Edmond Jackson's Stockwatch: A small-cap share poised to rebound

Repeatedly in Stockwatch pieces we have seen how "US QE3" that began in September 2012, helped boost equities in 2013 - to a peak either later that year or early 2014, then a drift back. The sentiment moves have been more emphatic in small caps, generally sensitive to any shift. Mind how within this technical market trend can also lie fundamental change.

Council housing maintenance group Mears is a good example. Its five-year chart shows a strong run since early 2012 once fears about a UK downturn were considered overdone, culminating in spring 2014 at 540p - a firm inflection point. The price has since fallen back to 362p with support achieved mainly by two directors buying £57,030 worth of shares that for now has achieved a prop at about 365p.

2014 trading review cites continued lower level of council housing maintenance opportunities

There is an underlying reason for the de-rating: at the interim results last August, management cited "a period of change in respect of housing finance and welfare reforms (that) has resulted in a short-term delay in new bidding opportunities." However, longer-term they are "expected to remain at historical levels." If true then the current share price offers value.

A 12 November "Interim Management Statement", albeit for the period 1 January 2014 to date, quantified all this by way of 96% visibility of the £864 million, consensus revenue forecast for 2014, albeit some 86% visibility of the £934 million projected for 2015. While conveying a sense of decline you would anyway expect reduced visibility on a circa two-month forward view versus 14 months, so it's hard to be sure the extent these numbers clarify the shortfall.

By way of comparison, at last year's IMS there was full visibility of the £900 million expected for 2013 and 87% visibility of the £915 million expected for 2014. So, indeed, there is a pattern of decline in revenue expectations albeit just 5.6% year-on-year, 2013/14; and while there is reduced visibility for 2015, the overall scenario is no sharp decline.

It's a flattening situation though: at interims the "social housing" side (86% of 2013 revenue and 77% of profit) had revenue growth of just 3% after excluding non-recurring items. The order book was slightly lower at £3.7 billion (2013: £3.8 billion). Being critical: are these signs effectively straws in the wind regarding UK public financial constraints on welfare provision? Politicians and councillors can talk promises but inability to stem the nation’s debt monster (£1.4 trillion) and councils' spending pressures, begs an elementary question.

Growth rating shaved down

Unsurprisingly, the market has shaved Mears' growth rating until resurgence is affirmed. Company REFS cites an annual average price/earnings multiple of 16.8 times for 2013 and 19.7 for 2014. From the table you can see how a reduction in the P/E multiple on normalised earnings, from 15.1 times to 11.5 then 10.1 in 2015, assumes a jump in profit and earnings this year and a further double-digit advance in 2015.

This scenario is based on recent forecasts (7-13 November) with Peel Hunt (the company broker) and Arden Partners appearing to trim slightly. The market is naturally wary of ambitious forecasts in context of management repeating a caution about visibility. At interims, pre-tax profit on continuing operations advanced by 21% to £18.7 million with normalised diluted EPS up 17% to 14.3p; then, the IMS affirmed "earnings to be generally in line with the board’s expectations for the 2014 full year." The market is therefore factoring in a sense of risk whether the previous extent of bidding opportunities can return.

Sub 3% prospective dividend yield, of itself is no prop

Another reason for the slide is no real support from the dividend yield. Mears' profile remains that of a growth/development company: earnings cover for the dividend is about 3 times (than say, 2-1) in a sense that shareholder value is better maximised with a decent element of retained earnings for organic growth and acquisitions. Hence, a current dilemma, the shares lack conviction for growth investors, while a sub-3% prospective yield is nothing special either for income investors.

At end-June, Mears had £72.7 million cash and £2.7 million net cash compared with £21.7 million net debt a year previous. Some of this will have been applied for October's £20 million acquisition of Omega Group, a provider of residential lettings and services to the council housing market, whose potential deferred consideration is up to another £20 million.

If the board's strategy is to continue to seek fairly substantive deals like this, any re-rating of the dividend is some way off. That would involve an inflation point for Mears' underlying dynamics: if/when its services' market is considered no longer "growth" hence cash should be more significantly distributed.

The stock is currently in no-man's territory

With growth and income investors side-lined, this helps explain the drift - and why Mears is interesting to watch because a lack of conviction implies the stock will fester to offer value. Implicitly, a non-executive director and the finance director reckon that point has been reached already: the non-exec has bought 10,000 shares at 387.7p to own 33,298 shares, and the finance director has added 5,000 shares at 365.2p to own 110,000 shares.

As usual in these situations, one has to consider if their perspective within the company is more acute than the market, or the market is the better judge of any macro trend. Presently it's quite guesswork. If Mears offered a better yield then this would help compensate for the risks; for now it’s essentially a question whether the 2015 consensus forecast is realistic, hence the implied price/earnings ratio should improve from 10 times.

Mears is therefore one to consider averaging into, pending the evidence.

For more information see: mearsgroup.co.uk.