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3 small-cap company stars

As reporting season continues with better results than expected, Tony Featherstone highlights three standout small-cap companies.

The reporting season has so far been a touch better than expected. Just over a third of companies had reported as this column was written. The number of positive profit surprises and the breadth of profit increases were slightly higher than usual.

Don’t get too excited: results quality often tails off in the last two weeks of the profit season and the resource sector is doing most of the heavy lifting in terms of earnings growth. But there is enough to suggest the Australian share market’s recent gains have been justified – and that the market is not as expensive as the bears claim.

I’m always more interested in the micro rather than macro details, that is, the small-cap companies that surprise the market with good results. I hesitate to say “outperformed market expectation” because so few broking firms cover many small-cap stocks these days, making consensus forecasts too rubbery to use.

Here are three results that caught my eye.

 

1. Nick Scali (NCK)

I have written about the furniture retailer among my favoured small-caps several times for the Switzer Report in the past five years. Nick Scali’s five-year annualised return (assuming dividend reinvestment) of 27% puts it among the market’s best small-caps.

Consider the context for that performance. A slowing housing market and patchy consumer confidence is a tough background for a discretionary furniture retailer. Not to mention, rising competition from bricks-and-mortar furniture retailers and furniture websites.

Yet Nick Scali increased revenue by 7.7%, to $250 million, and after-tax profit by 10% to $41 million in FY18. The market liked the result, driving the company’s shares 13% higher on the news, and helping it recover share-price losses in the last few months.

New stores are driving growth. Nick Scali opened six stores in FY18, including its first in New Zealand, taking its network to 55 stores. It plans to open at least another six stores in FY19 and quickly reach its target of 75 stores. New Zealand should be a source of solid growth, with the Auckland store so far performing ahead of expectations.

A larger store network is creating greater economies of scale and driving down Nick Scali’s cost of doing business (CODB) to sales. The ratio has fallen from 45% in FY14, to 38% in FY17. Simply, it is selling more furniture at a higher margin.

I still think the market is underestimating Nick Scali’s sales growth in “case goods”, such as entertainment units and coffee and dining tables – now about a third of revenue.

Longer term, the company’s business model is attractive. Nick Scali owns properties that house some of its key stores, meaning less exposure to shopping-centre rent increases. And requiring customers to pay for furniture upfront and wait weeks or months to receive it reduces store inventory and boosts operating cash flow and the balance sheet.

The main risk is an acceleration in the housing downturn but Nick Scali has shown it can perform in strong and weak housing cycles. The FY18 result was yet more confirmation that the company has a valuable competitive edge that is driving performance.

Nick Scali (NCK)

Source: nabtrade

 

2. Navitas (NVT)

After avoiding the international education stock for years, I became bullish on Navitas on valuation grounds and outlined a contrarian case to buy it for the Switzer Report in July 2018. Navitas rallied from $4.24 at the time of that story to $4.61.

As I wrote, new management is refocusing and rebasing Navitas, removing underperforming divisions and improving earnings visibility. Navitas’ forward Price Earning (PE) multiple of 18 is reasonable for a company with a 28% return on equity.

To recap, Navitas owns SAE Group, a media-technology institute with 51 campuses in 26 countries, and provides vocational training, English-language and other services for international students. The university pathways business, contributing about two thirds of revenue, is key.

Navitas’ FY 18 result, released at the start of the earnings season, was broadly in line with market estimates. No guidance was provided. The market liked the result, driving Navitas almost 3% higher on the announcement, despite the lower-than-expected dividend.

The big positive was Navitas maintaining its 2020 group targets on growth, quality and efficiency metrics. That suggests management has stabilised the business, having announced plans to exit several loss-making outlets in its SAE business.

Several metrics, such as revenue and margin growth, are expected to be significantly higher in 2020 than the FY18 result. After disappointing the market in recent years with an earnings downgrade, the maintenance of substantial growth targets is a good sign.

I suspect Navitas has kept some good news in the tank from its FY18 result, but more will be known at the September 18 investor day, a possible re-rating catalyst.

Longer term, Navitas’ exposure to the booming international education market should continue to support its return on equity.

Navitas (NVT)

Source: nabtrade

 

3. Breville Group (BRG)

The electrical-appliances maker is another preferred small-cap stock and I nominated it as a standout in a special Australia Day report for this publication in January.

The one-year total return is 27% (including dividends) – a terrific performance, given Breville is reinvesting more in the business and implementing a bold new growth strategy.

I like how the company has starred in international kitchen appliances, a market Australia has no right to excel in, given the commoditisation of such products. Breville has shown how clever design and innovation can differentiate products, build brands and boost margins.

My interest over the past 12 months was based on the new management team’s strategy to quicken the innovation model. Breville wants to morph from an Australian company that exports worldwide to a genuinely global company that knows its local markets.

Simply put, Breville is launching more products in more offshore markets and adopting a faster growth strategy than in the past. That brings risks, if management execution is poor.

The market has been sceptical of this approach, and the extra investment poured into marketing and research and development. Breville has an excellent strategy and its execution has so far impressed. The share price is re-rating as the market becomes more confident in the strategy.

Breville’s FY18 result helped. Revenue rose 7.7% to $652.3 million and underlying earnings (EBIT) rose 10.6% $87 million. The market cheered the result, driving the stock 12% higher on the profit news.

Breville is not cheap: a forward Price Earnings (PE) ratio of 26 times FY19 earnings has factored in much good news. An average share-price target of $13.21, based on the consensus of seven broking firms, suggests it is overvalued at the current $13.65.

Breville can do better than the market expects in the next few years. Management has shown it can simultaneously implement a complex transformational strategy and achieve double-digit earnings growth – a feat many small-cap companies cannot engineer.

Share gains might be slower from here and some price retracement in the next few weeks would not surprise, given the extent of the rally this month. But Breville, a star performer over the past decade, will reach new heights in the next three to five years.

From a technical perspective, Breville has broken through previous price resistance at $13.40. Decisively holding above that level could suggest the next leg of Breville’s price uptrend is starting.

Breville (BRG)


Source: nabtrade


About the Author
Tony Featherstone , Switzer Group

Tony is a former managing editor of BRW, Shares, Personal Investor, Asset and CFO magazines and currently an author at Switzer Report. He specialises in small listed companies, IPOs, entrepreneurship and innovation and writes a weekly blog for The Sydney Morning Herald/The Age on small companies and entrepreneurs.