1H21 Results and COVID Re-opening

Small retailers remain one of the most unrewarded sectors in the market. Having endured tough trading conditions for two years after bank lending standards were tightened and house prices fell from 2017 to 2019, small retailers were the first against the wall when COVID hit as investors realised how perilous their businesses may be through a lockdown. After respite from government stimulus and online sales, retailers were probably the most punished during this reporting season – measured by consistent upgrades to forward earnings met by almost universal share price declines. The logic is that the sales and margins they currently enjoy are not sustainable – and we would agree. A cursory look at 1H21 earnings results in the context of history for many of these retailers shows how much of an outlier they are – particularly at the margin level (even before Job Keeper). No different to the outlier in the other direction we see in earnings from airlines and travel stocks in 1H21. However, when we look forward to a post-COVID normalisation we believe many of these retailers are better businesses than they were going in. Not only have they had the benefit of bumper profits and strengthened balance sheets they have battle tested their omni-channel retailing models in a range of different and unpredictable market conditions (thanks to the ever-surprising state government responses). They have a more diversified route to customers, increased customer data due to large increases in loyalty membership, a more flexible workforce and greater bargaining power over their key landlord suppliers. In combination we believe that a select number of small retailers are going to come out of COVID as higher quality businesses. By looking to the multiple of earnings two years out (ie: removing all the COVID bump) these stocks continue to de-rate and the market remains in disagreement with our view.

On the other side, COVID re-opening names are absolutely looking through the trough here. For many stocks, enterprise values today (accounting for increases in both share counts and net debt) are higher than they were in January 2020. Despite the damage done to earnings, businesses and balance sheets, and the uncertainty about what the recovery may look like, from shareholders perspective in several names, COVID has ended up being a rewarding experience.

Resources, Mining Services and Accounting

Our medium-term outlook for resources was unchanged by February results. Post GFC fiscal austerity has given way to a growing consensus that government deficit spending to drive growth alongside easy monetary settings is the global policy setting du jour.
We are seeing ongoing evidence of strong demand and limited supply resulting in higher commodity prices across the board. For some transition metals (such as copper and nickel) the issue is compounded by steep cost curves – meaning that marginal new supply needs much higher prices to incentivise economic production. Our philosophy is to focus our investment on those resource companies that are proven economically viable producers (such as Iluka, IGO Ltd, Nickel Mines, Sandfire, Champion Iron Ore and Western Areas) and limit exposure to exploration and development companies whose economic outcomes are uncertain and can vary widely. New equity is being raised at a rapid pace to fund new projects and expand supply – creating a growing source of funding to explore, develop and expand mines.

Our investment thesis in mining services companies is relatively simple – in a cyclical business, when high prices stimulate new supply, this money will need to be spent by those companies involved in drilling, development and production. Simply riding a cycle in a low quality business doesn’t grow wealth and we focus on higher quality mining service names (such as NRW and Monadelphous) that can generate excess returns through competitive advantage not just deliver low value volume growth.

The problem we observed in the 1H21 results was despite clear evidence and management feedback that demand is building rapidly, there was little evidence of prosperous growth for mining services companies – even those we consider advantaged. Despite the market looking through COVID impacts for obvious sectors (eg: travel), the margin impact to mining services players due to cost of both labour availability and on-site productivity has been considered permanent by the market. We believe that mining services are a non-obvious ‘re-open’ beneficiary as a growing top line will be compounded by the benefit of lower costs as restrictions ease. For two years we have been wondering when the revenue growth will come, and now we wait to see when margins will be restored.

Elsewhere the use of aggressive accounting continues. We observed companies that didn’t talk to investors about any financials below an adjusted EBITDA number in their presentations. We saw more commentary on expanding total addressable markets than we did on sustainable advantages and how the economics of the business model can eventually sustain positive cash flows. One company capitalised the wages of fully one third of their employees – and was still unprofitable at the adjusted EBITDA level (even with these capitalised employee wages removed from the adjusted EBITDA!).

The narratives remain overwhelming. The twelve month forward P/E for the S&P / ASX Small Ordinaries Index increased from 21.6x at the end of January to 24.2x by the end of February (per Bloomberg) – in spite of the rally in bond yields putting pressure on the market towards the end of the month. For context, our portfolio saw a contraction in its twelve month forward P/E (from 17.1x to 16.8x).

Although long gone from our universe, it was interesting to look back at Afterpay from when it was a small cap to see that the consensus F2022E EBITDA is 31% lower (A$254m) today than what consensus forecast in early 2019 (A$366m), meanwhile over the same period the shares on issue are up 19%. So, F2022E EBITDA per share is down 42% meanwhile the share price is 700% higher. The market story of the past 2 years.