A Reporting Season All About Growth
– David Wanis, September 2021
“I always tell our team, it’s growth, growth, growth, but number four is unit economics.”
– Sezzle Founder and CEO Charlie Youakim, Sydney Morning Herald 1 Aug, 2021.
Charlie sums up the current market mood in assessing the financial performance of small companies. Growth, growth, growth then maybe something about whether that growth is profitable in any way. The domination of growth meant that for many companies, lower earnings or larger losses reported in F2021 and expected in the next 2-3 years pushing returns even further into the future was handsomely rewarded by the market. Stocks such as Nanosonics, Macquarie Telecom, FINEOS, Red Bubble, EML Payments, Megaport, Omni Bridgeway, Blackmores, Netwealth and HUB24 were all rewarded for promising more growth but asking for patience on the economics part of the equation. As investors we are all for less today in exchange for more tomorrow (and we own some names just mentioned) however sometimes more evidence of that better tomorrow is needed before assuming it will be delivered.
Quality Businesses Heading in the Right Direction
August showed cash flows and shareholder value heading in the right direction for many of the high-quality businesses in our portfolio. In most cases these companies are not the market darlings that sacrifice all to the altar of growth, they are companies compounding shareholder wealth at double digit rates and doing so in a measured way. Across sectors, we saw quality businesses with strong balance sheets and good management teams building real value – balancing the discipline of delivering cash flow today as well as investing for more tomorrow. Some examples include (with price change since result in parentheses);
Viva Energy (VEA, +14.0%) – Despite ongoing weakness in aviation and cruise shipping demand, strength elsewhere in commercial volumes, continued improvement in retail margins and a return to profitability in refining set the business up for even higher profits when the east coast economy re-opens. Strong cashflow and excess capital underpinned dividends and A$140m of capital returns to shareholders. Strategic infrastructure value in Geelong assets has yet to be priced by the market in our view.
HT&E (HT1,+8.4%) – Strong recovery in advertising volumes and good cost control saw underlying EBIT up more than 100%. HT&E are also going to realise the value of their Soprano investment with the upcoming transaction with Link Mobility, have over A$120m of net cash and A$250m of undrawn debt lines.
NRW Holdings (NWH, +14.1%) – Fears of W.A labour costs impacting margins and cash flow were realised, however future contracts reducing this risk saw guidance in F2022 better than expected. The worst of the margin pressure looks to have passed and the order book continues to grow as mining activity picks up.
IPH Ltd (IPH, +12.8%) – Consolidation of the intellectual property services market in Australia continues to deliver margin improvements and IPH are now also starting to see revenue synergies with referrals across their businesses in Australia, New Zealand and Asia. Strong cash flow and minimal debt set up the business for continued accretive M&A.
SmartGroup (SIQ, +5.6%) – Still struggling with the availability of new cars constrained near term revenue growth in their novated leasing business but cost control and good cash conversion are delivering returns to investors through dividends and set the business up for when supply chains return to normal.
Blackmores (BKL, +18.4%) – Domestic growth continues to be weak, however their Asian and China segments are growing at 15-20% p.a. Management expect this pace to continue for the next few years. They also provided guidance on their target margin in F2023e when the turnaround is complete. Results delivered to date under this turnaround plan give us confidence in managements’ ability to execute.
IOOF Ltd (IFL, -5.7%) – Complex result which was taken poorly by the market despite being slightly better than expectations. Ongoing cost out program remains on track. Margin compression is being experienced in both advice and platform businesses, but net operating margin should improve as cost synergies and simplification program takes effect over the next two years.
NewsCorp (NWS, -7.1%) – Results well ahead of market expectation with digital roll-out of Dow Jones showing continued traction, Foxtel streaming services performing well and revenue holding up despite broadcast subscriptions declining. CAPEX increasing in the short term for the rollout of new Foxtel set top box but long term expected CAPEX to decline. Strong capital position, accretive bolt-on M&A, potential for capital management initiatives and on-going review of options for Foxtel.
Whitehaven Coal (WHC, +28%) – A year marked by low coal prices and problematic ground conditions at Narrabri was the worst in the past decade, but the business still generated A$40m positive free cash flow. Post year end, the sharp rise in coal prices and more favourable mining conditions will likely set records in the other direction – with the first two months of F2022 generating 5x more free cash than all of F2021.
Janus Henderson (JHG, +9.6%) – Despite ongoing net outflows, profitability is improving from positive market movements and margin improvements from shift in asset mix. Flows are showing early signs of improvement year on year. A strong cash position and cash flow enables the company to conduct further buybacks.
Adairs (ADH, +6.2%) – Strong results confirming the strength of Adair’s omnichannel strategy. Significant margin expansion from strong sales growth and strict cost control. Significant growth opportunities remain with their Mocka business and further levers are available to improve sustainable margins of the group. Trading update reflects the impacts of current NSW and VIC lockdowns on the Adair’s segment but should be temporary.
No reporting season is complete without unexpected problems, and we were reminded by Bravura (BVS, -18.6%), Monadelphous (MND, -11.5%), Austal (ASB, -23.7%) and Accent (AX1, -6.4%) that all businesses have challenges to surmount.
Portfolio Positioning and Performance
We have written for months how the market’s obsession with speculation and growth has created many opportunities in forgotten swathes of quality small caps.
How do we have confidence that our process of finding these overlooked quality businesses is working? One way is to look at the components of our investment returns over the past two and a half years. Our portfolio has grown look through earnings per share (EPS) by around 15.5% per annum. This compares very favourably to EPS growth in the Small Cap Index (+4.5% p.a.) and the ASX100 Index (+6.6% p.a.). Our process of finding quality businesses is translating into greater portfolio earnings power and the delivery of EPS growth has outpaced the market by over 10% per annum. Quality does not have to come at the expense of real growth.
Very little of our return over the same period has come from expanding P/E multiples. Only about 2.5% p.a. This compares with the contribution of expanding multiples to the return of the Small Ords (11.5% p.a.) and the ASX100 (7.5% p.a.). Most stark of all are microcaps, of which only 31% are even profitable and more than 100% of the returns have come from re-rating as the earnings of this group have fallen since early 2019. So most of the returns from our fund since inception have come from quality businesses growing earnings, whereas the promise of future growth has been far more important to the small and microcap indices.
At the end of August our portfolio had a look-through return on equity of 17%, debt to EBITDA of 1.6x, an expected P/E ratio of 17x and a dividend yield of 3.1%. This continues to be a higher return on equity, lower geared and cheaper portfolio than the Australian market – small cap or ASX300 – made possible by our willingness to prioritise quality and value ahead of promised growth, growth, growth.