Two powerful opposing forces this year are increasing risks in small-cap industrial companies and making it harder to pinpoint value.
The first force is COVID-19 and pent-up demand. Years after the pandemic began, demand in some markets is still distorted by catch-up activity.
The second force is Australia’s slowing economy. As interest rates climb yet again this month to temper stubbornly high inflation, the risk of a recession is rising.
I still think Australia will narrowly avoid a recession due to commodities strength and a rebounding Chinese economy. But our economy is vulnerable to external shocks. For many, it will feel like a per-capita recession as living standards decline.
For investors, a key issue is whether the earnings tailwind from pent-up COVID-19 demand is as temporary as the markets expect or continues well into next financial year.
Moreover, investors must decide if the looming economic pain in financial year 2024 (as higher interest rates bite hard) extinguishes any lingering COVID-19 gains.
As I said, two powerful forces moving in opposite directions.
The outcome is not as clear-cut as it seems. Consider travel. Cutting back on holidays seems like a no-brainer as living costs rise and interest rates climb. Yet Qantas Airways last month said it expects to report a record profit next financial year (2024).
The airline expects strong travel demand to continue, based on its bookings. For Qantas, the tailwind of pent-up travel demand is offsetting the effect of a slowing economy.
Luxury vehicles are another example. Autosports Group, a car dealership, in May said demand for luxury and super-luxury vehicles continues to exceed supply.
Car sales in Australia broke records for May thanks to strong backorder deliveries. Total car sales are up 12% year-on-year. So much for an impending recession.
Economics 101 says discretionary spending falls as interest rates rise. A luxury vehicle is about as discretionary as it gets. Yet distortions from COVID-19 (when vehicle supplies stalled) continue to be felt through pent-up car demand.
The market, of course, looks forward. Pain this year from higher inflation and rates is just a glimpse of what’s ahead next financial year (2024). It will be a brutal next 12-18 months.
Conditions could change quickly if rates climb higher than expected – a growing risk – and unemployment lifts. Investors with longer memories know how quickly spending can stop when talk of recession and job losses abounds.
As always, the key issue is valuation. I’m looking for small-cap industrials that
- a) have an earnings tailwind from pent-up COVID-19 demand and
- b) have been oversold amid fears of slowing demand for their product as the economy contracts.
Here are two stocks to consider:
- SkyCity Entertainment Group (ASX: SKC)
SkyCity is New Zealand’s largest tourism, leisure and entertainment company. Dual-listed on NZX and ASX, SkyCity owns integrated entertainment complexes in Auckland, Hamilton, Queenstown and Adelaide. The business is best known for casinos.
Worldwide, casino stocks were belted during COVID-19 when properties were shut, or as social-distancing rules crimped patronage. As restrictions were relaxed in the US and later China, casino demand roared back to life and shows no signs of slowing.
US casinos broke records in the first three months of 2023. The US gaming industry has grown for eight consecutive quarters, according to industry reports. High inflation and interest rates in the US have not hurt casino demand.
SkyCity is benefiting from a recovery in NZ tourism activity. The reopening of NZ’s border has boosted SkyCity’s flagship Auckland property. Growth in machine gaming has been especially strong – a trend seen in other markets.
Regulatory headwinds have partly offset those gains. Operating costs, particularly at SkyCity’s Adelaide casino, are elevated due to higher regulatory costs. SkyCity faces an ongoing money-laundering investigation from AUSTRAC and a review into its suitability to hold a casino licence in South Australia (a further hearing is due in July).
In May, SkyCity downgraded its underlying earnings (EBITDA) guidance range to $300-$310 million – slightly below prior guidance at the midpoint. Although a minor downgrade, it increased selling pressure on SkyCity shares.
SkyCity has slumped from A$3.40 in early June 2021 to A$2.07, despite the recovery in NZ tourism activity and higher casino patronage there.
SkyCity is not the most exciting casino stock. Investors who want exposure to global casinos should consider Wynn Resorts (which has properties in Las Vegas and Macau).
But SkyCity has a monopoly position in its core casino markets due to long-dated licences. SkyCity is also unlikely to face the same reputation damage that Crown and The Star Entertainment Group faced from money-laundering probes (in part due to better compliance monitoring). A hefty regulatory fine for SkyCity is still likely.
SkyCity has spent more than $1 billion upgrading and expanding its Auckland and Adelaide properties. The Auckland project is due for completion in calendar 2025 and Adelaide was completed in FY21. These upgrades will boost SkyCity’s earnings growth.
Faster growth in SkyCity’s online casino division is worth watching. The NZ offshore online casino market is forecast to be worth over NZ$650 million by 2026, from NZ$200 million in 2018. SkyCity has more than 2,350 online casino games.
Chart 1: SkyCity Entertainment Group
- Serko (ASX: SKO)
Also from NZ, Serko is a travel-management and expense-technology company. Serko listed on NZX in 2014 and dual-listed on ASX in 2018.
Serko was a market darling for a time, drawing comparisons with Xero, another star NZ-founded tech company. Millions of people book corporate travel using Serko software.
In May, Serko reported total income of $48 million for FY23, just ahead of its revised guidance range of $42-$47 million. Strong growth from Booking.com (Serko has a strategic partnership with Booking Holdings) underpinned the result.
Serko is growing quickly. The company said it anticipated total income of $63-70 million for FY24 and confirmed its goal of $100 million in income in FY25.
The company said in May: “Business travel demand is tracking strongly, and Serko is well positioned to deliver increased scale and operational efficiency.”
Serko shares leapt by about 30% after its better-than-expected FY23 result. But at A$2.92, Serko is well down on its 52-week high of $3.92. The stock briefly traded at almost $8 at its peak in October 2021 as travel demand roared back to life.
At $2.92, Serko is capitalised at $355 million. The company had $88 million in cash – and no debt – at the end of FY23. In another good sign, Serko said its underlying monthly cash-burn rate peaked in the first half of FY23.
Judging by Serko’s share price over 12 months, the market expects growth in business travel to slow as companies cut costs, amid a weakening global economy.
Long-term, Serko has a strong position in cloud-based solutions that help corporates manage their travel and expense programs – and many avenues for growth.
As global tech stocks rally, the market might pay more attention to Serko, believing the recovery in business travel after COVID-19 has further to fly.
Chart 2: Serko
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 7 June 2023.
