Small consumer stocks at Christmas crossroads

The festive season is fast approaching, but not all consumer stocks will be celebrating.

Consumer stocks are approaching an inflection point. They have been among the best performers this year, but large cracks in market confidence are starting to appear.

Worryingly, some experts are now sounding the alarm that the sector has run too far ahead of fundamentals as we close in on the critical Christmas trading season.

This is the time of the year when most retailers make the bulk of their annual profits, and many investors have been piling into the sector in anticipation that a rebound in sentiment following the federal election will entice consumers to spend big during the festive period.

That is the line Treasurer Joe Hockey is pushing, and the logic does make sense. Consumer confidence has rebounded strongly since the September 7 election and house prices have risen materially in key cities.

This should put retailers in a sweet spot ahead of Christmas, if not for the fact that there is next to no evidence that improved sentiment is translating to an increase in consumer spending.

According to official statistics households are saving a little over 10% of their disposable income, which is close to a three-decade high. Yet, trend growth in retail sales in August was flat.

If a notable pick-up in consumer activity doesn’t happen soon, it could trigger a de-rating in consumer discretionary stocks; and there’s plenty of room for them to fall given how far they have climbed.

Credit Suisse strategist, Damien Boey, tells Eureka Report that if consumers are more willing to spend, they would be already.

“Most people would expect [that] with house prices up, employment still ticking over and wage growth still positive that retails sales would be accelerating,” says Boey.

“But anecdotal evidence says ‘no’ and I believe, in part, that is because the decoupling between activity and sentiment is a global theme at the moment.”

He points out that a similar story is playing out in the rest of the world, where consumers are slow to spend despite growing confidence in the economic outlook.

Further, he adds that Australian households are using cash to pay down debt, and demand for home equity withdrawals is low. This means rising home prices are not likely to fuel consumer spending like they have in previous cycles, and that is why Boey is recommending investors go underweight on the sector.

But you won’t find consensus on this topic. John Hughes from Thorn Group (TGA), the operator of the Radio Rental chain, thinks consumers are poised to change their conservative habits in a big way.

“We have seen no immediate change [since the election] and I don’t expect there to be any,” says Hughes.

“In my 40-plus years in retail, when I see environments like this, things just don’t happen [overnight]. Things change gradually and momentum builds.”

There is little doubt in his mind that consumers will be back in force, but we may not see the full impact of this until March next year.

The chief executive of advertising group Ogilvy Australia, Andrew Baxter, has also noticed a change in the air and he is expecting discretionary spending to be buoyant during the Christmas shopping season.

“It’s only been seven weeks, but the trend we are seeing across a range of retail categories is that consumer confidence is more positive than it was pre-election,” he says. “There is a slight lag in business confidence, particularly in the small business sector, but we expect this to rectify itself soon.”

Ogilvy Australia is owned by STW Communications (SGN), which is part of the Uncapped 100.

I tend to agree with Hughes and Baxter because there is a lag effect when it comes to consumers feeling better about their future and opening their wallets. In fact, we should be worried if we saw a sharp rebound in spending immediately after the election as it would raise questions about the sustainability of the change in behaviour.

It will also be a bearish sign for the market on the whole if consumers do not come back in any meaningful way, as that will have pretty big knock-on effects on business confidence. If you are bullish on equities, like I am, by default you have to have faith in consumers and JB Hi-Fi’s pleasing sales update at its annual general meeting today is reassuring.

The electronics and music retailer reported an 8.1% increase in sales in the September quarter and reaffirmed its revenue growth target of 6% to 8% for the current financial year.

By extension, this Christmas should be markedly better than the last few unless something comes out of left field. Don’t get me wrong, it won’t be sunshine and lollipops for the sector and the internet threat is still a big challenge for many consumer discretionary companies.

However, a number of Uncapped 100 stocks are well placed to see earnings upgrades should consumer spending momentum start to build. I’ve highlighted Specialty Fashion Holdings (SFH) as a buying opportunity in August, but there are another two worth looking at.

Uncapped 100 with "outperform" recommendations

CompanyCodeArticle datePrice* ($)Article titleTotal rtn* (%)
eBetEBT26-Jun-13$1.13Small cap with biggest earnings upgrade197.8
Tiger ResourcesTGS3-Jul-13$0.19Why a dog can be an investor's best friend107.9
Mint WirelessMNW2-Oct-13$0.18Four new stocks for Uncapped80.6
WDSWDS14-Aug-13$0.59A mining services revival?66.2
GI DynamicsGID17-Jul-13$0.60Five bargains for under a buck37.9
LogiCammsLCM7-Aug-13$1.47The next dividend dazzelers35.2
NRW HoldingsNWH14-Aug-13$1.14A mining services revival?30.7
NewsatNWT3-Jul-13$0.40Why a dog can be an investor's best friend26.6
ColorpakCKL17-Jul-13$0.73Five bargains for under a buck21.2
ThinksmartTSM21-Aug-13$0.36Biggest smalls earnings surprises9.9
M2 Telecommunications GroupMTU10-Jul-13$6.02Big expectations for small caps7.9
Beadell ResourcesBDR28-Aug-13$0.87Short-selling gold signals7.8
Wide Bay AustraliaWBB16-Oct-13$5.60Appetisers from the agri stocks field5.5
Silex SystemsSLX3-Jul-13$2.32Why a dog can be an investor's best friend3.5
Ridley CorporationRIC16-Oct-13$0.85Appetisers from the agri stocks field0.6
YTC ResourcesYTC9-Oct-13$0.26Xmas sale starts early for small caps0.0
Specialty Fashion GroupSFH18-Sep-13$0.93Small cap surprises for 2014-3.2
Collins FoodsCKF7-Aug-13$1.76The next dividend dazzelers-4.3
Starpharma HoldingsSPL17-Jul-13$0.94Five bargains for under a buck-4.8
Horizon OilHZN17-Jul-13$0.36Five bargains for under a buck-5.1
Universal BiosensorsUBI4-Sep-13$0.68Smalls in sweet spot-8.1
Forge GroupFGE18-Sep-13$5.23Small cap surprises for 2014-14.0
STW CommunicationsSGN30-Oct-13NewSmall consumer stocks at Christmas crossroadsNew
*As of publishing date
Source: Eureka Report, Bloomberg

STW Communications (SGN)

Any upswing in discretionary spending should breathe some life back into the anaemic advertising market, and that will only play into the hands of the advertising group.

But there are other reasons why I like STW. First, expectations are relatively low as the market is only ascribing inflation-plus like growth for the group in 2014 and 2015 (its financial year is the same as the calendar year).

What’s more, analysts polled on Bloomberg are playing it safe and are expecting 2013 earnings per share (EPS) to fall 16% to 12.6 cents when management said at its half-year result in August that “mid-single digit EPS growth remains achievable”.

Second, STW is trading on reasonable valuations, even though it has jumped 40.5% over the past year. Based on the downbeat consensus expectations, the stock is on a 2014 estimate price-earnings multiple of under 12 times, or around a 40% discount to its global peers, and has a yield of about 8% once franking credits are applied.

More importantly, the group is well run and has a pretty good track record in generating earnings and sales growth over the past few years in what can only be described as a challenging environment.

I have a new “outperform” recommendation on the stock.

Retail Food Group (RFG)

The franchise food brand owner announced a capital raising on Tuesday and reaffirmed its 2013-14 net profit growth of around 15%.

While that is a little behind consensus estimates of 17.5% net profit growth to $37.6 million, I won’t be surprised if management upgrades its full-year guidance at its half-year result.

Reading between the lines, its chief executive Tony Alford was tempted to, but decided to err on the side of caution, when he said it was “premature” to revise its current year guidance.

Details on the capital raising will only be released on Thursday but the proceeds are likely to be used to advance the expansion of its new pizza outlets and acquisitions as the current environment has created some attractive earnings accretive opportunities.

What I also suspect is that Retail Food Group will beat consensus net profit expectations for 2014-15 and 2015-16 as the roll-out of new Pizza Capers and Crust Gourmet Pizza outlets is going better than envisaged.

Management initially planned to open 70 outlets in 2013-14 and 60 outlets the following year, but will now open around 85 outlets before June 30 next year.

The opening of new stores for a retail establishment is significant for earnings as each new outlet tends to give the group added operating leverage. This means net profit is likely to grow in excess of sales.

Retail Food Group also owns franchise brands Donut King, bb’s cafe, Brumby’s Bakeries, Michel’s Patisserie and Esquires Coffee Houses.

I am upbeat on the news, but I will start my recommendation on the stock with a “neutral” until I see the details of the capital raising. Stay tuned as I will give an update on Live Markets on the Eureka Report site.

(UPDATE: Retail Food Group said on Thursday morning (October 31, 2013) that it has completed a $53 million placement to professional investors and is looking to raise another $7 million from existing shareholders via a shareholder purchase plan (SPP). I believe the SPP will be very well supported and urge shareholders to participate in the raising. Further, I am upgrading the stock to “outperform” as the growth in earnings from its aggressive store rollout and acquisitions will more than offset the dilution from the raising.)

Think big, go smalls!

Uncapped 100 - Australia's most interesting small cap stocks

Small cap stocks covered by the Uncapped team
CodeNameRationaleMarket cap ($m)Total return 1-year (%)Sector (GICS)
ACR Acrux One of the most successful Australian biotechs in recent history. Widely held by instos.446.28-16.07Health Care
ACL Alchemia /AustraliaOne of the few biotechs with revenue stream. Good pipeline of oncology treatments.192.988.18Health Care
AOH Altona Mining Noteworthy copper play with Xstrata pull-out of Roseby project in Australia and the good ramp up of its Finnish project.77.17-46.3Materials
AMA AMA Group Good turnaround story but under the automotive services group is radar of most.125.3442.6Consumer Discretionary
AMM Amcom Telecommunications Well covered junior telco but good candidate for core holding.507.4667.55Telecommunication Services
AZZ Antares Energy Liquid with good insto support. Already in production with exploration upside in Texas.126.22-8.33Energy
ARP ARB Corp Well covered but good candidate for core holding due to quality management.836.0716.18Consumer Discretionary
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding.806.9554.67Consumer Discretionary
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.245.3220.13Financials
AUB Austbrokers Holdings The insurance broker is a strong performer. Widely held and well liked by small cap investors.726.0564.43Financials
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 276.3643.37Financials
BDR Beadell Resources Will be a very big FY14 for miner as it has to prove it aims to produce 200,000 ounces of gold a year.737.170.81Materials
BGA Bega Cheese Corporate interest in Australian food companies makes the cheese maker worth following.663.65152.81Consumer Staples
BGL BigAir Group The wireless microcap has gained strong following over past year or two but is often overlooked by investors and the press.142.6960.59Telecommunication Services
BNO Bionomics One of the larger cancer treatment developers in this market.288.51123.53Health Care
BOL Boom Logistics Crane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid.87.06-38.33Industrials
BRU Buru Energy Substantial size but not often covered by press. Widely held with good insto support.498.27-40.57Energy
CAA Capral An aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 92.29-2.5Materials
CCV Cash Converters International Strong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.463.6026.13Consumer Discretionary
CWP Cedar Woods Properties Property developer with good ROE and earnings growth track record.519.3975.56Financials
CUV Clinuvel Pharmaceuticals Interesting skin disorder treatment developer that has done reasonably well over past year59.24-3.13Health Care
CLV Clover Corp One of the star performers in 2012. Operates in growing but relatively stable niche.78.46-7.79Health Care
CLH Collection House In similar space as Credit Corp. Strong stock performance has attracted a following and the stock appears to be well placed to run further217.8684.77Industrials
CKF Collins Foods One of the few food franchise listed companies.157.1750.13Consumer Discretionary
CKL Colorpak The small cap packaging company has grown via acquisitions over past few years.69.3156.26Materials
CCP Credit Corp Group Strong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.455.3242.91Industrials
DTL Data#3 Well respected IT company that receives little press coverage.177.076.71Information Technology
DRM Doray Minerals Widely held by instos. One of the more favoured gold explorers by brokers.98.60-17.26Materials
DWS DWS Will be a big beneficiary if governments start spending on IT again.201.197.38Information Technology
EBT eBet Potential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.50.88230.34Consumer Discretionary
EML Emerchants Trying to change way corporates and governments disburse cash with its trackable and controllable debit card offering. If company can get $1 billion in loaded value on cards, the stock will surge.67.32440Financials
ESV Eservglobal Mobile money transfer company that has been gaining traction. Widely held by instos but low press coverage128.26157.5Information Technology
FGE Forge Group One of the better performers in its industry. Good track record and potential core holding.387.7616.68Industrials
GEM G8 Education Only listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.942.95136.67Consumer Discretionary
GXY Galaxy Resources Good upside potential if it can get its problem-prone Jiangsu plant back on track. Won't be easy to right this ship.62.46-80.83Materials
GHC Generation Healthcare REITOne of the more interesting REITs. Income is more defensive than typical property stock and its greenfield expansion gives it earnings growth potential.120.8835.51Financials
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal liner on diabetics.322.7147.77Health Care
GXL Greencross Acquisitive veterinary group. Good profit growth and share price performance, but gets little press.238.35102.51Health Care
HSN Hansen Technologies Operates in a high potential/growth industry but is not covered by press or brokers.174.2234.25Information Technology
HZN Horizon Oil One of better regarded small energy stocks that doesn't receive much media attention.432.63-11.3Energy
IMD Imdex Drilling company is well supported by instos and should benefit from any rebound in exploration activity.159.43-41.57Materials
IMF IMF Australia Litigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.264.7725.72Financials
IFM Infomedia Interesting tech play in the car parts market. Strong share price gain but gets little air play.182.9784.1Information Technology
IPP iProperty Group Worth watching as it is trying to be the REA Group of Asia.336.49106.11Information Technology
JIN Jumbo Interactive Innovative small cap facing off industry dominated by giants. Worth watching to see if it can carve out a profitable global business.111.5743.53Consumer Discretionary
KOV Korvest The construction products and services supplier has been hit by project delays and deferrals. But its relatively high yield could give it some support.51.13-8.32Industrials
LGD Legend Corp Electronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.71.340.62Information Technology
LCM LogiCamms Strong price performance and reasonable valuation attracting interest.135.2484.72Industrials
MTU M2 Telecommunications Group Amazing growth story and well run company. High free float and strong insto support.1,133.0572.32Telecommunication Services
MXI MaxiTRANS Industries Transport equipment maker posted good interim result. Has appealing yield and growth.210.6725.32Industrials
MYX Mayne Pharma Group Sizeable generic drug maker with interesting board members.402.87197.92Health Care
MMS McMillan Shakespeare One of the best performers since the GFC, but ongoing risk of change to FBT rules is hanging over the company.967.324.17Industrials
MCP McPherson's The personal care and household products supplier had been relatively insulated from volatile discretionary spend and online threat, but its latest profit warning shows it's not immune.119.65-21.47Consumer Discretionary
MLB Melbourne IT A perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.133.404.52Information Technology
MRM Mermaid Marine Australia Its strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.870.1219.57Industrials
MNW Mint Wireless Huge market potential if the mobile card payment solutions provider can gain market traction. Management aiming for $1 billion in transaction value a year.131.261811.77Information Technology
MOC Mortgage Choice Has a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.364.1283.38Financials
MYS MyState Well regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.425.4340.47Financials
NAN Nanosonics A successful medical tech story. Should be close to turning in maiden profit with its disinfection device.218.1458.1Health Care
NEA Nearmap A stellar performer with an Interesting business that offers high quality aerial maps to companies & government.172.991428.57Information Technology
NTC NetComm Wireless Under appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.30.8984.62Information Technology
NWT Newsat Potential large cap if it can launch its own satellite in 2015.295.620Telecommunication Services
NXT NEXTDC The cloud computing company is an IT sector darling. Fairly widely held and followed.491.2025.63Telecommunication Services
NHF NIB Holdings /AustraliaOnly listed health insurer. Widely held. Good performer.1,071.1741.06Financials
NWH NRW Holdings One of the better regarded mining & civil contractors with good track record in delivering on projects.394.63-23.5Industrials
OTH Onthehouse Holdings Alternative small cap to online property leader REA Group. It is trying to use more timely housing data as a competitive edge against REA.63.6930.31Consumer Discretionary
PGC Paragon Care Emerging hospital equipment supplier that has been ignored by market.19.27134.54Health Care
PFL Patties Foods Illiquid stock but has suite of well recognised consumer brands. Defensive yield.191.22-12.98Consumer Staples
PEN Peninsula Energy Widely held by instos and large free float. It's the only uranium miner on the list.71.21-34.72Energy
POH Phosphagenics Sizable biotech with a game changing FY14 year ahead. Good insto following but questions of poor audit and governance standard could dog company.137.76-12.9Health Care
RCG RCG Corp The footwear retailer is one of the best performing consumer stocks as online competition is not a big threat. Company has a good yield as well.186.3386.28Consumer Discretionary
RCR RCR Tomlinson Good first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?504.41114.83Industrials
RKN Reckon Fierce competition for cloud base accounting software puts it in firing line.301.043.8Information Technology
REX Regional Express Holdings Well run airline that is overshadowed by Virgin and Qantas.113.94-15.16Industrials
RFG Retail Food Group Owns a number of well know franchise brands. Widely followed by instos.597.1547.32Consumer Discretionary
RIC Ridley Corp High corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.263.18-19.37Consumer Staples
RUL RungePincockMinarco IT company to resource industry. Facing tough operating climate with new CEO trying to restructure and turnaround company.84.8142.86Industrials
SAR Saracen Mineral Holdings Emerging gold producer that is widely held by instos. Hitting milestones and looks cheap. Key asset is close to gold majors, which makes it a potential takeover target.142.86-50.52Materials
SHV Select Harvests Noteworthy for turbulent past and exposure to soft commodity market.247.45278.8Consumer Staples
SLX Silex Systems Its uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.408.61-31.43Information Technology
SIV Silver Chef Strong jump in the share price of the equipment financing group has attracted a good following.238.7879.35Industrials
SRX Sirtex Medical A shining star in the biotech space and one of the best performing stocks in 2012. Great product (liver cancer treatment) and bright outlook.691.5414.45Health Care
SFH Specialty Fashion Group In early stages of turnaround. Can the women's apparel retailer sustain the momentum?173.0171.86Consumer Discretionary
SPL Starpharma Holdings Noteworthy for its good pipeline of innovations. Well run, widely followed.253.62-44.22Health Care
SGN STW Communications Group One of few companies able to benefit from online shift. Widely held and good insto support.629.9757.8Consumer Discretionary
SEA Sundance Energy Australia Analysts have a favourable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.506.5639.49Energy
TAN  Tandou The only direct equity exposure to cotton prices. Also trades water rights and receives little press.70.1517.75Consumer Staples
TGR Tassal Group Salmon farmer is finally turning a corner with an improved harvest strategy and growing demand for product.479.08137.79Consumer Staples
TFC TFS Corp The sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.212.51102.46Materials
TSM ThinkSmart Potential turnaround story worth keeping eye on.63.3081.4Financials
TGA Thorn Group One of few retail stocks that is performing well. The Radio Rentals chain owner is also well supported by instos.376.7135.34Consumer Discretionary
TGS Tiger Resources Future lies in its Kipoi copper mine expansion in the Congo but miner is fully funded with DRC govt holding 40% stake in tenement. Next 12mths will be interesting.266.538.22Materials
TOX Tox Free Solutions Widely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.438.6418.4Industrials
UML Unity Mining Growing Tassie gold producer with high free float. Valuation looks compelling too.42.82-54.81Materials
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.109.12-32.07Health Care
UXC UXC Company has turned corner and enjoyed re-rating. What's next?299.7311.59Information Technology
VOC Vocus Communications Telecom stocks are in favour but Vocus is one of the least covered217.9149.6Telecommunication Services
WDS WDS Widely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.126.6555.06Industrials
WBB Wide Bay Australia The building society is trying to turn its fortunes around. Also worth watching for its exposure to Queensland housing market, particularly around major resource projects.214.17-8.05Financials
YTC YTC Resources Next 12-mths will be eventful after YTC secured funding for its projects from Glencore.69.664Materials
Source: Eureka Report, Bloomberg