Stockopedia StockSlam - April 2019

Apologies but the date is not a misprint. Life has taken a front-seat since I had the pleasure of hosting our second StockSlam of the year! Nevertheless I know that many investors can't always make an event in central London and so I'm happy to provide this cleaned-up transcript of the event. As ever we had some excellent presenters and an engaged audience which made for an enjoyable evening. I hope that you find something educational or interesting from these brief notes of the event.

Stop press: I'm pleased to say that the next StockSlam will take place on July 9th! If you'd like to present, which I thoroughly recommend, please follow the instructions here:

Motorpoint (MOTR)

Okay, here is Motorpoint. Some of you may know this as a car supermarket. Motorpoint floated back in May 2016. As is typical with IPOs it profit warned within the first year. The share price duly halved in the first six months. They blamed this on Brexit. Since that point the business has done well, with margins normalising and sales increasing. The share price did recover back to an all-time high back in June ‘18, but since then the price has drifted down by almost 30%, down to 189p today. This fall is despite an ongoing share buy-back. They’re buying over £10m of their shares and this is continuing. Clearly off-setting this is a fair level of selling pressure in the company. I’m not saying this is necessarily the best time to buy, but at some point the share price fall is going to stall and it’s going to go back up, if the business is doing well.

So what’s the attraction here? Well the ROCE is 80%, exceptionally high, and it has very good cash generation. The reason why the ROCE is high is because it is a very asset-light business and has a very high turnover of cars, which means there’s not a lot of working capital tied up in the stock. Now, what you will also notice is that the operating margin is very, very low at 2%. Ordinarily this would put me right off because that kind of margin means you’ve got a lot of operational gearing with a fixed cost. If your sales fall by a small amount, profits are going to fall by a much larger amount. So it can be a dangerous position to be in. However, this is a business that operates with a very fast turnover of cars, they are quite skilled at extracting margin from those cars, and they know what they are doing. What’s interesting is that the share price is falling but forecasts are implying that profits are going to go up by 24% in 2019. Okay, then maybe not at all in 2020, but this will change, and yet it’s on a P/E ratio of 10 and it's yielding 4%. So there’s a lot to like about this company. It’s pretty cheap. It’s yielding well. It’s got very good returns on capital. It just appears to be unloved.

As we know, cars are out of favour at the moment, in the car sector all of the general dealers are on P/E ratios of 6 or 7, but at some point things are going to turn. The core difference for Motorpoint is that they sell nearly new cars, so we’re talking about ones up to two years old and under 50,000 miles, and they also have a target of opening more sites. Currently, they have 12 operating sites, they are looking for the 13th and they want to open 20. So there is growth built-in to this business. What is worth noting is that Motorpoint have these sites and they lease them. This means that the company is exposed to a certain level of lease liability, and some of these leases are going on for 10-20 years. So this ties in with the fact that there is operational gearing. The fact is there are certain risks here, and the leases could become a problem if sales collapse, but right now it obviously helps them operate and grow quite successfully.

One thing I did look up was what do employees think of the business? What do customers think of the business? It’s got to be true that if the customers don't like the business, or the employees aren’t happy, it’s not going to be successful. It turns out that if you look at Glassdoor, where employees post, they are almost universally positive about the company. They really love working there, which is great, and also the customer reviews are very good, which is quite impressive because for most car dealers, the feedback is pretty average. I think they look on most dealers as little better than Arthur Daley. The directors do have a reasonable share of the company. The CEO owns just over 9% and the founder, David Shelton, still owns something like 10% of the company, although he did sell about 10% last year. He moved to a NED role last year as well so that’s maybe why he was selling. There should be a full year trading update within the next few days, and if that’s positive at this kind of price maybe it will be a buy.

Q: One of the things I’ve learned recently is that earnings per share can be flattered by buy-backs, and as you say yourself there are a lot of buy-backs going on, so would that not make you ignore earnings per share to some extent?

A: Yes. That’s very true. That’s one of the reasons why they do buy-backs, is to improve the earnings-per-share. I think they bought back about 5% of the shares over the last year, so absolutely that will flatter it, but not by 24 or 25%. So it will help, and I think they’re looking on it as a use of cash as opposed to trying to boost reported earnings.

Naked Wines (WINE)

Today I am going to talk about Majestic Wine. It is a large group. They have four businesses within the group. One business is the retail business, which generates about 55% of their revenue, and the other one is Naked Wines, which generates roughly 40% of the business. Recently, management has decided to transform the group and close down the stores and retail side and reposition themselves towards Naked Wines, which is the online side of the business. So that’s why today I am going to only talk about Naked Wines. Let’s talk about what Naked Wines is. If we go back in history, the CEO, Rowan, was working for Virgin and he was starting up different businesses and he looked at wine and he saw that a lot of cost actually goes towards distribution, sales, marketing, and other items which are non-wine-producing related. If you remove that cost, then you could come up with a very compelling proposition for the customers. So he decided to set up a Naked Wines project. Essentially, it is a platform where you connect angels with winemakers. Angels are funding start-ups and other winemakers internationally. If you are an angel you get a preferential price, probably a 20-30% discount on the retail price that they get from those wine producers. According to them, they started up ten years ago from nothing, and now they have a revenue with Naked Wines of £175m. The majority of it is subscription revenue, which is recurring revenue, and according to them the market is quite huge, they are focusing on the United States, which is about a £17bn or so market. They are investing heavily in gaining market share from other competitors and for the amount of investment they have put in they think they can get back over four times that investment. If you look at the valuation of the business, it is a very low margin business. Roughly in wine retailing you are looking at 6% net margin. On that basis, it is trading at 15 to 16 times earnings ratio, and also on the top of it there is 8% growth rate. If we talk about risks, it is a highly competitive industry. There are supermarkets, there are brands, there are other players who want to take the market share away from you, so you have to be very competitive and have a compelling proposition that you can put towards your customers.

Q: I’m not saying that it would be wrong to invest. I just think there are considerable risks. One is that Naked Wines itself, as a prior customer, I just don't think their product is very good. Also I don't know what the prospects of Majestic are. Secondly, having spent probably 30 odd years in and around retail, you don't want to fight with the supermarkets. Thirdly, there are some pretty decent competitors in this area, like Laithwaites. Fourthly, young people drink less. So there are just an awful lot of potential negatives to wine generally, and Majestic particularly.

A: Yes, definitely. I totally agree there. There is a lot of competition in the market and also they have to really hone in on your proposition to the customers to get it right.

RA International (RAI)

At previous StockSlams my selections were both solid income-producing stocks, so I thought this time I should pick something a bit more exciting, so my selection is RA International. I certainly regard them as more speculative because they’ve only got a short track record as a public company. They’ve been listed since June last year. Their business involves site construction and services in remote locations. They operate in dangerous parts of Africa, which is the reason that they have done well because there are not many companies that have that capability and are prepared to work in those parts of the world. Their founders and executives come from an NGO background and have developed a track record of successfully delivering projects in difficult regions such as South Sudan and Somalia. They came to the market as well for a good reason. It wasn't founders selling out or private equity selling out. They wanted to actually raise some cash. Even though they had no debt at the time they came to market, they wanted to strengthen their balance sheet further and get the kudos of being a listed company so that they could undertake larger projects for more NGO clients. Their clients are principally blue chip NGOs, major natural resource companies, and large private contractors. As you can see from the stock report, they have good margins, which demonstrates the moat, and a good Return on Capital, so hence you get quite a good quality ranking for the stock at the top. When they floated initially they raised money at 56p. The shares climbed to a peak of over 80p but they are now trading at 37p. As was mentioned in our previous presentation, the classic thing of new IPOs is the early profit warning. What went wrong? Though the increased scale has indeed helped them to win larger contracts, those took longer to come through and localise than was anticipated, so they didn’t meet the market expectations, and as a result the shares look pretty cheap now. It seems to me that the downside is quite limited, with the latest forecast being for 10 cents EPS this year, and the potential upside if they do now deliver is large. So that’s where we are. I think we’re expecting results next week for 2018.

Q: I think they are in the running for several large contracts with a US Air Force base. Can you give us the full colour on that and potential upside if they do get it?

A: They recently announced one substantial contract, a framework contract where they have had the first order for 8.5m. Off the top of my head, I don't have the total pipeline but this is why the upside is potentially large; if these contracts do come through and they execute them successfully, which is obviously the risk, whether they execute successfully with the larger contracts, then earnings could grow very substantially and at a P/E of eight or so, that would look a real bargain. You could get both earnings growth and multiple expansion if they deliver, which, of course, is a big if.

Q: Do you have anything to say about the competition?

A: As I say, it’s a bit of a unique business because there are not many operators that work in these areas, so the short answer to your question is no, I haven't, but that might be because I haven’t done enough research into the competition.

Ashtead (AHT)

Ashtead, a FTSE100 company. We know elephants can’t run but this Dumbo flies. It has a CHER of 35%, cash conversion 93%. The share price has risen twice as fast as Facebook, a StockRank of 69 and a neutral style. You couldn't make it up could you? Contractors use Ashtead’s app like Uber, the short-term part of its 8bn rental fleet, ranging from hand tools to very large mechanical items, complete with driver ready-to-go in the USA, Canada, and the UK. Construction companies and small competitors cannot afford the rising cost, complication, and maintenance of new equipment which Ashtead provides with ease and reliability. In fragmented markets, big companies welcome Ashtead’s 7% share in the American market as healthy competition to United Rental's 12%. Forecast medium-term market growth is 5%. Ashtead is growing its market share through green-fields and bolt-ons, and expanding the addressable market through clusters and specialities. It is just 1% of New York. In the post hurricane clear up last year, Ashtead sent 1,800 lorries with equipment to work with Southern states and Puerto Rico, creating goodwill and vital experience for the clean-up of the current catastrophic flooding in the mid-west and they have used their skills before. Why a P/E of only 10? There’s been a lot of fake news about this company. People have sneered about hurricanes, favourable tax, and lorry driver's on $100,000 a year pay, pop concerts, hand tools, even Baillie Gifford the FANGs expert had a go. Last week’s scaremongering was Ferguson's Profits, which were marked fractionally down, and also the adverse yield gap, which this week has disappeared, and it’s now been replaced by a golden cross. Buy this late cyclical stock for short term gain whilst you follow the quarterly gold standard webinar, which explains the model, cash flows and long-term structural opportunities. Helping communities in need, you will boast you own a British company working over the pond.

Q: The debt seems to be going up by more than the turnover. Isn’t it a company that is going to get more and more in debt until it blows up?

A: Sorry, I missed that bit. The current management were there in 2009 when it nearly went belly-up. So they are keeping the compound debt at less than two times EBITDA and it is spread over a repayment period of 12 years. So it would be very difficult not to meet debtors as needed. Also, another piece I missed, it’s a late cyclical company. So it’s now producing cash like no one’s business. It’s just starting now.

Character Group (CCT)

Character Group is a toy distributor focused mainly on the pre-school market in the UK. They design, manufacture, and distribute toys like Peppa Pig or Fireman Sam. They licence the IP, they pay a royalty of about 10% of sales to the owners. Licences are normally for 3 years, but the company says they get renewed about 99% of the time. For example, they have had Peppa Pig for over 15 years and it’s just recently been renewed, and they’ve had Scooby Doo for 21 years. They also feel that they have some protection as each year they spend a couple of hundred thousand developing the products and toys that they own. So if the IP providers were to choose a new distributor, the distributor would have to put out a whole new range of toys themselves and look to market them. Character is rated as a SuperStock with a StockRank of 99 as of yesterday. Its forecast P/E is just under 11, but it has 15% of its market cap in cash. It also has freehold property assets of around £10m. They pay a 5% dividend and are buying back shares in the market. Most of their earnings flow straight through to cash. Its executives own large amounts of stock. So the stockholders like the company, but otherwise why buy it and why buy it now? Firstly, I think Character has got a really good chance of beating earnings estimates this year. The company normally makes 55% of its profits in its first half, and 45% in the second; the reason for that is the first half contains Christmas and Black Friday periods. In the second half of last year, after recovering from the Toys R Us bankruptcy in the first half, Character made 7m profit before tax, 28p EPS. The company says those were normal trading figures. Assuming that they manage to maintain that and they get their normal split of 55% in the first half of this year, they could easily be on course to do earnings per share of 60p or more, versus the current estimates of 48p. The first half results are expected by the end of this month, so now is potentially a good time, in case they beat them and the price goes up. Looking slightly further out, Character is looking to introduce their own IP and toy starting in July or August of this year. So far they have had really good response from toy companies and supermarkets and the company is very excited, but there is nothing in their numbers, so they are just waiting to see how it progresses. If it is successful, they think it will be a step change in terms of their revenues and operating profits. As mentioned, there’s nothing in the forecast for this but that’s just the moon shot, but otherwise you’ve got a SuperStock rated reasonably cheaply and I think there’s a good chance of it beating its forecasts.

Q: I understand the directors have a fairly high remuneration package in this company. You might say they are using it for their benefit. So I wonder if you had any comments on that.

A: There’s definitely a bit of worry about that, and the fact that it could be seen to be run as a lifestyle company. I don't have an exact figure off the top of my head but they get a significant percentage of operating profits. However, despite that, I think the company itself generates good returns and it pays out a decent dividend, and as I said, I think there’s a chance they’ll beat estimates. So I suppose you just have to factor that in to your calculation and see whether you think they’re doing a good enough job to get paid that.

Keystone Law (KEYS)

Keystone Law is a law firm quoted on AIM. Its StockRank is 64. Style is a high-flyer. They floated at the end of 2017, and since then every trading statement has contained that magical phrase "above expectations". It is a disruptive operator. It offers lawyers and firms outside of the big Magic Circle law firms a chance to work from home whilst being paid 75% of what they earn or what they bring in, in fees, and all the while not having to worry about client invoices, compliance, or where to meet clients in central London. Keystone has got its own office in Chancery Lane. Keystone has got 300 lawyers working in this way, and it estimates the addressable market is 47,000 lawyers, so it’s still got less than a 1% market share. As you can see, revenues are growing at 20% a year roughly; profits are growing faster than the operational gearing. Cash conversion is about 95%, and the dividend policy is coming out at two-thirds of its cash generated every year. As you’d expect from such strong cash conversion, it's got cash on the balance sheet as well. The company is run by James Knight, who is 52, and he set up the firm when he was 35. He continues to own 35% of the shares so he is very incentivised, acting like an owner. There are rivals to Keystone, but Keystone is the biggest operator, and between it and its rivals it has 1,100 lawyers, so about a 2% market share, so they aren’t really fighting each other but more fighting big companies. The two big risks are that one of the lawyers who works at Keystone messes up with its own clients and Keystone gets sued, but it does have professional indemnity insurance up to £30m so it wouldn't have a financial hit but it would have a reputational one. The other risk is that if the government says that Keystone must start paying National Insurance contributions for its lawyers, the lawyers operate through service companies, so if the rules changed and Keystone had to give NI contributions, that would be a hit to profits. Its current valuation exceeds a P/E of 30 times and analysts raised their forecast by 20% during last year. If that were to happen again, it would fall to around 25, which would be less than the growth rate of around 30%. I hold Keystone. I don't see why it won’t eventually control 10% of the market, in other words around 4000 lawyers, and that would mean around £50m in profits after tax versus about £35m today.

Q: You said about the work from home office. Would they be subject to things like IR35 because I think next year that’s due to classify them as employees.

A: They haven’t commented on that. I’m actually meeting them next week so I will ask them about that. I am not sure. Their official stance is that the rules are as they are and they won’t change yet.

Q: Do they have any issues recruiting new lawyers or is there a very willing and able pool?

A: Yes, there’s a willing and able pool. About a third of the lawyers are referred by their existing clients. Then they take 1 in 4 applicants, so they’re reasonably picky.

Q: Do you know if they’ve got much churn in the lawyers?

A: 5%, and that’s from retirement.

Crescita Therapeutics (CTX)

I am pitching Crescita Therapeutics, who are based in Canada, so their figures will be in Canadian Dollars, a research company with a variety of skincare products. Stockopedia has a middling ranking, but we haven't got the 2018 figures in yet. There’s been a significant change in recent years. In 2016 they were spun off from Nuvo Research, and in the same year they acquired Intega, who were financially backed by Knight Therapeutics, who are now a large shareholder and debt holder in Crescita. Knight have a £1bn market cap and they are run by Jonathan Goodman, who is an extremely successful Canadian pharma investor. Crescita then went on to acquire Arion in 2017, who do medical skincare products, and then they did a rights issue in 2018 which left them well funded and able participate in that, which was a bullish sign. The long description of a skincare business is rolling out client skincare brands, and also providing contract and manufacturing facilities. They did revenue of $9m last year, which was growth of 12%, at 46% gross margin. The prescription side of the business is more exciting, and they have a local anaesthetic cream. It’s mainly out licensed, which has had limited success, and in 2015 to 2017, royalties were only around 200,000 for the year. But they reacquired the North American rights and gave them out to a US company called Taro Pharmaceuticals. Taro have revenue of about 700m USD, so if it’s significant to them it is likely to be very significant to Crescita. As we have seen this relationship play out, in Q1 of 2018 royalties of $1.4m, in Q2 that went down to $0.3 as they worked through, but in Q3 it shot up to $1.1, and in Q4 it was $1.5m in 2018 at a run rate of 6 million, a very high margin for royalty revenue. Upfront milestone payments, in addition have been 6.6m. A big risk with this is that the patent does run out soon and they have a second generation of products with more protection up to 2031, but generic competition is a risk. So, looking forward, last quarter they were close to cash flow breakeven, if you exclude the additional milestone payments they got and the working capital movements. With the rapid growth to 6 million of royalty income, you could see them moving on to say 10 million within a year, which would result in 4 million cash flow. If you value that at ten times you’d be looking at 2.6 times the current market cap, not taking into account cash and dilution. Further upside potential comes from approving the non-prescription side of the business, and also from launching in Canada during this year. They’ve also got a drug called MyCalOne which they are looking to out-licence in 2020, and they’ve got some other products and technologies which could derive further upside. In terms of the downside, it obviously depends on how it plays out but net cash plus the brands and the technology they own would hopefully be worth at least $12m, which is circa 80% of the current market cap.

Q: Obviously it’s a very small company in this sector. Do you know if they’ve got an end game, a plan to be taken over, or some other kind of payout?

A: They’re not looking to be taken over at the moment. They have got a four pillar strategy of growth, and they are looking to get to 50m revenue over the next five years, so that’s growth rather than an exit.

Q: I see that they are loss-making at the moment. Is there an point where you think they’ll stop burning capital?

A: There aren’t any forecasts out for the company, and Stockopedia doesn't have all the 2018 numbers, which are out, but in 2018 they made $2.4m net income on $16m of revenue, so they made a profit but there were some tax benefits as part of that. It’s much better to look at the cash-flow break-even, which in the last quarter, if you exclude milestone payments, they would have slightly grown in cash, but over the course of the year you’ve gone from income of nearly nothing to $6m.

International Business Machines (IBM)

Why have I picked a dinosaur from the 20th century tonight when my work is all dividing information on the 21st century industries? The answer is that this is an exceptional opportunity to acquire growth and value in a company. If I just deal with value briefly at the beginning, it doesn't shine brilliantly on Stockopedia scores or anything; in fact surprisingly it is just above the stage of bankruptcy. But with growth, the company is trading on a multiple of ten times earnings, which is still quite reasonable. It’s not being valued as a unicorn, in which case it would probably be worth two to three times its market value. It’s being valued as a dinosaur in decline. The value of IBM changed radically when it purchased Red Hat about six months ago. Red Hat is an open source company which sort of came from nowhere, and managed to secure a considerable position in the cloud industry. Red Hat was purchased for $34m, which is probably somewhat over paying. The potential for Red Hat and IBM is red hot, and to multiply considerably in the period. There are certain risks attached to it, of course; Red Hat has competitors in the course of their business with Microsoft, Amazon, etc. They have the potential to open a hybrid account through resources in IBM. IBM also has lots of resources in terms of quantum computing and AI. On a valuation basis, in relation to its assets, the company is extremely good value.

Q: Would you not prefer Intel at the same rate with much better growth prospects?

A: I like both companies but for different reasons. I think Intel is undervalued in relation to other chip companies, but I don't think that it has the potential to change its complete earnings opportunity to the same extent as IBM.

Q: Is it undervalued?

A: No, I think it’s correctly valued by the market at present. I think there is a great growth opportunity because opportunity has to transform itself to reality. Now IBM has a rare legacy of making mistakes along the line, and I think that is taken into account.

XP Power (XPP)

XP Power came to market in the early 2000s. It made some hard investments in the more technical end of the market. It has about 4,500 customers, mainly Fortune 500 companies. Their business is spread internationally, 60% in North America, and their trading segments are industrial semiconductors, healthcare, technology, with semiconductors the fastest-growing, it’s about 24% of revenue compared with about 8% a couple of years ago. Pricing factors have been volatile recently but it did reach £37 last year, but then there was talk of softness in the semiconductor market, which had been growing rapidly, and the price practically halved, which was a ludicrous over-reaction, but that’s what the stock market does, and now at £25 on a multiple of about 13.5 times this year’s earnings, a yield of about 3.5%, and I think they are a very good solid small company with steady growth. The main risk factors are obviously the cyclicality of the semiconductor industry, which might be smoothed with things like AI, and basically global GDP. Those are the main risk factors that I see, but as a small company market cap is £400m, but there's lots of potential.

Q: I notice that they are building factories in Vietnam at the moment, and that is a cheaper place than China.

A: Yes. That’s why they’re doing it, because in China, if they want to they have to export product, and then re-import them to China to sell it there. It’s crazy.

Disclaimer: All of the information presented here is purely for educational and entertainment purposes and is not a recommendation of any of the shares mentioned

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