Australian Equities

Sobering reality of investing on borrowed time

05/07/2015

Australian Equities Team

The old saying to “sell in May and go away” certainly rang true this year with the Small Ordinaries Index giving up nearly all of its calendar year gains in the month of June. Everyone will point to a macro influence whether it is Greek bankruptcy or Chinese share market correction, however, the truth of the matter is that we are investing on - dare I say it - ‘borrowed’ time. The world is indebted with surreal levels of gearing burdening households, corporates and governments such that any loss of investor confidence has a compound impact on real time asset prices, with debt markets and share markets first to react, and latent transmission from the financial world to the real world. The shaky backdrop is making it difficult to hide from a downturn in asset prices with blanket selling when confidence abates. Perversely our general avoidance of IPO’s in 2014/15 has detracted from investment performance with many of these companies performing extremely well from listing and holding up in a falling market. The positive spin remains fresh in investors’ minds, whether this spin is substantiated over the course of time is debateable given the unwind of early vintages (e.g. 2013). We suspect the resolve of many of these shareholders will be tested over the next six to twelve months, when financials are presented. Many are well owned, and in the past crowded trades in small caps have eventually been savaged as they often fail to meet or sustain the lofty expectations set by their premium ratings.

When insiders sell it’s the old adage of ‘caveat emptor’. Winding the clock back to 2013, the first high profile private to public listing was Virtus Health (VRT) in June of that year. Quadrant was the vendor. After a hiatus following the dismal showing of the much hyped Myer IPO in 2009 the market cynicism towards private equity led listings quickly evaporated after a strong debut from VRT. This was followed by a raft of private to public selldowns. Of the sixteen in 2013 that were notable, eight are now trading below listing price with two - McAleese (MCS) and Vocation (VET) - down over 90%! Our misgivings with respect to VRT mentioned in monthly commentary at the time have played out with structural issues leading to a recent profit downgrade. We think the situation will deteriorate with the overall IVF market having peaked due to improved success rates and an increased take up of lower priced alternative procedures. These challenges combine with a highly competitive environment and a business model where key doctors have crystallised significant value via the selldown and are on the verge of retiring. The risks now include having to incentivise younger practitioners who have less alignment given suppressed levels of ownership, which can only lead to remuneration changes detrimental to remaining shareholders. Anyway you cut it the outlook for a VRT shareholder is sobering at best.

A couple of other listings worthy of analysis from 2013 given their profile and ensuing issues are OzForex (OFX) and Nine Entertainment (NEC). OFX listed in a blaze of glory and seemingly ticked all the boxes from an investment perspective. Unfortunately for those that didn’t sell when stock rerated egregiously, the disclosure since has been unflattering. Of particular note, the earlier reported cost structure was apparently unsustainable or perhaps understated with the board having to introduce increased short term and long term incentives to the tune of $4m in aggregate per annum to an underpaid management team. Whilst it doesn’t sound like much, relative to $32m of EBIT it’s clearly on the material side. Another increasing concern for OFX as has been mentioned in previous commentaries is the low barriers to entry in this evolving on-line world. Where OFX disrupted the thick margins (+300bp) enjoyed by the Banks on foreign currency transactions, it’s now apparent that OFX is being disrupted by the second generation of disrupter with likes of CurrencyFair charging 35bp on average versus OFX at 57bp. To make matters worse the average duration of an OFX customer is short and number of trades undertaken by a customer is few, such that OFX has to replace customers at a rapid clip just to stand still. The problem being that the second generation of disrupters are aggressively trying to attract the same customers such that the cost of acquisition (primarily google search words) is escalating rapidly. Sound familiar? Yes the same happened to Wotif.com (WTF) which suffered a similar fate, only to be swallowed by a global player when it was on its knees. To remain competitive it would appear that OFX needs to drop its pricing, this all other things being equal will lead to sharply lower earnings but potentially a more sustainable earnings profile. A very bitter pill to swallow for existing shareholders given the gains crystallised by vendors premised on profit forecasts that were evidently unsustainable.

Nine Entertainment (NEC) was listed in late 2013 with two distressed debt funds taking money off the table. NEC primarily and Seven West Media (SWM) to a lesser degree had directly benefited from the demise of TEN’s ratings share from near 30% to around 20%. At the time it seemed that TEN could do no right and therefore was mired at a 20% share. Roll forward to 2015 and TEN’s ratings have undergone a mini resurgence with NEC the biggest loser. Was it luck or was it good timing? One will never know. The only thing certain is capitalising audience shares where programming outcomes are pretty much a lottery, it is better to err on the side of conservatism and provide some allowance for mean reversion in the long term. Whilst there are a multitude of headwinds in the Free To Air (FTA) market including fragmenting eyeballs and rising content costs, it would seem that NEC is in a decent position to ride this out given its balance sheet strength. Whilst the share price has underperformed since listing and is now below its IPO price of $2.05, there does not appear to have been anything misleading or disingenuous in respect of the listing. Whether its rating share recovers to those published in the prospectus looks an unlikely outcome in medium to long term given historical audience and revenue shares, and industry pressures.

Other listings from the class of 2013 that are below listing price include Affinity Education (AFJ) – a child care rollup that has gone awry, iSelect (ISU) which has had many documented issues and Dick Smith which has underwhelmed. However, it has not been all doom and gloom for the class of 2013. Steadfast, Veda, Life Health Care, National Storage, Covermore, Hotel Property Investments and Pact Group have all had some degrees of success. Based on our arithmetic if you had bought a basket of IPO’s in 2014 (at the time of listing) weighted by market cap you would have generated an average return of nearly 60%. Based on the performance of the class of 2013, which has another year under its belt, it would appear incongruous to believe that the class of 2014 will continue its outperformance into 2015/16.

Given the tumult surrounding Slater and Gordon (SGH) in late June it would be remiss of us not to make some comment despite SGH entering the ASX top 100 index in May. The media headlines of hedge funds shorting, opaque accounts and margin loans are reminiscent of the Allco Finance Group and Babcock & Brown headlines in 2008. Our primary issue with SGH is the company simply does not produce enough cash flow to support its earnings. In eight years as a listed entity it has generated $187m of operating cash flow (after capex and before tax) versus $349m of EBIT. This is a cash conversion rate of only 54%. In its best year (2010) it converted only 76% of its EBIT to cash and in its worst year (2009) only 3%. The positive is that it does produce positive cash flow so it can be valued and it has a fairly consistent track record excluding 2009. The risks going forward are the significant Work-In-Progress (WIP) of $983m in the books post acquisition of Quindell ($580m before the deal), elevated gearing post the acquisition with net debt of $527m and the opacity of the accounts and business operations of Quindell. To be fair to SGH, the lack of cash flow conversion is not confined to it or its legal brethren. Many of the large engineering and consulting companies face similar accounting issues, and debt collection companies and insurers all estimate their earnings due to the long term nature of many of their contracts. Our investment process necessarily adjusts earnings to reflect underlying cash flow conversion such that in many cases these types of companies are unattractive in our universe of investable stocks.

Outlook

“What goes up must come down.” – Isaac Newtown. The simple fact that anyone could have bought all the major IPO’s last year and made on average a 60% return on paper implies that times are going to get tough. Life is never that easy. We would hope to perform better than the index in a falling market; however, recently the relative gains have been modest with a general malaise across the market and out-of-favour stocks becoming even less favourable. In saying that, there has been instability in the ranks of market darlings with several stocks that departed the Small Ords Index in recent years including Realestate.com (REA), Seek (SEK), and Flight Centre (FLT) warning on their profit outlook in the quarter. In the Small Ords Index we have seen downgrades from several wellloved companies including Greencross (GXL), Virtus (VRT) and Nine Entertainment (NEC). When highly rated stocks downgrade the share price impact is compounded usually by a de-rating. Further downgrades amongst the ‘clique’ of favoured companies should benefit our relative performance.

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