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Value is certainly in the eye of the beholder on the stock market. Too often, investors treat the search for value as a simplistic task, where they look for the lowest price/earnings (P/E) ratio as possible – preferably, in single-digits – and buy in, planning to ride the P/E to a re-rating into double-digits.
In practice, it doesn’t always work that way, with often low-P/E stocks staying that way – indicating that the P/E was low for very good reasons – and conversely, high P/E stocks often proving to have been good buying.
Investment is not wholly a numbers game. There needs to be a “story” in the company’s business that gives you some idea of why and how the numbers will change in your favour. Of course, these stories always come back to the numbers in the end, but numbers alone won’t help you find these situations.
Here are four low-P/E situations where I think the story justifies the numbers.
Caltex Australia has transformed its business over the last decade, with a couple of big decisions. The first was to move from being primarily a petrol refiner, and become an upmarket convenience retailer, shifting the strategy away from the volatility of refining – which couldn’t compete with more modern, bigger and more efficient refineries in the Asian region – and tie its future to leveraging its 800-plus outlets nationwide. The second was to change the business model of its retail operation from having franchised outlets, to having all the service stations and convenience stores directly operated by the company. Caltex has developed its own supply chain for its stores, and is now rolling-out its Foodary upmarket convenience retail concept.
Developing the convenience retail business is hugely important for the company, because its traditional fuel business is under heavy pressure. Caltex’s long-term partner Woolworths, with which it operates 530 service stations/convenience stores, has struck a deal to sell these to BP in a deal worth $1.8 billion. If that sale goes through – the Australian Competition and Consumer Commission (ACCC) has blocked it, saying the merger would have reduced competition and pushed up fuel prices – Caltex stands to lose 16% of its pre-tax earnings. Longer-term, Caltex has plenty of options to create value for its shareholders by spinning off its petrol stations, fuel terminals, depots and pipelines, or selling them into a real estate or infrastructure trust, or keeping them. Analysts are backing the company’s management team to build the value, and see the stock as highly attractive at these levels, backed by a grossed-up yield of 5.7%.
Childcare operator G8 Education shares have halved since December, but that fall has opened up significant value for prospective investors. The market became concerned that the supply of childcare places was exceeding demand growth: in 2017 supply growth ran ahead of demand growth by about 2.5%, and this flowed into reduced occupancy levels at G8’s centres. G8 says its like-for-like occupancy level is down by about 2.5%–3% so far in 2018. The company cites data (from building industry research firm Cordells and the Australian Children’s Education & Care Quality Authority [ACECQA]) showing that supply growth has slowed in 2018, to be running at 1%–1.5% ahead of current demand growth.
In April, G8 admitted that the market environment and the impact on occupancy would mean that the company’s earnings per share (EPS) target of 40 cents per share by 31 December 2019 (G8 uses the calendar year as its financial year) would not be met. However, the company said it expected the market environment would become more favourable from July 2018, and that delivery of its strategy would enable it to deliver significant growth for shareholders. G8 will provide a more specific three-year EPS target when it releases its half-year results in August, but in the meantime, Thomson Reuters’ analysts’ consensus puts FY19 EPS at 25 cents, with a dividend of 19 cents: FN Arena puts it at 26.4 cents, with a dividend of 19.5 cents.
The key to assessing GEM at current levels is the effect on its business of the Government’s new Child Care Funding package, which comes into effect on July 1. This package is expected to benefit lower- and middle-income families, which is G8’s sweet spot. Accounting firm PWC has advised G8 that 95% of existing G8 families will be better off because of the new package. EPS growth – while expected to be subdued in 2018 – should start to pick up again in 2019.
Childcare remains a highly fragmented industry, with the top five participants accounting for only 24%. It is a growing industry, driven by rising female participation in the workforce and greater government support for this trend, and parents’ increasing support for G8’s concept of “early education.” The company is Australia’s largest for-profit provider, with a network of around 500 centres across the country, and is in a strong position to lead the expected consolidation. At current price levels, even on revised earnings expectations, GEM looks poised for a rebound, with a strong yield outlook.
The $344 billion mortgage broking industry was heavily scrutinised under the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, and like many areas of the named industries, did not come out smelling of roses. The effect of that can be clearly seen in the share price of Australian Finance Group (AFG): anticipation of, and actual experience in, the Royal Commission, stripped more than 30% from AFG’s share price. Fellow mortgage broker Mortgage Choice (MOC) fell more than 40%.
This discrepancy in punishment could be explained by the different business models. Where Mortgage Choice is a franchisor – franchisees buy-in to a designated territory – AFG is a support service for independent brokers, who pay AFG for services such as technology and the right to use AFG’s credit licence, if they choose, in return for a cut of commissions. AFG maintains the primary relationship with the lenders, while its broker customers remain independent operators. AFG is also more diversified than Mortgage Choice, conducting home and small business lending in its own right. AFG is actually a poster child for greater completion and choice in the mortgage industry: at present, 37% of loans arranged through its brokers come from banks outside the big four.
It is not only the royal commission that has caused problems for mortgage brokers – disputes with the banks, regulation in general, slowing lending and disruption by newer, technology-savvy players are all headwinds for the industry. But while AFG will see a period of lower profit growth over FY18 and FY19, for a company with net cash on the balance sheet, it appears to have been sold down too far – and to levels that make its expected dividends very alluring.
Paragon Healthcare is emerging as an excellent exposure to the healthcare sector, which is poised to grow in coming years as health spending rises on the back of an ageing Australian population. Paragon provides integrated services to hospitals, medical centres and aged care facilities, supplying items such as beds and specialist furniture, medical refrigerators, storage systems and service carts, highly specialised medical devices and consumables. Providing the equipment and the consumable items positions Paragon as a provider of end-to-end solutions, and thus an essential component of the Australian and New Zealand healthcare market, which translates for investors into a lower-risk healthcare exposure.
In the last couple of years Paragon has announced a flurry of acquisitions, funded by a recent $70 million capital raising and an increased debt facility with National Australia Bank. The company has a strong balance sheet to allow it to pursue additional growth opportunities, with the ability to use its scrip for acquisitions. FY17 revenue was up 25%, to $117.2 million, but Paragon has a strategic target to lift that to $250 million. At the half-year result, revenue was down 4.5% at $52.5 million and net profit was 24% lower at $2.8 million, but in explanation, there were significant investment costs booked, and there is also a big second-half skew to Paragon’s results because of the seasonal nature of hospital procurement.
With natural business growth and recent acquisitions starting to contribute in FY19, Paragon has solid earnings and dividend growth prospects, and looks to be exceptional value at current price levels.