Weekly Commentary 07/06/21: Expectations Gap

Last week Brent crude was up +4% to $71 per barrel which helped BP +6% and Shell +4% lead the FTSE 100. Since the 7th May high the index has kept a narrow range between 7,130 and 6,950, currently 7,060. In the US, car companies like GM were up +7% (or +52% since 1st Jan) and Ford were up +10% last week (and +82% since 1st Jan). That compares to Tesla down -8% last week, and down -19% since the start of the year, but still with a market cap over $550bn vs Ford market cap of $60bn. The FT reported that around the world second hand car prices are rising as buyers who delayed purchases last year are returning to the market, while others who want to use their Covid savings on a more expensive car are also pushing up used car prices. The German 10y Govt bond yield is still negative at minus -0.18%, but the trend is gradually rising from -0.57% yield at the start of the year.

Audit quality Currently the UK Government is running a consultation on improving how major companies are audited, to restore public trust after the failures like Carillion. This follows 4 separate reviews: i) Sir John Kingman’s review of the Financial Reporting Council (the audit firms’ regulator which has been widely criticised) ii) the Competition and Markets Authority (CMA) investigation into lack of competition and poor audit quality; one recommendation was mandatory joint audits, including at least one non-Big Four firm. iii) Sir Donald Brydon’s review of audit quality and effectiveness which made 64 recommendations iv) A House of Commons report chaired by Rachel Reeves MP on ‘The Future of Audit’.

The current consultation ends on 8th July. Let’s hope something actually happens, rather than recommending a sixth report! Over the years I’ve been to a few conferences on improving audit quality, as I felt that the numbers that banks presented to investors during the financial crisis of 2007-9 were misleading, yet no one has ever been held to account.

Expectations gap Auditors typically defend themselves by saying that there is an ‘expectations gap’ between what people think an audit does and what it is required to do. For instance, auditors will point out that they are not there to spot fraud, instead their role is to say whether the Annual Report has been prepared in accordance with the correct accounting standards. The Brydon review suggested a new obligation for the auditors to assess the company’s internal controls and say what steps they, the auditors, have taken to detect fraud.

Source: Brydon Report

The most contentious suggestion is that firms should be separated, and non-audit work (mainly management consulting) should not cross subsidise audits. The current government review suggests that operational separation (separate Boards and separate financial statements) plus regulatory oversight of audit partner remuneration.

This week I look at a firm where audit quality has been highly questionable, and its shares were suspended last year because management couldn’t produce an audited set of accounts. Despite that, M&C Saatchi’s shares were up +12% last week, while we wait for FY 2020 accounts. I also look at bike company Tandem up +23% since the start of the year, and the staffing company Sthree up +57% since the start of the year. Meanwhile Supply@ME, the inventory lending “fintech”, has also delayed the publication of its FY 2020 accounts for a second time and I notice too that Water Intelligence has yet to produce a FY 2020 Annual Report (last year it was published at the end of June).

M&C Saatchi H1 trading update

This advertising agency with a December year end put out a trading statement saying that the first four months of the year had been stronger than anticipated. Bizarrely they still haven’t published their FY to December 2020 (expected at the end of June, but no firm date set). They haven’t given any numbers in the RNS, and apparently it took them the entire month of May to work out that the first four months (i.e. Jan-Apr) were ahead. This doesn’t fill me with confidence that the management control and reporting systems are up to scratch. On the positive side they did say that they’ve agreed a Revolving Credit Facility (RCF) of up to £47m, with a 3-year term. The statement also says they have net cash of £30,000,000 – which seems a curiously round number, and doesn’t give a balance sheet date. The shares were up +10% on the announcement.

Self inflicted damage Marketing, PR and advertising businesses are never dull, and tend to attract more than their fair share of larger than life characters. You need a strong Finance Director to add a dose of reality to marketing people who tend to believe their own b/s. At M&C Saatchi there was an accounting scandal that surfaced in mid-2019, but problems have dragged on. A December trading update last year announced a £12m downward adjustment of prior year PBT, which caused a 46% fall in the share price. The announcement also said the accounting problems could stretch back as far as five years. KPMG were the auditor for most of this time, until they resigned to be replaced by PwC when the problems were announced.

The warning resulted in the Financial Conduct Authority (FCA) launching an investigation in January 2020. Ironically the FCA were a client of M&C Saatchi (interesting PR that). The share price has fallen from above 400p in H1 2018, to trough at 30p in April 2020. No doubt some of that decline was due to the pandemic, but much of the damage looks to have been self-inflicted.

Option liabilities Then in September 2020 the company announced that the FY 2019 audited accounts would not be filed by the end of the month deadline (a listing requirement) hence the shares would be suspended. There was also a £11m write down to historic numbers (2018 and before) due to a change in accounting policy for put options issued to management, and the total negative impact on PBT (2018 and prior years) was £26m. The company’s share price decline had created a problem with the deferred consideration contracts used by the M&C Saatchi for acquisitions. Rewards were calculated at a fixed multiple of profits and this liability (calculated at £27m in June 2019) was expected to be paid in shares, with the result that as the company’s share price fell, this meant a greater number of shares had to be issued. This would have had a very significant dilutive effect. So shareholders experienced a “double whammy”; they suffered a sharply declining share price, but the dilutive cost of prior year acquisitions rose. The company has settled some of the cost in cash and the liability at the end of H1 2020 had fallen to £3.9m. Following the suspension in September last year, the shares began trading again a couple of months later.

Never a dull moment if you work at an ad agency!

Lessons I like to spend time looking at companies after things have gone wrong. I prefer to learn vicariously from other people’s mistakes, and hopefully that helps me avoid making my own. One lesson to draw from this shambles is that when companies talk about “net debt”, investors need to check the liabilities that have been created by acquisitions (ie future obligations to management of the company that they acquire) rather than a narrow definition of bank debt. An example of a company pretending that deferred acquisition costs are not liabilities is The Mission Group.

Ownership Some well-known institutions are on the shareholder register. Invesco 10.5%, Octopus 9.6%, Fidelity 8.1%. Plus Vin Murria, who seems like someone who knows how to do her due diligence, owns 12.5%. All in all 51% of shares are not in public hands.

Opinion To me the shares are uninvestable. Except we’re in the kind of market where someone thinks the shares ARE investable as the share price is up +72% since the start of this year and up almost 5x since its low in April last year. New management held a Capital Markets Day a couple of months ago, so I wouldn’t rule out them coming back and asking investors for more money (sometimes this is a condition of a bank agreeing credit like the RCF). As such I see M&C Saatchi more as a general indication of just how frothy some parts of the market are, rather than something that I’d invest in now.

Tandem H1 trading update

This sports (primarily bikes) and toy maker and retailer announced a trading update for 1 Jan-31 May saying Group revenue was up +24% y-o-y. Bike revenue was up +21% and interestingly e-bikes sales were very strong, up +112%. I’ve occasionally pondered whether electric cars might not be the future in cities, and perhaps in 10 years’ time, rather than driving Teslas, far more people will instead be riding e-bikes and e-scooters. Tandem have suggest that though revenue and profits are ahead of the prior year (no doubt helped by an easy comparison vs last year as the pandemic hit panic status) they flag inventory shortages (particularly bikes) and input costs increases, such as steel, oil, plastic and even cardboard. These issues put pressure on margins (gross profit margin was 33% in FY 2020).

History The company was originally listed on the LSE, but moved to AIM 21 years ago, with a placing at 5p per share to make acquisitions of companies in adjacent areas. In 2001 the company reported revenues of £26.5m and PBT of £1.7m. Over the following 20 years, revenues have grown to £37m (and have been flat for the last 5 years) and PBT was £4.1m FY 2020. There don’t seem to be any broker forecasts. ROCE was 18.4% last year, a steading rising trend for 6.2% FY 2016.

Ownership There doesn’t seem to be any institutional ownership, with Mr S Bragg 11% and Mrs D Waldron 7% the two largest shareholders. This is followed by management, Steve Grant former Chief Exec (now non-Exec Chair) owns 4.9% and Jim Shears Chief Exec since August 2020 (before that Finance Director) owns 3.4%.

Valuation There are no forecasts, but based on historic numbers the PER is 10.6x, which is undemanding. The share price enjoyed strong performance in 2019 +64% and 2020 +186%, but even after that performance the current valuation feels undemanding. There’s £10m of defined benefit pension obligations, and the fair value of the schemes assets were £6.8m, (so a deficit of £3.2m) with the company contributing £336K vs benefits paid of £757K. Pensions are a black box, but there’s the possibility that the company benefits as the discount rate used to calculate the liabilities increases as bond yields rise (ie higher discount rate, lower future liabilities).

Opinion This was pitched at Mello a few months ago. I think much depends on the revenue outlook; if the company can generate a few years of double digit revenue and profit growth, it could be a very good story. If inventory shortages create a short term disappointment, this might present a better entry to level. I think the downside is limited, as net cash was £3.8m at the end of December.

Sthree H1 Trading Update

This recruitment business specialising in Science, Technology, Engineering and Mathematics (STEM) graduates with a November year end, and put out an RNS revising up FY PBT expectations of £39.7m. They do caveat the increase with uncertainty around new Covid variants in H2, but the strength of H1 means that they expect to be “materially ahead” at the FY. They’ll give an H1 trading update on 14th June.

Geography and margins This is a global business, with a third of revenues coming from German speaking Europe (the company calls this DACH), 38% from Europe ex DACH and a quarter of revenues coming from the US and the rest Asia Pacific. 76% of revenue is placing short term contractors in organisations, and a quarter is fees for permanent hires. Of that 76%, the company then breaks this down into Freelance Contractor 48% and Employed Contractor Model 28%, the latter having margins that are 40% higher than Freelance.

Financials Gross margin has averaged around 26% over the last five years, and RoCE has been in the 40% for every year since FY Nov 2014, until halving last year to 22.8%, as revenue fell 9% to £1.2bn. FY Nov 2019 PBT was £56.8m falling -46% to £30.6m last year as the impact of the pandemic was felt.

The nature of this company’s activities means that there’s a material amount of accrued income, disclosed as “contract assets” of £58m in the FY Nov Annual Report. There were also big movements in working capital in the FY cashflow statement, a £41m positive from decreasing receivables and a £20m negative from decreasing payables. In all trade and other, receivables were £237m and payables were £157m. I think all those numbers are OK in the context of £1.2bn of revenues, but I wouldn’t like to see them accelerating faster than revenue. There was also £50m of cash on the balance sheet at Nov 2020, a Revolving Credit Facility (RCF) of £50m, so plenty of liquidity.

Ownership Many high quality institutions on the balance sheet, including JO Hambro 10%, Fidelity 5.6%, Legal and General 5.5%, HBOS 5.2% (now part of Lloyds), Harris Associates 5.2%, AXA 5% JP Morgan 5.1%.

Opinion I’m not a fan of recruitment companies, they are very sensitive to the economic cycle. But this does look like a high quality and resilient one, with a good balance sheet and historic revenue growth. The shares are trading on 18x FY Nov 2022F PER falling to 16x FY Nov 2023F. This is also a stock that’s participated in the vaccine rally +57% since the start of the year. Probably this has further to go if the market euphoria continues into the second half of the year.

Bruce Packard

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