Three Small Cap Investment Ideas

Richard Hemming

ASX Small Cap Stock Tips 

We are in an unprecedented time when many of the companies that have been in the S&P/ASX200 Index, but whose share prices have dropped and are now actually Small Caps. What are Small Caps? Under the Radar defines Small Caps as companies with market valuations of less than $600m. These include owners of brands that you are familiar with. Under the Radar Stock Report is looking closely at quite a number of these “fallen angels” or what we prefer to term “accidental tourists” to work out whether they are Small Caps to buy in 2020.

These ASX listed companies all have highly recognisable brands, which is the focus of our stock reports to find out whether these ASX stocks can leverage their brand once again and make Small Cap investors big profits. 

Small Cap Investment Ideas

The ASX stocks we are talking about don’t need introductions and include Myer (MYR), Seven West Media (SWM), Kogan (KGN), City Chic (CCX) and Kathmandu Holdings (KMD).
 
Small Investors may be wondering, can these ASX companies make their way back to the big end of town, or are they value traps? In the Radar's Portfolio we've already made big profits from Kogan, so we’ve been off to a flying start. In this article we look at three such companies and examine whether they can withstand COVID-19 and generate profit growth into the future for Small Cap investors.

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Factors Small Cap Investors Must Consider

One of the key factors for Small Cap investors to consider is the "accidental tourists" leverage to digital, or online retail. This is obvious with Kogan, which has no physical stores. City Chic also has an enviable online presence. But money can be made from companies that are transitioning their business from bricks and mortar to online. One is outdoor activities retailer Kathmandu; another is Accent Group (AX1) the owner of Athletes Foot, Hype DC and Platypus, which last week announced it’s re-evaluating the size of its physical store network.
 
This is a market to make profits from stock specific fundamental analysis, which isn’t possible from simply buying market index-linked funds such as ETFs. 

Small Cap Stock Picks 

City Chic (CCX)
Share price $2.10

Women’s apparel retailer

City Chic has been a remarkable retailing success story for Small Cap investors, having risen like a phoenix out of Specialty Fashion, which sold off most of its brands to NoniB (NBL) in late 2018. After reporting an impressive 1H20 result that saw shares in the niche apparel retailer climb close to $3.60 just prior to the global outbreak of COVID-19. CCX then briefly traded below $1 and have bounced from $1.50 level in early April when we last covered it, but it’s still in the accidental tourist category.
 
Most important City Chic’s online business continues to operate. It’s been the key driver of the group’s renaissance, with its low cost base and skew to the US (80% of sales).
 
The balance sheet is sound but due to the rapidly evolving coronavirus we assume no final dividend. No interim was paid either. The company has a lot of funding capacity with a $35m debt facility (expiring February 2023) and minimal net debt ($2.6m) at the end of December comprising $14.9m cash and $17.5m debt. Including lease liabilities of $34.7m, leverage was about 1.4 times. We note that debt covenants are undisclosed and City Chic was in a much stronger position at 30 June 2019 when it had net cash of $23.2m which helped fund the US$16.5m acquisition of US e-tailer Avenue Stores in October. That said Avenue Stores has increased the groups’ online exposure, which is positive.
 
Radar Rating: We wouldn’t be chasing this stock because of the depressed economic conditions, but the company is among the best positioned to take advantage of the accelerated online trend.
 
Kathmandu (KMD)
Share price $0.71

Outdoor and surf wear retailer

Kathmandu is a potential accidental tourist, its shares having fallen about 75% since early February. Earlier this month it completed a heavily discounted NZ$207m (A$197m) equity capital raising at 49 cents a share to shore up its balance sheet. Has it saved KMD’s bacon? For now, yes. But that doesn’t mean it’s an investable proposition.
 
Essentially this company is trying to reposition itself online but it’s got a great deal of work ahead of it.
 
All stores in Australia, NZ, Europe, North America and Brazil are closed. Online is open in Australia, Europe and the US. KMD has a relatively low online presence. On a proforma FY19 basis assuming a full period of Rip Curl, online represented 9% of group sales, wholesale 25% and retail stores 66%. Some of the wholesale clients such as SurfStitch are pure online retailers, while others such as bricks and mortar retailer Surf Dive and Ski also have an online presence.
 
Radar Rating: Balance sheet risk is lower post the capital raising but earnings risk is high. The shares are still trading well above the A$0.49 entitlement offer price. We suggest those that took up their entitlements sell them to make a quick gain.
 
Seven West Media (SWM)
Share price $0.0825

Television and newspapers

One of our first accidental tourists has stabilised but is still in intensive care.
 
Management has denied a media rumour that The West Australian newspaper group was up for sale with a sales memorandum being circulated, but this business must be brutal at the moment, with negligible newsagent copy sales, advertising down in some cases by 50%, and large empty newsrooms and under-utilised print plants slowly bleeding the business.
 
We still think SWM’s net debt problem is more likely to be reduced by organic cashflow, plus asset sales (The sale of Pacific Magazines for $40m finally completed on 1 May). 
 
The core television business and advertising revenue may not have been as hard hit as the market had feared. There can be no earnings guidance in the current environment, and the postponement of the Tokyo Olympics to 2021, with its implications for costs and revenues for FY20, FY21 and FY22, has not yet been brought to account. We think that when the economy recovers, SWM revenue will resume at some level and marginal revenue in the television business tends to be very high margin. This is offset by fixed operating costs which are hard to reduce in the short term, and we expect operating losses in 2H20.
 
The stock dropped briefly after we initiated coverage, and bottomed at around 6 cents, before recovering to 12 cents at best, and is now in the middle of that range.
 
Radar Rating: We do not think that SWM will be subject to an onerous debt restructuring in the short- to medium-term. In the short-term we think it is in a trading range from 6-12 cents.
 
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About the Author

Richard Hemming

Richard Hemming (r.hemming@undertheradarreport.com.au) is an independent analyst who edits www.undertheradarreport.com.au, which provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (AFSL: 409518). The author does not own shares in any of the stocks mentioned.

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