Two small laggards ready to rebuild

The decisive election win by the Coalition over the weekend could just be the catalyst needed to turn around the fortunes of two struggling small cap stocks.

The new federal government, under Tony Abbott, is tipped to give outer suburban home construction a big boost as highlighted by Robert Gottliebsen on Saturday.

The optimism can be seen in the share price performance of large cap construction-related stocks. Boral (BLD) is up 5.4% while CSR (CSR) and James Hardie Industries (JHX) have each added 4% this week.

However, it is stocks that are just emerging from a painful restructure that are best placed to benefit from this potential rebound due to their operating leverage, which means any increase in sales will translate to a bigger increase in profits.

This is because of expanding profit margins, and companies that have undergone or are close to completing a restructure generally see an improvement in margins as they have already made big cuts to their cost base and plugged holes in the weakest parts of their business.

Capral

One stock on the Uncapped 100 that fits this bill is semi-fabricated aluminium products maker Capral (CAA).

Click to enlarge

The company has been hit by the dramatic downturn in the housing construction market, the strong Australian dollar (which makes imports look more attractive), and an oversupplied market due to a badly timed expansion of production by the local industry.

To make a bad situation worse, Capral is accusing Chinese rivals of dumping their products on the local market. Dumping refers to selling at below cost, and these offshore producers can do so and yet remain financially viable because of Chinese government subsidies.

Like most manufacturers that are struggling to keep their heads above water, Capral is undergoing a corporate transition that includes a big write-down in asset values and cost cutting.

These headwinds forced the company to post a $52.6 million net loss for the six months to the end of June this year compared to last year’s first half-loss of $7.1 million.

The negative financial impact from the restructure is one-off in nature, and this gives Capral a cleaner slate to ride any increase in demand for its products now that its cost base has been cut by a third over the past five years.

“We do have a large fixed cost in our business and we are dependent upon volume,” says Capral’s managing director, Tony Dragicevich. “A 10% lift in volume will add roughly $5 million plus to the bottom line.”

That is significant given that consensus estimates are forecasting an adjusted net profit of $2.5 million for calendar 2014 (Capral’s financial year ends in December). 

Some recovery in 2014 is already factored into expectations as sales are expected to climb 18% to $366 million. Dragicevich says it is too early to say if the estimates are conservative, but acknowledges that the risk is to the upside.

Capral’s acquisition of OneSteel Aluminium from Arrium (ARI) that was announced last week for $19 million is expected to add between $3 million and $5 million to earnings before interest, tax, depreciation and amortisation (EBITDA) in 2014.

Further, the scrapping of the carbon tax (assuming that comes to pass) will add $1 million to $2 million to its net profit. This upside is not factored into market expectations, from what I can tell.

What’s more, the stock is trading at a close to 20% discount to the company’s net tangible asset value of 23.1 cents a share.

On the downside, the $14.1 million placement to fund the OneSteel Aluminium acquisition will dilute the share base by around 19% and could pin the share price to around the 18 cents mark for the interim, as that is the offer price for the new shares.

However, risk tolerant investors could use this as an entry point for Capral due to the potential tailwinds discussed above. While things are looking up for Capral, there are a lot of moving parts where a small change in assumptions can have a material impact on its valuation.

For this reason, I have to put the stock on “neutral”.

Wide Bay Australia

Another Uncapped 100 stock that is leveraged to a rebounding housing market and that is also undergoing a major restructure is Queensland-based home lender Wide Bay Australia (WBB).

Long suffering shareholders have seen the value of their stock halve over the past three-years as Wide Bay struggled to find a way to remain relevant in the marketplace as a regional credit union facing stiff competition from larger national lenders.

Further, the risk to its loan book is higher, as lending is concentrated around resource-sensitive townships and cities like Gladstone.

It’s a double blow for Wide Bay as it is not only a higher-risk business but one with lower profitability from skinnier margins, given that its cost of funding is higher than the banks.

Wide Bay put in a new chief executive, Martin Barrett, in February this year to right the ship, and the company has only just embarked on a three-year turnaround plan.

Unlike Capral though, the upside risk for Wide Bay doesn’t come from “operating leverage” but from the release of provisioning.

Click to enlarge

Wide Bay has set aside $5.4 million for distressed loans in its mortgage insurance business, which is more than double the claims it received in 2012-13.

The outlook for the resources sector has brightened since the federal election, and that should hopefully mean higher job security. The headwinds that have led Wide Bay to forecast a pessimistic claims environment is clearly easing, and if claims came in around the $2.5 million level experienced last year it could spark a more than 20% upgrade to the $13 million consensus net profit forecast for the current financial year.

“I think it is too early to call a strong recovery, but if the housing market continues to improve, then that can actually reduce some pressure on mortgage risk,” says Barrett.

Any increase in net profit will almost certainly flow through to higher dividends as Wide Bay is committed to paying out 70% to 80% of profit as dividends. The stock’s current forecast yield stands around 8% when franking credits are included for 2013-14.

There is room for Wide Bay to re-rate too. The stock is trading just under book value, which is understandable given its chequered past. But if Barrett can instil greater investor confidence towards Wide Bay’s strategic vision and outlook, there is no reason to think that the stock could not be fetching a 40%-50% premium to book value.

A more upbeat business sentiment in the wake of the new government will also help the junior lender. The company is close to getting a banking licence and aims to start a small business lending division at the end of October.

Things can turn quite quickly for Wide Bay, but it is probably a little early to buy the stock, especially since it looks to be struggling to stay above the psychologically important support level of $5. This support level marks a 12-year low for the stock.

I have a “neutral” recommendation on the stock.

Think big, go smalls!

Brendon Lau does not own stock in Capral or Wide Bay Australia.