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Some Potential Winners And Losers In The Year Ahead

Australia | Sep 24 2013

This story features G8 EDUCATION LIMITED, and other companies. For more info SHARE ANALYSIS: GEM

-Small industrials provide upside
-Scope too for small resources
-Optimism about internet savvy stocks
-Transport maintains low expectations

 

By Eva Brocklehurst

What is in play in the year ahead for equities, small-medium cap stocks in particular? Where do investors need to line up?

There is growing belief that FY13 will represent the bottom of the downgrade cycle and Citi notes small cap price/earnings ratios are now at the highest level since December 2007. This suggests to the broker that valuations are not as far fetched as they appear at face value. Citi prefers industrials, particularly those with some cyclical leverage, given the material earnings downgrades over the past 12 months and the resulting underperformance in the price. There's also scope for increasing exposure to small resources as the global growth cycle improves.

On a risk adjusted basis, some of the broker's preferred small cap industrials include SAI Global ((SAI)), G8 Education ((GEM)) and Amcom ((AMM)).

Following the decision by the US Federal Reserve to maintain bond purchases, the gold price rallied over 4% in US dollar terms, demonstrating the sensitivity of gold to money supply growth. Looking forward, Deutsche Bank expects tapering uncertainty may return for the Fed's October meeting but the first move is now forecast to be in December. Hence, the bounce in gold is expected to be short-lived and  long term interest rates, the equity risk premium, and the US dollar will eventually conspire against a sustained rally in the precious metal. The broker's preferred small gold exposures are Beadell Resources ((BDR)), Independence Group ((IGO)), Papillon Resources ((PIR)) and Alacer Gold ((AQG)).

Small resources may have been a value trap over recent years but Citi is increasingly comfortable with holding them, given the magnitude of downgrades over the past year and the fact the sector has been able to consolidate on the strong rally in the last three months. A preference is retained for small names with production exposure such as AWE ((AWE)) and Mt Gibson Iron ((MGX)).

Moelis found reporting season produced results that were generally satisfactory, against low expectations, but thinks small industrial valuations are now relatively full. The primary uncertainty is the timing of economic recovery. In particular at what point in 2014 it will occur. Which stocks stand ready to take advantage? A positive performance has been seen, and should continue, from the internet-driven stocks that are leaders in their respective segments such as Carsales ((CRZ)), REA Group ((REA)) and SEEK ((SEK)). Despite being a proxy for the sluggish domestic economy, Skilled Engineering ((SKE)) has been resilient and is now seen benefiting from successful cost base restructuring.

Consistent downgrades have remained a feature for the IT services sector through FY13 as projects were on hold given the uncertain economic and political background. Moelis sees further downside risk for IT services over the next 6-12 months given a likely ongoing deferral of both government and private sector activity around the federal election. An exception could be UXC ((UXC)) which has sustainable positive operating momentum from recent contract wins and ongoing targeted margin expansion.

GWA Group ((GWA)) is the broker's preferred exposure to the building sector recovery, as more than 85% of earnings are exposed to housing and renovation. Moelis is cautious toward companies positioned in the central areas of the retail sector where weak brand strength makes them vulnerable to ongoing private label substitution. Billabong International ((BBG)) and Pacific Brands ((PBG)) were cited as having ongoing earnings risk through FY13 as they need to make significant structural changes to their business models.

Global minerals services were the relative basket case in the earnings season as major resources stocks to control costs and the juniors were unable to raise new funds. Moelis is particularly concerned about Boart Longyear ((BLY)) given its demonstrated margin leverage to activity levels that has seen guidance for 2013 repeatedly revised downwards while the debt load poses considerable dilution risk to existing shareholders should its bankers force an equity issue. As a supplier to Boart, Imdex ((IMD)) is therefore likely to suffer from cost and volume pressures too, although oil and gas divisions will be supported by domestic coal seam gas activity. Ausenco ((AAX)) represents a late-cycle exposure to exploration and so the broker expects the impacts of the downturn to still flow through.

Stocks exposed to operations and mining volumes are preferred, although there are major disparities across this segment. Bradken ((BKN)) stands out for Moelis in being able to benefit from domestic volume increases via its own range of mining consumables. A contrast is Austin Engineering ((ANG)), hit by the coal downturn. Moelis expects both Emeco Holdings ((EHL)) and Macmahon Holdings ((MAH)) will continue to suffer, given the impact of industry pricing pressures with financial risks of over geared balance sheets a threat to shareholder equity.

UBS has looked at the transport sector volumes as optimism improves around the domestic economy. In this regard Toll Holdings ((TOL)) and Asciano ((AIO)) have outperformed. The lack of real time transport data in Australia makes it difficult to judge whether volumes are starting to recover and UBS notes the data up to July shows a broadly flat trend. Toll's Australian businesses only generated 2% top line growth in the June half, while Asciano’s domestic businesses were challenged by flat market container volumes and negative rail volumes. Both companies are predicting a continuation of these conditions into FY14, thereby setting the market up to retain low expectations.

UBS calculates Toll has 55% of its earnings directly exposed to the domestic economy whereas Asciano has 45%. Taking account of the different fixed cost profiles, relative earnings mix, and gearing the broker estimates each extra 1% growth in domestic volumes would drive a 3-4% rise in profit for each company. UBS recognises the earnings leverage in Toll (Neutral) from any improvement in global trade volumes but currently prefers Asciano (Buy) from better utilisation of contracted coal tonnes resulting from strong coal exports.

Dealer groups are Moelis' preferred stocks in the financial services sector. Flexigroup ((FXL)) is expected to obtain similar benefits from the Lombard purchase to what Certegy achieved and improving consumer sentiment should be reflected via improving lease volumes. In contrast, the broker doesn't favour Cabcharge ((CAB)) given the regulatory and technology risks faced by the payments operation in view of the Victorian reforms that will be implemented over the next few years.
 

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CHARTS

AMM ANG BLY EHL GEM GWA IGO IMD MAH MGX REA SEK

For more info SHARE ANALYSIS: AMM - ARMADA METALS LIMITED

For more info SHARE ANALYSIS: ANG - AUSTIN ENGINEERING LIMITED

For more info SHARE ANALYSIS: BLY - BOART LONGYEAR GROUP LIMITED

For more info SHARE ANALYSIS: EHL - EMECO HOLDINGS LIMITED

For more info SHARE ANALYSIS: GEM - G8 EDUCATION LIMITED

For more info SHARE ANALYSIS: GWA - GWA GROUP LIMITED

For more info SHARE ANALYSIS: IGO - IGO LIMITED

For more info SHARE ANALYSIS: IMD - IMDEX LIMITED

For more info SHARE ANALYSIS: MAH - MACMAHON HOLDINGS LIMITED

For more info SHARE ANALYSIS: MGX - MOUNT GIBSON IRON LIMITED

For more info SHARE ANALYSIS: REA - REA GROUP LIMITED

For more info SHARE ANALYSIS: SEK - SEEK LIMITED