In an environment of continued low interest rates, the chase for yield is potentially becoming over-crowded. One solution is to find a company paying a high yield that has attractive earnings growth and is trading at a large discount to valuation. That way, when the inevitable rotation out of income stocks occurs, there will be extra supporting factors to prevent a share-price decline.
Vita Group (VTG), with its earnings now largely exposed to its long-standing Telstra relationship, provides this exposure. The forecast dividend yield is at least 6%, with a price/earnings ratio of around 10, and average EPS growth of 20% per annum over our forecast period. The share price of $0.74 cents is also trading at a 34% discount to our discounted cash flow valuation of $0.95.
I first wrote about Vita Group in March (see Vita dials into Telstra’s growth plans), when the company’s share price was trading at $0.70.
A high yield for a small cap growth stock can often be a trap, and a case of too good to be true. For example, the market may be anticipating a dividend cut, or an earnings downgrade. We don’t believe that this is the case for Vita Group and, if anything, there is upside risk to our dividend forecast of 4.2 cents for FY14.
As Alan Kohler discussed on budget night, with the company tax rate decreasing from 30% to 28.5% from July 1, 2015, there is extra incentive for companies to clear unused franking credits at the higher tax rate. This is especially relevant for Vita, with its franking balance approaching half of its $100 million market capitalisation.
Operationally Vita is well placed, with the company benefiting from the transformation towards Telstra-branded stores and away from its own struggling Fone Zone, One Zero and Apple branded Next Byte stores.
The Telstra-branded stores and business centres now comprise 104 out of the 167 Vita-owned stores. This leaves the company far better placed than in 2010, when Telstra stores only comprised 22 out of its total 171-store network.
There is a very clear growth progression that occurs with Vita-run Telstra stores. The model works successfully due to Vita’s proven strategy of store refurbishment, and sales and leadership training programs.
Typically Vita’s Telstra-branded stores will achieve annual earnings, before, interest, tax, depreciation and amortisation (EBITDA) of $220,000 in the first year, growing to $440,000 in the third year. Currently the average age of Vita’s Telstra stores is entering the third year and, as a result, there is at least two years of very strong earnings growth to flow through for Vita.
In previous years any free cash flow was automatically cycled back into the business, as the company desperately needed to transition away from its poorly performing non-core stores as quickly as possible. With this situation now largely under control, there is more freedom for the company to pay increased dividends and utilise the large franking balance.
|Vita Group (VTG) Earnings Forecasts|
Vita’s three biggest challenges
In playing devil’s advocate, we think there are three potential reasons why the market may be discounting VTG. Firstly, the expectation of increased competition in the mobile retailing space from Optus, then the overhang from ex-joint CEO David McMahon’s stake in VTG, and thirdly, the half-year write-down of the Apple Next Byte stores.
In recent years Telstra has had an advantage over Optus in the mobile space with its superior network. However, Optus will most likely catch up over the next 2-3 years, with its 4G services national coverage set to reach 98.5%. This will likely mean Telstra and Vita will have to drop prices in the mobile space to maintain market share.
Even in acknowledging this competition risk, we don’t believe it outweighs the benefits of Vita’s store maturity opportunity and the growth to flow from a diversified range of products and services.
The diversified earnings exposure includes a greater composition of earnings from services to small business (SMEs), fixed line, unified communications, NBN, broadband, cloud and managed services.
The next issue is the joint 46% shareholding between current CEO Maxine Horne and ex joint -CEO David McMahon, who has retained his stake despite no longer having any involvement with the company. McMahon was joint-CEO until January 2013, and finished as a director in June last year. At some stage we would expect that he will look to sell his stake, and this could be a contributing factor to the current discounted stock price. However, if the stake was for sale, we believe there would be excess demand to take it up in a block trade.
Lastly, at the half-year result, the company announced a $19.4 million non-cash impairment write-down of the remaining goodwill for the Apple Next Byte stores. Whilst the performance of the Next Byte stores has stabilised, management decided it was in shareholders’ interests to redeploy capital into the telco business. This meant the prior earnings projections for the Next Byte stores would not be achieved, which forced the write-down.
Next Byte (Apple) only amounts to 15 of the group’s stores and, if anything, we view the write-down as a positive. We agree that shareholder funds are better used in the telco space, and the non cash write-down has had no impact on the company’s growth aspirations.
Vita provides a high yield, high earnings, growth opportunity with expected catalysts from increased capital returns and the potential clearing of a stock overhang in the form of ex-CEO David McMahon’s VTG stake. These combine to present a buying opportunity.
There is upside risk to our forecast 6% dividend yield, thanks to the large franking balance, and earnings growth will flow from the Telstra store maturity opportunity.
We have a “Buy” recommendation and $0.95c target price and valuation.
To read Vita Group's forecasts and financial summary, click here.