Fat Prophets' Hot Stock: McGrath (MEA.ASX)

Friday 23rd September 2016

As safe as houses?

What’s new?

Having had a disappointing debut on the Australian Stock Exchange, shareholders will be encouraged by McGrath’s relative share price gains since the release of their full-year results. This in our view is indicative of the fact that McGrath’s shares were oversold on the back of management’s decision to downwardly revise its prospectus forecasts. While this highlighted how cyclical the agency market can be, the reality is that the weaker earnings was systemic rather than company specific.

In fact, by virtue of having no debt (i.e. net cash), a relatively high rate of productivity (i.e. revenue per office or agent relative to peers) and some recurring revenue streams (i.e. property management rental commission and mortgage trail income), McGrath is arguably well placed to improve its market position at this stage in the cycle. In our view, leveraging the brand to expand its franchisee network will supplement this competitive advantage.

For the 12 months ending 30 June 2016, McGrath reported pro-forma revenue and EBITDA in line with management’s revised guidance in mid-April 2016. While McGrath’s pro-forma result for FY16 was disappointing (both compared to the initial prospectus forecasts and in absolute terms), it could have been a lot worse, with the company still generating a reasonable level of earnings on the back of a 10.6 percent net profit margin.

The fact that McGrath did declare a maiden fully franked interim dividend of 3.5 cents per share does provide a level of comfort that the company’s future earnings and cash flow generation will remain sufficient to cover future distributions at the current payout ratio. On this front, using McGrath’s weighted average shares as at 30 June 2016, this implies pro-forma earnings per share of 14.3 cents and an indicative full-year payout ratio of circa 50 percent (target is 40-60 percent).

Outlook

While management has not provided any earnings guidance for FY17 on the basis that “current industry volatility makes it challenging” to do so, it has reiterated its view that “the long term fundamentals of the real estate industry remain attractive, underpinned by historically low interest rates and population growth”. That said, management does expect these “challenging market conditions to continue in FY17 as seen through lower listing volumes”.

As a result of this backdrop, management has stated that McGrath will continue to focus on the factors that are within its control. These include (i) attracting and retaining high performing agents, (ii) continuing to grow the office network, initially on the east coast but ultimately on a national basis, (iii) increasing productivity of existing and new agents, and (iv) utilising technology to deliver efficiencies and enhance productivity.

Price

McGrath is currently trading at 10.2 times forecast earnings per share for FY17 and offering a prospective dividend yield of 4.6 percent. In our view, McGrath’s compelling fundamentals are supported by the stock’s technical set-up, with support having recently resected at the 61.8% Fibonacci retracement of $0.89, which is bullish. Moving forward, the stage is set for further gains over the broader term, upon a decisive break above overhead resistance located at $1.29.

Worth buying?

McGrath has not had the easiest of starts to its life in the stock market, and an adverse reaction to ‘revised’ prospectus forecasts within a few months of listing was understandable. While it may take some time for the ‘trust discount’ being applied to the share to be completely removed, there are a number of company specific and big picture factors that in our view warrant faith being placed in the company’s shares.

First and foremost, we are heartened by a strong balance sheet, which distinguishes McGrath from some other troubled high profile IPOs. We are also encouraged by the company’s degree of operating efficiency, and earnings capability from relatively small footprint. This bodes well for strong earnings gains as McGrath expands its network within its core market and nationally, with the company’s current per share metrics setting the scene for expected capital gains.

James Lennon is a senior analyst at investment research and funds management house Fat Prophets. To receive a recent Fat Prophets Report, CLICK HERE

Disclosure: McGrath is held in the Fat Prophets Concentrated Australian Share, and Small/Mid-Cap Models. The proprietors of Fat Prophets own a stake in McGrath.

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