An Aussie small cap: oversold and undervalued

Andrew Smith

Perennial Value Management

This time last year, we nominated a high conviction small cap for Livewire in an out-of-favour sector, healthcare. One of our preferred exposures was Integrated Diagnostics (ASX: IDX). Pleasingly, developments since have either delivered on our expectations or exceeded them resulting in the share price being up 41% at the time of writing. Livewire has reached out to reflect on the thesis, and to nominate another out-of-favour small cap today. 

Our thesis

At the time, IDX was in the middle of fending off a takeover bid (which in our opinion undervalued the company) at a time when the market was coming to terms with a relatively new CEO and CFO. The industry was also emerging from an unusually low level of industry growth as government regulatory changes had impacted referral patterns while there was also increased competition in key markets for IDX like Geelong after the opening of a new hospital.

Our positive thesis was based on the view that the market was underestimating the opportunity for operational efficiencies under the turnaround plan of the CEO and CFO. We also believed that the government regulatory environment would improve particularly as both sides of politics did not want to be perceived as meddling in healthcare. This combined with the ageing population was likely to see the industry return to the traditional growth rates of 5-7%

Any surprises. Positive or Negative?

Pleasingly developments since have either delivered on our expectations or exceeded them resulting in the share price being up 41% at the time of writing with the takeover bid rejected by the bulk of shareholders and the board. The 1H18 and FY18 result clearly showed the benefit of the operational improvements put in place by the CEO and CFO while industry growth rates also recovered to 5%+ late in the year. Into FY19 the regulatory changes on balance are positive with the drag from MRI restrictions on knees offset by new revenue streams from prostate and breast screening.

The competitive issues in Geelong also resolved much quicker than we anticipated with a competing Healthscope hospital closing which pushed volume back to IDX centres.

At the time we had not factored in any acquisitions so we were pleasantly surprised by a large acquisition in NZ which looks to have higher margins and a more stable regulatory environment.

Forward looking view on the stock

IDX is closer to fair value today post the share price move, however, more upside is possible if management can replicate their early success in M&A particularly in New Zealand. In addition, the revenue streams of IDX are defensive, an attractive attribute for the portfolio given the many areas of weakness in the Australian economy at the moment. Private equity also remains active in the space and IDX would be an attractive asset if they were to consolidate the sector further.

Another stock offering compelling value today

With the recent pullback in the market, we believe NGI offers compelling value. The stock has been sold off post the 1Q19 update but also with general market weakness (which is illogical given the underlying hedge fund assets are a defensive asset class).

The initial negative reaction was to the funds under management update which showed further attrition at the recently acquired Mesirow fund of fund business. Such client redemptions were well flagged by management at the time and is natural when transferring clients to a new platform however we believe most of the decline will be confined to the 1Q19. The deal structure of the Mesirow transaction also protects NGI from any downside in the business.

As we highlighted in our post (The Hub24 of hedge funds?) the market is also not factoring any growth in the platform only side of the business. Any client wins in this new vertical will be highly accretive given the costs are already sunk. In a recent visit to the US our team met with the new hire responsible for growing this business. We were impressed with his passion, the size of the potential opportunity and the competitive advantage of NGI thanks to its considerable technology spent in the space.

Disclaimer: Please note that these are the views of the writer and not necessarily the views of Perennial. This promotional statement does not take into account your investment objectives, particular needs or financial situation.

Andrew Smith
Head of Smaller Companies and Microcaps
Perennial Value Management

Andrew commenced with Perennial Value in July 2008. Prior to joining Perennial Value, Andrew was Head of Research at Linwar Securities, a boutique broker specialising in smaller company research. Andrew joined Linwar in 2003 and during this...

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