Three small caps facing a game-changing year

You wouldn’t be alone in looking forward to seeing the back of this financial year, given that small caps are likely to close out fiscal 2013 on the worst relative footing to their larger rivals on record.

While the S&P/ASX 100 Index has delivered an enviable 22% total return since July, which is primarily driven by investors snapping up high dividend paying stocks (such as the big banks and telecommunications giant Telstra), the S&P/ASX Small Ordinaries index has slipped around 6%.

But this isn’t the time to be throwing in the towel, as change is in the air. There is an increasing number of strategists calling the end of the “yield” trade, which I believe marks the start of a change in fortunes for out-of-favour junior stocks (as I was predicting in my March article “Small caps on a winter run”).

Goldman Sachs is the latest to urge investors to go overweight on the miners and underweight on banks, while Macquarie and Citigroup expressed their preference for “unloved” cyclicals over high yielding defensive stocks in the past few days.

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The switch to small caps probably won’t happen right away.  Large miners will benefit first from the turn in sentiment before investors wade into the junior end of the market in greater numbers.

Nonetheless, the new financial year is likely to play out very differently for small caps, and this is particularly so for three juniors as FY14 looks set to be a game-changing year for these companies.

NetComm Wireless (NTC)

The next year is a big one for the wireless equipment maker as it moves from “talking-the-talk” to “walking-the-walk”.

There are two issues that are hanging over NetComm.  The first is its ability to sustain earnings, as revenues in its traditional markets tend to be very lumpy.  The other is the (yet another) repositioning of the business to the M2M (machine-to-machine) space.  

M2M is starting to become ubiquitous in everyday life, but most do not know what it is.  The problem is M2M sounds like the latest “boy band” and not the next technological evolution.

Touch-and-go payments at the supermarket using a credit or debit card, smart electricity meters, wireless patient monitoring and smart electronic road signage are just a few examples of M2M applications.

The global market is estimated to be worth around $US40 billion and Vodafone is the market leader in this field.  This is noteworthy because the global telco has selected NetComm to be its exclusive supplier of light industrial M2M hardware, which is used for indoor applications (such as payment kiosks).

The thing is, investors have heard this before.  NetComm has refocused its business a number of times to pursue more attractive opportunities – from household broadband routers to mobile broadband equipment (i.e. 3G and 4G equipment).

To management’s credit, the tiny $30 million market cap company has a long track record of winning contracts with major global telcos, although sales of 4G equipment were one-off with no material repeat orders as customers are always chasing the next product upgrade.

The M2M market is much “stickier”, as customers are more concerned about security of long-term supply than the latest technology.

NetComm would not say what the Vodafone contract could be worth, but its chief David Stewart told Eureka Report that the company will post a step change in earnings over the next two years, starting with FY14.

This is in part thanks to the $12.5 million it will get in the new financial year from the SP AusNet smart meter contract, and Stewart believes the company will be announcing more Vodafone-like deals over the next several months.

NetComm is also anticipating a material order for wireless equipment from NBN Co. in the next financial year.  NetComm is the sole supplier of fixed wireless devices for the National Broadband Network.

A material uplift in FY14 earnings will be very welcome to shareholders, as NetComm issued a profit downgrade for the current financial year due to the repositioning of its business towards the M2M market.

Management expects revenue of between $45 million and $48 million, and earnings before interest tax, depreciation and amortisation (EBITDA) of $1.8 million to $2.5 million for FY13.  NetComm posted revenue of $59.5 million and an EBITDA of $4.9 million for the year before.

The stock has more than doubled over the past 12-months and is trading at around 28 cents.  But if the M2M opportunities come close to the company’s expectations, the stock could quite easily double in value again over the next year or two.

Phosphagenics (POH)

This budding biotech is maturing very nicely and the next 12-months will be critical in determining if Phosphagenics can morph from being a speculative drug developer into a “real” company.

I have been following the $133 million market cap biotech for some years now, and Phosphagenics has never really checked enough boxes for me to feel bullish about its prospects.  There are always a few “holes” in the business that I had issues with, and its venture into the cosmetics market didn’t help its credibility, in my opinion.

But I am at the cusp of changing my mind, and it isn’t so much to do with the progress it has made in clinical trials of its through-the-skin drug delivery technology (called TPM), but the opportunity in the animal health market.

The United States Department of Agriculture (USDA) is fully funding a study using a TPM vitamin patch on cows to control mastitis (blocked milk ducts), and the results are likely to be released in the March quarter next year.

This study is the biggest risk to the commercialisation of TPM in the dairy industry and the US market alone is worth $US3 billion a year.  A positive outcome will very likely lead to a licencing deal with a large pharmaceutical company. 

The opportunity is bigger than any other human market application for TPM, and the path to commercialisation is a lot more straightforward as the approval process is not as stringent.

This isn’t to say that the human drug market opportunity is not significant either.  Phosphagenics anticipates that it will sign a deal with a large pharma in the next 12 months or so for the use of a TPM patch to deliver Oxycodone and Oxymorphone (pain treatment drugs). 

What is also overlooked by many in the market is the deal Phosphagenics has signed with Novartis to use TPM in Voltaren Gel.  Sales of the new Voltaren Gel, which is used to treat joint pain, will start in the September quarter this year, and is likely to net Phosphagenics $5 million to $6 million a year.

Phosphagenics is only suited for those with a stomach for risk, but at around 13 cents, I think the risk-reward proposition is attractive.

Beadell Resources (BDR)

Among the miners, Beadell Resources is the one to watch in FY14 as that will be the year it proves to the market that can be one of the biggest and lowest-cost gold producers in Brazil.

Beadell only just achieved commercial production last month, and has recovered around 30,000 ounces of gold in the March quarter at its Tucano project.

The $470 million market cap miner is aiming to produce 200,000 plus ounces of gold a year, which would make it Brazil’s third-largest gold miner.

While gold miners are on the nose at the moment with the falling gold price, Hartleys believes the stock is still an attractive buy given that the estimated total cash cost for calendar 2013 is a little over $US600 an ounce.

This gives Beadell plenty of margin as the current gold price is hovering between $US1,300 and $US1,400 an ounce.

The other milestones that Beadell is expected to hit in the coming year include the mining of the Duckhead project in June (Duckhead holds extremely high gold grades), an extensive drilling campaign at its highly prospective Tropicana project in Australia, and the addition of 1 million ounces of gold resource before December this year.

Of the 14 brokers polled on Bloomberg, 13 (including Hartleys) recommend Beadell as a buy with an average price target of $1 a share.  The stock is trading around 65 cents.

Brendon Lau may have interests in some of the stocks mentioned in the article.