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These small-cap growth stocks deserve to trade at a premium

Shares in online musical instrument and equipment seller Gear4music (LSE: G4M) were down slightly in trading today as the market digested the latest set of full-year numbers from the York-based business. Given that a few highly-rated retailers, like ASOS and Superdry, have endured a difficult few months, such a reaction could actually be regarded as fairly encouraging. Indeed, following its “transformational year of growth and investment,” I still think the small-cap’s shares are worth buying.

Still on song

With new distribution centres now fully operational and the numbers of active customers rising 39% to 475,000, revenue jumped 43% to £80.1m over the 12 months to the end of February. Just under £36m (45%) of this came from the company’s international markets, which now include the US.

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As a result of increased investment in staff, marketing and its customer proposition however, gross margin fell to a little over 25%. So while gross profit rose 34% to £20.32m, earnings before interest, tax, depreciation and amortisation (EBITDA) dipped 4% to £3.46m. Pre-tax profit fell 43% to £1.5m.

As and the aforementioned ASOS have recently shown, companies working through a period of heavy capital expenditure often make previously bullish investors jittery. Nevertheless, those still holding Gear4music will likely be comforted by CEO and founder Andrew Wass’s comments that 2018/19 will be more returns-focused, “with the objective of delivering strong and sustainable revenue and profitability growth“.

To be sure, not everyone — including my Foolish colleague Roland Head — is a fan of the stock at its current valuation of 62 times forecast earnings. With a PEG of 1.3 however, one could argue that the shares still look a decent buy if management really is able to establish the company as the go-to musical instrument purveyor in Europe. I remain optimistic and continue to hold.

One to watch

Also reporting full-year results today was freight management service provider Xpediator (LSE: XPD)

Thanks to strong organic growth in all divisions (Freight Forwarding, Transport Services and Logistics & Warehousing), revenues at the 30 year-old business jumped 60% to £116.3m in 2017. Pre-tax profit also soared by 65% to £2.4m, albeit from a low base.

In addition to this, Xpediator raised £7.8m in new capital, secured “notable client wins” in Romania and the UK and made three acquisitions over the reporting period. In tune with its strategy of consolidating what remains a fragmented industry (and targeting e-commerce and fulfilment as growth areas in the current year), the firm also said that it has a “strong pipeline” of potential purchases going forward.

With signs that trading has continued to be buoyant over the last few months, Xpediator is starting to look like a very interesting proposition for those willing to venture into the small-cap universe.

A forecast price-to-earnings ratio of 16 for the new financial year means the stock isn’t exactly cheap relative to its peer group but — like Gear4music — the relatively low PEG ratio suggests investors will still be getting a good deal. The fact that the company has already started returning cash to investors (final dividend of 0.64p per share) is a positive sign, as is knowledge that substantial amounts of its stock still remain in the hands of its long-established management team.

The shares are already up 123% since listing on AIM back in August, bucking the trend experienced by many new entrants. I think there’s more to come. 

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Paul Summers owns shares in Gear4music. The Motley Fool UK has no position in any of the shares mentioned. 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.

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