Faith No More For Avastra, Kip McGrath

ABN Amro has ceased coverage on two stocks, Avastra Sleep Centres ((AVS)) and Kip McGrath Education Centres ((KME)). A growth by debt based acquisition model was the culprit, with sustained underperformance and unconvincing earnings outlooks finally spooking the broker.

It wasn’t that long ago when ABN Amro took an interest in the sleep disorder market and Avastra. In April 2007 the broker said it was a growing market and the company had a first mover advantage in the US. It felt the company’s push to grow via acquisition would pay off, with strong earnings growth expected to begin to deliver in FY09.

A Buy was slapped on the stock and the price target for the next six months, until March 2008, would be set at 90c versus an actual share price average of around 60c. Acquisitions, further US expansion and solid earnings were the feature of the broker’s comments over that period, with the broker lifting its earnings forecasts several times.

But in March 2008 the cracks started to appear. The broker was spooked by management’s downgraded guidance for the full year, suspecting that there might be some serious management issues. However, it was still sold on the business model, but not enough to keep it from moving to a Hold and dropping the price target to 22c (shares were at around 17c. Are we sensing a theme?).

That was all that was heard from the broker until today, when after reviewing the FY08 result, including another raft of downgrades, it decided enough was enough. Coverage was ceased at Hold, with the target dropped down to 3c, back in-line with the current price.

The FY08 loss was $4.1 million versus the $1.6 million the broker was expecting, while the debt position was $4.8 million. A 2 for 3 underwritten rights issue was announced and the broker couldn’t see how the company would hit its FY09 forecast of  $2-$2.5 million when it was predicting a result from minus 0.5 million to a positive $1.1 million at best.

The shifting of Steven Hull from CEO to President and Medical Director of the Midwest Sleep Centres substantial Board shakeout was seen as positive by the broker, but it now wants to see a bit more liquidity in the stock and evidence of sustainable profits from the restructure before it reviews its decision.

Kip McGrath Education Centres is a similar, if more protracted story. We join the tale in June 2006, when the broker shifted up to a Buy on the stock citing at the time recent price weakness and an attractive PE. It set a target of $1.01 versus a price at around 80c after pulling back from $1.20 over the previous six months.

The broker’s call was on the mark for the next 12 months as the share price pushed past $1.50 to June 2007, seeing the target raised four times over that year to $1.74 in mid-July 2007. The broker’s comments over that period were similarly upbeat, citing a theme of strong earnings, great growth prospects through acquisitions and a cheap stock based on its valuations.

The tide turned (just a little) this time last year after the FY07 result didn’t live up to expectations. The broker kept its Buy, but cut the target down to $1.47 versus an actual price that was nearing $1.00. However, most of the accompanying commentary remained positive, with the broker predicting FY08 would be a turnaround year, acquisitions were bound to pay off and the stock was still cheap (PE of 10x and a yield of 8%).

We all know now, FY08 wasn’t much of a turnaround year for anyone.

Based upon the 1H report in March 2008 most of the shine had worn off. ABN downgraded to a Hold and cut its target to 70 versus a trading price now in the neighbourhood of 50c. Higher costs and write-downs were the culprit, with the broker losing faith in the acquisition oriented business model. 

That takes us to today, when the broker finally gave up. The FY08 result of a $4.8 million loss was down 769% on the previous year and the problem was higher-than-expected operating expenses and an unfortunate $2.3 million impairment in relation to asset write-downs. Again, the broker sees little prospect of growth going forward, with little coming from the core businesses in the previous year.