, it was far more likely we would see sector rotation into beaten-up sectors like banks, emerging markets and commodities. As ARKK sells off, those sectors are rallying (LLOY and BARC are both up >20% in the last 3 months).

Meanwhile Scotland’s own version of ARKK, Baillie Gifford’s SMIT has also fallen through its 200-day moving average. At least Scottish Mortgage is a closed-end fund, so the fund managers shouldn’t be faced with forced selling in the face of outflows. James Anderson, previously the fund manager, announced that he would resign from running the fund in March. He may have timed the market perfectly.

This week I look at Hotel Chocolat, ULS Technology, Air Partner and Medica, who all reported last week. There seems to be a trend of companies declaring that they are ahead of expectations, without actually ever telling investors those expectations. I think it’s fine if management don’t want to be a hostage to fortune and give guidance; some of the biggest companies in the world refuse to do this, including Berkshire Hathaway and HSBC. At the same time though, there’s no point telling investors you’re ahead, if you’ve never committed publicly to a number. Imagine if darts players were allowed to keep score in their own head, without actually having numbers on the dartboard.

Hotel Chocolat Trading Update FY end June

This chocolate retailer announced that trading for the Full Year ending 27 June 2021 should be significantly ahead of expectations, though they don’t give any numbers. The forecasts tab on SharePad showed £148m of FY 2021F revenue, PBT of £4.2m and 2.8p of EPS. The FY2021F revenue forecast has now been raised +6% to £157, and PBT +33% to £5.6m and EPS +21% to 3.4p.

This year has been rather difficult for the chocolate retailer to make comparisons; both last year and this year have included lockdowns of different lengths, and this year they were online only for both Mother’s Day and Easter. I was surprised that the company would release a Trading Update which only covers 8 weeks to 25 April, but chocolate sales are highly seasonal. Many of the customers would be buying as a gift, and the period includes Mother’s Day and Easter, so the second largest seasonal peak (presumably after Christmas). Group revenue is +60% on the prior year, and also +19% vs 2019 when all physical retail stores were open. Management say that since they were allowed to re-open physical locations in England on 12th April, sales across all channels have been encouraging. They have 126 stores in total. Richard covered it in November last year, including trying the product.

History Founded by Angus Thirwell (current Chief Exec) and Peter Harris in 1993 they have traded under the Hotel Chocolat brand since 2003. They started out originally as Choc Express, selling chocolates to the corporate market, and then online.

Then in 2004 they opened their first shop in North London, and they now sell through a network of locations in the UK (98% of sales) and a couple of outlets in Japan and USA, plus they’ve also expanded the online business. It’s interesting to see a company that started online rolling out physical locations; most retailers are going in the opposite direction. The Group also has an organic cacao farm and hotel in Saint Lucia. In 2016 they listed on AIM at 148p valuing the company at £167m market cap. The company only raised £9m of new money but selling shareholders received £43m.

Financials The company reported a gross margin of 61%. Net cash was £47.6m, and in 2020 they had access to £35m of the Government’s CLBILs revolving credit facility. At H1 to 27 Dec there were some large movements in working capital, trade receivables falling by £12.6m and payables increasing by £23.8m. This meant that while PBT for H1 was £15m, cashflows from operating activities were actually £34m. The cash position was also helped by a £22m placing which they did in March last year at 225p. The two co-founders both supported the placing, taking £2m worth of shares each.

Broker forecasts Liberum are the broker, and I can’t get hold of their note. However, SharePad shows updated forecasts with +10% revenue growth in both 2022F and 2023F. This gives a PER ratio of 50x in June 2022F and 32x June 2023F.

Ownership The two co-founders, Angus Thirlwell and Peter Harris, both still own 29.7% each, so 60% of the shares are not in public hands. Aberdeen, (or should that be Abrdn?) own 6.95%, Capital 5.4%, Threadneedle 4.3%. I would imagine that these institutions would have been happy to take larger stakes, but it wasn’t possible due to the lack of free float.

Opinion This looks like a great entrepreneurial success story, in some ways similar to FeverTree, but without the geographic expansion. I like that the founders are still involved and own large stakes. My one concern would be valuation. SharePad shows a 2023F of 32x 2023F and 42x 2023F Price to free cashflow. Pre-Covid ROCE averaged 31% between 2017-2019, but had been trending down even before the virus. The other risk/opportunity is international expansion. If management can get this right then the shares could be an attractive long-term story, but growing the brand outside the UK is not without risk. That said, this looks like a very capable management team, so my money would be on them making it work.

ULS Technology Trading Update FY end March

ULS Technology, the mortgage conveyancing platform that made a large disposal last year and appointed a new Chief Exec announced revenues down -18% to £16.9m for FY to March 2021. They expect to make an underlying pre-tax loss of £0.8m (v £2.4m FY 2020) and a large gain from the sale of Conveyancing Alliance Ltd (CAL) for £27.3m. Again management claimed they were ahead of expectations, without revealing what those expectations were. The share price reaction down -2.5% following the results suggests otherwise.

Digital Move The company is attempting to broaden its offering from conveyancing comparison site to Digital Move, which saves time by connecting everyone (home buyer, broker, estate agent, conveyancer) in the home buying process and allows them to share documents on a secure platform. With the shift to the new platform, losing a couple of large contracts and the disposal of its non-core business (CAL), revenue has fallen from £30m FY Mar 2019 to £16.9m FY Mar 2021. The investment case is that when their new platform becomes more widely adopted then revenue should recover. By the end of the FY reporting period, over 40,000 instructions had gone through DigitalMove. I think that this means that 30,000 cases went through FY 2021, because 10,000 cases went through last year.

Forecasts I have forecasts from 6 months ago which showed revenue growth of +22% this year as DigitalMove was supposed to gain traction. The idea is that DigitalMove has much greater potential than the previous conveyancing comparison site, but in the meantime there will be a temporary dip in revenue. There are no forecasts on SharePad at the moment, but with £24m of cash (40% of the market cap) this looks a nice combination of defensive and growth potential.

Ownership Kestrel Partners, the tech specialists who had a lot of success investing in GB Group, own 28%. Schroders 10.6%, River and Mercantile 8.7%, Unicorn 7.9%, Herald 6.8%, Gresham House 6.5%.

Opinion It will be interesting to see the new Chief Exec, who arrived at the start of the year, present the investment case. If this works, it could be an attractive “network effects” business, which improves as more users join the platform. The housing market has undoubtedly benefitted from the stamp duty holiday, which has likely brought forward activity. We might see things slowing down in the second half of the year, which might prove to be a short-term headwind over the next 6-18 months? Longer term, I like the story and own the stock.

AirPartner FY to 31 Jan 2021 results

This LSE-listed air charter business, founded in 1961, reported revenue +6.7% to £71.2m, gross PBT +33% to £44m and statutory PBT up 8x to £8.4m. In June last year the company did a placing at 75p per share (less than a 2% discount to the market price at the time), raising £7.5m gross to help navigate the effects of Covid on air travel and pay down debt on an acquisition (Redline which does airport security training). The company had £9.9m of net cash at the end of January (plus a further £18m of customer “JetCard” cash, which doesn’t belong to the company, because it’s prepayment for future services). The company is paying a 2.4p FY dividend, and is targeting dividend cover of between 3.0-3.5x.

Last year there was huge variation between PBT in H1 which was £8.9m helped by emergency repatriation business and H2 which was a £500K loss, caused by global travel restrictions.

Accounting The company has had accounting problems in the past. In April 2018 they announced that they would restate receivables and deferred income from previous results between 2011 and 2018, cumulatively £4m. In this year’s Annual Report, management don’t show a full cashflow statement, instead starting with “cash generated from operations” of £19m vs Profit After Tax of £5.6m. Readers need to go digging to Note 33 to find a reconciliation for the two figures, and there’s a large change in receivables of £9.9m, which has benefitted working capital.

I also did the Steve Clapham trick of searching for i) related party transactions: (£7m owed by subsidiaries and £6m owed to subsidiaries); ii) contingent liabilities: the company’s bank hold a free and floating charge over the company’s assets from a Revolving Credit Facility. However given the company has net cash of £9.9m this shouldn’t be a concern, in my view; iii) Key Audit Matters: there is a French Tax investigation by the French VAT man. The company has already provided £300K for this, but there’s inherent uncertainty about what the company might owe.

AirPartner charter planes: they don’t own them outright, hence the business is relatively asset light. Goodwill and intangible assets are £18m in total vs net assets of £21m, so just £3m of net tangible assets vs a market cap of £54m. Despite some concerns about the historic accounting, SharePad’s quality metrics look very attractive for this year, with ROCE 34% and CROCI 47%.

Outlook Management point to their airport security business (Redline) and Private Jet chartering picking up, particularly in the US. In the past, they have talked about conferences and sporting events as significant drivers of business, so without numbers it’s hard to know how to take the optimistic noises.

Forecasts SharePad has revenues growing +11% to £79m for the current year, and +5% £84m next year. The shares are trading on 11x FY Jan 2024F PER, and 0.6x forecast sales in the same year.

Ownership Hargreaves Lansdown hold 11.7%, Schroders 11.2% and Amati 10%. Lord Lee owns a 4.7% disclosable according to the company’s website updated on 4 May 2021, but that holding is not mentioned in the company’s Annual Report.

Opinion I’ve owned this stock for a few years, mainly attracted by the dividend yield. It’s not a large position and it’s not been one of my better investments. Revenue doubled from £37.6m 31 Jan 15 to £77.5m FY to 31 Jan 19, though the share price, at 85p, is at a similar level to H2 2015. There’s a lot of year-on-year variance in profitability even before Covid, but I’m happy to keep holding as it provides some yield and diversification for my portfolio.

Medica FY results Dec 2020

Finally, a brief comment on Medica’s FY results. I wrote at the start of May that Tristel’s profit warning from low activity levels in routine NHS procedures might be continuing to impact Medica too. The group’s Elective (ie non-emergency) teleradiology procedures were impacted by the NHS prioritising Covid, so that the division saw revenue down -49% to £12.5m. However, the radiology group has been helped by “Nighthawk”, their urgent out-of-hours reporting service, which has been very resilient through Covid-19 and saw revenues rise +4% to £23.0m in 2020. All in all, Group revenue fell -21% to £36.8m and statutory PBT fell -78% to £2.07m.

Outlook The outlook statement reads optimistically, yet the company hasn’t felt confident enough to reintroduce guidance. Management believe that the NHS in the UK and HSE in Ireland will remain capacity-constrained for some time, hence rather than a short term spike, they expect a sustained period of increased business as the backlog of Elective cases is processed. Longer term they reiterate their aim to double revenue within five years (once the impact of the pandemic subsides). The plan remains to deliver strong organic revenue growth in the core business, with upside potential from new business lines and selective M&A.

Placing The company did a placing in March this year at 145p, a 5% discount to the then market price. They raised £15m or 9.6% of the existing share base. Hence although they had net debt at the end of December, the company’s financial position should be much stronger following the capital raise. In May they have arranged a £30m Revolving Credit Facility with Lloyds, NatWest and Silicon Valley Bank. The facility is extendable for up to two years. Variable interest is calculated on utilised facilities based on leverage with initial interest at Sterling Overnight Index Average (SONIA) + 2% and non-utilisation fees of 35%. Key banking covenants remain the same, with maximum net debt to EBITDA of 2.5x and interest cover of 4x. They clearly don’t need the RCF for existing operations, so we’re likely to see more acquisitions like Global Diagnostics (bought in Nov 2020 for £18.9m total consideration), RadMD (bought in March 2021 for £15.6m total consideration).

Forecasts SharePad’s forecast tab shows revenue is expected to bounce back strongly in 2021F +63% followed by +18% in 2022F. This puts the shares on 18.8x 2022F, and 2.5x 2022F sales. That seems like a reasonable valuation if management can achieve those forecasts and numbers don’t disappoint.

Opinion I like the story, though I haven’t yet bought any shares. My one concern has been margin pressure; the gross profit margin has been declining for a couple of years as the NHS renewed contracts at lower prices. Last year the company had said that they expect margin decline to continue even as volumes increase. More recently they pointed to the change in mix towards Nighthawk (emergency out-of-hours service) to offset some of the pricing pressure. There does seem to be a risk of being reliant on the NHS, which is clearly in a strong position when it comes to negotiating contracts – this seems to have been the problem at Novacyt, the PCR testing company. Medica is on my watch list, and I’m certainly interested to see how things develop.

Bruce Packard


The author owns shares in ULS Technology and Air Partner

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