3 Eye-Catching Small Cap Stocks Worth Putting On Your Watchlist

I look at a lot more companies than I write about. Sometimes, for one reason or another, I end up following a story, without ever forming a strong view of the stock. Some companies just have something about them that catches my eye, but for some other reason, I hesitate to buy the stock. Here are three companies that I don’t own shares in, but that I do like for a variety of reasons. One day, I could imagine buying shares in these three companies, but for now I thought I’d share them simply as interesting stocks I have on my watchlist.

Southern Cross Electrical Engineering (ASX: SXE) owns a group of operating businesses that essentially do low margin contracting work. Their businesses are focussed around electricians, and revenue comes from electrical contracting, maintenance of electrical systems, and manufacture of packaged electrical solutions such as switchboards.

Revenues are significant, at over $553 million. Profit grew around 11% to $15.3 million in FY 2022, a slim net profit margin of just under 2.8%. For this reason, Southern Cross could easily see profit wiped out in the case of operational mishaps or a tough macroeconomic environment. I’d say that Southern Cross benefits a bit from scale, but people businesses (involving charging a margin on someone’s direct labour) don’t typically scale particularly well.

Nonetheless, the business has increased both earnings per share and dividends per share over the years, in part due acquisitions, but also (for example) because of increased demand (more recently). There’s no real guarantee that large projects, especially in the mining industry, will be replaced, but the company is nonetheless forecasting a slight increase to operating earnings in FY 2023.

I’ve hesitated to own Southern Cross because its low margins mean slightly weaker demand could really threaten profit, but over the cycle I think that the stock is probably priced reasonably. Of course, it is also capital intensive, meaning it must retain some earnings to grow.

That said, Southern Cross Electrical has shown it will pay profits to shareholders, and the dividend yield based on the last twelve months is about 7.2% fully franked. The yield may not be perfectly reliable, but I would have thought Southern Cross will be profitable and dividend paying in most economic conditions. Its $53 million of net cash on the balance sheet means it could likely survive any tough times. It deserves a spot on your watch list as a dividend stock.

Dropsuite (ASX: DSE) provides third party backup for Office 365 and Google Workspace environments ensuring that companies have a seperate copy of their cloud work environments. This is obviously more important as more work takes place on the cloud, and also because this redundancy can be helpful in the case of a cyberattack. Dropsuite’s products are sold through managed service provider partners, and a core part of Dropsuite’s offering is that they make it easy for their partners to sell and implement the Dropsuite products.

Back in April I wrote that while Dropsuite “did see cash burn in the most recent quarter, it reaffirmed its guidance for positive cash flow in FY 2022, and it has over $20m in cash. At the current share price of 22c, the business has a fully diluted market capitalisation of about $155m, or about 9x ARR. This seems very high considering Dropsuite has gross margins (after hosting costs) of just 64%.”

However, since then the company is certainly on track for a cashflow positive year in FY 2022 (it uses the calendar year as its financial year) as promised. To wit, it has positive free cash flow of about $440,000 for the first 9 months of the years. On top of that, in the three months to September Dropsuite achieved “product gross margin of 66%, up 2 percentage points on the prior quarter, driven by storage cost initiatives.” That’s important because it suggests the company gets at least some cost benefit as it scales.

As I write the share price is 21.5 cents, giving Dropsuite a market capitalisation of $148.3 million and cash sits at $22.2 million, giving an enterprise value of below $130 million. Since April it has grown its annualised recurring revenue to $23.3 million, so it is now trading on a market capitalisation of about 6.4x ARR. That might not be obviously cheap, but it looks pretty attractive to me, given key metrics are progressing in the right direction. Strong growth, recurring revenue, and a genuine (albeit low margin) cybersecurity solution. I’m considering buying a modest speculative holding, just because of those three things!

iCollege (ASX: ICT) is a vocational education provider currently undergoing a 5 for 1 share consolidation. As I write (pre-consolidation) the share price is 25c, up over 100% since July giving the company a market capitalisation of around $273 million. Due to the strong share price run, it’s fair to say this is a bit of a hot momentum stock, due to the fact that international students are now returning to Australia, after the easing of travel restrictions.

Disappointingly, the CEO recently sold just over a quarter of his shareholding, but his remaining shares are worth over $2 million. His FY 2022 total remuneration was a bit over $500,000 so he still has a somewhat meaningful holding.

In Q1 FY 2023, iCollege had free cash flow of over $5.5 million, though it is important to keep in mind cash flow runs ahead of profit, since students usually pay in advance. This is an indication that the company is heading in the right direction, after a volatile couple of years that saw significant pandemic insights, and the acquisition of RedHill Education.

Now, the company says, “A significant part of the company‚Äôs growth in FY23 has been driven by international students returning to Australia in high numbers. However, iCollege domestic student numbers and revenues for our higher education and vocational healthcare courses are also growing in FY23 over the prior year.”

The company has given guidance of “EBITDA in the range of $5.5 million to $6.5 million,” for the first half of FY 2023. So even if we say it does $15 million EBITDA for the full year (implying strong half on half growth), it would have an EV/ EBITDA ratio of over 15. While I don’t think the stock is undervalued, I do think it’s worth a spot on your watchlist as a short term momentum play on the “return of international students” theme.

I wouldn’t be surprised if the company’s name change to NextEd and share consolidation precede a renewed investor relations push, though that is mere speculation.

Disclosure: the author of this article does not own shares in any of the companies mentioned in this article but reserves the right to buy shares any time from 10am Tuesday 22 November, more than 24 hours after this article is published. No undertaking is made to buy shares in any of these stocks and any purchase decision or lack thereof will be influenced by the whimsy of both the author, and the market. This article is not intended to form the basis of an investment decision and is not an official recommendation. Any statements that are advice under the law are general advice only. The author has not considered your investment objectives or personal situation. Any advice is authorised by Claude Walker (AR 1297632), Authorised Representative of Equity Story Pty Ltd (ABN 94 127 714 998) (AFSL 343937).

The information contained in this report is not intended as and shall not be understood or construed as personal financial product advice. Nothing in this report should be understood as a solicitation or recommendation to buy or sell any financial products. Equity Story Pty Ltd and BlueTree Equity Pty Ltd t/a A Rich Life do not warrant or represent that the information, opinions or conclusions contained in this report are accurate, reliable, complete or current. Future results may materially vary from such opinions, forecasts, projections or forward looking statements. You should be aware that any references to past performance does not indicate or guarantee future performance.

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