An underestimated small cap on an 'extreme' discount

Midwich distributes products such as speakers, projectors, scanners, lights and microphones. The group has a variety of end users, including schools and offices, but sells to 20,000 middlemen – typically professional AV integrators and IT resellers. 

After a lockdown slump, sales and profits boomed last year, helped by the return of live events and the persistence of hybrid working. Organic revenue rose by more than a fifth, while adjusted operating profit leapt by 50 per cent to £51mn. Growth was strong across all regions, but the business grew particularly quickly in North America, where Midwich made a canny acquisition just before Covid struck. 

Growth is expected to slow this year, but the pandemic has permanently stoked demand for the hardware that enables consumers to connect digitally. People are also increasingly seeking out interactive experiences – be it in conference rooms, lecture halls or visitor attractions. The flurry of ‘immersive art’ exhibitions in London this year – where paintings are projected onto the walls and ceilings of galleries – is a good example. 

It helps that the AV industry is still made up of fairly small players. “Midwich operates in a very fragmented market,” says Victoria Stevens, a fund manager in Liontrust’s Economic Advantage team. “Its scale and domain expertise provide it with a significant advantage when it comes to distributing a wide range of specialist branded products into a broad network of customers.” Indeed, for many of its vendors, Midwich operates as the sole or largest in-country distributor. 

Robust demand

The big question for investors is whether the dull economic backdrop will derail growth in the short term. While Midwich serves a wide range of end customers, AV spend is cyclical, and a downturn in consumer and business sentiment could prove damaging.

However, research by Berenberg provides grounds for optimism. According to a survey by the bank's analysts, end users spent an average of $300,000 on AV equipment last year, against a total IT budget of $10mn. “With the majority of survey respondents generating revenues between $50mn and $500mn, this implies that [about] 3.6 per cent of business revenue is spent on IT and just 0.1 per cent of sales on AV equipment,” it says. 

If companies are trying to reduce their outgoings, therefore, AV equipment is unlikely to be the first place they look. Indeed, participants in Berenberg’s survey expect to spend 2.7 per cent more on AV equipment this year than they did in 2022. This optimistic outlook is reflected in research from AV trade association Avixa, which expects the market to grow by almost 6 per cent a year between now and 2027. 

It’s not all about demand, of course. Profitability is also a challenge for distributors, given that their profit margins are often slim. Midwich is no exception. Indeed, its 4.2 per cent adjusted operating margin is significantly lower than those reported by bigger peers. 

Profitability is improving, however – albeit slowly – and management has a plan. It is increasingly focused on “technical” product categories, for example, which are higher-margin, as they require greater pre- and post-sales support. They are also fast-growing: last year, technical products were responsible for 53 per cent of group sales, up from 42 per cent in 2021.

The supply chain problems that have hobbled a host of industries since the pandemic have also “largely returned to normal”, said management in announcing 2022's results. The bosses added that in the second half of 2022 “supply chains, for all but the most specialist products, were stable, global shipping costs reduced and inflationary pressures in the AV industry were generally below those in the wider economy”.  

Value opportunity

Investors are clearly still nervous, however. Midwich shares trade on a forward price/earnings ratio of around 11, compared with a five-year average of 18.6. “The stock is probably cheaper than it has ever been,” says Neil Hermon, director of UK equities at Janus Henderson. “From an investor's perspective, there is nervousness over the global economy and the impact that could have on the top line. And there’s a lack of interest in the small and mid-cap space. It needs market sentiment to turn and to deliver its numbers.”

The distribution sector as a whole has struggled with poor market sentiment recently. According to Investec, distributors have underperformed the wider market by about 10 per cent for the past 12 months, and Midwich shares have underperformed this peer group by a further 10 per cent, taking the discount to more than three times its long-established historical level. 

Profit margins explain some of the discount, as does Midwich’s relatively small size. However, the disparity is extreme, particularly for a company that has a strong track record of growth and occupies a valuable niche. 

One thing worth keeping an eye on is cash. As they grow, distributors tend to suck in lots of working capital as they have to buy ever-larger quantities of stock. As at 31 December 2022, Midwich had working capital – ie, trade and other receivables plus inventories minus trade and other payables – of £151mn, up from £106mn a year earlier. Working capital also represents a larger portion of current year revenue now than it did a few years ago.

Sure, this is a natural part of the growth process. However, things have the potential to get sticky if demand for certain products falls and Midwich is left with kit that it can’t shift. This concern cast some shadow over the group’s 2022 results, when a negative swing in the provision for aged stock offset growth in profit elsewhere and caused its gross profit margin to plateau. 

It also means that debt is rising, as Midwich is borrowing money in order to expand. Net debt jumped from £79mn in 2021 to £119mn by Christmas 2022, causing finance costs to more than double. On an adjusted basis, the ratio of net debt to cash profit (Ebitda) now sits at 1.6 times and over two times unadjusted profit. While this is “comfortably” within the board’s target range, rising debt – together with a higher cost of borrowing – is likely to impact cash flow and future M&A decisions.

Despite those obstacles ahead, however, Midwich’s lowly share rating is hard to resist. Besides, as virtual and augmented reality continues to dominate the headlines, demand for AV products shows no sign of waning. Buy