Today I’m looking at two mid-cap stocks with the potential to deliver significant upside to equity investors.
These aren’t small, unprofitable speculative businesses. They’re well-established firms with real profits and solid reputations.
Sales up 48% to $228m
The first of these is FTSE 250 member Petra Diamonds (LSE: PDL). This diamond mining group is coming to the end of a long period of investment. As spending declines, the group’s profit margins and cash flow should improve.
Petra shares dipped slightly after the firm published its interim results on Monday, but the figures were broadly as expected and highlighted the group’s growth potential. Petra’s adjusted net profit rose by 348% to $28.2m during the six months to 31 December. The group’s operating cash flow was 89% higher, at $86.4m.
Analysts expect the group’s earnings to rise by 38% to $0.14 in 2016/17, and by a further 71% to $0.24 per share in 2017/18. This puts Petra on a forecast P/E of 13, falling to a P/E of 7.5 for next year.
These figures look good, but the modest valuation reflects the group’s rising level of debt. Net debt reached $463m during the second half of 2016. The group has facilities in place to borrow a further $57m, and expects to fund the rest of its planned capital expenditure with cash flow.
Over the next year, I expect the market to watch closely for evidence that cash flow is continuing to improve. If it does, then I’d expect the firm’s share price to rise to reflect its growing profits.
An increase of 55% from current levels would put the stock on a 2017/18 forecast P/E of 11.5. That seems reasonable to me, if diamond market and exchange rate conditions remain stable.
This gem might be my choice
I’m reasonably optimistic about Petra Diamonds, but the firm’s heavy use of debt is a concern. A less-indebted alternative is AIM-listed gemstone specialist Gemfields (LSE: GEM).
The group’s first-half results were hit by the Indian government’s decision to remove many large bank notes from circulation. India is a big market for Gemfields, which was forced to cancel one auction and postpone another to give Indian buyers time to adjust to the new cash rules.
This issue is a blow to Gemfields, which was forced to issue a profit warning on Monday. Sales and earnings guidance has been cut for the current year. However, chief executive Ian Harebottle is confident that this will be a one-off issue affecting the current year only.
Gemfields’ share price only fell by 6% following Monday’s news. This suggests to me that the market agrees with Mr Harebottle and is now looking ahead to 2017/18, when mine output and sales are expected to continue growing.
Gemfields’ earnings per share are expected to rise by more than 200% to about $0.05 per share next year, putting the stock on a forecast P/E of about 12. Brokers covering Gemfields believe the firm’s potential goes significantly beyond this. Prior to Monday’s news, brokers had an average price target of 82p on this stock. Even allowing for a more cautious view, the City view seems to be that upside of 50% or more is possible here.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.