Biggest smalls earnings surprises

Small caps are outgunning their larger peers as we head into the last hectic week of the reporting season, with this trend likely to stretch through till early next year at least.

The Uncapped 100 stocks are up 5% on average since the end of July, while the S&P/ASX 100 Index is struggling to break even. The performance of the S&P/ASX Small Ordinaries is also pleasing, as the index is up a little over 4%.

We can thank the reporting season for helping emerging companies close the performance gap, although the Uncapped 100 is still 5.5% behind the top 100 benchmark over a one-year time horizon. I believe this gap will narrow further as foreshadowed in the article Small caps on a winter run back in March.

Click to enlarge

While only about a third of emerging companies in the Uncapped 100 have handed in their profit report cards, their results have been better than what sceptics had feared – the same fear that left investors scurrying to the perceived safety of big caps over the past several months.

But the quality of the results from smaller companies has at least matched the bigger-end of town, with about an equal percentage of Uncapped 100 and S&P/ASX 100 stocks surprising on the upside.

Around 42% of Uncapped 100 stocks that have released results have outperformed the market on the day of their profit announcement compared with 41% for the biggest 100 stocks on our market. But the average outperformance to the market (called alpha) is 4.34% for the Uncapped 100 compared with 3.53% for the ASX 100.

That’s a credible result given the poor sentiment towards the small cap sector. Unless the last week of the reporting season goes horribly wrong, I think small caps will remain in investors’ good books over the next few months. This is thanks to the big lag that still exists between small and large cap returns, the generally positive management outlook statements, and the removal of political uncertainty post the federal election.

Click to enlarge

Turning to the results so far, there have been a number of notable surprises. If I use “alpha” to quantify the surprise, gaming systems company eBet’s (EBT) result today would be the best standout, with the stock surging 15% this morning to $2.10.

While the 17% jump in normalised pre-tax profit to $2.9 million for the year ended June 30 this year is pleasing, the real surprise is its maiden dividend of 3.5 cents a share.

The pre-tax number was in line with management’s guidance, but I didn’t expect eBet to pay a dividend until 2013-14.

Assuming an equal dividend for the next half year (this would work out to modest payout ratio of about 40% based on 2012-13 profits), the stock will yield 4.7% if the franking credit on 50% of the dividend is added in.

The dividend declaration also gives me confidence about eBet’s ability to maintain its growth momentum and build a strong recurring revenue business, with 48% of total revenue classified as recurring in 2012-13. Management is looking to lift this to between 55% and 65%.

While the stock is no longer cheap compared to when I first recommended buying it at $1.13 on June 26, I believe the stock has room to climb as the stock is trading on a reasonable price-earnings multiple of around 12 times based on last year’s earnings.

Further, as I reported a month ago, institutional investors are trying to build a position in the stock. The latest result will only attract greater interest from professional investors and I reiterate my “overweight” recommendation on the stock.

On the flipside, consumer financing company ThinkSmart (TSM) is the second-biggest disappointment (based on its alpha) after drilling services company Imdex (IMD).  

But there is a stark difference in the quality of their results, in spite of what their share prices are indicating.

Imdex’s fall from grace is understandable, with demand for drilling services remaining under a dark cloud as new mining projects are put on hold.

However, ThinkSmart’s price drop is driven more by profit taking as the stock has rallied 80% over the past 12 months in anticipation of a turnaround in its financial performance.

ThinkSmart’s chief executive, Ned Montarello, has been promising this turnaround for over a year and he has been delivering on his promises since the February reporting season (See Three small caps at a turning point).

The outlook for ThinkSmart is bright, with its aggressive expansion in the UK market looking like perfect timing in hindsight. The UK is emerging from a recession and consumer confidence has rebounded strongly, with English retailers reporting good results and outlook.

That country accounts for 54% of group revenue and ThinkSmart has agreements with major UK retailers Dixons and Currys to provide rental financing for electronics. The company is rumoured to be close to signing up another large UK retailer outside of electronics.

ThinkSmart has an interest-free finance offering called Fido in Australia, which is offered through JB Hi-Fi. It is also worth noting that JB Hi-Fi delivered a solid earnings result and gave an upbeat outlook.

The 9% drop in ThinkSmart today represents a buying opportunity, even though some might feel the stock is looking full priced as it is trading on a one-year forward price-earnings of around 13 times – a slight discount to market darling and rival FlexiGroup (FXL).

Earnings expectations are also set high for 2013, with consensus estimates tipping a net profit of $2.5 million. This means ThinkSmart has lots of catching up to do in the current half, even after posting a $700,000 profit for the six months to June compared with a loss of $1.5 million for the same period last year.

Montarello would not provide guidance, except to say that the positive earnings trajectory is expected to continue until 2014 at least.

It’s a big ask but ThinkSmart might be able to pull it off as it’s only just starting to reap the benefits of its restructure, and the collapse of the Australian dollar to a three-year low against the British pound will only help bolster its translated earnings.

There is also no shortage of room for ThinkSmart to grow. The company recorded $6.1 million in new originations for Fido in the first-half of the year compared with FlexiGroup’s $200 million, and Montarello estimates that the companies have only 8% of the underpenetrated market.

Patient investors with a one to two-year investment horizon should use ThinkSmart’s price correction as a buying opportunity.

Think big, go smalls!

Brendon Lau owns shares in EBT and TSM.

Click here for a free trial.