Understanding Small Cap Trends
Since the outset of 2022, small-cap stocks have been navigating a challenging terrain. The Small Ordinaries index has witnessed a decline of 22%, exacerbating further when excluding resource companies. This downward trend extends to the Small Industrials index, plunging by 24%. The disparity between small and large-cap industrial firms has widened, echoing levels last seen in 2014 and nearing a 20-year low.
Despite prevailing headwinds, there are glimmers of optimism on the horizon. With interest rates approaching cyclical peaks and economic fundamentals showing signs of improvement, there's cautious optimism in the air. Moreover, early indications suggest a shift in investor sentiment, accompanied by stabilised trading volumes, hinting at a potential turnaround.
Flight Centre
With everyone travelling post COVID, Flight Centre’s earnings are quickly recovering and we recently upgraded the stock to a BUY recommendation with a A$26.25 price target. Flight Centre (FLT) was founded in 1982 and has grown since to then to have company-owned operations in 23 countries and a corporate travel management network that spans more than 90 countries and is the fourth largest in the world.
Flight Centre didn’t waste a crisis during the COVID travel downturn. It used this period to transform its business model. Its Leisure business will have a materially lower cost base in the future as it has reduced its store count by over 50% and has diverted this business to lower cost operating models including online channels, independents and home-based agents.
It is rightly now focused on the high growth and high margin luxury segment of travel following its acquisition of Scott Dunn (UK, US and Singapore). Flight Centre’s agents are now more productive thanks to the new systems it put in place during COVID. Leisure is benefiting from pent-up demand and consumers prioritising travel spend over other retail categories. As airline capacity returns and airfares come down, we expect this will support further strength in demand for travel as it becomes more affordable.
FLT has the greatest risk, reward profile of our travel stocks under coverage. The risk is centred around execution given its changed business model, while the reward is material if FLT delivers on its 2% margin target. If achieved, this would result in material upside to consensus estimates and valuations. FLT is now targeting to achieve this margin in FY25.
Consensus assumes 1.5% margin and Morgans assumes 1.7% margin. We wouldn't be surprised if Flight Centre upgraded its FY23 earnings guidance further in June/July as May and June are the company’s biggest trading months. Cash flow is strong, especially as tax losses accumulated during COVID mean it won’t be paying tax for years, and this might lead to capital management.
In short, with greater confidence in the travel recovery and the benefits of Flight Centre’s transformed business model starting to emerge, we think the company is now at the cusp of an earnings upgrade cycle which may continue for the next few years and drive a material rerating in the share price.
Super Retail Group
With the cost of living crisis weighing heavily on consumer confidence, investing in discretionary retail stocks is a tricky undertaking at present, but there are some good opportunities for those with a longer-term time horizon. Super Retail Group (SUL) is a case in point. Super Retail is the umbrella organisation with four of the best known general retail brands in Australia and New Zealand; Supercheap Auto, rebel Sport, BCF and Macpac.
With a network of more than 700 stores and a number of high traffic websites, it has incredible reach to the domestic consumer. Sales spiked during COVID, given consumers had more time on their hands for leisure pursuits close to home. Even since COVID, demand has been resilient with sales over the past few quarters surprising investors on the upside.
The resilience of sales reflects the low average transaction value (90% of products are priced below $100) as well as a massive 10 million loyalty club members. Super Retail’s brands lean into the leisure pursuits of the Aussie consumer and it would be a very severe downturn indeed that would see many of us stop spending on fishing, footie and floor mats.
Many people see Super Retail as a mature in terms of its store rollout opportunity, but we think network augmentation is on the agenda. The group has invested in new concepts stores such as rebel rCX and BCF superstore (large format store) to great success. These stores are, in some respects, pushing back the boundaries of the customer experience and have led to a significant uplift in store revenue.
Not to be left out, Supercheap Auto has started a programme of store refreshment, with a series of locations converting to the Generation 4 format. There is more to come. Super Retail has net cash to fund ongoing store capex and we also see potential for capital management in the form of a special dividend or buyback. We think this could be announced at the upcoming result in August.
Whilst discretionary retail is somewhat out of favour, and consumer sentiment is at near record lows, we think that as inflation starts to moderate and the RBA stops tightening rates, the tide will turn and investors will seek out exposure to high quality retailers, with good trading liquidity and upside to earnings expectations. Super Retail is a great place to start.
Objective Corporation
Objective Corporation (OCL) is a best-in-class specialist software business, servicing the public sector and highly regulated industries. The business designs and develop Enterprise Content Management (ECM), regulation workflow, and Planning and Building Solutions, which are central to the day-to-day operations and workflow management of various government organisations within Australia, New Zealand and the UK.
Because of this defensive customer base, the company has strong recurring revenue and low levels of churn. Global Public Sector software spend is anticipated to grow at a low double-digit rate over the near term as governments look to streamline workflow, improve security, and modernise legacy IT infrastructure. We see Objective as being a beneficiary of this trend.
The launch of Objective’s new Nexus and Build products, as well as expansion into new under-represented and materially larger markets such as the US and UK, should unlock opportunities for annual recurring revenue growth over the medium term, with the company showing positive early adoption and interest from customers.
Objective has seen a strategic reset in its earnings in FY23 as it looks to prioritise subscription licencing revenue growth, streamline deployment of its solutions, and invest in product and sales support functions. Whilst this has recently weighed on the company’s share price, we believe Objective should be well positioned to see long-term revenue growth rates and margins return in FY24 and beyond.
The company is also strongly capitalised and well positioned to take advantage of M&A opportunities as private market technology valuations have contracted, which in our view could add incremental scale and scope for long-term growth.
Dalrymple Bay Infrastructure
Dalrymple Bay Infrastructure (DBI) owns the long-term lease to the 85 mtpa Dalrymple Bay Terminal (DBT). DBT is an open access export terminal located in central Queensland servicing relatively captive coal export mines in the Goonyella rail system. Approximately 80% of the coal processed through the terminal is metallurgical coal, which is a critical input to steelmaking. We like DBI for its yield, defensive attributes, and growth potential.
DBI recently hosted its AGM, where it provided first-time distribution guidance for the 12 months from 1 July 2023. Guidance was for annual DPS growth of 7% to 21.5 cps (paid quarterly), which is equivalent to the CPI escalation of the base element of DBT’s Terminal Infrastructure Charge. At current prices, this implies a cash yield of around 8% (and the distribution will likely be partly franked).
Furthermore, DBI reaffirmed its expectation to grow DPS by 3-7% pa for the foreseeable future; our expectation is that the growth in the distribution will be linked to the CPI tariff escalation. We think the distribution yield and growth guidance is attractive given the numerous risk mitigants that support its payment. DBT is protected from volume risk via 100% take-or-pay contracts combined with revenue socialisation (protects DBI from customer payment default or contract expiry).
Even in the case of a weather event damaging the terminal DBT will likely continue to be paid. Direct operating costs of the DBT are a 100% pass-through to the mining companies that use DBT, so only limited cost exposure at the DBI corporate level. Inflation is mitigated via annual CPI escalation of revenues. Interest rate and refinancing risks are mitigated via hedging and staggered debt maturities (albeit DBI’s debt service costs are expected to increase over time).
In most companies, increasing sustaining capex is seen as a negative as it is a drain on free cashflow without providing additional earnings. However, DBI earns additional high margin revenue as it commissions non-expansionary capex projects. This is a growth driver for DBI given it will require increasing amounts of sustaining capex (it is c.40 years old and operates in a marine environment).
DBI has committed to c.$280m of sustaining capex which when commissioned in 2027/28 we expect should add c.14% to EBITDA. DBI is also considering the 8x expansion of terminal capacity, albeit has indicated that it won’t proceed with the development without take-or-pay contracts underwriting an attractive return on the investment.
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