Big expectations for small caps

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.

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.

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.