Can these fallen small-cap angels regain their wings?

Tim Boreham

Independent Investment Research

One of the trickiest aspects of investing is deciding whether a fallen angel will ever fly again.

If they do regain their wings, the rewards of buying in at distressed levels can be enormous. But as they impress on newcomers in Masterchef safety briefings, trying to catch a falling knife can be highly injurious.

As per tradition, the red ink flowed liberally at the tail end of the profit reporting season (especially on Monday and Tuesday of this week, the last two permissible reporting days).

Amid the outright duds, here are some small to mid-cap plays worth a closer look.

Generally speaking, they’ve fallen from favour but are improving at an operational level.

Of course, when we say ‘worth a closer look”, we mean just that. Investors should do their own homework.

Freedom Foods (ASX: FNP)

Looking on the bright side of the specialist food maker’s recent woes, Freedom has ample revenue to play with, recording an 8% increase in full-year turnover to $559 million.

The net loss from ongoing operations was an ugly $38 million, but adjusted earnings before interest tax depreciation and amortisation (ebitda) came in at $22 million compared with a loss of $54 million last time around.

Controlled by the Perich dairy family, Freedom came a cropper last year after revealing close to $600 million in write-downs and write-offs – and unwanted regulatory attention.

One reason for the accounting hit was that some products were sold “at prices that did not fully recover their costs” – which just goes to show there are no new ways to lose money.

Freedom shares were suspended and lost up to 95% of their value when trading resumed on March 21 this year.

Crucially, the company has reorganised and recapitalised by way of a $265 million convertible note issues, which was backed by the Perich family but also included $139 million of new money.

As a maker of niche dairy and trendy plant products such as oat milk and organic coconut milk, Freedom is in the right sector. A key unknown is how much of the company the noteholders will control in six years’ time.

Adore Beauty (ASX: ABY)

The pureplay online beauty has been heading south ever since its overpriced IPO last October, which raised a chunky $270 million at $6.75 apiece.

Given the listing resulted from a private equity sell down – Quadrant decreased its holding from 60% to 30% – investors should have been on high alert about over-optimistic valuations.

Adore shares were hit hard in May when the company released an upbeat revenue update, which in reality missed market expectations by 5-10%.

Actual revenue for the year was $179 million, 48% up year-on-year and just ahead of the revised expectations. Active customers increased by 39% to 818,000.

Ebitda rose 53% to $7.6 million but net profit declined 31% to $1.23 million. So, take your pick.

The pandemic lockdowns are a thing of beauty for the company, with year to date revenue up 26%.

Our take on this one was that a tad too much foundation and rouge was applied to the initial valuation, but the subsequent 25 per cent share price haircut probably makes amends.

Cash Converters (ASX: CCV)

The consumer lender and pawnshop owner was affected by both positive and negative forces during the pandemic, but emerged an overall winner from the chaos.

Naturally, foot traffic through the pawnshops dried up in lockdown affected geographies, bearing in mind that only about 150 of the group’s circa 700 outlets are in Australia.

The company also experienced a drop-off in loan demand in the first (December) half, with locked-down customers also repaying their loans earlier.

Since then, demand has picked up across the company’s consumer and vehicle lending books, with gross loans rising 8% for the year to $178 million.

The company’s gross bad debt expense also fell from 35% to 23%.

The bottom line is that Cash Converters ‘converted’ a previous $10.5 million net loss into a $16.2 million profit, despite revenue falling 23% to $201 million.

The company paid a one cent dividend, taking the payout for the year to 2 cents.

With a $126m market cap and $72 million of cash, Cash Converters looks like a pawn shop bargain given its 26 cent share price compares with net tangible assets of 31.25 cents per share.

The stock isn’t everyone’s cup of tea, to put it mildly. Past sins include unconscionable lending practices that resulted in a $42.5 million class-action payout for dodgy lending practices.

Formerly a payday lender, the company says bit is moving from “short term high loss products to lower-cost longer-term cash solutions.”

Prospa (ASX: PGL)

The specialist lender to small businesses should be vulnerable to pandemic related corporate failures, but its bad debt costs declined 48% for the full year, to $27 million.

Sydney and Melbourne of course are disaster zones for anything to do with hospitality, travel, beauty or the arts, but SMEs elsewhere are largely resilient.

Prospa shares popped 6 per cent after the company reported ebitda of $375,000, compared with a $15.8 million deficit last time around. The net loss improved to $9.5 million from a $24.9m shortfall previously.

Put in context, Prospa listed in mid 2019 at $3.78 so investors have still done about 70 per cent of their dough.

Hummgroup (ASX: HUM)

Formerly known as Flexigroup, Hummgroup prides itself on being the country’s oldest buy-now-pay-later (BNPL) operator and perhaps the only profitable one.

It’s also been a giant disappointment for investors: Humm shares have lost almost 60% of their value over the last five years, at a time when other BNPL stocks have gone ballistic.

The name change reflects the consumer and commercial lender’s renunciation of its somewhat stodgier past to a groovy operator appealing to a younger BNPL audience.

Anyway, Humm’s net profit soared 121% to $68 million, with BNPL volumes surging 31% to $1.03 billion.

As with Prospa, Humm was aided by benign delinquencies, across its BNPL book as well as commercial leasing and cards.

Overall impairment expenses fell 60% to $58.7 million, which resulted in the bottom line being plumped up by $21.6 million through the partial release of a Covid-19 overlay provision.

Mesoblast (ASX: MSB)

The stem cell drug developer continues to bleed cash with only token revenues as it pursues multiple approvals for its flagship asset remestemcel-L.

The full-year loss of $US99 million ($135 million) follows on from last year’s $US78 million deficit.

As of June year-end, the company had $US137 million in the bank and $US80 million of debt, plus $US10 million undrawn, which kind of implies that things can’t go on as they are. The company – which is still worth more than $1 billion – has been adept at fundraising in the past and is in chats with its bankers about the loan facility.

In the meantime, the US Food & Drug Administration is proving a stick-in-the-mud in terms of allowing a phase III trial for a Covid-19 treatment.

The company is also pushing for approvals for chronic heart failure, lower back pain and graft-versus-host diseases in children. Success with any indication would be a company maker, but investors are losing patience with the share down 70% over the last 12 months.

Tim Boreham edits The New Criterion

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Disclaimer: The companies covered in this article (unless disclosed) are not current clients of Independent Investment Research (IIR). Under no circumstances have there been any inducements or like made by the company mentioned to either IIR or the author. The views here are independent and have no nexus to IIR’s core research offering. The views here are not recommendations and should not be considered as general advice in terms of stock recommendations in the ordinary sense.

Tim Boreham
Editor of New Criterion
Independent Investment Research

Many readers will remember Boreham as author of the Criterion column in The Australian newspaper, for well over a decade. He also has more than three decades’ experience of business reporting across three major publications.

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