Weekly Commentary 14/06/21: Innovation vs disruption

The FTSE remains range bound, up less than +1% to 7,125 last week, still below its 2021 high of 7,130 reached in early May. The S&P500 was flat at 4,239 and Nasdaq was up +1.4% to 13,960. Though companies are talking about input cost inflation, most commodities are also off their recent highs, with the exception of oil at $72 per barrel (Brent Crude NYMEX most traded composite). The US 10y bond yield has fallen over the last few weeks from a peak of 1.74% in late April to 1.50% currently, which suggests that bond market participants are less concerned about inflation than 6 weeks ago.

Martin Stamp Interview

There’s a fascinating 30 minute podcast interview with Martin Stamp the founder of ShareScope/SharePad. Martin started ShareScope in the 1990s and now, almost 25 years later, the site has won over 50 awards and is consistently voted ‘best investment software’ by the public. The interview covers a lot of ground and reminds me of Jim McKelvey’s (co-founder of Square with Jack Dorsey) book on entrepreneurship The Innovation Stack. Square didn’t set out to “disrupt” the payments industry, but McKelvey noticed that small businesses were poorly served by the card companies and very often couldn’t accept card payments at all. Square is up +2280% in the last 5 years and now has a market cap of almost $100bn. But that’s not because they disrupted Visa, which hasn’t lost market share and is up +1150% in the last 5 years and has a market cap of half a trillion dollars. Instead, Square’s innovation has created an entirely new market.

Similarly Martin didn’t set out to “disrupt” anyone, least of all Bloomberg or Thomson Reuters whose terminals are used by professionals at investment banks and costs tens of thousands of pounds a year. Instead he was dissatisfied with what was available to private investors, and as someone with a software programming background, thought that he could create a service that he and others would find useful. The aim was to provide not just information but also knowledge / education for amateur investors to take control of their own finances and make better decisions. Like Square, Martin’s innovation has created an entirely new market of customers who just weren’t being served by existing companies.

One thing that comes across is that Martin is particularly proud of the support and training sessions that SharePad offers. Probably most users don’t get the most out of all the features the platform has, and the interviewer asks what Martin thinks most users might be unaware of. It’s a hard question, about unknown unknowns. But he answers that right clicking on a column and quickly seeing summary statistics probably goes under appreciated.

I’ve shown that here for Amazon on Nasdaq. Right clicking on the P/Net Tangible Asset Value (NTAV) we can see that Amazon is on 22.5x. But is that currently expensive in the context of the Nasdaq? Well, probably not, the stats show a weighted average of 18.2x and a simple average of 67.6x, albeit with a very wide range.

The amount of financial data that we have access to can be overwhelming sometimes, so being able to put that data into context is something that I find really valuable.

This week I stay with the theme of innovation and look at a couple of hydrogen stocks (ITM Power and Proton Motor). I think the technology is fascinating, but on any conventional measure they are far too expensive to be considered high conviction investments. Both did very well last year, +626% and +204% respectively, but are off sharply so far this year. I also look at Water Intelligence, the US headquartered leak detection business who have produced their FY2020 Dec results. Water is less glamorous than hydrogen, but you could make the case that innovation in water conservation is as important as green energy and the company has received the “Green Economy Mark” from the London Stock Exchange. Plus we look at PCI-PAL, the loss-making payments company that allows people to give card details over the phone securely to call centres.

Water Intelligence

This US headquartered water leaks detection business released its audited FY to December results and a trading update through to the end of April. I commented last week that it seemed to take the company a long time to announce FY results (last year the Annual Report came out at the end of June, and the two years before in May). As a reminder, the Group produced FY 2020 Trading Results in Feb, which gave headline numbers like revenue +17% to $37.9m and statutory PBT +78% to $4.2m, but no p&l, balance sheet nor cashflow statements. At the end of April they also released Q1 2021 figures with Group revenue +38% to $11.4m and statutory PBT +152% to $1.66m.

Those numbers remain, but following last week’s RNS we now have FY 2020 financial statements to look at in detail and an extra month (April 2021) of progress. Growth accelerated in April to +47%. The growth is based on the fact that net profits from franchises that they buy back are significantly higher than the foregone net royalty income for doing the same thing. I don’t understand why though. Normally royalties and franchising are a very profitable way to expand (Domino’s Pizza and McDonalds are examples). For those fast food businesses the corporate owned stores are the least profitable, because they’re in prestigious locations with high rent costs, where the company believes that it’s important to have a presence (eg Oxford Street).

Excluding the 4 2019 and 8 2020 franchises WATR bought back, revenue was flat FY2020 vs FY2019 but profits before tax grew +27% to $2.3 million (2019: $1.8 million). Profit margins for Water Intelligence’s corporate-run locations reached 22% in FY2020, up from 14% in 2019 according to the company. I’ve had a quick look at Franchise Brands, the UK franchise plumbing business set up by the former Dominos Pizza management. The numbers aren’t directly comparable because FRAN owns consumer franchises (oven cleaning, dog holiday kennels) but it is the best we can do. Franchise Brands group operating profit margin is 8%, far lower than WATR’s claimed 22% for corporate owned franchises. Gross margin for FRAN is 42% versus Water Intelligence’s 77%. So I’d like to understand why the margins at WATR are so much higher, and if this is likely to change as the company buys back more franchises. I’ve used the SharePad “compare” tool to show the difference in valuation of the two companies, whether it is Price to turnover, EV/EBITDA or P/FCF WATR looks 2-3x more expensive.

Key audit matters mentioned are revenue recognition and intangibles on the balance sheet. One oddity is that the auditor is Crowe U.K. LLP (based in Ludgate Hill, London). I’m surprised that they haven’t got a “Big 4” auditor as they are an international business with related party transactions between Plain Sight Systems (a shareholder) that provides a technology licence on favourable terms to Water Intelligence and ALD (the US subsidiary). The Exec Chairman Patrick DeSouza owns 28% of the shares, but is also a shareholder in Plain Sight Systems which owns 14% of Water Intelligence’s shares. It’s also a little odd that the Plain Sight shareholders (Patrick DeSouza, and also Non Exec Michael Reisman’s background is law, rather than engineering for a leak detection business). None of this is material, but I think that it is worth mentioning.

Balance sheet and cashflow statements The most noticeable item on the balance sheet is the doubling of goodwill to $22m at the end of 2020, compared to a +33% rise in Property Plant and Equipment to $5.2m. The business is buying back franchises, so it’s natural that goodwill should be increasing, but this does raise a couple of questions in my mind.

For instance, the depreciation charge for plant and equipment is $1.6m, treble the charge for amortisation of intangible assets which is $524K. The depreciation charge is 31% of PPE on the balance sheet vs the amortisation charge which is 2% of goodwill on the balance sheet. Or put another way, the depreciation charge assumes that tangible assets need to be replaced every 3 years, but the amortisation charge assumes the useful life of the intangible assets is 50 years.

For both Franchise Brands and Water Intelligence the assets probably are customer relationships and the “know how”, rather than leak detection and plumbing equipment and vehicles. But if so, then how are the post acquisition “lock-ins” structured for WATR? If I’m an entrepreneur who has spent years of my life to build up a franchise, then sold it back to Water Intelligence for (say) a couple of million dollars, am I going to work as hard?

Ownership As of the end of December Patrick DeSouza owned 28% and Michael Reisman 1%. Plain Sight held a further 14%. Amati 4.6% and Herald Investment Trust 3.4% are the only UK institutions that own disclosable stakes.

Valuation SharePad has revenues growing +19% to $45m and EPS +14% to 28$c in 2021F. That puts the shares on 49x 2021F falling to 46x 2022F. The company is trading on 5.5x FY2020 sales.

Opinion I remain sceptical, partly due to the high valuation but also because I don’t understand whether margins are sustainable and the amount of expense required to support the intangible assets. Ignoring acquisitions, management have done very well to increase margins on flat revenue, I’ve rarely seen that achieved. Well done to more credulous investors, the shares are up +97% since the start of this year.

PCI PAL Trading Update June y/e

This secure payments company said that FY revenues to June were likely to be 5% ahead of expectations, and losses 5% lower than expected (previous revenues forecast of £6.7m and adjusted loss before tax £3.8m). Thanks go to the company for telling us what expectations were in the RNS: that immediately signals that management communicate well with investors.

Despite the statutory losses, management say that the company is generating cash, and following a placing of £5.5m in April at 95p (9.7% of the company’s share capital) the Board has decided to repay £1.7m of outstanding debt.

History In 2016 PCI PAL was originally part of a larger group, a listed call centre business called IPPlus. IPPlus sold their call centres to Direct Response Contact Centres Group for £6m, then span out PCI PAL which had software that was compliant with the Payment Card Industry Data Security Standard (“PCI DSS”). This means that financial data from before 2016 on SharePad should be ignored for this company.

The company has a couple of payment methods for call centre staff to take customer credit card details securely and in line with card scheme rules. In other words when you give your card details to someone over the phone, they press a button and you securely enter your card number using the telephone key pad, rather than reading the details out to the call centre worker.

Since then the company has raised money a couple of times. £5m at 45p in Jan 2018, £5m at 30p in March 2020 and most recently £5.5m at 95p April this year. The technology undoubtedly works, but I’m not sure how clever it is? Although it has to comply with security standards surely it can’t be that hard? In any case, I think most of the time people are now happy to enter their card details into websites; I can’t remember the last time I spoke to someone at a call centre and was asked to pay for something.

Financials The company has grown revenue from £1.9m in FY June 2017, to c. £7.0m FY June 2021F, but has been reporting losses of between £1.7m and £4.5m over that time period. So there doesn’t seem to be much operational gearing as revenues grow, hence the need for repeated capital raisings. FinnCap, their broker, have raised FY2021F in line with the RNS, but haven’t changed their FY2022F numbers. These show revenue growing to £10.4m and adj loss before tax increasing to £4m. Given the valuation of 8.3x FY2021F June sales, I think investors need to be confident that revenue growth will eventually drop through to the bottom line and will see not just profits but operational gearing.

Ownership Shareholders have been supportive with 3x placings since 2018. I wonder how long their patience will last though. Gresham House own 11%, Octopus 9.2% and Herald 5.4%.

Opinion I need to understand the “moat” here. It’s possible that the company is spending heavily on sales and marketing, and once customers are locked in, they have a high lifetime value. But the danger is that the revenue growth isn’t actually creating any value, and the losses continue. The valuation on 8.3x 2021F sales and negative free cashflow suggests investors are giving the company the benefit of the doubt, so far.

ITM Power and Proton Motor

I finish up with a couple of Hydrogen stocks. ITM Power released a trading update for FY to April and Proton Motor released FY results to December.

A former CSFB friend of mine who now runs a very large corporate pension fund told me that in the middle of last year he suddenly became inundated with investment bank research on the hydrogen economy. He has saved at least 30 research reports on his hard drive. One reason that I think investment banks might be excited and publishing research notes is that, like telcos in the 90’s TMT bubble, hydrogen fuel cells are likely to be capitally intensive. It remains unclear if these hydrogen stocks are the best way for investors to capitalise on innovation.

As an example, it’s possible to imagine 20 years ago that ESG investing and windfarms would be innovations worth backing. The CSFB colleague I mentioned pitched Vestas on a training course that we went on together in 2003. If I’d invested I’d have twenty bagged my money. In contrast, in 2003 I specialised in financials and should have pitched a financial services company: Impax Asset Mgt, the ESG fund manager. If I’d done so and backed my own judgement with money I would have had a 370 bagger over the same time period.*

ITM FY to April 2021 ITM said revenues would be £4m, down -26% y-o-y and losses would be “broadly in line with management expectations” without saying what those expectations are. The April year end cash figure was £176m, so they won’t run out of cash in the near future. The company raised £59m in October 2019, including £38m for the German gas company Linde and announced a JV. In November 2020 they raised £172m, including a £30m investment by Snam, the energy infrastructure company. The exciting numbers are “contracts backlog” up +194% to £154m and “tender pipeline” +131% to £607m.

Proton Motor FY to December At least Proton Motor is reporting sales growth: +146% to £1.9m. The company reported an operating loss of £7.4m or £15.8m after finance costs are included. Cash burn decreased to £4.7m vs £6.4m last year. There’s a huge Fair Value liability of £609m (including a £386m negative movement in FY2020), which relates to a €50m convertible loan from Falih Nahab, the brother of one of the company’s directors Dr Faiz Nahab. The company has £2.8m of cash.

History These stocks have been listed on AIM for a surprisingly long time. Proton Motor listed in 2006 at 80p, raising £5m and valuing the company at £25m. The market cap is now £464m and it’s trading on 244x sales.

Peter Hargreaves of Hargreaves Lansdown was an early backer of ITM Power, which listed in 2004 at 50p raising £10m, valuing the company at £43m. The market caps of ITM is now over £2bn and it’s trading on 505x sales.

And you thought that Tesla was expensive on 20x sales! To be clear: on any conventional valuation measure these companies are wildly expensive, similar to 4D pharma which I wrote about a couple of months ago. I’m highlighting them because I think they are interesting innovations.

Opinion I find it fascinating that Peter Hargreaves was an early backer of ITM, though he no longer owns a disclosable stake. Both ITM Power and Proton Motor are “story stocks”, but backing from the likes of Shell and Linde does give some credibility. Despite being listed for a decade and a half, ITM has just 9 hydrogen refuelling stations open to the public. That compares to 35,000 EV charging points across the UK, according to the utility EDF. PEM (Proton Exchange Membrane) hydrogen fuel cells could be part of the future, but I wonder if in terms of investing, the gains on the stock market have already been made?

Bruce Packard


*To be clear, I didn’t pitch Impax. I have a dreadful feeling that the company I actually pitched in 2003 was Bank of Ireland, the Irish bank which, among all the other Irish banks, needed rescuing in the 2007-9 financial crisis.

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