Exploit two small cap pricing anomalies

The doubling of the share price of Israeli-based technology group MTI Wireless Edge (MWE) since I initiated coverage and the 450 per cent share price appreciation of finance company ThinkSmart (MWE) in only 10 months highlight how extreme the mispricing can be, not to mention the magnitude of the profits that can be realised. Both holdings still offer decent investment upside.

The same is true of royalty finance company Duke Royalty (DUKE), a constituent of my 2021 Bargain Shares Portfolio, which offers potential for Covid-19 asset write-downs to reverse as the global economic recovery boosts royalty revenue and royalty partners' valuations. Duke's management is also proving adept at recycling cash from disposals into high yielding investments. Earnings upgrades beckon, one reason why the shares are starting to re-rate.

I have also been running my slide rule over Frontier IP (FIPP), a company that provides commercialisation services to university spin-outs in return for ‘free equity’ stakes. The online-article is worth a read ahead of likely valuation uplifts in this month’s interim results.

ThinkSmart unveils massive profit

• Revaluation of Clearpay stake delivers £52.9m uplift.
• Bumper growth in UK ‘Buy now pay later’ segment.

Half-year results from Aim-traded finance company ThinkSmart (TSL: 74p) delivered a hefty revaluation of its minority stake in Clearpay, a fast-growing UK payment platform that enables consumers to split the cost of retail purchases into interest-free payments.

The stake doubled in value to £106.6m (100p a share) in the second half of 2020, buoyed by Clearpay’s eye-catching operational performance and ongoing re-rating of Clearpay’s majority owner, Afterpay Touch (APT:ASX), a A$33.7bn (£19bn) market capitalisation Australian Stock Exchange-listed technology group. In the six-month period, Clearpay increased its active customer base 161 per cent to 1.6m (12.2 per cent of Afterpay’s total customer base), and almost quadrupled underlying sales to A$800m (£450m) to report revenue of A$37.4m and cash profit of A$6.5m, representing 8.2 per cent, 9 per cent and 13.6 per cent, respectively, of Afterpay’s global underlying sales, revenue and cash profits.

With an average transaction value of £80, and 90 per cent of customers (mainly Millennials and Generation X) linking repayments to their debit cards, bad debts remain low (98 per cent of customers pay on time). The ‘buy now pay later’ (BNPL) segment accounts for four per cent of the UK e-commerce market, and is set to maintain its rapid growth as Covid-19 pandemic accelerates the move off consumers online.

Furthermore, BNPL fintech companies such as Klarna, Paypal and Clearpay, which take a commission from the online retailer to fund a customer’s retail purchase, are the most likely winners of the Financial Conduct Authority’s recommendation to regulate the sector. Implementation is 18 to 24 months away during which time the three companies should continue to grow market share of the e-commerce credit market while impending regulation acts as a major barrier to new entrants.

Interestingly, Afterpay has just raised A$1.5bn to buy out the minority shareholders of its US operation, a read across of the price paid fully supports ThinkSmart’s valuation of its minority interest in Clearpay. The fact that the stake is subject to a put and call arrangement between the two parties – the agreed valuation principles being the market capitalisation of Afterpay, and Clearpay’s proportion of Afterpay’s gross merchandise value, profits and active customers – offers a clear exit strategy for ThinkSmart’s shareholders, although I expect Afterpay to try to buy out ThinkSmart’s well before its call option becomes exercisable in 2023.

ThinkSmart’s legacy finance business remains cash generative as the company winds down £4.5m of receivables (mainly IT equipment). Bad debts are miniscule, hardly surprising given customers need computers even more during lockdowns. Cash of £6.9m and other net assets of £3.1m are worth 9.5p a share, so the balance sheet is healthy.

The shares are up 400 per cent since I suggested buying in my April 2020 Alpha Report, and I fully expect the unwarranted 33 per cent discount to conservative net asset value of 109.5p to narrow further. Buy.

Frontier IP commercialising valuable technology

• Exscentia and Pulsiv’s fundraises at premium to carrying value of Frontier’s holdings.
• The Vaccine Group has undertaken animal trials with three vaccine candidates.

Investors are underestimating the potential for valuation uplifts from Frontier IP (FIPP:60p), a company that provides a range of commercialisation services to university spin-outs in return for ‘free equity’ stakes.

For starters, portfolio company Pulsiv Solar has recently raised £890,000 in new money through an equity fundraising to accelerate development and scale up of its technology which improves energy efficiency of power converters used in a wide range of everyday products. The fundraise and debt conversion values Pulsiv at £21.8m, with Frontier IP's resulting 18.8 per cent equity stake now worth £4.1m (8.1p a share). The investment was held at £3.6m (7.1p a share) in Frontier’s last annual accounts at 30 June 2020, representing 13.9 per cent of the company’s NAV of £25.9m (51p a share).

Furthermore, Pulsiv, a spin out from the University of Plymouth, has been working with a major multinational to incorporate its technology into a new consumer product line. It has also been working with German engineering giant Bosch to optimise design of an energy-efficient solar microinverter prototype to prepare it for mass manufacture.

Frontier’s largest portfolio company, Exscientia, a clinical stage pharma technology company that is pioneering the use of artificial intelligence (AI) to design new drugs, has just completed a US$100m Series C financing round. In May 2020, Exscientia raised $60m from investors including Bristol-Myers Squibb, Novo Holdings, Evotec and GT Healthcare Capital. Funds managed by BlackRock have just joined the investment round. The capital will be used to support Exscientia's platform development towards autonomous drug design and expand existing capabilities in biological analytics that support target selection and portfolio development.

Exscientia’s end-to-end AI-first drug discovery platform, CentaurAI™, is enabling the company to generate novel drugs and overcome conventional drug discovery limitations several years faster than industry benchmarks. Exscientia has demonstrated the platform's capabilities by creating the first fully AI-designed drug to enter clinical trials and advancing multiple drug candidates into preclinical testing. In addition to its growing proprietary pipeline, the company has conducted drug discovery partnerships with Bristol-Myers Squibb, Sanofi, Bayer and Dainippon Sumitomo as well as several biotech companies.

Frontier’s 2.4 per cent stake in Exscientia was valued at £4.4m (8.7p a share) at 30 June 2020, implying a read through valuation for the company of £183.3m ($256m). Following Exscientia’s fundraise this week, Frontier now holds 2.11 per cent equity but is set to book a hefty uplift on the value of its holding. Although the terms of BlackRock's funding are yet to disclosed, Sky News is reporting from sources that the investment round was priced at a $650m (£464m) valuation. On this basis, Frontier's stake in Exscientia could now be worth £9.8m (19.4p a share).

Covid-19 winner: Robotic technology in harvesting

Frontier’s other portfolio companies are performing well, too. Fieldwork Robotics, a developer of robotic technology to harvest soft fruit and vegetables that addresses the need for heightened food safety and the shortage of UK seasonal workers, is progressing with a raspberry-harvesting robot in collaboration with Hall Hunter Partnership, one of the UK's biggest soft fruit producers, and is working with Bosch to optimise the software and design of the robotic arms. An alpha prototype for manufacturability of its raspberry harvesting robot is expected for trials later this year. Fieldwork is also developing a cauliflower harvesting robot with Bonduelle, a leading vegetable producer in more than 100 countries. Frontier IP holds a 26.7 per cent stake worth £1.35m.

A novel approach to fighting Sars-Cov-2 in animals

One of the most exciting investments is Frontier’s 17 per cent stake (book value of £3m) in The Vaccine Group (TVG), a company that is developing vaccines initially for use in animals to tackle Sars-Cov-2, the virus causing Covid-19. As most diseases that afflict humans originally arise in other animals, it is sensible to tackle them at source. Moreover, there is considerable value in developing animal vaccines because of the economic damage diseases, such as bovine tuberculosis, can cause.

For instance, Sars-Cov-2 originally arose in bats and entered human populations via an unidentified intermediary species. Covid-19 has also been found in cats, dogs, ferrets and mink. Longer term, there is potential for TVG to develop a vaccine for use in humans. Indeed, Oxford University says there will be a need for second-generation vaccines because of the danger from virus mutations reducing the efficacy of those currently being deployed. TVG’s technology takes a different approach to attacking the virus than other vaccines under development. The science is worth explaining as it highlights the blue-sky potential for TVG, and the upside for Frontier IP.

Sars-Cov-2 infects people via its spike proteins which latch on to a protein, ACE 2, found on cells in alveoli and other parts of the body. The alveoli are where the lungs and blood exchange oxygen from the air and carbon dioxide in the process of breathing in and out. The spike protein forces an entry into a cell by cracking it open using the interaction with the ACE 2 protein. It is estimated there are more than 180 Sars-Cov-2 vaccines under development. Most are targeting the spike proteins: they aim to train the body’s natural defences to recognise the spike protein and destroy the virus in the body.

The concerns around the emergence of the Kent, Brazil and South African Sars-Cov-2 variants, all resulting from spike protein mutations, highlight two major issues:

• Firstly, the spike protein mutates more often than other proteins in the virus, perhaps because it is the contact point between the virus and host.
• Secondly, because it is the main contact point between the virus and host, mutations able to avoid or overcome the body’s defences mean a variant virus is likely to gain ground more rapidly.

Bearing this in mind, TVG’s vaccine candidates are targeting the nucleocapsid and membrane proteins, both essential to the virus’s structure. These proteins are building blocks necessary for constructing the virus’s core and surface, and are created earlier than spike proteins as the virus reproduces itself — meaning a vaccine that targets them can eradicate the virus sooner.

TVG has undertaken initial animal trials with three of the six current vaccine candidates and is analysing the data from these trials, with the other three about to be tested. The company is also making good progress with animal vaccines for Ebola, Lassa fever and other diseases causing human or economic harm, including bovine tuberculosis.

Frontier’s 17 per cent stake in TVG was last valued at £3m, a conservative valuation if the company succeeds with its government funded vaccine programmes.

I first suggested buying Frontier’s shares at 56p (Alpha Research: ‘A differentiated IP play’, 15 Nov 2019), and they still only trade on a modest premium to last reported NAV even though forthcoming interim results on Wednesday, 24 March 2020 should deliver valuation uplifts from several investee companies. Buy.

■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £3.25 [UK].

Promotion: Subject to stock availability, both books can be purchased for the promotional price of £25 with free postage and packaging.

They include case studies of Simon Thompson’s market beating Bargain Share Portfolio companies outlining the investment characteristics that made them successful investments. Simon also highlights many other investment approaches and stock screens he uses to identify small-cap companies with investment potential. Details of the content can be viewed on www.ypdbooks.com.