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Bargain Shares: On the hunt for value

A trio of anomalously priced small-cap companies offer potential for their ratings discounts with peers to narrow.
Bargain Shares: On the hunt for value

Earnings upgrades and contract wins are key share price drivers as shareholders in small-cap niche packaging engineering specialist Mpac (MPAC:633p) can testify. The recovery in trading that started in the second half of 2021 shows no sign of waning as highlighted by a 69 per cent increase in the first half order intake to £51.7m and 12 per cent higher closing order book of £62m.

Demand for Mpac’s digital solutions for artificial intelligence-enabled equipment in production facilities and warehouses is being driven by strong secular trends in its core healthcare (37 per cent of revenue), food & beverage (51 per cent) and pharmaceuticals (2 per cent) market segments. These industries are not only generating mid-single digit underlying growth rates, but the Covid-19 pandemic is accelerating the adoption of AI-enabled robotics to improve production efficiency.

Moreover, Mpac has won a major contract with New York Stock Exchange listed FYEYR Battery (FREY) to supply casting and unit cell assembly equipment for environmentally friendly lithium-ion battery cell production at its Norwegian plant. Electric vehicles and domestic storage are key end markets. FREYR plans to develop 43GWh of battery cell capacity by 2025, rising to 83GWh by 2028, making it one of Europe’s leading players. It’s not the only good news from Mpac.


Mpac on the upgrade

  • Mpac upgrades earnings guidance again.
  • 20 per cent first half revenue growth buoyed by 25 per cent higher Original Equipment Manufacturing (OEM) revenue.
  • Gross margin rises from 30.7 to 33.4 per cent.
  • First half underlying pre-tax profit rises almost 90 per cent to £4.7m to deliver earnings per share (EPS) of 18.3p.

Mpac’s eye-catching first half results highlight the benefits of last September’s $13.3m (£9.6m) acquisition of Ohio-based Switchback. Not only has the business widened the group’s customer base in order to build sales in North America, and enhanced its carton and end-of-line solutions offering, but Switchback continues to outperform management’s expectations.

Indeed, revenue in North America surged by two-thirds to £30.1m (68 per cent of group total, up from 55 per cent in 2020). Buoyed by the completion of several large contracts, Mpac reported notable growth (35 per cent) in OEM sales to the food and beverage sector which helped the division deliver 77 per cent of group revenue. This augurs well for Mpac’s service division in the second half which reported a 10 per cent rise in order intake in the first half.

Furthermore, with both gross margin and revenue rising strongly in a positive operating cycle, then Mpac’s level of profitability is on the upgrade, too. Analysts at both Panmure Gordon and Equity Development have taken note, pushing through 5 per cent profit upgrades for the full-year and pencilling in mid-teens growth in EPS to around 36p, rising to 38p in 2022. Reassuringly, although net cash declined from £14.6m (72p a share) to £10.3m due to working capital build, since the half year-end it has increased above January’s starting level.

Of course, Mpac’s progress has not gone unnoticed, hence why the share price has rallied by almost a third since I advised buying ahead of the interim results (Bargain shares: Engineered for a strong recovery’, 9 July 2021). It has also broken through the 600p target I outlined in that article to take the gain to 300 per cent on my 2018 Bargain Shares portfolio entry level.

However, the shares still only trade on a 2021 price/earnings (PE) ratio of 17.5 (cash-adjusted 15.5 times), an unwarranted nine-point ratings discount to the UK engineering sector average and one that suggests my new target price of 700p is achievable. Buy.


Sylvania’s bumper cash return

  • Net profit increases 143 per cent to $99.8m in 12 months to 30 June 2021.
  • Closing net cash rises 90 per cent to $106m year-on-year, and up from $67m at start of 2021.
  • Final dividend of 4p a share beat’s Liberum’s 2.9p a share estimate.
  • Production guidance flat at 70,000 PGM ounces.

Sylvania Platinum (SLP:101p), a cash-rich, fast-growing, low-cost South African producer and developer of platinum, palladium and rhodium, has rewarded shareholders with a better than expected 150 per cent hike in the final dividend to 4p a share (ex-dividend: 28 October) to add to the 3.75p a share special dividend that was paid in April.

The board can afford to be generous as the $29m cost of the 7.75p a share payout equates to less than a third of Sylvania’s $99.8m net profit in the 12 months to 30 June 2021. Furthermore, even after accounting for the final dividend payment, proforma net cash of $91m (24p a share) is still two-thirds higher than at this stage last year.

Admittedly, Sylvania’s share price has retraced the hefty gains made earlier this year, mirroring falls in the prices of palladium (down 19 per cent) and rhodium (43 per cent decline) as market fundamentals softened in the short-term due to the weakness in automotive production caused by semi-conductor chip shortages. The sector accounts for 82 per cent and 87 per cent, respectively, of end market demand for palladium and rhodium which are both used in catalytic converters. Auto inventories are currently at all-time lows, one reason why second hand car prices have surged.

However, Liberum Capital’s technology team believe that the chip shortage will peak this month and then ease for the rest of the year, a positive for Sylvania’s average basket price which has been dragged down by a third since May. Importantly, markets for both palladium and rhodium are still forecast to be in deficit this year. Furthermore, the group remains hugely profitably at current spot metal prices as Sylvania’s average basket price is more than four times higher than group cash costs of $755 per oz. Based on flat production of 70,000 PGM ounces, cash profits north of US$120m (£87m) should be easily achievable in the new financial year.

To put the valuation into perspective, strip out net cash from Sylvania’s £272m market capitalisation and the group is rated on an enterprise valuation of only 2.2 times cash profits at current spot metal prices. The holding has produced a 634 per cent total return since I included the shares in my 2018 Bargain Shares Portfolio and I continue to see scope for material further upside. Buy.


Arcontech unloved and materially under-rated

  • Flat revenue of £3m and pre-tax profit of £1.02m in 12 months to 30 June 2021.
  • Net cash up 8 per cent to £5.4m (40.6p a share).
  • Dividend raised 10 per cent to 2.75p a share.
  • High level of pent up demand with qualified list of prospective new customers across six countries.

Aim-traded financial software provider Arcontech (ARC:135p) delivered a resilient performance in its latest financial year despite the Covid-19 pandemic restricting customer contact due to remote working practices.

The company makes its money by providing software products and bespoke solutions for the collection, processing, distribution and presentation of time-sensitive financial markets data. Sales cycles are long and complex, which discourages clients from switching to another provider, so face-to-face meetings with key decision makers are key when pitching for a new contract. For instance, Arcontech needs to demonstrate: the potential cost savings of its solutions; how it can replicate the functionality of the clients’ existing products; and how it can deliver new benefits to minimise disruption. New contract awards are small initially and then scale up, so generating organic growth in future years.

Arcontech did manage to win new contracts in the 12-month trading period, one with a Tier One bank client, to add to its roll call of blue-chip clients which includes Barclays, JPMorgan, Morgan Stanley, and Bank of England. The small sales team has also been successful in strengthening the qualified pipeline of potential prospects, but Covid-19 restrictions have made converting the robust pipeline of opportunities difficult in the near-term, hence why the directors expect current year profits to be flat (or lower) as any pick up in revenue will not be fully reflected until the 2022/23 financial year.

The market reaction has been savage with Arcontech’s share price plunging below the 160p level at which I suggested buying at six months ago (‘Tap into a prodigious cash generator’, 28 February 2021). It’s a ridiculous overreaction. At the current price, the company has an enterprise valuation of £12.6m, or 12 times net profit, a low-ball valuation for a high margin (operating margin of 36 per cent), cash generative (free cash flow of £0.8m forecast in 2021/22) business that has strong defensive characteristics (recurring licence fees account for 93 per cent of annual revenue). Arcontech is also highly operationally geared given its relatively fixed cost base. Indeed, the incremental operating margin on new sales is around 60 per cent, so any contract wins have an accentuated impact on profits. Moreover, at the current valuation Arcontech is an obvious takeover target in a consolidating industry with peers trading on PE ratios of between 32 and 43 times. Recovery buy.

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