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Ecofibre (ASX:EOF) Quarterly Report Update Q1 FY 2020

Fabregasto — Mon, 14 Oct 2019 06:04:14 +0000

When Ecofibre Ltd (ASX:EOF) released its 4C (quarterly cashflow report) for the three months to 30^th September early last week, there was no notable share price reaction. However, we do note straight out of the gates that it was rather early, and not amidst the muddy scrum of 4Cs lodged in the last couple of days before the deadline. I like this, because I think it demonstrates that the company has its sh!t together and management have a steady hand on the tiller. That's important in a fast moving industry such as hemp products.

Ecofibre Ltd Quarterly Cash Flows and the Quest for Controlled Growth

The company hitting the ASX in late March 2019 and initially traded at a share price of around $2. Despite the strong share price rise since then, we only have a limited amount of available historical financial information – but the financial metrics reported yesterday were directionally pleasing and the growth trend remains intact. (In contrast, fellow cannabis stablemate Elixinol, reported stalling growth in recent months – as covered in our recent EXL quarterly update).

Back to Ecofibre, you can see below that customer receipts of $13.6M and unaudited revenue of $14.4M represented increases from the June quarter of 10% and 17% respectively, and operating cash flow of $3.9M was a 22% increase from the previous quarter. That is all pleasing and positive.

While the growth trend in revenue remains intact, the chart below left illustrates that on a quarter-on-quarter (“QoQ”) basis, revenue growth has actually slowed since March. While we must recognise that a company won’t grow exponentially ad infinitum, and that we should expect proportional growth to decelerate as revenue increases, this will be something to keep a very close eye on in the coming quarters.

In our recent piece on Elixinol we dissected EXL’s March and June quarter cash flow reports and noted that the expected increase in competition in 2019YTD was having a negative impact on margins. Further, we noted that Elixinol had taken the strategic decision to materially increase its cost base in the form of greater sales & marketing activities and an expansion of the management team ahead of its launch into Europe.

In fact, that doubling of Elixinol’s annualised cost base, coupled with a slight decline in annualised revenue (following the decision to ratchet down private label manufacturing), drove the company’s ~$10M 1HFY19 NPAT loss and required a surprise $50M capital raising in June. As a result, Elixinol has become a considerably higher risk proposition in the past few months.

The good news for Ecofibre shareholders is that it doesn’t appear to be experiencing Elixinol’s problems at this point. For one thing, the Ecofibre management seem focused on taking a more deliberate and disciplined approach to managing growth and a comparatively more judicious approach to managing its capital. As profiled previously, the company operates only in the United States (via its Ananda Health nutraceutical, dietary supplement and skincare products business) and Australia (the Ananda Food hemp foods business), and is focused on executing in these markets, before expanding into new regions.

As such, Ecofibre has taken a more controlled approach to its cost base – as can be seen from the chart above right. Grower & production and administration & corporate costs have declined as a proportion of receipts, as one would hope. Meanwhile, staff costs have been stable over the past three quarters, though note this is on a cash (not accrual) basis and so ignores, among other things, any release of inventory build; not that there appears to have been a material inventory increase.

Operational and other developments

The 4C was very light on operational detail, but did note that the Ananda Health range was being distributed in more than 3,800 US retail pharmacies at the end of September, up from ~3,200 at June. With close to 22,000 independent pharmacies in the US, that suggests penetration of just 17% of this channel and significant further potential runway. The company also released 2 new products during the quarter (in response to consumer demand): a CBD roll-on deodorant and a pain relief lotion. The company continues to invest in developing its product portfolio and we expect further new products over the short to medium term.

As we noted in our previous quarterly report (for Q4 FY 2019) on Ecofibre in late July, the company is about to commence the commercialisation of the Hemp Black business – and to that end the $4.7M of investing cash flows in the 4C table above relates to the construction of the company’s new US headquarters (with significant space dedicated to Hemp Black). The company has remained highly secretive around potential future products for this division, but as we detailed in our previous EOF report, management has recently revealed that the Hemp Black business (in partnership with Thomas Jefferson University) will focus on the manufacturing of products such as (1) high-performance textiles; (2) hemp-based anti-inflammatory nano-film suitable for wound dressings; and (3) polymer fibres for industrial uses. FY20 is likely to see only minimal contribution from this division, but I am cautiously optimistic about the medium term prospects of the Hemp Black business.

The company also announced in yesterday’s 4C that Ecofibre’s shares will shortly be tradeable on the Over-The-Counter (“OTC”) market in the US. While this will potentially make the company more visible to US investors, from memory the US OTC market already has something like 150 Australian companies trading under American Depository Receipts (“ADR”) – and as such I don’t expect this to materially move the needle in the short term – particularly with cannabis stocks out of favour at the moment (in comparison with the recent cannabis boom).

Quick thoughts on Valuation and closing thoughts

Ecofibre’s share price has held up pretty well amidst the recent carnage in global cannabis stocks, and at today’s closing price of $3.16 is only 15% below the $3.70 high reached after the company released its full year FY19 results in late July. As such, Ecofibre has materially outperformed ASX cannabis peers Elixinol (down 65% from its 52-week high) and Cann Group (down 53%), and international majors such as Canopy Growth (-64%) and Aurora (-70%), a major shareholder in Cann Group.

Ecofibre has a market capitalisation of ~$920M currently. In our previous note on Ecofibre, we noted that the company provided no formal FY20F guidance and so we pondered a number of potential different earnings outcomes which might justify its (then $1.1B) market valuation – see repeated table below:

We noted that EBITDA of $20-30M for FY20E could potentially deliver NPAT of $13-21M – which at Ecofibre’s current share price would represent an FY20E forward P/E of 47x – 73x. Clearly still not a Deep Value stock but growing nicely, but one could argue it is cheaper than other momentum darlings like ProMedicus and Nanosonics, even without ascribing any value to Hemp Black. As stated previously, I believe Hemp Black will be a meaningful generator of revenue and earnings from FY21/22F onwards, though it is also arguable that the market remains skeptical.

Sentiment towards the cannabis sector has soured from the recent frothy enthusiasm of early 2019 as the market has developed slower than many thought, and the regulatory regime has not opened up as quickly as the optimists hoped. If we were to frame cannabis in the context of the Gartner Hype Cycle, I would say that cannabis is currently in the Trough of Disillusionment which follows the Peak of Inflated Expectations. The Gartner Hype Cycle is of course imprecise as we can’t know how long technologies or new products spend in each part of the cycle, but it is still a useful tool for trying to understand the trajectory of the life cycle from inception to widespread adoption.

I continue to be optimistic about the cannabis thematic broadly (see our background industry report here) and about Ecofibre specifically, as my preferred ASX cannabis stock. While the company’s share price has held up much better than most of its peers, I wouldn’t be at all surprised to see some volatility over the short term if sentiment towards cannabis continues to remain subdued. And personally I would welcome that if it yielded an opportunity to add to my Ecofibre holding between $2.50 and $3.00.

Disclosure: Both I (@Fabregasto ) and Claude Walker hold shares in Ecofibre and will not sell for at least 2 days after the publication of this article. Fabregasto also holds positions in Elixinol and Cann Group.

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This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

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Elixinol Global (ASX:EXL) HY 2019 Stock Analysis

Fabregasto — Wed, 25 Sep 2019 22:33:19 +0000

Elixinol Global (ASX:EXL): It's Not Easy Being Green

It’s high time we checked in on Elixinol Global (ASX:EXL) post the release of the company’s 1H19 results late last month and following a very busy last several months which we’ll summarise in this update. This time however we’re going to do things backwards and start with the financials – where some of the developments since we last published on Elixinol in February have begun to manifest. Then we’ll triangulate the numbers to the narrative to understand where the company is at this point in time.

Financial performance 2019YTD

Let’s start with an overview of the company’s quarterly cash flow statements released since its IPO in very early 2018 (including quarterly revenue numbers announced to the market at the same time).

The most striking thing about these cash flow numbers is the significant blowout in negative operating cash flow. This is predominantly as a result of what looks like increased investment in the supply chain (in the form of significant purchases of raw materials) and also increased investment in the business – both ahead of revenue. The blowout in negative operating cash flow has also not been helped by a slowdown in revenue growth.

The table below illustrates more obviously the material acceleration in net operating cash outflow over the last 2 quarters, with quarterly net cash outflow increasing by ~$17M between December 2018 and June 2019: caused by a ~$14m increase in outflows and a ~$3M decline in quarterly receipts on an absolute basis (although revenue has increased versus the corresponding quarter in FY18: +25% and +21% respectively for March and June).

This increase in the operating cost base of the business over the first 6 months of this year is the key driver behind the material decline in financial performance for the period reported by Elixinol late last month (as summarised below left) – in which the company reported 1H19 opex nearly equal to that incurred for the whole of FY18 and an EBITDA loss of $11M. Note that the P&L reflects only the increased investment in the cost base; the suspected advance stockpiling of inventory is borne out in the balance sheet (below right) – which of course won’t go through the P&L until corresponding revenue is generated from the sale of those raw materials in future periods. The inventory build itself is not necessarily a concern – I understand that the shelf life of raw materials is several years.

This material increase in the cost base plus advance investment in raw materials was no doubt a major reason for the $50M capital raising announced around my birthday in June (guys, you really *shouldn’t have*) – presumably as well as the flexibility to make opportunistic investments. This was the second capital raising in 9 months following a $40M rattle of the tin in September last year, and the $86M net monies raised (net of costs) basically explains entirely the $85M increase in Net Assets between June 2018 and June 2019.

Significant increase in competitive activity

So, let’s rewind back to April and the release of Elixinol’s 4C (quarterly cashflow report) for the March quarter. As can be seen from the first table in this update, quarter-on-quarter revenue declined from $11.9M in December 2018 to $8.4M (which was still up ~20% from the March 2018 quarter – but absolutely below what the market was expecting). In that 4C management announced a change in strategy to pivot away from lower margin private label sales in the US and instead focus on higher margin Elixinol-branded products. This makes sense strategically – not just from the perspective of theoretically generating higher margins, but also from the point of view of not enabling competitive product. One would then expect that the natural result of this strategic decision would be an increase in gross margin, all else being equal.

The table and chart above however suggests that all else has not been equal over the past two quarters, with gross margin in fact declining from 56% for the June 2018 half to 47% in the June 2019 half – at the same time that the proportion of *higher margin* Elixinol-branded products as a proportion of total sales has increased from 31% to 43%. While to a degree this can be driven by sales mix, one would not ordinarily expect a gross margin (%) decline of this magnitude. What this suggests is that pricing for Elixinol’s premium product has decreased – and the most likely driver of this is pricing pressure from increased competition.

In a previous article on Elixinol in February 2019, we noted that on the FY18 results investor call, management had acknowledged that a significant number of new competitors had entered the market in response to the relaxation of the regulatory regime in the US. Further, we opined that “it will be interesting to see how successfully the company can defend and grow its market share as the market expands at a rapid rate and new competitors flood into the space – and the impact that this will have on margins”.

Management made a point of saying on that February 2019 investor call that it was confident that the combination of its premium product, long history and market share, and large production capacity would position it well to defend its market position. We should remember that consumers don’t necessarily care that much about a longstanding brand in what they perceive to be a brand new and rapidly expanding market. The excerpt below from the 1H19 results release suggests that competition over the first half of 2019 has indeed been intense and that sales have been impacted by a flood of lower quality competitive products into the US marketplace (where Elixinol has historically generated the vast majority of its sales).

Accelerating global expansion and significant new investments

It’s unlikely that competition is elevated in the US market alone; competition is likely to be rising all around the world in response to the emergence of CBD nutraceuticals and hemp food products, and the once-in-a-lifetime relaxation in the regulatory regime surrounding medicinal and recreational cannabis – including a landmark Australian development announced yesterday (see final paragraph).

Diversifying outside of its home US market has for some time been a strategic imperative for Elixinol. In early February, the company announced its direct expansion into Europe via the establishment of sales offices in the UK, Spain and Netherlands, and the appointment of a European MD and the recruitment of a European sales team. Pleasingly, over the last 4 months further progress has been made in the region:

In April, the company announced a new partnership with UK pharmacy buying group Cambrian Alliance Group (which represents ~1,200 UK pharmacies) and a new distribution agreement with a major UK distributor (from which it had already received a purchase order for 60,000 SKUs);
In July, Elixinol announced an exclusive arrangement with German pharmacy distributor MedVec International to market Elixinol-branded and white label products to its network of more than 15,000 German pharmacies, and also revealed a partnership with PharmaCare to create CBD capsules for UK retailer Holland & Barrett; and
In August, the company announced a new distribution agreement for Belgium and Luxembourg with Belgian distributor 25^th

Elixinol has also made further inroads into the US with the appointment in April of US retail broker Presence Marketing (which services ~15,000 US stores), and the first agreement (via Presence Marketing) to commence distribution to a large US retailer (which I understand to be Albertsons) – 330 stores in initial phase, expanding to more than 1,000 stores in time.

In June the company announced the formation of a 60:40 (respective Elixinol: RFI ownerships) joint venture with US-based RFI Ingredients to develop CBD-infused ingredients for the food and beverage and nutraceutical industries, and then in July Elixinol acquired the global intellectual property rights for Bionova’s microencapsulation technology – in order to deliver Elixinol’s CBD-infused product via capsule form. Presumably this JV will be key in the supply of CBD capsules to Holland & Barrett in the UK.

Most interestingly of all (at least to me as a near term driver of volumes), in April the company also acquired a 25% stake in Pet Releaf, a US manufacturer of CBD-infused products for pets, for ~US$4M in cash and $2M in EXL scrip. With Elixinol having been Pet Releaf’s exclusive CBD supplier for more than 4 years, this acquisition further cements this relationship. Then in early August the two parties entered into a contract under which Pet Releaf will purchase a minimum of US$18M of Elixinol’s CBD product over an initial 18-month term. I believe this is significant as it underwrites a material increase in the company’s annual revenue run-rate, and also signals that demand for Pet Releaf’s products is increasing at a rapid rate (especially as Pet Releaf’s total FY18 sales were just US$8M).

Closing thoughts = highwire tightrope

Both the current September 2019 quarter (for which the company will lodge a 4C in late October) and the next December 2019 quarter (4C end of January, followed by FY19 results in late February) are going to be pivotal for the company. DUH, me.

The material inventory build over 1H2019, the flurry of new distribution agreements in both Europe and the US, and the new take-or-pay contract with Pet Releaf suggest that the company is likely to report a material increase in revenue over the next few quarters. If that occurs as expected, then the current comparatively lower growth half-year period will have been a necessary period during which time a significant amount of recalibration has been undertaken – not that management has been resting on its laurels, with a number of key agreements executed during this period.

There are clearly a LOT of moving parts here. In amongst all of the above described developments over the past several months and against the backdrop of intense (and potentially irrational) competition in the US, there have been some material changes in the leadership team. Significant new regional hires have been made to lead the growing new markets Elixinol has entered into. In April, Board member Stratos Karousos became more hands-on as Chief Commercial & Legal Officer, and then in July became even more hands-on as the new CEO (with long time CEO Paul Benhaim transitioning to Chief Innovation Officer).

One recent development we haven’t yet covered relates to Nunyara - Elixinol’s early stage Australian medicinal cannabis business. In July, Nunyara obtained a licence for the manufacture of medicinal cannabis, but is still waiting for a licence to cultivate the cannabis to be used in the manufacturing process. Management has flagged (somewhat ominously) that the company will review its capital requirements in relation to Nunyara. So, despite the $48M cash balance at June, and my feeling that operating cashflow will improve considerably over coming quarters as the net $14M inventory build over 1H2019 converts into sales (and therefore cash – though may well still be negative), it is entirely possible that there is another capital raising in the next 6-12 months to support the establishment of a manufacturing facility.

As an illustrative datapoint, ASX-listed Cann Group will have spent upwards of $130M (funded by a mix of equity and debt) to construct its large cultivation and manufacturing facility in Mildura which will be able to process 70,000kg of dry flower annually. Cann’s situation is different to Elixinol’s: Canadian cannabis major Aurora Cannabis holds a 23% stake in Cann and earlier this year the two entered into an offtake agreement under which Aurora will acquire all of Cann’s output until 2024 (beyond that needed for Australian medicinal cannabis demand). I’m certainly not predicting that Nunyara will require a manufacturing facility anywhere near this size – or will even need any additional equity funding at all – but this should give readers a feel for what may be another material capital raising on the horizon.

As we have flagged since we initiated coverage of the company in October last year, EXL is a high-risk investment – and right now it is arguably higher risk than it was back then. *Fortunately* (spoiler: actually not at all fortunate for existing EXL shareholders like yours truly), the company’s share price is materially cheaper than it was – and at yesterday’s closing price of $1.96 is down 67% from its peak in early April at the height of the cannabis boom. The haemorrhaging of the Elixinol share price has no doubt in part mirrored the malaise of cannabis stocks globally as the air has come out of the cannabis balloon. Former poster child Tilray, for example, is down 84% in the last 12 months and is down 67% over the past 6 months. But make no mistake, the market was underwhelmed by the half-year results released by Elixinol last month and the quarterly 4Cs for March and June – delivering results below expectations is a sure-fire way for the air to come out of a momentum stock’s share price.

With news yesterday that the ACT has become the first Australian jurisdiction to legalise the possession and cultivation of cannabis for personal use (and one would expect other regions to follow in time), it is possible that the ASX cannabis stock rollercoaster may reignite for a period. Readers should temper their enthusiasm for what this will mean for Elixinol specifically (given its focus on the US and Europe and comparatively miniscule operations in Australia). Readers should also continue to view the company as a higher-risk speculative investment – but believers in the long term widespread use of CBD products and cannabis more generally will be heartened by this news. At this stage I plan to keep holding my Elixinol shares – though I will be keenly watching the 4C released late next month.

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Disclosure: I (@Fabregasto ) have a position in Elixinol. In the future I may add to or sell my position –though not for at least 2 days after the publication of this article. I also hold a position in Cann Group (not covered by Ethical Equities) mentioned above, and also in Ecofibre (which we do cover – please see here for our coverage of Ecofibre’s FY19 results).

Please note Claude Walker has previously broadcast his intention to sell his Elixinol shares here and here – and having followed through on that, no longer owns the stock.

For occasional exclusive content, join the FREE Ethical Equities Newsletter.

This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Appen (ASX:APX) FY 2019 Results Analysis

Fabregasto — Sun, 01 Sep 2019 23:24:49 +0000

Appen Ltd (ASX:APX) FY 2019 Half Year Results Analysis

On Thursday Appen (ASX: APX) reported its results for the first half of FY19 (the company has a December reporting year-end). The stock price moved violently in response, initially soaring 10% within the first hour of trading to almost $30 (within sight of the $32 all-time high set in late July), but from that point plunged 20% to below $24 and ended the day down 11% from its previous close. On Friday the share price rebounded 7% as the market digested the key takeaways, and the APX share price managed to record a 2% gain for the week despite the nausea-inducing rollercoaster ride. In fairness, there was quite a bit to digest, but also readers should remember that over the past couple of months the markets have been particularly jittery amidst the ongoing trade/tariff wars, inversion of the yield curve and other macro concerns.

Figure Eight

A key focus of the result and accompanying commentary was Figure Eight (“F8”) which Appen acquired in March for upfront consideration of US$175M plus an expected earn-out of US$60-80M. This acquisition was announced only a couple of weeks after our initiation report on the company (see here for background on the company and the evolving Artificial Intelligence (“AI”) landscape).

The acquisition was met with a degree of puzzlement in some quarters but made sense strategically. Appen had planned to invest significant funds in developing an annotation platform to drive efficiencies amongst its crowd-sourced human workforce. F8 had spent more than a decade developing a high quality SAAS machine learning annotation platform to transform unstructured text, image, audio and video data into customised AI datasets. F8’s datasets have been used for autonomous vehicles, consumer product identification, natural language processing, search relevance and intelligent chatbots.

The strategic rationale for the acquisition is summarised below left, but essentially management believe that the combination of Appen and F8 will transform APX into the preeminent provider of high quality datasets for the Machine Learning (“ML”) market).

By acquiring the F8 platform – instead of investing capital into developing its own annotation tools over 2019/2020 – management argue that Appen has gotten the jump over its rivals (named in the graphic above right), and at the current super-fast pace of growth as the industry ramps, this time saving (presumably 12+ months) may prove to be a canny strategic decision indeed.

The acquisition of F8 also delivered to Appen a new high quality customer base with little overlap with the company’s existing tech giant customers, and recurring high-margin SAAS revenues:

New technology customers including eBay, Adobe, LinkedIn, Yahoo, Twitter, and Spotify (as well as some volumes with existing Appen clients Microsoft, Facebook and Google); and
Contracts with US government departments (representing Appen’s first meaningful foray into this market segment), including the US department of Defence.

This new Government segment appears to be an important future growth driver for the company, with growing US government interest in AI (no doubt stimulated by what it views as the AI threat from China – more on that later) and the potential for large-scale projects given the size and nature of these customers. The government sector will no doubt have high barriers to entry in the form of accreditation and extremely high security clearances – so given F8’s experience with working with the US government, I would hope that Appen is be well placed to win future lucrative contracts in this space.

Appen quoted Annualised Recurring Revenue (“ARR”) for F8 of A$27M for FY18 and management iterated its expectations for continued strong ARR growth for F8 over the medium term. Indeed, the US$60-80M (A$81-108M) Earn Out included in the transaction price was predicated upon strong growth in FY19, and the 5.1x to 5.4x incremental revenue multiple underpinning the Earn Out range (calculating to A$16-20M of incremental revenue) suggested that Appen expected FY19 ARR for F8 of A$43-47M.

F8 is currently still operating on a standalone basis and integration with Appen won’t commence until January 2020 (management have been focused on finalising the integration of late 2017 acquisition Leapforce). At the time of acquisition, Appen management forecast that F8 will generate positive EBITDA by the December 2020 half-year (prior to estimated post integration synergies of ~$10.5M).

1H19 results

Appen’s first few months of ownership of F8 don’t appear to have gone completely to script. The company provided an FY19 ARR range for F8 of A$30-35M, well below the range above, and admitted that F8 was “behind plan” due to distractions resulting from the acquisition and missing out on some key new customer contracts that it had expected to win. Appen believes it has remedied this initial disappointment with a new sales leader and stated that F8 is still expected to meet budgeted EBITDA for FY19 (based on a more profitable 1H19 than expected but a slower start to 2H19 based on contract delays and lost momentum). This speed bump with F8 is likely to result in a significantly lower Earn Out paid to the vendors of this business – now expected to be in the range of US$26-37M, less than half of the originally expected payment. This material saving is of course positive to APX shareholders in the long run (provided of course that F8 delivers expected longer term benefits and earnings).

The underperformance of F8 appears to be one of two key reasons for the (delayed, once the market had gotten through the shiny headline pages) negative share price reaction. The other driver I believe is the lack of an earnings upgrade – which we’ll get to later.

The results themselves were impressive at a headline level and demonstrated the strong revenue and earnings growth currently being generated by the company (half-year numbers ONLY below, refer to our previous Appen note for full-year historical numbers):

The company generated an 81% increase in underlying EBITDA from the comparable 1H18 period on a 60% lift in revenue – although the notes to the 1H19 results reveal that approximately $2M of the ~$21M EBITDA boost relates to the adoption of AASB 16 (Leases) which moved these costs below the line into D&A and Interest expense. The numbers are impressive nonetheless.

The Relevance division (which provides data sets for ML algorithms designed to improve content relevance (accuracy of search results) in online search grew revenue by ~$74M (+56%), $11M of which was contributed by F8. Margin increased by ~3% to 21.5% with management noting improved operational efficiencies following the integration of Leapforce, however excluding the $2.7M drag from F8 on this division, margin actually increased by 5.5% to 24%.

The Speech & Image division (which provides speech data collection and annotation services for use in voice recognition and voice synthesis – such as for AI assistants like Apple’s Siri, Amazon’s Alexa) increased revenue by ~$18M (+85%) with margins improving by 200bps to ~37%. With the Leapforce acquisition finally integrated, we would hope that margins will recover back to FY16 levels (i.e. north of 40%) for this division.

What may have been overlooked by some market observers is that the company significantly increased its investment in R&D over 1H19 , in order to “future proof” the company, according to management. R&D investment increased nearly-10-fold from $1.4M in 1H18 to $13.3M, and clearly the un-capitalized component of this additional investment will have impacted 1H19 earnings. This sacrificing of near term earnings in order to bolster the longer term revenue and earnings potential of the business is eminently sensible in my view, especially considering the vast potential of the fast-growing ML/AI market and what we should assume are increasing competitive pressures. No doubt a primary aim of this additional investment will be to improve internal efficiencies and enhance/protect margin (i.e. in the event that competition leads to future pricing pressure).

FY19 guidance vs. Appen’s earnings upgrade history

As mentioned earlier, the second reason for the negative share price response to the 1H19 results appears to have been the lack of a “hard” upgrade to FY19 guidance previously provided by the company (which was US$85-90M initially provided in February, and then reiterated at the AGM in May). This previous guidance had been pegged at an AUD F/X rate of $0.74 against the USD, and again the company reiterated this EBITDA range at the same F/X rate.

As we noted in our initiation piece on the company, Appen has a long history of earnings upgrades (versus consensus expectations) – 13 of them in fact – and this continuous cycle of upgrades has driven a material inflation in the company’s forward P/E multiple since 2015 (chart below updated from our previous APX report).

As noted previously, for most of FY15, FY16 and FY18, actual forward P/E was below broker consensus P/E – meaning that even after brokers upgraded forecasts to account for APX’s new guidance, the company still ended up outperforming broker forecasts. This resulted in an inflation of the forward P/E multiple from 20x to above 40x over the last year or so as the market began to automatically assume future earnings upgrades. The share price soared by 70% following the release of the FY18 results (and accompanying broker upgrades) in February this year – up until the late July 2019 peak, at which time the company was trading on a forward FY19E P/E multiple of over 55x (“HA, CHILD’S PLAY!” snorted Pro Medicus and Nanosonics from above the clouds).

You can see from the chart above that Appen had delivered “hard” earnings upgrades at the release of each of its 1H15, 1H16, 1H17, and 1H18 results (i.e. for 4 Augusts in a row), and so unsurprisingly the market had already presumptuously factored in yet another. When this did not eventuate, the share price uncoiled accordingly. Following the recent decrease in share price, Appen is back trading at ~45x forward P/E – a level it first breached about a year ago.

But note: the $0.74 AUD/USD F/X rate assumed by the company is ~10% less favourable than the current spot rate ($0.67) and ~5% less favourable than the average over CY2019YTD ($0.70). As such, there is likely to be a strong currency tailwind in 2H19 – as there was in 1H19 – and therefore a very real possibility that Appen outperforms this guidance range (indeed management expressed its confidence that it would hit the top end of the range – which was already a “soft upgrade” without factoring in potential F/X upside).

Readers should note that the company has in prior years upgraded guidance late in the year – October 2015, November 2017 (via the Leapforce acquisition) and November 2018. I have a feeling there may be another upgrade around November this year - at which point management will have good visibility on likely CY19 numbers including the benefits of currency tailwinds. We shall see.

China’s increasing importance in AI

At Appen’s AGM in May, management for the first time called out China as potential new market for the company. This makes a lot of sense strategically – as China is the second largest AI market in the world (behind the US where Appen is focused heavily), and in mid-2017 China announced its ambitions to become the global leader in AI by 2030. This included a vision for the country to develop a “new generation” of AI theory and technology (both software and devices) by the end of 2020, and then a “major breakthrough” in AI technology by 2025 in order to facilitate “industrial upgrading and economic transformation” in areas such as smart cities and also its military (cue global AI arms race).

The chart below left from Appen’s investor presentation from last week includes forecasts from German online statistics portal Statista that the Chinese AI market will reach $14BN of value by 2020, representing a CAGR of 55% since 2015 (albeit off a low base).

According to the Nikkei Asian Review, China filed more than 8,000 AI patents between 2009 and 2014 – significantly closing the gap on the US – and since 2015 has been the largest filer of patents in the world (and largest publisher of AI-related publications) (see middle chart above). As at June 2018, China had the second largest number of AI start-ups in the world (behind the US) and this is expected to accelerate in response to the Chinese government’s AI policies and funding packages (which have included science parks, incubators and development zones). Cynical observers might note that China’s comparatively lax data privacy regulations may prove to be a highly valuable (and potentially unlimited) source of data for AI algorithms

Appen entered China in 2017 with the establishment of an office in Beijing, and has since expanded to other cities such as Shanghai and Wuxi. While initially the focus was on providing Chinese language data to US customers, presumably the company has its eye on securing contracts with Chinese AI leaders such as Baidu, Tencent, Didi Chuxing and Alibaba. Contracts won with any major Chinese AI players could potentially move the needle for Appen, so we will be watching that space with interest.

Ethical Equities readers should note that Alibaba has backed a couple of Chinese AI start-ups which are focused heavily on facial recognition technology and which are providers of these AI products to the Chinese government (including in suppressing the Muslim-majority Uighurs in Xinjiang province in China’s West): near-term IPO aspirant Megvii Technology, and SenseTime (also backed by Softbank and valued at US$7B during its 2018 funding round). At this stage, we don’t know if Appen will be working with these companies.

Closing thoughts

Over the past few months there had been murmurs in the market that Appen might be impacted by the ongoing privacy issues of its huge technology customers (i.e. revelations of AI assistants recording private conversations and much pearl clutching over the potential use of this information etc). Appen management did not comment on this however (particularly amidst commentary on the outlook for future demand), so this may have been overblown.

At the release of 1H19 results last week, management reiterated its “strong conviction” on the F8 acquisition and the benefits from combining the companies, in particular the acceleration of Appen’s technological capabilities resulting from F8’s best in class platform and the diversification of its customer base (including into the lucrative US government market). I am a believer, personally. If the company can land some large contracts for the US government – as it races against China in the perceived battle for global AI supremacy, I would see that as the start of a new growth engine for the company. And if the company could demonstrate serious traction in the Chinese market, that would also represent a potential step change in Appen’s revenue and earnings base.

In our initiation report on the company in February we included the (then) latest (from August 2018) Gartner Hype Cycle for Emerging Technologies – a very helpful tool for understanding how close emerging technologies are to widespread adoption (following initial flurries of excitement). Fortunately for both of us, dear reader, Gartner released the updated 2019 version of its Hype Cycle last week and it is presented below.

When compared with the 2018 chart (refer to our previous APX report), we can see that AI has been split into multiple categories including AI Platform-as-a-Service and “Explainable AI” (where AI outputs can be understood by human experts), and “Augmented Intelligence” (the use of AI to improve human intelligence, not replace it). Further, we can see that Autonomous Driving Level 4 (no need for a human to monitor safety) has moved further down the curve, and that Autonomous Driving Level 5 (“steering wheel optional”) has appeared for the first time. As far as I’m concerned, investing in Appen offers direct exposure to these exciting emerging themes (alongside technologies that have already arrived within the last few years such as AI assistants and chatbots, and augmented reality – and which are becoming mainstream).

As we mentioned last time, APX has not been “cheap” by traditional value measures since 2015 and is unlikely to be any time in the near future while the broader market and Appen’s top and bottom line are growing so quickly. We continue to recommend that the company is only suitable for readers with a higher than normal risk appetite, and are prepared to weather some share price volatility along the way.

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Disclosure: I (the author) own shares in Appen and consider the company to be a cornerstone of my Growth portfolio. I aim to add to my position over the coming months during any bouts of share price weakness – though, as always, not for at least 2 days post publication of this article.

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This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Audinate Group Ltd (ASX:AD8) FY 2019 Annual Results Analysis

Fabregasto — Sun, 25 Aug 2019 04:05:44 +0000

It has been a busy several months since we last checked in on Australian digital audio networking technology company Audinate (ASX:AD8) following the release of its 1H19 results in February (coverage here). Since then the share price nearly doubled (reaching an all-time high of $8.66 in mid-June) before trading back to the low-$6 mark briefly last month before recovering back above $7. The share price fell 6% today in response to the company’s FY19 results and is now 20% below its all-time high – more on that later, but first a re-cap of developments since our last report.

Capital raising and key growth initiatives

The $8.66 all-time high was achieved after the company announced in early June a $24M capital raising (comprising a $20M institutional placement and, welcomingly, a $4M Share Purchase Plan) – at $7.00 per share. The capital raise was launched to accelerate Audinate’s growth ambitions, specifically:

Expansion into new overseas markets;
Expansion of the Dante product range and investment to shorten software implementation periods;
Development of the next generation Dante IoT platform; and
Financial firepower to provide capacity for potential strategic acquisitions

This all makes sense strategically – as we’ve mentioned previously, Audinate is executing a land grab and positioning itself to be the de facto industry standard in the emerging audio and video digital networking industry. The company is a long way ahead of competitors. Per the oft-updated protocol-enabled-SKUs chart from the FY19 results presentation below, almost 6x as many products in the marketplace are based on the company’s Dante protocol, than its nearest competitor.

However, competitor metrics have not been updated since June 2018 and therefore may not be perfectly accurate. According to Audinate, Cobranet had 343 products at June 2018; Audinate’s 2,134 is therefore 6.2x as many but doesn’t give Cobranet the benefit of any additional products released into the marketplace in the last 12 months.

The mention in capital raising materials of the next generation Internet of Things (“IoT”) Dante platform I found interesting – and this is the first time I’ve seen the company reference IoT before in its materials – but this makes complete sense to me. As Ethical Equity readers will know, IoT is the extension of internet connectivity into physical objects to enable the networked connection of devices and sensors for the purposes of monitoring and control. IoT is a constantly evolving area which is benefiting from developments in machine learning and real-time data analytics, and further advanced through progress made in miniaturising sensors and processors. Readers will no doubt recognise IoT in the consumer context of the “smart home” which in the prototypical example involves the use of smart devices (smartphones, smart speakers such as Amazon’s Alexa etc) to control appliances and devices within the home.

The professional AV market feels like a logical area to utilise IoT connectivity – and clearly management are already thinking about what the Dante Domain Manager software will look like in its next iteration. Neither the capital raising materials nor the FY19 results presentation contained any further information on this IoT initiative – so I look forward to more detail in time.

In relation to potential M&A activity, I might have missed it previously, but in the capital raising presentation was first time I saw this explicitly called out by management. Given the company’s heavy focus on developing its Dante platform and technology, I personally feel that any strategic acquisitions are more likely to be concentrated on bringing additional capability and skills into the organisation – as opposed to bolting on companies with similar products which presumably won’t be immediately compatible with the Dante protocol. The potential for M&A activity was not reiterated in the FY19 results presentation – so we will have to see on this front.

The Dante ecosystem

As to the expansion of the Dante product range, in mid-July the company announced the commercial release of the Dante AV (combined audio & video) product – which was launched at a European trade show earlier in the year and for which the company has high hopes. The company has estimated the Video segment of the professional AV market to be similar in size to the Audio segment (~$400M currently) – so the launch of this product would seem to double the company’s Total Addressable Market.

The release of Dante AV follows the release of 2 software products in June (which enable the interoperability of Dante with Linux software and also PC and Mac applications), and the release of a suite of Dante AVIO adaptors (which enable legacy analogue equipment to be interoperable with the Dante system). Capital raising proceeds have been explicitly earmarked for the development of further AVIO adaptors and Dante AV product extensions in the short term.

This acceleration of product development in my view only serves to strengthen the Dante ecosystem. If the company’s protocol does become the industry standard, in future all OEMs will need to have Dante embedded in their products. The chart below rolls forward the company’s key metrics to 30 June 2019 and in my opinion is *the* key set of metrics to understand for Audinate and its long term growth potential.

This chart illustrates the growing Network Effects in play here as the Dante ecosystem expands with each new OEM customer added and each Dante-enabled product released into the consumer market.

Note from the above that in the 12 months to June 2019:

Licensed OEMs increased by 8% to 459 (CAGR since FY14: 25%. This includes pre-eminent global AV manufacturers such as Yamaha (a ~10% shareholder in the company), Sony, Bose, Roland and Bosch; and
The number of OEMs selling Dante-enabled products increased by 22% to 270 (CAGR since June 2014: 39%).

In my view, the chart above directionally points to the company’s future growth runway. The blue line represents all OEM customers who have signed up to license Audinate’s technology, while the orange line represents those OEMs who have actually released Dante-enabled products into the market. The delta between the blue line and the orange line therefore represents licensed OEMs which are still in development phase (which I understand to be 12-24 months) and yet to launch their first Dante-enabled product. Critically, this delta suggests a significant future pipeline of Dante-enabled products which will be generating meaningful revenue for Audinate in the medium term – as only ~59% of licensed OEM customers as of June 2019 have yet released products utilising Audinate’s technology.

Most striking of all, the total number of OEM Dante-enabled products for sale (the green line) increased by 30% to 2,134 (CAGR since June 2014: 57%). This suggests an average of 7.90 Dante-enabled SKUs in the marketplace per OEM (an increase from 7.68 at December 2018 and 7.41 at June 2018). That means that Audinate continues to increase its penetration within its OEM customers’ product portfolios. I continue to believe that this represents a small fraction of the OEMs’ product range, and that further long term growth will be possible as existing OEM customers embed Dante in more of their products.

We should think of this chart like a funnel. One would expect that the majority of newly licensed OEM customers (blue line) will in time become OEMs selling Dante-enabled products in the global market (orange line). And over time if Dante becomes the de facto standard, then the average number of Dante products per OEM is likely to increase, and therefore the total number of Dante-enabled products available will also increase (green line). **In my opinion**, an increase in the slope of the blue and orange lines should in time result in an even steeper slope in the green line (and accelerating revenue for Audinate).

Management have previously estimated that there are more than 2,000 professional AV OEMs in Audinate’s target ‘Sound Reinforcement’ segment. As such, the 459 licensed OEMs at June 2019 represents customer penetration of only ~23% - suggesting there is still substantial potential upside from contracting new OEM customers and increasing the blue line above.

The company has also previously quoted research from Frost & Sullivan that the digital audio networking market would grow from ~$360M in 2016 to ~$455M by 2021. At that pace of growth, market size is probably currently ~$400M. Management has previously estimated that digital penetration of this market is still only 7-8%. If this is accurate, Audinate’s FY19 revenue of ~$28M (which should be entirely audio products given video-enabled products were only made commercially available in mid-July) would represent a market share of close to 90%.

FY19 results and illustrative FY20E projections

On Friday, the company released its FY19 results – which are summarised below.

The headline numbers are impressive: 44% annual revenue growth and improving EBITDA margins, demonstrating the company’s operating leverage. Gross margin has remained stable at 74-75% over the last 3 years which is a good sign, and the company will continue to invest in R&D to grow the top line and further entrench its already strong market position (signalling on the conference call that the R&D and engineering team will be doubled over the next 2 years).

To understand why the market may have been slightly underwhelmed by the result, however, we need to dig into half-on-half performance. The table below shows historical 1H vs 2H performance for FY17 to FY19 and my attempt at projecting both halves of FY20E based on management’s guidance on revenue and seasonality.

Management provided FY20 guidance of 26-31% revenue growth and a reversion to historical 1H/2H sales splits (approximately 45%/55% in FY17 and FY18). Interestingly, management commentary was that economic conditions (including as a result of the tariff war) were creating potential uncertainty heading into FY20 and that 1H19 had benefited from the pulling forward of some customer orders from 2H19 (i.e. in advance of tariffs taking effect). We can see this in the fact that 1H19 ended up comprising 50% of full-year FY19 revenue – such that 2H19 demonstrated minimal growth on 1H19. However, such an explanation is difficult to verify, and it is possible that the second half was a bit weak. We note they did not mention this pull-forward when reporting the first half results.

My FY20E projections in the table above are based on management’s FY20 guidance above, plus some assumptions of my own, namely:

75% assumed gross margins (being the weighted average over FY17 to FY19);
35% increase in employee costs over FY20 as management expands its R&D efforts (staged 30% YoY in 1H20E, 40% YoY for 2H20E, assuming it will take time to ramp this investment);
20% increase in marketing costs to accompany the launch of the Dante AV (combined audio & video) product, and newly released software products; and
Growth in miscellaneous opex of 8% in 1H20E vs. 2H19 and 7% in 2H20E vs 1H20E

These assumptions result in a forecast skewed towards 2H20E from both a revenue and EBITDA perspective (in line with management guidance) and slower growth of ~16% for 1H20E vs both 1H19A and 2H19A. Given the recent launch of Dante AV and the software products, I’m not surprised that revenue might be skewed towards the second half as there will likely be a lag before (A) these new products demonstrate real traction, and then (B) start receiving repeat orders from OEM customers.

This slower half-on-half growth from 1H19A to 2H19A (flat) – and then implied growth from 2H19A to 1H20E (16% is nothing to sneeze at but below historical levels) – is likely what drove the 6% share price decline today, and it wouldn’t surprise me to see a bit of further weakness over the short term as the market fixates on 1H20E numbers. But note the implied 2H20E growth – 41% at the top line based on guidance – above historical trend.

These assumptions result in a 36% increase in FY20E EBITDA to $3.8M – but clearly the key moving parts here are the actual revenue levels achieved (noting that management have historically skewed towards the conservative end of the spectrum in forecasting revenue) and the timing of the acceleration in investment in R&D (which of course is a short term hit to earnings in order to drive revenue over the medium to longer term – especially in the current Land Grab phase). The assumed FY20E increased employee costs may prove to be too aggressive – we won’t know until 1H20E results in February (given Audinate is no longer required to lodge quarterly cashflow reports).

Closing thoughts

I continue to believe that Audinate remains an attractive longer term investment opportunity. The key operational metrics suggest the business is now scaling nicely and demonstrating Network Effects (our favourite Economic Moat). There continues to be a significant growth opportunity in the migration of the audio networking industry from audio to digital (below 10% penetration currently), and approximately 77% of global OEM players haven’t yet started licensing the Dante platform and products. The company generates very high gross profit margins from its IP portfolio, and is focused on further expanding its product portfolio and innovative capabilities.

Given the Audinate share price is up 40% over the last 6 months alone, it wouldn’t surprise me if the stock took a breather and either tracked sideways for the next several months or retraced further in the current Risk Off environment. I would think very hard about adding to my position if the stock price returned back to low-$6 levels – reflecting my view on the long term growth trajectory for the company.

At a current market cap of ~$450M the company is clearly not a Value stock and relatively expensive on traditional metrics – particularly as earnings are sacrificed in the short term as management instead invest in R&D and growing longer term revenue. As we flagged in our previous note, the focus now is (rightly, in my view) on investing to build a dominant global leader – and so in the absence of meaningful profits over the near term we continue to suggest Audinate is a stock for readers with a higher appetite for risk.

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Disclosure: I (the author) owns shares in Audinate. I participated in the Share Purchase Plan and then bought more shares on market during the share price drop in July, and the company is one of my largest positions. I continue to view the company as a long-term portfolio cornerstone (Tier 1 High Conviction for readers who made it through the Gent Manifesto omnibus.) I may buy more shares in the future – but, as always, not for at least 2 days after the publication of this article.

For occasional exclusive content, join the FREE Ethical Equities Newsletter.

This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Fun Times With Ecofibre (ASX:EOF): FY 2019 Results Analysis And Valuation Meditation

Fabregasto — Tue, 30 Jul 2019 08:23:00 +0000

Ecofibre (ASX:EOF) Full Year 2019 Results Analysis And Valuation Meditation

Ecofibre (ASX:EOF) today reported its maiden set of full year results as a public company. The company’s share price has been something of a rollercoaster ride over the 4 months since listing: a 70% first day stag profit on its $1.00 IPO price, then essentially 3 months in a sideways range between $1.90 and $2.20 before soaring to $3.60 in early July in advance of its June quarter 4C (quarterly cashflow report). Since the release of its 4C, the stock traded down below $3.00 – no doubt a mix of profit taking; general recent choppy market trading over the past few weeks during which time the broader market has arguably gone “Risk Off” in advance of reporting season; and raised eyebrows at “valuation” (presumed historical P/E multiple of ~300x at a market capitalisation of ~$1 billion). And then yesterday the share price soared 25% to $3.69 (a record close) in response to the FY19 results, before retracing to #3.39, today.

Strong operating momentum

As will be surprising to exactly zero readers, there is strong momentum in the business – as evidenced by FY19 annual revenue growth of more than 500% (spoiler alert: unlikely to continue ad infinitum). The FY19 results and accompanying investor presentation didn’t contain a lot of new operational metrics – the US independent pharmacy channel bar chart at right was included in the June quarter 4C. The key takeaway is still that the Ecofibre pharmacy network of 3,200 stores represents just ~15% of the total US independent pharmacy market and that there is significant further penetration growth available.

It was curious to note that selective bulk white label contract manufacturing for certain “strategic” customers has increased from 10% at 1H19 to 16% for the full year – implying that 2H19 white label and bulk sales comprised 20% of total 2H19 sales. I’ve previously assumed that these sales are typically lower margin than Ananda Professional volumes to distributors and Ananda Hemp sales to consumers via the company’s website – and yet gross margin increased materially from 65% in 1H19 to 76% for FY19.

I was interested to see mentioned in the investor presentation that the company has created a CBD 360 online education portal for the pharmacists and practitioners in its independent pharmacy network – a sensible investment in my view – both in ensuring a well-informed pharmacy sales channel capable of driving sales to consumers, as well as building trust with pharmacists.

FY19 results: US business the growth engine

In the June quarter 4C (see here for our previous article), the company guided towards full year FY19 revenue of $35.6M and profit before tax of $4.5M – both of which were higher than our back-of-the-envelope estimates from our April initiation report (see here). Ecofibre’s full-year FY19 results are summarised below left. Note that FY19 NPAT is inflated by the first time recognition of Deferred Tax Assets ($2.0M), otherwise NPAT would have been closer to $4.0M.

It’s clear that the company’s current stellar growth trajectory is being driven almost entirely by its US business – which posted growth of 646% to $34M in FY19, demonstrating that Ecofibre’s strategic decision to grow market share through the independent pharmacy channel is working. The investor presentation included a quote from US market research firm Information Resources Inc which suggested Ananda is the “clear market share leader of CBD products across all US retail pharmacies (as measured by sales)” – however I wasn’t able to track down this report, and I imagine the market is extremely fragmented at such a nascent stage. Hopefully the company will share further information from this type of market research in the future.

The Australian business still increased revenue by 24% in FY19 – albeit off a very small base of ~$1M. Ecofibre’s investor presentation did disclose that the Australian business will commence supplying to Woolworths’ private label Macro Foods brand from August 2019 onwards – which I expect to materially increase the volumes of this business going forward and hopefully tip it into profitability in its own right.

As previously noted, the Hemp Black business (in partnership with Thomas Jefferson University, a top 20 shareholder in the company) is pre-revenue. FY20 will prove a pivotal year for this division with early commercialisation activities about to commence. The company has previously been highly secretive around potential future products for Hemp Black, alluding to confidentiality required by patent law – but the investor presentation for the first time referred to 5 “core” Hemp Black products:

Hemp Black: “carbon infused high-performance fibre and intelligence textile” – this could be the performance apparel (with anti-odour properties and thermal regulation) described in Ecofibre’s prospectus;
Hemp Black Nano: Ananda full spectrum extract nano-film – described in the prospectus as being suitable for wound dressings and textiles with anti-inflammatory properties;
Hemp Black Hide: Ananda full spectrum extract vegan leather and Hemp Black Element: Ananda full spectrum extract infused polymer fibre – both presumably for industrial uses such as fabrics for motor vehicles and offices etc; and
Hemp Black Ink: “carbon infused conductive water based ink” [I don’t know what this is either].

CEO Eric Wang has previously stated his belief that Hemp Black will eventually become the largest revenue generator for the company. I am also cautiously optimistic on this given the thousands of years of human history of utilising hemp fibre for industrial uses such as clothing and building materials. It’s going to be another 12 months at least before we’re able to more accurately gauge the revenue potential of this division in any event.

FY20E – *Illustrative Speculation*

The company provided no hard numerical FY20 guidance – not surprising given how fast revenue is growing and the number of moving parts in such a nascent hyper-growth market (as we’ve noted previously). Note that Ecofibre did not provide any formal FY19 forecast guidance in its prospectus, waiting instead until the release of its March quarter 4C in mid-April to provide revenue, gross profit and opex ranges for the forecast year to 30 June.

Clearly the lack of formal guidance is unhelpful for any Deep Value investors chewing through their fingernails with extreme frustration/puzzlement while watching from the sidelines. As Wise Monkey Matt Joass has noted in his seminal piece on Inflection Points however, traditional value metrics (both historical and 1-year forward) appear ludicrous for companies which have just become profitable (as Ecofibre has for the first time in the year just passed).

So what range of FY20E potential outcomes might be acceptable in the context of Ecofibre’s current $1.1 billion market valuation (at today’s $3.69 share price)? The following bewildering – even to me – table ponders a number of different scenarios:

Four scenarios in relation to revenue growth – ranging from 25% to 200% (all arguably conservative in the context of the 519% top line growth achieved in FY19, however we must expect that revenue growth WILL start to slow); then
Five Gross Margin % scenarios – ranging from 60% to 80% (compared with 72.4% generated in FY19). I personally expect gross margin % to improve as the business scales, but this would allow for potential lower-margin-but-higher-revenue-generating white label agreements in future. The combination of parts 1 and 2 therefore gives 20 (5 rows of 4) scenarios which feed into part 3;
Three (being 3A, 3B and 3C) scenarios in relation to growth in operating costs – under which, respectively, opex increases by 53%, 104% and 155% from FY19A to FY20E (and thereby respectively represents 30%, 40% and 50% of FY20E revenue (down from 58.7% in FY19 as Ecofibre should generate operating efficiencies as revenue increases)).

Phew! There are therefore 60 different FY20E EBITDA possibilities in the “analysis” below – ranging from, at the lowest end, EBITDA of $4.5M (25% revenue growth @ 60% gross margin with 155% growth in opex – orange shading) to FY20E EBITDA of $53.4M (200% revenue growth @ 80% gross margins with 53% growth in opex – blue shading).

But… 60 scenarios is too many!! So, the table at the very bottom then estimates what FY20E NPAT *might* look like for EBITDA of $10M, $20M, $30M, $40M and $50M (all within the EBITDA possibilities presented) making certain assumptions re below-EBITDA items (see fine print below table):

The above is clearly the by-product of the combination of several assumptions regarding (fast) moving parts – a meaningful variation in any one of which (even including effective tax rate) could significantly move the needle from an FY20E EPS perspective.

I think FY20E EBITDA of $20-30M is certainly possible however (noting that EBITDA increased by ~$14M in FY19). For illustrative purposes (see green shaded cells), a combination of:

Revenue growth of *only* 100% in FY20E (a significant slowdown from 519% in FY19 but of course revenue growth is very likely to slow from here); plus
Growth margin of 75% (a slight improvement from FY19 only despite the doubling of revenue); plus
Opex growth of 104% from FY19A (growing faster than sales – perhaps reflecting increased investment in Sales & Marketing – such that Opex represents 40% of revenue for FY20E)

……would deliver EBITDA of $24.9M For FY20E, and NPAT of ~$17M (per fine print assumptions re below-EBITDA items above) – being the mid-point between $20M and $30M EBITDA in the bottom table. Ecofibre would then be trading on a ~65x forward P/E at its current share price of $3.69 – but then would have almost tripled NPAT in FY20E (or more than quadrupled if you removed the one-off tax-benefit). I don’t think it’s extremely far-fetched that the company could generate EBITDA of $30M-$40M in FY20E (cc: @AussieBaggies) – at which point the current forward P/E is probably closer to 45x. Note however that as the business scales, it will require significant focus from management to rein in costs and pull the right levers to protect profitability in this high-growth environment.

Please note that this section on FY20E is merely some “thought bubbles” round what potential revenue growth and margin assumptions could be encapsulated by the company’s current market valuation. This of course ignores any value attribution to Hemp Black – which is unlikely to generate any revenue until FY21E – and about which I am personally very optimistic.

Closing thoughts

I continue to be optimistic about Ecofibre. I added a little more to my position in early June around $2.00 (though not as much as my gut was telling me to – for which I am now kicking myself).

At a current historical FY19A P/E multiple of ~168x (including the benefit of the one-off tax gain), the company is clearly not going to be a Deep Value staple any time soon – but readers will know that we are focused on relative growth profiles of companies which look forward more than one year (often a few years out) to try to determine if we are buying Growth at a Reasonable Price (“GARP”). Fast-growing companies are simply not available to buy at mid-teen P/E multiples and so we must be prepared to pay a higher multiple for this growth.

**If** Ecofibre can continue to grow its top line at 100% (or more) for the next 2-3 years as the CBD market expands, I would expect the share price to be considerably higher than it is today despite the frothy FY20E forward multiple. Sceptics may opine that the current share price projects a continuation of FY19’s impressive growth rates into FY20 – but actually it doesn’t: a 500% revenue increase in FY20 (to revenue of >$200M) would probably generate NPAT of ~$50M using the spaghetti of assumptions above – at which point the company would be trading on a P/E of ~23x currently. **For the avoidance of doubt, I absolutely do not believe the company can continue to grow revenue at 500% in FY20**.

The company has pledged to give shareholders increased clarity on FY20E forecasts as the year unfolds – but I’d be surprised if we got any meaningful FY20E guidance until after the release of 1HFY20 results in February (mid-February at that given how refreshingly punctual (read: non-tardy) management have been in releasing 4Cs and results so far. For the meantime I will continue to hold my $EOF shareholding – although I expect the share price to continue to bounce around a lot (I expect some profit taking shortly with buyers in June having generated returns in less than 2 months of 70-80%).

Accordingly, we continue to hold Ecofibre, but only as an appropriately sized very high risk investment, especially given the current optimism in the share price.

Disclosure: Both I (@Fabregasto ) and Claude Walker hold shares in Ecofibre and will not sell for at least 2 days after the publication of this article.

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This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Ecofibre (ASX:EOF) Quarterly Report Update Q4 FY 2019

Fabregasto — Tue, 16 Jul 2019 23:26:29 +0000

Ecofibre (ASX:EOF) has performed strongly over the past few months since we initiated on the company in April (see here) – In that time the share price is up 52% and it’s up a total of 222% for investors fortunate enough to get into the March IPO.

Nearly all of that share price run since April has occurred in the past couple of weeks – immediately prior to a bullish market update released on 4^th July – which confirmed the predictive abilities [cough] of those who bought into the stock over 2^nd and 3^rd July (during which time the share price jumped 25%). That market update included a quick update on the growing number of independent US pharmacies stocking Ecofibre’s Ananda Professional product range, and foreshadowed the release of the company’s maiden quarterly cashflow report (4C) for the June quarter on 11^th July.

To quickly re-cap, Ecofibre comprises three businesses, two of which are generating revenue:

A US-based vertically integrated manufacturer and distributor of zero-or-low THC hemp-based nutraceutical, dietary supplement and skincare products. This division sells Ananda Hemp branded products through its website to wholesalers and retail customers, and sells Ananda Professional branded products through independent pharmacy chains; (Ananda Health);
An Australian-based manufacturer and marketer of hemp foods (Ananda Food); and
A pre-revenue business focused on commercialising the production of hemp-based textiles and composite materials, in partnership with Thomas Jefferson University, a top 20 shareholder in the company (Hemp Black).

The US business generated ~90% of sales for 1HFY19 (to December 2018) and is the key growth driver for the company given the strong growth in that market following the signing of the US Farm Bill into law late last year. The chart below illustrates Ecofibre’s increasing penetration of the US independent pharmacy channel to date after formally launched the Ananda Professional brand less than a year ago.

The number of pharmacies retailing Ecofibre products has more than doubled between December and June to 3,200 – which per the company has underpinned the very strong growth in revenue for FY19 (discussed shortly). The prospectus detailed that there are ~22,000 independent pharmacies in the US – suggesting a penetration rate of ~15% as at June and a long potential growth runway.

Preliminary FY19 results

In our Ecofibre initiation piece, we tried to estimate FY19 results based on some high level guidance provided by the company in the March quarter 4C released in April. Our back-of-the-envelope calculations suggested revenue of at least $31.5M and profit before tax somewhere in the region of $0.5M.

Pleasingly, based on the preliminary unaudited FY19 data points shared in the June quarter 4C this week, the company has outperformed the previous guidance and our rough estimates – with unaudited FY19 revenue of $35.6M (up 519% from FY18A) and a maiden profit before tax of $4.5M. The June quarter 4C also detailed that Ecofibre generated operating cash flow of $3.2M during the period. We will provide further detail on finalised FY19 results once release in August.

Closing thoughts

As we’ve discussed previously in pieces on ASX stablemate Elixinol (ASX: EXL) and our broader cannabis industry pieces, the hemp-based nutraceutical, dietary supplement and cosmetics market is in a hyper-growth phase which has seen a flood of new competitors enter the market in the past year. It is too early to gauge which operators will be the long-term dominant players in the market; the near and medium term focus for all players will be to establish a market position and try to defend it –against both existing rivals and future new entrants attracted into the sector by the strong growth potential).

The next few years represent a substantial land grab opportunity in both individual regional markets and the global marketplace as a whole. To this end, Elixinol recently completed a $50M capital raising to accelerate its US growth ambitions, and we would not be surprised to see Ecofibre undertake a similar strategic move – although we note the company boasted a ~$26M cash balance at the end of June (an increase of~ $1M during the quarter post some investment and debt pay-down).

As I mentioned in our Ecofibre initiation piece, I am very intrigued by the Hemp Black division and feel that it could eventually be the largest generator of sales for the company – and this echoes comments from CEO Eric Wang. Hemp Black will likely require further capital at some point as it moves towards commercialisation – however that is probably a year or two away at this point, and won’t necessarily require the company to consider a capital raising. The company has also left ajar the potential for the company to enter the medicinal marijuana space (which management have shied away from until the regulatory picture is clearer) – which would also likely require more capital – but there is no visibility as to whether Ecofibre will even go down that path.

In the meantime, EOF – like EXL – will continue to trade on premium (read: eye-watering) multiple from a traditional historical multiple viewpoint. At its current market capitalisation of ~$1 billion, Ecofibre is trading on a historical P/E multiple of close to 300x (assuming final FY19 NPAT of $3.0-3.5M). Frothy stuff indeed, but readers will appreciate that the company has only just recently reached its profitability inflection point – which of course means that traditional backwards-looking valuation multiples (which do not factor in future growth or relative growth profiles versus in comparison with other companies) will look extreme. As a result, we expect that Ecofibre’s share price will continue to be volatile – and reiterate out caution that the company is suitable only for those Ethical Equities readers with an appetite for risk.

We will provide a further update on the company post the release of its maiden full year results next month – which hopefully will contain some initial guidance on the new FY20 trading year.

Disclosure: Both I (@Fabregasto ) and Claude Walker hold shares in Ecofibre and will not sell for at least 2 days after the publication of this article.

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If you don't yet use Sharesight, please consider signing up for a free trial on this link, and we will get a small contribution if you do decide to use the service (which in turn should save you money with your accountant, or time if you do your own tax.) Better yet, you can get 2 months free added to an annual subscription.

This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Straker Translations Ltd (ASX:STG) Initiation Report And Analysis

Fabregasto — Sun, 23 Jun 2019 06:17:39 +0000

Straker Translations Ltd (ASX: STG) listed with little fanfare in late October last year – essentially midway through the grinding Risk Off phase that impacted the Growth sector between the end of August and the Christmas period of 2018 (during which time many growth stocks were down 20-40% from their August highs). Floated at a price of $1.51 per share, the company debuted relatively strongly and reached a peak of $1.91 in the first few days of trading – but has spent the majority of the period since trading underwater versus its IPO price, and bottomed out below $1.20 in April – before recovering over the past couple of months (closing at $1.55 on Friday).

Straker recently reported its maiden set of full year results as a listed company (for FY19 – like many Kiwi companies, Straker is a March year-end). We’ll focus on the financials later, but first some background on the company and the language translation market in which it operates.

I’ve seen comparisons between Straker and high-flying Appen (ASX: APX), covered here previously. While there are some similarities, in my view Straker is much closer to what Appen was in its earlier days, before Appen moved so successfully into providing training data sets for the large technology giants and their Machine Learning (“ML”) programs.

Company background

Straker is a cloud-based end-to-end language translation services platform which uses a combination of Machine Learning (“ML”)-based machine translation and a crowd-sourced pool of freelance translators. The company was founded in 1999 and for the first decade of its life Straker provided a multilingual content management platform – before deciding to develop its own proprietary RAY Translation Platform in response to the inefficiencies management perceived in the third party translation services it had been using. Development of the RAY platform commenced in 2010 and the company pivoted to focus on translation services in 2011. The RAY platform took 8 years to develop and per the graphic below from Straker’s prospectus comprises 7 modules (3 customer-facing and 4 translator-facing – which enable fast collaboration between all stakeholders):

The RAY platform creates a first draft translation based leveraging ML techniques and based on previously translated work. As to be expected with ML algorithms, the more translating the RAY platform does, the better the algorithms can become, and the more accurate the first draft is. That first draft is then passed onto one of Straker’s contracted workforce of ~13,000 crowd-sourced human translators for review and refinement as necessary, until the translation is completed and passed to the customer.

Straker charges the many of its customers on a per word basis, whereas it pays its human translators on an hourly rate (around US$30 per hour). This differs from some competitors, which Straker says pay translators by the word. This business model allows Straker to profit if the company can provide translators more efficient ML algorithms, and translation platforms.

Target market and customer base

The global language services market was approximately US$50 billion in size at the end of 2018 per Frost & Sullivan, and is projected to increase by 34% to $67 billion by the end of 2022. Language translation (the space in which Straker plays) represents by far the largest segment of the market (~$35 billion in its own right in 2018).

This market growth should provide a tailwind for Straker. We note:

The continuing decades-long trend towards globalisation, with increasing exports and the need to translate into multiple languages to effect trade, and the continuing rise in e-commerce volumes;
The growing proportion of global trade comprised by emerging markets which naturally have their own languages (i.e. Indonesia, Vietnam);
The explosion in online (especially) and offline content – with the Straker prospectus quoting a predicted tripling of IP traffic between 2016 and 2021; and
Continued regulatory requirements for translations – especially in the EU zone.

As we’ll focus on in the next section, Straker has made a number of acquisitions over the past few years. As such, its customer base includes customers acquired through this M&A activity, ranging from individuals/sole traders needing language translations for a single transaction to large “blue chip” companies requiring a mix of recurring and one-off work. Notable larger clients include IBM, Microsoft, Sony, Universal, Linked In, Deutsche Bank, HSBC, Macquarie Bank, Amazon, Mars and Walmart. In FY18 Straker provided services to ~8,400 customers globally, with the largest customer comprising ~11% of revenue and the top 20 customers approximately 54%. In FY19 the company generated 52% of total revenue from Europe, the Middle East and Africa (“EMEA”), 34% from North America, and the remaining 14% from Asia Pacific (including Australia & NZ). This is a truly global company.

The competitive environment and Straker’s acquisition strategy

Straker’s prospectus and investor presentations focus heavily on the company’s acquisition strategy – which is arguably the key plank of its overall medium term growth strategy. In a conversation that Claude had with the CEO recently, he revealed that customers tend to be very “sticky” and therefore difficult to win away from incumbent providers. That suggests that the main path to grow market share open to Straker is to acquire smaller rivals…. and there is an awful lot of them, as can be seen from the pie chart in the page bottom left.

Since the market is extremely fragmented, with the top 100 language service providers (including Straker) comprising just 15% of the market and an estimated 18,500 players in total, there is plenty of room for consolidation. But profitable roll-ups must add value, and so this opportunity must combine with discipline and the provision of a superior translation platform. One potential weakness here is that larger customers often have significant negotiation power, and so can sign per-hour translation deals with Straker, thus ensuring that they benefit from any technological improvement.

Most of Straker’s larger peers are domiciled in the US and these are all private: TransPerfect, Mission Essential Personnel, Global Linguist Solutions, LanguageLine Solutions, and Lionbridge (owned by Blackstone, which appointed brokers in December last year for a potential 2019 ASX IPO). By number however, most of Straker’s rivals are located in Europe – where approximately 56% of all players are located, and this makes sense when you consider the large number of languages concentrated in such a comparatively small geographic area.

There are arguably few barriers to entry for a new player into the localised language services market – especially with the sheer number of small existing operators which could be acquired relatively cheaply, but a new entrant wanting to provide ML-enhanced translation services to global enterprise customers would need to develop/acquire their own technology platform, build/acquire their own large data repository to enable accurate and efficient ML processing, and also pool together a global base of human translators.

The Straker prospectus mentions a global translator pool of 333,000 people in 2012 – approximately 78% (260,000) of which are freelancers – which doesn’t sound like a huge number, and given the explosion in language translation apps such as SayHi, iTranslate, Google Translate, Trip Lingo and many others, it’s possible that the global human pool may shrink over time. What level of threat these translation apps constitute to Straker’s offering is yet to be determined – presumably these programs are more conversational in nature as opposed to being suitable for official business translation, but that may change in the medium term. Ultimately, the main difference is quality assurance – we’re not yet at the stage where we can be confident in machine translation without human oversight.

Straker aims to deploy a disciplined acquisition strategy that involves:

Acquiring smaller companies at a low multiple of revenue (typically at 1.0x or below);
Migrating the target’s volumes and customers onto Straker’s platform – at which point the company can generate operating efficiencies (and margin improvement) from its ML-based RAY technology;
Removing cost duplications via the use of Straker’s global back office tech infrastructure; and
Generating economies of scale in global production capacity and translator resources.

On a pessimistic view of it this is a garden variety roll-up strategy via which Straker aims to generate shareholder value through the smart use of capital and effective integration, though Straker is smart to target specific acquisitions that can bring in attractive new customers or enable expansion of its global footprint. The CEO has said to Claude that the primary purpose of acquiring is to get a foot in the door of large enterprise clients. He said in large organisations, it can be difficult to identify who owns the decision about where to procure translation services, so direct sales can be expensive.

Historically, Straker has focused on companies with $2-3M of revenue with 20-30 employees and limited technological capability (which enables the smooth transfer onto its RAY platform). At these revenue levels, these sub-scale targets are at best only slightly profitable on a reported (pre-synergy) basis.

To date Straker has acquired 6 companies (detailed below), with the latest announced yesterday morning. Deals are typically structured around a mix of ~40-60% cash and/or scrip upfront plus an earn-out based on the next 2 years of revenue. The company has provided information to demonstrate the meaningful lift in margins for Eurotext and Elanex following migration onto the Straker platform. Note that the other 4 acquisitions have all been undertaken within the past year and it’s too early to assess margin uplift.

Per the graphic in the previous table above right, Straker is now setting its sights on bolting on slightly larger companies of $3-15M revenue – no doubt as a result of the $20M raised in the IPO last year.

On the FY19 results investor call management re-iterated that it is very active in hunting acquisition targets that meet its criteria and financial hurdles, and indeed it subsequently announced the acquisition of On-Global Language Marketing for less than 1x revenue. This is its third Spanish acquisition and it is seeking a meaningful acquisition into the US which would deliver an existing enterprise customer base.

The key question for me from all of this is the breakdown of organic vs. inorganic (i.e. acquired) growth in the historical numbers, and what we can expect for organic growth going forward – remembering that Frost & Sullivan’s target market growth projections presented earlier estimate annual growth in excess of 7%. Straker’s investor presentations want us to focus on pro forma revenue – that is, as if all 5 acquisitions had been undertaken at the start of the period. The below table summarises information from the prospectus and different investor presentations in April and May 2019 (and excludes the COM acquisition made at the end of FY19). Notable here is the winding down of some key contracts in the Elanex business which was known prior to acquisition by Straker.

Please note, the above table does not represent statutory results for FY 2016 and FY 2017 but it is simply trying to split out acquired vs organic growth. For illustrative purposes, I’ve pushed Eurotext’s and Elanex’s FY17 revenues back into FY16, which may not be accurate. This analysis is likely distorted by what I believe is the migration of some acquired volumes to the “Straker – pre acquisitions” line – which is growing considerably faster than the acquired businesses (as reported separately by Straker). In the absence of any breakdown of FY19 revenue by business unit, I’ve apportioned the $0.9M revenue beat versus prospectus forecasts between all businesses on a weighted average basis (using the FY19F numbers from the prospectus). Given the likely migration of volumes within the group, this analysis unhelpfully doesn’t help definitively answer the organic-vs-inorganic growth question – although it’s likely the core (excluding acquisitions) Straker business is generating decent (at least) organic growth. This may be direct sales resources are focussed disproportionately on the Straker brand.

Further, it’s still evident that even on a pro forma basis, the group has increased revenue at a CAGR of 15% between FY16 and FY19 – faster than the market, which is important to note in my view. Management stated on the FY19 results investor call that 2H19 organic growth was ~9% on a constant currency basis (down from 14% in 1H19).

Aside from inorganically acquiring smaller rivals, Straker’s organic strategy revolves around:

Winning new enterprise customers with recurring volumes – via a new direct salesforce established over 2018/2019 comprising 16 salespeople in 7 countries;
Expanding volumes with existing enterprise customers;
Integrating the RAY platform with popular content and eCommerce platforms such as Wordpress, Adobe and Magneto; and
Expanding transactional (i.e. non-recurring) volumes as a means to provide cashflow (as the majority of transactional revenue is paid upfront) and soak up excess capacity amongst its translator pool.

Financials

Straker’s historical financial performance is detailed below left. Note that this is on a pro forma basis – as if the first 4 acquisitions had all been completed prior to FY16 (and so excludes the recent COM acquisition) and differs from statutory reported results. Gross margins are healthy at ~55% and one would hope that margins will increase as the ML algorithm becomes more efficient and accurate. As can be seen from the chart below right, the company generated ~83% of its revenue from repeat customers in FY18 (including enterprise Master Service Agreements), an increase from 76% in FY16 and a pleasing upward trend.

The company recorded a slight beat versus prospectus forecasts at an underlying EBITDA (+$0.1M EBITDA) on a $0.9M pro forma revenue beat. Management did not provide any FY20 guidance (steadfastly refusing on the results investor call) – primarily due to the recent COM acquisition presumably – but we’d hope that some FY20YTD progress at least (if not actual FY20 guidance) is provided at the upcoming AGM.

Straker is reaching its EBITDA and cashflow breakeven inflection point around about now (after being cashflow neutral over the last two quarters combined), and as such there should be a reasonable amount of inherent operating leverage as additional translation volumes are added to the platform. Management want us to use Eurotext and Elanex (the first 2 acquisitions) as examples of the kind of operational improvements that the company is able to achieve post acquisition – and both of these businesses were generating 22% EBITDA margins within 2 years, suggesting that there should be some meaningful earnings uplift as the company continues on its acquisition path.

Closing thoughts

It needs to be noted that Straker’s future growth prospects rely heavily on the future acquisition pipeline (both the quality of these targets and management’s success in post-acquisition integration). The language services market is extremely fragmented and there is absolutely a consolidation opportunity available to the company (and ~NZ$18M of cash to fund this at the end of March).

It also needs to be remembered however that roll-up plays don’t always go according to plan (as shareholders in Paragon Care, National Veterinary Care, G8 Education and most recently Think Childcare (with its incubator tipped into administration last week) would lament). While Straker is keen to communicate that its acquisition and integration process is proven and repeatable, the company has finalised only 2 integrations to date, with operating synergies from the other 4 acquisitions yet to be fully realised.

At a $100M market cap (on a fully diluted basis) and a reasonable line of sight on the medium term growth trajectory – albeit dependent on the number and size of bolt-on acquisitions not yet initiated – Straker is not overly expensive at current levels, though it will need to grow earnings materially over the next year or two to grow into its current valuation given it’s only tipping into break even territory presently. The key is that the company is able to improve margins in acquired company through the provision of superior technology. Even then, it’s possible that margins will be competed away longer term, so we believe that the company must reach and maintain positive free cash flow (excluding acquisitions) if is to demonstrate a viable growth model.

While I am generally positive about its prospects, I consider it a relatively lower conviction holding for me personally at this stage, and am waiting for FY20 guidance which will hopefully be provided at the upcoming AGM before adjusting my own personal view. Finally, unlike the doubling of other Ethical companies Audinate and Appen in the past year for example, I feel that Straker is likely to be a slower burn from a share price appreciation point of view – unless the company supercharges its growth ambitions by undertaking the acquisition of a $10-15M revenue target (although that require a higher multiple paid by Straker and an associated capital raising). Industry organic growth of 7-10% is nothing to sneeze at – but personally I feel that Straker is unlikely to end up commanding premium multiples like Appen over the medium to longer term.

_______

A note from Claude:

I contributed to this report and I agree with its contents. For me, it is extremely important that the company prove it can make a profit and generate a positive free cash flow yield. If it can, then it could use its current cash-hoard to fuel revenue, margin and profit improvements until it has enough free cash flow to fund further acquisitions. Should this virtuous fly-wheel gain momentum, then I believe it will be impressive to watch. However, my entire thesis relies on this fly-wheel of self-funding growth and I have no interest in investing in “multiple arbitrage” roll-ups. I’ll sell without warning if I decide Straker is in the latter camp, but not for at least 2 days after the publication of this article (obviously).

Disclosure: Both Fabregasto (the author) and Claude Walker own positions in Straker and will not trade STG shares for at least 2 days after the publication of this article.

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Ethical Equities is currently underfunded. If you don't yet use Sharesight, please consider signing up for a free trial on this link, and we will get a small contribution if you do decide to use the service (which in turn should save you money with your accountant, or time if you do your own tax.) Better yet, you can get 2 months free added to an annual subscription.

This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

The Gent Manifesto: My Journey And Investment Process

Fabregasto — Thu, 09 May 2019 09:25:12 +0000

The Gent's Manifesto: My Journey And Investment Philosophy

Ethical Equities Founder, Claude Walker has suggested that I share with readers some background on my investing journey to date. This is my own fault and the just desserts for my hubris in publishing portfolio returns on Twitter. However, in the spirit of continuing to share ideas and in the hope that readers may find something useful for their own investing journey, the following is an overview of the evolution of the Gent Portfolio over the past few years, and then – more helpfully – some background on my style and what I’m trying to do.

Starting at the end

Here is the end result of my recent investing journey so far: portfolio returns to the end of April versus the benchmark I’ve chosen to use – the ASX Net Return Index (INDEXASX: XNT) (previously called the ASX Accumulation Index, which assumes the reinvestment of dividends back into the market). Please note that my portfolio balance includes small regular monthly contributions – which will have contributed about 20bps of the 353bps increase below (on a contribution basis only, pre including time weighted returns from that additional funding).

Net Return Index from: https://www.marketindex.com.au/asx/xnt

The portfolio is up 353% in a little over few years and clearly beaten the benchmark – but I’m extremely aware that this has been boosted considerably by tailwinds that are favourable to my style. Also, as a retail pleb I have considerable size advantages over the larger professional players – in particular that I can own much smaller companies than they can (whether due to their mandates or minimum cheque sizes), and that I can (usually) jump in or out of stocks without materially moving the share price. My investing style has largely stayed the same over this journey to date, but hopefully I am getting better as I absorb new information (from a mix of books, articles and podcasts – more on that later) and gain more experience. Not that this has stopped me making mistakes – you’ll see I’ve made some howlers – but hopefully I am making new and more exotic mistakes instead of repeating the classics.

Personal background and earlier spells in the market

I am approaching my mid 40s and over the past 18 years I’ve worked in fields that are either adjacent to the market or connected to the market in some way – though not directly professionally in stockmarket investing. My real world experience has included a few years in investment banking, several years in private equity, and several years in corporate finance – and I use the word “experience” here in the context of the Howard Marks quote that “experience is what you get when you didn’t get what you wanted”.

Nevertheless, my background has proven useful for my investing career to date, and I’ve been able to draw upon it when developing “gut feelings” about certain actual and potential investments. I’ve worked on buy- and sell-side transactions, met management teams and been involved in board meetings, dealt with a variety of different types of advisors, and have seen a bit of what is behind the curtain, so to speak. As readers would well know, gut feelings are often a necessary evil in investing outside the ASX Top 100 stocks – especially when there are gaps in information available which makes it difficult to see what is going on behind the scenes.

Before returning to the market in early 2016, I had been in and out of the market a few times over the preceding 20 or so years – but my two most active periods were in the mid-to-late 1990s (already, you know where this is going, don’t you?) and then for a few years prior to the GFC. This pre-Gent Portfolio “investing” experience was largely before the vast majority of my professional career – and is much closer to speculation than analytical investing. At those times I lacked the ability to properly parse financial statements and understand the broader context of companies and the industries in which they operate. Certainly, those periods were prior to later gained financial analytical skills and the development of a more rational decision making process. To wit:

My first ever investment experience was a big fat ZERO: the infamous Star Mining and its Sukhoi Log deposit (apparently one of the world’s largest gold reserves). SCN is a classic study of sovereign risk, with the Russian government seizing control of the mine, (then) Foreign Minister Alexander Downer attempting but failing to save the situation and Star Mining shareholders losing their shirt; also
At the time of the Dotcom crash I was foolishly dabbling in extremely speculative higher risk things like miners-pivoted-to-telcos and other similarly daft sh!t (in amongst some sensible things such as Fosters Brewing Group). The higher risk stocks were largely pre-meaningful-revenue (let alone pre-earnings) and many were opportunistic cash-ins on the Internet 1.0 bubble. I even owned Options in pre-revenue mining-turned-to-telco companies! And so I paid the price on that speculative cr@p – as I deserved to do. I had a poor grasp of risk/reward back then.

I did have some successes in the short interim period in the mid-00s (when my dabbling was closer to “investing” but still nowhere near as thought-out as my process is these days). This included a greater than 10-bagger with Cellestis (eventually taken over by Qiagen) and then early success with Nanosonics (drink for you Three Wise Monkey fans) way back when. I cashed out of the market (from memory around 2007) to use the funds for other purposes.

The Gent Portfolio (2016 – 2019 YTD (April))

When I re-entered the market in 2016 I had been sitting on the sidelines for nearly a decade – during which time I had significantly enhanced my financial analytical and commercial due diligence skills through my aforementioned day jobs. While I re-acclimatised to the market and got back into the grind of vigilant stock and portfolio monitoring, I decided to take a fairly cautious approach initially.

The evolution of my portfolio (focusing on key stocks) is illustrated below. At its official inception in January 2016, the Gent Portfolio largely comprised:

Traditional dividend-paying blue chips such as 3 of the big 4 banks, Woolies and Crown;
Supposed blue chips but actual-future-turkeys QBE, AMP, Flexigroup and Ardent Leisure (all sold largely pre downgrades, though from memory I weathered one on Ardent Leisure);
(Then) higher risk oil-related stocks Santos and Origin Energy (which back then some commentators believed could go under with the WTI crude price below $30); and
A smattering of growth stocks which together comprised 20% of the then portfolio: A2 Milk, BWX and Catapult Group (made a measly 20% on CAT through impatience, missed out on a further 80% gain (but also subsequent crash)).

2016

Going back to the main chart at the start of the article, you can see that for the first 12 months or so, the performance of the Gent Portfolio largely tracked the benchmark. Calendar year 2016 included some good results:

Nice returns on Origin (+71%) and Santos (+60%) as the oil price rebounded, though exited way too early on both (in hindsight);
Handy gains on the banks as they rebounded from their late-2015 nadirs (between 10% and 35% up excluding dividends (reinvested via respective DRP programs);
Some good returns in small caps such Cogstate (+51%) and Vitaco (+37%, fortunately taken over as it delivered a profit warning during the protracted takeover process); but net of
Some complete fails in the Mid Cap space such as Mayne Pharma (-47% after successfully nailing the absolute top [FACEPALM] and then averaging down a few times [Edward Munch “The Scream” emoji]) and Baby Bunting (-24%), as well as losses in mediocre mid-caps such as OFX (more foolish averaging down) and Capilano Honey.

During this time A2 Milk was up 66% and BWX 20%. BWX I would eventually hold to a 98% gain (missing the top by about 15%) – but I abandoned it soon after the Andalou acquisition (which immediately felt “off strategy” to me) and fortunately pre the profit warnings which have occurred since. Watching BWX from the sidelines and profit downgrades from other serial acquirers I fortunately haven’t owned has made me personally very wary of the growth-by-equity-diluting-bolt-on-acquisition model.

While my performance was broadly *meh* vs the benchmark, the time in the market generating actual profits and losses, and the time spent researching stocks gave me the chutzpah to want to take the training wheels off and focus more on what I’m most interested in: growth companies and those that can potentially become multi-baggers (more on that later).

Sometime during 2016 I started listening to investment podcasts, reading investment blogs and classic investment books and generally trying to sponge as much information as I could to help my decision-making and investment-screening process. I have a large pile of investment books I’m slowly working my way through – probably not helped by the fact I’m buying new ones quicker than I’m reading the ones I already have. I also initiated my pre-investment checklist around this time (which continues to evolve) – which has definitely helped me screen potential investments better, but has definitely not stopped me from committing various investment crimes.

Overall, a key driver of the increase in overall portfolio value since 2017 has been Afterpay (added in April 2017 at $2.45 initially pre the merger with TouchCorp, back when the ticker was $AFY). Afterpay has been without doubt the single biggest contributor to the performance of the portfolio. When screening the stock, I thought I could see potential for two Economic Moats: early signs of Network Effects and also Switching Costs (retailers not wanting to switch out of a payment platform which materially increased basket size). The latter is debatable but the former has certainly proven true in Australia IMO.

2017

Also driving performance during 2017 was the doubling of BWX (exited early 2018), the tripling of A2 Milk (though I took profits below $3 and at around $7 – compare this to recent trading above $15 [FACEPALM]), and success with new investments in Pushpay and Titomic (both since exited, however I re-entered Pushpay during the market melt-down just before Christmas last year). Calendar year 2017 contained yet more head scratchers (and valuable lessons) however – such as:

Failing spectacularly in trying to catch falling knives in Vocus (-28%) and BPS Technology (-21%, which I misinterpreted as a Deep Value play);
Speculative fails such as Nuheara (-30%) and Mitula (-36% post a painful profit warning which exhibited operational incompetence (theirs as well as mine)); and
A couple of examples of not doing enough research – the one which has stuck with me the most is Smart Parking (only a 7% loss – but I flipped quickly from thinking it was an interesting novel new technology pre-investment to post-investment realising the technology was literally everywhere already and deployed by much bigger companies than SPZ. This realisation spurred me to deepen the competitor analysis I do pre-investment).

The end of 2017 (and early 2018) also included a hospital stint (re-admission to deal with an infection picked up during an initial knee operation) and heavy antibiotic treatment which lasted a couple of months. This period – probably due to boredom but also at least in some part due to the heavy duty antibiotics (which definitely messed with me physically) – was characterised by much higher levels of trading and arguably higher levels of risk taking. While overall this period was profitable, the net positive outcome is driven by a single 51% return from a relatively large position in Elmo Software – which covered for a string of small losses on lower quality flotsam and jetsam. I learned a valuable lesson about over-trading and not sticking to my system, but it could have been much, much worse and thankfully I wasn’t buying Bitcoin at the December 2017 peak in my delirium and hospital pyjamas.

So, despite various flavours of stupidity, the portfolio was up 79% for 2017 with A2 Milk and Afterpay responsible for a good chunk of gains.

2018

These 2 companies continued to underpin returns throughout 2018, as did Appen (added belatedly in late 2017) and Audinate (early 2018), as well as Titomic (+321% overall gain before exit) and Pushpay (+75% for the first time I held it). In 2018 the portfolio posted a 28% return – however this was down 20% since the highs of August, with the market going Risk Off in early September.

One of the reasons I *wasn’t particularly fazed* by the selldowns in November and December was that a number of my stocks in the portfolio had already shredded 30-40% in September and October (ouch!), and didn’t lose that much more over the rest of the year. I added to positions in new stocks Serko and Straker Translations as well as re-entered Pushpay (then down 30% from its August high) in the week before Christmas – which felt very uncomfortable at the time. *What I should have done* was add more to core higher conviction holding Appen (which has since nearly tripled from the December low – but then Appen and I have a painful past (saga described later) and I’ve struggled previously with valuation on that one at times (despite its long history of earnings upgrades).

Calendar year 2018 wasn’t without new and exciting investment crimes however – including but not limited to:

Ignoring price action and being stubborn with Know-Your-Customer software companies Kyckr (just seen down a whopping 75% since I exited – phew) and I Sign This (annoyingly since doubled – L) – both ~20% losses after being up 30-50% each;
Giving the benefit of the doubt for far too long (and being a baggie) with seed technology company Abundant Produce (38% loss, but since re-entered recently at one third of my exit price following 2 positive Australian distribution announcements); and
Copping a 54% loss on Pivotal Systems – a technology provider to the cyclical global semiconductor industry – sadly a lesson not learnt until the recent profit warning for Revasum.

These are all smaller companies – which are typically riskier than large- and mid-caps – the reminder for me here is not to ignore share price and volume signals – particularly in higher volatility periods, as small- and micro-caps can disproportionately suffer in market downturns.

Thankfully, overall there was less churn in the portfolio through 2018 – as I finally (hopefully) learned to stop wasting time on lower conviction companies and try to maximise attention on my higher conviction names.

2019 YTD

Portfolio performance in 2019 (to the end of April) has been frankly ridiculous – and likely unsustainable (more on that later) – with a 61% gain for the first 4 months, which I would be ecstatic to hold onto for the rest of the year. Key drivers of this result have been Afterpay (+106% in 2019), Appen (97%), Audinate (+81%), A2 Milk (+55%) and first cannabis investment Elixinol (+86%), as well as recent IPOs Next Science (+60% to end of April) and Ecofibre (+120%). Given the performance of Afterpay since I first entered the company (up 940% to the end of April and further since) and its increasing proportion of the total portfolio, I’ve sold one quarter of this holding (and also lightened some A2 Milk) partly for risk management purposes, but primarily to fund my participation in the two aforementioned IPOs and new positions in a handful of other companies that I like the look of.

Portfolio stratification and composition – end of April 2019

The table below left (an abbreviated version of my main dashboard (which includes VWAPs and actual returns)) shows how I think about my portfolio, which includes dividing it into three tiers:

Tier 1: higher conviction stocks – which *I personally* believe are reasonably likely to be longer term multi-baggers (and have started this compounding process already) – and so I plan to hold until I see evidence to the contrary (i.e. that growth is likely to slow considerably);
Tier 2: companies that I like as potential longer-term high conviction stocks (may move into Tier 1) – but where I am looking for more evidence (careful not to repeat a past mistake of jumping to a high conviction belief too quickly based on share price action alone); and
Tier 3: companies that I like the look of but are typically earlier on in their development than Tier 2 companies and will likely need at least 12 months of monitoring to make a more accurate later assessment.

This stratification isn’t at all revolutionary and I know other investors who think about their portfolios similarly anyway, but I find it helps me focus more on (1) letting Tier 1 companies run until I see evidence that my initial investment thesis is coming apart; and (2) continually monitoring my other positions for signs that my thesis is either wrong or playing out as hoped – and, if the latter, averaging up and increasing my position (which I struggle with due to my atrocious Anchoring Bias but hopefully am getting better at).

New positions are typically 2-3% of my overall portfolio size until they prove (usually via the next set of reported numbers and key metrics) they deserve to be added to – or divested entirely.

Since the end of April I have trimmed slightly – such that cash is now up to 5%. Philosophically I am normally largely fully invested, with cash having averaged ~3% since inception of the portfolio (though I did trim holdings to increase cash weighting to 8% in September 2018 as I felt the market going Risk Off – and redeployed these funds three months later).

It’s worth mentioning at this point that I monitor my portfolio very closely indeed. I have the ASX Today’s Announcements page sitting in the background all day long at work and I’m constantly scanning intraday for (1) news on my companies which may change my perspective, and (2) potential new investments – especially during 4C and half/full year results seasons. I believe that higher levels of monitoring are needed when investing in Growth stocks and small- and micro-caps generally – as these companies are more likely to experience volatile up and downwards share price movements (in comparison with larger more stable blue chips – though blue chips are not immune from profit warnings, see AMP, IOOF and others).

Prior to buying my first shares in a company, I aim to make sure that I have figured out internally what my personal investment thesis is for the company – what needs to be true in order for the company to be a long term multi-bagger, usually a combination of financial metrics (revenue, margins and profitability), market share and competitive position, and whether potential Economic Moats are actually evolving as hoped (all covered in the Pre-investment Checklist section below).

My overall investing style: aiming to be a baggie of a different kind

For all my adventures and misadventures since the start of the Gent portfolio, my investing style and aim has largely stayed the same: I am trying to find companies that can become multi-baggers over the longer term. In an ideal world, I’d have a portfolio in 20 years’ time comprised of CSLs (up 260x in 25 years since its 1994 float, it had a 3-for-1 stock split in 2007)

*Waits patiently for half an hour until roaring laughter dies down.*

But this is actually not that far-fetched.

If you were to compare the composition of the ASX Top 100 two decades ago versus today, you would see that a number of companies have seeming vaulted into this bracket from nowhere in 1998, and a lot of this is driven by technological advancements over the intervening period as well as the high quality of management teams of those companies. In just the last decade there have been many examples of considerable multi-baggers on the ASX – including but not limited to):

Appen: up 51x since its IPO at $0.50 in January 2015 (just over 4 years);
Afterpay: up 27x since its IPO just 3 years ago;
Altium: up 92x over the last 10 years;
Promedicus: up 27x in the last 10 years;
Webjet is up 13x over the last 10 years; and
Xero is up more than 9x since 2013;

The above returns of course assume that investors stayed the course over the journey and weren’t either tempted to take profits (as earnings multiples expanded considerably) or shaken out of their positions during times of market turmoil. But this absolutely proves that the key to generating multi-baggers in your portfolio is having the mental stamina and conviction to hold these stocks for that long in the first place.

Furthermore, the last 10-20 years is not an unusually fertile once-in-a-century period which provided the environment for technology companies to generate supernormal returns. There were 100-bagging stocks nearly a century ago:

Thomas Phelps’s 1972 book “100 to 1 in the Stock Market” (not yet read but in the pile on my bedside table) details the 365 US stocks which were 100-baggers between 1932 and 1971.
Christopher Mayer’s 2015 book “100 Baggers: Stocks That Return 100-to-1 and Where to Find Them” (have read, recommended) updated this analysis and found a further 365 US stocks which were 100-baggers between 1962 and 2014.

It is of course impossible to predict with any degree of certainty that any company is going to go up 10-50x from the point you buy it. By definition, that company is likely to be a micro- or small-cap, and companies in the smaller end of the market tend to be higher risk with typically lower quality financial and operational information (i.e. versus larger caps with their typically more sophisticated reporting).

It should be noted that companies inherently bear an asymmetric payoff profile: you can only lose 100% (cold comfort of course if you do actually completely lose 100% of an investment) whereas the upside is uncapped in theory.

Of the investment blogs, books and podcasts I’ve digested so far, the content that has resonated most with me personally has been from Ian Cassell and his Microcap Club website (Ian has also been one of the key drivers of the interesting Intelligent Fanatics project). Ian seems to be more of a traditional Value investor, but I think a lot of the key learnings are still applicable at the Growth end of the spectrum – particularly in terms of hunting multi-baggers.

Pre-investment screen checklist

I mentioned earlier that I have developed a personal screening checklist for my own artful purposes in evaluating potential stocks – largely a combination of things I’ve pilfered from elsewhere so I claim no IP here – feel free to borrow any bits (if any) that resonate with you for your own checklist.

This continues to evolve over time and is by no means a fail-safe predictor of success, but it has definitely helped fine tune my decision-making process with respect to potential long term investments.

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Right now the checklist simply adds to a score but isn’t weighted with higher points awarded to the more important factors – which is the next logical step. I have thought about doing this, and will probably re-calibrate in this way. However, I no longer use the checklist as the sole arbiter for the decision-making process. While the score is useful – certainly in knocking lower quality things out of contention – the most important use of the checklist IMO is to ensure I am thinking about the right things before I dip my toe in the water and buy a starting position in a company. The checklist has also helped me make faster decisions – especially if I can quickly see that a potential investment has most/all of the factors I care about most, and few/none of the red flags. This quicker decision time has also been very helpful, especially when I originally used to take as long as 2-3 weeks to analyse a potential investment (during which time the share price could move considerably away from me).

Before buying into a new company I try to do as much efficient research as possible – not “boiling the ocean” combing the internet for every last sentence on the company, but trying to extract the key information I need to help with the checklist. Typically this includes:

Latest annual report, full-year results and half-year results – especially accompanying investor presentations
For loss-making companies, last 12-24 months of 4C (quarterly cashflow) statements
Last 12-24 months of ASX announcements – with investor presentations
Broker research on the company and competitors (to the extent available)
If the company has been floated in the past few years, the IPO Prospectus (often extremely valuable for industry analysis).

The Gent Investment Manifesto

“Manifesto” is no doubt overselling it, and I’d expect readers to have worked out many of these points themselves already, but below are some things that I’ve learned along the way which I try to remember:

Don’t get jealous. I used to get jealous seeing others doing well on stocks that I didn’t have (particularly if I’d passed on that company). But it’s just not possible to be in every stock and you have to choose which ones you’re going to sink your funds into. Also, different investors have different strategies, I need to focus on MINE, and if I’ve chosen well, my time will come. It’s more important to focus on personal growth (i.e. comparing to yourself 2 years ago, not to other people).
Investing is an emotional competition. Being able to keep a handle on your own emotions and psychology (in particular, feelings of greed and fear) is a key advantage in my view. You need to keep your eye on what the market is doing obviously, but keeping a clear line of sight on your strategy and goals and not being buffeted around by the emotions running rampant in the market prevents you from being shaken out of investments which can potentially be precisely as good as you thought they were before investing initially.
Curate your information feeds. In connection with the previous point, and as discussed a bit further on, there is simply too much financial and market commentary out there – the vast majority of which I personally get zero value from. I read the AFR every day, but I ignore news finance segments, don’t watch Sky, and instead spend the time listening to podcasts and reading blogs and other information sources that I find much more useful and hopefully which will give me an informational edge at some point in the future. I’ve found that this curation has stopped my brain (which is easily distracted, not that dissimilar to the prototypical hamster wheel) from being filled with garbage which can slow down and pollute my decision-making process.
You don’t need to have an opinion on everything. I’d much rather have deeper knowledge of a couple of dozen companies (so I can understand quickly if something changes) than shallow knowledge of 1,000 companies – and be slow to react to developments. This may be more to do with individual personality type, but I don’t need everyone to agree with me (in fact I love having a different view). For the same reason, I generally prefer not to use mental bandwidth to debate stocks.
The natural extension of this to stick to areas where you have knowledge and edge, and to understand what you’re good/not good at. For example, I’m not very good at technical analysis and charting. Sure, I can eyeball a chart and make up my own mind as to whether I think it looks positive or negative, but I couldn’t definitely pinpoint when/where it is time to get into a new stock. Instead, when I have found a potential new investment, I start watching price action, trading volumes and the buy & sell queues like a hawk, trying to develop a “feel” for momentum and lack thereof. You may also have noticed I don’t hold any mining or oil & gas related companies – I’m just not good in that space, and until I spend the time to educate myself on that sector I would be operating at a disadvantage vs people who have many years trading and investing there.
Turn over the most rocks. This is of course that famous Peter Lynch quote: “he who turns over the most rocks wins”. Lynch estimated that only 10% of companies were worth considering. You need to continually be looking at new ideas, because your portfolio probably won’t remain static over a 12-month period (unless you have chosen exceptionally well). You’ll always need good ideas to replace portfolio holdings that turn bad or don't work out as well as planned. Personally I love researching new ideas – though have to caution myself that they need to be as good as (or better than) those companies I already have to warrant inclusion, otherwise by definition I am diluting the position of higher conviction positions. This is of course connected to the great Warren Buffet quote (“Mercy! Is there anyone The Gent WON’T steal from?”) – about waiting for your pitch and not pulling the trigger on lower quality stocks.
“The market is always right.” This is more about realising that we are small players in a huge ecosystem and are individually powerless to turn the tide. But also, we must recognise that sometimes we don’t have access to information that other market participants seem to, and that there may be a very real reason for share price movements which we cannot (yet) see. Investment is just as much about survival as anything else – you have to live to fight another day so that you can win later on – if you are completely wiped out trying to hold fast against the weight of the market you won’t be able to mount your comeback. This is a key reason why I’ve never used leverage (which would just add another layer of risk onto the already-higher-risk area in which I play) – I’ve seen what leverage and margin calls in particular can do to a portfolio.
Try to take a longer term investment horizon. In particular, I try to look out 5-10 years and understand whether what a company does will “still be a thing” at the end of that period. I looked briefly at Big Unlimited (ASX:BIG), now bankrupt, at 70c (without seeing it for what it was) but passed quickly as I just didn’t believe it was going to “still be a thing” in 2027 or even 2022 (and missed out on a potential 7-bagger at the top). The key for me is to understand whether a company’s product or service will be redundant over that time period, or whether it will be something that is still monetisable or just bundled together with other products/services. An example of this email in the Internet 1.0 era – which we all take for granted now of course (but which didn’t stop MCI Worldcom paying more than $500M for Ozemail in 1998).
Know your portfolio, and be ready to sell. You need to be up to date on all the stocks in your portfolio, to understand why you’re holding them and what could potentially go wrong to invalidate your investment thesis. The motivation for following companies this closely is that you can tell quickly if something is not working out and you need to abandon ship – such as signs of management incompetence or unethical behaviour, or if the longer term narrative is changing in a negative way (which can bring Growth company multiples crashing back to Earth).
Think in levels of conviction. A large proportion of investors think in terms of DCF valuations and P/E multiples, and price targets derived from these valuation approaches. As I’ve discussed before on Ethical Equities, the standard P/E ratio does not factor in relative rates of earnings growth between companies. This is where the PEG ratio (P/E multiple divided by EPS growth rate) comes in. For example: I personally would rather own a company trading on a 40x P/E and growing at 20% annually (a PEG ratio of 2.0x) than a company trading on a 15x P/E and growing at 3% annually (a PEG ratio of 5.0), although the latter company is more likely to pay a dividend which narrows the difference somewhat. Unless a company’s valuation becomes truly crazy and the company’s actual revenue and earnings are years away from justifying that (i.e. even after using a PEG ratio), I try to think in levels of conviction – letting winners ride if they are still delivering strong growth. Taking profits in A2 Milk at $3 and watching the remainder of my holding soar above $10 (currently $15) really drove home this point for me personally. You have to remember that as each fiscal year rolls over, the forward earnings period rolls over too, the new year gets pulled forward in the DCF model, increasing base earnings (and terminal value) and thereby increasing DCF valuation as a whole – so valuations and price targets will rise year on year if the company is growing. You can see this happen in the market – going back to A2 Milk for example, I believe that over time the market starts to look through to the following fiscal year (June reporting year-end) EPS as early as April of each year. This is a great reason to try not to get persuaded by price targets and DCFs for fast growing companies, and to consider the PEG ratio as well. There is little point selling if the company is going to become a Hold (fair value) or Buy in several months’ time when the company rolls into a new financial year (and you would want to re-add the company to your portfolio).
Let them bag. As mentioned much earlier (sorry, I should have scheduled an intermission) serious wealth creation comes from letting multi-bagging companies do their thing over time. As Ian Cassell has pointed out, every multi-bagger will have periods of stagnation as fundamentals backfill (earnings catch up to price) and bored, impatient old shareholders sell to new shareholders with a longer term perspective. Patience is a key source of advantage over other investors (short term traders especially) in the market. A multi-year run is comprised of many mini-cycles (look at the share price charts of A2 Milk and Appen for example). Yes it’s true that “nobody ever went broke taking a profit” – but the OPPORTUNITY COST (lost profits) can be extreme. How much money did I leave on the table in my A2 Milk profit-taking example above? Yes, I reinvested the proceeds into other things – and probably recycled the capital a few times since then – but have those things all gone up by 5x? I doubt it. Another thing I have been guilty of a bit – but not much thankfully – is trimming holdings as companies become bigger proportions of my overall portfolio. I know some people who do this continually – which is the exact reverse of how you get long-term life changing multi-baggers.
High concentration is OK. In fact, being highly concentrated is not just OK, it’s one of the keys to building serious wealth over time and also outperforming the market in the process (provided you have selected stocks well, of course). Portfolio diversification is a key risk minimising strategy, but the more stocks you own, the more likely that your returns will mirror the index. Further, a number of recent studies have shown that after about 20 equally sized positions, the benefits of diversification disappear. But naturally, the lower the number of stocks in your portfolio, the higher volatility it becomes. Everyone will have their own ideas about what is the optimal number of stocks to own. Since the inception of the Gent Portfolio I’ve held an average of 12 stocks (as low as 9, as high as 17 at the end of April (which may be the upper end of my personal tolerable limit, I’m starting to get a bit twitchy). Maybe I’ve broken rule #6 above and let a handful of lower quality ideas into the portfolio? Perhaps, although two of these are recent IPOs Next Science and Ecofibre (which I do like longer term – to be proven, currently in Tier 2).
Inflection points are particularly useful. I have long been on the hunt for companies reaching an inflection point (particularly the point where it reaches its cashflow and profit break-even point). Friend of Ethical Equities, Matt Joass, has written an excellent piece on inflection points – which also includes other factors which can lead to a structural spike in revenue and profitability – such as a new product launch or a turnaround. In tracking the quarterly cashflows of loss-making companies I am particularly looking for signs that a company is not far away from reaching cashflow break-even (which the market interprets generally as a major de-risking point) – especially for highly scalable companies where investment has been made in technology, systems and people, and where increasing revenue will lead to greater proportional increases in margins and profitability due to this operating leverage.

Shooting myself in the foot

All this planning and process is all fine and dandy, but I continually run afoul of rule #2 above – in particular, I find it a continual struggle not to succumb to my vast collection of cognitive biases.

There are many articles about behavioural biases and how they can impact investor performance. This Investopedia article is a good summary of the most famous biases, following on from the pioneering work of Kahneman & Tversky, including:

Anchoring Bias – anchoring to a particular share price or metric
Confirmation Bias – ignoring information that contradicts earlier impressions and absorbing only that which confirms them
Loss Aversion – failing to sell losing investments because of the triggering of a capital loss and the recognition that the investor may have made a poor investment decision
Familiarity Bias – such as filling your portfolio with very similar companies in the same industry

By far my biggest problem has always been overcoming my profound Anchoring Bias – in particular, failing to pull the trigger on a potential new investment because it has increased from a lower share price to which I’ve mentally anchored, but also failing to average up (buy more) of higher conviction (Tier 1) holdings as they have performed well and started to prove out my investment thesis. Hindsight is 20/20 vision but I should have been adding more Appen and Audinate in particular last year during the Risk Off phase.

My anchoring bias has resulted in the following Sins of Omission (i.e. notable absence of the following higher quality stocks from my portfolio):

Altium: at around $10, waiting for it to fall back to $9 (current ~$33, all time high $35.59)
Promedicus: at $9.10 before last Christmas, hoping for $8.50 (around ATHs of $20.52)
Nanosonics: at ~$2.70 before Christmas – and having owned it from ~$0.50 to ~$1.05 a long time back, hoping it would come back to $2.50 (current $4.85, having hit $5 recently)
Xero: at ~$20 in mid-2017, hoping it would fall back to $18 (where it started 2017) (currently around ATHs of ~$55)
Polynovo: at 55c, hoping it would go down to 50c (current: $1.03, having reached $1.16)

I could add more but I’m turning into a goth as I write this section.

The last example is Appen – you may have noted that I do in fact have APX in my portfolio – because I finally belatedly did pull the trigger – above $7 following the acquisition of Leapforce.. having been frozen to my chair and unable to buy around $4.50 just weeks earlier.. because I was anchored to the $2.50 share price it had been trading at – just prior to not buying it at $2.80. YE GODS MAN!

Predictions of doom and my plan of attack

There is always, always, a tremendous amount of commentary in the financial media – a lot of opinions and predictions and very little accountability and measuring of accuracy after the fact from what I can see. The cynical part of my brain interprets a good chunk of this content as being designed to generate broker commissions as well as sell newspapers etc. There are perma-bulls and perma-bears (both of which will be right at some point), and those that clutter the ether in between. Long ago I decided that this garbage was distractive filler, and that spending more time on curated information sources is a much better way of (1) maintaining my sanity, and (2) saving my mental energy for learning more useful content.

For the last couple of years there has been talk in some quarters of another major global recession, or worse, a repeat of the GFC. The latter seems unlikely to me. I think the GFC was closer to the Great Depression (albeit over a much shorter timeframe) than a normal common or garden recession. A number of recent articles, such as this one from Morgan Housel discuss how investor mindsets are driven by the events experienced during their lifetime. For example, many investors who saw their wealth shredded by 90% over the harrowing 10 year period following the 1929 crash – then lived through the Second World War – were largely not mentally ready to be taking risks investing in the American consumer products boom which started in the 1950s fuelled by easy credit and low interest rates (Morgan again). I am wary of letting my fear of a repeat of the GFC constrain my optimism for future technological advancements and the potential accompanying investment opportunities.

There has also been commentary calling for a repeat of the Dotcom Crash (the bursting of the internet bubble in 2001) due to the elevated valuation multiples currently being enjoyed by the Australian WAAAX stocks (and other tech stocks globally). I definitely do think there is likely to continue to be periodic corrections in Growth companies over the medium to longer term – this is par for the course with higher growth companies as the market oscillates between periods of Risk On and Risk Off. I don’t, however, believe that there is another global reckoning which will see the tech sector come off 70-90% and remain subdued for several years. I don’t like to pull out “This Time It’s Different” Trap Card, but it feels nonsensical to compare the 1998-2001 bubble to now. The Dotcom bubble was Internet 1.0 – when the internet was relatively new, and we were all going to live our lives entirely online from exquisitely modern homes on Saturn by the year 2005. The bubble burst – and continued to deflate for years – because it became quickly apparent that prevailing technological capabilities were massively short of where they needed to be to deliver on the hype, and multi-billion market capitalisations for companies which were not generating meaningful amounts of revenue (let alone earnings) were of course completely nonsensical.

Roll forward to 2019 (and the nearly two decades of technological advancements in between which have made it possible to realise many of those Internet 1.0 era promises) and we have:

Apple trading on a trailing P/E of 18x and generating US$266B of revenue for FY18;
Facebook generating gross margins of 83% on US$56B of revenue (up 37% in FY18) and trading on a 26x trailing P/E; and
Amazon generating US$233B of revenue for FY18.

Obviously these are three of the largest companies in the world, and [gum-chewing teenager voice] like, the most obvious examples ever, but the point remains: they are the vanguard of the tech sector, are all entrenched enormous and highly profitable businesses, and will not be plunging 70-90% in any Tech Crash 2.0. Unless, of course, we have a repeat of the dinosaur-killing asteroid which landed in the Chicxulub crater – in which case, guess what, your odd collection of pimply unloved Deep Value stocks is not going to save your portfolio.

That said, it does feel to me like we are in the last stage of a bull market, and there are a number of signs suggesting this to me – including but not limited to:

The rush to IPO for a number of large loss-making companies including WeWork, Uber and Lyft (never mind the ridiculousness of a $4B valuation (40x revenue) for recently listed US meat substitute company Beyond Meat, or Pitbull recommending biotech stocks);
A lot of backslapping on recent (insanely) profitable investments and from what I can see widespread feelings that it’s become easy to make money in the market in 2019 (especially from younger investors who’ve never seen a bear market, of which many of whom were previously ecstatic, then shattered, crypto speculators); and
Spectacular share price movements in Growth names in 2019 – soaring way above previous mid-2018 highs to new pinnacles.

That great Warren Buffet quote about being fearful when others are greedy feels particularly poignant right now (to me). I do think there is a good chance that at some point in the next year or so we will experience a bear market and 20-30% drawdown. There have been different articles recently about the length and extent of corrections (10-20% drawdowns) and bear markets (20% or more), but broadly (using US figures as the ASX is likely to follow suit just as it has done continually in the past few decades):

The average length and depth of a US correction is about 13-14% and 4-5 months:
The average length and depth of a US bear market is 30-33% and 13-14 months.

That would not be fun (2H2018’s meltdown in Growth stocks certainly wasn’t) – but if history is any guide it’s inevitable at some point. But also, it’s not going to last forever and historically equities have returned to their long-term upwards trajectory afterwards.

Typically, stocks perceived by the market to be higher quality rebound first (i.e. before the more speculative names that soared just because they operate in the same sector etc). Hopefully my portfolio includes some of these higher quality names and any downturn in my portfolio would not be prolonged. It’s up to me and my process to select those higher quality names.

And if I have chosen companies which will continue to grow revenue and earnings and aren’t so impacted by either a falling share price or the reasons behind a broader market rout (i.e. a recession), then I’m personally not that fussed if the share price falls 20-40% (and like the thought of attractive buying opportunities). I’m not confident in my ability to time the market (selling before the plunge in order to buy back at the bottom), I don’t want to trigger capital gains in trying to be too cute, and if these are long term holdings for me which I plan to hold for years (as long as the company continues to grow in line with expectations of course), then why go through the hassle of selling to buy back later? That didn’t work for the masses of people who sold out of the market in late December 2018 (when press commentary was at its most bearish and everyone was certain of a global bear market (which hasn’t eventuated)) – with many stocks up 20-80% since those December lows (and some people only returning to the market in March when they thought it was “safe” again).

There have been many articles in the last few years about the danger of trying to time the market – and they revolve around the fact that a calendar year’s returns are generally driven by just a dozen or so key trading days, with the other 230-240 trading days in a year adding to not much. Not being in the market on those days can put a serious dampener on your returns. I’m not smart enough to know when those days will be and don’t believe I have any edge (i.e. versus the rest of the market) in timing when to liquidate my portfolio (duh, at the top, dummy!) and buy back my holdings (at the bottom!).

In the event of a downturn I’m more likely to be a buyer – providing I have some dry powder of course – hoping to add more to my higher conviction (Tier 1) names, potentially also Tier 2 depending on the extent of share price carnage and the opportunities presented for those companies. Each individual investor will have their own personal feelings about what is a sensible amount of cash to be holding at any given time – just bear in mind that this is also an “active” position (i.e. betting that stocks will go down).

Don’t try this at home..?

You might expect with my Growth style and ludicrous aim of hunting multi-baggers that I would be a perma-bull who gleefully throws cash around without any regard for potential danger, but actually in my personal life I am pretty frugal and fairly risk averse. I own a 13yo Mazda for example (will never own a Lambo – spending money on frivolities like that is not how to get or stay rich). If I had a time machine I would probably go back 20 years and slap younger me about the face about the way I wasted money on CDs and DVDs and other shortly-redundant material possessions. Too late did I realise the key point about compounding: you have to start ASAP – by delaying 5 years you are not forgoing the first 5 years where the snowball is rolling slowly downhill eking out yawn-inducing returns; you’re robbing future retired you of the last 5 years where your nest egg is growing each year at MULTIPLES of your initial investment.

I probably have a higher appetite for risk than others (which I try to couple with an analytical evaluation and research process which hopefully de-risks my strategy somewhat) – so I don’t recommend that readers set out to follow my strategy to the letter as your investment goals and horizons are likely to differ from mine. In particular, I don’t think you could follow my style if you weren’t prepared to keep monitoring your portfolio and the market very closely (which I know some would find extremely tedious). So I encourage readers to follow their own path and decide which investment style is for them – but I greatly recommend that you read as widely as you can, as that can potentially give you an edge over the masses in being able to successfully understand new companies from different industries (personally I like science and astronomy, itching to participate in the Rocket Lab IPO if that happens).

There are many different ways to make (and lose) money in the market – and this is mine. It will probably be anathema to self-righteous bearded value investors [thank you John Hempton for that awesome imagery (he said, stroking his self-righteous beard)].

I believe my investment style fits with my personality type and world view (optimistic about the pace of technological innovation, trying to look 10 years out). My style has worked recently but there’s no certainty that it will continue to work equally well in the future. I have a long way to go from an investment development perspective – there will always be new things to learn – and I’m looking forward to seeing where the path takes me. Onwards and upwards.

Thank you for reading this far if indeed you have.

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Epilogue: recommended reading/listening

Below is a short list of information sources – in the case of podcasts and blogs, ones that I listen to/read regularly – as part of an overarching mission to educate myself, broaden my horizons, and try not to be as ignorant as I have been for most of my life.

BOOKS

There have been a number of Recommended Reading lists published by various professional and retail investors in recent times – a good one here by another friend of Ethical Equities, the giant red cartoon hound 10foot Investor (Twitter: @10footinvestor). I would add a handful to this list (and would have added more if I’d made more progress with my ever-growing pile):

100-Baggers – Christopher Mayer
The Most Important Thing – Howard Marks
The Outsiders – William Thorndike
Money Masters Of Our Time – John Train
Zero To One – Peter Thiel
The Little Book That Builds Wealth – Pat Dorsey (great discussion on Economic Moats)
The Little Book That Beats The Market – Louis Navellier
A Short History of Financial Euphoria – John Kenneth Galbraith

PODCASTS (and Twitter handles)

Australian

Three Wise Monkeys (Claude Walker, Matt Joass, Andrew Page).
The Acquirers Podcast (Tobias Carlisle).
The Rules of Investing (Livewire).
Australian Investors Podcast (Owen Raszkiewicz).

Invest Like The Best (Patrick O’Shaughnessy: @patrick_oshag) – my single favourite podcast, with a wide variety of very smart guests from very many different fields, strongly recommend going back to listen to all of them.
Capital Allocators (Ted Seides: @tseides).
The Meb Faber Show (@MebFaber).
Masters In Business (Bloomberg – Barry Ritholtz).
Against The Rules (Michael Lewis).
FYI – For Your Innovation (Ark Invest).
The Disruptors – About The Future (only recently discovered, a long backlog of episodes to catch up on).

INVESTMENT BLOGS (and Twitter handles)

Microcap Club: microcapclub.com/category/blog/educational/ (Ian Cassel: @iancassel).
Morgan Housel: collaborativefund.com (@morganhousel).
Michael Batnick: theirrelevantinvestor.com (@michaelbatnick).
Nick Maggiulli: ofdollarsanddata.com (@dollarsanddata).
Matt Joass: mattjoass.com (@MattJoass).
10foot investor: 10footinvestor.com (@10footinvestor).

This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). The author owned shares in the companies disclosed above at the end of April 2019. Authorised by Claude Walker.

Readcloud (ASX:RCL) Quarterly Cashflow Report Q3 FY 2019

Fabregasto — Fri, 03 May 2019 01:13:21 +0000

ReadCloud (ASX: RCL) released its 4C (quarterly cashflow statement) for the March quarter earlier this week. The 4C didn’t contain much that hadn’t already been telegraphed in the previous quarter’s 4C and the 1H19 results, but did include the company’s expectations for cash outflows in the current June quarter, as well as some vague guidance on customer receipts. The table below presents RCL’s quarterly cashflows since listing early last year:

As can be seen above, the company’s cash balance declined $0.5M in the March quarter to $2.4M. However this was driven by seasonally higher payments to publishers and booksellers which had already been flagged in the December 2018 4C (and were broadly in line with estimates). These payments are expected to be 70% lower in the June quarter.

Of note, the company flagged that June quarter customer receipts are “expected to exceed the March quarter”. Assuming this holds true, the company would generate a minimum positive net cash flow of $0.4M for the current quarter (based on ~$1.6M of customer receipts). However, I expect a significant increase in customer receipts for the June quarter – based on 1H19 achieved revenue of $2.3M and management’s forecast of higher revenue for 2H19 (vs 1H19, reiterated in the new quarterly update) – suggesting a range of $4.5M to $5.0M for full year FY19, and incorporating known seasonality in receipts:

Invoicing of AIET revenues in April ($0.9M for FY18 but likely to be higher in FY19 given the significant number of new VET schools signed since acquisition); and
Receipts of some Direct Schools and Reseller channel sales invoiced in the March quarter but not received by quarter end;

In the table above I have included $2.1M of customer receipts as a placeholder for 4Q19 – which would take full year receipts to around $4M. Given that the vast majority of sales are invoiced in the 2^nd & 3^rd quarters (received respectively in the 3^rd and 4^th quarters), I wouldn’t expect much straddling of receipts between financial years, and I believe that full year receipts should be broadly in line with full year revenue – suggesting there is upside to my $2.1M estimated receipts above.

The combination of RCL’s outflow forecasts and my receipts assumption above yields a year end cash balance of around $3.4M. This *potentially* looks sufficient to fund operations through the seasonally slower December half of the year (before 2020 school year receipts start flowing into the coffers) – based on a $0.9M opex quarterly run-rate and the seasonally lower publisher/bookseller fees. This would not however leave much in the kitty for increased investment in sales & marketing ahead of the 2020 selling season (which would not surprise me and is arguably justified by the substantial increase in revenue and key metrics in FY19 vs FY18 (discussed below)).

The investor roadshow – flagged at the release of the company’s 1H19 results at the end of February (then, for March) and also in the Operational Update released in early April (for April) – has not yet materialised. Shortly after on Twitter (follow me here for an endless stream of vaguely intelligible nonsense), I placed the odds of a capital raising at 50/50 – and while the expected positive operating cash flow for the current quarter arguably lessens the need, I believe there is still a reasonable chance (30/70 or 40/60) of a fundraise to provide a bit of buffer and more fuel for growth in FY20 and beyond. This is a natural follow-on to an investor roadshow (should that still happen) and it may be that any capital raising takes the form of a placement (i.e. to small-cap fund managers, noting that Thorney is already on the register with 12%) – though that may be naïve/wishful thinking on my part.

The March quarter 4C also included updated customer and operational metrics (summarised below) – with a further 21 schools added since the end of February (mainly by AIET). In total, RCL has increased its school customers by 60% since June 2018 (including AIET in that base) – with a 115% increase in higher margin direct schools, a 48% increase in resellers, and a 54% increase in VET schools since the AIET acquisition was completed in November. Prima facie, this is some pretty impressive growth across all parts of the business.

Full year FY19 sales of $4.5M to $5.0M would represent a ~155%-185% increase on FY18 (which was a ~190% increase on FY17). Excluding ~$1M of revenue for AIET (which is starting to look like a savvy acquisition) would still constitute a ~100%-125% increase in FY19 for the historical core business.

This is a strong platform from which to enter FY20, with further growth likely from a combination of recent developments, continuing strong momentum and operational improvements:

A 3-year exclusive distribution agreement announced in early April with Australian Training Products (“ATP”) for the use of the RCL platform for ATP content to its ~1,000 Australian and international customers in the VET (including TAFE), university and commercial training sectors;
Converting the 2020 school year pipeline for direct schools (“stronger than ever” per the recent 4C);
Cross-selling opportunities for AIET content in RCL’s existing contracted schools (it sounds like there has been little of this to date);
Increasing revenue per direct school as a result of expanding the RCL platform to additional year levels in existing schools – a good sign for the potential scalability of the business;
Further wins in the VET sector following the positive momentum since acquisition;
Increased revenue from the Reseller channel from the new resellers added to the network in 2018 (a 48% increase from June 2018); and
The remaining digitalisation of the AIET platform (with some of this process apparently undertaken in the March quarter, ahead of schedule).

While shareholders should expect recent rapid growth to decelerate in the near future, I am expecting that another meaningful (i.e. 50%+) increase in revenue for FY20 would see the company reach its cashflow and NPAT breakeven inflection points based on the inherent scalability of the business. As I opined in our last RCL piece, I would personally also like to see some further visibility on key metrics, such as breakdown of revenues between RCL/AIET, Resellers/Direct schools for the core ReadCloud platform, as well as other measurable such as average revenue per school or by student.

We caution that RCL is still a relatively risky investment at this early stage of the company’s life cycle – but note that historical losses have been modest and its market cap is “only” $28M – not at all exorbitant for a fast growing education/encryption software business which is nearing its profit inflection point. FY20 is going to be a pivotal year for the company and I personally remain cautiously optimistic – as such I will continue to hold my position (and may add, subject to the disclaimer below).

We will update readers further in August at the release of ReadCloud’s full year FY19 results – though may report on the June quarter 4C statement should that provide any useful insights on the investment thesis for the company.

Disclosure: I (@Fabregasto ) own shares in ReadCloud and may buy more shares in the future – but not for at least 2 days after the publication of this article. Claude Walker owns shares in Readcloud and will not trade them for at least two days after the publication of this article. This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

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We Decided To Buy Ecofibre Ltd (ASX:EOF): Analyst Initiation Report On A Cannabis Stock

Fabregasto — Wed, 17 Apr 2019 00:26:45 +0000

The Mysterious Fabregasto's Initiation Coverage Of Ecofibre (ASX:EOF)

Ecofibre (ASX:EOF) listed in late March and has been a strong performer – closing its first day at a share price of $1.70 (a tidy 70% gain on the $1.00 IPO price for those who participated in the float).

The stock fell back to below $1.50 in the following week, with a number of (probably retail) shareholders happy to lock in a handy stag profit, but it has subsequently powered to a recent high of $2.64 (with the most recent close being $2.12).

The enthusiasm for the stock since listing is likely to be at least partly attributable to the stellar run of Elixinol Global (ASX:EXL). (You can read our coverage of Elixinol's FY 2018 Results). In truth, there are some striking similarities between the two. But (“Gah!” said grammar nerds, starting a sentence with “But”!) there are also a couple of key differences.

Like EXL, Ecofibre comprises three operating businesses, two of which operate in the same space, have been trading for some time, and are generating revenue. They are:

A US-based manufacturer and distributor of hemp-based nutraceutical, dietary supplement and skincare products; (Ananda Health) and
An Australian-based manufacturer and marketer of hemp foods (Ananda Food)

Ecofibre’s third arm is pre-revenue, and focused on commercialising the production of hemp-based textiles and composite materials (Hemp Black). Unlike many listed players, EOF has deliberately decided not to focus on the emerging medicinal cannabis space at this time (with the current regulatory framework making this market difficult, in management’s view).

For more background on the cannabis sector, please refer to our broader sector piece on Cannabis Stocks, The Industry Opportunity.

Because it is a freshly listed company yet to attract broker coverage, there is a limited amount of publicly available information on Ecofibre, apart from its prospectus, its website, and its maiden quarterly cashflow report. The IPO was not underwritten and the prospectus was prepared by the company itself – and as such is a little on the “skinny side” in terms of detailed descriptions and elaboration – but we will make do with what we have.

Ananda Health

This business launched in early 2017 and at this stage generates the majority of Ecofibre’s revenue and earnings (just as Elixinol’s US business does for it). Ananda Health is focused primarily on the manufacture and sale of zero-or-low-THC hemp-based nutraceutical products under the Ananda Hemp and Ananda Professional brands – predominantly in the US market. This division also selectively undertakes bulk white label contract manufacturing for certain “strategic” customers – presumably in order to absorb latent production capacity as well as generate additional revenue and margin. This contract manufacturing comprised ~10% of 1H19 sales per the prospectus.

Ananda Hemp sells CBD-oil and hemp-oil derived products (predominantly dietary supplements) via its website to wholesalers, distributors and directly to retail customers. The product range is marketed towards the health and wellbeing customer segment, in particular consumers seeking anti-inflammatory and anxiety relief or assistance with sleeping. Key Ananda Hemp products include CBD oil herbal extracts for humans (in a variety of strengths) and also pets, hemp extract gel capsules, hemp flower extract topical cream, and also a cannabis infused Ananda Bliss oil for “your inner sexpot” (Hello Sailor! [Ed: Keep it PG, Mr “Gentleman”]).

Ananda Professional is a brand distributed exclusively throughout independent pharmacy chains – with differentiated branding and packaging, but essentially mimicking the Ananda Hemp range above (excluding the racier Ananda Bliss oil).

Ecofibre signed its first pharmacy customer in 1H18 and formally launched this brand in 2H18. This brand was sold in ~1,500 independent US pharmacies as of late February 2019 (out of a total of ~22,000 nationally per the prospectus) – suggesting a store penetration rate of just 7% and ample opportunities for growth. As consumer awareness of CBD-based products increases following the signing of the US Farm Bill into law in December 2018 (discussed in our $EXL coverage), we think demand will increase. Management aim to accelerate new product development in line with the significant market opportunity in the US – although competition is likely to increase too, as newer players enter the market with their own expanding product ranges.

Ananda Hemp sales to retail customers comprised just 5% of total 1H19 sales, with the remaining 85% (after including white label above) derived from Ananda Hemp wholesale and Ananda Professional.

Sales have grown quickly since inception of this business – as demonstrated by the financial information disclosed in the prospectus (compiled and presented below left). Note that Ananda Health sales for 1H19 are already 160% higher than sales for the whole of FY18. We are loathe to make lazy projections based on a limited number of data points, but if no further growth was achieved in 2H19 (i.e. vs. 1H19), full-year FY19 sales would be in the ballpark of $24M (422% revenue growth from FY18). This would be very impressive growth even though it will not continue ad infinitum. On top of that, gross margin has increased to 67% in 1H19 from 39% for FY18, suggesting a degree of scalability in this business.

The US operations are vertically integrated. Ananda Health processes high-CBD concentrated hemp sourced from contracted local farmers at its Kentucky production facility to produce “dried green material” which is used as the base feedstock from its hemp extract product range. Per the prospectus, this site has been extended twice since commissioning in 2016 in order to accommodate growth, and a bottle and packaging line was added in July 2018.

Ananda Food

This business was launched in late 2017 post the inclusion of low-THC hemp as a food in the Food Standards Australia New Zealand code (which effectively legalised hemp as a food in Australia). Currently Ananda Food is focused purely on the Australian market, but has plans to expand into Asia at a later stage.

The Ananda Food product range includes hemp protein powder, hemp flour, hemp seeds and hemp seed oil. The majority of these volumes go through the wholesale channel which includes health food stores, grocery stores, and distributors, but there are also some white label and bulk customer sales per the prospectus.

While still small, this business is growing quickly (like the US division above it achieved higher sales in 1H19 than for the whole of FY18), and appears on track to break even in FY20.

Ananda Food contracts the growing of cannabis crops to growers in Tasmania, New South Wales and Queensland – using genetic material supplied by the company in order to produce maximum quality crops, over which Ecofibre retains ownership at all times. In November 2018, a manufacturing facility was commissioned in Newcastle which will focus on de-hulled seed, hemp protein and fibre powders. As part of its vertical integration strategy (i.e. to mirror the US operations), Ecofibre is also seeking to bring in-house the pressing of hemp seed (into oil) which is currently outsourced.

Hemp Black

This division is focused on developing hemp-based textiles and composite materials in partnership with Thomas Jefferson University (“TJU”, which is a top 20 shareholder in the company).

Hemp farming is not a recent innovation from the hipster community, it dates back to the beginning of recorded human history. Cannabis originated on the Central Asian steppes and was being used as early as 8000BC as an industrial fibre in clothing, building materials, lighting fuel and medicine. For thousands of years hemp was the world’s largest agricultural crop and was farmed throughout Europe and East Asia. As such, there is a long history of humans using hemp in industrial applications.

Ecofibre’s prospectus quotes research from Grand View Research Inc’s Industrial Hemp Market 2019 report that expects:

The global hemp fibres market to grow from US$1.7B in 2018 to US$4.4B in 2025; and
The global hemp textiles market to increase from US$955M in 2018 to US$2.8B in 2025.

Given the ubiquity of hemp as an industrial fibre throughout human history, I personally feel that these 2025 market estimates are likely to be on the conservative side, but time will tell. It is also well worth noting that hemp uses less water than cotton, and it would therefore be a positive for parched river systems if we used more hemp.

Hemp Black commenced operations in mid-2017 (when Ecofibre and TJU formally started collaborating) and is still in the R&D phase and yet to launch its first product. The relationship between Ecofibre and TJU is governed by a Research and Share Subscription Agreement (“RSSA”) under which TJU provides research services to the company until December 2022 – for which Ecofibre will not pay more than US$5M in total (excluding licence fees).

All intellectual property will be owned by TJU but Ecofibre will have global exclusive rights in regard to the commercialisation of products using this IP. Interestingly, under the RSSA, TJU has the ability to take payment for its research services in EOF stock (issued at A$0.537 per share per the prospectus).

Should TJU take all of its R&D fees from 2019 to 2022 in scrip – as it should with the EOF share price currently hovering at 4x this level already – TJU’s ownership in the company will grow from 1% currently (obtained via the conversion of R&D services to date into shares) to 4%. In addition, the prospectus detailed that TJU has an option to subscribe for a further 12.2M shares (representing ~4% of the company) at the same A$0.537 share price – provided that TJU has elected to receive payment in EOF shares for all R&D services provided under the RSSA.

The prospectus outlines two potential paths for commercialising the Hemp Black technology:

Hemp Black bi-component fibres: via the pyrolysis (heating) and then spinning of fibres into different patterns and concentrations which per the prospectus may have anti-odour and anti-microbial properties, moisture management, thermal regulation and low friction. Potential commercial applications include multi-filament yarns, performance and athleisure apparel, 3D printing filament, and fabrics used in motor vehicle seats and office furniture, amongst other uses.
Hemp Black Nano: the use of hemp flower extract to create CBD-rich fibre mats with potential anti-inflammatory benefits which could be incorporated into wound dressing and textiles, and in drug delivery and filtration technologies.

Last year TJU filed six provisional patent applications – however the IP and potential products themselves remain confidential at this stage under patent law. Management currently anticipate that the first prototypes of these products will be introduced to the market in mid-FY20.

Ecofibre has commissioned the equipment needed to produce the feedstock required for this first generation of products, and has commenced the establishment of a dedicated Hemp Black commercial facility at a new site in Kentucky which is expected to be completed in the June 2020 quarter. In addition, the company has commenced establishing its supply chain for Hemp Black operations, and has identified a commercial partner to spin Ecofibre’s pyrolised bi-component hemp fibre at commercial scale – with this partner injecting $3M of equity into the company in December 2018.

The company does not expect Hemp Black to become a manufacturer of the products described above – but envisages that this business will be a supplier of the technology (presumably under licence and including royalties), Hemp Black feedstock and CBD extracts.

Financials & “Valuation”

Consolidated historical financials for Ecofibre appear below including the Ananda Health and Ananda Food business, and also Hemp Black (which incurred $1.3M of costs in FY18 and also for 1H19). The company is clearly growing very quickly, and if there was no growth in 2H19 from 1H19, Ecofibre would achieve 364% top line growth versus FY18 – impressive albeit impossible to sustain indefinitely.

The prospectus contained no official forecasts – perhaps unsurprising given the growth trajectory and potential difficulty in nailing down accurate forecasts in this environment.

My read of the prospectus suggested to me that the company is on track to break even in 2H19 – this view was supported by the company yesterday, with the release of its 4C quarterly cashflow report for the March quarter. The commentary included in the 4C noted that Ecofibre achieved unaudited revenue of $10.1M for 3QFY19 – more than 75% of revenue generated in the December half and suggested that growth has accelerated further in early 2019 (annualised $40M of revenue ignoring seasonality).

Pleasingly, the 4C also included the company’s first guidance for FY19E with respect to year-on-year growth for revenue, gross margin and opex (included in the table above), as well as confirmation that management believe Ecofibre is on target to record a small profit for the current financial year – that’s better than breaking even exactly and capturing the Infinity P/E Multiple, a very rare Pokémon indeed.

The table above extrapolates an estimated small profit based on this guidance (and holding several other things constant from FY18 (as broadly suggested by 1H19 actuals). Note however that if March quarter revenue was $10M and there is no discernible seasonality in the business, we would expect FY19E revenue to be closer to 6x FY18 levels (~$34M) – which would require June quarter revenue of $11M, not at all absurd given the apparent acceleration in revenue in 3QFY19 vs 1H19.

Ecofibre listed with a market capitalisation (at the $1.00 IPO offer price) of $309M (excluding the option held by TJU) – which has swelled to $656M at yesterday’s close. The current market capitalisation is a rich valuation indeed for a company just breaking even, however its growth trajectory is impressive and clearly the market is less bothered with traditional valuation measures and more focused on medium term growth potential – as it is with peer Elixinol:

At current respective share prices, Ecofibre is trading on a 19-21x multiple of FY19E (June year-end) revenue. That is actually higher than Elixinol, although the limited financial information we have does suggest that EOF is growing faster than EXL at this point in time (EXL only grew revenue by 125% in the year to December 2018). Note that the revenue figure above is EXL’s latest FY18 (December year-end) comparable, and that annualised revenue for Elixinol to June 2019 is likely to be closer to $50M given its growth trajectory – which would put EXL on a 12x revenue multiple – more than a third lower than Ecofibre. Of course, if EOF can continue its growth trajectory in FY20 (which will commence in only several weeks), then the forward revenue multiple will decrease significantly. Note that even a doubling of revenue in FY20 from FY19 would represent a considerable slowdown from the 450% increase flagged by Ecofibre management for FY19E.

The takeaway of course is that it is EOF and EXL trade on comparatively eye-watering multiples because these companies are enjoying this spectacular growth in a rapidly expanding market which is benefiting from regulatory tailwinds. Both companies have also just recently reached their inflection points from a cashflow and profitability break-even point of view – and as such traditional valuation measures such as P/E multiples make these companies look very expensive indeed. We have previously discussed on Ethical Equities the PEG (P/E multiple divided by medium term % Growth rate) ratio – which factors in respective earnings growth rates and thereby enables more informed comparisons of company valuations – particularly between sectors and especially when comparing Growth vs. lower growth companies.

Closing thoughts

As noted in our last piece on Elixinol, the market for hemp-based nutraceutical, dietary supplement and cosmetics products is currently in a hyper-growth phase – which will attract a raft of new competitors all keen to get a slice of this rapidly growing market. To this end, Ecofibre investors will be keen to see how the company can grow market share and defend against new market entrants – and will be very focused on preliminary FY20 guidance, which I hope will be given in August at the release of full-year FY19 results.

The next few years represent a land grab as the global market opens up gradually as different countries relax regulations at different speeds, and existing and new industry participants wrestle to build defensible market positions. It will take some time to identify which companies will be the long-term cannabis winners. Ecofibre, with its focus purely on hemp is another comparatively smarter way to play the cannabis boom (but without the uncertainty in relation to licenses for medicinal cannabis cultivation and export etc). In particular, I personally find the Hemp Black division very interesting, though it is unlikely to be a significant revenue generator for a couple of years at least – however Ecofibre CEO Eric Wang (18% shareholder, alongside Chairman Barry Lambert (of Count Financial fame) who controls 24% of the company) has stated publicly that he believes in time Hemp Black will eventually be the largest part of the business.

The company may also move into the medicinal cannabis at a later stage. Chairman Barry Lambert has been a vocal advocate of the legalisation of medicinal marijuana for several years, with his granddaughter suffering from Dravet Syndrome (a severe form of epilepsy), and donated $34M to the University of Sydney in 2015 to establish the Lambert Initiative for Cannabinoid Therapeutics.

We feel that EOF, along with EXL, represents the second wave of the ASX cannabis boom (or Cannabis 2.0 if you will) – denoted by more professional, better organised, and more appropriately capitalised operators than those that mostly comprised the first wave over 2015 to 2017 (including a number of back door listings and pivots from other industries).

While the share price return of EOF to date is dwarfed by those briefly enjoyed by the first wave of more speculative players, there is little doubt that the company has been caught up in the renewed hype for cannabis stocks in 2019 following the passing of the US Farm Bill in late 2018, and the explosive YTD returns of EXL (at its recent high point up 137% from the end of December). As such, investors in EOF should expect continued volatility for the time being while cannabis stocks are once again in vogue with the shorter-horizon trading community, and we recommend Ecofibre only in small doses to readers with a high risk appetite (as with EXL).

Personally I am very curious to see initial FY20 guidance provided in August – and will be holding my EOF shares in the meantime.

Note from Claude: I am very proud to present this excellent research into a second investable ASX cannabis company. However, I do note that I would not mind if the company did not provide any specific guidance.

Disclosure: I (@Fabregasto ) subscribed for shares in Ecofibre in the IPO (though due to scaling back only received half the number of shares I was hoping for) – and may add to my position in the future – though not for at least 2 days after the publication of this article.

Claude Walker owns shares in Ecofibre and will not sell for at least 2 days after the publication of this article.

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This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Readcloud (ASX:RCL) H1 FY2019 Half Year Report

Fabregasto — Sat, 02 Mar 2019 00:16:26 +0000

Readcloud (ASX:RCL) H1 FY2019 Half Year Report

When we last checked in on ReadCloud (ASX: RCL) a month ago – RCL #3 (limited edition with the holographic cover) the company had just released its 4C quarterly cashflow & operational update for the December quarter. This new information helped clarify some outstanding questions following the frenzy of activity over the last 6 months of 2018 and the level of opaqueness that existing previously in regards to seasonality of revenue and outgoings. A quick summary of what we learned:

The seasonal peak for cash receipts is indeed the March quarter every year (predominantly for customers invoiced in November and January). There was $1.6M of outstanding invoices at December period end which will be collected in the current quarter.
The majority of Reseller revenue (which represented the bulk of total RCL revenue in FY17 and FY18) will be invoiced in this March quarter. While the company is transitioning to a higher proportion of higher margin direct sales, presumably this will be for new schools signed up to the platform, and not shifting Reseller volumes to the direct salesforce. FY18 Reseller sales were $1.2M, and the company has communicated that the number of Resellers has increased by 48% between June (50) and December 2018 (74).
“Almost all” of the revenue from the recently acquired AIET is invoiced in the June half. This was $0.9M in FY18 with some growth expected in FY19.
Combined with Reseller revenue, this suggested that RCL was on track for $4M of FY19F revenue at least – plus additional school sales achieved in the current March quarter (remembering that a meaningful portion of school sales had been delayed into 2019 by a change to the school curricula in Queensland). While below the $7.5M FY19 revenue target needed to trigger the final tranches of management’s performance rights, this would still be a large increase on the $2M in FY18 (which included $0.3M of R&D incentive income).
The noticeable increase in operating costs for the December quarter was due to transaction costs for the AIET acquisition, as well as 2 months of AIET staff costs from 1^st November to 31^st

On Thursday the company released its half-year results for 1H19 (to December) and supplied an additional operational update. A lot of the metrics in that update were the same as those detailed in the 4C provided a month ago, but some of the information was new. Let’s look at this new intel, and then use it to parse the financials and what it potentially means for the remainder of FY19:

Direct schools: The number of Direct schools has increased from 20 at June 2018 to 38 at December with a further 3 signed in the last 2 months, and more expected by the end of FY19. Average revenue per school increased in 1H19 as a result of expanding the RCL platform to additional year levels in existing schools – a good sign for the potential scalability of the business;
AIET: Following the cancellation of the RTO licence of a leading WA provider to Vocational Education and Training (“VET”) schools in that state, AIET has signed up 20 new WA schools, plus a further 5 in other states in early 2019, to take its total to ~121 VET secondary schools. AIET’s RTO registration was recently renewed until 2025; and
Resellers: Based on the 48% increase in Resellers in 1H19, management expect a significant increase in revenue from this channel over FY19/20.

Back to the financials (summarised below). 1H19 revenue of $2.1M (excluding R&D rebates) was 102% higher than for 1H18 and is already higher than full year FY18. This was slightly higher than I expected based on the sum of 1Q18 and 2Q18 customer receipts plus the invoiced and uncollected revenue of $1.6M at December. It’s difficult to get a handle on half-by-half Gross Margin at this point – due to the timing of payments to publishers and booksellers (which have varied over the historical period, and may well vary again with the incorporation of COGS for the AIET business). Underlying EBITDA was a $0.5M loss, in line with 2H18. Higher opex reflects the increased cost base following the AIET acquisition (with invoicing occurring almost entirely in the second half -> cost ahead of revenue).

Based on the following factors (gleaned from management commentary to date), I believe that FY19 revenue is now likely to be in the region of $5M (excluding R&D income):

Invoicing of AIET revenues in the June half ($0.9M previously but likely to be higher given the new VET schools signed (above);
Invoicing of the majority of Reseller channel sales in the March quarter (which I would expect to be $1.5M to $2.0M based on the 48% increase in Resellers between June and December, and with reference to the $1.2M of Reseller revenue in FY18);
A portion of the delayed RCL platform revenue slipping from 1H19 into 2H19 following curricula changes in QLD – unquantified but could be a few hundred thousand dollars.

Full year FY19 sales of ~$5M would represent a near tripling at the top line from FY18 – off a low base but certainly nothing to sneeze at, and signalling some significant momentum since the end of FY17 – with a near tripling of revenue also achieved from FY17 to FY18. This would represent a strong base heading into FY20, when we could reasonably expect to see the first meaningful synergistic and cross-selling benefits from the combination of the core ReadCloud platform with the AIET business. Opportunities include:

Cross-selling opportunities for AIET content in RCL’s existing contracted schools;
The digitalisation of the AIET platform (update: delayed slightly, will now be ready in advance of the 2020 school year); and
Potential partnership with other content publishers in the wider VET market – with management disclosing that commercial negotiations have commenced in this regard (presumably in preparation for the 2020 school year, and too late to contribute to FY19F).

Management believe (per the 1H19 results commentary) that minimal additional headcount would be required to deliver significant growth – potentially suggesting the scalability that I originally expected to be a characteristic of this business (part of my personal investment thesis). Sounds positive – but they need to demonstrate this to me.

In our last piece on ReadCloud, I estimated that the company *could* generate a small profit (at NPAT level) in FY19 based off $5M of revenue and the improvement of gross margins back to pre-IPO levels. The volatility in COGS between periods (see table above) makes this difficult to predict – albeit management expect margins to increase in 2H19 – and so I believe that the company is more likely to generate a NPAT profit in 2H but not completely claw back the $0.9M loss for 1H19 above – and so record a smaller loss for full year FY19. I do expect the company to post positive underlying EBITDA however for FY19 (reversing the $0.5M 1H19 loss). Apart from COGS for the RCL platform, this also hinges on the contribution from the AIET business – which the company has described as generating higher margins that the core ReadCloud business, so potentially there is some upside to these rubbery estimates (we live in hope).

Again management have not provided any hard numerical guidance for FY19 – however the company had advised there will be an investor roadshow sometime this month with an accompanying investor presentation. This will be designed to increase awareness for the company and its growth profile – and hopefully may include some useful forecast information, or at least updated metrics on how the 2019 selling season has ended up (with school purchasing presumably finalised given we are now in March). If not, I would expect to gain this insight on the release of the March quarter 4C at the end of April (30^th April “Deadline Day” if previous lodgement dates are anything to go by).

It would be nice to see some further breakdown of revenues between RCL/AIET, Resellers/Direct schools for the core ReadCloud platform, as well as other metrics such as average revenue per school or by student – but that may be wishful thinking so early in the company’s listed life. Glossy presentations and a sea of KPIs don’t necessarily translate into profitability – just ask Livetiles shareholders.

As we flagged in the last ReadCloud update, the March quarter 4C will provide some clarity on whether more capital is going to be required to fund the company’s growth into FY20.

There was $2.9M in the coffers at the end of December, with a further $1.6M invoiced but not received as of that date.
In the December 4C management estimated $2.0M of outflows for the March quarter including $1.1M of COGS – so that suggests the company will have around $2.5M plus any receipts received by then from the billing of Resellers and AIET customers (net of further COGS for those volumes).
So it appears the company will be fully funded through the end of FY19 (excluding any further expansion of the salesforce ahead of the FY20 school year) – but note the seasonally weakest half of the year from a cashflow perspective is the December half.

I would hope the company has at least $2.5M-$3.0M in the kitty at June to get through the six months to December 2019. That’s because 1H19 operating cashflow was -$1.3M per our previous ReadCloud update, and we could expect that to increase to $1.5M including a full period of AIET staff costs. 2020 school year receipts would then start flowing into the bank account from January next year if normal seasonality is a good guide.

So there remains a lot to be optimistic about on this company, in my opinion. A 700-800% increase in revenue over 2 years (albeit from a sub-$1M base in FY17), while still posting only moderate losses, positions the company well for FY20. At a $13M market capitalisation, there would be meaningful share price upside from the company reaching its cashflow and profit breakeven inflection point in the next 12-18 months. In the meantime, I will await the upcoming investor presentation (this month) and next March quarter 4C (due end of April) with keen interest.

We continue to flag that RCL is relatively early on in its life cycle and as a result is a comparatively higher risk, speculative stock, at this point. We will provide a further update on the company in our next issue (RCL #5 Return Of The Killer ReadCloud) following the release of the March quarter cashflow report.

Appen Ltd (ASX:APX) Initiation Report and FY 2018 Full Year Results

Fabregasto — Wed, 27 Feb 2019 23:09:56 +0000

Appen (ASX: APX) listed in early January 2015 at a $0.50 per share IPO price. Since that time, the company has been one of the best performers on the ASX, becoming a ~47 bagger. This remarkable run has been fuelled by significant top and bottom line growth which has been supercharged by a couple of canny acquisitions and a long history of earnings upgrades.

On Monday Appen reported a stellar set of results for the FY18 financial year (December year-end) and the share price responded with a 22% increase to $22.90. It has climbed further to $23.40 over the last couple of days. But enough of that, let’s look at the business itself and the Artificial Intelligence (“AI”) market in which it operates.

Company background

Appen is a leading global provider of high quality training data sets for the Machine Learning (“ML”) market. Machine Learning is an iterative process in which computers receive datasets and information about that data, and are then trained to perform a task using an algorithm, without explicit instructions, instead relying on inference and recognising patterns, with corrections and adjustments made by humans as required to improve accuracy. This intersects with traditional computer programming where computers were fed data and a program and simply derived the answer. Machine Learning is a subset of AI and differs from Deep Learning (a further subset of ML), which involves the development of a deep artificial neural network with the end goal of the computer learning and making intelligent decisions on its own (hello, SkyNet).

The company operates 2 divisions, with a degree of overlap and certain capabilities leveraged across both units:

Content Relevance – this unit provides data sets for ML algorithms designed to improve content relevance (accuracy of search results) in online search. Data sets provided by this division link search engine users with relevant websites, products, videos, maps, social media content and advertisements – and can therefore be used for highly personalised marketing. The key customers for this business are therefore global search engines such as Google and Microsoft, who are keen to optimise their search algorithms to deliver the fastest and most relevant results with the least spam; and
Language Resources – this unit primarily provides speech data collection and annotation services. This segment enables voice recognition and voice synthesis (i.e. in AI assistants such as Apple’s Siri, Amazon’s Alexa etc, or in text-to-speech systems), but also includes the compilation of pronunciation and other custom dictionaries, language translation and various types of linguistic analysis. This data is used by government customers (as in government surveillance), automated call centres, and manufacturers of voice-activated speakers and other devices including in-car systems.

The company’s datasets are created by a crowd-sourced human workforce of more than 1 million people spread across the world – in 130 countries and covering 180 languages (all stats per APX’s FY18 results investor presentation released on Monday). This broad geographic spread suggests to me the ability for the company to access the resources required to expand into other markets if requested by existing or new customers, or should management see opportunities in adjacent verticals.

Revenue for both of these divisions is typically earned over 12-month contracts – but note that this work is typically project-driven and therefore lumpy, and not recurring per se – though Appen notes very little customer churn over the historical period and a high degree of follow-on projects per the chart below left. A meaningful proportion of this repeat revenue is generated from some customers’ need to continually refresh the data – as often as weekly in some cases (per the chart at bottom right).

The Content Relevance division was given a significant boost by the transformative acquisition of Leapforce in late 2017 for A$105M. This was funded primarily by debt but also a small ($30M) capital raising – the only time the company has raised additional capital since its IPO. Leapforce was a global leader in Content Relevance with a crowd-sourced workforce of >800,000 people – and the deal immediately established APX as the #1 global player.

The vendors received 20% of consideration in the form of APX shares (issued at $5.66 – so they will be ecstatic with the quadrupling of the share price since the transaction was completed) – escrowed for 3 years. I think this was a smart way to ensure alignment with the company and its shareholders. The transaction was priced at a comparatively cheap 5.9x forecast EBITDA. So it was hugely accretive (35% to EPS, before synergies).

The company said that the Leapforce integration has proceeded according to plan with some re-engineering of APX systems to optimise the combined platform. Management commented on the investor call that the acquisition has given the company “bulk scale” and positioned it well to take advantage of expected strong future growth. Management also estimated synergies of ~$6M in FY19 following the integration of Leapforce – funds which have been earmarked for reinvestment in R&D to further boost the earnings potential of the company.

In addition to Leapforce, Appen has made 3 other acquisitions since inception in 1996 (as a linguistic technology company):

2011: Merger with Butler Hill (US) – expansion into Content Relevance;
2012: Acquisition of Wikman Remer (US) – internal workforce management tools; and
2016: Acquisition of Mendip Media group – speech transcription services.

It wouldn’t surprise me to see another similarly transformative acquisition in order to gain new capabilities or enter adjacent markets. Management were keen on Monday’s investor call to hose down talk of any near term large acquisitions, but did state a couple of times that it is “keeping its eyes and ears open”. The company has recently expanded into China (with a beachhead established at Shanghai) – which is the next logical stage for large scale AI growth given that government’s stated intention to dominate the global AI market. The resulting logical question was asked around a potential acquisition in China to accelerate this expansion, however management were keen to stress that APX is taking its Chinese market entry slowly and that valuations of Chinese players have been “eye watering” – so shareholders should expect that growth in China is likely to be organic at this stage.

It also wouldn’t surprise to see Appen itself be a takeover target – there have been literally dozens of AI-related acquisitions by Google, Facebook, Microsoft, Baidu, Apple, Samsung, Tencent and other technology giants over the past 5 years. Even after the jump in the share price this week, APX’s market capitalisation is *still only* around $2.5 billion – certainly doable for these large tech giants with big cash holdings – though I’d imagine a high degree of dis-synergies from any tech giant acquiring Appen resulting from lost business from its rivals.

Talk of any takeover for APX is premature and probably just wishful thinking at this point. There is a significant growth opportunity open to the company (which as a shareholder I’d prefer management to execute on prior to any takeover) – so let’s take a quick look at the key industry drivers that have underwritten the company’s growth to date, and underpin its medium term future.

Growth of AI

The chart below left comes from Appen’s August 2018 investor presentation and describes the large market opportunity as different industries begin to embrace AI (with AI still comparatively nascent). The slide below right from the FY18 results investor presentation frames APX’s Total Addressable Market (“TAM”) – being the $17 - $19 billion (by 2025) Data Labelling segment of the total global AI market.

AI is expected to transform the majority of industries over coming decades and significantly boost profitability – but AI is not some far off distant technology, we are already enjoying the early benefits of AI in our everyday lives:

Smart phones – digital assistants such as Siri, adaptive camera effects, apps and games with mixed/virtual reality;
Smart cars – such as the Tesla models (connected to the Tesla network to share learnings);
Social media feeds – personalised news, ads and notifications (all curated by AI);
Music and media streaming – with personalised recommendations and curated playlists;
Navigation & travel – pretty much any activity that relies on location-based services;
Video games – powering the non-human (bot) players in the game and adapting for human skill levels;
Banking & finance – used to track potential fraudulent transactions etc
Smart home devices – such as those used to set lighting, regulate temperature and manage appliances; and
Security and surveillance – using facial and object recognition in deciphering videos and images.

In its 2017 report “Artificial Intelligence – The Next Digital Frontier?”, renowned consulting group McKinsey estimated that global AI spend in 2016 was US$26 - $39 billion. The technology giants (likely to primarily comprise cashed-up major players Google, Amazon, Microsoft, Facebook and Apple) are estimated to comprise US$20 - $30 billion of this total.

While Appen typically does not disclose the identity of its clients, it has revealed that it works with 8 of the top 10 global technology companies, plus we know that Facebook and Google generated the vast majority of Leapforce’s revenue, and that Microsoft was APX’s largest customer prior to the acquisition of Leapforce. Based on the customer relationships graphic from earlier, these would still seem to be large APX customers.

McKinsey estimates that Machine Learning accounted for ~60% of the 2016 total AI spend – primarily due to it being an enabler for the other technologies and applications below – which includes speech recognition, autonomous vehicles and computer vision (both video and images).

A key current driver of demand for APX’s services is in the AI assistant space (i.e. Google’s Siri and Amazon’s Alexa, as noted earlier) – which combines both of Appen’s divisions:

Language Resources: speech data collection for customer voice recognition, as well as voice synthesis (the assistant conversing with the customer); and
Content Relevance: the need to precisely understand what the customer wants, and then have high accuracy internet search abilities to find that good/service exactly, and continue learning to incorporate new contexts and meaning in order to better deal with future customer wants.

Smart phone AI assistants have been a “thing” since Siri’s launch in 2011 and the use of Voice in searches continues to increase due to its convenience and the difficulty in using keyboards on some devices. The game-changing widespread adoption of AI assistants is likely to be in the home – especially following the advancements made in speech recognition accuracy in the past couple of years.

Professor Scott Galloway of NYU Stern believes Voice is the next battleground for the tech giants and describes Alexa and Siri as beachheads into the home – from which Amazon and Google respectively aim to have their products involved in every retail decision made – in a future where all households will have an Amazon Prime account (100 million US households as of April 2018) and all retail purchases will be delivered to the home. Sales of AI assistant speakers (including Amazon Echo and Google Home using the above examples) were predicted to reach 100 million units globally for 2018. Last month Recode reported that ~52 million units were sold in the US alone in 2018 – increasing the number of installed US speakers to 118.5 million (an increase of 78%).

Impressive history of revenue and earnings growth

Appen reports according to the calendar year, and the 2018 numbers were eye-catching. FY18 revenue increased by 119% to $364M – reflecting the first full year contribution from the Leapforce business acquired in late 2017. Appen’s revenue grew at an impressive pace prior to this acquisition (48% CAGR between FY14 and FY17), but Leapforce has certainly supercharged the top line growth potential of the business.

EBITDA increased by 147% in FY18 – demonstrating the scalability of the business, while underlying NPAT increased by 114% (with a significant increase in depreciation following the Leapforce acquisition, and higher effective tax rate), and adjusted EPS rising by 97% (including shares issued to the Leapforce vendors). Cash conversion was strong at 92% of EBITDA.

Gross margins declined in FY18 primarily due to a less favourable project mix in Language Resources (lower volumes of complex higher margin government work). Following the acquisition of Leapforce, Language Resources comprised just 14% of full year revenue in FY18 (compared with 44% in FY14).

Margins in the Content Relevance business increased in FY18 to a high watermark of ~24% – per management reflecting the increased scale of this division following the integration of Leapforce and also increased automation. As mentioned earlier, management plan to reinvest the estimated $6M of synergies back into the business in the form of increased use of AI within the business – i.e. using ML to take the first crack at datasets with humans taking over from there. This could lead to a material improvement in internal efficiencies and margins – and could drive Return on Invested Capital back closer to the very attractive historical levels (north of 50% and growing prior to the acquisition of Leapforce and associated increases in debt and equity).

With almost all revenue derived outside Australia (mainly in USD), Appen is also likely to be the beneficiary of any further depreciation in the AUD – but earnings would naturally be impacted if the AUD moves in the other direction.

FY19 guidance

In terms of forward outlook, management guided towards FY19 EBITDA of $85M-90M assuming an AUD F/X rate of $0.74 against the USD (note currently around $0.715 – so upside for APX if exchange rates averaged at these levels throughout the year – but always wise to give a buffer when quoting F/X for forecasting purposes). This reflects EBITDA growth from FY18 of 22-29%. Factoring in similar depreciation & amortisation and effective tax rate in FY19 as just recorded in FY18, and a degree of continued debt pay-down – and FY19 EPS could be 30-40% higher than FY18. Given the 24% increase in the share price since FY18 results were released however, that still equates to a forward P/E in the vicinity of ~40x FY19 earnings.

The total value of sales generated to mid-February and the forward order book at that time was $165M – already 45% of total FY18 sales.

One analyst on the investor call – no doubt bearing in mind the string of earnings upgrades since listing (see next section) tried to get management to admit that this FY19 guidance might be conservative based on the strong second half of FY18 – which management disclosed contained some unusually large projects which are not expected to repeat this year. I’m more inclined to believe that this guidance is probably a little conservative – note APX has never delivered an earnings downgrade versus 13 upgrades if you include this week. Time will tell however and we won’t have a feel for how FY19 is tracking until the company either releases half-year results in August – or issues yet another earnings upgrade.

Continual earnings upgrades = enormous share price momentum

As referred to at the start of this article, APX has been a stunning performer since listing just over 4 years – as borne out by the chart below. This chart includes the company’s share price as well as its forward P/E multiple – both the consensus (research analyst) forward multiple, and also the company’s actual forward P/E multiple in hindsight. Note that (A) the forward EPS estimates are always for the financial year in progress, and (B) Appen has a December year, and so on 1^st January the EPS estimate used rolls forward to the new financial year; and (C) the distortion of a falling P/E in late 2017 is due to the amount of new equity issued for the Leapforce acquisition, as well as the resulting significant EPS upgrades for FY18 including Leapforce.

Apologies for the many flavours of everything that is going on in the chart above but you can see that:

APX has a long history of earnings upgrades – I counted 12 between June 2015 and November 2018 (or 13 including this week). This included upgraded guidance at all four of the company’s half-year result reporting dates, one upgrade on the release of full year results (12 months ago, but also again this week) and the remainder during the normal trading year (including at the time of the material Leapforce acquisition);
For most of FY15, FY16 and FY18, actual forward P/E was below broker consensus P/E – meaning that even after brokers upgraded forecasts to account for APX’s new guidance, the company ended up outperforming broker forecasts.
In response to the growing earnings profile combined with the string of upgrades, the company’s forward P/E has inflated considerably from ~20x in 2016 to between 30x and 40x ever since (and around ~40x currently for 2019F – though I’m writing this before seeing updated broker estimates).

Valuation considerations

Make no mistake: the current ~40x forward multiple is a premium multiple which very few ASX companies enjoy – which means a lot of earnings expectation is baked into Appen’s share price and that any material underachievement versus market expectations could trigger a savage decrease in the share price.

High growth, relatively expensive companies like APX are also likely to be sold off during the market’s “Risk Off” phases – as occurred when Appex’s share price declined by 35% between the end of August and the end of October last year; and these high growth companies are generally considerably more volatile than more stable Blue Chip companies (though try telling that to long-suffering shareholders of AMP, Telstra and the big four banks).

It must be noted, however, that not all companies are cut from the same cloth. It’s easy to compare APX’s forward P/E multiple to other (especially more mature and non-growth) stocks and conclude that Appen is very expensive. While true prima facie (in the context that APX commands a higher multiple), this exercise ignores comparative growth rates between the companies. It is useful to use a PEG Ratio (which incorporates future growth rates) to make comparisons like this more meaningful, and personally I’d rather own a company with a 40x forward P/E and a 20% EPS growth rate (PEG Ratio = 2) than a company on a 15 forward P/E and a 5% EPS growth rate (PEG Ratio = 3).

Closing thoughts

It’s worth recalling Appen’s total addressable market (the Data Labelling segment of the total global AI market) of $17 - $19 billion, by 2025, and the concept of the company being the global #1 player (though I would expect the number of competitors (in China in particular) is growing weekly). A 10% share of that market would translate into nearly $2 billion of sales. That’s a 400% increase on FY18 revenue just reported. This is a very easy and *obvious* calculation to make – and one which is not necessarily going to come true of course – but it demonstrates the size of the opportunity in front of the company.

Management’s excitement over the size of this opportunity was palpable on the investor call. The CEO expressed his confidence in the extremely high growth prospects for the Data Labelling market and made it clear that the management team are keen to execute. The CEO sees demand for data sets growing substantially over the medium term – and in order to meet this demand APX is investing in technology to make its global crowdsourcing workforce more efficient. A key question will be whether the company can continue to grow its crowd to meet forecast demand, and whether there will be margin pressure if Appen is forced to “fight for talent” against emerging rivals. As the market grows, management will need to continue to execute as it has done admirably to date. But at a ~40x forward P/E there is little margin for error.

There is little question that the growth potential of the business is enormous – we haven’t really touched on Autonomous Vehicles or Augmented/Virtual Reality in this article. Both are expected to be significant opportunities in their own right over the next few years, having passed the “Peak of Inflated Expectations” and working their way through the “Trough of Disillusionment” in the Garner Hype Cycle. (The August 2018 version is below; I find it a great tool for understanding how close previously hyped technologies are to actual widespread adoption):

APX has not been “cheap” by traditional value measures since 2015 – and many readers will not be comfortable with paying such a premium multiple. We therefore suggest that Appen would only ever be suitable for investors with a higher than normal risk appetite, and are able to endure a higher degree of volatility than exhibited by more mature companies.

In addition, the share price has doubled since the depths of December – so I would expect a degree of profit taking over the next couple of weeks. I will not be one of them personally – I am happily strapped in and curious to see where this ride takes me.

_______

Disclosure: I (the author) own shares in Appen – although it took me a long while to commit and this has significantly reduced my returns from owning the company. After stalking it around $2.80 (being too “cute” in waiting for it to fall to $2.60) pre earnings upgrade, then being thwarted by my Anchoring Bias above $4.00 (pre-acquisition of Leapforce), I eventually gritted my teeth about the valuation and bought some above $7.00 in late 2017. I personally consider APX a longer-term portfolio cornerstone, and may purchase more shares (though I know I will continue to grapple with the valuation) – but not for at least 2 days after the publication of this article.

Claude Walker also owns shares in Appen (and will not trade within 2 business days of publishing this article).

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This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Elixinol (ASX:EXL) FY 2018 Full Year Results: Greens Are Good For You

Fabregasto — Wed, 27 Feb 2019 04:27:58 +0000

Elixinol (ASX:EXL) FY 2018 Full Year Results: Greens Are Good For You

Elixinol Global (ASX: EXL) released its full year FY18 results today and followed up with an illuminating investor call. The share price climbed ~7% to $3.55 in response (not far from the all-time high of $3.69 reached earlier this month) – though there arguably wasn’t a whole heap of new or surprising information in today’s news.

EXL had already flagged full year revenue of $37M (as detailed in our report on the company’s 4C in late January) - however it was pleasing to see $0.7M of underlying EBITDA of $0.7M for the year (albeit after a considerable investment in ramping up capabilities ahead of the growth expected in the business for the new year – including continuing to fund the start-up Nunyara medicinal cannabis business). We flagged this likely investment in our previous report:

“…… readers should be cognisant that given the significant market opportunity available to Elixinol as a result of the opening up the US hemp market, it’s also possible that near term profitability is deliberately put on the backburner while the company invests in its supply chain and sales & marketing capabilities to meet the accelerating demand for hemp-based products – with the expectation that this would hopefully result in a significant boost to market share and profitability over the medium term.”

The table below summarises FY18 performance for the business, and splits the financials between the two main businesses: Elixinol in the US (which accounted for 87% of full year sales and all of the group’s profitability) and Hemp Foods Australia (“HFA”).

Providing true comparable historical financials for EXL is made difficult by:

HFA’s switch from a June year end reporting period to a December year end prior to listing (with no comparable HFA December year end numbers included in the prospectus for 2015 and 2016);
No pro forma historical 2015 and 2016 numbers included in the prospectus for the consolidated group; and
A change in the amount of detail reported for each division in today’s FY18 results vs what was provided in the prospectus – though not unusual for a fast-growing newly listed entity.

So we’ll work with what we have. We can see that the lion’s share of group growth in FY18 was generated in the US business – recording an impressive 144% growth rate. However, the EBITDA margin declined from 19% to 14%, due to a combination of significant growth in lower margin private label volumes and increased investment in sales & marketing costs (including a complete makeover for the consumer-facing website and a large promotional campaign). The company is positioning for a substantial expansion of the market in 2019, particularly following the signing of the Farm Bill just before Christmas and the resulting opening up of the mainstream retail market. Interestingly, the company reported that the US product range had increased by 50% from 30 at August 2018 to 45 currently, with further products to be launched this year.

The Australian business also recorded an impressive lift in sales versus FY17 – however a restructuring of, and additional investment in, the sales & marketing function dragged EBITDA for HFA to a $1.5M loss. A number of new products were launched by HFA in late 2018 and early 2019, and management has high hopes for continued strong growth in 2019.

No financials were reported for the fledgling Nunyara medicinal cannabis business – there is no real update since the release of the December quarterly cashflow report. The company is still waiting to receive licenses from the Australian Office of Drug Control for medicinal cannabis cultivation and manufacturing. In the meantime, the ramp up of this business continues with construction of the “state-of-the-art” (per management) 5,000m² fully integrated greenhouse cultivation, extraction and manufacturing facility scheduled to commence this year. Management expect to commence production (1-2 tonnes of medicinal cannabis in Year 1) and sales in 2020, and described the facility as designed in a way as to enable rapid modular expansion should market demand warrant it (a good example of long-term planning).

Operating cashflow was -$5.7M for FY18 – which includes prepayments to suppliers in order to lock in hemp requirements for 2019.

Earlier this month Elixinol announced its expansion into Europe – via the establishment of sales offices in the UK, Spain and the Netherlands, a sales team of 12 and a European MD. This followed the company’s $40M capital raising late last year to fund future growth opportunities. The company has been selling into Europe via distributors since 2017, but has decided to take control of its destiny in this region, so to speak. Supply will come from locally-based contract manufacturers. EXL has an ambitious goal of becoming a top-5 CBD business in Europe in 2019.

The investor call and investor presentation also touched on recent developments and initiatives that were already known – but which in combination point to a year of further growth in 2019:

Launch of the new Sativa Skin Care range (moisturisers and creams, shampoos, deodorants) in the US (and also available in Australia on the Hemp Foods Australia website);
Launch of the Essential Hemp branded snack bar range in Australia and earlier this month the launch of ready meals (including Hemp Burgers – looking forward to trying that one personally);
Increased R&D investment in the future product pipeline – with a number of new products scheduled for release in 2019;
Commissioning of the new Colorado manufacturing facility which double production capacity – which management expects will deliver meaningful gross margin improvement; and
Entry into the New Zealand market in January via the sale of products on a prescription basis.

Management did also reveal the recent launch of a new range of CBD powdered drink mixes (rapidly dissolvable in water) – comprising three daily drinks: Create for the morning, Build for during the day, and Dream at bedtime. Based on the CEO’s enthusiasm for this product on the investor call, the company has high hopes for this new product.

And finally the company did also flag likely expansion into Asia (outside of Japan, where EXL is already the #1 brand) and Latin America in the near term – which could provide a meaningful catalyst for increased sales and earnings and a higher share price.

The most important takeaway for me personally from today’s investor call however was management’s acknowledgement of a significant number of new competitors entering the market in response to the relaxation of the regulatory regime in the US. This wasn’t surprising given the enormous potential of cannabis products in many verticals from food & beverages, to medicine and cosmetics. The investor presentation and results announcement contained updated medium term market size estimates for both the US ($22 billion in 2022 per the Brightfield Group) and Europe €116 billion by 2028) markets.

It’s these sorts of mind boggling numbers which attract the attention of new market entrants and quicken the heartbeat of excited investors. That's fair enough, but we need to remember that it’s difficult to accurately predict medium term volumes for such a fast-growing space, and that these are likely estimates of the total market including segments (such as alcoholic beverages and tobacco being just one example) in which EXL does not currently play.

It will be interesting to see how successfully the company can defend and grow its market share as the market expands at a rapid rate and new competitors flood into the space – and the impact that this will have on margins. On the investor call, management iterated that it was “very confident” of the company’s market positioning. This confidence is based on its long history (comparatively, having launched in the US in 2014), brand equity, existing market share, large production capacity, ability scale, and also the significant investment being made to expand its sales & marketing activities to drive sales.

The company gave no hard guidance for FY19 – which was not unexpected given the rapid growth environment and the sheer number of moving parts here – but the CEO did sound very bullish on the opportunity ahead of the company. The combination of the huge growth potential of the market and Elixinol’s progress to date are reasons to be optimistic, in my view. As such, this paragraph from our initial report on the company still holds true in my view:

“We still think that EXL is a comparatively smarter post-hype (or first wave of hype) way to play the potential cannabis boom – as the only listed ASX cannabis player which is (1) generating meaningful revenue, and (2) profitable, albeit only recently and potentially with meaningful near term profitability deliberately pushed back while the company attempts a Land Grab in the US market.”

Given the significant run in the share price from $1.34 in September to $3.55 today, I would expect a some profit taking – especially as there may not be any share price catalysts until the release of the company’s March quarter cashflow in late April (unless the company announces new developments separately of course). As a “pot stock” I would also expect a degree of share price volatility over the course of 2019 as the market grapples with how to value a fast-growing company like this (as we await further financial updates on progress) – so we continue to recommend the company only to readers with a higher appetite for risk. Personally, I will continue to hold my EXL shares while I wait to understand how successful the company is in delivering on its growth ambitions.

Note from Claude: I have nothing further to add other than to say that the valuation makes me nervous, especially since we haven't really had a set of clean results as a result of acquisitions and the IPO. As yet I have not sold any shares, but I am not buying at these prices, and I may choose to reduce my position size at some point in the future.

Disclosure: I (@Fabregasto ) have a position in Elixinol – though sadly not added to since our initiation report or the previous December 4C update – and may add to my position in the future – though not for at least 2 days after the publication of this article. Claude Walker also owns shares in Elixinol (and will not trade within 2 business days of publishing this article).

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This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Audinate (ASX:AD8) 2019 Half Year Results: A Sonic Boom

Fabregasto — Wed, 20 Feb 2019 08:11:48 +0000

Audinate (ASX:AD8) Half Year Results [H1 2019]

When we last checked in on Australian digital audio networking technology company Audinate (ASX:AD8) in late January, the company had just released its December 4C (quarterly cash flow) report – which revealed positive operating cash flow for the Dec-18 quarter and a 49% lift in cash receipts versus the corresponding quarter a year earlier.

As a quick reminder, Audinate supplies its Dante branded software and hardware products to global Original Equipment Manufacturers (OEMs) who in turn embed the Dante platform and the associated hardware components (such as chips, cards, modules and adaptors) within their own products which are then sold into the professional Audio Visual (AV) market. The company is leading the migration away from old world analogue point-to-point cabling to the digital distribution of audio signals across computer networks. In short, this technology is the wave of the future. Refer to our initiation report on AD8 from 6 months ago for more background information on the company and the industry as a whole.

Today the company released impressive results for the first half of FY19 which illustrate a favourable combination of accelerating growth, operating leverage and strong Network Effect benefits. Let’s start with the financials:

Audinate posted a 60% increase in revenue (less in constant currency) versus the December 2017 half-year, a significant acceleration from the 32% CAGR between FY14 and FY18 above. Gross margin declined slightly from 74.6% to 73.3% - a function of product mix, and a result of a greater proportion of comparatively lower margin hardware component sales (+59% growth in units), and a lower share of higher margin software sales (+22% growth in units). Management commented on this morning’s conference call that this is expected to reverse over time as the network of Dante products expands – which will lead to higher margins in the future.

Who can complain about a company generating 73% gross margins, in any event? The company’s operating leverage translated into a material lift in half-year EBITDA of $0.1M in 1H18 to $1.7M in 1H19. This included additional investment in headcount and consulting costs as Audinate scales to meet the significant forecast increase in demand for its platform and products.

In addition, the company is debt-free with $12M of cash in the bank at December 2018. With the company reaching profitability in the current financial year, it is well positioned and capitalised to continue investing in the business to drive top line growth and increased profitability.

How did the company generate such a significant increase in revenue and profitability in 1H19, and what are the key trends and implications for forecast growth? Let’s look at Audinate’s key oft-reported metrics. The constant refreshing of KPIs enables us to better understand the main drivers and maintains a degree of management accountability.

Audinate is attempting a land grab and aiming to be the de facto industry standard in audio and video digital networking – such that in future all OEMs will need the company’s technology embedded within their products. The updated chart above illustrates Audinate’s growing Network Effect – with the Dante-enabled ecosystem growing with each new OEM customer and Dante-enabled product released. In the last 12 months:

Licensed OEMs have increased by 16% to 455 (CAGR since June 2014: 28%);
The number of OEMs selling Dante-enabled products increased by 19% to 228 (CAGR since June 2014: 39%); and
Total OEM Dante-enabled products available for sale increased by 36% to 1,751 (CAGR since June 2014: 58%) and grew a further 4% to 1,820 in the month of January 2019 alone (as shown in the chart below).

Note that only about half of licensed OEMs at December 2018 had released Dante-enabled products into the market. The remaining licensed OEMs are still in development phase and yet to launch their first Dante-enabled product – suggesting a significant growth runway if you just double current run-rate annual revenue of ~$30M. Note further, however, that the above metrics suggest an average of 7.68 Dante-enabled products per OEM (an increase from 6.73 at December 2017). I would expect this to be a tiny fraction of the OEMs’ product range – suggesting further long term growth as existing OEM customers embed Audinate’s Dante technology in their other products.

But most importantly, Audinate has previously estimated that there are more than 2,000 professional AV OEMs in its target ‘Sound Reinforcement’ segment. As such, the 455 licensed OEMs at December 2018 represents customer penetration of only ~23%, suggesting significant potential upside from new OEM customers.

Previously the company has quoted research from market research firm Frost & Sullivan that the digital audio networking market would grow from ~$360M in 2016 to ~$455M by 2021. At that pace of growth, market size was probably ~$400M at the end of 2018. Management estimates that digital penetration of this market is still only 7-8%. If accurate, Audinate’s current annualised revenue run rate of ~$30M suggests the company enjoys a market share somewhere in the vicinity of 90%.

The company did not update competitor metrics in the chart above (showing June 2018 comparatives) but note that the chasm between Audinate and its rivals has presumably widened even further based on their respective lower historical growth rates.

Finally, management provided an update on the three most recently launched products:

The Dante Domain Manager (system management software) recorded sales in line with budget for 1H19 with the distribution channel expanding to 133 resellers (+33% vs June 2018);
Dante AVIO adaptors (to enable legacy analogue equipment to be interoperable with the Dante system) were ahead of budget for 1H19 with 77 resellers (+50% vs June 2018) in 45 countries appointed; and
The brand new Dante AV (combined audio & video) product was successfully launched earlier this month at a European trade show and the market response has been positive to date – with a commercial launch of this promising new product in mid-2019

Management believe that the addition of these 3 products more than doubles Audinate’s target addressable to A$1 billion.

Once again, management did not provide any hard number guidance (in line with previous) but did reiterate a continuance of historical growth rates (probably around 30% per year). Based on 1H19 growth (60% versus 1H18) and the accelerating Network Effects observable in the key metrics above, I would not be at all surprised to see this exceeded.

The share price jumped ~10% to $4.80 in response to today’s result and hit an all-time high of $4.91 during intraday trading. This reflects an increase of ~50% from recent lows of around $3.20 plumbed during the peak of the Risk Off period in December – and so I wouldn’t be surprised to see some profit taking at current levels.

Despite this recent strong share price action, I believe that Audinate remains a compelling long-term growth story – driven by:

The momentum in the business as its Network Effect continues to strengthen as the number of licensed OEMs continues to build, and the network of Dante-enabled products continues to grow;
The substantial growth opportunity represented by the very low digitalisation of the audio networking market, the 77% of OEM players which don’t currently use AD8’s Dante products, and the fact that approximately half of licensed OEMs are still in development phase and yet to launch their first Dante-enabled product; and
The very high gross profit margins generated from a growing product range and strong intellectual property portfolio, with continuing investment in R&D to further strengthen this position.

Audinate shareholders should not necessarily expect a significant ramp up in profitability from here – despite the strong 1H19 results, the company has flagged that it will continue to focus on strengthening its market position and will invest further in internal operating capabilities to that end. Management flagged on the conference call that 2H19 EBITDA margins are likely to be lower than 1H19 as a result. As we have mentioned before this is all about the end game – domination of a growing market and the substantial cashflows that would accrue to the company if successful.

Readers should continue to view Audinate as a higher risk stock and will need to decide for themselves whether the company is a suitable investment for their own portfolio.

_______

Disclosure: I (the author) own shares in Audinate – accumulated between January and August 2018 at a VWAP of $3.31. As foreshadowed in our AD8 re-initiation piece, I purchased an additional small parcel of shares 3 days after publication of that report. I am strongly considering buying more shares – but not for at least 2 days after the publication of this article.

A note from Claude: To paraphrase Munger, I have nothing to add to this analysis.

I consider these results from Audinate to be pleasing. However, I suffer a state of slight discomfort when my larger share holdings fail to generate free cashflow. I already knew, from the quarterly, that Audinate did not generate free cash flow in this half. Nonetheless, I anxiously await that milestone. Audinate is currently my third largest position and I will not buy or sell shares for at least two days after the publication of this article. I am very pleased that the share price is up over 30% since we made it one of our Best Buys Now For October 2018.

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Disclosure: The Author of this piece, Fabregasto, and Claude Walker both own shares in Audinate at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Readcloud (ASX:RCL) Q2 FY2019 Quarterly Report

Fabregasto — Sun, 03 Feb 2019 22:01:36 +0000

ReadCloud Ltd (ASX:RCL) Quarterly Report

At the time of our last update on ReadCloud (ASX: RCL) in early December there had been a lot going on with the company over the previous few months – which in combination clouded the picture – in my mind at least – as to what we should expect over the remainder of this current FY19 period:

Management had disclosed in late July that the sales pipeline ahead of the CY2019 school year was 6 times the size of the CY2018 pipeline 12 months earlier – which no doubt helped to propel the share price to its all-time high of 62c in mid-August.
In mid-September the company signed a direct digital content distribution agreement with global major Oxford University Press which should significantly increase margins versus the previous indirect arrangements with RCL resellers (on those titles).
In late October, the Sep-18 quarterly update revealed that several new large direct schools had been signed, and that via reseller OfficeMax a further several indirect schools had been locked in for the 2019 school year – this suggested a total of 80-85 schools based on the 70 schools that had been secured at the end of June.
The Sep-18 quarterly update also announced a distribution agreement with the Australian Institute of Education & Training (“AIET”) – a provider of 34 different Vocational Education and Training (“VET”) courses to approximately 4,000 Year 11 and Year 12 students in more than 90 secondary schools in Victoria, SA and WA.
Less than 3 weeks later in Nov-18, ReadCloud then announced the acquisition of AIET – comprising $350K cash up front which a further ~$450K of cash and ~$2M of RCL scrip payable to the vendors dependent on revenue and EBIT targets. The company flagged a 4.5x EBIT multiple for the acquisition – suggesting that AIET is forecasting EBIT of $650K for FY19 (and had achieved ~$1M of revenue in FY18, suggesting this business is very high margin and will be very accretive to RCL).
However, in the same AIET acquisition announcement, the company disclosed that sales traction in the core school textbooks business had been impacted by curriculum changes for 2019 – causing publishers to need to alter their content and thereby delaying school purchasing decisions by several weeks. The company suggested this was pretty much a non-issue which just meant that the selling season would be extended deeper into early 2019.

The last two developments certainly had me stroking my beard in perplexed thought, but it was clear that we were unlikely to have a good handle on the financial impacts of all of the above moving parts for at least a few months – and so that’s where we were 2 months ago. [Exhale]

The company released its 4C quarterly cashflow for the December quarter (with accompanying operational update) on 31^st January (“deadline day” – as evidenced by the slew of 4Cs from other small companies).

Summarised quarterly cashflow information (from RCL’s short listed life) is presented below, updating the table from our last report on company, adjusted for some minor item reclassifications and a small -$7K revision to the previous quarter’s cash outflows.

Several things jump out at you from the above – however it’s critical to read the accompanying commentary in the 4C to better understand the context (salient points from which I’ve added in bold below) – without which the cashflow report appears much less positive:

Dec-18 receipts were actually below Sep-18 receipts by $20K. This was contrary to what I had expected – having understood that the December quarter was seasonally stronger from a cashflow perspective -> however given RCL only listed in early February (a week after the requirement to lodge a 4C report for the Dec-17 quarter), we didn’t have a feel for the Sep-17 vs Dec-17 cashflow profile. It’s important to note that in FY18, it was the March quarter which generated the majority of cashflow for the year (61% of total FY18 cash receipts, and ~4.5x the cashflow generated from the previous 2 quarters combined). IF the company generated the same proportional increase in the March 2019 quarter vs the Sep-18 and Dec-18 quarters – in comparison to the FY18 year – this would suggest somewhere in the region of $1.6M of customer receipts for the current quarter. The commentary in the Dec-18 4C bears this out almost precisely – not only confirming that the majority of annual cash receipts are received in the March quarter (having been invoiced in November/December every year) – but stating that there was $1.6M of outstanding invoices at 31 December, with the potential to generate more receipts from sales within the current quarter – including the invoicing of the majority of its Reseller revenue.
This last point is particularly interesting. The company has communicated that for FY18 the reseller channel represented 71% of total sales (so ~$1.2M, excluding R&D income from the calculation) – down from 88% of total sales in FY17 in line with the company’s focus on increasing the contribution of higher margin direct Given the 48% increase in the number of resellers from 50 in FY18 to 74 estimated for FY19E, and commentary around increased momentum versus last year, that sounds like a meaningful increase on last year’s $1.2M of reseller revenue – the majority of which is to be invoiced and received in the March quarter per the above. So, is that an additional $1M to $1.5M on top of the $1.6M of outstanding receivables at December?
The seasonality in Cost of Sales payments is still quite disconnected from the timing of customer receipts – as we noted previously, and potentially confirming our thoughts re annual payments – which makes longer term cashflow forecasting tricky. Note only $14K of COS for the Dec-18, but $1.1M due in the March quarter. 4C confirms this disconnect, though doesn’t refer to annual payments per se. There is definitely some lag effect happening in the numbers above, suggesting that the June quarter is likely to include significant COS outgoings as well (note that it was the June quarter in FY18 when the majority (~80%) of COS was incurred, not March – however the $1.1M forecast for March above seems to suggest less of a lag this year).
It seems that based on the likely $2.5M to $3.0M ($1.6M above plus resellers (?)) that the company is tracking towards something like $4M for the full year – excluding AIET revenue. Per the 4C commentary, “almost all” of AIET’s revenue is generated and received in the June half. In FY18 this was ~$1M with some growth expected in FY19 – *suggesting* FY19E revenue of ~$5M. This would be an impressive increase from $2M in FY18 (including $0.3M of R&D incentive income) though tracking below the $7.5M FY19 revenue target needed to trigger the final tranches of management’s suite of performance rights (which also include the FY19 $2.0M EBITDA hurdle – though that hurdle may have been made far more achievable with the inclusion of AIET’s $0.6M of EBIT). This also suggests only a partial conversion of the 6-fold increase in the core RCL textbook pipeline trumpeted back in July (though arguably it would have been unreasonable to assume perfect conversion in the first place).
Actual Dec-18 opex ended up being $915K - $240K (36%) higher than the $674K forecast in the Sep-18 quarterly report. This included transaction costs for the AIET acquisition, as well as 2 months of AIET staff costs from 1^st November to 31^st

As we noted previously, AIET looks like a good strategic acquisition: expanding the company’s offering in the secondary school channel, opening up cross-selling opportunities for AIET content in ReadCloud’s existing contracted schools, and generating significantly higher margin than RCL’s core school textbook content (with further potential synergies expected from the digitisation of the AIET platform which has already commenced).

The acquisition also significantly increased ReadCloud’s contracted school base to above 200 schools per the company’s AGM presentation. This was confirmed in last week’s operational update: 208 total schools estimated for FY19E, including 96 for VET courses and 112 schools for the core RCL business – a pleasing increase on the 80-85 suggested by the Sep-18 quarterly update (above) and indicating that the expanded salesforce has made inroads with direct school sign-ups. The operational update also disclosed that the AIET acquisition had also opened up potential partnership opportunities with other content publishers – time will tell the degree to which these convert into meaningful revenue.

As it did at the time of the AGM in November, management again shied away from providing financial forecasts for FY19. I had expected that by the end of January – with the new school year having just started (29^th January for New South Wales and Victoria) – that management would feel more comfortable about providing guidance with the 2019 selling season presumably not far from wrapping up (though perhaps there are meaningful sales into February and March). While this is somewhat disappointing, as iterated previously there are a lot of moving parts here – especially with the AIET acquisition only just completed.

And yet the data points we do have are useful – though we need to bear in mind that any exercise in trying to fill in the rest of the puzzle using our own assumptions is fraught with danger. Full year FY19 revenue of $5M would be a significant increase on FY18 and would represent a strong base from which to enter FY20 (when I imagine the first synergistic and cross-selling benefits of the AIET acquisition would be realised (at earliest)). What level or profitability could the company generate in FY19 from $5M of revenue?

It’s difficult to use FY18 as a guide. As detailed in our initiation report on the company, based on the unexpected collapse in Gross Margin from 67-70% in FY15, FY16 and FY17 to just 27% in FY18 – driven by the unexplained material increase in Cost of Sales last year, the company recorded an underlying EBITDA loss of $147K (versus my expectations of a $0.5M to $0.6M EBITDA profit). (Please ignore the $1.2M “horror loss” trumpeted by the Stockhead article from the day of the results release, this ignored the $0.8M of one-off IPO costs and share-based payments).

Based on $5M of revenue for FY19, I estimate the company *could* generate NPAT of somewhere in the vicinity of $0.5M. This is predicated on the following (rubbery assumptions):

An increase in gross margins back to the ~70% GM% level generated consistently prior to FY18 – if not an improvement to 75% or higher – based on the higher margins generated by the AIET business and the improved margins in the core ReadCloud textbook business (from the increasing mix of direct sales vs. resellers) and assuming no more Cost of Sales curve balls!;
An operating cost base now including AIET of ~$3.5M; and
Similar depreciation & amortisation to FY18 (though this is potentially higher including the acquired AIET assets), and the continuing benefit of carry forward tax losses.

But note that every single number outlined above is my assumption, and in the continued absence of guidance from the commentary, the range of potential outcomes for FY19 is pretty wide in my view. It’s possible that management provide actual full year guidance at the release of half year results at the end of February, but I suspect it more likely that we’ll need to wait until the March 2019 quarterly cashflow statement. That 4c is going to be key – not only will it include the vast majority of full year revenue and cashflow, from both the core ReadCloud textbook business (including the reseller channel) and AIET, but it should also provide clarity on whether more capital is going to be required to execute on the company’s strategy.

Cash was down to $2.9M at the end of December, meaning the company has burned through nearly half of the $5.5M raised in the IPO a year ago (1^st year anniversary is this Thursday 7^th February in actual fact) – although a meaningful chunk of this capital was used to increase the sales & marketing team in the pursuit of growth (the results of which we can’t yet quantify). It seems that no more capital will be required just yet – with March likely to be by an order of magnitude the highest cash generating quarter of 2019, and the June quarter still likely to include some meaningful cash receipts (from AIET in particular). But of course there will be the comparatively lower cashflow generating period to get through over the second half of the year, before customer receipts for the 2020 school year begin to flow in.

We continue to flag that RCL is very early in its life cycle and as a result is a comparatively higher risk, speculative stock at this point. There is a lot to be optimistic about – not just with the positive momentum in the core RCL platform business, but also if the AIET acquisition yields the financial and operational benefits flagged by management.

It’s also worth noting that at a share price of 30c (as of 1^st February 2019), RCL has a market cap of only ~$13M – so arguably not much upside is reflected in the current share price, and any meaningful increase in profitability is likely to drive a significant increase in the share price. Investors will need to continue to await the next key reporting milestones for confirmation (or otherwise) that the investment thesis for the company is still intact.

Note From Claude: While I mostly agree with the Gentleman's take on the situation, I don't have confidence that gross margins will return to prior levels and I don't think management have done enough to explain the key drivers of margins within the business. For this reason, Readcloud remains a low conviction position for me, among my very smallest.

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Disclosure: I (@Fabregasto ) and Claude both own shares in ReadCloud and may buy or sell shares in the future – but not for at least 2 days after the publication of this article. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Elixinol (ASX:EXL) Q4 2018 Quarterly Update

Fabregasto — Thu, 31 Jan 2019 21:50:23 +0000

Elixinol Global Ltd (ASX:EXL): Growing But Still Early Stage

A lot has been happening with Elixinol Global (ASX:EXL) since we initiated coverage on the company in late October. During that time the stock price has more than doubled to hit a high of $3.55 earlier this week, before falling 11% today in response to the release of EXL’s 4C (quarterly cash flow report) for the December 2018 quarter.

As a quick refresher, EXL is a profitable US-based vertically-integrated manufacturer and distributor of hemp-based nutraceutical, dietary supplement and skincare products, and also here in Australia a manufacturer and marketer of hemp food and cosmetic products. The company also has designs on becoming a cultivator, manufacturer and distributor of medicinal cannabis products (leveraging its expertise with hemp goods) via an early stage Australian business (recently renamed Nunyara Pharma per the Dec-18 4C). Please refer to our initiation report on the Elixinol and to some background detail on the science of cannabis and cannabinoids, the global hemp and recreational and medicinal cannabis markets, and also a snapshot of the evolving regulatory landscape.

There has been a lot of enthusiasm towards the stock in the past few months, fuelled by the signing just before Christmas of the 2018 Farm Bill by President Trump – which ended the prohibition of hemp under the Controlled Substances Act. As we foreshadowed back in our October articles, hemp is now classified as a standard agricultural product (naturally, hemp was the world’s largest agricultural crop for thousands of years and farmed for food and as an industrial fibre in clothing, building materials and medicine). Broadly, this means that hemp farmers will now be able to access crop insurance and US Department of Agriculture programs, and will have greater access to banking services and mainstream payments technology; and (2) hemp products can now be transported across US state lines, and are able to be advertised in mainstream journals and newspapers – thereby opening up the national mainstream retail market. The positive ramifications for EXL’s US-based CBD-derived hemp products business are obvious.

More generally, media commentary and market analysts continue to focus on the increasing momentum in the US and globally for the legalisation of medicinal and recreational cannabis, while there has been a string of M&A deals in the past couple months both amongst existing cannabis players and companies looking to enter the space, as well as more tie-ups between cannabis operators and food & beverage and healthcare companies – all ahead of the expected regulatory reform and opening up of regional – and potentially global - markets.

But we’re getting ahead of ourselves – there is some way to go before global legalisation of medicinal and recreational cannabis – and from EXL’s perspective the company is focused in the meantime on executing the rapid expansion of its profitable hemp products business. Shortly after the signing of the Farm Bill, the company announced that it would proceed with appointing national advertising, PR and marketing agencies to improve awareness of the Elixinol brand and immediately commence its assault on the US national retail market.

The December quarter 4C revealed a significant increase in revenue for FY18 (financial year end is December) – up 121% from FY17 – and as can be seen from the below an acceleration of growth from the June 2018 half (+107% versus 1H17) to the December 2018 half (+132% versus 2HFY17.

Full year results won’t be released to the market until late February – so til then we won’t know the level of profitability generated by the company in the fiscal year just ended. The company generated a maiden (small) profit in the June 2018 half, and in our initiation piece we hypothesised that the company could generate NPAT of ~$2M for FY18 based on a continuation of 1HFY18 growth rates, similar margins in the established US and Australian businesses, further start-up losses for Nunyara, and a degree of operating leverage with respect to opex. However, readers should be cognisant that given the significant market opportunity available to Elixinol as a result of the opening up the US hemp market, it’s also possible that near term profitability is deliberately put on the backburner while the company invests in its supply chain and sales & marketing capabilities to meet the accelerating demand for hemp-based products – with the expectation that this would hopefully result in a significant boost to market share and profitability over the medium term.

The December quarter 4C also provided an operational update which included the launch of the new Sativa Skin Care range (moisturisers and creams, shampoos, deodorants) in the US (and also available in Australia on the Hemp Foods Australia website), the launch of Essential Hemp branded snack bars in Australia and preparation for the launch in 1Q19 of a product in the “ready meal” category, the ramping up of European marketing operations, and increased R&D investment in the future product pipeline.

And as announced to the market last week, the company also entered the New Zealand market following the passage of the Misuse of Drugs (Medicinal Cannabis) Amendment Act – which enables the sale of EXL’s CBD products to patients on a prescription basis. We assume that NZ sales won’t meaningfully “move the needle” revenue or earnings-wise over the short term, but are hopeful that this development can be replicated in larger markets.

The 4C also included some commentary which one might potentially attribute to “growing pains” for a company growing so quickly: (1) some minor delays associated with the planned commissioning of the new Colorado manufacturing facility – scheduled for first half of this year, and which will double US production capacity from current levels; (2) lower than expected yields from the maiden harvest of high-CBD hemp under the NCHPP farming joint venture; and (3) frustration that Nunyara had not yet been awarded medicinal cannabis cultivation and manufacturing licences by the Australian Office of Drug Control.

It’s conceivable that this less-than-rosy commentary was a key driver for the share price decline today, as well as the lack of any specific guidance for FY19 (which we think was always more likely to be provided at the release of full year results next month), and potentially also because some market participants were hoping for higher FY18 revenue than was achieved. Given the doubling of the share price in the last few months – despite the “Risk Off” period endured in the Australian market since late August – the share price had arguably overshot and was due for a correction at some point. It’s also not unusual for high-growth companies such as EXL to be bought heavily leading into results and then sold off once numbers are released as certain investors “Buy The Rumour And Sell The Fact” etc.

The share price action since we initiated on the company (*probably* more correlation than causation, though hopefully we have some degree of EXL ownership in the Ethical Equities community) has highlighted the speculative nature of the stock, and the significant increase in the share price has made the company even more expensive in a traditional fundamental sense. On the other hand, as we highlighted back in October not many companies have the potential growth profile of Elixinol.

We still think that EXL is a comparatively smarter post-hype (or first wave of hype) way to play the potential cannabis boom – as the only listed ASX cannabis player which is (1) generating meaningful revenue, and (2) profitable, albeit only recently and potentially with meaningful near term profitability deliberately pushed back while the company attempts a land grab in the US market.

Given recent share price movements, readers will need to make up their own mind whether EXL is a suitable investment candidate for their individual portfolios – but clearly the company is not a Deep Value play and it will likely be years before it pays a dividend.

With a view on the longer term potential of the company I personally will continue to hold while I wait to gather more information on the likelihood of my personal investment thesis playing out (i.e. whether management can deliver on the large market opportunity).

Note from Claude: I am tempted to sell but also holding on for now (and I will not trade for at least 2 days after publication of this article). For me, a profitable full year result would be bullish. A loss would have me a concerned.

Disclosure: I (@Fabregasto ) have a position in Elixinol – though sadly not added to since our initiation report – and may add to my position in the future – though not for at least 2 days after the publication of this article.

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The Author of this piece, Fabregasto, and Editor, Claude Walker, own shares in one Cannabis stock Elixinol Global. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Readcloud (ASX:RCL) Update On AGM and Acquisition

Fabregasto — Mon, 03 Dec 2018 07:22:56 +0000

Readcloud: The post-AGM Update

When we last checked in on ReadCloud (ASX: RCL) in early September the company had just reported its maiden full year results as a listed entity – having raised $5.5M (post IPO costs) at 20c per share in February.

After touching the vertiginous heights of 62c in mid-August, the shares were down to 47c at the time the FY18 results were released to market, and recently bottomed (he said, optimistically) at 29c. The shares strengthened to 36c ahead of the AGM and closed at this level on Friday. ReadCloud has certainly helped remind shareholders of the volatility prevalent in the small cap sector – which can be magnified by illiquidity, and RCL is a comparatively illiquid stock.

Since the release of the FY18 results, the company has appointed a CFO and also signed a direct distribution agreement with global major publisher Oxford University Press (OUP) for its digital content. ReadCloud had been hosting and distributing OUP content indirectly through RCL resellers (presumably at lower margin than it will be able to generate on OUP content going forward).

We noted in our last RCL piece the 3 tranches of performance rights available to management which were vestable in halves based on a mix of 2018 and 2019 user, revenue and EBITDA targets; and a 4^th tranche based on share price hurdles. Following the achievement of (1) both share price triggers; (2) the achievement of the first of the user targets; and (3) one of the two FY18 financial targets, a large chunk of these performance rights vested and management’s stake in the company increased by around 3%. The FY18 EBITDA hurdle was missed by a mile – as telegraphed in April – not helped by the unexplained large increase in Cost of Sales for FY18.

Business momentum and trying to understand the cashflow profile

As we iterated last time the success or otherwise of a potentially high growth small company like RCL would come down to execution. When FY19 started, the general vibe was that momentum was starting to increase.

What no doubt helped power ReadCloud shares to their August high was the June quarterly cashflow statement released at the end of July, which bullishly disclosed that the company’s sales pipeline ahead of the CY2019 school year was 6 times the size of the CY2018 pipeline 12 months earlier. Conversion of this pipeline would therefore be key. [No sh!t, Gent]

The September quarterly 4C seemed to indicate things were on track, with the company advising that several new large direct schools had been signed, and that via reseller OfficeMax a further several indirect schools had been locked in for the 2019 school year. That seemed like a good start when you consider that 70 schools had been secured by June. ReadCloud then teased OfficeMax’s appointment to a 2-supplier panel for the Catholic Archdiocese in Sydney, which could result in up to a further 38 secondary schools (an OfficeMax-vs- other-panel-member purchasing decision) – though not until the 2020 school year. The company also flagged new reseller agreements executed during the September quarter with 3 new “stationary” (sic)] / book suppliers – which increased the total number of resellers to 7 including OUP above. Better learn how to spell “stationery”, fellas.

Finally, ReadCloud disclosed the signing of a distribution agreement with the Australian Institute of Education & Training (AIET) – a provider of 34 different Vocational Education and Training (VET) courses to approximately 4,000 Year 11 and Year 12 students in more than 90 secondary schools in Victoria, SA and WA. No more acronyms, I promise (NMAIP).

So far, so good, although a little vague and lacking in hard numbers or targets – perhaps not surprising given (a) the lack of detail provided by the company in its short listed life to date, and (b) the low base from which the company grew through FY18.

Cash at September was $3.7M, down from $4.6M at June – reflecting the seasonality profile telegraphed by management: December and March quarters are seasonally the strongest cashflow-wise as schools purchase their school year curricula during these quarters. Readers will remember that cash raised from the IPO in February was $5.5M (so, cash declined by a third in 7 months), and close watchers of the company’s ASX announcements will have noted the increased investment in the ReadCloud platform, and also the increase in MD and CIO salaries for the FY19 year (to $250K, not exactly multi-million ASX Top 50 company salaries to be fair).

And this may well explain some of the share price action over the past few months – fear of a potential capital raising. Without much in the way of revenue or earnings guidance for the current financial year (again, not unusual for a microcap), my eyebrows were certainly twitching at this point. Quarterly cash-burn is outlined below, including the December forecast outflows (only; companies rarely think to provide forecast cash inflows) from the September 4C:

Note the regular disconnect above between Cost of Sales payments (to publishers for content and potentially also to resellers for indirect sales to schools (depending on payment terms)) – this suggests annual / other irregularly timed payments which don’t align with the company’s incoming cash receipts – which don’t make our attempts to forecast the cashflow cycle any easier.

Using management’s estimated R&D refund (which will likely have hard calculations behind it given the company’s track record of achieving R&D refunds historically (which requires the preparation of tax returns and providing supporting information)), and assuming management’s forecast Dec-18 outflows are near the mark, net cash burn if RCL received zero customer receipts for Dec-18 would be just $0.4M. This is obviously extremely unlikely given the known cashflow seasonality profile, and bearing in mind the increased number of schools and resellers over the past several months. December *should* be the best or second best cashflow quarter (RCL hasn’t been listed long enough for outsiders like us to have a definitive handle on this). If anything, the ~$0.7M of customer receipts from the March quarter should be below the mark.

Note that Sep-18 quarterly receipts were higher than that for 1H18 – which gives a sense of the trajectory here. Also note that the FY19 financial hurdles for management’s remaining performance rights are $7.5M of revenue and $2.0M of EBITDA – this is of course no guarantee that the company will get near these targets, but the investment in the sales team in 4QFY18 and the big news below suggest they intend to give it a good old crack. So, based on the above and communicated trajectory – unless sales pipeline conversion is very poor – a capital raising *should not* be required.

Sales update + acquisition of AIET

But just when you thought you were starting to get a handle on the potential cashflow profile of the business over the next several months, in mid-November ReadCloud announced two materially price sensitive pieces of information:

Sales traction had been impacted by curriculum changes for 2019 – causing publishers to need to alter their content and thereby delaying school purchasing decisions; and
RCL had agreed the acquisition of AIET (with which it had signed a distribution agreement, above) for up to ~$3M – comprising $350K of cash up front (which seems a decent use of the R&D refund), and up to ~$450K of further cash and up to ~$2M of RCL scrip based on sliding revenue (up to $0.9M) and EBIT ($0.2M to $0.6M) scales.

ReadCloud company disclosed that AIET achieved revenue of ~$1M for FY18 with further growth expected in FY19, and announced that the total potential acquisition cost for AIET (up to ~$3M) was a 4.5x EBIT multiple – suggesting AIET’s forecast EBIT for FY19 is ~$650K. AIET would have to go backwards in FY19 for its vendors to not achieve the full benefit of both earn-outs above. All of a sudden management’s final tranches of performance rights are looking more achievable.

Prima facie, the acquisition of AIET looks like a sound strategic move, providing a complementary product which is sold in ReadCloud’s existing secondary school market. ReadCloud also noted that:

The AIET acquisition enabled cross-selling opportunities for AIET content into RCL’s existing schools (with confirmation at the AGM 2 weeks later that this had already begun);
It will accelerate and complete the digitisation process begun by AIET which will result in cost saving synergies for AIET post transaction; and
AIET is significantly higher margin per student compared with RCL’s school textbook content.

The delay in purchasing decisions for RCL’s school textbook content seemed problematic, but the company iterated that this logistically just extended the selling season by 4 weeks – which sounds reasonable given the schools will still need their digital content, however we won’t definitively be able to confirm that this is a non-issue until early next year.

There are obviously a number of moving parts here. ReadCloud started FY19 with 70 schools and had signed what sounds like a further dozen schools during the September quarter. Add in AIET’s 90 schools and the company would need to sign a further ~30 during the current and last 2 quarters of FY19 to hit the new target of 200 disclosed in the AGM presentation.

The AGM presentation disclaimed that “management is not in a position to provide financial guidance at this point in time” as the company won’t have a meaningful grasp of CY2019 direct and indirect (via reseller) school year sales until January. This is unsurprising given the delayed school purchasing decisions communicated and the AIET acquisition completed last week. Does this mean that ReadCloud will start providing hard financial guidance in the future?

I hope that the release of the company’s December quarter 4C in late January will provide commentary to help shareholders:

(1) understand how the CY2019 school year is shaping up (bearing in mind that sales will probably still being made into February) and the extent (if any) of the impact on sales of the school curriculum changes;

(2) confirm that there are no cashflow concerns or imminent need for more capital; and

(3) see the first financial contribution from AIET (recognising this is likely to be small given the acquisition was only completed in late November). Put it in your diary: that December 4C release in late January could be materially price sensitive – hopefully to the upside for RCL shareholders like myself.

And now, dear readers, here we are back where we were in May – share price-wise. But now we arguably have more reason for optimism, given the expected uplift in revenue and earnings from the AIET acquisition, as well as the suggested stronger momentum in school textbook volumes in FY19 vs FY18. That optimism will have to suffice for the next couple of months in the likely absence of any further new information. I am optimistic but I am keenly awaiting the next reporting milestones for confirmation (or otherwise) that my investment thesis for the company is still intact.

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Disclosure: I (@Fabregasto ) own shares in ReadCloud and may buy more shares in the future – but not for at least 2 days after the publication of this article.

Claude Walker also owns shares in Readcloud, and will not trade for at least 2 days after the publication of this article.

This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Cannabis Stocks: An Overview Of The Opportunity and The Industry

Fabregasto — Thu, 04 Oct 2018 11:54:35 +0000

Cannabis Stocks: An Overview Of The Opportunity and The Industry

Author: Fabregasto

Ethical Equities is proud to present the first of three part series on ASX Cannabis Stocks.

Today, Fabregasto, covers the opportunity, the science, and gives readers the tools they need to assess pot stocks for themselves, in Part 1.

Part 2 (published next week) will be a joint piece on the ASX stocks themselves -- and why most of them are too risky for our portolios.

And Part 3 (initially for members of the Ethical Equities Newsletter and twitter followers of The Gentleman himself) will cover the one ASX Cannabis stock we like best.

Understanding the Science

The endocannabinoid system (ECS) is a complex intercellular communication system that plays an important role in the human body’s central nervous system (CNS), affecting a number of key physiological and cognitive processes – including how we feel, move and react. The ECS is also involved in regulating fertility, pregnancy, pre- and post-natal development, and in moderating the effects of physical activity (including exercise-induced euphoria such as the “runner’s high” (recently found to be attributable to cannabinoid AEA, not endorphins as previously believed)).

Cannabinoids are the natural chemicals produced by the human body that interact with receptors in the ECS to regulate immune system functions, pain sensation, motor learning and memory, appetite and mood. The two main endocannabinoid receptors are CB1 and CB2 – located primarily in the CNS, and the immune system, respectively.

The ECS is named after the plant Cannabis sativa and its active ingredient tetrahydrocannabinol (THC). Marijuana and hemp are two of the most well-known cannabis plants and differ significantly in the way they are cultivated and used. Marijuana is used predominantly for medicinal and recreational purposes, whereas hemp is used in healthy dietary supplements, clothing, cosmetics and accessories, and industrially in construction, plastics and even making cars.

THC is one of more than 100 cannabinoids which have been identified, and is a psychoactive chemical credited with causing the marijuana high and the potential for addiction. The other well-known cannabinoid is cannabidiol (CBD) which is found in the hemp plant and is not a psychotropic substance (meaning it does not make you high, alter brain function or cause temporary changes in mood, behaviour or consciousness).

Marijuana plants contain high levels of THC (typically 5-35%), whereas hemp plants contain very little THC (less than 0.3%) – which has resulted in the different legal circumstances surrounding the two plants (e.g. in the US the fact that CBD-derived nutraceuticals are not classified as drugs and don’t require FDA approval). The successful interaction of CBD with cannabinoid receptors is not dependent on the corresponding levels of THC. Because CBD is thought to be beneficial to humans, hemp crops with high CBD command higher prices than those with low CBD, just as crops with higher THC sometimes command higher prices than those with low THC.

Crucially, cannabinoids found in cannabis plants are identical in action to the cannabinoids produced by the human body, suggesting they are not harmful. Studies seem to indicate that cannabinoid production within the body declines as we get older – which may be a contributing factor to the wide variety of medical conditions people contract in the last stages of their lives. This is part of the reason some people may wish to supplement with hemp-derived CBD products.

The Growing Hemp Market and Recreational Cannabis In Beverages & Tobacco

Independent hemp research organisation the Hemp Business Journal (“HBJ”) estimates that US sales of hemp-based products reached $820M in 2017, and forecasts this to reach $1.9BN by 2022, driven by a degree of relaxation of some of the current legal and regulatory barriers, and increased consumer awareness and education (including overcoming the current stigma associated with hemp). The HBJ projects that hemp-based CBD products (such as hemp oils and essences) will increase from 23% of the US market in 2017 to 34% (US$646M) over this period, at a CAGR of 28% (slightly below the 30% CAGR it forecasts for industrial applications (e.g. packaging and building materials).

Here in Australia there have been many relatively fluffy press articles around hemp being the next “super food” (especially post hemp being officially classified as a food in November 2017). This is driven by a number of hemp’s nutritional properties, including its high levels of protein and essential fatty and amino acids, and its comparative ease to digest (in comparison with certain grains, nuts and legumes). Hemp is also gluten free, meaning freaky people (such as myself, unfortunately) can use hemp flour for cooking purposes (*if I ever cooked).

Meanwhile, global beverage giants have been keenly watching the creeping legalisation of the cannabis sector in different jurisdictions, and in the past year have made strategic moves to enter the space. In October 2017, Constellation Brands acquired a 10% interest in listed Canadian cannabis company Canopy Growth for $191M, and in August 2018 invested a further $4BN to lift its stake to 38% and lock in Canopy as its exclusive global cannabis partner for the development of marijuana-infused beverages. Also in August, US brewer Molson Coors established a joint venture with listed Canadian cannabis cultivator Hydropothecary Corp to introduce a range of marijuana-infused drinks for the Canadian market.

Last week Bloomberg reported that Coca-Cola has held discussions with several cannabis producers (most recently Canadian producer Aurora Cannabis) to develop cannabis-infused beverages that will target inflammation, chronic pain and cramping. And Heineken has developed a THC-infused sparkling water drink for the Californian market (where recreational marijuana is legal). Predictably, a number of specialist marijuana beverage start-ups have commenced operations in the US in the last couple of years, and you can expect this would be a hotly contested space were recreational cannabis to be properly legalised, complete with a large number of smaller boutique players (akin to craft beer). Comparisons have been made to the ending of Prohibition in the US with the repeal of the Volstead Act in 1933 – but for as much as I enjoyed Boardwalk Empire, I want to emphasise that I believe the bigger investment opportunity for cannabis is in healthcare.

Tobacco producers are also expected to look to cannabis to offset the long term structural decline in tobacco sales. In June 2018, UK-based tobacco giant Imperial Brands became the first major global operator to invest in cannabis with the acquisition of an undisclosed shareholding in UK biotech Oxford Cannabinoid Technologies. This followed small listed US tobacco manufacturer Alliance One International taking a controlling stake in two Canadian cannabis producers in February.

Medicinal Cannabis

The real game changer with respect to cannabis is likely to be in healthcare.

Medicinal cannabis refers to products which include any part of the cannabis plant and are used to relieve the symptoms of a particular medical condition. The cannabinoids CBD and THC have been clinically shown to have therapeutic benefits for a range of medical conditions, including:

Multiple Sclerosis
Epilepsy
Chronic pain, inflammation and migraines
Osteoporosis and Rheumatoid Arthritis
HIV/AIDS-related nausea, pain and appetite loss
Parkinson’s Disease
Depression, Anxiety, Schizoprenia, Post-traumatic Stress Disorder and other mental disorders
Glaucoma

There is also evidence that CBD and THC may have anti-tumoral properties (i.e. could potentially be used to suppress tumours and treat cancer-related pain and side effects).

It’s still however early days in the medical research into cannabis.

I recommend that both of our readers (hi Sebastian and Millicent!) listen to the Bloomberg Radio Masters in Business podcast from June 2018 with Todd Harrison, founding partner and Chief Investment Officer of CB1 Capital. CB1’s website includes a useful database of recent scientific studies undertaken into cannabis – helpfully organised by target area (https://www.cb1cap.com/cbd-research-studies-authorities/). In addition to the serious medical conditions above, CB1 estimates that there are currently 80-90 FDA clinical trials focusing on the use of cannabinoids (not just CBD and THC but the “minor cannabinoids” as well) to treat:

Cardiovascular Disease
Autism spectrum disorders and Attention Deficit/Hyperactivity Disorder
Alzheimer’s Disease
Huntington’s Disease
Complex motor disorders (i.e. spasms and twitches, including Tourette’s)
Fibromyalgia
Endometriosis
Crohn’s Disease and Irritable Bowel Syndrome
Muscular Dystrophy
Weight loss and eating disorders
Type 2 Diabetes
Sleeping disorders
Dermatitis, psoriasis and other skin conditions

CB1 is careful to describe the current medicinal cannabis landscape as early days “frontier science”. We shouldn’t expect that cannabis will be the silver bullet panacea that puts an end to all of these serious conditions and allows us all to live well into our 200s (long enough to see Fast & Furious 57, or to see Catapult Group finally turn a profit). But research and trials to date in a number of these areas have apparently been highly promising, and there is real optimism that cannabis will be able to be legally used for the treatment of a number of serious physical and mental conditions.

Childhood epilepsy was the first medical condition to have a cannabis-based drug pass a US Food and Drug Administration (“FDA”) Phase 3 placebo-controlled trial: British pharma company GW Pharmaceuticals (“GWPH”)’s Epidiolex. In June 2018, the FDA approval of GWPH’s drug as a prescription medicine for childhood epilepsy represented an important breakthrough for the medicinal cannabis industry. In 2010 GWPH launched in the UK the world’s first cannabis-based prescription medicine: a spray for Multiple Sclerosis. GWPH currently has a market cap of US$4.8BN and a portfolio of other clinical stage cannabis-based drugs in development.

To date there seems to have been little focus on cannabis-based drugs from the large multinational pharma players such as Merck, Pfizer, Novartis and Sanofi. There is a narrative that big pharma nefariously worked behind the scenes to encourage the initial US ban on cannabis in 1970 and has continued to work in the shadows to prolong the prohibition since that time. Post the FDA approval of Epidiolex, commentators in some quarters view it increasingly likely that the pharma giants are likely to enter the sector in order to defend the cannibalisation of the supernormal profits earned from on-patent drugs.

Finally, there appears to also potentially be scope for cannabis to assist in battling the opioid “endemic” often hysterically reported in the media. This hinges on the evidence that CBD acts to block the psychotropic actions of THC (as noted earlier) and therefore may be useful in detoxification and weaning addicts off opioids (including heroin, and synthetic opioids such as fentanyl and legal prescribed pain relievers).

The Changing Legal Landscape For Hemp And Marijuana

In the US, hemp was made illegal to farm under the 1970 Controlled Substances Act because of its connection to marijuana, and its cultivation was only recently re-legalised by the 2014 Farm Bill. Hemp farming is now permitted in 31 states, including Colorado where EXL’s US operations are headquartered. However it is still currently not legal to move the crops across state lines, nor to market hemp products – both of these impediments will be removed by the passing of the 2018 Farm Bill expected within weeks (as of the end of September 2018).

The chart below from EXL’s September 2018 investor presentation illustrates slow acceleration in progress towards legalisation over the past 5 years.

In June 2018, the US Farm Bill – which contains provisions pertaining to the legal cultivation, processing and sale of industrial hemp – passed through the US Senate (easily, on a vote of 86-11) and is now awaiting sign-off by President Trump. Once signed into law, industrial hemp will be classified as a standard agricultural crop which can be transported across state lines, and hemp products will be allowed to be advertised in mainstream journals and newspapers. The Bill will also make hemp plants eligible for crop insurance, enable water rights for farmers, and will open up access to mainstream payments technology.

Hemp legalisation enjoys broad bipartisan support in the US. Political commentators have suggested that the Republican Party are keen to take leadership of the hemp legalisation issue as the country heads into mid-term elections – hence the recent spearheading of this initiative by Senate Majority Leader Mitch McConnell. The legalisation of marijuana for recreational use is likely to take a lot longer in the US, and is not as much of a fait accompli. Canada became the second country in the world to legalise recreational marijuana in June 2018 (after Uruguay in 2013).

In Australia, the February 2016 Narcotic Drugs Amendment Act enabled the licensed cultivation of cannabis for medicinal and scientific purposes, and in April 2018 legislation was passed to enable Australian cultivators to export cannabis seeds, oils and raw materials to other markets.

Sign up to the Ethical Equities Newsletter to receive parts 2 and 3 of this series, where we will take a closer look at the individual listed stocks.

Please feel free to sign up to the forums and let me know what you think!

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ReadCloud (ASX:RCL) FY 2018 Annual Results: Initial Coverage

Fabregasto — Sun, 02 Sep 2018 02:01:15 +0000

Author: Fabregasto

On Wednesday, ReadCloud (ASX:RCL) announced its maiden full year results as a listed company.

Background

ReadCloud is an emerging Australian education technology company which provides digital learning solutions to Australian secondary schools. Specifically, ReadCloud’s Software-as-a-Service (“SaaS”) eReader platform delivers entire school curricula in one app. Within this app, teachers and students can collaboratively share notes, questions, videos and website links, and import third party content such as YouTube videos and TEDTalks.

The platform includes data analytics (so teachers can track actual reading time) and integrates with each school’s Learning Management System, to synchronise timetables and classes. The eReader platform is more cost effective for schools than traditional hardcopy textbooks, and in short, investing in the company is a play on the digitalisation of the classroom.

From the limited financial information included in the prospectus, ReadCloud’s growth trajectory seems to have been considered and steady and without the long runway of cash burn often seen in the technology sector. Founded in 2009, the first version of the eReader was published for iPad in 2011, and in 2013 the platform was deployed in two pilot schools. Per the prospectus, over 2014/2015 the current senior management team joined the company and redefined the commercialisation strategy. From three schools in 2015, the platform had been rolled out to 50 schools and 21,800 users at June 2017. Unlike a number of ASX listings in recent times, ReadCloud was already profitable at IPO, generating positive NPAT in FY16 and FY17 (albeit before incurring typical annual ASX listing fees and corporate expenses which it will from this point forwards).

In order to fund the next phase of growth, ReadCloud listed on the ASX in February 2018 with little fanfare (which has proven to be characteristic of management (a plus in my view)). The company raised $5.5 million (after costs) with which it aimed to fund an expansion of its sales and marketing team, plus further investment in the eReader technology platform.

ReadCloud generates revenue from selling licences for its eReader software and for eBooks in the digital library. At IPO this digital library included more than 170,000 titles via direct distribution agreements with global publishers such as Simon & Schuster, Allen & Unwin and Penguin Random House, and educational publishers such as Jacaranda and Macmillan. These agreements automatically make new eBooks available on the eReader platform as soon as they are released by these publishers.

The company operates two distribution channels:

(1) Direct sales to schools under 1-4 year contracts, with the majority of revenue received at the start of the school year (when that school’s curriculum is purchased); and

(2) Via resellers – such as Officemax (a large school book and stationery supplier) and Jacaranda (a sizeable textbook publisher).

ReadCloud also white labels its platform for a number of channel partners.

As you would expect, the company generates higher margins from supplying schools directly: the prospectus quoted respective gross profit margin per user of $42 from direct sales in FY17, versus $15 per user via the reseller channel. The planned use of IPO proceeds is to grow its direct sales capability. Management hope this will lead to significant gross profit growth as the product gains traction. In FY17, 88% of sales were achieved via the lower margin reseller channel, and 12% via ReadCloud’s direct salesforce. The prospectus set a target to double direct sales to 24% of total revenue for FY18, but actual FY18 results showed this had already increased to 29%.

Accelerating growth into FY19 and reported FY18 results

The prospectus included no financial forecasts, but did include a June 2018 target of 45,000 users across 75 schools. In a quarterly update to the market in late April, ReadCloud announced it had at that point surpassed 50,000 users across 70 schools and that, following a significant increase in inbound enquiries from potential new schools, the sales pipeline ahead of the 2019 school year was at record levels. In a late July 2018 update the company disclosed that the sales pipeline for CY2019 was more than 6 times the level of the pipeline at the same time last year.

In the April 2018 update, the company noted that the $500K FY18 EBITDA hurdle (needed to trigger a portion of performance rights held by management (more on these later)) would not be met due to the decision taken to scale up its workforce to meet the strong sales pipeline. While management easily met the first half of the Class A performance rights target with 8 months to spare, the decision to pull forward expenditure into FY18 in order to accelerate the growth trajectory in FY19 (and “sacrifice” a portion of management incentives in the process) is noteworthy. However, the FY18 EBITDA hurdle may not have been met, anyway, based on the full year FY18 results released yesterday.

The FY18 results confirmed the late July guidance that FY18 revenue exceeded $2 million – a significant increase from FY17, though obviously off a low base. As is not unusual for a newly listed entity, maiden reported full-year results included some significant one-off costs related to the IPO (presented below Underlying EBITDA (management’s definition) below).

As noted above, the company previously did not incur corporate expenses associated with being a listed company: blue shaded costs below are management’s estimates of these costs from FY15 to FY17 (which seem a little on the low side), included in Underlying EBITDA in the FY18 results.

The first thing that stood out to me from the FY18 results is the unexplained significant increase in publisher & bookseller fees – from ~30% of sales between FY15A and FY17A to ~73% of sales in FY18A – and the resulting decrease in gross profit margin. The annual report commentary explained this away as “a result of growth in sales during the period”, but this was unexpected (to me), and a 559% increase in cost of sales on a 189% increase in sales revenue – which looks like it may contain a large one-off payment – requires some explaining in my view.

All else being equal, if ReadCloud had generated the same ~68% gross profit margin for FY18 as it did in FY17, Underlying EBITDA would have been $723K higher (and $576K instead of -$147K). Approximately $0.7M of R&D costs were capitalised during the year.

FY19F and management performance rights

The expansion of the sales and marketing team flagged in the prospectus (which has driven the significant increase in the CY2019 pipeline as noted above) is behind the material lift in employee operating costs in FY18. The June 2018 4C included estimated quarterly cash operating expenditure outflows of $430K (excluding ~$300K of R&D spend, the majority of which I’d expect to be capitalised). This suggests that the annualised cost base of the business is now closer to ~$2M at the commencement of FY19. This sounds “about right” given the business is probably targeting revenue of around $7.5M for FY19F – being a trigger for management’s performance rights (discussed shortly, I promise).

I say “probably” because no formal FY19 guidance has been provided by the company (just as no forecasts were included in the prospectus). The FY18 results press release also did not provide a further update from the positive commentary included in the June quarterly 4C (just one month ago, to be fair). Shareholders will already have surmised that the company is not “flashy”, and doesn’t bombard the ASX announcements department (if there even is such a thing) with bombastic press releases on its progress.

I don’t mind this at all – I prefer management to be focused more on execution and growing the business, and less on spruiking the company on Soviet-era-looking internet forums and engaging in nefarious behaviour on Twitter. But it does mean there may not be a further update on progress until ReadCloud’s AGM in November.

So – as with all genuine high-growth companies, this is going to come down to execution. Specifically, the conversion of the strong sales pipeline communicated by the company, into actual sales.

Cash at the end of June was $4.5 million (noting $5.5 million was raised in February). The company has flagged previously that the December and March quarters are the seasonally strongest quarters from a cash flow perspective. This is to be expected with Australian school years commencing in January / February and school curricula presumably purchased between November and March.

The June cash balance of $4.5 million should comfortably fund operations through the quieter September quarter, and through the seasonally higher Q2/Q3 sales cycle – but clearly actual sales conversion will be critical for cash generation through the back half of FY19 (duh, Gent). And then, through the seasonally quieter first quarter of FY20.

Now, to the performance rights. As brazenly noted in the May 2018 investor presentation (Thorney Group, who put on the conference, holds ~13% of the company), “management are rewarded for doubling user numbers again for FY19”. The full suite of management’s performance rights – which vest in halves (50%/50%) – comprise:

Class A: 45,000 users by December 2018 (met); 100,000 users by December 2019 (pending)

Class B: FY18 revenue of $2M (met); FY19F revenue of $7.5M (pending)

Class C: FY18 EBITDA of $500K (not met); FY19F EBITDA of $2M (pending)

Class D: share price VWAPs of $0.30; and $0.40 for 30 consecutive (presumably trading) days (likely met, given the share price has not been below $0.40 since 18^th June).

Shareholders will be hoping that management are successful in triggering the FY19 $2M EBITDA hurdle above. The big question is whether they mean reported or underlying EBITDA. If it is reported EBITDA, the majority of this $2M EBITDA would fall to NPAT. In this scenario, investors can dream of a ~20-25x P/E ratio for FY19F (based on yesterday’s $0.43 share price). Claude’s note: colour me sceptical.

Business momentum heading into FY19 is strong based on management commentary. The May 2018 investor presentation referenced a significant shortening in the sales cycle – via two examples of a successful sale to a large school in 2017 (4 months) versus another in 2018 (3 weeks). The company attributes this to growing awareness of ReadCloud’s platform – which will be key to meeting FY19 targets. Also key is likely to be a partnership with the Queensland Secondary Principals’ Association (QSPA) which was announced in May, and which gives ReadCloud exclusive marketing access to 175,000 students in 210 Queensland schools over a 30-month period until November 2020.

Looking beyond FY19: dare to dream

ReadCloud’s stated target market is the Australian secondary school sector, comprising 2,700 schools and 1.6M full time students – but there doesn’t seem any natural impediments to expanding into the adjacent Australian primary or tertiary markets, or indeed moving offshore. The company cited a forecast by business intelligence firm ORC International that 63% of Australian schools (~1,700 of the 2,700 schools above, likely to be in the region of 1M students) will be completely digital by 2020.

In the company’s characteristically un-flashy manner, the May 2018 investor presentation also casually included a line referencing the $5.8 trillion global education market, 2% of which is digital according to IBIS. ReadCloud’s existing alliances with global publishing giants would likely position it well for any future international expansion – though we are getting a little ahead of ourselves in daring to dream these dreamy little dreams. Management’s near term focus is, rightly, on the Australian secondary school market, and on converting the strong pipeline leading into the CY19 school year. Nail that first, global domination can come later. Cool? Cool.

Going forward, as with most SaaS companies, ReadCloud’s platform should be inherently scalable as it adds users, with the potential to generate significant ROIC in future years if/when the product gets real traction.

Small cap volatility

While the potential growth runway is undeniable, and the recent trajectory is impressive, readers should note that ReadCloud is on the more speculative side of the spectrum. At yesterday’s closing price of $0.43, its diluted market cap is under $50 million. Trading is relatively illiquid and the stock is not widely known at this point (certainly not big enough to have attracted broker coverage just yet).

Recent price action has been volatile. Its late May investor presentation drew the market’s attention to the strong growth in FY18 and potential market opportunity. The share price ran from $0.33 at that point to $0.45 in the week preceding the release of its June quarterly 4C statement in late July. The quarterly 4C confirmed full year revenue of $2.1M and so the share price quickly ran up to its all-time high of $0.62 in mid-August. However, the share price retreated to $0.47 immediately prior to the release of results (potentially profit taking and nerves ahead of results), and plumbed an intraday low on Wednesday of $0.41. Savvy investors will note however that the sell-off from $0.60 on 21 August down to $0.43 yesterday has been on very low volume – only ~850,000 shares traded in total over this 7-day trading period.

As noted above, there is potentially an information vacuum for the next 2-3 months until a further update is provided at the November AGM. At that point in time, the company should have reasonably good visibility as to pipeline conversion and what the start of the CY2019 school year will look like. Until then however, the share price may be volatile and potential investors will need to determine for themselves if ReadCloud is in line with their risk appetite.

Disclosure: I (@Fabregasto ) own shares in ReadCloud – accumulated between February and early August 2018 at a VWAP of $0.396 – and may buy more shares in the future – but not for at least 2 days after the publication of this article.

Note from Claude:

This is an excellent and thorough piece of writing about a relatively unknown and fascinating small company. I own shares in Readcloud and I am inclined to purchase more in the future (not for at least 2 days after publication, though).

However, I note that there are unanswered questions. First, why did gross margins take a hit? Second, do the performance rights trigger with underlying EBITDA? And Third, why, if management are focussed on the business, is one of the performance rights hurdles based on share price?

In my view the decision to incentivise management based on a temporary share price trading range lacks a compelling rationale. So although I like this stock; I own this stock; and I may buy more of it: I am cautious.

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Disclosure: The author (aka the Gentleman), and Claude Walker own shares in RCL at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Audinate (ASX:AD8) Sounds Good: FY 2018 Results And Investment Thesis

Fabregasto — Tue, 28 Aug 2018 00:50:52 +0000

Yesterday, Australian digital audio networking technology company Audinate (ASX:AD8) announced its full year FY18 results. The company joined the ASX on the last day of the FY17 financial year and has enjoyed a strong start to its life as a listed company, with its share price rising from $1.22 at IPO to above $4.30 late last month.

Audinate supplies software and hardware products to global Original Equipment Manufacturers (OEMs) under its Dante brand – which stands for Digital Audio Network Through Ethernet. These OEM partners embed the Dante platform and the associated hardware components (such as chips, cards, modules and adaptors) within their own products which are then sold into the professional Audio Visual (AV) market – products such as microphones, mixers, amplifiers, speakers, receivers and tuners, intercoms, headsets and public address systems. These products end up in recording and broadcast studios, airports and public transport areas, sporting stadiums and racetracks, night clubs, theatres and concert halls, universities, hotels, conference rooms and other public areas. The Dante technology was first developed in 2004, and the company founded in 2006 and spun out of the National ICT Australia (now part of the CSIRO) soon after to commercialise the technology.

Audinate’s blue chip customer base includes prominent OEMs such as Sony, Bosch, Bose, Roland and Yamaha – its largest customer (22% of FY16 revenue) and interestingly also a 10% shareholder. Having been a customer since 2009, Yamaha partnered with Audinate in 2012, making a $5M strategic investment. The following year it released its first Dante-embedded products.

As you can guess from the Dante acronym, Audinate’s software distributes digital audio signals across computer networks using standard IP networking. The company is leading the migration away from old world analogue point-to-point cabling. (The old system allows only one channel per cable and can therefore result in the kind of spaghettified tangled mess of cords that I’ve had in my lounge room for much of the last 20 years). The next generation digital technology permits the transmission of multiple channels via a single cable without any deterioration in signal quality, and typically is lower cost than traditional analogue installations.

The digital audio networking industry is still in its infancy – only ~$360 million in size in 2016 per market research firm Frost & Sullivan. It is projected to grow to ~$455M by 2021 – tiny compared to both Audinate’s target Sound Reinforcement segment (~$9B globally in 2016) and the broader professional AV market (~$150B) as a whole. However, it seems the migration from analogue to digital audio networking is a genuine structural shift and a (sine) wave the company is going to ride.

Audinate appears to be the largest player in the digital audio networking space – as measured by its continually reported benchmark of OEM adoption for its products versus its competitors (more than 5x its nearest rival as at June 2018 (per the oft-repeated chart originally in the prospectus – below)).

Note that the company’s nearest rival is Cobranet – apparently the first mover in the space (in the 1990s) but which appears to have been left behind (1) following a period of underinvestment since its acquisition by Cirrus Logic in 2001; and (2) by Audinate’s accelerating traction with OEMs over the past few years.

Observers with a keen eye may have noted that the number attributed to Cobranet appears to have increased from 220 per the previous version of this chart from February 2018 to 343 below. However, this may just be a definitional issue and doesn’t detract from the conclusion of the widening chasm when compared with Audinate.

Audinate is attempting a land grab. It is aiming to become the de facto industry standard and on the way build our favourite economic moat: the Network Effect. The Dante-enabled ecosystem grows with each new OEM customer and Dante-enabled product released.

The key KPIs communicated by the company to track its progress on this front are summarised in the chart below:

The other metric it would be interesting to know would be the proportion of Dante-enabled products in the market as a proportion of each OEM’s product portfolio – which I haven’t seen pointed to. I would expect the 1,639 figure above (just 7.4 SKUs on average for the 221 OEMs) to be a tiny fraction of their range – suggesting there should be a long runway of future OEM product rollouts as the structural tailwinds strengthen. Also, nearly half of licensed OEMs at June 2018 are still in development phase and yet to launch Dante-enabled products, further supporting the medium-term revenue outlook.

The company estimates there are more than 2,000 professional AV OEMs in its target ‘Sound Reinforcement’ segment – in which case only ~22% have adopted the Dante technology to date. So if Dante does become the industry standard, there is a large potential revenue opportunity available to the company. Management believe digital penetration is only 7% of a ~$400M current market size. This suggests Audinate has ~70% market share based on FY18 revenue.

Audinate generates ~85% of its revenue from hardware components with the remaining ~15% from royalties, license, maintenance and software fees. Once an OEM has embedded the Dante technology into its products, it will need to reorder Dante chips, modules or cards, and pay royalty fees to the company.

Revenue increased by 30% in FY18 from FY17 in A$ terms, or +35% in US$ terms (Audinate generates ~99% of its revenue from outside of Australia). Pleasingly, FY18 revenue beat the prospectus forecast by ~6%, and revenue has grown at a 32% CAGR since FY14.

Audinate generates very high gross profit margins (~75%) – reinforcing the company’s commentary around its strong IP portfolio (25 patents in force in US, UK, Germany and China as of November 2017 with 13 patent applications pending at that time). As the company aims to further strengthen its market position, management is focused less on the bottom line (noting that the core product portfolio is likely already nicely profitable given those gross profit margins), and instead is focused more on investing in R&D to expand the product portfolio, and in marketing to increase OEM adoption.

To that end, operating expenditure (opex) increased by 34% versus FY17 though according to the company this includes $1.2M of public company costs not borne previously. Adjusting for these costs suggests EBITDA increased by $1M in the financial year just ended.

One positive for the future is that R&D investment increased significantly in FY18 – up 73% year-on-year and comprising two-thirds of the increase in total opex from the year prior. The intense R&D focus is aimed at growing Audinate’s addressable market from ~$400M currently to more than $1B.

To that end, the company previewed a video prototype in early June 2018 which it expects to release commercially to OEMs at the end of FY19 with initial revenues commencing in FY20. In the second half of FY18 the company also launched a system management software product (Dante Domain Manager) and a suite of Dante AVIO adaptors (which will enable legacy analogue equipment to be interoperable with the Dante system). On these recently launched products, management reported stronger initial sales than expected. We would expect further significant levels of R&D over FY19 and the medium term as the company aims to grow the market via expanding its product portfolio.

Management has also flagged further investment in the sales and marketing team to accelerate penetration with OEM customers. Actual marketing spending in FY18 of $2.3M was $0.3M higher than the prospectus forecast – although mysteriously FY18 actual employee costs ended up being $1.5M lower than forecast, which may reflect a higher proportion of capitalised R&D than assumed in the prospectus. Given the skew in the workforce towards engineers and development personnel as a proportion of total staff, and the material jump in R&D spend above, it seems unlikely that management skimped on making key hires in the engine room.

Finally, Audinate’s statutory NPAT benefited from a one-off $2.4M tax gain from the company entering into a tax consolidated group (not contemplated by the prospectus); the FY18 tax benefit line also includes the R&D incentive previously recognised in Other Income (which was forecast to be $0.6M).

In terms of the outlook for FY19, the company did not provide much in the way of hard number guidance – as is de rigueur – neither did fellow (much larger) growth stablemates A2 Milk or Aftepay. But there are many reasons for optimism ahead as directionally suggested by the Dante OEM adoption chart above.

The potential market opportunity for Audinate is significant. The company appears to have a dominant market share of a growing market which it is itself building. So far it has demonstrated an attractive combination of high margins derived from its intellectual property, and a strong recent growth trajectory.

This trajectory could accelerate given:

(1) the increasing trend in Dante-enabled products launched by its existing OEM customer base;

(2) the significant amount of licensed OEM customers still in development phase and yet to launch Dante-enabled SKUs;

(3) the increased investment in R&D to expand Audinate’s product portfolio and underpin the launch into new market segments (i.e. video); and

(4) the expansion of the global sales and marketing team to further grow OEM adoption (only ~20% of global OEMs to date).

Just don’t expect fat dividend cheques anytime soon. The next several years for Audinate are about maximising this land grab opportunity – reinvesting gross profits into building the value of the network and sacrificing short term NPAT for the long term benefits of the positive feedback loop. The aim is to become the industry standard in a much larger global market. Fingers crossed.

Disclosure: I (@Fabregasto ) own shares in Audinate – accumulated between January and June 2018 at a VWAP of $3.14 – and I am strongly considering buying more shares at least 2 days after the publication of this article. As Stephen King once said, “I write to find out what I think” – and writing this piece has further increased my enthusiasm for the company and its potential opportunity. This is however by no means a recommendation and readers will need to decide for themselves whether Audinate is a suitable investment for their own portfolio.

A note from Claude:

We are extremely lucky to have this comprehensive coverage from The Gentleman. It is one for those who never saw my original recommendation. Right or wrong, this is honest and thoughtful analysis.

As both of you still reading will probably know, I encouraged many people to buy this stock at $2.90. I bought myself around those prices. I continue to hold and – after 2 days or more – I shall consider adding to my holding. And a special thanks to the person who told me to recommend this at $2.00. That was next level, I should have listened.

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Disclosure: The Gentleman and Claude Walker both own shares in Audinate at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.