December 2018 | Market Commentary
What went right this year? (Top contributors)
Mount Gibson Iron (MGX) – MGX recovered strongly on the back of a strong iron ore price and increased confidence in the Koolan Island restart. It was only a few years ago the company was written off when it was trading sub 20c versus its cash backing at the time of approximately 30c. Cash is higher now at about 40cps due to cash generation from operational mines less money spent on the re-start of Koolan Island. Ore sales at Koolan are expected to commence at the end of March 2019. The mine has a six-year life, is low cost and at current iron ore prices would be worth an incremental 70cps, equating to a potential valuation > $1 per share. Investing in microcaps is never easy, MGX case in point, given it fell nearly 90% from peak to trough in 2014 to 2016. It has not been a ride for the fainthearted but symptomatic of the irrational behaviour that permeates this end of the market. There tends to be opportunity in times of fear and derision.
Sirtex Medical (SRX) – as most are aware SRX was the subject of a bidding war in early 2018. The lesson learnt is be greedy when others are fearful and buy when risks are skewed to the upside. In this case we bought SRX after the medical trials proved somewhat disappointing relative to extremely high expectations. When we initiated the position in the company it was essentially trading on 10x EBIT (free cash flow before interest and tax) with $120m of net cash in the balance sheet. Our research also indicated that the take-up of the product in the key USA market would be unaffected by the weaker than expected trial results. We ended up selling before completion of the final deal given our concerns in relation to foreign review approvals for the Chinese buyer in the USA. This proved incorrect, nevertheless we nearly doubled our money on this investment.
Technology One (TNE) – had a perceived hiccup at its first half result in February 2018 that created a huge opportunity to increase our position in one of the best companies in the small cap market at a ridiculously low multiple. For whatever reason we believe the market does not adjust for cash (gearing) when valuing companies (TNE has ~$100m of cash) hence why we focus on enterprise values, EBIT multiples and free cash flow multiples. Clearly, the market has now re-engaged with TNE and it is now trading on a much fairer multiple given the robustness of the business model.
What went wrong this year? (Top detractors)
Class (CL1) – suffered an extraordinary de-rate as growth in account additions slowed due to lower industry formations, and the main competitor discounting to migrate desktop customers to its new cloud-based product. Taking a step back it is hard to rationalise the de-rate given when CL1 listed it had only 90k accounts and has almost doubled that to 170k now. Given the retention rate is 99.2%, there is a highly recurring revenue stream that would be the envy of many. Unbelievably, despite nearly doubling its account base the share price is nearly back to its IPO price. That is very difficult to comprehend given the lifetime value of its customers. It feels like competitor antics and emotion are over-riding objectivity of the value equation at this point. A worst-case scenario is the industry declines as lower value accounts are closed, analogous to the ATO taking on lower value (<$6k) inactive accounts in the industry fund sector which will impact Link Admin (LNK). Incredibly, LNK has effectively re-rated (+15x EBIT) despite the documented ~10% headwind, whilst CL1 has de-rated to 10x EBIT on a “potential” scenario. With CL1 having over $20m of cash in the bank, we expect some form of capital management in due course. We believe the company has ample fire power to buyback a significant amount (up to $20m) of stock and make strategic acquisitions by utilising debt. We feel the next step for the industry is consolidation (organic growth having slowed) as smaller players lacking scale cannot be making money. The situation reminds us of Technology One (TNE) in 2000-03 when it fell over 80% to an all-time low of 20cps due to a slowing of its growth during the Dot Com bust – that company is now trading at over $6 per share.
Isentia (ISD) – after multiple profit warnings investors justifiably gave up on Isentia. Investors paid the price for management’s poor strategic decisions of the past, technological evolution that is structurally changing consumption and monitoring of media and the frankly irrational pricing of its main competitor. The new CEO is dramatically re-shaping the business but is constrained by a weak balance sheet (FY18 net debt of c1.8x forecast EBITDA) and an onerous copyright contract. We believe the balance sheet could be addressed expeditiously by the partial or full sale of the Asian division, albeit the suspension of the dividend ought to be sufficient to deleverage the business in time. Our understanding is that a renegotiated copyright contract (not assumed in guidance) could also be favourable for ISD and present a headwind to its key competitor, Meltwater. Regrettably aggressive price competition from Meltwater is likely to continue hence the need to re-engineer/automate the back-end systems to drive efficiency in a lower pricing environment. At c4x EV/EBITDA however the market is pricing the business for failure. We think the situation isn’t so dire and hence retain our position.
Bega Cheese (BGA) – the share price was trounced in the back part of the year due to difficult conditions in the Australian dairy industry that resulted in a profit downgrade in December. The severe drought has reduced overall milk supply putting upward pressure on the farm gate milk price (a key input for BGA’s dairy products). We believe the retracement to be an overreaction to a temporary affliction. On a through the cycle basis we believe BGA is fundamentally inexpensive given the quality of its assets and management/board.
Mortgage Choice (MOC) – fell due to falling industry mortgage volumes (regulatory driven credit tightening) and continued noise that broker commissions will be banned. We note that MOC’s FY19 settlement guidance implies a 17% decline in settlements from the levels achieved in FY17. Remarkably MOC only saw 10% declines during the GFC, which highlights the dangerous extent of the credit contraction imposed on the Australian economy. As to potential changes to broker commissions, we note that MOC’s trail book from its $55bn of loans is worth at least $1 per share in a run-off situation on a conservative basis. We believe trail commissions in the worst-case scenario would be grandfathered, otherwise, the elimination would fall straight to the bottom line of the banks (unpalatable for all stakeholders outside of the Big 4 banks!). This run-off scenario gives us great confidence that risk is skewed to the upside for MOC. On the other hand, if we assume commissions are NOT banned, we note that brokers continue to increase share given their independence, service proposition and competition they bring to the market. Without brokers (a flat fee model) we believe it will be back to the days of the Big 4 banks dominating mortgage volumes at the expense of competition. Anyone with some corporate memory will remember the gouge that occurred back then. This is hardly the outcome the government and ACCC would desire. Let’s hope the financially illiterate fail in their back to the future agenda.