Four small caps well positioned for high inflation
Marc Whittaker discusses four small caps that are ready to ride out the current sharemarket volatility. They're well established with strong market position, good cash flows and earnings and the ability to pass on costs to their customers.
Interview transcript between David Scutt (Ausbiz host) and Marc Whittaker (Portfolio Manager Investors Mutual)
David: Well let's get to our first guest of the show and it's great to welcome back to the program Marc Whittaker from Investors Mutual with four stocks that have caught his eye at the moment. So Marc, welcome back!
Marc: David, how are you going?
David: Very good thank you. Look, let's go and kick off number one you've flagged Reliance Worldwide plumbing, it had a really good run over the course of the early days of the pandemic we've seen a lot of building take place, come off the ball a little bit, now how does it sit in this uh this period.
Marc: Yeah, it's an interesting name obviously it's probably split in two camps those who think housing's coming to an end and the cycle is moving against housing exposures like Reliance. But for those who don't know Reliance it's basically a fittings provider in the plumbing space and its key product is the sharkbite product. So it's basically a push to connect device for copper plumbing in particularly in the US. The alternative is soldering of copper pipes, and all you can use this push to connect fitting.
The reason I like it is it's actually quite defensive. Now people might say "Marc, why is it defensive, it's exposed to housing." It's actually exposed to existing housing, so if you look at the housing stock in the US in particular, which is the majority of its business, the median age of a house in the US is over 40 years old, so as you all know old homes come with leaky pipes and and creaky joints and so I think Reliance is very well positioned. It's a company that generates very good cash. What I really like about it is it self-manufactures over 80% of its own products, so it has end-to-end control of its supply chain. So, we talk about competitors with disruption around logistics supply chain, procuring basic materials, Reliance has a very strong control over its own supply chain, good balance sheet, ability to invest and grow the business to an M&A acquisition.
I think Heath Sharp is a very good CEO. It's trading very cheap, twelve and a half times, dividend yield over 4%. I think there's a lot to like about Reliance despite the fact it's perhaps a little bit contrarian for some people in the market at the moment.
David: Obviously if you've got to talk about the entire housing stock that's a whole different kettle of fish when it comes to pricing power. Are you confident that it's got that in this marketplace?
Marc: It does, look traditionally it probably hasn't given its exposure to the likes of Home Depot and Lowe's in the US. Very big retail homeware chains. But in the current environment they're putting through good pricing increases and recovering a lot of that costing process they're seeing. So brass is the material made to manufacture the key fittings are Shark by brand so it's a copper and zinc sort of conglomeration. They have seen some pricing increase, some pricing pressures but they are recovering that through some very good price increases at the moment. And, all the names I'm taking you through, I think they're all very good examples of companies that are able to take price at the moment, and recoup some of these imposts that they're seeing.
David: All right keep that in mind, so have pricing power which is important. Also when it comes to Reliance, so give us a sense about some M&A activity in that space and their ability to go and grow via acquisition.
Marc: Yeah, so they've proven that ability over the last three or four years they made the John Guest acquisition in the UK, which is more in the plastic push to connect space, but very complementary and has given them new verticals new markets. The easy flow acquisition, which they made more recently is still, I guess, a case in terms of to see how it plays out. It has been knocked around by Covid but their ability to grow their portfolio, vertically integrate to the different product channels, I think is quite strong, plenty of opportunity as well. It's a very fragmented market plumbing, and I think they've got ample scope to really push that aggregation integration angle going forward.
David: OK, so RWC is on the watch list for a potential buy at the moment. Uh Invocare, of course, funeral operator at the moment. We know that it's part of life, uh what do you like about it at the moment? A few people have got different views on the program who have come on recently. You like it for a reason, what is it?
Marc: Well look, again, I think one of the common features you'll find across the names I'm highlighting to you today is the idea of resilient in demand so demand it's not going to go away despite economic cycles. The economy may do one thing, stock markets may do another thing, but the demand for these particular products or services isn't going to go away. And Invocare as a death service provider across Australia New Zealand certainly fits into that category of resilient in demand.
Look this is a company of great operating leverage so when price is moving in its favour, and when volume is moving in its favour, you get significant operating levels dropping through to the bottom line. They've been hit around a little bit in recent times with COVID which has obviously impacted on volumes. Ironically enough, Covid, it's been a great period for people to actually, live a little bit longer. Everyone's been very cognisant of their health and socially distancing and so forth, so we've seen a drop in death rate in recent times.
That's beginning to normalise if we look at the ABS statistics for January for example, January 22 was 20% higher than January 21. We've got a pretty severe influenza season approaching, I suspect, I think we all know somebody at the moment who's going through, if they haven't got Covid they've got a flu or some sort of uh chest or head cold. So that sort of idea of people getting sick again, sort of returning to normality, being exposed to all sorts of different things, is very strong, so I think that volume certainly comes through. I think that operating leverage certainly comes through.
Look it probably looks a little bit expensive on earnings multiples, but if we look at the free cash flow multiples that this business trades on, it's a very different story. It looks far more attractive but the cash earnings for this business is actually far greater than its reported earnings or its accounting earnings. And a lot of that has to do with the DNA that it reports. It's also ex capex it's been spending a lot of capital in recent years on the NBO program so that's come coming to an end.
And if we look at the NPS scores, and the consumer satisfaction scores that they've been reporting very recently, they're very high, upwards of 80% so that really attests to the fact that that capex has been well spent. Customers/consumers are having a good experience with Invocare with the services that they're providing and that speaks to an ability to upsell, you know, higher value services and so forth. So, I think that operating leverage will come through, and that will be a great opportunity for the company to report some very strong earnings.
David: All eyes on IVC. I want to get your thoughts on the other food space, protein. And well you can't escape anywhere you look around the supermarket, you know, meat prices are going up, grains prices are going up, but what's some of the companies out there that may have been left behind in that thematic at the moment.
Marc: Yeah I like Tassal, so Tassal's one I've spoken to before across the various programs I'm on, but I really like this company. I think this is the leading salmon farmer in the country, produces up to 50% of all salmon domestically. I think there's two things about this company that the market's either missing, or not paying attention to.
The first one is that the industry structure around salmon in Australia has improved significantly, so we've had JBS come in and acquire Huon, which is the number two player in salmon production. JBS, in my view, and historically around the world has proven themselves be a very rational owner and operator of businesses. So I think that speaks well to a very well-running duopoly in salmon in Australia. So I think that's one of the first things to take note of and that's playing throughout. We've seen that at the moment salmon prices are moving higher, I mean that's a global phenomenon, but we're certainly seeing it locally and we're not seeing any incentive on the part of the local operators to undercut that strong pricing, so I think that's playing through nicely.
I think the other thing is this company again is a company that's ex-capex, so it's spent a lot of money in recent years investing into its salmon production. It's been moving into prawns as well, so using the IP that has developed in salmon to move into prawns and that's involved a fair degree of capex as well. A lot of that capex is coming to an end now, so again it's a company ex capex. You've got production stable or growing, you've got prices are moving higher, that speaks to a tremendous turnaround and free cash flow and I think that's the other point that the market's missing about this particular stock.
You've got an improving industry structure, you've got a far stronger free cash flow outlook for this business that's only trading on 12 and a half times, very similar to Reliance, a dividend yield of well over four and a half percent, so I think that speaks really well. The demand for protein is not going away, the demand for salmon is not going away, and supply globally is constrained. So the likes of Chile and Norway which are significant global producers aren't producing additional volumes to any great degree, but that global demand for for protein, for salmon, for fish isn't going away.
David: You said it's putting a lot of effort when it comes to going expanding operations. Operational expenses though, I've got to go and ask you about the margin side of the equation because, of course, for all the demand that's coming through you also have to go and feed these animals as well, they're going to harvest them.
David: What are we seeing on that front?
Marc: Yeah, so feed costs are going up, but again Tassal's demonstrated a very great ability to put price increases through. So when you're dealing with the likes of Woolworths and Coles that historically hasn't always been an easy argument or discussion they have with those particular types of players, but for the last six to nine months Tassal's been able to put through price increases and they've stuck. The sales through those retail channels have held up very strong. There's also an export channel that Tassal can sell into as well, to be mindful of, so if you can't get the volumes through on the retail side, and there's a bit of a trouble there, the export market will take them. So that's that's very strong as well.
David: Don't know about you Marc, but I've certainly noticed the price of uh smoked salmon's gone up quite a lot.
Marc: It has, but compare it to the price of red meat, for example, that's your alternative.
Marc: And you're paying 80 dollars a kilo for, you know, a great cut of red meat or you're paying you know 30 or 40 dollars for salmon. I know what I'm preferring to buy at the moment.
David: Yeah absolutely, I know it's still very yummy even though it's a little bit more expensive at the moment. I asked you about the margin side of the equation because Ridley corporation's the final stock that you want to go and have a chat about, obviously link to that, Give us a bit of sense of what you like about at the moment ,we know that agricultural side of the economy here locally is doing so strong at the moment.
Marc: Yeah, that's right, so really the sort of the largest leading stock feed provider into Australia, we talk about animal nutrition but it's really selling stock feed.
Marc: Its customer base is doing really well so Australian agriculture, you know, these times that we're seeing are as good as it gets, so its customer base is doing well, so it's doing well, and I think the point to note is that Australian agriculture increasingly has been corporatising over time. So we've got less operators but they're larger so there's a move to scale on the on the operator side and when you see that what they need is a move to scale on the supplier side. So if I'm a large corporate agricultural player I want a supplier that can supply to me at scale when I want the quantum that I want and at a price that I'm happy to pay and Ridley really is well positioned to become one of the leading scale suppliers of feedstock into the Australian agricultural space.
It's still a very fragmented space, but really doing very well in aggregating and growing out, and I think really under the leadership of their CEO Quinton Hildebrand, doing a great job really transforming the company culture, um improving the quality of the earnings so we're seeing earnings more predictable, more forecastable which is great, that allows the stock to be priced on a higher premium. And as I say, another very good generator of cash so resilient in demand, Australian ag doing well, generating good cash, and putting capex in the right places good growth projects in front of it.
And last point I would note on this one is I think this is a great M&A target potentially. So we had the likes of GrainCorp talking about moving into animal nutrition. You can either buy or build. I think Ridley's a great way to to buy into that particular space, not saying Graincorp will make a bid at all, but um, but I think lots of talk about moving into that space. It's a very attractive sector to be exposed to, and it really is a great way to play.