Bruce looks at the prospects for Commercial Real Estate (CRE) and wonders if this will become a source of market instability in 2024. Companies covered CML, SOLI, and SDI.
The FTSE 100 was flat last week, hovering around the 7,500 mark. In the US, the Nasdaq100 and S&P500 were both up less than half a percent. The best-performing stock exchange last week was the Mumbai (India) index +3.4% and +17% YTD, while the FTSE China 50 was the worst performer -3.3% last week and -19% YTD was the worst performer.
The rating agency Moody’s cut their outlook on China’s long-term debt from stable to negative last week. Chinese local government revenues are struggling because in the past they relied so heavily on selling land to property developers. However, with the collapse of Evergrande last year the property sector looks like it is no longer the cash cow for local governments that it once was. Barclays has calculated that since the beginning of 2020 at least 60 Chinese property developers with $140bn of outstanding bonds have defaulted. The OECD said recently that “structural stresses” in China were a downside risk to global growth.
The Bank of England released their bi-annual Financial Stability Report. The Central Bank is keen to assure us that there’s not going to be another banking collapse, or indeed another LDI bond market sell-off like October last year. One figure that caught my eye was that household debt/disposable income now stands at 139% — the lowest level since 2002 (when the Halifax house price index was c. £100K, compared to £284K currently).
The BoE also look at Commercial Real Estate (CRE) which many investors think is more sensitive to rising interest rates because of the “Work from Home” trend.
The UK’s CRE decline has been more pronounced than the Euro area and the US – possibly because UK banks have been less willing to extend credit to troubled commercial borrowers. I see that Muddy Waters, the (in)famous US short-selling firm is now targeting Blackstone’s Mortgage Trust vehicle (enterprise value $24bn).
In Europe, we’ve seen a couple of large borrowers Cevdet Caner’s Adler and Rene Benko’s $27bn Signa blow up in, leaving banks with billions of exposure to probably overstated commercial property collateral, so it’s surprising to see that European CRE hasn’t performed worse. This FT article suggests that German office buildings are going to be a real problem, but that German banks, particularly Landesbanks (which are not listed on the stockmarket) have been slow to recognise losses.
Meanwhile, in UK equity markets we saw another couple of bids for Smart Metering Systems and Ten Entertainment, TEG (not to be confused with Ten Lifestyle, TENG). By my count that makes 15 companies since DX Group in mid-September. That compares to under 670 companies currently listed on AIM Allshare and 572 on the FTSE All Share. Below is my updated table of all the bids that we’ve seen in the small-cap space in the last few months.
This week I look at H1 September results from CML Microsystems, Solid State plus H1 Oct results from SDI. I own all three but am most nervous about the near-term outlook for SDI, and the chance of a third profit warning as organic growth has stalled but brokers’ forecasts imply a strong recovery over the next 18 months. CML’s share price decline on the other hand looks harsh to my eyes, and I am more upbeat on their near-term prospects. If I had to own just one of the three, I would go with CML.
CML Microsystems H1 September
This cash-rich mixed-signal microwave semiconductor company announced H1 results to Sept with revenues +5% to £11m. PBT was up +9% to £1.9m, if you exclude exceptional acquisition cost for a US company MwT, which completed in October. They had £21m of cash at the end of September, but that will drop as $7.65m in cash (or £6m) has been paid for MwT, with another $5.5m in shares after the period ends.
MwT was founded in 1982 in Silicon Valley and involved in the design, manufacturing and marketing of GaAs and GaN-based MMICs, Discrete Devices and Hybrid Amplifier Products for Commercial Wireless Communication, Defence, Space and Medical (MRI) applications. MwT was loss-making but I think management know what they’re buying, even if most readers’ eyes glaze over. CML management have a good track record as they achieved a 10x return over a couple of decades when they sold a subsidiary, Hyperstone in 2021 for $49m (£33m at the then exchange rate) in cash to Swissbit, an Internet of Things (IoT) company.
The group already had operations in the USA (North Carolina), with 19% of revenue coming from North America, 23% from the UK and Europe and 58% from the Far East, including a production facility in Wuxi, China. At the back of my mind, I do wonder if the latter presents a risk to the investment case with tensions rising between China and the West. CML’s China presence could also explain why it took US authorities so long to grant regulatory clearance for their MwT acquisition.
Property: The company’s headquarters are in Oval Park in Essex, and they have a property development opportunity (planning permission awarded in Feb 2023 for around 15 acres of excess land). There’s also a further opportunity for development of land that they own in Fareham and Hampshire, however, the H1 statement says negotiations have now ceased. In all, there’s £2m of property held for sale as a current asset and £6.1m (£5.2m H1 last year) in non-current assets. I’m surprised that they haven’t written up the value of property by more than that, given that with planning permission awarded I would have expected the value to have risen significantly.
Outlook: The RNS says that they expect full-year revenues (Progressive forecast £20.6m, +21% growth) to be slightly ahead of current market expectations, with the majority of the growth attributable to the addition of MwT. PBT is expected to be in line (Progressive forecast £3.6m), with anticipated costs relating to the incorporation of MwT likely to temper further growth this year. The share price reaction of -9% over the previous few days looks harsh, given these results were “in line”. That may signal investors were disappointed with the organic revenue growth (similar to SDI which I cover below). CML’s revenue progress since the pandemic has been encouraging, but the longer-term track record of profits and RoCE is disappointing.
Valuation: The shares are trading on a PER of 19x Mar 2024F (Progressive have only forecast out to March 2024F, which is rather disappointing). By my calculations, the company should have between £15m – £20m of cash on the balance sheet at March year-end. Deducting that from the market cap gives a cash-adjusted PER of 12x.
Opinion: I own this; one interesting aspect of the shares is that the price has fallen -40% this year from a peak of 580p in February, without the company having delivered a profit warning. That seems very harsh, given the cash and property backing of the balance sheet. SharePad shows that both Otus Capital (9.7% currently) and Premier Miton (11.85% currently) have trimmed their positions. So I do wonder if that is caused by institutions seeing outflows. That in turn might present an opportunity for amateur investors to take the other side of professional investors who might be reluctant forced sellers.
Solid State H1 September
This components supplier and manufacturer of “rugged” computers reported organic revenue growth +35% while maintaining adjusted operating margins at 9.2%. The group has grown by acquisitions, so including that revenue was up +48% to £88m and PBT up +45% to £6.1m. Net debt recovered to £3.9m v £16m H1 last year after contingent consideration was paid out.
Outlook: The open order book has fallen -11%, to £100m end of September, presumably as supply chain problems have eased. They say the order book bounced back too. £109m at the end of October, and they are confident of meeting FY Mar 2024F expectations, which they give in a footnote.
Given the strong organic growth reported it is a little disappointing that revenue growth is forecast to drop to around +15% at the FY stage then is forecast to go backwards next year, and PBT flat. I would imagine that this business does see quite lumpy orders though. I prefer to invest in a company that is seeing irregular but sustainable growth, than a company consistently delivering a smooth double-digit growth rate that then hits a brick wall and then implodes (Norther Rock is an obvious example, but FUTR which also reported last week and is down -84% since the beginning of last year is a more recent example).
Valuation: Using Cavendish’s forecast, the shares are trading on 15x PER Mar 2024F and 2025F. That seems about right given the flat EPS, but hopefully, management can exceed those rather pedestrian forecasts.
Opinion:I last wrote about the company 12 months ago, when the share price was £13.35. That shows the sort of year that AIM stocks have had if the company can deliver +35% organic revenue growth and stable margins, but the share price goes down over 12 months. SOLI has benefited from an increase in defence spending, management mentions £23m of NATO contracts in the RNS, so that probably can’t be extrapolated in a straight line. However, I think there’s nothing fundamentally going wrong, and eventually, EPS and share price will resume an upward trajectory. I own the shares.
SDI H1 October
This scientific instruments and digital imaging company released H1 results with revenue up +2% to £32m for H1 to September. Reported PBT halved to £3.4m, as a result of a Covid-related contract, where their Atik Cameras division was supplying components for PCR testing machines, coming to an end. SDI management warned about this in May, however following last week’s RNS Cavendish have slashed FY April 2024F EPS by -19%. So effectively this is a second profit warning.
They have a net debt of £13m as of the end of October, but in early November, they made another acquisition: Peak Sensors for a total consideration of £2.6m. Given SDI’s track record of growing via acquisitions, there’s over £40m of intangible assets on the balance sheet. The tangible equity is just £2.9m. That should be fine as long as the business continues to generate cash (the management commentary says cash generated from operations was £3.3m in H1 but if you look to the cashflow statement then this figure drops by two-thirds to £1.1m after interest costs and tax paid). The group has used less than half of its £25m loan facility with HSBC, and there’s a further £5m accordion available if needed.
Divisional Performance: The business is split roughly 80/20 between Sensors & Controls and Digital Imaging. The latter includes the Atik Camera’s division, hence saw revenues decline -57%. Even excluding this underlying revenues were down -12%. Margins also contracted from an eye-catching 37% to just below 12%. The larger Sensors & Controls business saw revenue growth of -40%, but that was boosted by the acquisitions of LTE Scientific and Fraser Anti-Static Techniques (FAST). On an organic basis, revenue growth was +7%. Margins are also going in the right direction, expanding from 15% last year to 18% this H1.
Outlook: The expiry of the large Covid/PCR-related contract is mentioned in the outlook statement, but that was the cause of May’s profit warning. Other factors mentioned include de-stocking from the supply chain concerns of a year ago, plus a slowdown in Germany and China. They say that their strategy is to buy private companies at a significant discount to those trading on the stock exchange, and then encourage them to grow organically. I agree that has been the strategy, but the latter part has disappointed, organic revenue growth has fallen below +4% for the last 18 months. Management say they have a strong pipeline of acquisition opportunities, I wonder if they should be more focused on trying to repair what has gone wrong with organic growth in their existing businesses.
Valuation: The shares are trading on a PER of 14x Apr 2024F falling to 11x the following year as Cavendish forecast a +28% recovery in EPS next year. Such an impressive bounce-back does leave scope for EPS to disappoint a third time if the outrun is less benign than hoped for. That said, peak earnings achieved in Apr 2023F were 9.1p, so that optimistic recovery is within the bounds of reality.
Opinion: Unlike CML, Solid State, MS International and others, SDI doesn’t seem to have much exposure to increased defence spending and NATO contracts. Instead, it relies on university and research institute spending. This was a top 5 position for me at the start of the year, and it remains so because my other large positions like SLP and IPX have also done badly! I’m going to stick with it though and may even increase my position size when/if I feel we are past the downgrade cycle.
Notes
Bruce owns shares in SDI, CML, MS International and SOLI.
Bruce co-hosts the Investors’ Roundtable Podcast with Roland Head, Mark Simpson and Maynard Paton. To listen you can sign up here: privateinvestors.supercast.com
Got some thoughts on this week’s commentary from Bruce? Share these in the SharePad “Weekly Market Commentary” chat. Login to SharePad – click on the chat icon in the top right – select or search for “Weekly Market Commentary” chat.
Weekly Market Commentary | 12/12/2023 | CML, SOLI, SDI | Instability from property?
Bruce looks at the prospects for Commercial Real Estate (CRE) and wonders if this will become a source of market instability in 2024. Companies covered CML, SOLI, and SDI.
The FTSE 100 was flat last week, hovering around the 7,500 mark. In the US, the Nasdaq100 and S&P500 were both up less than half a percent. The best-performing stock exchange last week was the Mumbai (India) index +3.4% and +17% YTD, while the FTSE China 50 was the worst performer -3.3% last week and -19% YTD was the worst performer.
The rating agency Moody’s cut their outlook on China’s long-term debt from stable to negative last week. Chinese local government revenues are struggling because in the past they relied so heavily on selling land to property developers. However, with the collapse of Evergrande last year the property sector looks like it is no longer the cash cow for local governments that it once was. Barclays has calculated that since the beginning of 2020 at least 60 Chinese property developers with $140bn of outstanding bonds have defaulted. The OECD said recently that “structural stresses” in China were a downside risk to global growth.
The Bank of England released their bi-annual Financial Stability Report. The Central Bank is keen to assure us that there’s not going to be another banking collapse, or indeed another LDI bond market sell-off like October last year. One figure that caught my eye was that household debt/disposable income now stands at 139% — the lowest level since 2002 (when the Halifax house price index was c. £100K, compared to £284K currently).
The BoE also look at Commercial Real Estate (CRE) which many investors think is more sensitive to rising interest rates because of the “Work from Home” trend.
The UK’s CRE decline has been more pronounced than the Euro area and the US – possibly because UK banks have been less willing to extend credit to troubled commercial borrowers. I see that Muddy Waters, the (in)famous US short-selling firm is now targeting Blackstone’s Mortgage Trust vehicle (enterprise value $24bn).
In Europe, we’ve seen a couple of large borrowers Cevdet Caner’s Adler and Rene Benko’s $27bn Signa blow up in, leaving banks with billions of exposure to probably overstated commercial property collateral, so it’s surprising to see that European CRE hasn’t performed worse. This FT article suggests that German office buildings are going to be a real problem, but that German banks, particularly Landesbanks (which are not listed on the stockmarket) have been slow to recognise losses.
Meanwhile, in UK equity markets we saw another couple of bids for Smart Metering Systems and Ten Entertainment, TEG (not to be confused with Ten Lifestyle, TENG). By my count that makes 15 companies since DX Group in mid-September. That compares to under 670 companies currently listed on AIM Allshare and 572 on the FTSE All Share. Below is my updated table of all the bids that we’ve seen in the small-cap space in the last few months.
This week I look at H1 September results from CML Microsystems, Solid State plus H1 Oct results from SDI. I own all three but am most nervous about the near-term outlook for SDI, and the chance of a third profit warning as organic growth has stalled but brokers’ forecasts imply a strong recovery over the next 18 months. CML’s share price decline on the other hand looks harsh to my eyes, and I am more upbeat on their near-term prospects. If I had to own just one of the three, I would go with CML.
CML Microsystems H1 September
This cash-rich mixed-signal microwave semiconductor company announced H1 results to Sept with revenues +5% to £11m. PBT was up +9% to £1.9m, if you exclude exceptional acquisition cost for a US company MwT, which completed in October. They had £21m of cash at the end of September, but that will drop as $7.65m in cash (or £6m) has been paid for MwT, with another $5.5m in shares after the period ends.
MwT was founded in 1982 in Silicon Valley and involved in the design, manufacturing and marketing of GaAs and GaN-based MMICs, Discrete Devices and Hybrid Amplifier Products for Commercial Wireless Communication, Defence, Space and Medical (MRI) applications. MwT was loss-making but I think management know what they’re buying, even if most readers’ eyes glaze over. CML management have a good track record as they achieved a 10x return over a couple of decades when they sold a subsidiary, Hyperstone in 2021 for $49m (£33m at the then exchange rate) in cash to Swissbit, an Internet of Things (IoT) company.
The group already had operations in the USA (North Carolina), with 19% of revenue coming from North America, 23% from the UK and Europe and 58% from the Far East, including a production facility in Wuxi, China. At the back of my mind, I do wonder if the latter presents a risk to the investment case with tensions rising between China and the West. CML’s China presence could also explain why it took US authorities so long to grant regulatory clearance for their MwT acquisition.
Property: The company’s headquarters are in Oval Park in Essex, and they have a property development opportunity (planning permission awarded in Feb 2023 for around 15 acres of excess land). There’s also a further opportunity for development of land that they own in Fareham and Hampshire, however, the H1 statement says negotiations have now ceased. In all, there’s £2m of property held for sale as a current asset and £6.1m (£5.2m H1 last year) in non-current assets. I’m surprised that they haven’t written up the value of property by more than that, given that with planning permission awarded I would have expected the value to have risen significantly.
Outlook: The RNS says that they expect full-year revenues (Progressive forecast £20.6m, +21% growth) to be slightly ahead of current market expectations, with the majority of the growth attributable to the addition of MwT. PBT is expected to be in line (Progressive forecast £3.6m), with anticipated costs relating to the incorporation of MwT likely to temper further growth this year. The share price reaction of -9% over the previous few days looks harsh, given these results were “in line”. That may signal investors were disappointed with the organic revenue growth (similar to SDI which I cover below). CML’s revenue progress since the pandemic has been encouraging, but the longer-term track record of profits and RoCE is disappointing.
Valuation: The shares are trading on a PER of 19x Mar 2024F (Progressive have only forecast out to March 2024F, which is rather disappointing). By my calculations, the company should have between £15m – £20m of cash on the balance sheet at March year-end. Deducting that from the market cap gives a cash-adjusted PER of 12x.
Opinion: I own this; one interesting aspect of the shares is that the price has fallen -40% this year from a peak of 580p in February, without the company having delivered a profit warning. That seems very harsh, given the cash and property backing of the balance sheet. SharePad shows that both Otus Capital (9.7% currently) and Premier Miton (11.85% currently) have trimmed their positions. So I do wonder if that is caused by institutions seeing outflows. That in turn might present an opportunity for amateur investors to take the other side of professional investors who might be reluctant forced sellers.
Solid State H1 September
This components supplier and manufacturer of “rugged” computers reported organic revenue growth +35% while maintaining adjusted operating margins at 9.2%. The group has grown by acquisitions, so including that revenue was up +48% to £88m and PBT up +45% to £6.1m. Net debt recovered to £3.9m v £16m H1 last year after contingent consideration was paid out.
Outlook: The open order book has fallen -11%, to £100m end of September, presumably as supply chain problems have eased. They say the order book bounced back too. £109m at the end of October, and they are confident of meeting FY Mar 2024F expectations, which they give in a footnote.
Given the strong organic growth reported it is a little disappointing that revenue growth is forecast to drop to around +15% at the FY stage then is forecast to go backwards next year, and PBT flat. I would imagine that this business does see quite lumpy orders though. I prefer to invest in a company that is seeing irregular but sustainable growth, than a company consistently delivering a smooth double-digit growth rate that then hits a brick wall and then implodes (Norther Rock is an obvious example, but FUTR which also reported last week and is down -84% since the beginning of last year is a more recent example).
Valuation: Using Cavendish’s forecast, the shares are trading on 15x PER Mar 2024F and 2025F. That seems about right given the flat EPS, but hopefully, management can exceed those rather pedestrian forecasts.
Opinion: I last wrote about the company 12 months ago, when the share price was £13.35. That shows the sort of year that AIM stocks have had if the company can deliver +35% organic revenue growth and stable margins, but the share price goes down over 12 months. SOLI has benefited from an increase in defence spending, management mentions £23m of NATO contracts in the RNS, so that probably can’t be extrapolated in a straight line. However, I think there’s nothing fundamentally going wrong, and eventually, EPS and share price will resume an upward trajectory. I own the shares.
SDI H1 October
This scientific instruments and digital imaging company released H1 results with revenue up +2% to £32m for H1 to September. Reported PBT halved to £3.4m, as a result of a Covid-related contract, where their Atik Cameras division was supplying components for PCR testing machines, coming to an end. SDI management warned about this in May, however following last week’s RNS Cavendish have slashed FY April 2024F EPS by -19%. So effectively this is a second profit warning.
They have a net debt of £13m as of the end of October, but in early November, they made another acquisition: Peak Sensors for a total consideration of £2.6m. Given SDI’s track record of growing via acquisitions, there’s over £40m of intangible assets on the balance sheet. The tangible equity is just £2.9m. That should be fine as long as the business continues to generate cash (the management commentary says cash generated from operations was £3.3m in H1 but if you look to the cashflow statement then this figure drops by two-thirds to £1.1m after interest costs and tax paid). The group has used less than half of its £25m loan facility with HSBC, and there’s a further £5m accordion available if needed.
Divisional Performance: The business is split roughly 80/20 between Sensors & Controls and Digital Imaging. The latter includes the Atik Camera’s division, hence saw revenues decline -57%. Even excluding this underlying revenues were down -12%. Margins also contracted from an eye-catching 37% to just below 12%. The larger Sensors & Controls business saw revenue growth of -40%, but that was boosted by the acquisitions of LTE Scientific and Fraser Anti-Static Techniques (FAST). On an organic basis, revenue growth was +7%. Margins are also going in the right direction, expanding from 15% last year to 18% this H1.
Outlook: The expiry of the large Covid/PCR-related contract is mentioned in the outlook statement, but that was the cause of May’s profit warning. Other factors mentioned include de-stocking from the supply chain concerns of a year ago, plus a slowdown in Germany and China. They say that their strategy is to buy private companies at a significant discount to those trading on the stock exchange, and then encourage them to grow organically. I agree that has been the strategy, but the latter part has disappointed, organic revenue growth has fallen below +4% for the last 18 months. Management say they have a strong pipeline of acquisition opportunities, I wonder if they should be more focused on trying to repair what has gone wrong with organic growth in their existing businesses.
Valuation: The shares are trading on a PER of 14x Apr 2024F falling to 11x the following year as Cavendish forecast a +28% recovery in EPS next year. Such an impressive bounce-back does leave scope for EPS to disappoint a third time if the outrun is less benign than hoped for. That said, peak earnings achieved in Apr 2023F were 9.1p, so that optimistic recovery is within the bounds of reality.
Opinion: Unlike CML, Solid State, MS International and others, SDI doesn’t seem to have much exposure to increased defence spending and NATO contracts. Instead, it relies on university and research institute spending. This was a top 5 position for me at the start of the year, and it remains so because my other large positions like SLP and IPX have also done badly! I’m going to stick with it though and may even increase my position size when/if I feel we are past the downgrade cycle.
Notes
Bruce owns shares in SDI, CML, MS International and SOLI.
Bruce co-hosts the Investors’ Roundtable Podcast with Roland Head, Mark Simpson and Maynard Paton. To listen you can sign up here: privateinvestors.supercast.com
Got some thoughts on this week’s commentary from Bruce? Share these in the SharePad “Weekly Market Commentary” chat. Login to SharePad – click on the chat icon in the top right – select or search for “Weekly Market Commentary” chat.