Interactive Investor

Stockwatch: proof of a major threat to small-cap profits in 2022

18th January 2022 11:09

Edmond Jackson from interactive investor

Our companies analyst sees rising prices causing serious problems for small companies in the coming months.

Despite strong revenues, new year trading updates contain daily warnings as to the likely impact of inflation on 2022 earnings. As yet, this seems focused on small-cap firms inherently less able to absorb higher input costs. Mind, this is before revenues feel the effect of higher taxes and energy bills on consumers from springtime. 

Card and gift retailer Card Factory (LSE:CARD) is a prime example, with revenue ahead of expectations for its 31 January financial year. From April, like-for-like store sales and transaction volumes showed an overall upward trend towards pre-Covid 2019 levels, with the groups stores out-performing…particularly strongly through December.”   

This was despite imports compromised by global supply chain issues later in the year. Strong cash generation also meant a 31% reduction in net debt. 

Yet profits will fall in the next financial year as inflation impacts margins. Mitigating actions will continue but the company has already declared they will not be enough. 

A substantial re-rating of the cost base 

To show how serious this is for a £188 million company: its cost base is set to rise by £30 million, relative to £360 million revenue guided for the financial year soon to close, with pre-tax profit targeted in a £7 million to £10 million range. This does include IT development, part of a strategic plan, but the chief culprit is the rising cost of freight, and also staff and utility costs. 

Consensus had previously been for a net profit recovery to £8.5 million in respect of January 2022, soaring to £33 million for January 2023 – roughly half what was achieved pre-pandemic (see table).  

The stock dropped 12% to 55p in response to the update, recovering only 1p given the forward PE looks to be well over 20x. While tables show net asset value of around 60p a share seemingly limiting downside risk, intangibles constituted 158% of end-July net assets. 

Yet reasons exist to justify a ‘hold’ stance. 

The board reckons a number of these cost headwinds will subside, although I would caution that tough lockdowns are being re-applied in China - which does not appear to have a convincing vaccine versus Omicron – which may mean supply chain issues will persist. 

More usefully, it cites price increases to be put through across ranges, which I guess could well work for occasional cards. Being at the low end of the price chain, Card Factory could also benefit from people switching from much pricier cards elsewhere. 

Card Factory - financial summary
Year ended 31 Jan

  2015 2016 2017 2018 2019 2020 2021
Turnover (£ million) 353 382 398 422 436 452 285
Operating profit (£m) 56.6 88.9 85.7 75.5 76.6 73.6 -7.5
Operating margin (%) 16.0 23.3 21.5 17.9 17.6 16.3 -2.6
Net profit (£m) 33.2 66.4 65.7 58.3 52.7 51.6 -13.6
IFRS3 earnings/share (p) 10.6 19.5 19.3 17.1 15.4 15.1 -4.0
Normalised earnings/share (p) 19.5 19.5 20.1 17.7 18.7 16.0 -3.2
Earnings/share growth (%) 253 0.2 3.2 -12.2 6.1 -14.9  
Operating cashflow/share (p) 24.1 23.2 24.0 21.3 37.6 32.3 21.5
Capex/share (p) 3.2 3.4 3.1 3.8 3.5 4.3 2.2
Free cashflow/share (p) 20.9 19.8 20.9 17.5 34.1 28.0 19.3
Dividends per share (p) 6.8 8.5 9.1 9.3 9.3 2.9 0.0
Covered by earnings (x) 1.6 2.3 2.1 1.8 1.7 5.2  
Net debt (£m) 101 123 135 161 291 288 251.0
Net assets per share (p) 83.0 78.0 73.2 64.0 64.4 64.8 60.4

Source: historic company REFS and company accounts

Reporting narratives vary on freight costs impact

ProCook Group (LSE:PROC), a £162 million importer of kitchenware that listed only last November at 145p, has cited an £800,000 increase in freight costs in its fourth financial quarter, and therefore a slight easing in its gross margin. Underlying product margins remain strong.” 

The company is enjoying very strong sales momentum, which has more than doubled on a two-year like-for-like basis.  An update also cites a 70% rise in new customers for its latest quarter and we remain well-stocked, having invested in working capital to protect availability throughout this period of continued supply chain disruption”. 

This shows how management and the business set-up can be a deciding factor in the current challenge for importers. 

It is a good update, although the 12-week period to 9 January will have benefited from Christmas gift-giving. Interims to 17 October had shown a 34% rise in revenue to £32.1 million, with underlying pre-tax profit up 11% to £4 million.  

I have not examined this companys prospectus to rate its stock, which currently stands at 150p, but I note how competitive cookware is: Google searches throw up a plethora of choice and supermarkets offer anything essential. 

Buoyant times for consumer spending, in the wake of Covid’s boost to household finances, provided a good opportunity for ProCooks flotation. My instinct is to await more of a listed track record, although management looks as though it already deserves credit for its adept importing.   

Energy cost rises look unlikely to abate this year 

AIM-listed Accrol Group (LSE:ACRL), a £71 million manufacturer of tissues, has cited further inflationary pressure on input costs including pulp prices, supply chain costs and most significantly energy costs”.

This initially weighed on its stock from 31p to 22p, with some recovery now to 24p. Consensus has been for £900,000 of net profit in the groups current year to 30 April, soaring to £5.4 million in April 2023 – although that would only restore pre-2018 profits, since when there have been material losses and dilution. 

Management says it is confident of being able to continue passing on price increases to its customers, which include many of the UKs leading discounters and grocery retailers”. 

Investors appear sceptical – with Aldi advertising a commitment to low prices – and despite Accrols market price seemingly at a discount to net asset value of 27p a share, intangibles weigh heavily at 72% of net assets. 

Back in 2017, Accrol traded over 150p but fell from that October to as low as 8p in March 2018, subsequently recovering to 70p a year ago. 

The board is responding with the proverbial strategic review, which seems likely to mean exceptional costs despite the carrot of ensuring that shareholder value is maximised”. 

I expect more such responses among small caps, where takeovers could emerge as a more radical means to take out costs – including head office and boardroom.  

A hold’ stance is therefore justified for Accrol, on the grounds that it may be best to see how much red ink may get spilt before buying. Any predator would likely wait for that. 

DP Poland shows wage costs now boosting inflation  

The transitory” inflation camp has argued it will abate before wages go up. But the AIM-listed pizza provider DP Poland (LSE:DPP) fell 8% to just 6.0p yesterday after warning of higher food and wage costs – such that despite sales growing at double-digit percentages, 2021 profitability is below expectations. 

A recovery in tourism and elimination of lockdown measures is hoped for 2022, but it sounds as if a costs review is underway. Part of the dilemma is Poland not providing state support for its hospitality industry. 

This stock has a disappointing 11-year track record and its best value may be as a tax loss – in which case, ‘sell’ when you need it.  

Taylor Wimpey bailed out by house price inflation 

Valued near £6 billion, house-builder Taylor Wimpey (LSE:TW.) is no small cap, but it is relevant to assess a sector affected by materials price rises and labour shortages pushing up wage costs. 

Its stock started January at 168p but is currently 158p, despite an update asserting an excellent performance” in 2021 with full-year results in line with expectations, helped by a significant improvement in operating margin. 

House price inflation has fully offset build cost inflation and (illustrating my point about small-cap risk) our national scale and strong partner relationships enabled us to effectively manage these pressures.” 

What was not clear was the extent to which historic land buying might have helped to offset margin pressures, which is tricky anyway to decipher from house-buildersaccounts. 

The update cites an excellent order book with 47% forward sold for 2022, but not surprisingly investors are concerned at the potential effects of higher mortgage rates. They will be hoping forecasts are fair enough to affirm tables showing a near 8% prospective yield. Hold. 

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

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