Canada Connection: Three small caps
These days, Canadian small-cap specialist Martin Ferguson admits he is in a pretty good but somewhat careful mood about the coming prospects for the Canadian equity market.
Ferguson, director and small-cap portfolio manager at Calgary-based Mawer Investment Management Ltd., says he expects Canadian small caps to deliver at least single-digit returns over the next 12 months.
While Ferguson expects that is in line with larger-cap companies north of the border, he adds that much hinges of the U.S. economy and whether it “rebounds from its moribund 0.7% annualized growth for the first quarter of 2007 and that interest rates do not rise meaningfully from here."
As a result, Ferguson says his approach to the Canadian small-cap market is “cautious, but not bearish."
Ferguson personally handles about C$1-billion of the C$4.7 billion that Mawer has currently under management. And he believes one of the main drivers in coming months will be merger and acquisitions.
"Despite the recent hike in interest rates, many stocks remain more attractive than fixed income alternatives,” he says in his latest outlook.
In choosing Canadian small caps, Ferguson says he looks for companies with a market cap of C$500-million or less at the time of his first purchase. They must also ideally have significant competitive advantages, with management that must "have a thorough knowledge of the business and be financially astute."
Among Ferguson’s favorite Canadian small caps:
AltaGas Utility Group Inc. (TSE: AUI)
This Calgary-based firm is a regulated natural gas transmission and utility company. AltaGas Utility Group distributes natural gas to more than 65,000 customers in three Canadian markets: Alberta, through AltaGas Utilities, Nova Scotia, through Heritage Gas, and Northwest Territories, through Inuvik Gas.
"I like this company as it has stable, predictable revenue and is growing that revenue," Ferguson says.
The company has a market capitalization of C$60-million. Patricia Newson, president and CEO, is a solid manager, Ferguson says. The company was spun out of AltaGas Income Trust, which retains 26.7% of AltaGas Utility Group Inc. and is a "good parent."
The stock trades at a reasonable valuation, Ferguson says. Its dividend yield is around 1.9% and the company can use its free cash flow to increase its dividend and/ or make acquisitions. Ferguson's EPS estimate is C$0.54 for 2007 and $0.57 for 2008. It currently trades at about C$7.37.
DirectCash Income Fund (TSE: DCI.UN)
Calgary-based DirectCash, with a market cap of about C$95 million, operates ATMs, debit terminals and sells prepaid cash cards and prepaid cellular and long-distance airtime.
"Its core business is transaction processing for which it receives a fee," says Ferguson. It therefore has recurring revenues from this, as the contracts are for the long-term, notes Ferguson. "Furthermore, the trust's capital expenditure is modest."
DirectCash has 5,338 ATMs of 30,000 non-bank ATMs in Canada. In total there are about 50,000 ATMs in Canada.
Ferguson expects this income trust to generate distributable cash flow (after maintenance capital expenditure) of C$1.70 in 2007 and C$1.85 in 2008. Its current distribution per unit per annum is $1.38. It currently trades at about C$15.80, right in the middle of its 52-weeek trading range of C$12.80 and C$18.
"The valuation on this trust is quite reasonable," he says.
ZCL Composites Inc. (TSE: ZCL)
This Edmonton-based company, founded in 1987, makes fiberglass liquid storage tanks and related lining products primarily for the energy sector. Its products are mainly manufactured from glass-fiber-reinforced plastic. ZCL has a market capitalization of about C$273-million.
ZCL is in the unique position of having more than 90% of the market for underground storage tanks at Canadian gas stations. At the beginning of this year, ZCL acquired Xerxes Corp., a similar business in the United States, and "has a strong market niche," according to Ferguson.
Xerxes' production will be upgraded by ZCL, "which has cutting edge products that are better suited to the regulatory changes being introduced south of the border," says Ferguson.
ZCL's products are also ideal for the new fuel-ethanol regime in the United States, he adds, while ZCL's president and CEO Ven Cote "is one of the most knowledgeable players in this niche in the world."
Ferguson expects this company to produce a return on equity of more than 15% in 2007 and more than 20% in 2008. His EPS estimate is C40¢ for 2007 and C65¢ for 2008. His estimated book value per share for ZCL is C$2.62. It current trades at about C$10, also smack in the middle of its 52-week trading range of C$5.10 and C$15.55.
