Stockwatch: a capable CEO leading another turnaround

by Edmond Jackson from interactive investor |

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A rising tide of money from global central banks is lifting all boats. Can this one stay afloat? Our companies analyst shares his view.

The bumpy chart of perennial turnaround Hornby (LSE:HRN) is rising once again. Admittedly, not by a lot numerically, but in percentage/chart terms it is behaving like many others this year.

Many stocks lurched lower in March, then made a near-complete recovery, despite impaired fundamentals and uncertainty giving any medium-term guidance while Covid-19 is at large. Hornby now trades at 37p, but is still worth just £62 million.

Is it the case that we have to adjust our perception of ratings to factor in central bank stimulus, making many stocks an easy bet as a rising tide of money lifts all boats? Are higher-risk small-caps benefiting most in a tighter market, as traders look for "bargains", or are such stocks becoming higher risk in case hopes are ultimately dashed? 

Speculation versus investment is personified this week by Dave Portnoy, the American day trading celebrity who is dissing Warren Buffett. “I’m the Captain now” he boasts, after loading up with airline stocks Buffett dumped at end-March; his 1.5 million Twitter followers are making a killing too. 

“Stocks only go up” he asserts, due to central bank stimulus and, indeed, yesterday the Bank of England declared £100 billion extra to be pumped into markets. Inevitably a good portion will support equities given virtually no returns from bonds or cash. 

The parallel between AIM-listed Hornby and stocks favoured by noise trader Portnoy, is a poor financial record (see table below) in recent years; the kind of perennial turnaround Buffett learned to pass over, decades ago. Its shares have recovered all of March’s drop, despite latest annual results showing only reduced losses - around £3.5 million net - than conviction about profits ahead. 

Years ago, in a normal monetary environment and amid a recession, stocks like this would get punished due to lower liquidity in chastened times, and small-caps lagging those bigger businesses even when the economy turns out of recession. Yet the new monetary normal – the US Federal Reserve says it will provide support for at least two years – means we probably have to modify our assumptions. 

High-calibre CEO and supportive investor parent 

From a financial view, these are prime virtues. Hornby’s CEO since October 2017 has been chairman of Oxford Diecast – a company he built into a successful international business based on diecast models, where he remains the majority owner. This was presumably a key reason why Phoenix Asset Management took majority control of Hornby, although it has done something similar at AIM-listed Stanley Gibbons (LSE:SGI) – thinking that both companies can capitalise on people enjoying collectibles’ hobbies, and plenty is to be gained online.

Hornby had issues with a Chinese supplier, but nowadays sources from India. We’ve seen Games Workshop (LSE:GAW) turn around to become a highly successful £2.6 billion company in collectibles.

From a marketing view, however, I confess that when Google pushes Hornby ads alongside my web-browser, as a result of investigating the group, I wonder how many people want to buy say a £200 train set nowadays? I feel unqualified to answer, but it seems the CEO is a tad backward-looking - to make much of 2020 being the 100th anniversary year of the first Hornby locomotive. Is it really a growth market, to help Hornby over its various high-cost hurdles?

Source: TradingView. Past performance is not a guide to future performance.

Sales plus the gross margin have improved in 2020 

A Christmas trading update initiated this theme, citing good reception by the trade for Hornby’s new products. Latest prelims for the year to end-March 2020 quantify revenue growth at 15% to £37.8 million, helped by new releases which also improved the gross margin from 41% to 44%. 

Both Hornby and Scalextric models are benefiting from new technology such as wireless control from a smart phone. Some £2.4 million was spent on “product tooling” which seems a recurring aspect of cost, to a lesser or greater extent, for keeping models refreshed.  

Unfortunately, £16.7 million gross profit did not cover fixed/variable costs, despite the CEO achieving some reductions in recent years as a result of no longer discounting products, also improving sales. But last year, overheads rose 8% to £19.4 million due to sales-related costs and recruitment – despite cost savings in other areas – hence a £2.7 million operating loss.

The CEO didn’t use a standard adage of turnarounds, about how “much remains to be done”, but it would appear there is, to better leverage sales as a means out of the costs trap. 

Hornby -   financial summary
year ended 31 Mar 2015 2016 2017 2018 2019 2020
Turnover (£ million) 58.1 55.8 47.4 35.7 32.8 37.8
Net profit (£ million) -0.1 -13.7 -9.7 -9.9 -5.3 -3.4
Operating margin (%) 0.6 -23.5 -19.4 -27.7 -15.9 -7.4
Reported earnings/share (p) -0.3 -26.8 -12.4 -10.0 -4.2 -2.7
Normalised earnings/share (p) 1.0 -16.8 -9.7 -8.5 -3.7 -2.6
Operational cashflow/share (p) 11.5 -19.3 -0.4 -5.9 -2.3 -2.3
Capital expenditure/share (p) 12.4 8.9 2.6 1.8 2.1 1.6
Free cashflow/share (p) -0.9 -28.2 -2.9 -7.7 -4.4 -3.9
Cash (£m) 0.5 0.7 1.6 3.9 0.7 5.9
Net debt (£m) 7.5 7.2 -1.5 -3.4 1.8 -5.9
Net assets (£m) 31.8 32.1 29.7 30.9 25.8 37.0
Net assets per share (p) 78.1 56.3 34.5 24.2 20.3 22.2
Source: historic Company REFS   and company accounts

Where has two-thirds of February’s capital-raise already gone?

The classic model of a successful turnaround involves a capable boss taking the reins at a business of proven mettle that somehow lost its way. Last February’s £15 million equity offer appeared to underline the latter stage of a turnaround, with attention to new ideas: billed as raising funds “towards product development, digital marketing, upgrading central systems and flexibility for further investment”. A 36p price equals the market price at the time, indicating credibility and keen support for such a prospectus.

So, it’s perturbing how the 31 March balance sheet cites cash of only £5.9 million. Some two-thirds of what was raised, as if to underwrite the next two years’ development, is already gone, and within a detailed set of results I can find no explanation.

Changes in the balance sheet are normally evidenced by the cash flow statement, where its "financing" side shows an £8.3 million repayment of a shareholder loan following £7.8 million such proceeds. A “Financing” section in the results statement also cites both a £12 million facility with PNC Credit to June 2023, and a £9 million Phoenix facility at a margin of 5% over LIBOR. But there's no explanation of any change. 

My guess is that a high-cost preferential loan was taken out with the majority shareholder, who effectively converted this to equity via the placing. I further surmise it was bridging debt to boost inventory - the balance sheet shows up 31% £14.2 million and is explained as accelerated purchases ahead of the Chinese New Year, also growing concerns at the impact of Covid-19 on suppliers. 

But, if so, then the placing was really to address short-term working capital under the guise of medium-term corporate development. Debt repayment featured well down the agenda for raising £15 million equity capital. The income statement shows interest costs jumped from £177,000 to £615,000, as if the board was keen to exit a costly loan.

Trading continues to improve in the new financial year

Despite my concern about this, I respect that products do appear currently to be gaining traction – quite whether sufficient and sustainably enough, to imply an inflection point versus costs. I was also expecting more by way of strategy in this results statement, beyond “continuing to implement the third stage of the turnaround plan.” Here I am, of positive mindset towards Hornby as risk appetite increases in the stock market, but I feel stalled. 

If owning Hornby shares, I would stay around to see what the current financial year may bring. Despite no dividend and market value at 1.7x book value, of which 20% comprises goodwill/intangibles, this CEO looks to be steadily turning the corner. 

This company is effectively underwritten by Phoenix, and its stock by central bank zeal to prop asset values. I’m 80% Buffett however, with a modest 20% nod to Portnoy on how the modern stock market is rigged. Intrinsic value will ultimately prevail, hence, on a fresh money view, I want more evidence about where Hornby can be in the longer run. Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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