Weekly Commentary 11/10/21: Wish you were here

Another volatile week, with the FTSE 100 falling to 6,950 but recovering to 7,080 on Friday. The AIM index is up +24% in the last 12 months, but more recently has given back performance relative to the FTSE 100 +18% because that index has a higher weighting towards bank and oil sectors.

Paul Hall, from SharePad’s support team, presented a ‘Learn Stock Screening in SharePad’ webinar last week, showing all the tools that SharePad has to help users to understand the order book. It’s half an hour long is available on the YouTube channel if you missed it.

The newspapers, who have had to be responsible about how they reported the pandemic over the last 18 months, are now whipping up the same old fears (fuel shortages, stagflation) from the 1970’s. UK Govt bond 10y bond yields have risen sharply over the last 3 months to 1.08%, back to the same level as mid-2019. SharePad has UK 10y bond yields chart going back to 1994, which shows that in the mid-1990s the yield was over 8%.

In the mid 1970’s, the era most people associate with stagflation, yields peaked at double that level: over 16%; see this long-term graph, sourced from the OECD. That puts the current 1.08% yield into context.

A few years ago, when I was “between jobs”, I spent time in The Guildhall Library at Gresham Street reading archives* from the 1970’s “cost push” stagflation and secondary banking crisis. Reading investment commentary that’s decades out of date can be rather fun, not because commentators are stupid, but because they’re intelligent, articulate, persuasive and are often looking in the wrong direction. What people think is important often turns out to be tangential to spotting opportunities.

Did they get you to trade…

For instance, contemporary sources revealed that following the England football team’s victory in the World Cup Finals in 1966, there was a feeling of national pride and exuberance, but also structural pressure on the pound versus the US dollar. Hence in 1967 Harold Wilson’s 14% devaluation from $2.80 to $2.40 and his infamous “pound in your pocket has not been devalued” lie. Fear of further devaluation drove many people into speculative activity, whether it was the stock market or property. There then followed the “Barber Boom”, as Ted Heath’s Chancellor deregulated lending and money supply surged. House prices jumped and the stock market boomed…if only bitcoin had existed back then! Contemporary sources were also concerned with the supremacy of London’s markets vs European capitals (turnover in London was higher than Brussels, Paris, Frankfurt, Amsterdam and Zurich combined).

…your heroes for ghosts?

Then in the early 1970’s interbank wholesale markets were exposed to a liquidity crunch when the OPEC-related oil price shocks hit. Secondary banks and Slater Walker, which had been an industrial conglomerate, but evolved into an unregulated shadow bank, needed a “life boat” from the Bank of England. Most property speculation had been financed by debt, and many borrowers were forced to liquidate into a falling market. Property, bonds and equity became heavily correlated (falling in value). In fact, the London Stock Exchange fell a terrifying -73% in 1974-75, all at a time of double digit inflation. The UK Government itself needed a rescue from the IMF in 1976. It wasn’t all bad though: in the middle of all this, Pink Floyd released their album “Wish you were here” and David Bowie moved to Berlin, recording “Low” and “Heroes” there.

So the music was good, and if investors had cash available to take advantage of the situation when the market hit its nadir in 1975, so were the investment returns. I’m not suggesting a similar magnitude fall, but I do think that a naïve assumption that increasing inflation is good for equity markets (or property) should be challenged. I suggested back in April that stock market conditions were as frothy as a Bavarian’s beer glass, and in June that H1 performance was unlikely to be sustained for the FY, so holding some spare cash to invest was sensible. I’m still deciding if the sell off has further to go, but am much more likely to be a buyer over the next few months than sell any more of my existing positions.

This week I look at 3 businesses that are dependent on regulatory approval for their profits: Renewi, SIMEC Atlantis Energy and Polerean. Plus also two “Quality at a Reasonable Price” businesses that reported last week: Hotel Chocolat and Cake Box.

Renewi H1 to September trading update

This international waste and recycling utility announced a trading update ahead of H1 results due on 9th Nov. They feel confident enough already to say that they are “materially ahead of expectations” for the FY to March 2022. Revenues have increased more than +10% versus last year (affected by Covid) and 7% ahead of FY to March 2020 (pre Covid). Leverage is below 2x net debt to EBITDA at H1 (down from over 3x FY 2019 following a couple of disposals). The shares participated in the vaccine rally (+186% in the last 12m), but also benefits from rising commodity and energy prices, so has continued to do well in the last 3 months (+14%) while other stocks have sold off.

History This is the old Shanks waste business, which has had multiple profit warnings (blamed on falling commodity prices and cold weather) before buying Van Gansewinkel Groep (VCG), an unlisted Benelux waste business in 2017, for half a billion Euros. The deal was structured so the owners of VCG received €357m in cash and the rest in shares. They then rebranded themselves Renewi.

The merger and rebranding didn’t halt the profit warnings though, with the shares falling from over £10 per share at the start of 2018. In November 2018 Renewi said that it hadn’t satisfied regulators in the Netherlands that their soil treatment facility in Moerdijk was up to standard, so they could not continue to supply their treated soil back to the market. These problems took over a year to resolve. Eventually they were cleared by the regulator in late 2019. However, they said in May this year, that it has still taken longer than expected to receive local permits for thermally treated soil. From over £10 at the start of 2018, the shares fell to a low of £1.89 in September last year before recovering sharply to 690p today.

Financials This is a low RoCE (5%) low margin (4.3%) business, however it does generate significant cash from operations of €176m FY 2021 before working capital movements, and €258m after working capital.

That compares to €18m of statutory PBT FY 2021 or €47m on an underlying basis. Goodwill and intangible assets are €602m, which is 2.5x shareholders equity. That suggests to me investors need to be confident that the cashflow is sustainable, even in times were the operating environment is more difficult.

Ownership Sterling Strategic Valued fund 5.96%. Paradice Investment Management, a Sydney based firm founded by David Paradice are the second largest shareholder with 5.8%. They’ve held since before the merger in 2017. Avenue Europe own 5.7%. I haven’t heard of any of these institutions before, they don’t strike me as “smart money”.

Opinion I think probably the easy money has been made, but if you’re confident that they have fixed the problems of the past then there could be more to go for from here. Despite the share price doubling, the valuation remains attractive on 11x March 2023F PER. Renewi don’t currently pay a dividend, but they are forecast to pay 15.5p March 2024F, putting the shares on a forward yield of 2%. That may sound unexciting, but a reinstatement of a dividend is an obvious performance catalyst that might attract income fund managers.

Polarean and SIMEC Atlantis Energy

Last week we had bad news from Polarean Imaging (which fell -60% on the day) and SIMECAtlantis Energy (which is down -93% since the start of the year). I wouldn’t normally comment on stocks that are down so strongly, but I could see both appearing in the “top 10” of user searches.

Polarean’s healthcare technology uses Xenon gas to improve MRI scan images of lungs. They received a disappointing Complete Response Letter from the FDA, the US regulator, which sent the shares down more than 60% at one point last week. Polarean management will try to address the issues raised in the letter, then resubmit their technology for approval. In the meantime they have $38m of cash at the end of June.

Polarean’s most recent set of results show H1 to June 2021 revenues of $622K, and a statutory loss before tax of $4.9m, so they are not in any immediate risk of failure. I think I’d need to understand why the investment case rests so strongly on approval from the US, and why the technology hasn’t been more widely accepted by the NHS and in Europe. The experience of Tristel (share price 605p, market cap £285m) shows that it’s possible to build a highly profitable healthcare business without the approval of the FDA.

SIMEC Atlantis Energy also received a disappointing letter from their regulator, Natural Resource Wales. SAE owns a 77% stake in the world’s largest tidal project, MeyGen off the North East tip of Scotland and 100% of the Uskmouth Power Station coal conversion project. They IPO’ed in 2014 at 100p, then Atlantis acquired Uskmouth in 2017 when they merged with Sanjev Gupta’s (of GFG) Simec. Gupta, the steel magnate, has been in the news recently because of his links to Lex Greensill’s supply chain finance operations. The plan was to convert the former coal fired power station into burning pellets made from non-recyclable waste which otherwise would have ended up in landfill. However last week’s letter says that the Welsh Government has blocked NRW from making a decision on Uskmouth.

SAE reported revenue of £5.2m H1 to 2021 and a loss before tax of £10.7m. They did a placing in September of £2.6m at 2.5 pence per share, before that they had also raised £7.5m in August 2020. There are significant assets on the balance sheet, £128m of Property, Plant and Equipment versus borrowing of under £50m and shareholders equity of £72m. So this is the reverse of Renewi, because it has considerable asset backing to the debt but is loss making. SIMEC Atlantis may not have permission to burn waste pellets, but looking at their H1 cash flow statement they have found it much easier to burn cash. Cash from operating activities was negative -£1.6m and cash from investing was also negative -£1.7m, so their finances are not currently sustainable.

A high risk situation, where shareholders could be wiped out. There’s also a convertible loan due for repayment in December 2021 and bond refinancing due in June 2022. Most institutions have sold out, but Janus Henderson still owns 5.4% and Morgan Stanley 5.1%. In any case, I’m a fan of spending time looking at a few exciting story stocks that haven’t worked, to remind myself not to get too carried away with exciting, but unproven, technologies.

My suggestion is that funding innovation and green energy can be done on a portfolio basis, through the likes of Impax AM or IP Group. This doesn’t guarantee returns, IP Group is down -25% over the last 5 years, but it does provide some protection and diversification.

Cake Box H1 Sept Trading Update

This retail franchise of egg free cakes announced an H1 trading update to September. Last month the company’s auditor (RSM) resigned, to be replaced by another audit firm that I hadn’t heard of: MacIntyre Hudson. When an auditor resigns, under the Companies Act 2006, management are required to send a copy of the resignation letter, including the reasons given for the resignation, to shareholders. RSM was concerned about “the robustness of the Company’s control and governance frameworks due to delays in the provision to us [RMS] of audit evidence, which was not provided on a timely basis.”

Investors could be forgiven for wariness after the black hole in Patisserie Valerie’s accounts a couple of years ago. But the trading update itself sounds positive, with revenues +91% to £16m – though that has Covid lockdowns as a comparison. The 4m vs 4m last year comparison shows +50%, which is a more useful figure. They seem to be benefiting from the market share battle between Uber Eats, Just Eat and Deliveroo, with online sales +68% to £7m, or +35% 4m vs 4m last year. Net cash was £4.2m at the end of September.

The group has a franchise model similar to Domino’s Pizza, which is a capital light way of expanding a successful concept. This is reflected in SharePad’s quality metrics (RoCE 38%, FCF conv 169%).

20 new franchise stores were opened in H1, to bring the total to 174 at the end of September. Currently they have a good pipeline and are holding deposits for 62 further franchises. They have also begun rolling out kiosks in shopping centres and supermarkets.

Ownership Sukh Chamdal the founder and current Chief Exec owns 32%. Other company directors own 11.1% in total. The largest institutions are Canaccord, 10.6%, Amati 10.6%, Axa 4.8%, Ennismore 3.4%.

Valuation CBOX is trading on 25x PER March 2023F falling to 22x PER March 2024F. It’s on 4.2x price / sales March 2024F which seems reasonable for a business reporting 38% ROCE. The shares are not a bargain, but fit the Quality at a Reasonable Price filter.

Opinion It’s noteworthy that the lack of controls flagged by the resigning auditor hasn’t prevented the company from providing a timely update, with both a revenue and a net cash figure. It’s understandable that a fast-growing business might have not prioritised control functions, so I think this business should be OK. As noted above, poor controls are not priced in though, the shares have a quality premium, so if the wheels do fall off, the share price is likely to be badly punished.

Hotel Chocolat FY June

This online and shops premium brand chocolate retailer with a June year end announced FY revenues up +21% to £165m. Statutory PBT was £7.8m, an impressive recovery versus a -£7.5m loss last year. They have net cash of £16m at the end of September, following a placing in July when they raised £40m at 355p. The money raised is for factory expansion and to fund growth, and they believe should increase production capacity to support £250m of sales per annum. Prior to that they had raised £22 million equity in a placing at 225p in March 2020.

Unusually HOTC started off as an online retailer, then expanded into physical stores. Pre-pandemic a third of sales in FY19 were online, which grew to 52%, even as physical stores have re-opened in the ten weeks from mid-April to end of June. They have also enjoyed success with the online sales channel in the USA, generating +84% increase of revenue in the 10 weeks mid-April to end June, compared to the same period in FY19. However the US remains less than 5% of group revenue.

Financials The balance sheet looks very healthy, as you would expect following two placings in 18 months. Despite having a valuable brand, intangible assets recorded on the balance sheet are less than £4m, versus shareholders’ equity of £72m. Gross margin fell from c.65% to 62% due to increased stock handling over lockdowns and inventories more than doubled to £32m end of June, but I imagine this reflects the challenges of running a business during the pandemic. Presumably for the same reason trade and other payables increased by +55% to £42m, so just worth keeping an eye on the working capital movements as the business continues to grow.

Outlook They have started the new financial year in a “strong position”, but they don’t give any figures. SharePad shows forecasts of £226m revenue in June 2023F an impressive +17% CAGR. EPS June 2023F is forecast to be 15p, putting the shares on 31x June 2023 PER.

Opinion Looks good, I like the combination of online and physical stores. International expansion in the US and Japan seems to be progressing well. Again, like CBOX, I’d classify this stock as Quality at a Reasonable Price.

Bruce Packard


*The Guildhall library is a reference library, and you can read The Economist, The Financial Times and The Banker from the 1970’s, but you can’t remove them. I also spent time in the Lloyds Bank archives, but the Bank of England destroyed much of their material from the 1970’s. It is widely believed that they did this deliberately, to prevent embarrassment.

If you’re looking for a book on the secondary banking crisis, I recommend Margaret Reid’s. She was an FT journalist, and a colleague who worked with her at the time told me that whenever she had a particularly confidential source on the telephone, she would climb underneath her desk to prevent other journalists overhearing her side of the conversation.

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