Small caps: The bright spot this earnings season

Model portfolio stocks Qube Logistics, Ridley and GWA Group have reported pleasing results.

A common theme this reporting season has been price-earnings ratio de-ratings for even a slight earnings miss or uncertainty in the outlook statement. Many of the big disappointments have been from large cap stocks, but the test for small caps will be this week with a large majority of them due to report.   

Prior to this reporting season the market had been comfortable with high PEs due to the comparative value vs bond yields. But in many sectors operating conditions have remained difficult, and valuations have become inflated relative to earnings growth forecasts.

The chase for yield has continued to encourage management teams to increase their dividend payout ratios rather than re-invest in their business. Although the increased dividends provide short-term share price support this increases medium-term risk, as the lack of re-investment will in some cases result in lower earnings growth in years to come.

Out of my coverage list there weren’t too many surprises last week, with many of the results pre-announced. Four of the “Growth First” model stocks reported last week in Qube Logistics (QUB), Ridley (RIC), GWA Group (GWA) and ToxFree Solutions (TOX) (see Small caps: Earnings season lessons).

Ridley Corporation (RIC): Increased agri-products and property upside

Ridley reported a strong result in line with our expectations. The 20 per cent increase in net profit after tax was achieved on 4.1 per cent revenue growth. The stock has been a strong performer, with the share price up about 30 per cent since the half-year result.

The company is the country’s leading provider of premium quality, high performance animal nutrition solutions. The company also has a large land portfolio with an opportunity to release value from development projects.

Ignoring property and corporate costs the AgriProducts business increased earnings before interest and tax (EBIT) by 26 per cent from $40.1 million to $50.4m. This is an excellent operational result, with the company benefiting from the positive industry conditions (strong feed demand) and efficiency gains.

Operating cash flow was very positive, up 50 per cent to $47m, and gearing (net debt/equity) declined to 14 per cent.

The final dividend of 2 cents combines to a 3.5 cent full-year dividend.

Corporate costs of $8.9m are consistent with the prior year. Property costs increased to $3.6m, which is due to the maintenance and closure of the former salt field at Dry Creek in South Australia. Management are in the process of finalising negotiations to develop a commercial solution for the entire Dry Creek site, which should create shareholder value.

The reclassification of $33.5m of Dry Creek assets from non-current investment property to current assets held for sale is further evidence that management are towards the end of the sale process.

The other property costs of $2.7m are $0.5m higher than last year due to consulting and advisory activity for the Nelson Cove project. This development involves discussions with the Victorian state government following its review of the Corio Bay peninsula.

The outlook remains positive, partly due to strong demand for the core agriproducts, and partly due to continued efficiency initiatives within management’s control.

We maintain our buy recommendation with a $1.40 valuation.

Qube Logistics (QUB): End markets weak, but long-term value emerging

Qube announced a solid result with underlying revenue up 18 per cent and underlying net profit after tax up 19 per cent to $105m. The FY15 dividend of 5.5 cents per share was roughly in line with expectations. The second half was however a little soft, and management had previously announced that they expect the weak conditions to remain into FY16.

With revenue at $1,459m, management has focused on diversifying earnings in regards to both the customer base and the end market exposure. Despite this, the very weak conditions in resources and particular iron ore (Arrium, Atlas) will have a material impact on FY16 results.

But there are still organic growth opportunities, and strategic projects such as Quattro (grain) and the Moorebank Intermodal terminal. Qube has significant non-operating strategic assets that will become operating over the next few years. This needs to be taken into account when considering the FY15 and FY16 PE ratios that are at a premium to the market.

There was no further update on Moorebank, but this is not surprising given the extensive update provided in recent months after the contract agreement with the government.

Management’s strategy will continue to focus on driving efficiencies and reducing supply chain costs to provide superior logistics solutions and maintain and grow its customer base. Their ability to identify and integrate acquisition and investment opportunities is second to none in the sector.

Although guidance for FY16 is cautious, it is important to take a long-term view with Qube as strategic projects such as Moorebank and Quattro are setting the company up for growth into the next decade.

As we have seen with the takeover bids for Asciano (AIO) and Toll Holdings (TOL), the Australian market has a history of taking too much of a short-term view with these strategic and valuable infrastructure and logistics assets.

Specifically management has guided that Ports and Bulk underlying EBIT will be lower in FY16 vs FY15. But they also highlight that there will be other organic growth opportunities and further clarity around the positive impact from Quattro and Moorebank.

With the prospects of further market weakness, Qube is a stock that investors can confidently buy for the long term due to our confidence in management’s ability to navigate the company through weak markets and the strength of their long-term opportunities such as Moorebank.

We maintain our buy recommendation with a slightly reduced $2.95 valuation.

GWA Group (GWA): Earnings in line, significant re-structure

GWA Group’s full year results were roughly in line with expectations in a year that included asset sales and significant re-structuring.

Net profit from continuing operations increased 19 per cent to $45.2m and normalised EBIT was up 13 per cent to $72.8m.

After the divestment of Dux hot water, Brivis Climate Systems, and Gliderol doors, the company is solely focused on bathroom and kitchen fixtures/fittings and locks.

For these core products the company also exited manufacturing, and is now a distributor, importing from third parties overseas.

The significant items and one-off restructuring costs resulted in a reported net loss of $16.2m against a reported net profit of $18.6m last year. But with the bulk of the company changes successfully executed it is the underlying net profit from continuing operations that is more relevant.

GWA returned 28.8 cents per share to shareholders, through a return of capital of 22.8 cents per share and a partially franked special dividend of 6 cents per share paid on June 15.

There was no final dividend paid for FY15 due to the lack of retained earnings. But this shouldn’t be an issue for next year, with an interim dividend expected to be paid.

The divestment of poor performing and non-core businesses should improve group profitability and returns as well as freeing up management to focus on the core business. Further closing the manufacturing facilities will reduce the capital intensity of the business and improve returns and cash flow.

The transformation has been costly but was required given the reduced cost of imports. Management has also had to deal with a number of other structural changes. Including a consolidating customer base, with GWA now dealing with a smaller amount of large customers – the clear top three being Reece, Tradelink and Bunnings.

Although housing activity has been strong, the higher proportion of apartments has resulted in reduced margins and volumes. Multi-residential housing now comprising about 50 per cent of new dwellings, up from about 30 per cent in FY06.

GWA is a late cycle housing play and given the increased lag in this cycle from approvals to completion earnings should stay stronger for longer once approvals have peaked. This translates to the likelihood of double-digit earnings growth for FY16 and FY17.

GWA is not trading at a large enough discount to our revised $2.60 valuation to maintain the buy call, and we are downgrading to a hold recommendation.

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