Exploit a glaring valuation anomaly

I included the shares, at 29.5p, in my market beating 2019 Bargain Shares portfolio when the company was called Mercia Technologies, and subsequently covered the annual results in a positive light when I interviewed the directors at length four months ago ('Mercia aims to double assets under management to £1bn within three years', 8 July 2019). The share price subsequently hit a high of 39p in late July, but has fallen 40 per cent from that high water mark, a de-rating that is wholly unwarranted.

I would stress that the share price weakness has nothing to do with Mercia’s operational performance. It’s simply down to the fact that the beleaguered Woodford Investment Managements funds, which are now being wound down by Link Fund Solutions, hold 19.99 per cent of Mercia’s issued share capital of 303.3m shares. The stock overhang has created a major disconnect between the market pricing of Mercia’s equity and the substantial intrinsic value in Mercia’s asset management business, directly held investment portfolio and cash holdings.

Importantly, this disconnect will become apparent when Mercia releases interim results in early December. Indeed, chairman Ian Metcalfe told shareholders at September’s annual meeting that "since our March year end, Mercia has continued to focus on the development of the direct investment portfolio as well as seeking to expand its successful fund management operations. We look forward to updating shareholders on further positive progress by both pillars of Mercia's value creation strategy throughout the year."

Mercia business is focused on providing capital across four asset classes – balance sheet, venture, private equity and debt capital – initially nurturing technology businesses through investment from the third-party funds it manages by tapping into a strong UK regional footprint of eight offices, 19 university partnerships and extensive personal networks. This network provides Mercia’s investment teams with access to high-quality deal flow and at favourable entry points.

The company is cherry picking investment opportunities in the rest of its portfolio, too. That’s because by focusing initially on the provision of finance through Mercia's managed funds, the company can identify, help build and de-risk managed fund portfolio companies ahead of providing, on a selective basis, capital to these companies from its own balance sheet. Indeed, Mercia has been successful deploying capital from its own balance sheet, achieving an impressive 14 per cent annualised internal rate of return (IRR) on its directly owned portfolio since IPO in December 2014. Clearly, other investors can see the value in some of Mercia’s portfolio companies.

For instance, earlier this year, a syndicated funding round by second-largest holding, Oxford Genetics – a specialist designer and developer of biological molecules such as proteins, viruses and cells within the growing synthetic biology market – valued that company’s equity at £30.5m, and led to a decent uplift on Mercia’s 33 per cent holding. In the past year, Oxford Genetics has signed six licensing deals for its scalable gene therapy manufacturing technologies and has quadrupled annual revenues.

Another interesting investee company is Medherant, a clinical-stage company developing innovative products for pain and central nervous system diseases using a unique transdermal delivery technology, TEPI Patch®. The global transdermal drug delivery market in which Medherant operates is expected to reach US$7.1bn by 2023 from an estimated US$5.7bn in 2018. Medherant spun out of the University of Warwick in 2014 and received its first investment from Mercia's managed funds in 2015. Since then the company has developed an extensive patent estate and secured an exclusive worldwide licence from international adhesives company Bostik SA for the medical use of a novel adhesive. Mercia booked a £1.2m valuation gain on its stake in the 2018/19 financial year, valuing its 31.4 per cent holding at £5.2m, and has since participated in a £2.4m syndicated investment round.

Quantifying the value proposition

Including £5.9m of investments made by Mercia since the March year-end, I reckon the directly owned portfolio of 22 investments has a pro-forma value of £93.6m, a sum worth 30.9p a share. In addition, I estimate Mercia has free cash of around £23.9m (7.9p), a sum equating to 19 per cent of its last reported net asset value (NAV) of £126m (41.6p a share) and one that also backs up a third of the company’s market capitalisation of £69.8m.

Effectively, net of cash on the balance sheet, Mercia’s directly owned investment portfolio is in the price at a 50 per cent discount to book value even though chief executive Mark Payton revealed to me during our last interview that the board has received a number of approaches for its portfolio companies, thus highlighting scope to make realisations and potentially achieve significant further valuation uplifts on disposal.

The other point worth considering is that Mercia has a valuable and fast growing third party fund management business which closed the 2018/19 financial year with assets under management (AuM) of £381m (including free cash of £168m) and generated management fees of £10.7m. Analysts at brokerage Canaccord Genuity believe that this asset management business could break even on average AuM of £512m. Bearing this in mind, Mercia continues to win mandates – AuM has increased 16-fold from £22m at the time of the IPO. Moreover, the operational gearing of the fund management business model means that once it turns profitable, and given a relatively fixed cost base, an increasing proportion of management fee income earned on incremental AuM will convert into profit after this inflexion point is reached.

Clearly, Mercia’s asset management business has value, and certainly far more than the £9m (3p a share), embedded in Mercia NAV. In fact, I believe that it’s worth £30m (10p a share). However, the asset management business is effectively in the price for free even though the directors are aiming to boost Mercia’s market share (from 6 per cent to 20 per cent) of the £1.3bn regional investment market, and double total AuM to £1bn within three years. It’s worth noting, too, that the board and senior management have significant skin in the game, controlling 23 per cent of the issued share capital, so are well incentivised to scale up Mercia’s asset management business in order to enhance its value.

Inefficient market pricing

This is not the first time that a disconnect has appeared in my small-cap space. It happened last month when shares in Aim-traded insurance sector investment company BP Marsh & Partners (BPM:271p) were sold down to a bargain basement 39 per cent discount to its last reported NAV, a cracking buying opportunity, at 216p, as I highlighted at the time ('Takeover, tenders and taking profits', 9 Sep 2019).

The same was true of specialist residential development finance firm and asset manager Urban Exposure (UEX:58.5p), shares in which have rallied by 33 per cent since I noted that they were trading, at 45p, on half of book value of 93p a share (net tangible value of 85p a share) even though cash of £46.4m (29p a share) and a high-quality loan portfolio worth £83.6m (53p a share) offer solid asset backing ('High yielding Ben Graham play', 11 Sep 2019). For good measure, the board has maintained guidance to double the payout to 5p a share in 2019, so the prospective dividend yield is currently 8.3 per cent.

Furthermore, shares in private equity investment company LMS Capital (LMS: 59p) have risen by 20 per cent since I outlined a compelling investment case in my April small-cap report when the value of the company's quoted securities and cash on the balance sheet backed up 60 per cent of its market capitalisation, meaning that legacy investments were being thrown into the price at an eye-catching 61 per cent discount to carrying value.

Sum-of-the-parts valuation

In the case of Mercia, I strongly believe that the lowly rated shares are priced to deliver a very positive outcome for both short and long-term investors at this bargain basement level. Positive news on deal flow, and an unwinding of the aforementioned stock overhang, are key catalysts to drive a deserved re-rating to narrow the discount to my sum-of-the-parts valuation of £146m (48p a share).

Interestingly, there is a strong technical case to buy the heavily oversold shares at this particular juncture, too. That’s because the 14-day relative strength indicator (RSI) has a reading in the mid-teens, meaning that Mercia’s shares are in heavily oversold territory. In fact, the last three occasions the 14-day RSI had a reading this low (September 2017, August 2018 and June 2019), the shares subsequently rallied by 49 per cent, 40 per cent, and 29 per cent, respectively.

Trading on a bid-offer spread of 22.8p to 23p, Mercia's shares rate a bargain buy.

*Since this article was published on our websiteon 31 October, Link Fund Solutions has reduced its stake from 19.99 to 10.99 per cent,and Invesco has cut its stake by a third to 19.48 per cent. Over33 per cent of theshare capital tradedon 31 October and1 November across888 bargains, thus reducing the stock hang.Mercia’s share price subsequently rallied from 23p to 29p. Simon maintains his buy recommendation and sum-of-the-parts valuation of 48p a share.

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