2018 Small Cap Portfolio Outlook

This week the TAMIM Australian Equity Small Cap Individually Managed Account team present their portfolio outlook for 2018. A more stock-focused piece than the other TAMIM outlooks, this is a must read for any small or micro cap enthusiasts (read investors).

As we start the new year, we review our key holdings and explain why we are very excited about the potential of these holdings heading into 2018. As set out below, all the holdings represent a very powerful combination of value (trading on low earnings multiples) and of growth (expecting strong increases in revenue and earnings). The companies generally are unknown or otherwise misunderstood by the market, therefore offer significant upside potential when they do become ‘discovered’. 

​Zenitas Healthcare Limited

Market Cap: $81m

Allied healthcare company Zenitas (ASX:ZNT) owns the largest network of physiotherapy clinics in Australia, the largest aged care podiatry business as well as a network of general healthcare practices and home care support businesses. 

It reported a strong trading and operational update at its recent Annual General Meeting, and advised it is on track to pay its maiden dividend. FY18 EBITDA guidance of between $13m to $13.5m (an increase  from $7m in FY17) was re-affirmed. 

We believe ZNT continues to trade on a low multiple (11x earnings) for a defensive, diversified (by geography and funding source) business with a large runway of organic and acquisitive growth opportunities. 

Management are executing with diligence and confidence. The expanding depth of the management team and its operational systems is particularly encouraging, 

The company’s balance sheet is extremely strong, as it has recently undertaken a $35m capital raising. The raising was underwritten by an Asian healthcare investor with strong ties to Australia through the Aveo aged care business (and which now has a 11% holding in ZNT).

In summary, the business offers a powerful combination of value (with the multiple of 11x earnings representing a 40% discount to the sector average of 18x) and growth (organically at 10% and through acquisitions).

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Pioneer Credit Limited

Market Cap: $179m

​Financial services company Pioneer Credit (ASX:PNC) provided a trading update at its recent AGM where it noted that its revenue and profit were tracking to expectations.  

FY18 NPAT is expected to be at least $16m as the company had previously guided. This represents a 48% increase in its profit from the previous year.

PNC has also spent many years developing new financial products and services that it intends to offer in part to its significant (rehabilitated) customer book as well as other consumers. 

Financial services products will represent an increasing focus for PNC over the next several years, and, if executed well, will provide significant revenue diversification and upside to the company’s valuation. The market is not currently assigning any value to this segment of the PNC business. 

Trading on 11x earnings, PNC again represents a fast growing business (48% growth expected in FY18) trading on a very low multiple relative to its peers and the market. 

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Konekt Limited

Market Cap: $48m

Workplace services provider Konekt (KKT) held its AGM during November. At the AGM, KKT confirmed forecast revenue growth of more than 70% and underlying EBITDA growth (excluding one-off items) of greater than 70%.
 
A key focus of the AGM was therefore on updating the market on its recent Mission Providence acquisition – pleasingly, KKT noted that there have been no surprises following completion and that the business was tracking to expectations. The acquisition diversifies KKT’s existing revenue streams, and enhances its ability to provide return-to-work (RTW) employment services, to complement its existing core offering of delivering RTW injury management programs (essentially managing the process of rehabilitating injured workers and getting them back into jobs – and where it is the current national market leader). 

A private equity fund has recently bought a majority shareholding in one of KKT’s key competitors – APM (the largest provider of disability employment services to the Federal Government). Apart from this transaction, there has been growing private equity interest in the sector – possibly driven by the potential to capture some of the increasing amount of government funding committed to the disability sector.
 
KKT continues to trade on a PE multiple of less than 10x, with EPS growth (excluding amortization, abnormals and potential cost synergies) of 15% - 20% forecast over the next two years – again a powerful combination of value and growth. 

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Dreamscape Networks Limited

Market Cap: $82m

​Dreamscape Networks (ASX:DN8) is Australia’s largest domain name (30% market share) hosting company through its “Crazy domains”  business. It operates a very favorable business model where it is paid cash in advance to service a 2 or 3 year hosting subscription. While this business is low growth, the very strong and stable cash flows ($12m pa) generated by the business support its current market capitalisation of $82m

While the Australian business is mature, Dreamscape see real potential to replicate its Australian success in gaining market share in the markets of South East Asia. South East Asia is the fastest growing internet market in the world with 3.8 million people coming on line each month, and the market growing at around 25%pa.
To this end, Dreamscape is emerging as one of the largest South East Asian Online Solutions providers, and is now Singapore's largest Hosting provider. Dreamscape is building out from its dominance in Singapore into adjacent geographies of the Philippines, Vietnam, Malaysia and Indonesia.

Given the cash flows of the Australian business essentially support the current value of the company, we view this as an opportunity to acquire a free option over the success of the South East Asian operations, which based on the success to date, looks like having a very attractive pay off.  

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​Joyce Corporation Limited

Market Cap: $40m

Diversified investment company Joyce Corporation reported a strong trading update at its AGM in respect of each of its businesses lines:

• Lloyds online auctions – revenue growth for Q1 of FY18 of 61%
• KWB Kitchens - revenue growth for Q1 of FY18 of 13%
• Bedshed network - revenue growth for Q1 of FY18 of 5%
• Investment properties – both now generating external rent with re-valuation gains expected.

JYC continues to invest in the intellectual property and development of each business unit to ensure long term sustainable growth. JYC reiterated that on the whole, its businesses are resilient to economic cycles and are unlikely to face any significant threat from Amazon. 

To summarise our investment case here, JYC has interests in:

• The fastest growing, and one of the largest, online auction sites in Australia (FY17 revenue growth of 56%, and YTD growth of 61%);
• The largest specialist kitchen renovation business in Australia; 
• A large bedding and furniture franchise business; and
• Approximately $20m of recently refurbished real estate.

We view the sum of each of these equity interests to be significantly higher than JYC’s current $40m market cap. JYC continues to trade under 10x forecast earnings and is on a 9% yield. 

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Blackwall Limited

Market Cap: $52m

Blackwall Limited (BWF) - fund manager, property manager and manager/developer of the Wotso shared workspace business, held its AGM during November. BWF highlighted that by locating its Wotso workspaces in city fringe and suburban sites, it is able to achieve industry leading margins of 25% to 30%. This is because it incurs significantly lower rental expenses but is still able to charge similar rates for its spaces as city-based co-working spaces. 

Wotso is a very fast growing business - during FY17, Wotso grew its revenue by 84% and operating profit by 93%. It manages the largest number of co-working sites in Australia, together with a Singaporean business, and is currently looking at New Zealand opportunities. 

BWF has a number of  investment assets on its balance sheet – we estimate BWF’s net assets to be worth approximately $35m in total.

Deducting the value of these net assets from BWF’s market cap of $52m implies that BWF’s three growing profitable operating businesses (the fast growing Wotso business, and BWF’s fund and property management businesses) are being valued in total at just $17m.  The fund management business has generated performance fees of $14m in the last 6 months alone! To provide an indication of sector values for larger co-working companies, we note that WeWork, the world’s largest co-working company and Wotso’s largest Australian competitor, is currently valued at an incredible 20x its forecast annual sales. (Wotso’s annual sales are currently tracking at approximately $8m). 

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​Paragon Care Limited

Market Cap: $128m

Healthcare equipment and consumables supplier, Paragon provided revenue and EBITDA guidance at its AGM which was in-line with market expectations and translates to ~10% organic EPS growth for the year (pre any acquisitions).

A number of growth drivers for PGC were articulated in the AGM presentation:

• A growing demand for the provision of preventative equipment service and maintenance throughout the medical, scientific and allied health industries, with these recurring service revenues now expected to contribute ~10% of PGC’s FY18 revenues;
• Extending PGC’s geographic footprint – i.e. the rolling out of a new South Australian warehouse and logistics site in January 2018. Queensland and New Zealand are areas that remain underserviced by PGC;
• PGC continues to benefit from increasing demand in the aged care sector with these revenues increasing 20% to $14m for FY17
• PGC’s e-health offering Midas, a web reporting software platform, is making strong progress towards contributing profit; and
• Strong pipeline of value accretive M&A to add to PGC’s product range, service and maintenance offering and geographical footprint are being reviewed.

Whilst the current PGC share price is disappointing, we expect the PGC share price to be materially higher this time next year. PGC have stated some aggressive financial targets (revenue of $250m and EBITDA of $37.5m) - and have an excellent track record in achieving its targets. 

PGC trades on 12x forecast earnings – a significant discount to the market average (17x)  given the quality of the business and its track record.

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Gale Pacific Limited

Market Cap: $104m

​Shade cloth manufacturer and retailer Gale Pacific (ASX:GAP) reported that trading during the first quarter of FY18 had been adversely affected by a poor grain season in Australia as a result of a very dry winter, leading to reduced demand for grain cover fabrics, and hurricanes affecting key retail markets in the south of the USA (Florida and Texas). 
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As a result, earnings in the first half will be below the prior corresponding period.  GAP, however, are confident of a strong second half performance, driven by strong momentum in the Americas where GAP have already secured significant product ranging commitments in its core window shade and shade sail categories. 

As a result, GAP’s guidance for the full year is for earnings slightly above FY17’s underlying pre-tax profit of $13.5 million. This would see GAP generate ~3.5c of earnings for  FY18 (current share price is 36c) so is on a PE of 10x for a growing global manufacturing business, that has strong  distribution channels, and is experiencing very rapid growth in America,  including generating very strong sales through Amazon.

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Apollo Tourism and Leisure Limited

Market Cap: $286m

​Apollo Tourism and Leisure (ASX:ATL), a leading integrated, global player in the RV (recreational vehicle market) – manufacturing, importing, retailing and renting RVs in Australia, NZ, United States and Canada, reported a positive update, with growth in international visitor numbers forecast for all geographic regions that it operates in. Management has advised that forward rental bookings are tracking well across all geographies as guided, with NZ and Canada emerging as key growth regions.  

Sales of RV vehicles remain strong, with ATL well placed to drive market share growth from its recent purchase of RV dealerships. 

Growth into FY18 for ATL will be supported by earnings contributions from its recently acquired Australian caravan and motorhome retail operations and its new wholly-owned Canadian RV subsidiary, CanaDream Corporation  -   one of the largest RV rental and sales companies in Canada. FY18 results will benefit from 12 months of SydneyRV & Kratzmann, 11 months of CanaDream & 10 months of George Day, and Apollo noted it has confidence in the quality of its recent acquisitions, all of which have been accretive and at least tracking in line with expectations. 

ATL is a growing international business, supported by encouraging thematics, and well led by experienced industry operators who continue to own the majority of the company.

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