Weekly Commentary 24/01/22: Market wobbly

Bruce looks at Terry Smith’s investor letter, admires his simple process. SharePad is also great research tool for assessing funds like Fundsmith, not just individual companies. Plus 3 companies that reported last week.

The FTSE 100 was 7,521, down -0.3% last week. The US markets have sold off much harder last week, with the S&P500 down another -3.9% and the Nasdaq100 -4.9%. Netflix warned on subscriber growth and Peloton has stopped production of its exercise bikes due to falling demand. $PTON shares are now at the level they were in January 2020. The US 10Y govt bond yield which reached 1.87% last week is also at its January 2020 level. Brent Crude is up +14% since the start of the year to $88 per barrel. I suggested two weeks ago that there might be a market “wobbly” as Central Banks talked about raising interest rates. We are officially in “wobbly” territory now.

Terry Smith published his annual investor letter. Many fund managers have benefitted from the decline in bond yields and investing in “superstar” US tech companies, but Terry Smith’s fund should be less exposed to hubris than other fund managers. I enjoy reading what he has to say, because like all good former banks’ sector analysts, Terry take issues that are complicated but can focus on their essence. I used to sit next to an insurance analyst, who did the opposite; whenever I asked him a simple question about insurance companies (for instance how much of their balance sheets were equities vs corporate bonds vs Government bonds) his answer used to start: “It’s complicated….” After 10 minutes of insurance industry exegesis, I was more confused than when I asked the question in the first place and certainly none the wiser. Eventually he admitted that he believed that it was his job to thoroughly confuse everyone else, particularly fund managers, saying that “Bruce, if you make your sector simple for fund managers to understand, then they won’t need a sector specialist to explain things for them, and you won’t have a job.” I’m no longer an equity research banks’ analyst, and neither is Terry Smith, so I suppose he had a point.

In Terry’s letter there’s a section on Unilever where he suggests management have become more focused on virtue signalling than running their business. That was before last week’s news that ULVR bid for GSK consumer brands. His ULVR investment is an interesting case study of holding on despite fears that management have (in his words) “lost the plot”. Despite his disparaging comments, he believes that strong brands and distribution compensate for a weak management team.

One of my poorer investments has been PZ Cussons, which is a similar business to Unilever (but much worse performer over the last 5 years.) Brands no longer need a large budget to advertise on national TV, but instead social media means that ads can be targeted more carefully and it costs less marketing spend to build a challenger brand. So I do wonder if adtech has made life more difficult for consumer brand companies.

Below I look at BOTB’s warning, which has been driven by inflation in the cost per thousand impressions (CPM) charged by Meta (ie Facebook/Instagram). FinnCap BOTB’s broker says that marketing cost inflation and reduced efficiencies caused by Apple’s IOS14 update – which allows users to opt out of tracking – has meant BOTB’s average customer acquisition cost has risen by 2.4x in Q4 2021 to £50.36 versus the same quarter in 2020 and is quadruple that of Q2 2020.

It’s arguable who captures the value from this trend though, The Trade Desk is on 88x forecast PER but down -26% since the start of the year. Digital Turbine is down -55% from its peak. Wherease Alphabet and Meta (formerly known as Google and Facebook) trade on a forecast PER of 25x and 23x respectively, and are a better way to invest in this trend, I think.

Richard has built a Terry Smith style filter for UK companies here. Aside from Andrews Sykes, I don’t own any companies in the filter, nevertheless I do admire the Fundsmith process:

• Buy good companies

• Don’t overpay

• Do nothing

Although I use SharePad to research individual shares, it is also great research tool for funds. Morningstar ratings, investment style, top 10 holdings, valuation, volatility measures and other portfolio statistics. Fundsmith’s companies trades on aggregate 29x forecast PE, 6x turnover and 22x price to cashflow.

This week I look at 3 companies: The Pebble Group, which has an interesting niche designing promotional products for companies, Sanderson Design Group which continues to do well with its luxury wallpaper, and BOTB which came out with a third profit warning since its placing at £24 per share.

Also David Stredder’s MelloMonday returns this Monday evening at 6pm.

The Pebble Group FY Dec Trading Update

The Pebble Group (PEBB) not to be confused with Pebble Beach (PEB) announced a trading update for FY Dec 2021. Their Brand Addition division designs promotional products for large companies (T shirts with company logos, diaries, pens, water bottles or more bespoke products).

The RNS says group revenue for FY Dec 21 will be circa £115m (FY 20: £82m, FY 19: £107m). They also expect to generate £15m of Adjusted EBITDA (FY 20: £10m, FY 19: £15m). That £10m adjusted EBITDA in 2020 translated to a statutory PBT of £5m and £7.5m cash from operating activities. That’s pleasing given that group revenue was down -23%, and PBT ex 2019 IPO costs was down -29% in 2020.

£100m of revenue (or 87% of Group) comes from Brand Addition. They’ve won some client contracts and are expecting these wins to contribute to revenue growth in FY 2022F. The other division is Facilis (13% of group revenue) and in 2021 recurring revenue was up +40% ahead of the prior year in US$ terms. Facilis has much higher margins, and in FY 2020 was 54% of group Adj EBITDA. Facilis helps SMEs with Customer Relationship Management (CRM), product search and order processing. Subscription fees are fixed at the beginning of each year based on the prior year’s Gross Merchandise Value (GMV) and then paid monthly.

History This company started life as Brand Addition in 2010 formed as a spin-out from businesses within 4imprint, which is listed on the LSE (current market cap £730m). In February 2012 there was a Management Buy Out (MBO) led by Christopher Lee and Claire Thomson (the Group’s current Chief Executive Officer and Chief Financial Officer), backed by Private Equity firms H.I.G. Capital and by Beechbrook Capital LLP.

A few years later in 2017 there was a second MBO, this time supported by Elysian Capital LLP and Beechbrook. In December 2018 Pebble bought Facilisgroup, a SaaS provider of business intelligence software helping SMEs with promotional product distribution in North America.

PEBB listed on AIM just before the pandemic, in December 2019 at 105p per share, raising £79m of which £56m went to the selling shareholders (Private Equity firms Elysian and Beechbrook Captial, Christopher Lee and Clair Thompson). Following the placing they were valued at a £175m market cap. Facilisgroup came through the pandemic well, whereas in 2020 revenues and margins fell at Brand Addition. Management point that activity was down, but they didn’t lose any major client from Brand Addition.

Ownership Liontrust own 19.8%, Blackrock 13.3%, Fidelity 9.8%, Capital 8.0% and Amati 6.4%. That’s an impressive list of institutional ownership, so management must have ticked many boxes. Christopher Lee still owns 3.6% and Claire Thompson still owns 1.7%.

Valuation The shares are trading on 23x FY Dec 2023 and 1.5x revenue that year. RoCE was 18% in 2019, but roughly halved to 8% FY 2020 due to falling revenue at Brand Addition.

Opinion This looks like a small, fast growing business with operational gearing (Facilis) masked somewhat by a larger, lower c. 10% EBITDA margin more cyclical business which is the bulk of the revenues. There are some presentations on PI World.

Worth keeping track of progress, because as Facilis becomes a larger part of the p&l, the shape of the group could change substantially. I listened to the last FY results presentation, and feel that management could do a better job of giving tangible examples of how things work in both businesses, because I’m not familiar with how promotional products work.

Sanderson Design Group FY Jan Trading Update

This luxury wall paper company that used to be Walker Greenbank with a 31 Jan year end put out a positive RNS. Group revenues are expected to be slightly ahead of expectations (c. £112m +19% vs FY Jan 2021 £94m) margins have improved, driven by higher licensing income, so PBT should be “significantly ahead”. Management now expect adjusted PBT of at least £12m for FY Jan 2022 (+69% £7.1m FY Jan 2021). That PBT guidance is a 13% increase versus previous expectations forecast by Progressive Research in a 56 page note published last November.

SDG management comment that their UK based in-house manufacturing capabilities have benefitted from supply chain worries (Brexit / Covid 19). Both of the Group’s UK manufacturing sites, wallpaper printing in Loughborough and fabric printing in Lancaster, performed well and order books are “very strong”. Meanwhile North America has recorded growth of c. +40% on a constant currency basis, and now represents c. 19% of sales. UK brands that can do well in the USA are normally well worth following (Fever Tree, Games Workshop, Ashtead and before it lost its way, WPP).

One thing to mention is that the strong licensing income from agreements with the likes of UK retailer NEXT plc and new US client, Williams Sonoma, is partly driven by changes in how income is recognised under IFRS15. So some of that PBT increase and margin improvement is an accounting artefact, as opposed to underlying performance. Worth keeping an eye on the cashflow statement when the FY results come out.

The net cash position at 31 Jan 2022 is expected to be more than £15.4m (ex lease liabilities of c. £6m) versus £15.1m Jan 2021 on the same basis.

Valuation Progressive have increased their EPS forecast for FY Jan 2023F and FY Jan 2024F by 15% and 11% respectively. That gives EPS of 11.3p next year and 12.1p FY Jan 2024F, implying a PER ratio of 15.8x and 14.8x FY Jan 2024F.

The last couple of years SharePad shows that SDG has struggled to generate double digit RoCE, which is disappointing for a company that owns valuable Intellectual Property in the form of quality design brands (Sanderson, Morris & Co., Harlequin, Zoffany, Scion, Clarke & Clarke and the recently launched direct to consumer brand: Archive.)

It now looks like returns are increasing with the revenue growth and improved margins, so I’d expect to see better RoCE and Return on Equity in future years.

Opinion The shares have good momentum, and the price is up 6x since their Marc 2020 low of 29p. I should have bought this last year, but I’m not keen to chase it higher now. The long-term chart shows that when conditions worsen, then >80% peak to trough declines can happen. Well done to holders who bought the shares at a lower level though.

BOTB H1 to end October

Speaking of >80% peak to trough share price declines, BOTB the online car competitions business released H1 results to 31 October, and also updated on current trading through November to early January. Although the H1 figures were inline with previous guidance, the outlook looks more difficult. The shares fell -30% in response. H1 revenue fell -14% to £19m and PBT more than halved to £3.0m (v £6.8m H1 2020). There was £8.3m cash at the end of October (down by -26% vs October 2020).

Although revenues and profits were growing steadily before the pandemic, the long-term history in the chart below gives some context on just how large the 2.6x revenue and 3.5x profit increase was last year.

Competition Then last May the company warned that more online competition meant that the cost of acquiring players had significantly increased. Two thirds of BOTB’s marketing spend is cost per thousand impressions (CPM) on social media, and the company said in August last year that cost was up +60%. They said that they would hold back spending on marketing, but increase it as soon as market conditions (ie returns on their customer acquisition costs) looked likely to improve.

Unfortunately, following a period of stabilisation, the new financial year starting in November 2021 has seen a further c. 37% increase compared to 6 month April-Oct 2021 average. This means that revenues for FY Apr 2022F will now be £45-35m and PBT £4.25m-4.75m.

Broker forecasts FinnCap, their broker, have slashed EPS forecasts by 32% to 44p FY Apr 2023F and by 35% to 49p FY Apr 2024F. For comparison, I looked at the FinnCap note that they published in March last year, which had forecast EPS of 165p FY Apr 2023F. Unfortunately that -73% decline in EPS forecast shows how operational gearing can go against you.

Ownership After their share sales last year William Hindmarsh and his wife still own 32% of the issued share capital. Rupert Garton, also management, still owns 9.4%. Slater Investments holds 9.1% having bought in the placing back in April 2021 at £24 per share. I wonder what Mark Slater is thinking now – well I can guess, but it’s likely unprintable.

Opinion Looking back at my previous comments, I should have been more pessimistic when the first warning came out in May last year. I wrote that near-term expectations were too high, but longer-term the business model wasn’t threatened. That was not negative enough; they do say that profit warnings come in threes, and the company first warned in May, then August 2021, so this is the third warning.

I can’t see many people pay much more than 10x the new forecast of EPS of 49p Apr 2024F, which would imply a target price of 490p. There’s operational gearing, so that if the outlook improves, they could enjoy a renaissance. With the share price at 405p, the £8m of cash is over 20% of the company’s market cap. So another possible catalyst could be management using excess cash to buy back shares, which they have done in the past.

Longer term, I wonder if they should go back to having a physical presence with their cars/winning prizes in “pop-up” locations, as the business’s reliance on the adtech and social media platforms does seem to have gone from a blessing to a curse.

Bruce Packard

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