Reality distortion field set to spin
– David Wanis, Feb 2023
Steve Jobs pioneered the reality distortion field (RDF), an “…ability to convince himself, and others around him, to believe almost anything with a mix of charm, charisma, bravado, hyperbole, marketing, appeasement and persistence”.
Source: Google images
Like every good technology, adoption spreads and management presentation of results in February has seen broad adoption of the power of the RDF. Even when the objective results themselves are terrible, which many in February were, only the positives are put forward – as inconsequential as they may be to the fortunes of shareholders.
Analysts, armed with a quiver of “How should we think about…?” questions try to penetrate the spin, but management are hard to push off script. A few brave souls held management feet to the fire, and while they probably question the career risk, they would make fine investors with the approach of looking for the truth instead of the narrative. Consensus 12 month forward EPS estimates for the S&P / ASX Small Ordinaries Index were downgraded about 3%. About a third of this came from higher interest expenses rather than operating downgrades.
Six months ago, we noted our disappointment in not finding many investible bargains among the stocks hit hardest since late 2021. This reporting season confirmed those concerns – many of these businesses are still trading on stories and have yet to demonstrate attractive unit economics, the foundation of every great business. Large swathes of the small cap market remain un-investible in our view.
Accounting shenanigans are alive and well. The euphemism “earnings quality” protects commentators from defamation – and we saw numerous examples in these results. During February ASIC announced they are suing the former CEO and CFO of Freedom Foods alleging disclosure failures and breaches of director and officer duties.
The share price of Noumi Ltd (formerly Freedom Foods Group Ltd) is down about 98% since just prior to the alleged issues being uncovered. Markets judge outcomes far quicker than the courts. Have we seen in these results examples of earnings quality like what we saw in Freedom Foods? Very possibly.
We are always fascinated by continued investor demand for companies reporting low quality earnings and perilous balance sheets simply because they meet the thematic du jour. A market needs a diversity of investor types, and alpha should accrue to those who can navigate the distortion fields and see reality clearly.
What We Learned In February
Travel & Leisure: The post COVID recovery in travel and leisure continues, arguably held back by capacity constraints and not expected to reach pre COVID levels of activity until 2025.
Source: Qantas 1H23 Result Presentation, Company Accounts, Bloomberg Consensus Forecasts for F2025E.
For those surviving players, there appears to be greater market share and less competition than pre-COVID, although the survivors are not themselves unscathed. For a number of companies (Corporate Travel, Flight Centre, Tourism Holdings, Auckland Airport) their current enterprise values (the value the market puts on their businesses) are within 10% of pre COVID levels, but the expected EBIT in 2025 (once fully recovered) looks like it will be anywhere from 20% (FLT, AIA) to 100% (CTD, THL) higher than F2019 EBIT.
Source: Qantas 1H23 Result Presentation, Company Accounts, Bloomberg Consensus Forecasts for F2025E.
The Australian Consumer: Results across consumer and retail businesses were mixed, however what is clear is the demise of the consumer is yet to appear. Some of the biggest downgrades were more company specific, such as from City Chic, Baby Bunting, BWX and Adairs. Strong performances from Super Retail Group, Accent Group, Kathmandu, Universal Stores and Lovisa Holdings showed consumer dollars are still available.
Source: Bloomberg Consensus EPS estimates: Jun 2022 to Feb 2023.
General caution on guidance is similar to what we have seen from retailers for some time now – they keep getting told a consumer recession is coming, and despite nothing in the now-cast, management are not going to tempt fate with a high confidence view conditions won’t deteriorate in the face of higher interest rates and fixed mortgage roll offs.
Lithium miners and Electric Vehicles (EVs): Lithium mining project NPVs are under pressure from upwards development cost estimates, kept afloat only by large increases in Lithium price assumptions (prices having doubled since the end of 2021). As with all commodities, lithium prices are determined by supply and demand and according to Benchmark Mineral Intelligence, the market is back in balance and likely headed into oversupply over the next 2-3 years. Lithium prices have fallen 38% since peaking in November 2022.
Source: Bloomberg Lithium Pricing, Benchmark Minerals / Citigroup Lithium Market Balance Estimates, Lithium Developer ASX Announcements.
For investors who prefer not to invest in pre-production mining companies, another way to invest in the increasing penetration of EVs has emerged. Thanks to recent government subsidies, consumers can purchase an EV through a novated lease at significantly reduced prices.
Source: SmartGroup F22 Result Presentation (EV % of quotes), Longwave Capital Partners MMS Forecasts.
The two largest listed novated leasing providers (McMillan Shakespeare and SmartGroup) are seeing a significant pickup in interest and demand. They are both high quality, cash producing, high ROE businesses with strong balance sheets.
Employment: Companies were more consistent in their comments regarding tight labour markets, echoing what we all see in the very low unemployment statistics. Some companies felt opportunities are being missed due to a lack of available workers.
Inflation, margins and working capital: Cost inflation remains. Those who moved early and have pricing power have largely sustained margins. Those late to move on prices or lack pricing power are having trouble catching up and seeing pressure in their margins, both gross and operating. We also saw low market power businesses take the hit through their balance sheets, as customers and suppliers flexed trading terms. Working capital terms (receivables, inventories, payables) are a hidden source of pricing power when thinking about return on capital not just margins.
Balance sheets: For several companies, the state of their balance sheets has deteriorated shockingly quickly. Healius is a case in point, where only six months ago they talked about their “Fortress Balance Sheet”, funding acquisitions and share buybacks, and here we are today looking at the shrinking distance to bank covenants.
Source: Bloomberg Consensus EPS estimates: Jun 2022 to Feb 2023
We have seen this movie before and although alert to the risk and underweight levered businesses, we have not been without investments whose balance sheets have become far worse, far more quickly than we expected.
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