Weekly Commentary 26/07/21: Red flags from China

Markets sold off at the beginning of last week, with the FTSE 100 falling to 6,849 before recovering to above 7000 at the end of the week. We saw similar sell offs in the Europe and the US markets, including Nasdaq which was down -2.5% early last week, which seems odd if jitters were caused by localised concerns over the Delta variant of the virus. The Nasdaq index contains many “Covid winners”. The US 10 year bond yield rose to 1.30%, while the German 10y bond is still negative at around 0.40%.

Delta variant or Chinese financial system?

A couple of weeks ago the Chinese central bank cut the required reserve requirements for banks. This is a better way of the Chinese managing their economy than cutting interest rates, because it means banks can lend out more money which goes into the Chinese economy. However, similar to Northern Rock’s debt-fuelled growth, there’s a diminishing return on lending more money and increasing debt levels. The effect is to stimulate the economy but at some point the Chinese authorities will need to deal with a credit crunch. The FT reported last week that local governments in China have raised $17bn of rescue funds to bail out troubled state-owned enterprises facing financial difficulty. Short sellers like Jim Chanos have been warning about this for a decade (see YouTube here and here and here.) He has of course been far too early, but markets have a habit of proving people right, even if their timing is wrong.

China had a good 2020 compared to other large economies; their trade surplus increased partly helped by their containment of the virus and partly because people in Europe and the US bought lots of goods (from laptops to FPP masks) rather than services (buying meals in local restaurants). If everyone in the US uses their stimulus cheques to buy laptops, then China will be the beneficiary. These trends can’t continue forever though.

Other indications of stress are Chinese high yield corporate credit spreads which blew out a month or so ago. Then at the start of last week China Evergrande’s, the property developer, share price fell 30% in Hong Kong because a court in Jiangsu province froze a $20m Evergrande deposit, in response to a request made by China Guangfa Bank. Evergrande responded by threatening to sue the bank. Later in the week they claimed to have resolved the dispute.

The Chinese property developer has already been downgraded by Fitch. Their bonds maturing in 2024 are trading at around 50 cents on the dollar. According to the first link above they are also a large issuer of commercial paper. You might think that short dated commercial paper was a particularly risky way to fund speculative property development. You’d be right, but it wouldn’t be the first time that it had happened. Paul Reichmann used the Eurodollar markets and commercial paper to fund the development of Canary Wharf in the 1980s, only for it to go horribly wrong in the early 1990s, ending in bankruptcy. We probably won’t know the full story on Evergrande, because no doubt the Guangfa bank and Evergrande both have political patronage networks who will keep the resolution out of the newspapers. But if Evergrande is struggling with its debt burden, it’s likely that there are others, which explains why shares in the Chinese property developer sector have fallen on average -15% since June. Property crises tend to go hand in hand with banking crises, because savers begin to doubt the value of commercial property collateral. The expression “more red flags than a communist party parade” springs to mind though.

One curious question, who would buy commercial paper issued by a Chinese property developer whose bonds have now been marked down severely? This chap, @lastbearstanding who is an anonymous short seller on Twitter is suggesting that Tether, the “stablecoin” cryptocurrency that is pegged to the US dollar has lots of commercial paper. Jim Cramer has suggested that Tether’s commercial paper is Chinese. Tether will not give any more details on the commercial paper that they hold, not even to deny that they have Chinese exposure. Study silence to learn the music.

Does this matter? If the problems really are coming from China, that would be negative for commodity prices and probably also banks, as it suggests a deflationary wave would start rippling out from China. Also imagine if the cryptomarkets are funding speculative Chinese property development; that feels like a story that doesn’t have a happy ending.

I pointed out in June that markets had been strong till the end of May, and that might not continue into the second half. From that perspective the recent market sell off has been healthy, so far. But if investors are too focused on all the noise about hospitalisations from the Covid Delta variant, it could be we miss other more significant red flags, such as warning signs of a sharp deterioration in the Chinese financial system.

This week I look at the recommended bid for Sumo from Tencent, the Chinese payments app and gaming network with 1.2bn users; Creighton’s delayed results, which alleviated some concerns and SDI Group, which continues to go from strength to strength.

SDI Group FY to April

SDI Group, the scientific instruments and digital imaging maker reported revenues up +43% y-o-y (or +19% on an organic basis) to £35.1m. Statutory PBT was up +73% to £5.6m. They’re not paying a dividend at the moment, but will continue to review that decision.

Net cash was £0.8m at the end of April, though that was helped by large one-off downpayments. Cash from operating activities doubled to £10.3m, helped by a £6.1m increase in trade payables, which is presumably the large downpayments benefitting working capital.

Intangible assets are now £26.2m versus shareholders’ equity of £26.8m. Intangible assets were £2m in 2015. I don’t think that 13x increase in intangibles matters given the strong cashflow, it just highlights how the business has grown in the last five years. The strategy is to buy SMEs with digital imaging or sensor technologies. They’re looking for businesses with high-quality, niche technologies that have sustainable profits and cashflows. Management say that they expect to acquire one or two new businesses for the Group in the coming financial year.

Outlook Trading in their March 22 FY remains in line with market expectations and they look to the future with confidence. In February this year the company put out a trading update with revenue and PBT expectations all the way out to April 2022F, suggesting £42m of revenue and £8.7m of adj PBT.

Comparison with Judges Last week Judges Scientific, which has a similar strategy of acquiring and developing companies in the scientific instrument sector, put out an H1 trading update to H1 June.

Judges organic sales were up +5% and the order book continued to increase to 16 weeks of budgeted revenue (11 weeks 30 June 2020, 14 weeks 31 Dec 2020). Judges management reiterated market expectations for the FY should be met, without actually saying what those expectations are. The table above shows a valuation comparison and I’ve used SharePad’s multigraph feature (CTRL+click) to compare the two’s share price performance over the last 10 years (log scale). Both companies have ten bagged, though much of JDG’s performance was achieved earlier in the decade, whereas SDI has done better more recently.

Broker forecasts FinnCap, SDI’s broker, have revenue growth and profits in line with management guidance to 2022F, but then revenues falling back to £40m and PBT reducing by -26% to £6.7m in FY to April 2023F. This is caused by the completion of a large contract in FY 2022F. The brokers numbers also exclude the impact of future acquisitions, which would boost numbers.

Valuation Putting SDI shares on 2022F EPS of 6.4p implies 29x PER and 2023F EPS of 5.0p implies 38x. That looks OK for a management team with a strong track record, the shares are up +163% since 1 Nov 2020 (beginning of the vaccine rally) but the market cap is still less than £200m so plenty of room to grow. We’re in an expensive market, but it does feel like paying up for quality growth is likely to lead to less sleepless nights than looking for turnaround situations in beaten up sectors.

Opinion This is a multi-bagger, up 16x in the last 5 years. Normally it’s best to keep running your winners, than worry too much about valuation. I’ve owned the stock since Nov 2015, I like the strategy and the management so I think I’d need a reason other than valuation to sell.

Sumo recommended offer from Tencent

Sumo, the computer games company, has recommended a cash bid for 513p or £919m from Tencent, the huge Chinese company which has 1.2bn WeChat users and is run by a chap called Pony Ma. That bid is a 43% premium to Sumo’s share price on 16th July. Tencent has held an 8.75% stake in Sumo since November 2019, and received irrevocable undertakings in favour of the deal from shareholders with a further 27% of the shares. The deal is structured as a Scheme of Arrangement, so they need 75% approval for this to go through.

History Headquartered in Sheffield, Sumo Group was cofounded in 2003 by Carl Cavers (currently Chief Executive) and listed on AIM in December 2017, through a placing at 100p a share. This raised £38m which valued the market cap of the company at £145m. It co-develops games alongside publishers such as Microsoft, Sony, Sega etc. rather than owning the IP themselves. As they work on a contracting model, management believe they are less exposed to the “blockbuster vs flop” dynamics of creative industries.

Sumo was originally set up as a “work for hire” games developer, similar to Keywords Studios, providing services to developers and publishers. However they managed to grow their expertise so that they became responsible for start-to-finish development projects – which can last 5 years. Although they don’t own the Intellectual Property for most games that they work on, Sumo say that one of their competitive advantages is “game engines” – they have a library of tools and technology that helps developers to build games. However this does mean that their gross margin is lower 46% (FY 20) vs 86% for Codemasters but above Keywords 38%. There are some management presentations on PI World, which give a good introduction to Sumo. If you’re interested in a background to Tencent, then Packy McCormick wrote it up in August last year. It’s a fascinating payments, social network and gaming company, that also invests minority stakes in other exciting businesses. They have stakes in 83 companies that were worth more than $1bn last year, including Tesla, WeBank, JD.com, Snap, Pinduoduo and Epic Games (the maker of teenage shoot-em-up Fortnite).

Comparison with Codemasters In the second half of last year there were a couple of competing bids for Codemasters, the racing game specialist. Take Two offered 528p in cash and shares, followed by a better offer of 604p from Electronic Arts (EA) all in cash. The 604p bid valued Codemasters at c. 50x PER, compared to last week’s 55x PER for Sumo Group, despite having different dynamics (being a racing game specialist CDM had lumpier earnings, but higher gross margins). Possibly we could see a higher bid come from a US computer games company, but it’s worth noting that Tencent have started the bidding at a high price earnings multiple 55x, which was the multiple EA’s winning bid came in at. Interestingly Sumo has not traded through the terms of the offer price of 513p, in contrast to Codemasters which reached 656p, 10% higher than EA’s 604p bid, before retreating when it became clear that a raised counter offer was not going to be made.

Ownership Perwyn, a private equity fund, owns 16.7% of Sumo and have already given their irrevocable undertaking to vote in favour. They are a Private Equity firm who were part of a buyout in 2016 pre IPO, and have gradually been selling down their stake. Other large shareholders are BlackRock 8.4%, Swedbank 5.3%, Liontrust 4.7%, Miton 4.4% and Lake Street Labs 3.9%.

Readacross I’ve used SharePad’s compare table to make comparisons with other UK games companies. Having seen two computer game companies bid for in the last 12 months, investors may be wondering if Team17, Keywords or Frontier Developments might be next.

I have mixed feelings about this. The computer games sector has been a real success story, mixing creativity and technical know-how (not to mention tax breaks!) so it’s a shame to see these businesses gobbled up by larger overseas companies. But at the same time innovation can’t stand still, hopefully FinTech, clean energy, life sciences or maybe even graphene are the next success stories on AIM.

Creightons FY to March 2021

This toiletries, fragrances and skin care company announced FY results to March 2021, following a couple of weeks delay caused by the auditors not completing their work in time (similar to Renold, Gateley and ULS Technology – I wonder if this will be a problem for companies with a December year end?) The shares bounced +10% in relief when it became clear there were no nasty surprises in the figures.

Financials Revenue was +29% to £61m and statutory PBT was +46% to £5.1m. It’s worth noting that a quarter of that revenue figure is from Covid-19 hygiene related products (hand sanitiser etc) and the figure was zero the previous year. So a “one-off” benefit, and they had to take a provision because they were left with too much stock as demand reduced rapidly following the easing of the first lockdown. However the virus also had a negative impact on sales with both private label and contract sales, where other brands or retailers outsource their manufacturing to Creightons, both declined. Hopefully growth in private label and contract sales should recover FY 2022F to offset the fall in hygiene product.

Net cash “on hand” was £6.2m. This figure excludes a £2.8m long term secured mortgage on their factory with a 10 year fix of 3.04%. That mortgage doesn’t seem much of a risk, but always worth checking when companies use phrases like “on hand” or “net bank debt”; the latter excludes obligations from acquisition earnouts.

Gross margin was down slightly this year to 40.6% vs 42.2% FY 2020, which the company attribute to a change in mix and also additional costs caused by the virus; for instance they gave staff who worked on site through the virus peaks a bonus. Procurement was also more costly because they had to air freight some items. As trade normalises this implies that margins should bounce back. They also expect higher costs from Brexit, but they are not going to materially impact on the group’s performance.

InnovaDerma On 26 January Creightons made an opportunistic approach to Innovaderma, the anti-ageing and skin care brands company, market cap less than £10m. The offer was 2 Creightons shares for 3 InnovaDerma shares, valuing IDP at 44p per share (a premium of less than 5% to the then share price). IDP management rejected the bid, and their shares have now fallen -26% to 32.5p. To my mind InnovaDerma is too small to benefit from being a publicly listed company, and IDP shareholders would have profited from being part of a larger group.

Ownership The Creightons Chairman, William McIllroy, owns 25%. There aren’t any institutions that I recognise on the shareholder register, but I don’t think that is too concerning because the market cap is £50m, so institutions would likely struggle with the liquidity. The full Annual Report is not yet available on their website, so I’ve made a mental note to look up key audit matters and related party transactions when it is published. The company works hard to communicate with private investors, and they’re doing a webinar on Wednesday.

Valuation There are no broker forecasts. Diluted EPS FY 2021A was 5.9p, putting the shares on 14x historic earnings. Perhaps that dips FY2022F due to the hygiene sales benefit of Covid, but there’s a history of revenue growth (quadrupled from £21m FY March 2016). Management have published medium aspirations for FY March 2025 sales to reach £100m, with a net profit margin of 9% and RoCE to remain at 20%. Pleasingly the long-term SharePad DuPont Analysis shows that as the business has grown, returns on capital have improved, suggesting this is a business that enjoys positive scale advantages as it grows.

Opinion Assuming management’s medium-term aspirations are achievable, this strikes me as a good story. The whole management team has been heavily incentivised with options, with potential dilution of 9.5m ordinary shares (ie 15% of ordinary shares outstanding). It seems a straightforward business on a reasonable valuation.

Bruce Packard


The author owns shares in SDI and Creightons

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