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Five mid-cap value stocks

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Performance at the top of the stock market is not uniform. If we look at the market’s elite – the S&P/ASX 100 – there is a startling performance gap between the top half (the S&P/ASX 50, the 50 largest Australian-listed companies by market capitalisation), and the bottom half, those companies that are ranked 51 to 100 in terms of market capitalisation (this group has its own index, the S&P/ASX MidCap 50 index).

In the 12 months to the end of May 2019, according to S&P Dow Jones Indices, the S&P/ASX 50 large-caps have generated a return of 13.6%, powered by the mega-caps (the S&P/ASX 20), which have gained 14.2%.

But the S&P/ASX MidCap 50 have lagged this performance badly – they are up just 3.3% collectively, in the year to the end of May.

The S&P/ASX MidCap 50 ranges from Crown Resorts (CWN:ASX) – valued at $8.5 billion – to Spark Infrastructure Group (SKI:ASX), with a market capitalisation of $3.9 billion. It is a disparate group of companies, and there is little to explain its underperformance, except the highly concentrated nature of the Australian stock market, in which the top 20 stocks (and within that, the top 10) are the major driver.

But investors who want to back the MidCap 50 to ‘mean-revert’ – to redress its performance lag to the large caps – might also be looking to compound that strategy, by looking for the best-value opportunities they can find in the MidCap 50: to buy the under-performers in the under-performing market-cap sector.

Here are five candidates for such a strategy.

 

1. James Hardie (JHX:ASX)
  • Market capitalisation: $8.1 billion
  • 12-month total return: –15.5%
  • FY20 forecast yield: 3.9%, unfranked
  • Analysts’ consensus target price: $21.04 (Thomson Reuters), $21.57 (FN Arena)

Building materials supplier James Hardie was an early reporter of full-year FY19 results, because it uses a financial year to March 31. The company lifted its full-year revenue by 22%, to $US2.51 billion ($3.63 billion), and boosted net profit by 57% to $US228.8 million ($A331 million), despite the weak housing market in Australia. The result was helped by higher sales in Hardie’s North America Fiber Cement segment, and a promising start for the recently acquired Fermacell gypsum fibre board business in Europe. Also contributing was lower-than-expected asbestos-related adjustments. The Australian and Philippines businesses were also strong drivers, gaining volume growth above that in their underlying market.

These positives outweighed the fact that US housing market demand for Hardie’s products remain weak: operating profit in the final quarter of the year actually fell 9% compared to the same time in 2018. But Hardie expects conditions in the US is expected to improve in the current financial year, and projects modest growth in the US housing market in FY20.

As the company gets some degree of cost relief, its margins in the US are likely to improve, and that provides upside for Hardie. Like rival Boral, James Hardie has been on the nose with investors over the past year due to weak conditions in the US residential construction market, but the outlook from Hardie points to an improving picture there, and that is making analysts a bit more positive in what they expect from JHX, to the point where the stock looks to be good buying.

 

2. WorleyParsons (WOR:ASX)
  • Market capitalisation: $6.1 billion
  • 12-month total return: –14.9%
  • FY20 forecast yield: 4.0%, unfranked
  • Analysts’ consensus target price: $18 (Thomson Reuters), $18.57 (FN Arena)

In April, global engineering services company WorleyParsons announced that it would seek approval from shareholders to change its name to Worley, and that it would buy the global Energy, Chemicals and Resource (ECR) division of US company Jacobs Engineering Group Inc.

The $4.6 billion Jacobs acquisition will almost double WorleyParsons' revenue, to about $9.15 billion, and make it harder for the Australian company to be taken over – in particular, the Dubai-based Dar Group that has been creeping up the Australian company’s shareholder register after an unsolicited $2.9 billion offer was rejected by WorleyParsons’ board in late 2016.

The deal gives WorleyParsons bigger businesses in North America, the Middle East and India, and adds an additional 39,000 employees, to bring its global staff up to 57,600. The acquisition is also well timed to take advantage of rebounding confidence in the resources services sector, and will also help Worley benefit from the expected global shift towards lower-carbon energy. WorleyParsons is on record as expecting a long-term move towards renewables – wind, solar and gas – but it also forecasts demand for oil will continue to rise until 2040.

Earlier in the year, WorleyParsons missed first-half profit expectations, which prompted analysts’ earnings forecasts to be trimmed for the FY19–FY21 period. But the size of the order book did increase at the half-year, by 10%, with the number of announced contract awards in the first half being the highest in 10 years, according to the company. If it can successfully integrate the Jacobs businesses, Worley should be able to see earnings growth that justifies buying at these levels – which are still depressed from the effect of issuing $2.9 billion of new stock to help fund the buy.

 

3. Seven Group Holdings (SVW:ASX)
  • Market capitalisation: $6.3 billion
  • 12-month total return: –3%
  • FY20 forecast yield: 2.4%, fully franked
  • Analysts’ consensus target price: $22.60 (Thomson Reuters), $22.69 (FN Arena)

The mining revival has been good news for a welter of companies on the ASX, and Seven Group Holdings is no exception. The company’s WesTrac Caterpillar dealership and equipment management business is benefiting from a flurry of deals, including last month’s news that it would supply a slate of state-of-the-art heavy machinery – including autonomous trucks, loaders, diggers, graders and blast drills – to Rio Tinto’s $US2.6 billion Koodaideri iron ore mine, as part of a deal reported at $US200 million ($285 million).

Seven Group Holdings is an industrial services, media and investment conglomerate which also owns the hire business Coates Hire. It also owns 41% of media company Seven West Media. Coates Hire is tapping into the pipeline of infrastructure projects in NSW and Victoria in particular, but the downside of a conglomerate is that one area of business can lag the others – and in SVW’s case, that is Seven West Media, which saw impairments drag its net profit down by 62% in the first half.

But the rest of the business has earnings momentum on the back of its high-quality exposure to the resources and infrastructure sectors: SVW has upgraded guidance to about 40% growth in earnings before interest and tax (EBIT), up from 25%, on the back of the business opportunities for WesTrac. The stock appears to be very good buying at current prices.

 
4. Whitehaven Coal (WHC:ASX)
  • Market capitalisation: $4.0 billion
  • 12-month total return: –17.3%
  • FY20 forecast yield: 7.4%, unfranked
  • Analysts’ consensus target price: $5.13 (Thomson Reuters), $5.05 (FN Arena) 

The federal election result, and the improved chances of Adani's Carmichael mine being approved in Queensland, appeared to re-open investors’ eyes to Whitehaven Coal in May. Being a pure coal play has been a lonely road in recent years, but Whitehaven is generating the kind of cash flows that investors notice. While analysts are more bullish on metallurgical (steelmaking) coal than thermal (electricity) coal, Whitehaven is adamant that strong demand growth in Asia underpins its growth profile. The company predicts that its coal production, which was about 23 million tonnes (Mt) in FY18, will grow to more than 40Mt by 2030.

Whitehaven currently has six mines in the Gunnedah Basin of New South Wales, producing high-energy thermal coal and metallurgical coal. To that base it is adding the Vickery project (near its other NSW mines) and the recently acquired Winchester South project, in Queensland’s Bowen Basin. Vickery is due to start up in FY21, and Winchester South in about FY24, depending upon approval timing.

Many investors will not want to participate in coal. But for those that do, Whitehaven cites International Energy Agency (IEA) figures that project coal demand for both steel and electricity generation to increase by 12% in the Asia Pacific region by 2040: demand is projected to fall in China and Japan (nuclear restarts), but increase significantly in India and South-East Asia. Whitehaven says it will benefit from this growth, by supplying high-quality thermal coal into Asia and increased volumes of steelmaking coal into India.

Having lagged badly over the last year, analysts believe that WHC’s share price is cheap. It also offers a high (but unfranked) dividend yield, with potential upside to the dividend in the FY19 result, and franked dividends to begin in FY20.

 

5. Viva Energy (VEA:ASX)
  • Market capitalisation: $4.2 billion
  • 12-month total return: n/a
  • FY20 forecast yield: 5.3%, fully franked
  • Analysts’ consensus target price: $2.61 (Thomson Reuters), $2.64 (FN Arena)

Retail fuel and refinery business Viva Energy listed last July at $2.50, in what was the biggest float of 2018, but has bombed on the stock market following a series of profit warnings, most recently in April, when it said that a spike in crude oil prices had squeezed margins on retail petrol and diesel. As if that were not disappointing enough, the company’s inaugural annual general meeting saw shareholder groups questioning the company’s remuneration report.

Viva is preparing to invest up to $200 million to upgrade its Geelong refinery (formerly owned by Shell), which came to it along with the Shell service stations. It has also bedded down a renegotiated fuel supply agreement with Coles under which Viva sets the bowser price and pays Coles a sales commission as operator of the stores. Viva paid Coles $137 million in compensation – equivalent to Coles Express’ 2018 earnings – to reflect the value transfer.

For Viva, the deal was viewed as taking back responsibility of the retailing of its product: Viva felt that if it wanted to build volume, it could not be at the mercy of someone else setting the price in part of its network. The opportunity to raise Coles Express volumes should compound the additional margin that Viva can earn now that it has renegotiated the alliance.

Cyclically, it is a weak time for fuel refining and retail margins, but Viva now has the tools to boost its retail margins in particular. Given Viva Energy’s southward performance since floating, that could very well represent a longer-term buying opportunity for investors.

James Dunn is a regular finance commentator on Australian radio and television. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531). All prices and analysis at 31 May 2019. This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.