Stockwatch: Is this AIM share good value after crash?

Does an 8 March profits warning from AIM-listed Conviviality (CVR), a retailer/wholesaler mainly of alcoholic drinks, signal growing pains or over-stretch?

After the stock had plunged over 75% from last November’s high, briefly below 99p last Friday, the chief executive bought 44,176 shares at 114p and the finance director 120,000 shares at 109p.

The fall was likely exacerbated by market confusion over the risk of breaching banking covenants, which a Thursday 8 March announcement implied, but Conviviality’s accounts imply low-risk because invoice discounting is excluded from covenant calculations. Thus, in early Monday trading, the price rebounded to 126p, although retreat to 115p reflects wariness.

Forecasts downgraded, including dividends

If downgraded forecasts by Shore Capital are fair (possibly reflecting guidance from the company, and mind how Shore was bullish before the slump), then the year-end April 2018 adjusted pre-tax profit expectation falls from £53.8 million to £38.4 million, and 2019 profit from £65.9 million to £43.9 million.

Mind such profit will exclude exceptional costs arising from acquisitions (see the trend of historic IFRS3 profits lower than normalised profits in the table).

If you are content to overlook this, the 12-month forward price/earnings (PE) ratio is just over 6 times with the stock currently around 120p; and with dividends downgraded from 13.5p to 5.7p in respect of 2018, also from 14.9p to 6.2p for 2019, the prospective yield is about 5%.

I’m not at all surprised by the slash to dividends, having warned of the balance sheet risks when arguing “Time to sell this AIM star” last November at 412p.

The stock had doubled in 2017, thus pricing in margin improvements before proven; and a 3.5% yield would not support the stock nor the balance sheet, if the narrative was to change adversely.

Time to sell this AIM star

I said the extent of payout was unwise, that priority should be to improve the balance sheet, and in the current climate I would mind any board that cites “second-half weighted” results (as Conviviality was indicating). My view was to “take profits”.

Is supplying alcohol really a UK growth industry?

The medium-term crux is can this assembly of suppliers prove genuine growth? Or is it yet another example how “growth” mainly correlates with acquisitions, up to the point where strains manifest?

It’s no real surprise, the stock has de-rated hugely as it searches for a level where loss-takers and traders balance those buyers who judge the yield is adequate for the risks.

There’s also wider relevance after a near-decade of ultra-low interest rates has encouraged takeovers generally, with rates now set to rise.

Yes, it’s a substantial £51 billion market with Conviviality enjoying an 8% share of sales – from soft drinks to fine wines (also selling select grocery and tobacco/vaping in Bargain Booze off-licences).

This would appear relatively recession-resilient, and if pubs/restaurants etc see lower sales in a consumer downturn then off licences could benefit; although supermarkets might also take share, thus an overall downturn for Conviviality.

Also, the long-term trend is not great for alcohol consumption, with steady small declines as younger people steer away and teetotalism grows.

Cancer risk warnings linked to drinking alcohol have become more regular. Thus, drinks groups need to adapt to newer non-alcoholic options, to grow, but overall Conviviality has made a big dash mainly for alcohol supply.

The bull case was largely a promise of better margin

I drew attention to Conviviality as a ‘buy’ at 211p in December 2016 on the basis of a trading update: “strong performance across all divisions…organic growth in each unit…existing and new customers recognising Conviviality as the leading UK drinks supplier.”

It marked an inflation point after the stock had traded sideways through 2016, priced on a single-figure PE and fat prospective yield of 6.8% significantly because operating margins were low.

Stockwatch: Exploit this 6.6% yield

I was largely trusting management’s claim that “economies of scale should enhance margin”, although I pointed out balance sheet issues also: goodwill/intangibles representing 131% of net assets, and the ratio of trade receivables to trade payables at 0.83, as if profit might be enhanced by delaying payments.

Last August’s annual report conveyed a capable management team, with strong industry relations as a distributor to hotels/pubs/restaurants also off licences/wine stores. The directors continue to proclaim virtue in a “one stop shop” model, with sales “holding up”.

But on a key performance measure of acquisitions integration, the table shows the operating margin gradually declining from 2.88% in 2013; and in the 29 January interims it is down from 1.67% from 1.79% like-for-like.

Then the 8 March update cited EBITDA (which approximates to operating profit) some 20% below expectations due to a material error on the wholesaling side – whose margins also softened in January/February and which will remain down to the April 2018 year-end.

While this could reflect a new-broom finance director arriving four months ago, it’s a typical sign of an acquisitions-driven group running into control issues.

The margin fail is a key performance metric, while profits/earnings growth from acquisitions has seen various share-based payments to senior management and the chief executive’s annual remuneration risen to nearly £1 million.

Thus, it also begs a question of corporate governance failure: that the board has not aligned management incentives appropriately with investors, for good risk management besides rewards.

Conviviality – financial summary           Broker estimates year ended 30 April 2013 2014 2015 2016 2017 2018 2019                 Turnover (£ million) 374 356 364 864 1,560     IFRS3 pre-tax profit (£m) 6.6 4.8 9.0 9.1 22.5     Normalised pre-tax profit (£m) 7.1 9.3 9.7 18.9 33.1 38.4 43.9 Operating margin (%) 2.9 2.8 2.7 2.4 2.3     IFRS3 earnings/share (p) 7.2 5.7 10.1 4.4 10.4     Normalised earnings/share (p) 8.1 13.0 11.1 12.7 16.5     Earnings per share growth (%) 16.1 61.7 -14.9 14.4 29.7     Price/earnings multiple (x)               Annual average historic P/E (x) 18.7 15.6 13.5 17.7 21.0 19.9   Cash flow/share (p) 27.8 10.4 15.0 18.9 38.0     Capex/share (p)   2.5 7.2 10.1 7.9     Dividend per share (p)   2.0 8.0 8.4 11.6 5.7 6.2 Yield (%)           4.8 5.2 Covered by earnings (x) 5.4 6.3 1.5 2.1 1.5     Net tangible assets per share (p)   20.3 11.9 -39.2 -40.0

Source: Company REFS           Past performance is not a guide to future performance

27 March pre-close update will be crucial

That six directors/associates bought £583,235 worth of shares at prices of 297p to 306p, straight after interims, evidently does not reflect value at such prices, it more likely suggests they could not see risks manifesting.

Yet they ought to be able to stabilise the situation given management is now under pressure. Covenants are probably not at risk and drinks sales seem broadly firm, but we can’t know if future updates may reveal more skeletons, as tends to be a risk after a few years of rapid acquisitions.

Further out, the difficulty is projecting how robust are drinks sales in a tighter consumer environment, in support of Conviviality’s cash flow improving its balance sheet. Net debt is re-iterated at about £150 million for end-April, though mind how net assets of £208 million include £289 million goodwill/intangibles (hence negative net tangible assets).

At end-October 2017 the ratio of trade receivables to trade payables had continued to deteriorate, from 0.87 to 0.75 like-for-like. While this could reflect the working capital profile of companies acquired, if delaying on creditors then profits may be artificially boosted.

It’s potentially another example where a new FD could take a more prudent approach, albeit slightly crimping profits.

And it’s hard to tally with the 2017 annual report projecting strong customer relations: instead of the board saying it has introduced a “super-stretch target” where the chief executive can earn potentially 150% of base salary as bonus, and other executive directors to 120%, first there should be no regular question mark over settling creditors.

Scope for long/short traders alike

Right now, Conviviality is a speculation: who knows if more “accounting issues” will arise, sales soften and debt service costs become more challenging.

More positively, the group’s reach does offer strategic value in drinks supply, and while the industry outlook could get trickier, this grouping will be valuable to someone (though quite whether at past inflated share prices).

So it’s likely rivals will be watching, which adds to intrigue. The stock is high-risk: debt/structural issues may conflate with a more difficult environment and you can’t yet identify a responsible dividend payout.

But traders should be alert to the 27 March update, which may help define prospects, hence sentiment more clearly, either way. The forecasts I’ve dropped into the table are from Shore Capital while other brokers await more information.

For investors currently, whose first priority is capital protection: Avoid.

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