Register Log-in Investor Type

News

Testing times sees major underperformance from River and Mercantile UK Micro Cap

221214 RMMC

River and Mercantile UK Micro Cap (RMMC) has published its annual results for the year ended 30 September 2022. During the period, RMMC provided an NAV total return of -48.03%, while its benchmark posted a total return of -26.91%. The chairman, Andrew Chapman says “There can be no doubt that the last year has been an extremely testing time for the portfolio”. He goes on to say that the gloomy economic situation has been particularly tough on UK listed stocks, and UK small companies in particular.

Investment manager’s comments on performance attribution

“The following is a detailed review of all the positions that made a negative contribution to relative performance of greater than 0.5% and includes a review of over half the positions we held in the period.”

Science in Sport (-2.8ppt relative impact) – is a leading sports nutrition brand that has delivered high organic growth in sales and gross profit over the last seven years. The challenge for early-stage growth businesses is balancing profitability with investment for growth but the progress in underlying profitability over the last few years was encouraging. Having experienced a record period for sales in the first quarter of 2022, a combination of a slow-down in sales and input cost headwinds have impaired profitability which, alongside a now complete capital investment programme, left the company requiring an equity raise at the end of September 2022. The 79% decline in the share price is extreme and, we believe, fails to reflect the strength of the brands. Moreover, the company is now fully focused on generating cash and has guided that it should be breakeven in 2023 without assuming an unwind in elevated input prices.”

Joules Group (-2.2ppt relative impact) – was purchased as a Recovery investment case in 2020 as we believed that margins could return and potentially exceed pre-pandemic levels given both the success of their ecommerce offer and a reduction in store lease costs. Costs for both transporting product from China to the UK and the cost to distribute within the UK meant that profitability deteriorated rapidly and with that came the expectation of a need for additional equity and a 97% decline in the share price. What did we get wrong? Firstly we had misplaced conviction in our belief that margins would continue to improve, and we were too slow to acknowledge the headwinds to margins and the subsequent funding risk. We exited the position in November 2022 and if we consider our investment in the company going back to April 2020, the total realised loss is low at 0.3% of our average NAV for the period.”

Brand Architekts (-1.2ppt relative impact) – is a portfolio of beauty brands which now also includes four brands acquired through the purchase of InnovaDerma. Brand Architekts has struggled with scale following the disposal of the Swallowfield manufacturing business in 2019 for £35m. The market capitalisation of Brand Architeckts at the end of September 2022 was c.£9m which is less than their net cash position of £11.3m and, applying the 1.3x sales multiple that the company paid for InnovaDerma in March, would support a share price many multiples of the current price. The shares declined 81.5% in the period.”

SigmaRoc (-1.2ppt relative impact) – is a buy and build of UK and European quarries. The shares have de-rated over the last 12 months on concerns over rising energy prices and energy rationing risks given the location of its European operations, despite the company demonstrating its ability to pass on cost inflation and, where possible, converting kilns to alternative energy sources. Its recent strong set of interim results reinforces the diversity of its end markets which, coupled with lower operational gearing than widely perceived, provides downside protection. We believe the market misses the multiple ways in which management can continue to create value despite a depressed share price, proven by the recent joint venture with ArcelorMittal and the fact that inorganic growth can be self-funded post its merger with Nordkalk. With the shares down by more than 60% in the last 12 months with no downgrades to consensus earnings, we believe the shares are attractively valued and added 0.5% of NAV to the position in the period.”

CMO Group (-1.1ppt relative impact) – is the largest pure play online building merchant, a large market which is vulnerable to disruption from online players given the high list price and trade discount model that exists in the industry. We invested at IPO in July 2021 at a price of 132p, equivalent to a market capitalisation of £93m. The company has traded relatively well since IPO and has continued to take market share, but expectations have been downgraded given the impact of higher prices on demand. The share price at the end of September 2022 was 27p, a decline of 80% versus the IPO price. Recent results show that the company continues to grow organic revenues and deliver positive free cash flow, as such the share price performance, a decline of 86% in the period, seems unjustified and we have recently added to our position.”

Allergy Therapeutics (-1.1ppt relative impact) – is a specialty pharmaceutical company focused on research and development of allergy treatments that deal with the underlying cause, and not just the symptoms, of allergies. Relative weakness over the period reflects earnings below expectations and the long duration nature of the asset with a lot of potential value sitting in its R&D pipeline. In our view, the profit miss was due to temporary factors such as factory improvements, product phasing and pandemic related disruption with doctors busy administering COVID-19 vaccines. The cash cow core European business coupled with a strong balance sheet following a recent fundraising supports R&D investment in a rich pipeline of both near market and early-stage opportunities. A successful US market entry, where the company has the potential to be the first player to launch an ultra-short course allergy vaccine in the largest allergy market offers significant upside optionality.”

The Ince Group (-1.0ppt relative impact) – was purchased as a Recovery investment case through a fundraising to recapitalise the balance sheet following the reverse takeover of Ince by Gordon Dadds. Ultimately, the company did not raise sufficient capital and between a cyber incident earlier this year and another poor acquisition, the company required further recapitalisation at which point we exited our position at a significant loss.”

Kooth (-0.9ppt relative impact) – through their partnership with the NHS, enables access to online mental health services. 62% of the UK’s 10-25-year-olds are currently eligible for their anonymous services. Kooth’s economic assessment suggests that every pound spent on early intervention saves the NHS £3.20. Progress in the UK has been a little slower given the reorganisation within NHS England to 142 Integrated Care Systems, but the proposition and potential remains as it was. The company has secured a large pilot program with the State of Pennsylvania which could, alongside other opportunities in the US, add to the already significant growth potential. Having come to the market at 200p in September 2020, the share price exceeded 400p in September 2021 but declined to 112.5p by the end of September 2022, a decline of 71.5% in the period. We added 0.3% of NAV to the position in the period.”

Supreme (-0.9ppt relative impact) – the vertically integrated manufacturer and distributor of everyday branded consumer products warned on profits twice during the period. In April 2022, the company flagged higher distribution costs and raw material (whey) inflation impacting their Sports Nutrition business. In July 2022, the company issued a negative update on their Lighting business driven by retailer overstocking. Following material downgrades to consensus earnings, Supreme trades on a depressed valuation which we think undervalues a business with a solid balance sheet position and strong growth potential, particularly in vaping which is the dominant driver of group earnings.”

Aquis Exchange (-0.8ppt relative impact) – operates the pan-European Aquis equities exchange with a disruptive subscription pricing model that enables firms to reduce trading costs in adherence with MiFID II best execution requirements. Whilst the company continues to grow and generate cash, market share gains in trading volumes have been slower than those delivered over the last few years. Caution towards illiquid early-stage technology companies has driven a large derating of the shares which declined by 57% in the period.”

Mind Gym (-0.8ppt relative impact) – a provider of behavioural science solutions to corporates that are proven to deliver business improvements, declined 50% as it missed revenue growth expectations at a time of heavy investment for growth, citing pandemic related disruption on client decision making. The company is investing to produce a highly personalised learning experience which is expected to enable corporates to deliver behaviour change at scale. Combined with strong thematic tailwinds as sustainability issues are high on management agendas, there is robust support for long-term growth, but it does come at a cost to short-term profitability as the business reinvests profits. The shares trade at a valuation which is well below historic levels and at a significant discount to private market transaction multiples for learning and development peers.”

Revolution Bars (-0.8ppt relative impact) – is the operator of 69 bars which we invested in through an equity fundraise in 2020 and 2021 with the view to an eventual normalisation in trading and profitability. The business returned to profitability and strong cash generation in their last financial year despite curtailed trading over the peak Christmas and New Year trading period. Whist we recognise the inherent financial gearing given the leasehold strategy and negative working capital position, the balance sheet was in a net cash position ahead of the acquisition of a portfolio of pubs which will bring some diversification to trading. Like many other consumer exposed stocks, the market value at the end of the period discounts the tough outlook with the shares falling by 57% in the period. There is however evidence in the financials that the company is delivering to our Recovery investment case.”

Virgin Wines (-0.8ppt relative impact) – if you were to write a list of attributes for a company not to possess over the last year, the following would all rank fairly highly: a recent IPO, of an ecommerce business model, with exposure to the UK consumer. The 75% decline in the shares was not helped by a downgrade to expectations but the current valuation does not, in our view, recognise a profitable business with a net cash balance sheet that has continued to take market share over the last few years. We added 0.5% of NAV to the position in the period.”

DF Capital (-0.8ppt relative impact) – is a specialist lender of inventory finance for holiday homes, caravans and commercial vans. It is another example of the current price failing to reflect the opportunity. The company is trading at a large discount to book value whilst delivering excellent growth in their loan book. Ironically, the key challenge they’ve had in growing the loan book has been loan facilities being paid back too quickly. A short average loan duration protects the business from a mismatch in assets and liabilities which should support net interest margins. The business remains well placed to grow and deliver mid-teens return on equity which should support a re-rating. We added over 0.5% of NAV to the position in the period.”

Cake Box (-0.8ppt relative impact) – was initially impacted by a blog which highlighted several issues (see March 2022 Interim Report for more details) which the company is addressing through investment in internal functions. Importantly, we cannot see any manipulation of revenue, profits or cash generation in the inaccuracies which points to poor reporting as opposed to anything more sinister. Whilst the company had delivered strong top line growth post the pandemic, it is not immune to wider macro challenges. The shares fell further as management downgraded expectations due to a softer demand environment coupled with cost pressures, specifically in raw material and distribution, which will be passed onto consumers with a lag. Cake Box remains profitable and cash generative with a strong balance sheet, trading on a double-digit free cash flow yield, with a pipeline of new store openings to support its growth ambitions.”

Strip Tinning (-0.7ppt relative impact) – the tier two auto supplier, has seen a material downgrade to expectations set at its recent (February 2022) IPO. The company revealed that its core glazing business was not the robust cash generator that we had expected and has since taken action to restore cash generation by focusing on profitable product lines and pricing improvements. The company also announced the loss of an EV battery control system contract with a leading German original equipment manufacturer (“OEM”). Although disappointing, it is important to note that the lost contract represents less than 10% of the group’s EV pipeline and the EV growth opportunity remains intact. The significant decline in the share price leaves the company trading on less than 1x revenue for a business with a net cash balance sheet, a trading history of double-digit operating margins and significant EV optionality.”

RA International (-0.7ppt relative impact) – provides construction and facilities management services to clients including the UN and the US Government in remote locations. A strong pipeline of large contracts was expected to deliver revenue and profit growth but, in part due to the severe challenges in Mozambique where the company had heavily invested in Total’s Cabo Delgado LNG project, the company has failed to deliver and we exited the position given the deteriorating strength of the balance sheet and extremely poor liquidity.”

IOG (-0.6ppt relative impact) – see comments in Portfolio Activity.”

City Pub Group (-0.6ppt relative impact) – much has been written around the many headwinds to profits for pubs including the cost-of-living crisis and inflation in food, energy and wages. Whilst certainly not immune, we think the freehold backing and low financial leverage leaves the business relatively well placed. It is trading at a 50% discount to the directors’ valuation of the estate.”

Venture Life (-0.5ppt relative impact) – has had a year of rebuilding confidence in their buy and build strategy following a poor prior year. Evidence to date is positive – the company has recently reported a solid set of interim results despite no real progress being made by their new Chinese distribution partner which was a key element of the prior disappointment. Low leverage and an extremely low starting valuation should support equity returns. The shares fell by 53%, which we expect was the result of Shareholders exiting the register given the low liquidity as the share price performance is at odds with the fundamentals. We added over 0.6% of NAV to the position in the period.”

ActiveOps (-0.5ppt relative impact) – is an early-stage enterprise software business that has delivered to expectations but been derated as market sentiment has aggressively moved against long duration growth businesses. Net cash represents a quarter of the period-end market value of the company and the business has been free cash flow positive in each of the last five years. The 57% decline in the share price seems unjustified for a business with revenues that are almost entirely recurring and a net revenue retention rate that has consistently been above 100%. We invested an additional 1.2% of NAV in the position during the period.”

Serabi Gold (-0.5ppt relative impact) – a Brazilian gold exploration and production company is progressing with production, albeit at higher costs, from their existing asset but has been required to prepare an additional impact study for the recently acquired Coringa asset that they are developing. A combination of lower production, higher costs and the permitting concerns alongside the weak gold price has seen the shares decline 63% in the period.”

Manager’s comments on portfolio activity

“The Company’s portfolio activity during the year ended 30 September 2022 is detailed below.”

IOG (2.0% position at year end) – is in the early stages of building a Southern North Sea gas production business. The acquisition and re-commissioning of the Saturn Banks pipeline is key to the investment case and should enable the company to bring incremental production online over the next few years with low capital investment and low operating costs. To put this in context, the business model has been built with a long-term gas price of 45p per therm which compares to a year-to-date average in excess of 300p. In short, when producing, the company is generating significant profits and cashflow. However, the ramp up in production has not been without its challenges and the company has had to reduce production guidance several times this year. Whilst most of the issues are not insurmountable – a permanent reserve downgrade at their smallest asset the exception – they will take time and potentially additional capital investment to overcome. The shares have materially underperformed since we initiated the position and, whilst we have made some small additions to the position, we will look for operational momentum to improve to de-risk the investment before adding more. The sustainability credentials of the investment, a critical consideration for us given the sector, have been discussed in the Sustainability section.”

Renold (1.9% position at year end) – is a manufacturer of highly engineered industrial chains typically used in demanding environments and high-tech applications (e.g. automated warehousing systems, power stations, rollercoaster rides) in a broad range of end markets. It provides a low cost but critical product that affords it pricing power through the cycle. Sustainability trends are a commercial opportunity as Renold’s product is typically longer lasting than that of the competition and has a lower environmental footprint as it is more energy efficient (less friction) and has lower or no lubrication requirements. Management has resolved historic under-investment, previously a restraint on recovery potential, positioning the business for higher growth, margins, and cash flow generation. There is evidence of underlying improvement in operating efficiency that should enable strong operational leverage when end markets recover. Balance sheet strength underpins scope for value accretive bolt-on merger and acquisition (“M&A”) which is key to growth in a market where customers are sticky. This is most recently evidenced by the value accretive purchase of a Spanish conveyor chain business which operates in a market where Renold is underrepresented and offers meaningful manufacturing and procurement synergies. We have identified upside risk to consensus mid-term forecasts and the stock trades on a depressed valuation (<0.5x FY23 EV/sales) presenting a compelling risk/reward opportunity.”

1Spatial (1.2% position at year end) – We initiated a holding in 1Spatial, the data governance software which enables the Government, Utilities and Transport sectors to make better decisions based on accurate location data. The company is having success with its new strategy focused on product standardisation – for example its Next Gen 911 Emergency Services solution has now been rolled out to eight US states – driving an improved growth outlook, margin accretion and improving cash generation. We are encouraged by momentum in new contract wins and recurring revenue growth ahead of expectations, though this has coincided with cost and working capital investment to support onboarding of larger deals. Trading on 1.5x EV/sales, we believe the current share price offers asymmetric risk/reward.”

Strip Tinning (1.0% position at year end) – We participated in the IPO of a tier two auto supplier with leading market share in specialist automotive electrical glazing connectors. The appeal at IPO was a compelling growth opportunity in both its core glazing business and an emergent EV battery cell connector business. The latter is an enabler of EV growth which is key to decarbonising the auto sector. We expected high revenue cover and strong gross margins to be underpinned by patented manufacturing related intellectual property (“IP”) and a +65-year heritage of reliably supplying leading auto OEMs. We believed glazing growth potential could be augmented by entry into the rear glazing connector market catalysed by regulatory change, with Strip Tinning providing a differentiated lead-free solution and the ongoing trend towards increasing functionality being embedded in auto glazing (e.g. autonomous driving sensors). EV connector growth potential is substantial with a fast-growing sales pipeline, and, at the time of IPO, there was EV product validation from a high-end German OEM. We believed execution risk was low given that the manufacturing process for glazing is relevant to the EV opportunity and thought that the IPO valuation provided us with a margin of safety given the cheap starting valuation for what we believed to be a relatively robust cash generative core operating business. As detailed above in the attribution section, in addition to external events outside the company’s control, there have been company specific issues that have compounded the downgrade in expectations and led to poor relative performance post IPO.”

“We exited Ince Group and RA International, both have been discussed in the Performance Attribution review. We also took profits in Instem, Capital and Litigation Capital as well as selling down our position in Real Estate Investors to a minimum position weight (0.5% of NAV).”

“Having started the period with a high cash balance given our concerns around excessive sentiment and valuations, we net invested £8m (compared to net sales of £44m in the prior year) during the year and made gross investments of just under £19m (compared to £24m in the prior year). The number of new positions, four, (compared to seven in the prior year), reflects capital markers being very depressed but, as we have commented in the Performance Attribution section, we have made meaningful additions to many of our existing positions as we see fantastic value.”

Leave a Reply

Your email address will not be published. Required fields are marked *

Please review our cookie, privacy & data protection and terms and conditions policies and, if you accept, please select your place of residence and whether you are a private or professional investor.

You live in…

You are a…