The magic of investing in successful small-cap stocks is that they can often grow into much larger companies than you might expect. And if they operate in a field dominated by larger firms, there’s always the possibility of a takeover bid.
I believe both of these potential attractions apply to the two companies I’m looking at today.
A smart acquisition
Packaging firm Macfarlane Group (LSE: MACF) has announced plans for a step change in the size of its operations. The company will pay up to £16.75m to acquire Nottingham-based peer Greenwoods Stock Boxes Limited.
The deal will be funded with a mix of cash and new shares, and as part of this process Macfarlane will raise £8m in a share placing to help fund the deal. Although this creates some dilution for shareholders, the firm still expects Greenwoods to make a positive contribution to earnings in the first full year of ownership.
This acquisition certainly seems attractive to me. Greenwoods generated an operating profit of £1.6m last year from sales of £14.1m. That gives the firm an operating margin of 11%, more than twice the 4.9% margin generated Macfarlane’s 2016 operating profit of £7.8m. So this deal should help to lift the combined company’s profit margin, boosting future returns.
If Greenwoods fails to perform as expected, Macfarlane will be able to claw back £3.25m in cash, as this will only be paid if certain trading targets are met over the next year.
Management says that there is “minimal overlap” between the two companies. They expect the combined group’s shared customer base to provide new selling opportunities, which sounds positive to me.
Macfarlane stock currently trades on a forecast P/E of 11, with a prospective dividend yield of 3.2%. If Greenwoods performs as expected, I believe there’s scope for decent gains over the next couple of years. I’d rate this stock as a buy after today’s news.
Due for re-rating?
I have to admit that the performance of electric shower and bathroom fittings group Norcros (LSE: NXR) has been a little disappointing in recent years. This firm owns brands such as Triton Showers, Vado, Jonson Tiles and Croydex and operates in the UK and South Africa.
Despite generating stable profits, reliable dividends and strong cash generation, the company’s shares trade on a forecast P/E of just 6.1. One reason for the market’s caution may be the group’s pension deficit. At £62.7m, this is quite large when compared to the market cap of £104m.
However, this deficit is largely the result of ultra-low bond yields. If the Bank of England raises interest rates as expected in November, bond yields could strengthen. In common with many companies, Norcros would only need a relatively small increase in bond yields for its deficit to fall significantly.
In my opinion, this is fundamentally a good company, with a robust business and good long-term growth potential. I think it makes sense to keep the faith for a little longer yet.
Based on last year’s figures, I expect this year’s forecast dividend yield of 4.5% to be well covered by free cash flow. And as I’ve already mentioned, a low forecast P/E of 6.1 means that Norcros stock has scope for re-rating if it can deliver on growth forecasts.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Norcros. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.