Small caps in AGM firing line

Not everyone is basking in the post-election afterglow. With the starting gun for the annual general meeting season having already gone off, a number of Uncapped 100 companies have come out early to warn that they can’t shake their earnings funk.

Drilling company Imdex (IMD), trailer and tipper maker MaxiTRANS Industries (MXI), and four-wheel drive accessory supplier ARB Corporation (ARP) are some that have complained about the lack of an earnings rebound despite the dramatic pick-up in confidence after the federal election.

MaxiTRANS crashed 13.7% on the day of its AGM on Friday, and on Thursday ARB Corporation reversed 5.7%, and Imdex fell but managed to recover to close flat.

You can bet we have not heard the last of the downbeat outlooks, given that more than 80% of the Uncapped 100 companies have yet to front investors at their annual meetings.

I am not throwing in the towel and abandoning my view that the next six months will be a strong one for emerging companies as I think there will be more good than bad news from this AGM season. Adam Carr also gave four reasons why you should expect an earnings upswing last week.

For instance, hospital equipment supplier Paragon Care is one that has come out to say it has seen a sharp pick-up in demand for its equipment since the Coalition came into power, and it won’t be only one feeling in a celebratory mood as we head into Christmas.

However, it pays to be aware of the companies that are at risk of issuing disappointing outlooks or guidance at their AGM, as research has shown these offenders can lag the market for weeks, if not months.

Click to enlarge

Looking at the last 15 years, Macquarie Equities has found that stocks tend to fall around 4% behind the broader market in the 40 days after management issues a profit warning. What’s also interesting is that these stocks tend to drift lower in the month leading up to the bad news.

Mind you, not all stocks that fall ahead of their AGM will disappoint, but it’s one of the early warning signals that’s worth watching, especially if expectations are set high for the company.

Click to enlarge

If you have been following the Uncapped articles, you’d know I am bullish on the market. But the consensus estimates for some companies in the Uncapped 100 might be too bullish.

Melbourne IT (MLB): Underperform.

The domain name registration and web hosting group is in the midst of a major restructure and analysts polled on Bloomberg are anticipating the benefits to start flowing through in the 2014 calendar. Sales are tipped to rebound 28% to $140 million and earnings per share is forecast to jump 40% to 10.4 cents.

That looks way too high to me, as I doubt we will see any real tangible signs of a turnaround until 2015 (Melbourne IT’s financial year is the same as the calendar year) at the earliest. Granted that earnings for the embattled group are coming off a low base, and there are great expectations that the new domain name system will contribute significantly to revenue.

Click to enlarge

The new name system allows companies registering for web addresses to swap “.com” for just about anything (such as “.flowers” or “.food”). The belief is that companies would book multiple domain names to protect their brand.

Forecasting demand for these new addresses is next to impossible and some experts suspect that demand won’t be as robust as what others might believe.

The other problem is that the English domain names will probably only be available from mid-2014, and will take a year or so to fully roll out.

This leaves me wondering where sales growth for 2014 will come from, especially since total revenue for Melbourne IT are set to fall after it sold its Digital Brand Services and For The Record businesses this year.

Even if Melbourne IT’s web hosting division shows some growth, it is unlikely to book such robust double-digit sales and earnings growth that is implied by the consensus forecasts.

The real question though is whether the market believes the consensus estimates. From the looks of things, I think the answer is “yes” as the stock is trading on a price-earnings multiple of over 15 times based on the optimistic 2014 forecast.

Given that Melbourne IT has really just embarked on its three-year transformation, and no one really knows what the business will look like at the end of the period (management is looking to make some acquisitions with the asset sale proceeds, but the company doesn’t have a good track record on this front), I think the stock should be trading at or below its five-year average P/E of 10.6 times.

While the group holds its AGM in May, I think it will dawn on investors that Melbourne IT is really a 2015 or 2016 story when they listen to what other IT companies say during this AGM season.

You don’t want to be holding the stock when that happens, and I have an “underperform” rating on the company.

Regional Express Holdings (REX): Neutral.

The regional airline should be heading for clearer skies, having come through a tough year or two. But I fear management will be too battered and bruised to offer much in the way of an upbeat forecast.

Regional Express is the only listed company I am aware of to explicitly say how bad the former Labor federal government was for business.

Management told investors when it released its full-year earnings in August that its expects 2013-14 performance to deteriorate further “if Labor wins” but improve slightly “under a Coalition government”.

Its chairman, Lim Kim Hai, went on to say this “is one of the most toxic environments ever to face aviation in Australia” as sales plunged “almost immediately from 1 July 2012 after the federal government’s carbon tax was implemented, together with a whole host of policies hostile to regional aviation”.

The airline posted a 45% plunge in 2012-13 net profit to $14 million and noted that the carbon tax had shaved $2.4 million off its bottom line.

It will be a clear win for the airline when Tony Abbott scraps the carbon tax, but the timing of this is still uncertain and management is likely to shy away from giving any guidance. I also suspect that it will say it has not seen any notable rebound in demand along its routes, and that might prompt shareholders to sell down the stock.

However, with the stock nosediving 16% over the past two-months, and given management’s good reputation, a further dip in share price could be seen as a buying opportunity.

Regional Express’ AGM will be held on November 27 and I have a “neutral” recommendation on the stock, pending the outcome of the meeting.

Forge Group (FGE): Outperform.

All eyes will be on engineering contractor Forge Group when it hosts shareholders at its AGM tomorrow (Thursday, October 24) morning.

There is growing concern that Forge could announce some disappointing news due to project deferrals, which could lead analysts to downgrade their 2013-14 estimates on the group.

The stock has slipped around 7% since the start of the month, and Macquarie is the latest broker to flag this risk after Forge was forced to delay work at the Vista Coal project, Dugold River project and Cape Lambert power station due to regulatory issues and changes to mine design.

This means if Forge is to meet consensus revenue estimates of $1.21 billion for 2013-14, which is up 15% from last year, the Roy Hill iron ore project will have to start on schedule.

While these delays are outside management’s control, shareholders will be keen to get an update of project timing from the company.

Any hints that the Roy Hill project has to be pushed back will likely see the stock dip further.

Forge has been one of my worst “outperform” calls since I highlighted it on September 18, but I am still convinced it will come good for those willing to hold it for at least a year because of its compelling valuation and management’s good track record in winning and delivering projects.

I maintain my “outperform” rating on Forge, but those looking to buy the stock might want to wait for an update at the AGM.

Update: Forge did indeed give a downbeat near-term outlook at its AGM on Thursday and highlighted the increasing risk of project deferrals, which sent the stock dipping 0.8% to $4.84 in morning trade. You can read more about it here. Investors should use the dip as a buying opportunity.

Others in the firing line

The three companies above aren’t the only ones to watch out for, although they are the more likely ones to deliver downbeat outlooks.

Biotechs Acrux (ACR) and Sirtex Medical (SRX) are also keeping investors on edge after their disappointing full-year results in August, and investors will be keen to get further updates from management.

Spray-on treatment developer Acrux has been hit by a surprising slowdown in growth in the global testosterone treatment market, and demand for Sirtex’s kidney liver treatment has been more volatile than expected.

Acrux’s AGM is on November 21, and Sirtex is scheduled for next Tuesday.

Update: The bad news for Acrux has come sooner than expected with its partner Eli Lilly reporting a drop in sales of Acrux’s flagship testosterone treatment drug, Axiron. You can read more about it here.

Debt collection agencies Collection House (CLH) and Credit Corp Group (CCP) could also be facing some headwinds in the year ahead.

Competition to buy outstanding debt has heated up recently and is making debt ledger purchases more expensive. Further, any pick-up in economic activity and interest rate hikes could also weigh on earnings for the companies.

Analysts are forecasting a more than 20% increase in Collection House’s sales and a 17% improvement in Credit Corp’s top line in 2013-14.

Collection House’s AGM is set for this Friday, and Credit Corp’s meeting will be held on November 7.

Think big, go smalls!