Downer unfairly sold down

Wilson Asset Management

Over the past six to nine months, small-cap companies have underperformed relative to their large-cap peers by 11%. Although a number of large-cap companies have seen their PE multiples expand over this period, we believe a significant component of this underperformance is due to an estimated $4-5 billion being stripped out of the small-cap space from a number of superannuation funds internalizing their investment management functions and a number of large-cap focused funds exiting the small-cap space. With the big four banks, BHP and Rio Tinto now looking fairly valued, we believe that investors will start to seek opportunities among small-caps with companies on more attractive valuations, offering earnings certainty and potential catalysts such as acquisitions, earnings upgrades or capital management initiatives.

Trading updates leading into reporting season are key

We believe that the next few months leading into the August reporting season will be crucial for small-cap companies to continue the outperformance that has occurred since May. As we saw 12 months ago, a number of companies, such as Credit Corp, Nick Scali and Webjet provided positive trading updates upgrading expectations going into their FY16 results. A number of these small-cap companies have since seen their share prices de-rate over the past 12 months, despite meeting or even exceeding earnings expectations, and maintaining their positive outlook statements. For these reasons, we believe that a string of positive trading updates going into the FY17 reporting period can reinforce the strong earnings growth outlook for small-caps compared with their large-cap peers and drive a re-rating of their PE multiples as a result.

Downer unfairly sold down

In the mid-cap space we believe that Downer has been unfairly sold down, which has also coincided with the controversial takeover offer for Spotless in March 2017. While the market initially responded negatively to the Spotless acquisition, we see two outcomes for the acquisition of Spotless, which should benefit its share price in the near-term.

The first outcome is that Spotless actually achieves its FY17 earnings guidance of $80-90 million and Downer proceeds with the acquisition. In the event this occurs, we believe the market may have more confidence in Downer’s ability to achieve its stated ~10% EPS accretion on an NPATA basis at the time of the acquisition. We note that on 2 June Downer released an update to the Spotless deal highlighting that it intended to waive all remaining conditions in the event it held at least a 50% of Spotless’ shares by 16 June.

The second outcome we see is that if Spotless does not achieve FY17 guidance, then the acquisition may not proceed. With Downer recently stating that its $1.15 price was its final offer, we believe that the funds raised by Downer could be returned to shareholders rather than used for another acquisition. If this was to occur, we believe that the favourable outlook for infrastructure expenditure and an improving outlook for mining can benefit Downer’s existing operating business.

Contributed by Equity Analyst, Oscar Oberg


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