4 small-caps on steroids

The past 12 months should have been a time for my Small Caps on Steroids screen to shine. That’s because the screen focuses very much on the trashier end of the small-cap value spectrum. 

It was these types of companies that saw their shares rocket most when vaccine breakthroughs were announced last November. The news sparked a so-called “dash for trash”. This is a common phenomenon when economic storm clouds begin to clear and investors anticipate a recovery. The weakest companies with shares at near-death valuations tend to benefit the most as they’re rapidly rerated to reflect expectations that they may live another day after all. 

Indeed, since I ran this screen last year, the MSCI UK SmallCap Value index has delivered a bumper total return of 45 per cent compared with 25 per cent from the broader MSCI UK index. 

But sadly, the nine stocks highlighted by the screen last October proved disappointing by comparison. Only two beat the MSCI Small Cap Value index and the overall total return of 15 per cent was poor in this context.

The reason the screen can be regarded as focusing on trashier small-caps is due to its love of both low valuations and high debt levels. Focusing on heavily indebted 'value' stocks turns conventional wisdom about value investing on its head. Normally, value investors are told to seek a “margin of safety”. That’s because of the risk that in buying cheap stocks investors may end up buying stocks that are cheap for a very good reason. Situations where times are tough but continue to get tougher rather than getting better – often referred to as 'value traps'. 

Debt just makes things a whole lot worse. Given companies have to pay their borrowings and other debt-like liabilities – such as lease commitments and pensions – before paying shareholders, high debt levels and poor trading can conspire to quickly erase all the value of a company’s equity. 

But in 2015 Brian Chingono and Daniel Rasmussen published a paper titled 'Leverage Small Value Equities' which highlighted an alternative narrative about heavily-indebted smaller companies with cheap shares. 

Their idea was based on the observation that when heavily indebted companies pay debt they can rapidly transfer value to shareholders. This is based on the idea of enterprise value (EV). EV looks at the valuation being put on a business taking into account all sources of funding. 

In its most basic form, EV is market capitalisation plus debt minus cash. So if debt falls, market capitalisation has to rise by the same amount to keep EV constant. Adding to the power of the impact of debt paydown on share prices is the fact that investors are generally inclined to put higher valuations on shares as balance sheet risk falls. Chingono and Rasmussen described the dynamics using the colloquial term favoured by one of their university lecturers; “small-caps on steroids”.

To cash in on this phenomenon, Chingono and Rasmussen directed their data-crunching endeavours on trying to identify the most reliable indicators of a company that would go on to successfully pay down debt. As it turns out, the most reliable indicator the duo found was simply that a company had already started to reduce borrowings. Chingono and Rasmussen now run a quantitative investment firm called Verdad, which seeks to implement the strategy.

The original 2015 research was carried out on the US market where there are richer pickings when hunting out debt-ladened, cheap smaller companies. That means my screening criteria represents an anglicised version. The full criteria are:

• Among the cheapest third of stocks based on: EV / Earnings before interest, tax, depreciation and amortisation (Ebitda). 

EV is calculated using the basic method of adding net debt (including preference shares and lease liabilities but not pension deficits) to market capitalisation.

• A market cap of less than £750m, but more than £25m.

• Net debt to EV that is the higher of either the median average of all companies with net debt or 33.3 per cent. 

This year a low median average net debt to EV of 16 per cent means I’ve introduced the 33.3 per cent back-up test.

• Improving asset turnover (sales to total assets) over the past 12 months.

• Falling net debt over the past 12 months.

Given the racy nature of this approach, it probably won’t come as too much of a surprise that performance from the screen has been a rollercoaster ride. The first year was spectacular, the second was lousy and last year was poor compared with the market, albeit decent in absolute terms. 

The cumulative total return over the three years stands at 21 per cent compared with 30 per cent from a 50:50 split of the FTSE Small Cap and Aim All-Share indices. While the screens run by this column are meant as a source of ideas rather than as off-the-shelf portfolios, if I add in a fulsome 2.5 per cent annual charge to represent the high cost of dealing in unloved small-caps, the cumulative total return drops to just 12 per cent.

This year I have only found four stocks that fit the screening criteria. Details can be found in the table at the end of the article with extra fundamentals in the downloadable excel version.

The low number of results is likely to reflect the travails created by lockdown. Indeed, the stock I’ve taken a closer look at this week, car dealer Pendragon, has actually seen its debt position benefit from reduced trading over lockdown. The benefit looks likely to reverse as life gets back to normal. Nevertheless, there are grounds to think there may be value lurking beneath what is currently a rather murky surface.

Pendragon

While the risks are high, there could be significant value set to emerge from car dealer Pendragon (PDG) in the coming years. But before looking at why that may be the case, it is first important to consider the basis on which the screen has highlighted the shares: debt pay-down.

Debt comes in many forms, and especially so for Pendragon. For instance, were this screen only to take account of the net debt number reported by the company, there is no chance it would find a place among its picks. That’s because Pendragon actually reported a modest net cash position of £9.5m when it released its half-year results to the end of June 2021. 

But the screen also takes account of lease liabilities when assessing debt. Until 2019, lease liabilities – contractual commitments to pay rent on properties, equipment, vehicles and the like – did not have to be reported on a company’s balance sheet. Thoughtful investors had to try to estimate lease liabilities for themselves. 

However, a change to accounting rules means companies now have to put a number on these very debt-like commitments. The commitments are debt-like – at least from a shareholder’s perspective – because they have to be paid before owners of the shares can get their slice of profits. 

Another consideration with the debt number the screen looks at is that cash flows are seasonal at Pendragon. The balance sheet tends to be plumper at the mid-year stage, which is the last reported figure and the one the screen looks at.

Pendragon also has debt-like liabilities that go beyond the scope of what’s monitored by the screen. 

There is an underfunded defined-benefit pension scheme, which the company has agreed to try to eliminate with payments of £12.5m a year increasing at an annual rate of 2.25 per cent until the end of 2028. The reported deficit fell sharply in the first half. However, this reported deficit is different to the triennial valuation on which actual top-up payment decisions are based. Still, the reported fall is an encouraging sign.

Pendragon’s biggest debt-like item, though, is borrowings to fund motors on Pendragon’s forecourts. This is not readily seen in its balance sheet as it is lumped in with other 'payables', such as money owing to suppliers. 

This type of borrowing has been plummeting recently. That’s due to falling inventory levels (motors parked on forecourts). This is due to a Covid trading slowdown and reduced new car production because of the chip shortage. Lower inventory levels have also benefited the reported net cash position. The chart below illustrates the breakdown of Pendragon’s borrowings and how inventory financing has simply tracked lower with inventory levels.

With such huge financing requirements and the sensitivity to inventory levels, the apparent recent progress on debt (both actual borrowings and debt-like liabilities) needs to be seen in light of depressed trading and supply problems. 

Perhaps a better guide to where debt is likely to settle can be gleaned from the company’s five-year plan, which foresees interest charges of about £40m by 2025 compared with £38m last year. Broker Liberum meanwhile forecasts year-end net debt of £83m.

Glass half full?

Given the huge funding commitment associated with inventories, it is a shame Pendragon isn’t better at squeezing profit from them. A key way to measure how effective a company is at creating shareholder value from money tied up in inventory is to measure sales against average annual inventory levels. Pendragon’s record is uninspiring.

It also compares poorly with rivals as can be seen in the peer-group comparison table below. The table also shows the strong connection between share valuations in the sector and inventory turn (inventory to cost of goods sold). Forecast growth also playing an important role in determining what investors are prepared to pay for shares.

But Pendragon’s management believes there is an opportunity to turn around the fortunes of its car dealership businesses. The glass is half full in the company’s view rather than half empty.

Having sold its US dealerships, Pendragon’s car retail operations are now chiefly focused on its Franchise UK business. This sells new and used cars as well as providing high-margin aftermarket services, such as MOTs. It also has a lossmaking used-car superstore business called Car Store.  

A five-year plan is in place to try to make the Franchise UK business massively more profitable. The company believes the business can go from an £18.5m operating profit in 2020 to £75m by 2025. That figure includes the company’s aftersales work, which last year generated £111m of gross profits (two-fifths of the Franchise UK total) on £236m of sales (less than a tenth of the Franchise UK total). The planned turnaround at this business is a lynchpin in the plan to increase pre-tax profit from £8.2m in 2020 to £85m-£90m in 2025.

Cost savings will play a large part in hitting targets and the company has already made big strides here. During lockdown the company cut 1,400 jobs and over the 12 months to mid 2021 the number of dealership locations dropped from 160 to 141. At the half-year stage annual savings were running at £45.2m. Meanwhile, operating profits for the six months surged to £37.6m from a loss of £18.1m in the Covid-blighted first half of 2020. The strong performance has been helped by exceptionally strong selling prices caused by supply shortages. 

It is hoped the group’s separate Car Store used-car business can go from a £1.2m loss in 2020 to an operating profit of about £20m by 2025, with an online relaunch a major focus.

Considering the group has other more valuable operations that we’ll pursue in a minute, the low rating of Pendragon’s shares suggests the company still needs to convince the market its strategy can work. 

A major reason for scepticism is the burgeoning competition car dealers face from digital disruptors, especially in the used-car market where Pendragon derives 45 per cent of group revenue and has growth ambitions. There are also fears car manufacturers could make a push to sell direct to customers online.

Pendragon’s turnaround strategy is itself partly based on hopes of becoming a disruptive presence. It wants to do this by enhancing its online capabilities, and rebranding and relaunching its Car Store business online. But there are reasons to worry that it is late to the party. Nearly new car dealer Motorpoint already has a very slick hybrid operation. Meanwhile, online start-ups Cazoo and Cinch have huge ambitions with financial backing to match. 

Investors also have good reason to be wary about targets linked to underlying profits at Pendragon. Huge adjustments have been made by the company to reach its underlying figures over the past four years. Indeed, the cumulative underlying profit over that period of £100m compares with a total statutory loss of £223m. Much of the adjustments concerned writedowns and impairments to reflect a marked deterioration in business prospects. 

Still, an endorsement of the turnaround potential can be seen in the backing of Swedish car retail and services investment company Anders Hedin. Hedin holds 15 per cent of Pendragon’s shares and has been steadily adding to its stake since first emerging on the register three years ago.

Better value under the bonnet?

The woes of the car dealership business may be overshadowing hidden value elsewhere. Particularly in Pendragon’s software business. Its Pinewood business sells dealership management systems (DMS) software. It operates a cloud-based, software-as-a-service (SaaS) model. Traditionally, this business was very reliant on Pendragon itself as a customer, but such sales now only make up about a fifth of the total. 

Recently international sales have been growing fast and bar a Covid-related slowdown last year, the operation has been producing good revenue growth over the past decade. Even with the Covid setback, the five-year revenue compound annual growth rate stands at 12.1 per cent. Profit progress is harder to distinguish given Pendragon used to report external software revenues as almost pure profit but now seems to allocate costs more objectively.

The DMS software market is very fragmented. Pendragon reckons the disparate nature of competition as well as the need for dealers to sell more online, where Pinewood can offer solutions, should provide it with growth opportunities. The hope is it can take profits from £12.1m last year to £20m by 2025.

SaaS businesses with a decent growth story can trade on giddying multiples. This is due to the sticky and recurring nature of revenues coupled with the low incremental costs of new sales. If Pinewood can establish itself as a major player in its market there is the potential for the business to become very valuable. 

Broker Liberum puts a value on this business of £133m, or a little under two-fifths of Pendragon’s entire enterprise value (market cap plus forecast net debt). But that valuation looks fairly light. It equates to just 10 times its forecast operating profit. In a market where some small software firms are being valued at about 30 times operating profits, such estimates may be seriously overlooking the real worth. Indeed, broker Panmure Gordon notes that one of Pinewoods two big rivals in the UK was recently sold to private equity for 15 times cash profits. After applying a decent discount to that bid multiple, the broker puts a £191m value on Pinewood.

Another reliable but less exciting source of profits for Pendragon is vehicle leasing. This business leases and maintains fleet cars. When the lease is over and the keys are handed back, the cars are taken back into the dealership network and sold. 

The sharp rise in used car prices is boosting the profit from sales of ex-fleet cars. At the year-end, the estimated value of leased cars due to be returned stood at £81m. Rising prices helped half-year profits from leasing leap 72 per cent to £8.1m. The five-year plan for this business is to keep profits at the historical level of about £13m, although the tailwind from selling prices means this year could shape up much better. 

Transitory but tantalising

More generally, the backdrop of strong selling prices has led to a raft of upgrades this year. But the buoyant conditions are unlikely to last that long and the balance sheet is likely to bulge out again as supply returns. What the screen has picked up on is at least in part transitory. Meanwhile, there are risks aplenty that could upset the turnaround.

However, the idea that a credible SaaS software business may be hidden inside this embattled car dealer means there are grounds to think there could be a hidden gem in the dirt. And even if the company can get part way to its 2025 profits targets while kicking its habit of massive profit adjustments, the shares would look cheap.

Major disruption in the industry from new players is the clear and present danger. But this looks like a genuinely interesting value pick even if the debt paydown part of the story is not what it first appears.