A stock we ‘think’ is cheap

Matthew Kidman

Centennial Asset Management

This time last year, I was nominated to put forward my best stock idea at the Future Generation Investment Forum. The stock I chose was HRL Holdings. At the time Livewire reached out to reflect on the thesis, HRL had gained 50%. Off the back of their recent AGM however, the stock has seen a hiccup. In this wire, I take a look at what the recent hiccup means, what we are closely watching, and nominate another microcap that we ‘think’ is cheap today.

HRL Holdings (HRL)

HRL Holdings is a diversified environmental and geotechnical service provider with offices and laboratory facilities across Australia and New Zealand.

The business has 3 main operating divisions:

  • Hazardous Material Testing
  • Geotechnical Services
  • Food/Environmental Testing

Our Initial Thesis

We initially took a position in HRL at 8.5c/share on the back of a capital raise to acquire a New Zealand based specialist testing business called Analytica. This acquisition enabled HRL to enter the higher value environmental and food/agriculture testing market in comparison to its existing business which focused on more commoditised processes such as asbestos testing.

At 8.5c/share, the stock traded on a FY18E EV/EBITDA multiple of 6x. At this price it was trading at a significant discount to its domestic and global peers which traded on 12-15x EV/EBITDA. Whilst HRL is a much smaller player in the industry, it had high margins due to its operating efficiencies and had significant opportunities for growth in the near term, including;

  • Increased demand for methamphetamine residue testing in the NZ property market due to the introduction of new standards.
  • Increased demand for agriculture product testing such as dairy and honey due to global consumer demand, e.g. infant formula in China.
  • Opportunity to leverage Analytica’s processes across the existing business to drive margin improvement and leverage the Analytica brand and reputation to enter new markets in Australia.

Based, on the above we believed that post the acquisition HRL’s valuation would be re-rated to reflect a higher quality business with significant growth potential. The stock doubled to 17c/share within 6 months of the acquisition announcement. We started selling our position at this point due to it exceeding our valuation target. However, we continued to follow the company closely, looking for the next catalyst that could provide us an opportunity to enter the stock.

Looking Forward: “Testing times”

In June 2018, the NZ government released a report on the management of methamphetamine testing and decontamination concluding that the current thresholds for contamination were too low and recommending a 10-fold increase in the threshold. This was a negative for HRL as it would lead to a reduction in testing volume. At the time, the impact on HRL’s revenue and profitability could not be quantified but the company believed it could be more than offset by the increased demand in their other testing channels. The market did not react aggressively to this news and the stock continued to trade sideways around 18c/share. This update significantly increased the risk of owning HRL, especially at a heightened multiple of 11x FY19 EV/EBITDA.

At the company’s recent AGM a trading update was provided and the adverse impact was quantified to have a $2.2-2.5m impact on the FY19 EBITDA, which implied a decrease of 30% in earnings. The stock was sold off and now trades at 12c/share. This recent ‘hiccup’ could present a buying opportunity, if the rest of the business can continue to grow at current margins. However, until we start to see a replacement of these lost earnings, we believe the current valuation doesn’t provide much upside given the risk of another earnings miss. HRL’s next two reporting periods will need to be closely watched to see if they ‘pass the test’.

A stock we currently own and like is Think Childcare (TNK).

Think Childcare is an operator of childcare centres. It owns, operates and manages 55 centres, predominantly located in Victoria and has the ability to expand substantially in the coming years. Think acquires the majority of its centres from an incubator on a contracted 4x EV/EBITDA multiple once they have reached an acceptable level of operating performance.

The childcare industry has recently been faced with several headwinds that have negatively impacted occupancy. Occupancy is one of the main drivers of a childcare centre’s profitability, due to the operational leverage on a fixed cost base. The major issue which has seen earnings downgrades over the last year across all the listed childcare operators is the oversupply of childcare centres. This has been compounded recently by issues with the implementation of a new childcare government subsidy.

As a consequence, Think’s share price has fallen over 50% from its all-time highs. In early November both Think and competitor G8 Education (GEM) provided updates to the market, indicating average centre occupancy had stabilised on the prior year and they were beginning to see a benefit from the new government subsidy program. The issue of centre over-supply still remains a short-term headwind but with lending standards for new centres tightening, developers are having difficulty accessing credit.  Industry analysts expect the supply/demand imbalance to moderate towards the back end of 2019.

These updates provided more certainty around our future earnings estimates for Think and was the catalyst to buy the stock. Think’s valuation is undemanding. It is currently trading on a 2019 price to earnings multiple of 10x with potential of double-digit earnings growth through organic occupancy increases and a pipeline of accretive acquisitions. We ‘think’ it’s cheap!

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2 stocks mentioned

Matthew Kidman
Principal and Portfolio Manager
Centennial Asset Management

Matthew is the Principal and Portfolio Manager at Centennial Asset Management. Prior to this, Matthew was the CIO at Wilson Asset Management between 1998 and 2011, achieving 18% p.a. over the period.

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