Outlook For Small Industrials Appears More Sustainable

This story features DOMINO'S PIZZA ENTERPRISES LIMITED, and other companies. For more info SHARE ANALYSIS: DMP

-FY14 forecasts looking more realistic
-Small industrials outperform in August
-Strong revenue growth underscores Buy-rated stocks
-Margin risk underscores Sell-rated stocks
 

By Eva Brocklehurst

Are FY14 expectations looking more realistic for the small industrial and emerging company sector? Citi thinks so. So does Morgan Stanley, with some caveats, as FY13 results were marginally positive compared to expectations. Morgan Stanley thinks revenue growth will still be a challenge and there remains a bias towards bigger stocks.

There have been some downgrades after the FY13 reporting season but Citi thinks the worst has now passed. Profit growth for the small industrials sector was 4.6% in FY13, well below the 10% expected at the start of the year. There are signs the global economy is synchronising gears and there is the further stimulus from lower interest rates on the local front. Citi is forecasting bottom-up sales growth for the sector of 9.5% for FY14 while earnings per share growth forecasts are stronger, at 14.9%. Morgan Stanley finds the small industrials outperformed large industrial peers in August, as evidenced by Navitas ((NVT)), Domino's Pizza ((DMP)) and Cardno ((CDD)).

Citi's preferred stocks based on this outlook include G8 Education ((GEM)), which is delivering strong revenue growth and has significant balance sheet capacity to drive earnings opportunities. Another education stock which has strong earnings leverage is Navitas. Morgan Stanley has an Overweight recommendation. A return of foreign student volumes to Australia should, given recent price trends, procure margin expansion and growth in return on capital invested. SAI Global ((SAI)) is another for whom Citi thinks the worst has passed. The stock hit guidance for the first time in 18 months and there is plenty of room for Compliance division margins to improve. Morgan Stanley has also reiterated an Overweight call for this company, considering the earnings as defensive with long-term structural drivers. 

Mining service names outperformed in August and for Morgan Stanley the question is now: how high can they bounce? Some expectations may be pared back through the AGM season in October and November. In this segment the broker prefers Mineral Resources ((MIN)), Tox Free Solutions ((TOX)), Mermaid Marine ((MRM)) and Ausdrill ((ASL)). Morgan Stanley thinks Ausdrill is one of the most undervalued stocks in the Australian emerging company sector. The FY14 price/earnings ratio is still just 5.9%, despite the 87% rise in the stock price from the July low. Revenue, rather than margin, remains the key risk.

Cardno is another emerging company which the broker thinks will show continued growth, forecasting 10% profit growth in FY14. Mermaid Marine continues its strong record and, significantly, has announced a $100m vessel contract, which underpins earnings and moves the stock up the contractor supply chain. Contrary to most resource-linked names, Morgan Stanley expects Mineral Resources to grow FY14 earnings by 30%. Price realisation remains a risk but the volume drivers for this growth are considered largely in place.

Citi also likes Forge Group ((FGE)), which has had a big win with a Roy Hill contract and has growth potential with its power business roll-out in Asia and Africa as well a the US asset management business. On Morgan Stanley's list of those favoured by a significant contract win is Tox Free, where a $170m contract with Chevron provides a significant increment to the company's sustainable earnings base.

Others rated Buy by Citi include Amcom Telecommunications (AMM)), with ongoing growth, and NextDC ((NXT)), with strong sales from existing businesses and pre-sales for the Sydney data centre. Morgan Stanley also has greater conviction on software service company, CSG's ((CSV)) turnaround, with sustained annuity earnings growth seen over a 4-5 year horizon, supported by a 9c pay-out. An Overweight call on UXC ((UXC)) is also retained, as the company continues to take share in a tough market. The acquisition of Domino's Japan has underscored Domino's Pizza's compelling growth profile, according to Morgan Stanley, tarnished only by cost issues in Europe.

On the Sell-rated side in the sector for Citi is Wotif.com ((WTF)), where heightened competition remains a risk to margins. Morgan Stanley is also worried about Wotif.com, seeing structural challenges from increased competition and the response to that competition underlining an Underweight call. Jetset Travelworld ((JET)) has negative momentum across all its divisions and Morgan Stanley thinks the company is at risk of losing share in FY14 and FY15. Citi has a Sell on GUD Holdings ((GUD)), where margins are compressing and the medium-term outlook for industrial products is modest. Emeco ((EHL)) is another where Morgan Stanley expects losses for at least the next 12 months.

Fantastic ((FAN)) has guided to a weak second half and the focus is on strategies to capture opportunity in both top-line growth and ultimate margin expansion. Morgan Stanley notes trading conditions are still tough and retains an Underweight recommendation. A second year of double digit earnings decline is also considered likely for SMS Management & Technology ((SMX)). Despite cutting forecasts aggressively Morgan Stanley finds the downside risk still lingers and there is a risk to the stock's premium rating in the near term.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms