Being a proud Yorkshireman, there’s nothing that Richard Gill likes more than a good old bargain. In this article, he scours the small-cap markets for just that.
One sector currently unloved by investors is car retailing. The UK industry has experienced some tough times of late, seeing challenges associated with meeting new emissions regulations, a fall in diesel sales due to uncertainty over government policy and the Brexit malarkey seeing consumers and businesses delay big ticket purchases. Out of all the London listed vehicle sellers the cheapest in my opinion is the South-East England based car dealership Caffyns (LON:CFYN).
The business has a history going back to 1865, when William Caffyn opened a gas & hot water fitting shop in Eastbourne. Caffyns moved into motors in the industry’s early days in 1903 and has been selling new and used cars ever since. As of today the company operates 13 car dealerships across Sussex and Kent representing seven major manufacturers including Audi, Volkswagen and Volvo.
Caffyns is one of those businesses that likes to keep a low profile. Over the past few years the most material news investors have seen has been limited to the interim and full-year results. These have generally showed stable trading over the long term, with the cyclical effects of the UK car market being smoothed out over the years.
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The most recent numbers were for the six months to 30th September 2018 and showed a period of relatively flat trading, delivered amidst tough market conditions. At the top line, revenues were down by around £1.5 million at £105 million, with a 10.4% like-for-like fall in new car unit sales offset by like-for-like used car sales up by 6.7% and after sales growing by 9%. Pre-tax profits for the half grew marginally, by 3% to £0.7 million.
The real attraction of the investment case appears on the balance sheet, with Caffyns having a strong property portfolio and owning the vast majority of the freeholds for its operating premises. Not only does this provide substantial asset backing, it minimises exposure to periodic rent reviews.
As at 30th September 2018 the total portfolio plus investment property stood at £48.5 million. Providing further “hidden” value, the last annual revaluation (as at 31st March 2018), completed on an existing use basis, showed an excess value of £10.3 million, which as per the firm’s accounting policies has not been incorporated into the accounts.
Elsewhere on the balance sheet, net borrowings were £12.2 million at the September period end, with total interest payable covered over 4 times by underlying operating profits. There was also a modest pension deficit of £6.9 million which under a recovery plan is being reduced by annual cash payments of £0.48 million, increasing by a minimum of 2.25% per annum.
Like many of its peers, Caffyns saw its shares fall off a cliff in 2007/08 as the financial crisis took hold. Yet, a recovery in trading over the past decade hasn’t been mirrored in the share price. It’s worth noting that in 2007 the shares peaked at a price of £11.50, with the company making just over 40p of adjusted earnings for that financial year and paying a dividend of 25p per share. The most recent annual earnings and dividend figures are only marginally behind 2007 (38.2p and 22.5p respectively) yet the shares trade at only a third of their pre-recession high.
While we have minimal guidance on what the figures will be for the full year to March 2019, Caffyns commented in the interims that the outcome will be dependent on the success of the bi-annual registration plate change in March. Looking at the latest figures from industry body The Society of Motor Manufacturers & Traders there were 458,054 new car registrations in March, down just 3.4% compared to March 2018. This was better than some commentators were expecting and well up on the September figures which were the worst since 2011. That gives reasonable confidence that second-half trading would have been steady, so assuming that the first-half performance is repeated, we are looking at earnings of around 35p for the full year. That puts the shares on a reasonable looking price/earnings multiple of 11.3 times.
Where the real value is apparent is in the wide discount to net assets. With a current market cap of £11.4 million the discount to NAV as at 30th September 2018 is a huge 61%.What’s more, this figure doesn’t include the unrecognised £10.3 million surplus mentioned above. If it did the discount would be a more pronounced 71%.
For income seekers, the yield will be an attractive 5.7% if the dividend is maintained at 22.5p per share for 2019. This looks likely in my opinion given that the interim payment was held flat, considering the sound financial position and that the board have been committed to making consistent distributions to shareholders.
There has been a lot of disappointing news in the transport sector over the past few months for both commuters and investors. Fares continue their onward march upwards, rising by 3.1% in January, and large new projects such as Crossrail seem to be announcing delays on a quarterly basis – it was supposed to be ready for the Olympics wasn’t it? On the operator’s side, Virgin Trains and partner Stagecoach (LON:SGC) were recently excluded from bidding on a range of franchises due to pension concerns. However, one transport operator which continues to deliver for its passengers and shareholders is AIM listed Rotala (LON:ROL).
The Rotala business was formed in 2005 and joined AIM in March that year as a cash shell looking to acquire businesses within the parking and transportation management sectors. Over the years the company has expanded its operations through the acquisition and amalgamation of a number of local coach and bus operations, now having operations at Heathrow Airport, in the West Midlands, the North West and South West of England. The current strategy remains largely unchanged, with the focus being on acquisitive and organic growth around depots situated where there is a suitable density of population and prospects of economic growth.
The business is currently divided into three segments, with the largest in the last financial year being Commercial Services. Here, Rotala provides a purely commercial bus service where, in contrast to the Contracted Services division discussed below, it takes all the risk of operation.
Second largest division, Contracted Services, provides local bus services under contract to local authorities and individual customers. Here, the service is delivered under contract, to specified standards, with the price for the service determined by the contract alone. This is a less risky operation for the company and provides good visibility of income.
Finally, the relatively small Charter Services division provides a transport management service to a variety of customers. Typically this covers business or service disruption (such as rail replacement buses) and bespoke large event management.
Across all the operations, Rotala currently operates more than 600 vehicles, employs more than 1,500 members of staff, with its registered bus services carrying more than 29 million passengers every year. Key brands include Diamond, which provides bus services in the West Midlands and Worcestershire areas; Diamond North West, offering a mix of Commercial and Contracted bus services in around the Manchester area; transfers and private hire business Hallmark Connections which is based near Heathrow; and Preston based Preston Bus.
The last financial year was a good one for Rotala, with revenues surging ahead by 19% to £62.4 million in the 12 months to November. This was on a continuing basis, with minor operations in the South West discontinued during the period. However, the business continued to expand via the £1.95 million acquisition of Central Buses, an operator of commercial and contracted bus services in the northern part of the West Midlands.
At the bottom line, the adjusted pre-tax profit figure grew by 18% to £4.23 million, with earnings up by a more modest 9% to 7.22p per share after a rise in the number of shares in issue. The cashflow from operations was impressive at £4.125 million, ahead of the statutory pre-tax profit of £3 million and after adding back £3.4 million of depreciation.
One major event of 2018 was the entering into of new banking facilities with HSBC for a total of £24.5 million. At the end of the period that gave c.£10 million of headroom to finance further potential acquisitions. Also providing certainty for the current financial year, all of the company’s fuel requirement for 2019 was covered by hedging contracts at an average price of 100p per litre, thus eliminating exposure to volatile oil prices.
Shares in Rotala haven’t performed as badly as some small cap companies in recent months, having fully recovered from the sell-off which investors saw last October. At the current price of 54p the company is capitalised at just under £26 million. That prices it on a multiple of just 7.5 times last year’s adjusted earnings figure and on a historic yield of bang on 5%. Rotala should be attractive to income investorsgiven that, as well as the high yield, the company has a progressive payment policy and has set a target dividend cover of 2.5 times earnings.
There is also good asset backing on the balance sheet, with the major items being £39.4 million of property, plant and equipment (mainly vehicles and freehold property), along with £15.9 million of trade receivables. Net assets of £34.9 million at the period end mean that the company is currently trading at a 26% discount to book value. Even if we strip out goodwill and intangibles of £14.9 million, this nonetheless means that 77% of the market cap is backed by hard assets.
Overall, Rotala is a solid, strongly cash generative business, trading on a low multiple of earnings and offering investors decent income. What’s more, the headroom in the banking facilities provides further firepower for more acquisitions, which the board are said to be, “actively engaged in hunting out”.
Finally, a long-term favourite of fellow Master Investor contributor Simon Cawkwell is industrial engineering company 600 Group (LON:SIXH). This business is a distributor, designer and manufacturer of industrial products which takes its name from its early head office address at 600 Commercial Road in East London. The company formed its first machine tool company in 1932, became the UK’s leading lathe manufacturer in 1954 and now has three main areas of operation. While the majority of income comes from the US (65% last year), 600 sells into more than 100 countries around the world.
The Machine Tools business focusses on metal turning machines (used for shaping pieces of metal) with products ranging from small conventional machines for education markets, Computerised Numerical Control (CNC) workshop machines and CNC production machines (see image below). Outsourcing partners support the manufacturing of these machines and they are marketed through a wholly owned international sales organisation and global distribution network. This division operates in a global industry which was estimated by Oxford Economics in Spring 2018 to be worth nearly $79 billion in annual sales.
Second, Precision Engineered Components distributes machine spares to global customers to help maintain the installed base of group machines which number in excess of 100,000. Additionally, work holding products and taper roller bearings are sold via specialist distributors to OEMs, including other machine builders.
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Finally, the high margin Industrial Laser Systems business has proprietary software and technology which offers a superior alternative to ink jet marking. Subsidiary TYKMA Electrox is headquartered in, Ohio, US, and specialises in the design, production and distribution of industrial laser systems for a broad range of industrial manufacturing applications from telecommunications to pharmaceuticals.
One of the features of 600 Group is that trading is cyclical, with it being exposed to the investment decisions of manufacturers and typically lagging the main cycle of the economy. However, by all accounts the 2018 financial year (to March) was a good one, with revenues rising by 12% to $66.01 million and net profits up by 19% at $3.05 million. But an arguably more important event came after the year end.
For a long time, the pension was a prominent feature of 600 Group’s balance sheet, showing a healthy surplus (unlike many of its peers) over recent years but having a high level of liabilities given the company’s size. In July last year, just before the full year numbers were published, it was agreed for the pension scheme liabilities of c. £201 million to be bought out by insurer Pension Insurance Corporation Plc. This removed a high level of risk in terms of potential future financial obligations, with surplus funds having also been received.
As a result of the good operational performance in 2018, the reasonable commercial outlook and following the resolution of the pension scheme, the Board decided to resume payment of a dividend, recommending a pay-out of 0.5p per share. Trading has continued steadily since then, with revenues up by a modest 2% to $32.8 million in the six months to 29th September 2018 but with underlying pre-tax profits surging by 36% to $1.46 million. A 5% rise in the order book provides good visibility, with an interim dividend of 0.25p being made.
After bottoming out at 7.35p in March 2016, investors in 600 Group saw the shares rise to a peak of 19.45p before last year’s small cap sell off drove a slippage to the current 14.15p. But despite the almost doubling in value over the past three years the shares still look incredibly cheap.
On last year’s underlying earnings figures, and at current exchange rates, the company is now being valued on a multiple of just 5 times.Analysts at research house Hardman are looking for earnings of 3.6 cents in 2020, which means the multiple falls to 4.4 times if targets are met. Following the reinstatement of the dividend last year, the historic yield is a decent 3.5%.
Again, this is a company with good asset backing, with net assets of $28.31 million (£25.13 million) as at 29th September 2018 representing 157% of the current market cap. If we strip out goodwill and intangibles however, which amounted to $11.19 million (£10 million), the coverage falls to a still decent 95%.
As Mr. Cawkwell pointed out with regards to 600 Group early in 2018, “Month after month goes by and no evidence emerges that this stock is anything other than very cheap.” Over a year on and this still seems to be the case. Granted, 600 Group is a cyclical stock. However, that looks more than priced in given the current valuation.