Long in the tooth and lacking bite

Investors will have to wait a while yet for clarity on share price catalysts for NRW Holdings and Starpharma Holdings.

Waiting for greater clarity on potential catalysts for NRW Holdings (NWH) and Starpharma Holdings (SPL)? You will have to keep waiting as the recent reporting season has done little to shed light on the anticipated re-rating of the stocks.

This isn’t so much a reflection on management. If anything, managers of the engineering contractor and biotech hopeful are among the most highly regarded in their respective sectors, and they are arguably more a victim of circumstances outside their control.

NRW Holdings

Take NRW for instance. Management reassured the market that civil and mining construction isn’t falling off a cliff when it forecast flattish 2014-15 revenue of between $1 billion and $1.2 billion. Its chief executive Jules Pemberton told Eureka Report that he is confident there is enough work to support the group’s top line at around the $1 billion mark for the next few years.

But investors remain jittery. The stock jumped over 5% when the group’s results were released on August 20, but the stock has given up all its gains and then some as the market focuses on profit margins.

There are some early signs that things are stabilising in civil and mining construction industry, but margins are likely to remain under pressure due to the general underutilising of resources among contractors.

The compression of margins accelerated in the June half for NRW with the company posting a 17.5% drop in revenue last month to $1.1 billion, while net profit plunged 40% to $44.2 million for the year ended June 30, 2014.

While Pemberton is comfortable giving revenue guidance, he declined to give a forecast on margins. This shows how difficult it is for even well run contractors to predict this element due to the complexity of the projects. Bad weather and other unforeseeable events can have a significant impact on the bottom line.

This highlights the risk of a cost blowout on NRW’s fixed priced projects. Again, NRW’s enviable track record shows management is good at controlling such risks, but these risks exist.

I’ve set my price target at $1.15 using a blend of price-earnings (p/E) and enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiples. This is ahead of the current share price, but against the backdrop of so many unpredictable outcomes, it is prudent to start formal coverage on NRW with a “sell” recommendation for now.

However, this isn’t to say there are no potential near-term positive catalysts for the stock. In fact there is a re-rating trigger that has escaped the attention of most in the market. In three simple words, it’s “off-market buyback”.

Indeed, the amount of cash on NRW’s balance sheet is worth half the market capitalisation of the company. It wouldn’t be wise to use all or most of the $155.5 million cash stash on capital management, but NRW’s ability to launch an attractive share buyback scheme is bolstered by the $50 million in franking credits it has on hand.

The final shape of the buyback depends on many factors, but management could conceivably offer to purchase shares at a sizable discount to the current market price of around $1.03 but sweeten the deal with a franking credit top up, which would push the final offer price comfortably ahead of the market price. This is similar to Telstra’s latest buyback and Woodside Petroleum’s (WPL) plan to repurchase Shell’s stake in the Australian oil & gas producer. 

Such a move could reduce the number of shares on issue by up to 40%. This is significant given the impact that would have on the “multiples-based” valuation of the stock.

Pemberton said the company would actively consider some type of capital return if management cannot find suitable acquisition opportunities in the next six to 12 months.

This worries me. I would have preferred management to explore the second option first even though I can be criticised for contributing to the “lack of animal spirits” problem highlighted by Reserve Bank of Australia governor, Glenn Stevens. He believed the focus on capital return and dividends is unhealthy as it discouraged companies from using the cash to expand their businesses.

The thing is, I’m generally a sceptic when it comes to acquisitions in the sector. You can buy assets but you can’t buy people – and its people that drive value for an engineering contractor. Further, as the Forge Group (FGE) debacle has shown, making a wrong buy can really kill a company.

The only corporate activity shareholders should embrace with open arms is a takeover bid for NRW at a healthy premium to the current share price.

I can see a catalyst for NRW, but I can’t predict “if” or “when” a buyback will happen. This uncertainty will further cloud the already challenging outlook for NRW and I think the stock will be trapped in a trading band over the next few months. Until there are clearer indications of how management is going to spend its cash, there are arguably lower hanging fruits in the small cap sector.

To see NRW Holdings' forecasts and financial summary, click here.

Starpharma Holdings

In the case of Starpharma, the issue of catalysts are more convoluted and have taken longer to come about than I had anticipated.

The stock slid to a near four-year low of 55 cents in June before bouncing 25% to 85 cents on news that the Australian Therapeutic Goods Administration approved the sale of Ansell’s (ANN) condoms that is coated with Starpharma’s VivaGel, which inhibits the spread of sexually transmitted diseases.

That is good news, but I was expecting more when I gave the stock the thumbs up in July last year when the stock was trading at 94 cents. While it has been a busy year for Starpharma with the company securing approval for VivaGel condoms in Japan, starting of a phase 1 anti-cancer trial and signing a deal with agrichemical giant Gowan to test Starpharma’s technology to improve Gowan’s products, the lack of financial details or milestone payments is weighing on sentiment.

Investors have grown restless and I suspect that changes in the global pharmaceutical sector that is earmarked by mergers and acquisitions and major restructuring activity may be impeding Starpharma’s deal making ambitions.

If so, Starpharma isn’t the only one impacted. Central blood pressure monitoring company AtCor Medical Holdings (ACG) cited these industry changes as the key reason for its weak result.

While I think long-term shareholders will ultimately be rewarded given that the market opportunity for Starpharma’s portfolio of technologies is huge, it is hard to make an earnings forecast with any real level of confidence given the lack of details and the early development stage for most of these opportunities.

I believe investors will be waiting a while for a re-rating event. Further, Starpharma is unlikely to deliver a maiden profit until 2016-17 and time is on investors’ side.

Even if the company delivers positive news in the nearer term, such as gaining approval to sell VivaGel condoms in other markets and a positive outcome for phase 3 clinical trials proving that VivaGel can cure Bacterial Vaginosis (BV), there will still be time to buy the stock.    

The irony is that most would feel more comfortable predicting the price of iron ore in two years than Starpharma’s sales, and it means building a financial model for the company at this juncture is a little meaningless.

For these reasons, I have decided not to start formal coverage on Starpharma – at least not until it kicks a few more goals. This will free up resources to cover other small cap opportunities in the coming weeks with closer value inflection points.

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