Three companies on the growth radar screen

Eureka readers will note that the growth portfolio has a vacancy available for a new entrant. So in this article I would like to identify some of the potential new entrants and present my thoughts on their individual pros and cons as well a potential acquisition price.

There are three high-quality stocks that currently present as “in value” or “close to value” through the MyClime valuation service. These are:

• Monadelphous Limited (ASX:MND);
• Adelaide Brighton Limited (ASX:ABC); and
• SMS Management Limited (ASX:SMX).

Adelaide Brighton Limited (ABC)

The high quality of this company is shown by its 8.5 star Clime Quality Rating (CQR), which measures the quality of its balance sheet and financial ratios. The business has a long history of profitable trading in the cement market of Australia. Given the massive rationalisation that has occurred in this industry, ABC does appeal as a strong survivor.

The production of cement is clearly critical for the building and infrastructure industries in Australia. Further, our economy continues to grow through our population growth and our trade alignment with South-East Asia. Thus, there seems no doubt that ABC will benefit from this economic growth for many years. In addition, the company has developed import sourcing and export markets to alleviate the burden of the high Australian dollar. Indeed, ABC will be a major beneficiary of a weaker $A when that eventuates. In the meantime, ABC seems active in driving rationalisation of manufacturing plants with other building companies in an effort to maintain profitability. Therefore, the performance of the company’s management is rated highly.

The current price and the assessment of value are currently closely aligned based on market consensus earnings. The growth in future value is solid but not spectacular, and this suggests that buyers of ABC need to be disciplined in purchasing. Thus, with a current valuation of $3.32, an entry price of closer to $3 is suggested. The adopted normalised return on equity (adjusted for franking credits) may well be conservative should the $A devalue, and so readers should monitor the currency closely.

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Monadelphous Group Limited (MND)

In reviewing MND, readers should note the highlighted performance below. If you can imagine that you are the single owner of a ‘private’ MND, then you have achieved the following returns over the last five years:

1. Opening owner equity of $102 million, growing to $280 million;
2. Equity reinvested $48 million and equity retained $136 million; and
3. Dividends (fully franked) received $412 million.

These are extraordinary returns from one of Australia’s premier mining services companies. However, that is the past and the short-term outlook is for flat to declining earnings over the coming 12 to 18 months, so that needs to be adopted in any current valuation. It certainly means we should be patient in purchasing MND and utilise the negative market sentiment to our advantage.

The key to valuing MND now appears to revolve around the quality of its management team. It would be foolhardy for investors to assume that MND’s management will not react to the slowing resources capital investment cycle. In particular, MND has a superb balance sheet that gives management scope to opportunistically diversify. Further, MND will definitely use the slowdown to adjust its cost base and slow reinvestment. This is significant as it suggests that MND should maintain a fairly solid dividend as a sensible capital management strategy. Why reinvest capital if the return on that equity is falling?

So MND is very much in buy territory at present. It is interesting to observe the market price of close to $20. That price is actually forecasting that MD’s return on equity will plummet to levels not seen in the last decade. This may well be a significant downturn in the resources services sector, but it appears that the current investor pessimism may be too excessive. Readers need only think back six months to the nadir of the retail sector share prices. They have bounced solidly from oversold positions despite a lack of earnings growth.

I think MND becomes very interesting at below $20 and with a forecast pre-tax dividend yield heading towards 10%.

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SMS Management & Technology (SMX)

The share price of SMX has recently fallen sharply and into buying territory for value investors. Share price momentum is one thing but I am more interested in business momentum, which I suspect is under some short-term pressure in this IT services business.

In particular there are two key negative forces at play, and these are:

1. The declared federal election and difficult budget position that will stifle government projects and related business opportunities for the next six months; and
2. Extremely poor business sentiment at present that is restricting capital investment across the private sector.

So the above suggests that there will be continued pressure on the business, and the share price. Momentum investors will continue focus on the short term and ignore the likelihood of improved business conditions in 2014 if a new government is installed and the $A weakens.

Indeed, SMX is acutely sensitive to an improved investment cycle and the recent declines in normalised return on equity towards 30% will be quickly reversed in a growth cycle. In deriving a valuation of mid to high $5 range, I have assumed a sustainable improvement in profitability from both its Australian and Asian operations in 2014. The yield at current market price of $5 has lifted to 6% fully franked and a strong balance sheet suggests the company has potential to grow through judicious investment.

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Clime Growth Portfolio Statistics

Return since June 30, 2012: 31.67%

Returns since Inception (April 19, 2012): 22.43%

Average Yield: 5.69%

Start Value: $111,580.24

Current Value: $149,941.19

Dividends accrued since 31 December 2012: $3,199.26

John Abernethy is the Chief Investment Officer of Clime Investment Management.

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