Big expectations for small caps

Injecting some realism into earnings expectations.

Summary: High hopes for small caps are a cause for concern for some market experts who warn that profit growth expectations are still too optimistic. We look at two companies likely to meet them: M2 Telecommunications and RCR Tomlinson, and one which may struggle: RungePincockMinarco.
Key take-out: Some small caps won’t clear high earnings hurdle.
Key beneficiaries: General investors. Category: Shares.
Recommendations: Underperform. (RungePincockMinarco, Neutral (RCR Tomlinson), Outperform (M2 Telecommunications)

Reporting season jitters will soon be upon us but it’s not the 2012-13 earnings investors should be anxious about.

It’s the current financial year’s outlook that is causing more angst as market experts are warning that profit growth this year is still looking too optimistic even though analysts have been steadily revising down their forecasts over the past year. Trying to work out which emerging company is at risk of disappointing and which are likely to meet lofty expectations is tricky in this volatile environment, and I suspect management teams won’t be giving much clarity in August with the date of the federal election still up in the air and before currency and commodity markets settle down from their big swings.

The 2013-14 earnings per share (EPS) estimates for the ASX Small Industrials Index is currently 9.3% lower in aggregate terms than it was at July last year; and while earnings expectations are the lowest it has been since December, consensus forecasts are implying around a 16% increase in EPS this year.


Graph for Big expectations for small caps

In contrast, small caps outside the resources sector are only expected to record a modest 3.6% median EPS growth for 2012-13.

This means the real downside risk to earnings expectations is for the current year, and I believe it won’t be until February when we get more of the “light at the end of the tunnel” outlook statements that investors are craving for.

Against this backdrop, I will highlight two fast growing stocks on the Uncapped 100 that are likely to meet high market expectations, and one that is at risk of disappointing.

RungePincockMinarco (RUL)

Mining software and technology consulting company RungePincockMinarco is the one that I suspect will struggle to please investors as there seems to be a fair amount of optimism build into its share price.

The stock is up close to 40% over the past year and consensus estimates on Bloomberg is tipping a more than four-fold year-on-year increase in its 2013-14 underlying earnings before interest, tax, depreciation and amortisation (EBITDA) to $15 million.

That may be too aggressive given the challenging climate in the mining sector, and even its 2012-13 EBITDA estimate of $3.7 million, which is down around 60% from the year before, is too bullish given that its first half operating EBITDA crashed 87% to just $700,000.

Like just about all companies servicing the mining industry, management noted a significant drop off in demand for its services. This forced RungePincockMinarco to undertake a major restructure and write off the value of some of its businesses.

There is room for earnings to recover, but I don’t think it will happen quickly given RungePincockMinarco’s material exposure to new mining projects, particularly in the coal, iron ore and gold space.

Its other traditional source of income – providing advice to miners looking to list on the Hong Kong stock exchange – is also not likely to make much of a comeback unless sentiment towards the mining industry changes dramatically.

If the 2013-14 forecast is to be believed, it would imply that RungePincockMinarco’s earnings performance would be nearly as good as in 2011-12, which turned out to be one of the company’s best years thanks to buoyant market conditions.

What’s worst, on the current year’s estimates, the stock is trading on a price-earnings multiple of 8.6 times.

That may not sound onerous given that the stock’s five-year average P/E is 13 times, but I cannot see why RungePincockMinarco should trade at a premium to mining contractors, which are on P/Es or around six times.

I would recommend investors sell the stock for better opportunities in the mining services space.

M2 Telecommunications Group (MTU)

M2 Telecommunications Group has also some high hurdles to clear as analysts are expecting the fledging telco to deliver a 50% increase in EBITDA this year.

This comes on top of the expected doubling in its EBITDA for 2012-13 to $110.9 million, which is largely driven by its Primus Telecom acquisition. 

This time, it is the takeover of Eftel and Dodo Australia Holdings that will help lock in the strong rise in EBITDA for 2013-14.

While acquisitions have been key to M2’s stellar growth over the past few years, the strategy has become a double-edged sword when it comes to valuing M2.

I say this at a time when M2’s share price is above even the most bullish broker price target reported on Bloomberg of $6 a share, which puts the stock on a P/E of around 14 times for 2013-14.

However, M2’s peers are trading on P/Es well ahead of the group. TPG Telcom is on 19 times, Amcom Telecommunications is on 20 times and iiNet is on 16 times.

The difference is that these companies have a track record in generating organic growth, while experts are not quite sure what organic growth for M2 looks like in the wake of its aggressive acquisition strategy.

This is why the market is discounting the stock, even though I believe M2 deserves to trade on par value with iiNet.

This means M2 should be trading closer to $7 to reach fair value. This, coupled with its gross-up dividend yield of around 6%, could potentially net investors another 20% over the next 12-months.


Graph for Big expectations for small caps

Source: Bloomberg

RCR Tomlinson (RCR)

RCR Tomlinson’s expected EBITDA growth of 33.2% to $78.1 million for 2013-14 might pale compared with the other two stocks, but that’s still a very big number given the poor outlook for engineering contractors.

But if its takeover of struggling Norfolk Group comes to pass (Norfolk shareholders will be voting on the deal next week), RCR should not have much difficulty in meeting expectations as Norfolk is expected to double RCR’s revenue base.

Norfolk came into strife because of poor management of its contracts, an over geared balance sheet and big restructuring costs.

RCR on the other hand, has a much stronger track record in delivering shareholder value. If RCR can extend its magic touch to Norfolk, the deal will create a lot of value for RCR.

The market is giving RCR the benefit of the doubt so far with the stock trading on a one-year forward P/E of 7.5 times, which is a close to 30% premium to its peers.

I believe on a relative valuation perspective, RCR is looking fully valued, although there is plenty more upside to its current share price of $2.25 if RCR can turnaround Norfolk’s businesses.

But until I see clearer signs of that happening, I would keep the stock on a “hold”.


Brendon Lau owns shares in MTU.

Uncapped 100 - The Real Top 100

Small cap stocks covered by the Uncapped team
CodeNameRationaleMarket cap ($m)Total return 1-year (%)Sector (GICS)
MMS McMillan Shakespeare LtdOne of the best performers since the GFC, but doesn't get much press or analyst coverage. Good management team.1,31365.57Industrials
MTU M2 Telecommunications Group LtdAmazing growth story and well run company. High free float and strong insto support.1,07289.56Telecommunication Services
BRG Breville Group LtdWell covered but good candidate for core holding due to good track record.95880.29Consumer Discretionary
NHF NIB Holdings Ltd/AustraliaOnly listed health insurer. Widely held. Good performer.91350.13Financials
MRM Mermaid Marine Australia LtdIts strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.89549.44Industrials
ARP ARB Corp LtdWell covered but good candidate for core holding due to quality management.89239.85Consumer Discretionary
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding.72058.07Consumer Discretionary
SRX Sirtex Medical LtdA shining star in the biotech space and one of the best performing stocks in 2012. Great product (liver cancer treatment) and bright outlook.68493.92Health Care
GEM G8 Education LtdOnly listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.674171.85Consumer Discretionary
SGN STW Communications Group LtdOne of few companies able to benefit from online shift. Widely held and good insto support.64575.63Consumer Discretionary
AUB Austbrokers Holdings LtdThe insurance broker is a strong performer. Widely held and well liked by small cap investors.62761.13Financials
ACR Acrux LtdOne of the most successful Australian biotechs in recent history. Widely held by instos.604-10.32Health Care
RFG Retail Food Group LtdOwns a number of well know franchise brands. Widely followed by instos.58683.81Consumer Discretionary
CCV Cash Converters International LtdStrong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.50984.71Consumer Discretionary
AMM Amcom Telecommunications LtdWell covered junior telco but good candidate for core holding.49489.18Telecommunication Services
NXT NEXTDC LtdThe cloud computing company is an IT sector darling. Fairly widely held and followed.47541.8Telecommunication Services
SEA Sundance Energy Australia LtdAnalysts have a favorable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.45373.45Energy
CCP Credit Corp Group LtdStrong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.44562.73Industrials
SLX Silex Systems LtdIts uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.441-40.46Information Technology
TOX Tox Free Solutions LtdWidely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.43634.64Industrials
BRU Buru Energy LtdSubstantial size but not often covered by press. Widely held with good insto support.423-51.26Energy
BDR Beadell Resources LtdWill be a very big FY14 for miner as it has to prove it aims to produce 200,000 ounces of gold a year.422-12.3Materials
FGE Forge Group LtdOne of the better performers in its industry. Good track record and potential core holding.41415.96Industrials
HZN Horizon Oil LtdOne of better regarded small energy stocks that doesn't receive much media attention.40928.57Energy
CWP Cedar Woods Properties LtdProperty developer with good ROE and earnings growth track record.40560.15Financials
BGA Bega Cheese LtdCorporate interest in Australian food companies makes the cheese maker worth following.39372.83Consumer Staples
MYS MyState LtdWell regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.38051.82Financials
UNS Unilife CorpThe developer of one-use prefilled syringes is close to an inflection point as the market is expecting the company to announce a major contract with a pharmaceutical giant in the coming weeks.3374.24Health Care
RKN Reckon LtdFierce competition for cloud base accounting software puts it in firing line.32220.28Information Technology
UXC UXC LtdCompany has turned corner and enjoyed re-rating. What's next?31792.15Information Technology
TGA Thorn Group LtdOne of few retail stocks that is performing well. The Radio Rentals chain owner is also well supported by instos.30740.61Consumer Discretionary
MYX Mayne Pharma Group LtdSizeable generic drug maker with interesting board members.30163.78Health Care
RCR RCR Tomlinson LtdGood first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?29732.02Industrials
MOC Mortgage Choice LtdHas a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.28486.8Financials
NWH NRW Holdings LtdOne of the better regarded mining & civil contractors with good track record in delivering on projects.265-67.95Industrials
SPL Starpharma Holdings LtdNoteworthy for its good pipeline of innovations. Well run, widely followed.263-37.07Health Care
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 25457.39Financials
SIV Silver Chef LtdStrong jump in the share price of the equipment financing group has attracted a good following.237161.25Industrials
RIC Ridley Corp LtdHigh corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.234-13.52Consumer Staples
IMF IMF Australia LtdLitigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.23337.74Financials
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.21316.06Materials
NWT Newsat LtdPotential large cap if it can launch its own satellite in 2015.210-29.09Telecommunication Services
SHV Select Harvests LtdNoteworthy for turbulent past and exposure to soft commodity market.210196.31Consumer Staples
DWS DWS LtdWill be a big beneficiary if governments start spending on IT again.20013.36Information Technology
CLH Collection House LtdIn similar space as Credit Corp. Strong stock performance has attracted a following and the stock appears to be well placed to run further196129.85Industrials
WBB Wide Bay Australia LtdThe building society is trying to turn its fortunes around. Also worth watching for its exposure to Queensland housing market, particularly around major resource projects.192-7.82Financials
MXI MaxiTRANS Industries LtdTransport equipment maker posted good interim result. Has appealing yield and growth.19277.44Industrials
GXL Greencross LtdAcquisitive vetinary group. Good profit growth and share price performance, but gets little press.191133.28Health Care
NAN Nanosonics LtdA successful medical tech story. Should be close to turning in maiden profit with its disinfection device.18941.18Health Care
MLB Melbourne IT LtdA perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.18243.11Information Technology
PFL Patties Foods LtdIlliquid stock but has suite of well recognised consumer brands. Defensive yield.181-14.4Consumer Staples
DTL Data#3 LtdWell respected IT company that receives little press coverage.1809.57Information Technology
GXY Galaxy Resources LtdGood upside potential if it can get its problem-prone Jiangsu plant back on track. Won't be easy to right this ship.177n.a.Materials
CKF Collins Foods LtdOne of the few food franchise listed companies.17074.18Consumer Discretionary
VOC Vocus Communications LtdTelecom stocks are in favour but Vocus is one of the least covered16318.44Telecommunication Services
IFM Infomedia LtdInteresting tech play in the car parts market. Strong share price gain but gets little air play.161182.86Information Technology
IPP iProperty Group LtdWorth watching as it is trying to be the REA Group of Asia.154-5.56Information Technology
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal shealth on diabetics.151-37.22Health Care
SFH Specialty Fashion Group LtdIn early stages of turnaround. Can the women's apparel retailer sustain the momentum?15157.05Consumer Discretionary
HSN Hansen Technologies LtdOperates in a high potential/growth industry but is not covered by press or brokers.1455.43Information Technology
BNO Bionomics LtdOne of the larger cancer treatment developers in this market.14417.35Health Care
IMD Imdex LtdDrilling company is well supported by instos and should benefit from any rebound in exploration activity.143-57.69Materials
RCG RCG Corp LtdThe footwear retailer is one of the best performing consumer stocks as online competition is not a big threat. Company has a good yield as well.14163.36Consumer Discretionary
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.13132.74Health Care
TFC TFS Corp LtdThe sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.130-1.06Materials
REX Regional Express Holdings LtdWell run airline that is overshadowed by Virgin and Qantas.1259.56Industrials
AZZ Antares Energy LtdLiquid with good insto support. Already in production with exploration upside in Texas.12123.38Energy
TGS Tiger Resources LtdFuture lies in its Kipoi copper mine expansion in the Congo but miner is fully funded with DRC govt holding 40% stake in tenement. Next 12mths will be interesting.118-43.55Materials
MCP McPherson's LtdThe personal care and household products supplier had been relatively insulated from volatile discretionary spend and online threat, but its latest profit warning shows it's not immune.114-15.81Consumer Discretionary
AMA AMA Group LtdGood turnaround story but under the automotive services group is radar of most.109152.48Consumer Discretionary
POH Phosphagenics LtdSizable biotech with a game changing FY14 year ahead. Good insto following but accounting irregularities is a cloud hanging over stock.102-33.33Health Care
BGL BigAir Group LtdThe wireless microcap has gained strong following over past year or two but is often overlooked by investors and the press.10062Telecommunication Services
CLV Clover Corp LtdOne of the star performers in 2012. Operates in growing but relatively stable niche.10061.54Health Care
ESV Eservglobal LtdMobile money transfer company that has been gaining traction. Widely held by instos but low press coverage100100Information Technology
ACL Alchemia Ltd/AustraliaOne of the few biotechs with revenue stream. Good pipeline of oncology treatments.99-42.45Health Care
LCM LogiCamms LtdStrong price performance and reasonable valuation attracting interest.9837.09Industrials
NEA Nearmap LtdA stellar performer with an Interesting business that offers high quality ariel maps to companies & government.92595.12Information Technology
JIN Jumbo Interactive LtdInnovative small cap facing off industry dominated by giants. Worth watching to see if it can carve out a profitable global business.8179.99Consumer Discretionary
CAA Capral LtdAn aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 7332.14Materials
PEN Peninsula Energy LtdWidely held by instos and large free float. It's the only uranium miner on the list.71-27.27Materials
CUV Clinuvel Pharmaceuticals LtdInteresting skin disorder treatment developer that has done reasonably well over past year70-0.82Health Care
AOH Altona Mining LtdNoteworthy copper play with Xstrata pullout of Roseby project in Australia and the good ramp up of its Finnish project.69-55.93Materials
RUL RungePincockMinarco LtdIT company to resource industry. Turnaround potential under new CEO.6835.91Industrials
DRM Doray Minerals LtdWidely held by instos. One of the more favored gold explorers by brokers.65-44.29Materials
SAR Saracen Mineral Holdings LtdEmerging gold producer that is widely held by instos. Hitting milestones and looks cheap. Key asset is close to gold majors, which makes it a potential takeover target.64-78.92Materials
TAN  Tandou LtdThe only direct equity exposure to cotton prices. Also trades water rights and receives little press.6114.87Consumer Staples
WDS WDS LtdWidely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.56-5.41Industrials
CKL Colorpak LtdThe small cap packaging company has grown via acquisitions over past few years.5519.99Materials
BOL Boom Logistics LtdCrane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid.54-55.77Industrials
KOV Korvest LtdThe construction products and services supplier has been hit by project delays and deferrals. But its relatively high yield could give it some support.5444.07Industrials
YTC YTC Resources LtdNext 12-mths will be eventful after YTC secured funding for its projects from Glencore.50-22.45Materials
UML Unity Mining LtdGrowing Tassie gold producer with high free float. Valuation looks compelling too.50-43.2Materials
LGD Legend Corp LtdElectronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.48-25.4Information Technology
TSM ThinkSmart LtdPotential turnaround story worth keeping eye on.4726.09Financials
ISS ISS Group LtdGood turnaround story from 2012 but the resource industry software developer under the radar of most. ISS has received a takeover offer after its inclusion in the Uncapped 100.4485.11Information Technology
OTH Onthehouse Holdings LtdAlternative small cap to online property leader REA Group. It is trying to use more timely housing data as a compeitive edge against REA.360.88Consumer Discretionary
NTC NetComm Wireless LtdUnder appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.30118.18Information Technology
EBT eBet LtdPotential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.2192.91Consumer Discretionary
MBO Mobilarm LtdUnique product that could change global maritime safety practices with its man-overboard location beacon.18100Information Technology
PGC Paragon Care LtdEmerging hospital equipment supplier that has been ignored by market.1465.79Health Care
Source:Eureka Report, Bloomberg

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