The FTSE 100 hit a high for 2021 at 7,314. The S&P500 also continued to trend upwards, hitting a new high of 4,680 and now up +25% since the start of the year. In contrast, the FTSE China 50 Index is down -16% since the start of the year. The US bond yield was at 1.6% last week, the same level it was in May this year. Brent Crude was down -3%, but remained just above $80 per barrel at the time of writing.
THG has fallen below 200p, versus an IPO price of 500p in September last year, as Blackrock sold half its stake at 195p. It’s worth noting that Blackrock already owned an 11% stake before the IPO, having first invested in the company several years ago. Metro Bank said last week that it has received an approach from Carlyle Group, which sent the shares up +26% to 133p. That may be a positive for recent MTRO shareholders, but the shares are still down -94% since the IPO. Like Blackrock with THG, Fidelity invested in MTRO well before the 2016 overpriced IPO at £20.
Similarly, Woodford, Old Mutual, Artemis and Fidelity all owned disclosable stakes in Purple Bricks pre-IPO. The disruptive estate agent warned on profits last week, and the shares have fallen -66% from the IPO price in 2015 of 100p to 34p last Friday. One way institutional active fund managers can outperform index trackers is to commit money to unlisted, high potential, early stage ventures pre-IPO. When the time comes to IPO, index trackers are forced to pay a less attractive price when companies are listed in public markets.
I recommend John Hempton’s (the well-respected Australian short seller) latest monthly letter. The whole letter is worth reading, but I will summarise: as a short seller Hempton wants to “short delusion” and profit from craziness in markets. So he is short AMC, the US movie theatre company and meme stock.
Hempton thinks that AMC shares, up +1730% since the start of the year is a crowd delusion. Reddit and Twitter are full of people who think that hedge funds manipulate the stock in “dark pools”, issuing massive numbers of fake shares. They say that the SEC are conspiring with Citadel (a large market maker) to manipulate the stock. Finally they think that ganging up together they can “democratize capitalism”, at the same time this will bankrupt short sellers.
You might laugh, he says, but the shares are owned by over 4 million individual shareholders – more than almost any other company in America.
His view is that this is an unforeseen effect of the pandemic, lockdown and spending too much time online with people who are reinforcing, not dissipating, delusion. I think he’s correct, but I’d add one extra thought. In trying to protect borrowers from economic shocks with lower interest rates, Central Banks have played their part in feeding the delusion. And in trying to protect retail equity investors, there’s been an unintended consequence of reducing the number of early stage companies to invest in on stock exchanges. As noted earlier, financial insiders and institutions, can invest early in exciting, high potential companies, then IPO companies at high valuations to the detriment of index trackers but also amateur investors.
So perhaps it’s reasonable that digital natives imagine there’s a Central Bank / financial services conspiracy against them, even if they articulate it in completely crazy ways. With house prices unaffordable, banks paying well below the c. 5% rate of inflation on savings, and public equity markets seemingly rigged against them, it’s an understandable reaction from the Reddit crowd. Buying crypto and meme stocks is not just about high risk/high return investing, it could also be a form of protest against the current financial system.
This week I look at K3 Capital, where I do a “deep dive” into how companies disclose their liabilities related to earn-outs and lock-ins from acquisitions. Plus UPGS, and SDI reported positive trading statements.
Monday is another online Mello Event. Companies presenting are Sosander, Sulnox and Property Franchise Group, plus the ever entertaining BASH. David has shared a code 0811MelloGuest if you’d like to watch. The pass is a meant as a free ticket for those new to Mello to see what the event is about, and that it’s good to share ideas with investors who don’t refer to themselves as “apes”.
This speciality finance company has 3 divisions which act as an umbrella for many niche brands: i) M&A Advisory 34% ii) Tax Advisory 11% and iii) Restructuring 55% of reported revenue FY results to May.
They have grown by acquisition, buying randd and Quantuma, paid for via £30.5m placing in June 2020 at 150p and then a further £10m placing at 340p in July this year, to buy Knight R&D and Knight Corporate Finance. The latter is not included in these FY May 2021 numbers, as it happened after the financial year end.
Headline financials FY May 2021 revenues grew +215% to £47.2m and PBT was +18% to £7.6m. They give an organic revenue growth figure of +8% for their M&A division, but that’s not particularly meaningful as last year was so transformational: 2/3 of the £47.2m revenue was from businesses that they acquired during the year. Revenue is recognised when performance obligations are satisfied, so there’s £4.8m (or 10% of FY revenue) in income, which hasn’t yet been invoiced for, as well as a further £5.2m of trade receivables. I listened to the call on InvestorMeetCompany, where management said that they preferred to report lower revenue and lower “Work in Progress” on the balance sheet, but their auditors said that they were being overly prudent. Net cash was £14.3m at the end of May (£8.3m May 2020).
Accounting for acquisitions Below is a discussion of acquisition accounting. The next couple of paragraphs may be too technical for some, so just skip to the next section if you find yourself losing the thread.
Looking at the note “business combinations” in the K3 accounts, earn-outs for the business that they bought are valued at £23m, which has been reduced to £14m “Fair Value” liability, using scenario analysis (ie how likely they are to trigger the future maximum payout) and a 3% discount rate. These earn-outs are payable in a mixture of cash and shares. However there is a much lower figure of £4.2m on the face of K3’s balance sheet (split £1.7m current liabilities and £2.5m in non-current liabilities) valued using amortised cost.
I think that shareholders should be aware that although the net cash figure is a healthy £14.3m, that should be netted off against £14m Fair Value of likely future payments to come in cash and shares, which could reach a maximum of £23m future liability. Net tangible assets (ie after deducting goodwill) are just £7m, so would be negative if earn-out liabilities were recorded at Fair Value on the face of the balance sheet. This isn’t at all obvious unless you dig into the notes of the accounts.
Out of curiosity, I looked at Mission Group’s and RBGP’s accounting treatment on this issue. Mission Group seems more common sense to me: they record the full cost of previous years’ acquisitions, included within goodwill on the asset side of the balance sheet, and on the liability side the full £8.5m deferred consideration is split out. RBGP record deferred consideration as a liability, but don’t include this figure as a separate item on the consolidated balance sheet, instead including it in “trade and other payables”
K3 management also expense £3.9m as an exceptional item “deemed remuneration” through the p&l, which refers to lock-ins from previous acquisitions. Again, I listened in for management’s explanation on the call: money has been paid out to retain key staff, who will have to repay the cash if they do resign. K3’s auditors have said this figure cannot be capitalised on the balance sheet, the £3.9m needs to be expensed through the p&l. As an aside, Sharepad shows a very high Beneish M score of 11.47 (in red below) for K3 Capital.
My feeling is that it makes sense to have earn-outs and lock-ins when companies make acquisitions, but it’s important to understand future payments as a liability/debt, and how this is disclosed. True, the staff at Mission and RBGP were both willing to be flexible on their deferred consideration, because the pandemic created a situation where it made sense. But I am a little uneasy because accounting for deferred consideration caused problems at M&C Saatchi, so investors need to be aware of potential risk scenarios in the future.
A final observation When you have companies like Mission, RBGP and K3 growing by acquisitions made partly with shares, then management have every incentive to try to keep their share price buoyant, because their own share price serves as currency for acquisitions (both purchases already made but only partially paid for, and future deals). I mentioned last week that Northern Rock’s management attitude towards accounting revealed that they were also taking other risks with their business model.
Forecasts FinnCap left their forecasts for K3 unchanged. They expect revenue to grow +21% CAGR to £69.5m FY May 2023F, and Adj EPS to reach 24p in the same year. That puts the shares on 14x May 2024F.
Opinion Last year was transformational. So far, the strategy is working, but we’ve had a very helpful corporate finance and capital raising environment in the last 9 months. I’m a little wary because corporate financiers can often be over-confident about their ability to do deals and expand too aggressively. I own shares in Mission, which listed in 2006 and then in the next four years saw its share price fall -90% as a combination of over paying for acquisitions, leverage and the financial crisis hitting revenue called into question the company’s future. Let’s hope the same doesn’t happen to either K3 or RBGP.
UP Global Sourcing FY July 2021
This consumer goods company that makes small domestic appliances, speakers and houseware products, which it then imports from 269 suppliers in China. The share price has been weak in the last couple of months because fears of supply chain disruption. They manufacture their own brands Beldray, Intempo and licence brands from Russell Hobbs. Best-selling items are frying pans, mugs and speakers.
In July, 2 weeks before their financial year end, they acquired the Salter brand (kitchen and bathroomware) which they had had a licence agreement for since 2011. They are paying an initial £30.6m consideration, plus a further £3m deferred consideration after the year end. They partially funded this by raising £15m via a placing at 210p per share.
Their headline FY July 2021 numbers are in-line with prior expectations announced in a trading update in August: revenue +18% to £136m and adjusted PBT +36% to £11.2m. However, the shares reacted well +7% on the morning of the results probably because investors had feared that the outlook statement would reduce expectations for FY July 2022F.
Net debt increased 5x to £18.9m, due to the Salter acquisition, meaning net bank debt/adj EBITDA is 1.4x. This looks reasonable, given that the numerator (debt) is a year end balance sheet number, but the denominator (adj EBITDA) is the cumulative earned over the financial year and doesn’t contain the contribution from Salter.
The main adjustment to EBITDA is share-based payments, but also includes repayment of furlough loans and acquisition expenses. I note that the company’s definition of free cashflow was £6.5m after working capital and capex, much lower than the adjusted EBITDA figure. They have £16m of headroom for their banking facilities – NB They’ve almost certainly made a typo mistake in the sentence; they say at end of July 2020, but they obviously mean 2021 (because they give the previous year’s £21m headroom figure in brackets).
History Founded in 1997 by current Chief Executive Simon Showman and Barry Franks. The business originally bought surplus inventory from third parties to sell, but then became a sourcing business, helping customers source own brand goods from China. Lloyds Development Capital (Lloyds Bank private equity arm) took a 47% stake in 2005. After the financial crisis they focused on the sale of branded goods, either selling brands they’d directly acquired (Beldray and Intempo in 2009), or entering into licence agreements (Russell Hobbs and Salter in 2011). In 2014 management bought back LDC’s stake. UPGS listed on the LSE in March 2017, raising £50m at 128p from selling shareholders, valuing the company at a market cap of £105m. Following the IPO the company ran into problems but has since recovered to above the IPO price.
Outlook They say that shipping costs and availability are challenges which they expect to remain until after February 2022 (Chinese New Year). But they reassure that current trading is in line with expectations. Longer term they believe they are set to benefit from more homeworking and home cooking. I’m not so sure about this, that is: I agree with more homeworking trend and 15% of revenue comes from selling through Amazon and other online retailers, but I’m not convinced that UPGS is a major beneficiary from Covid in the way that tech companies are.
Forecasts Equity Development released a note on the morning of the UPGS results, maintaining their current forecasts for FY July 2022F and FY July 2023F. These forecasts assume an organic +6% sales growth both years (though FY July 2022F benefits from the inclusion of Salter, which gives +19% growth to £162m.) That means EPS FY July 2022F is forecast to be 14.1p and 15.3p the following year, suggesting a PER ratio of 15.5x and 14.9x respectively.
Ownership Co-founders Simon Showman 21% and Barry Franks 8% still own large stakes. Barry Franks has stepped down as Non Exec Director. Andrew Gossage, who is Managing Director owns 9%. There are a couple of related party transactions with the management owning property that they then rent out to UPGS, the amounts involved: less than £300K a year seem reasonable though. This hasn’t prevented a couple of institutions also taking sizeable positions: Schroders 15%, Ennismore Fund Management 6% and Slater 4%.
Opinion Looks good, 28% ROCE according to Sharepad. I’ve not seen management present but they’ll be appearing on 17th November on a Sharesoc webinar. The shares are already up +140% versus this time last year – though on c. 15x earnings not expensive. The other slight concern looking at the chart history is the vicious drawdowns in share price when things don’t go to plan – so understandable some shareholders may be quick to exit if the company hits problems again.
SDI Trading Update H1 31 Oct
This scientific instruments maker (digital imaging and sensing control applications) said that they expect to report H1 revenue to October of £24.7m, which equates to organic growth of +40% y-o-y. Including acquisitions Monmouth Scientific and Uniform Engineering revenue growth rises to +75% y-o-y. Their Atik Cameras division has benefitted from orders for cameras used to amplify DNA in PCR tests, related to testing for COVID-19. They have continued to ship orders through H1 2022, but there will be a substantial reduction in H2, which the company has flagged previously. They have raised their FY guidance to “around £45m” and they also expect PBT to be “modestly above current market expectations of £9.2m.”
Forecasts In February this year, SDI set out its expectations until April 2022F, suggesting £42m of revenue and adj PBT of £8.7m. So they’re +7% ahead of February guidance on top line growth. There is a risk that the strong numbers being reported now are merely pulling forward demand from next year (ie April 2023F.) FinnCap, their broker have only increased sales by +2% to £41m next financial year, implying a -9% decline as orders for the PCR test related equipment reduce. That implies an adj EPS of 5.3p April 2023F, or 40x PER for a company with strong quality metrics.
Future acquisitions So far in this financial year SDI haven’t bought any companies, but it sounds like they could be planning to. They have just expanded their loan facility with HSBC to £20m, with a further accordion option of an additional £10m (at the discretion of HSBC). They don’t give their current net cash figure in the RNS, but it was £0.8m end of April 2021. In any case, management have demonstrated a very strong track record of buying, integrating and growing businesses. The shares are up +468% in the last 3 years.
Opinion I like the shares and continue to hold. I think the PER of 40x is suggesting that investors believe management can keep going. There is a risk of either a duff acquisition, or lumpy orders, which would clearly damage the growth rating the business trades at. But I don’t see any reason to reduce my position at the moment.
The author owns shares in Mission Group and SDI
This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.