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Insightful analyst, fund manager and accountant lan Robertson shares his tips to help investors understand what questions to ask when making investment decisions.

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October 10, 2023

Small-cap fund manager- how difficult can it be?

In this blog post, I run through how I would look at an investment when I was a time-pressured small-cap fund manager. It is based on a worked example of The Restaurant Group as it stands today – a relatively easy-to-understand business in an interesting situation.  It is not going to reach any investment decisions.

Obviously, the approach of small-cap fund managers will vary according to their processes, fund sizes, objectives and risk appetites, as well as their market capitalisation ranges. However, this blog broadly reflects the type of ‘views’ taken, assumptions made, and processes followed.

It is difficult for outsiders to gain an insight into how small- and mid-cap fund managers really make investments decisions.  Although sell-side research provides some clues, it is generally too focused on price targets and conveying other messages to reflect the processes (and needs) of the buy-side.  More importantly, the marketing spiel of many fund managers may reflect how they want people to think they work rather than the actual processes followed.

Most small-cap investors will not be taking the numbers apart and creating precise targets. Rather, they will look at what drives earnings growth and what can make sustainable and repeatable improvements to earnings, cash and returns – and they will consider possible newsflow and its timing. Detailed analysis of property portfolios and DCFs are marketing fantasies – and if they aren’t, from my time on the buy-side they certainly didn’t work better than the approaches described in this blog.

Small-cap investors will also look at the potential downside, which is usually not something that sell-side analysts dwell on in their published research.

Although there is a danger of simplifying the process, it is worth remembering that small-cap fund managers will be analysing several stocks in some detail every week, as well as monitoring existing holdings, trawling for new prospects and carrying out their all-important marketing.

Now, to look at The Restaurant Group…

The Restaurant Group restructuring

On 11 September 2023, The Restaurant Group plc (TRG) announced the disposal of its Leisure division, principally the Frankie & Benny’s restaurant chain (F&B), to The Big Table Group (BTG) with a dowry payment to BTG of £7.5m.  This is part of the ongoing restructuring of The Restaurant Group under what has become something of a controversial management team.

At the outset, I should admit that as a small-cap fund manager I inherited a chunk of The Restaurant Group, or City Centre Restaurants as it then was, in a fund I had been charged with restructuring. Despite not being enthused by its brands and rollouts, I decided that, with a then-favourable economic backdrop, it wasn’t a priority. Quite quickly it became apparent that it was a better story than it was a stock investment.

(Note: The photo is from an urban explorer website. This F&B (Burton upon Trent) had been closed for some time and the vandals had been in. It is now a Tim Hortons drive thru)

Where is The Restaurant Group now?

Following this transaction, TRG is a curate’s egg with debt. It has three divisions: Wagamama, Pubs, and Concessions.  Estimated FY23 revenues are around £930m with adjusted EBITDA of approximately £80m, supporting £180m-£190m of net debt at the December year-end, according to guidance given at the time of the interims prior to the F&B announcement.

Looking at the three businesses in turn:

trg combi chart

Wagamama

With 156 locations Wagamama is the leading noodle / Asian food-based restaurant business in the UK.  It is undeniably the jewel in the TRG crown and the major driver of both revenue and profit.  It has a clear format that is relatively easy to roll out and not especially demanding in terms of site or location.  The returns on investment in new regional sites are very impressive: over 35% in H1 FY23.  It is difficult to justify applying constrained financial resources elsewhere.

Management suggests that TRG will have opened six new restaurants in FY23 (December y/e) and that it is looking at opening 8-10 restaurants per year at a typical cost of £1.2m-£1.5m. That’s 4%-6% growth in underlying earnings for Wagamama plc, as it were, just from rollout. Management looks to a long-term target of 200-220 restaurants.[1]

(Note: The photo is Wagamama on London’s South Bank. Credit: Garry Knight)

So, as I see it, this is a brand driven by rollout, possibly with some potential upside in margins.  It has an early lead and is well placed in a fiercely competitive market with a good format and understood brand. However, the shakedown of the restaurant market is far from complete. The key question is how far it can go and whether a slow rollout might allow opportunities for competitors to become established.  The peak Waga question is one to which there could be a wide range of sensible answers, with clear potential for fans/investors to get carried away.

Pubs

Brunning & Price (B&P) is a well-regarded and well-run managed pub company, but it is far from unique.  In an aggressive and entrepreneurial sector, it runs something of a cookie-cutter approach.  That is not a pejorative comment. Endlessly diverse and innovative pub formats can only get a pub company so far, and they do not appeal to private equity (PE) buyers or public market investors seeking consistency and predictability of returns.

The ROIC (return on invested capital) for B&P is stated as having been over 20% for the 29 pubs opened in 2013-21 – impressive, just not as impressive as Wagamama’s.

Management suggests that the current outlook for new openings is around 1-3 per annum.  On a current position of 79 pubs, adding 1%-5% per annum is not driving B&P’s earnings that hard. Management refers to a maximum portfolio size of 120-140.

Despite the wider turmoil in the pub industry, B&P looks to be an attractive business.[2]

My initial view is that, although the pubs market is very difficult, B&P has a good approach and position. There is no brand as such but there is a proven formula with a focus on execution.  The ability to grow is something of a question and the languid state of the trade sale market is a concern, but I would see most participants as rational.

Concessions

Once upon a time, airport concessions looked like an interesting place to be if you had appealing brands and restaurant management skills. Now this is a gnarly business with big, savvy airport operators, big concession operators and big brand owners.

Although Concessions is a material part of TRG, it is not a big enough business to drive the rest of the group forward, nor does it offer good enough returns to justify growth investment at the expense of Pubs, let alone Wagamama.  Perhaps more importantly, it is not a business in which TRG can be said to be truly in control of its own destiny.

Management states that it is looking at 2-4 openings or renewals per year, to set against the ongoing expiry of the existing concessions.  At the start of the year, TRG had 42 sites;  as at 6 September, it had 40.  The one-off capex requirement for a new or renewed concession is between £0.5m and £2.5m. This business could be seen as being in run-off, so I have to be mindful as to at what level of revenue / number of concessions the business might just topple over.  For this analysis, I broadly assume that management keeps the business size broadly as is.

Concessions showed particularly strong growth in H1 FY23 as a result of the bounce-back in airport passenger volumes.  However, these volumes are now approaching 2019 levels, thereby placing this business back on more of a ‘normal’ – less enticing – growth path.

At scale or with a USP, this business might have attractions.  But it is very much ‘take it or leave it’ –and I think this is likely to be the view of most people involved, including potential buyers.  To me, the business dilutes the returns, growth and investor appeal of the rest of TRG.

Debt

Set against these operating businesses, TRG has year-end debt guidance of £180m-£190m (pre-IFRS 16).  Looking at FY23, taking consensus EBITDA (c.£80m) less onerous lease payments (£9m) and maintenance capex (£30m, guidance for capex of £43m-£45m less expansion capex guidance c.£14m) gives £41m cash to service debt.  Setting this against guided cash interest costs of £22m-£23m is cover of c.1.8x, which is not ‘comfortable’.  After expansionary capex, debt is getting repaid, but it’s a bit of a grind.

What are the options for TRG? What might I be buying into?

As noted above, some controversy surrounds TRG, its management, the rate of progress made with restructuring the business, and just how far the restructuring can and should go.

There are a number of options.  TRG could maintain the status quo, sell or run down concessions, and/or sell B&P.  It would appear that the agitating investors (and perhaps some other investors too) would like management to simply get a move on with cleaning up the business and delivering Wagamama plc. Any of these paths could conceivably generate value ahead of the current TRG share price.

Same direction – where could this take TRG and what’s holding it back?

It makes sense to start the analysis with the current stated direction – the one for which financial guidance is given, even if this guidance may be for a company that no one wants to exist.

Given the debate, I need to understand whether it is actually possible to stop the restructuring at this stage and to keep three divisions going forward.  The group looks a more sensible entity than it has for some years, but the debt still casts a long and heavy shadow.

Management talks in terms of aiming for net debt / EBITDA ratio of 1.5x before the end of FY25.  This sounds very encouraging, but with the DA so large (FY23 guidance is £35m-£36m pre IFRS 16, with consensus adjusted EBITDA of £80m) and interest rates having increased in recent years, it doesn’t give much of an indication as to how hard the business can be grown while this indebted.

For me, the more relevant number relates to the ability to service the debt.

In FY23, from the above, £41m cash to service debt against guided cash interest costs of £22m-£23m is cover of c.1.8x, which, as noted, is not ‘comfortable’.  Debt is being worked down once expansionary capex has been invested, but progress is far from rapid.

For FY25, taking consensus EBITDA (c.£109m) less onerous lease payments (£4m) and maintenance capex (£35m, guidance for capex of £50m-£45m less expansion guidance c.£17.5m) gives £70m cash to service debt. On guided cash interest costs of £15m-£18m, this is cover of >4x, which is definitely ‘comfortable’.

So, I have a number of positives for EBITDA.  There is, of course, rollout, and there are operational gearing effects, easing of utilities costs, other overhead cost savings and some revenue per outlet improvements, all of which help make TRG somewhat more attractive for investors (see table below). High-teens EBITDA growth is not to be sniffed at.

Looking further down the income statement to earnings per share, the increase in forecast earnings is even greater.  I admit that at first sight my reaction was to think deleveraging, but the principal driver is increased EBITDA vs high interest costs; a reminder how important it is to look at interest cover and the scale of ITDA, rather than at EBITDA and balance sheet ratios.

trg estimates

What is there to look forward to in the medium term for a ‘three-division TRG’?

Looking to 2025, the balance sheet should be better able to support a more aggressive rollout of Wagamama than the current trajectory of 8-10 per annum.  If I take a figure of 15 new Wagamamas – one every three and a half weeks – for the post FY25 rollout, what does this do for earnings?  Furthermore, can the balance sheet / cashflow can support such expansion?

The italicised text below describes the simple calculations I would use to examine these questions:

Market estimates for FY25 adjusted EBITDA are £109m, to which I must add the EBITDA for six more Wagamamas, which is just under £2m.  Fifteen new Wagamamas is capex of £20.25m, plus the ongoing investment of two new pubs at £5.5m, and the renewals of concessions at £4.5m, with maintenance capex up on FY23’s £30m (see above re debt) at £35m.   That’s £62.25m of ‘capex’ in one form or another, leaving £43.75m of cashflow prior to tax and interest.

Guidance for net debt with the normal rollout is for it to decline to less than 1.5x EBITDA before the end of FY25 – that’s £165m.  Add the extra Waga rollout capex (6 x £1.35m) less their EBITDA gives a debt of £171m.  The term loan debt is SONIA +6.5% and there are various fees, but estimating debt at the start of the year as £175m (approximately halfway between FY23 guidance and the FY25 target) taking a rate of 12.5% suggests interest of about £21m. 

I assume tax is full 25% rate in FY25. For the sake of simplicity, and to be conservative, I assume Depreciation is roughly the same as Capital Allowances (i.e. not creating deferred tax issues). With Depreciation at £40m (from FY22 Depreciation of Property, Plant & Equipment +10%), PBT is therefore £47m and tax, at 25%, is £12m.

These calculations get me to £35m of cash generated after tax and capex but before interest of £22m; 1.6x cash covered. This suggests to me that TRG can support a more aggressive Waga rollout once the balance sheet is restored, but probably not with enough comfort for many shareholders.

That said, this also suggests that TRG does not have to act as a forced seller of B&P or Concessions should management follow the Wagamama plc path.

This also triggers the perennial question for any rollout: how to pay for the sites. As a restaurant business, Waga leases its sites.  Leases are a notorious blind spot for equity investors.  The path of TRG to become a sprawling mash of brands, losses and commitments and then back to being a sensible looking business is, I would suggest, a testament to that.  I don’t have insight into the Wagamama lease structure, but this is not a material problem for now, particularly if I am only looking at this investment for the transition to Wagamama plc.

Back on the income statement, the growth of Wagamama will be diluted by the relatively slower growth of B&P and the possibly stagnant Concessions business.  My basic model still shows low double-digit underlying earnings growth. However, if I take the top end of the management’s target range of 220 as a hard stop, this growth will only last a couple of years.  And going forward from peak Waga in FY27/28, it is difficult to see much with this path to excite investors. (Dividends do not excite.)

Continue the disposal programme – how much better is the new destination?

To find the value in further restructuring, I need to know what the clean Wagamama plc market capitalisation should be so as to compare it to the current TRG market capitalisation, remembering that this current value may already have some implied value for the potential deal(s).

What could Wagamama plc be worth?

To find the market capitalisation of Wagamama plc, I need to consider not just Wagamama’s earnings but also how many outlets Wagamama can open in a year and what this implies for its underlying earnings growth – with the constraint that the expansion is funded out of cashflow.

The italicised text below describes the simple calculations I would use to examine these questions:

Once again, I take 15 as an aggressive rollout figure for a debt-free Wagamama plc in FY24. It is physically achievable, provides attractive underlying earnings growth and allows the rollout to continue into the medium term before it runs up against a ‘realistic’ peak Waga figure. 

In my basic model from the interim results information, I have revenue driven by units and rev per unit, an outlet level EBITDA and I know the divisional and the group central overheads.  Fifteen more units gives revenue of £546m (remembering that it is average across the year and that the new outlets don’t all open on 1 January) with some further progress made on like-for-like sales, with outlet EBITDA margin still at 16.6%, holding the divisional overhead about the same (£16m) and assuming that the group overhead figure is worked down (say £10m, from around £15m), perhaps not by as much as I would like.  This comes down to an EBITDA of £65m.

I take an FY24 Depreciation figure for Wagamama plc of £22m, based on the FY22 figure in the accounts at Companies House plus 10% to reflect estate expansion.

There is no interest cost (or income).  Tax is assumed standard rate at 25% (£10.7m). So earnings are £32m with this growth in earnings expected initially to be in the high 20’s % (FY25) then fading a bit to low 20s % (FY26, FY27).  This is greater than the growth in outlet EBITDA because of operational leverage over the relatively fixed overhead.

Taking the tax figure and the capex figure (£40m) from the EBITDAs gives £14m and £24m for FY24 and FY25, respectively.  So I now know that Wagamama plc is still reasonably cash-generative with this rollout. 

Simply put, on these rough calculations (which could be wrong), I have Wagamama plc rolling out 15 new sites each year, still generating cash and delivering earnings growth in the 20s % per year.  Note that this earnings growth is not being distorted by the fixed overhead (risk) of debt as I have with our TRG as is numbers, putting IFRS 16 and leases as debt issues aside.

But I have to ask how long this Wagamama growth can last.  On this rollout profile, the estate hits management’s top end of range figure of 220 in FY27/28.

But I don’t have to agree with that peak Waga number.

I don’t even need to have a precise view on where peak Waga might be. Furthermore, I know that some investors who are Waga fans could have in their minds a peak Waga that is completely unrealistic. It is worth remembering that although I might not have perfect visibility on peak Wagamama, visibility on the rollout and on what is happening in the market is very good compared to most other UK small-cap businesses.

The table below might help the thought process on a range for peak Waga.

outlet numbers

So, what P/E multiple is appropriate for around 20+% earnings growth from a restaurant chain with a strong market position and reputation, and good execution?

As a starting point, in order to match the current market capitalisation for TRG (£376m), it would have to be 12x.  The table below shows the leading listed pub companies and their valuations. DYOR to find what Wagamama plc could be worth.

trg comparators

Route to Wagamama plc?

1. Sale of Concessions

As noted above, Concessions is not a major factor at TRG and it is difficult to see a material role for it within the group.  If sold, the price achieved is likely to be at a valuation multiple discount to the wider group, noting that SSP Group, the UK listed concession operator, trades on lower EV/EBITDA multiples to the pub groups.  In fact, applying multiples to the EBITDA figure that would normally apply to an ongoing business may not even be appropriate if the buyer looks at it as a book of business in run-off with declining revenues.

As with the final stages of the departure of Frankie & Benny’s, a parting of the ways with the Concessions business is unlikely to make a lasting impact on TRG’s share price and its trajectory. It is neither a big enough number to matter, nor is there enough information to make a confident call.

While I might say to myself that I understand the business, I cannot reasonably say that I have that much visibility into either the run-off or sale process.

2. Sale of B&P

The starting point in my thinking above on Wagamama plc is the simplifying assumption that a B&P sale just clears out the debt (give or take a bit) and Concessions makes no difference.  If and when the B&P sale comes in, I just add or subtract the value achieved over or below then current group debt to reach a new view on the correct market capitalisation for the newly renamed Wagamama plc.

Debt to clear?

The net debt (pre IFRS 16) as at H1 FY23 was £196m and guidance for the year-end was £180m-£190m.  Added to this I must consider the obligations under the onerous leases due for payment in FY24 and beyond, around £15m, and the dowry to BTG of £7.5m.  All in, around £205m of debt to be cleared.

Route to value realisation

Although a direct sale of TRG’s Pubs would mean placing it on the market alongside a number of other pub and restaurant enterprises vying for the cash of hardnosed financial buyers and operators, this looks to be the most likely outcome. Trade journals online can provide some insight into what is happening in the market, but I would not assume that their output is necessarily reliable.

Floating Pubs off might be an option, but without the established growth engine of a team finding and buying new sites it is simply another yield story on the LSE.  Although this doesn’t rule out its return to the LSE having been kick-started by a PE investor and a motivated management team.

Chunks of B&P could be sold, possibly on a regional basis. However, to sell enough to make a meaningful dent in the debt would leave TRG with a stub managed pub business that might be of little interest, or even a turn-off, to investors in the wider group.

Realising what value?

The professional valuation referred to in the Report and Accounts for the freehold sites, around half the Pub division’s sites, is £160m. Anyone who has read the RICS red book will know to not use this figure as a basis for an equity investment decision.  The figure provides some kind of a baseline for my thinking, but not much.

In March 2023, the FT cited people close to Oasis, the lead activist investor, as pointing to a valuation of ‘upwards of £250m for the whole business’. Less ambitious figures from brokers’ analysts of around £230m appeared in the press at that time.  Listed pub cos are generally trading on high single-figure forward EV/EBITDAs, so a ‘back of the envelope’ calculation would suggest outlet level EBITDA in the mid to high £20m’s to which some central overhead has to be applied to reach divisional EBITDA – say low £20m’s – so these figures look to me to be a bit ambitious but in the same ballpark.

Simply clearing out the debt would be perhaps the most realistic ambition.  Sometimes when you are selling something, the value of what you are going to spend the money on can be just as important as the value of what you are selling. Potential B&P purchasers will be all too aware of this, but who knows what the potential buyers might be thinking and what their own motivations might be.  And for me, concentrating on +/- £20-30m on pub sales risks becoming a distraction. As ever, DYOR.

So where is TRG really, and which way is it pointing?

So TRG can keep going on a three-division strategy.  Once the balance sheet strength is restored, TRG could then ramp up the rollout of Wagamama – but that may not deliver interesting levels of earnings growth for long.

TRG could also free itself of Pubs and Concessions – potentially freeing itself of much or all of its debt, perhaps even with a bit to spare. As ‘Wagamama plc’, there would appear to be potential for strong cash-generative earnings growth, with an attractive ROIC at least into the medium term. As with other rollout stories, there is significant potential for things to get ahead of themselves – in both operational and share price terms.

If Wagamama plc has significantly greater value than TRG plc and a deal is ‘seen by the market as likely’, I would expect that TRG would be trading at higher multiples than its current make-up and outlook justify.  Given the mixed messages from the valuation table above, the only clear indication that something is afoot (or getting a wiggle on) is the share price increase of 53% from the start of the year, or £127m in market capitalisation terms – an increase that is difficult to justify by the F&B exorcism on its own.

However, if the gap is great enough, the deal becomes inevitable – be it under this management or the next.  How patient an investor I can be depends on many things, most of which will have nothing to do with TRG.  Playing the waiting game with a consumer stock is probably something for a wider diversified portfolio.

So what is the downside risk?

There are two key downside risks: the restructuring stops and/or trading worsens.

If the restructuring process does not continue, where does the share price go to?  As noted above, the current share price will contain some deal premium, and this will clearly fade as / when it becomes clear that no reasonable deal is going to happen, for whatever reason or whoever is at fault.  Despite the turmoil, the underlying growth at TRG is better than most listed pub or restaurant companies.  I would expect that the ending of the restructuring process would lead to significant underperformance but not a crash, because there is a clearer picture on the value and the path that can be taken. Something of a chicken and egg situation as the share price weakness could stimulate calls for change.

As a premium brand-driven offering in pubs and restaurants, TRG will be hit if the economy worsens, but possibly not as badly as some of the more geared or traditional comparators.  TRG also has some defence in its ability to slow the rollout to preserve cash. The consumer and debt exposure is, to a great extent, priced in with the lowly rating across most of the sector.  A worsening in trading will almost certainly result in share price underperformance, but this has to be considered as part of the wider portfolio’s sector / consumer exposure, where TRG is providing both sector and deal potential exposure.

Investment decision – enough information?

Having come this far and assuming that the numbers are pointing to upside, as a fund manager, do I now have enough information to make me comfortable with a purchase decision?

Assuming that I were to be positive on the stock – subject to a meeting with management, more sensitivity analysis (focusing on downside) and, MiFid permitting, contact with sell-side analysts to check for outlier issues and reaffirm logic – this might get me to make a less than full weight holding in a 100-stock portfolio with a view to moving on after the transaction or a certain time (probably <1 year).

For a holding in a 50-stock fund, more work and examination of historical data and market info (deals, competitors, basic general lease details, concession exits, tax etc.) would be required, and possibly multiple meetings with management and a more detailed model.

There is no reason why much of this process, except meeting with management and contact with sell-side analysts, can’t be done by a private investor – but it takes time. The decision really depends upon (Wagamama plc – TRG plc)/TRG plc, and the maths isn’t that complicated. As ever, DYOR.

A final note…

There are clearly a significant number of variables, so the first step in the process is to decide what not to consider – either because the variable doesn’t matter or because analysis of it is not going to merit the time and effort.  If you do not put some things to one side at the start of an analysis, seeing the wood for the trees can become difficult.  You can always bring these factors back into consideration later.

Some of the more evident ‘whatabouts’ are:

Price of Leisure closure – Frankie and Benny’s is gone, perhaps not entirely forgotten or forgiven, but not a key factor to anything now.

Leases – The leases offered to and taken up by rapidly expanding retail and restaurant businesses need not necessarily fit with the requirements of a more mature chain. Taking a longer-term view on Wagamama requires this to be considered, if only to tick the box.

Barburrito – Purchased for £6.3m in July 2022, this 16-outlet concession-focused brand looks a bit like the last hurrah of a former strategy.  But it is small enough to ignore.

Management – You can’t do anything about this. I would be surprised if anyone is buying this company for the management.  The transactions are guided by advisors et al. and the businesses are operated by proven teams.

Wagamama overseas – Headline figures for overseas ventures for UK small-cap leisure and retail stocks can sound great, but they rarely amount to much that the UK company can control or extract value from on a timely basis.

Tax – Tax is not currently a big feature of TRG’s financial statements.  If there is an aggressive rollout, then much of the tax may be deferred – charged in the income statement but not paid for a few years.  That said, it is best to think in terms of taxed figures when considering what the share price should be, while noting that not everyone will be as mindful, or as conservative.

Debt covenants etc. – TRG has plenty of debt (£196m pre-IFRS 16 at H1 FY23) and plenty of charges registered at Companies House.  If looking at this restructuring as one where the goal is to be debt free or near enough debt free, I would expect lenders to be happy with that, albeit possibly nabbing a fee or two in the process.  Given the improvement in trading and the Covid recovery, it is reasonable to consider that the worst has passed on this front (though that is not guaranteed).

Detailed estimates – I have taken consensus revenue and EBITDA figures and then built a very basic model incorporating number of sites, sales per site, capex per site, new sites etc. taken from the company’s FY23 interim results presentation to investors to examine the impact on earnings and cashflow.

IFRS 16 lease accounting – I look at everything on a pre-IFRS 16 basis.

 

Ian Robertson

irobertson@progressive-research.com

 

[1] The recent interim results (September) show the business to be in good health, with ongoing like-for-like (LFL) underlying dine-in revenue growth of 14% year on year at the time of the interims.

[2] As with Wagamama, the recent interims show Pubs to be growing strongly, with ongoing LFL underlying dine-in revenues growth of 10% year on year at the time of the interims.

 

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