Small caps: Earnings season strength

Vita Group (VTG)

Vita Group announced a strong full-year result, in line with expectations. The company has been one of the best performing ASX-listed retailers over the last two years in regards to both earnings and share price growth.

Led by Maxine Horne, the performance has been achieved by optimising the portfolio of Telstra-branded retail stores, and more recently Telstra Business Centres (TBC). The transition away from Fone Zone, One Zero and Next Byte is largely complete.

When we first identified VTG at 70 cents it was trading on a PE of 7, with the market concerned about the write-down of the Apple Next Byte stores. The stock recently hit a high of $2.15 and is now at $1.80. This implies an FY16 PE of 13 and fully franked yield of 5 per cent.

There were five Telstra retail stores acquired during the year, taking the total number up to the licence limit of 100. Further, there are now 16 TBCs. With the retail stores at the licence limit the easy gains have been made. The focus is now around store optimisation and the Small-Medium Business (SMB) and Enterprise channels.

Although there is no limit on TBCs, the company is likely to eventually target one for every four to six retail stores, in line with its store clusters strategy.

Although the growth from Telstra business and enterprise growth looks promising it is much more difficult to quantify compared to the retail store growth.

Result details

Acquisitions and organic growth produced 45 per cent EBITDA growth to $39.2 million. As flagged the second half saw EBITDA down 2 per cent due to the first half benefits from the iPhone 6 launch. Vita also expensed up-front costs for its business and enterprise channel growth plans.

Store acquisitions produced about one-third of the growth, with like-for-like Telstra store sales up 26 per cent. The small-medium business channel growth was a very strong 79 per cent, but off a low base (7 per cent of EBITDA). Enterprise was up 60 per cent again off a low base.

The high level of organic growth is a credit to Maxine Horne's focus on strong relationships particularly with employees. This includes customer service training, career development and most importantly performance-based incentives.

Underlying NPAT was up 76 per cent to $18.1m, or earnings per share of 12.4 cents. A final dividend of 3.86 cents combines for a full-year dividend of 8 cents.

Vita has been releasing franking credits by special dividends that have been funded via DRP placements. A further 2 cent special dividend was announced making it 8 cents for the year. This method of releasing franking credits is now “under review” due to the ATO potentially preventing the strategy.

Risks

The major risk is obviously a change to the Telstra license agreement affecting revenue per store. Telstra has had a good run against other telco providers – an improved offering from competing telco providers would be detrimental to Vita earnings. Although we think the assumed growth from SMB/Enterprise is conservative, the lack of detail does present an element of risk.

Valuation

Our forecasts assume an average annual earnings per share growth of 12 per cent over the next three years. This is a base case assumption with upside risk from the SMB and Enterprise opportunities. Our discounted cash flow valuation and target price increases from $1.65 to $1.90, and we maintain our hold recommendation.

Empired (EPD)

Empired reported a solid full-year result but failed to get the reaction from the market it probably deserved. Revenue was up 94 per cent and earnings per share of 4.8 cents were up 85 per cent. Despite this strong result, the share price has weakened to 71 cents.

In the second half the company achieved $65m of annuity based contracts – well above what was expected when the company announced a $100m pipeline at the half-year result. Staff numbers increased from 419 to 919 during the year. The new contracts have initial setup costs and as such costs will decrease and margin gains will be achieved into FY16.

The company has guided for FY16 revenue to increase from $130m to $155-$175m. Further there is a strong pipeline of major strategic contracts to be awarded within the next 12 months to support organic growth in FY16 and increase contracted revenue in FY17.

With this continued high level of growth the largest constraint is finding the staff to complete the work. As such we view the decision to cut the final dividend as prudent. One of the ways to get the additional staff is acquisitions and as such the conservative approach to cashflow is likely to end up being in shareholders' interests. Especially in a weaker market when raising equity may be more costly. The balance sheet is in excellent shape with net debt of $6.9m.

As well as the dividend cut, the other reason for concern was the operating cashflow conversion that was below market expectations. The percentage of this that was due to new contract wins is likely to be a key driver into FY16.

There are expense savings of $3m per annum to be achieved in FY16. The business is scalable and as such further margin gains will be achieved through overhead leverage and expense savings in years to come. In FY15 the EBITDA margin was 8.5 per cent – FY16 has the potential to range from 10-12 per cent, with our forecasts assuming 11 per cent. But similar to this year that margin may depend on the amount of new work won in FY16 and any setup costs.

The major contract wins have been in high growth services including Data Insights, IOT and Cloud. The company has successfully positioned to benefit from the new IT services landscape that focuses on consumption based usage (as-a-service) of Empired's internally developed and owned software as a service IP.

Further structural shifts in the industry include Social, Mobile, Analytics and Cloud supported by multi-million dollar contracts and in-house IP. The shift to consumption based computing is accelerating. Empired Managed Services is benefiting strongly form this shift with referenceable multi-million dollar consumption based managed services contracts.

As well as the structural shifts, the cyclical component of IT services spending appears to be picking up. This is mainly government and large corporate contracts that have been delayed in recent years. Just about every ASX-listed IT services company has exceeded expectations this reporting season or announced major contract wins.

Valuation

Our prior discounted cash flow valuation of $1.05 has reduced to $1.00, due to a more conservative assumption around margins. At 71 cents, the stock is on a FY16 PE of 8.5, and we maintain our buy recommendation.