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Blackwall Ltd (ASX:BWF) FY 2019 Results And Initiation Report

2019-08-26T06:52:03+00:00

Blackwall Ltd (ASX:BWF) FY 2019 Results And Initiation Report

BlackWall Ltd (ASX:BWF) is the management company for BlackWall Property Trust (ASX:BWR) and various other private property syndicates. The company is a turnaround specialist, buying under-occupied or over-leveraged properties and improving their fortunes via capital restructuring, change of use or investment in fixtures and fittings. Management is long-term focused and seeks to exit an investment only when it can no longer grow rent, and the after tax return from a sale exceeds expected future income from continuing to hold. In addition to its asset management activities, BWF also owns WOTSO which provides flexible workspace mainly to sole traders and startups. The majority of BWR’s properties house a WOTSO operation and around half of all WOTSO operations are located in BWR premises. As you can see, the two entities are inextricably linked and so a proper analysis of BWF also requires an examination of BWR.

Historical listed performance

A couple of years after listing, BWR was successfully sued by a trust which claimed to have invested in P-REIT (as BWR was then) under special redemption terms prior to BWF taking control. The impact on BWR was twofold. Net tangible assets (NTA) per unit dropped from 30c (pre 10:1 consolidation) at the time of listing in 2011, to 22c just a year later as BWR recognised a provision of almost $20 million against the action. Then in 2014 BWR raised $7.8 million at 3 cents (an 80% discount to the prevailing price) through an entitlements issue to help pay for the damages and associated fees. This caused the NTA per unit to crash from 24c to 13c, but the low price ensured close to full participation and the shortfall was just 5.9%. BWF co-underwrote the deal along with Aims Property Securities Fund, the trust that brought the case against BWR.

BWR has performed well since this stumble early in its listed life. Since 2014 it has returned 74.5 cents (post 10:1 consolidation) of tax deferred distributions to unitholders, utilising the tax losses created by the legal stouch. NTA per unit has risen from $1.33 to $1.48 over the same period. Meanwhile, BWF has paid out 20.2 cents in dividends and grown NTA per share from 17 cents to 50 cents since 2012.

Coworking

Coworking is a new, fast growing sector (although serviced offices have been around for a while) and it is unclear what the long-term economics of the model look like. US based and Softbank backed WeWork is competing aggressively at home and overseas by securing prominent CBD locations on long-term leases and spending lavishly on fitouts. It loses money, but is well funded. Whilst there is some advantage in being able to offer customers access to offices in a multitude of cities, I don’t think it is a major draw since people mostly spend their time working close to home. Branding is important and WeWork’s heavy investment is helping in this regard, but I suspect it is spending more than is wise.

Blackwall CEO, Stuart Brown, sees coworking more like providing storage space (a business that BWF has been involved in) for people and so convenience is the key. This is why WOTSO is focused on suburbs where property is cheaper than in city centres, but demand is still strong. I think this is a winning strategy and evidence of a competent management team. WeWork may move into the suburbs too, but it wouldn’t make sense to open in an area already occupied by WOTSO while other neighbourhoods remain underserved. Therefore, it should be a while before the two companies bump into each other and by then BWF will have had time to establish itself. Other competitors such as Servcorp Limited (ASX:SRV), Regus and Victory Offices Ltd (ASX:VOL) are focused on CBDs (like WeWork) and cater primarily to the corporate market. A network of global offices is more desirable for these businesses because their customers are typically larger and often multinationals.

When the economy struggles WOTSO is likely to be badly affected since its clients are not tied to multiyear contracts whereas it enters into fixed term leases with landlords. This risk was born out when WOTSO launched in Singapore. Shortly after opening competition intensified, the site became unprofitable and remained so. BWF has now withdrawn from this building and fortunately has not had to pay a penalty in doing so. This experience has prompted BWF to seek management fee arrangements, where it receives a percentage of turnover rather than entering into leases, thus reducing the chance of losing money. The drawback of this structure is reduced upside as leasing arrangements are more profitable if high occupancy is achieved. BWF is applying a blended approach to the WOTSO portfolio with some management fee and some lease agreements depending on which option is likely to yield better results. With BWR often on the opposite side of the trade, management has the tricky task of maximising returns for both sets of shareholders (more on that later). An advantage that WOTSO has over its competitors is that it is still relatively small and so is not already enumbered with large lease liabilities. I would prefer it if WOTSO focused solely on management fees and said so to Stuart. My view is that the opportunity cost of a management fee model is insignificant when there is such an abundance of potential sites available.

WOTSO works (though perhaps not everywhere)

WOTSO revenue is growing rapidly as can be seen above and based on the research I have done it also has happy customers. I found videos created independently by WOTSO clients in Brisbane, Adelaide and Canberra all containing positive commentary about value for money and the work environment. Additionally, all WOTSO offices in Sydney, Adelaide, Canberra and Brisbane have an average review rating of at least four stars on Google.

I visited two WOTSO premises both in Canberra under the guise of a potential customer. The more established North Canberra location had two floors dedicated to flexible workspace. The ground floor was full and had a buzzing atmosphere, whereas as the third floor was quite empty and had more of a stark traditional office-like feel. I was told that the third floor is a transition space and occupants will be transferred to the fourth floor once it has been fitted out. The South Canberra location was only opened in October last year and most desks are still vacant. The surrounding area is sparsely populated and I am doubtful about the long-term prospects for WOTSO at the site. The fit-out is attractive enough and work is ongoing to improve facilities such as the installation of a reception desk. Both buildings house traditional office tenants in addition to WOTSO clients. A third Canberra location is planned for the Westfield shopping centre in Woden. This follows the success of the Westfield Chermside WOTSO space in Queensland. The appeal of working close to the shops is obvious and the relationship with Westfield could be a significant growth driver for the business. It should be noted that the two Canberra locations are among the three worst performing properties in the BWR portfolio so I doubt the over capacity I observed is representative of the group.

Although I was underwhelmed by the vacant areas in both Canberra properties, I was impressed by the customer value proposition. You can hire a ‘hotdesk’ for $220 per month. This typically includes services (all present in North Canberra) such as 24/7 access, reception desk for handling mail and meeting visitors, bike racks and showers, free tea, coffee, soft drinks, beer and snacks, onsite cafe and high speed broadband. Access to more than a dozen (and growing) WOTSO locations is also covered and there is no lock-in period. All the staff I spoke with were helpful and friendly.

The Bakehouse Quarter

The Bakehouse Quarter is a commercial development in Sydney in which both BWR and BWF held a stake until its sale in April 2019 for $380 million. Blackwall’s founders and current board members, Seph Glew and Paul Tresidder, arranged the original purchase of the property in the 1990s and at maturity the investment delivered an impressive annualised internal rate of return in excess of 15%. The trust that owned the Bakehouse quarter has been rolled into BWR increasing the net tangible assets of BWR from $155 million to $220 million on an NTA for NTA basis. This is effectively a low cost capital raise for BWR and shows strong commitment by the Blackwall board given they collectively owned a significant portion of the Bakehouse trust. The Bakehouse Quarter is a good example of management’s long-term approach in action. The rejuvenation process involved converting part of the space to WOTSO offices, a trick repeated with a property in Pyrmont which looks set to be a similarly successful investment.

Insider incentives

Insider ownership is particularly important in the case of BlackWall because there are potential conflicts of interest between the management company, the trust and the private funds which BWF also manages. Management fees are one area that could be open to abuse and another is lease terms between WOTSO and BWR. BWF owns $16.2 million of BWR representing about a third of BWF’s market capitalisation which provides some comfort for both sets of owners.

It is unclear from BWF’s accounts exactly how it derives asset management fees. BWF charges BWR 0.65% of gross assets but discloses neither asset values nor fees for the other funds it manages. When I asked Stuart if BWF should disclose these figures he said that it used to report total assets under management, but shareholders became too fixated on it. I think that investors have a right to know exactly how BWF generates fees as long as the information is not sensitive from a competition standpoint. Similarly, company results do not contain a breakdown of the commercial arrangements between WOTSO and BWR for each location. Revealing this would allay any fears that BWR or WOTSO is getting the better side of the deal. Occupancy figures for each WOTSO site are not disclosed either and Stuart says these will be given in time. He says that the metric is currently distorted by the ongoing conversion of additional space within existing buildings to WOTSO facilities.

As an example of the type of issue between BWR and BWF that potentially could occur, imagine a consistently loss-making WOTSO location within a BWR building. Would management want to close such an operation supposing it generates incremental income for BWR, but a smaller loss for BWF? This particular case has been partially addressed by the news earlier this month that WOTSO is to be spun out of BWF. More on that later.

The following table summarises the shareholdings of BlackWall’s directors in both BWF and BWR. As you can see the interests of management are well-aligned with investors in both entities. Insider ownership is much higher in the trust when measured in dollars and similar to the company in percentage terms. There may be a lack of transparency in the way management communicates with external shareholders, but this is trumped by strong alignment of interests.

In recent months directors have mainly been buying units in BWR on market rather than shares in BWF and I wondered if this says something about the relative value of the two securities. I asked Stuart about this and he said that the directors preferred to leave the little liquidity that exists in the company’s stock to other participants. He also said that he receives options in the company as part of his remuneration package and these already provide him with heavy exposure to the company. I note the trust is currently trading at a more than 10 percent discount to NTA so perhaps this also partly explains their choice.

Valuation

BWF suits a sum of the parts valuation. NTA per share is 50 cents and consists primarily of cash and BWR units. The asset management business generates recurring revenue based on assets under management (AUM) and pass-through property management fees with offsetting costs. Historically, it hasn’t made much profit other than when it has received performance fees as can be seen below. It received a total of $10.5 million in performance fees from Pyrmont Bridge Trust in 2017 and 2018. Overall, the division has delivered $20.5 million in pre-tax profits after all group overheads since listing in 2011. The WOTSO business is the fastest growing subsidiary with revenue rising from $1.2 million in 2014 to $10.2 million in 2019. Profit margins are still low and it takes several years for a new location to reach maturity. In 2019 WOTSO earnings before interest, tax, depreciation and amortisation margin (EBITDA%) was about 12%, but management thinks mature locations can achieve over 20%.

The remaining 55 cents of BWF’s share price that isn’t covered by NTA equates to about $35 million, which is $15 million more than the cumulative pre-tax earnings of the asset management arm in the eight years since listing. WOTSO has the potential to become by far the most valuable part of BWF, but the division delivered just $1.3 million EBITDA last year. I think that WOTSO and the asset management business are comfortably worth more than $35 million combined.

At the start of August, Blackwall announced its intention to spin-off WOTSO into a separate listed entity. Often this type of corporate action is beneficial to shareholders as it forces the market to value the parts of the group individually whereas conglomerates often trade at an intrinsic discount. I think that such a discrepancy exists with BWF as per the ‘sum of the parts’ analysis outlined above. A fund manager acquaintance made the point (which had not occurred to me) that a downside to the demerger is the doubling of listing costs which are significant given Blackwall’s size. I don’t think this will be much of a long-term hindrance provided WOTSO can maintain its growth trajectory.

I used to hold shares in BWF and have sold them since the demerger announcement because I wanted to use the money for an alternative investment. At my selling price I felt that BWF was the least undervalued share in my portfolio.

At the time of writing BWF shares last changed hands for $1.05 and I think the chances of holders suffering permanent loss of capital from here are low. The key question is regarding how much upside potential there is and this depends on the longterm success of WOTSO. If I held stock then following the spin-off I would probably only retain WOTSO and dispose of my interest in Blackwall management on market depending on valuations at the time. This is because I think that unlike the management company, WOTSO has the potential to deliver significant market outperformance over coming years.

The market may ascribe a lowly valuation to WOTSO in the short-term because of the additional corporate costs of two separate listings as mentioned above. In addition, sentiment towards managed office space providers is pretty poor at the moment. For example, Victory Offices recently listed on a price-to-earnings multiple (PE) of 9 times and continues to trade close to its IPO price despite boasting an impressive growth profile. However, I think both these risks are temporary and so would potentially see them as an opportunity to reacquire stock should they be realised.

Disclosure: Matt Brazier does not own shares in BWF or units in BWR and Claude Walker owns shares in BWF (a very very small position), but not units in BWR at the time of publication. Neither Matt nor Claude will trade either security for at least two days. 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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Webjet Limited (ASX:WEB) FY 2019 Full Year Results Analysis

2019-08-22T06:40:52+00:00

Webjet FY 2019 Results: The Turbulence Will Soon Be Over

Online travel agent Webjet Limited (ASX:WEB) released its results for FY 2019 earlier today. Total transaction value was up 27% to $3.8 billion, revenue increased 26% to $366.4 million, EBITDA jumped 43% to $124.6 million and NPAT before acquisition amortisation was up 46% to $81.3 million. On a per share basis earnings before amortisation rose 31% to 63.3 cents translating to a price-to-earnings multiple (P/E) of 20 based on the share price at the time of writing ($12.60). Total dividends rose to 22 cents, up from 19.8 cents last year. Statutory NPAT was $60.3 million which was slightly behind market consensus forecasts of $61.9 million as was revenue ($375.3 million forecast). On a statutory basis the stock trades on a historical P/E of 26.

Closing net debt excluding client funds was $23.7 million compared to net cash of $42.2 million at the end of last year. This deterioration was largely due to the acquisition of DOTW during the year. Cash flow from operations was weak at $45.7 million compared to $120.8 million in FY 2018, but was impacted by delays in paying suppliers in FY 2018 due to issues implementing a new ERP system causing $53 million of payments to fall into FY 2019. Purchase of intangibles and property, plant and equipment increased to $32.7 million up from $27.8 million. This was more than covered by depreciation and amortisation of $36 million although that includes acquisition amortisation of $19 million. Therefore, statutory NPAT is arguably a more accurate measure of business performance than NPAT before acquisition amortisation.

B2B

The impressive group performance was largely thanks to the group’s business to business (B2B) division, WebBeds, which matches hotel inventory with travel agents and tour operators on a global scale. WebBeds was only launched in 2013 and yet contributed 50% of total revenue in FY 2019. Revenue rose 62% to $184.5 million and EBITDA increased 148% to $67.3 million with all regions making a strong contribution. In particular, the Asia Pacific region looks very promising given it contributed a $0.6 million EBITDA loss in the first half followed by a positive $6.4 million contribution in the second half. This part of the business has massive potential.

WebBeds has made two acquisitions in the past two years, JacTravel and DOTW. The company says that assuming both acquisitions had been held for a full twelve months in both years EBITDA would have increased by 30% to $78.4 million representing robust organic growth. The WebBeds performance was all the more impressive given the difficult global environment during the year featuring Brexit, trade wars and an extraordinarily hot European summer.

WebBeds now has 30,000 direct contracts with hotels which contributed to 55% of sales in the division in FY 2019. The strategy is to increase this number to 40,000 in the future as direct contracts are higher margin than inventory sourced through aggregators. Importantly, long term prospects for WebBeds are strong with the company on track to convert 8% of TTV to revenue by 2022 (8.6% in FY 2019) at an EBITDA margin of 50% (36% in FY 2019).

RezChain is Webjet’s blockchain powered solution for resolving data mismatches between WebBeds parties. It is already helping the company to reduce costs and is a major reason for management's confidence in achieving the margins above. Plans for RezChain were first announced in 2016 and it is impressive that the technology is already in place and delivering results across the entire WebBeds business.

WebBeds TTV still represents less than 4% of the total market and there is the opportunity to both grow organically and through acquisitions. RezChain is one reason why Webjet is able to significantly improve the efficiency of the businesses it acquires. I am usually leary of acquisitions, but when done properly there is the potential to create bucketloads of shareholder value.

In the coming year, WebBeds will start to receive a return on sales to Thomas Cook ($197 TTV in FY 2019), the embattled UK travel company currently undergoing restructure, although margins will be much lower than for the rest of the business. Until now, WebBeds has not been charging Thomas Cook as part of the deal struck when WebBeds acquired Thomas Cook’s inventory in 2016. TTV from Thomas Cook is expected to be between $150 million and $200 million in FY 2020, below original expectations of between $300 million and $450 million.

WebBeds owns 51% of Umrah Holidays, an initiative targeting the substantial and growing religious holiday segment. Saudi Arabia is hoping to increase visitors to 30 million by 2030, up from 6 million today and the market opportunity is estimated at US$10 billion TTV, roughly three times current group TTV. Umrah Holidays is uniquely able to sell visa and hotel packages giving management reason to think the venture will be successful.

The outlook for WebBeds for FY 2020 is for $27 million and $33 million of additional EBITDA, down from $40 million as guided upon release of the half year results which might partially explain why the shares fell 12% today. This is largely due to the Thomas Cook situation described above and excludes any organic growth. WebBeds TTV is up 50% (excluding Thomas Cook) in the first six weeks of 2020, although this includes a contribution from DOTW which was acquired in November 2018.

B2C

A soft Australian economy and May’s federal election caused the traditional consumer online travel agent business to struggle in FY 2019. Despite this, the segment grew revenue at twice the rate of the overall market and a favourable product mix boosted margins. Revenue was up 3% to $150.5 million and EBITDA was up 4% to $60.8 million. 50% of flights booked via an online travel agent in Australia are done through Webjet, but this still represents just 5% of all flights. TTV for the first six weeks of 2020 was up 9% on the prior corresponding period hinting at a possible market recovery.

The small New Zealand operation was impacted by the Christchurch attack in March and recorded a slightly worse performance than last year. Revenue was unchanged at $31.4 million and EBITDA was down 6% to $12.5 million.

Conclusion

I think that Webjet shares offer good value despite trading on a full earnings multiple of 26 times. The WebBeds business appears to have a huge growth runway ahead of it and is well placed to improve profit margins. It is destined to dominate the group and so the slower growing B2C division will become less important to overall performance in time. There is a good chance that B2C returns to growth when economic conditions improve in any case. CEO John Guscic said the group has had “a cracking start to 2020” and that there is “a nice pipeline of [acquisition] opportunities in front of us” and my view is that today’s share price reaction will prove to be short lived.

Disclosure: Matt Brazier and Claude Walker both own shares in Webjet at the time of publication, and will not sell for at least two days.

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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.

Laserbond (ASX:LBL) FY 2019 Full Year Results

2019-08-20T01:07:40+00:00

Laserbond (ASX:LBL) FY 2019: Triple Digit Profit Growth

Additive manufacturing company Laserbond Limited (ASX:LBL) released its full year results for 2019 earlier today. At the time of writing, its share price has gained 18% to 57 cents, up 137% from when we initiated coverage on it last year. Revenue rose 44.9% to $22.7 million, net profit after tax (NPAT) was up 190.3% to $2.8 million and earnings-per-share (EPS) grew 185.8% to 3.0 cents. The results are better than the most recent guidance issued by the company in May of revenue between $21.6 million and $22.2 million and profit before tax of between $3.2 million and $3.5 million ($3.8 million actual). The board declared a final dividend of 0.5 cents making total dividends 1 cent per share for the year, up 66% on last year.

Cash from operations was $4.1 million up from $0.4 million last year and $3.4 million was spent on plant and equipment to increase capacity and improve efficiency. A significant proportion of this investment relates to a new high powered laser system commissioned in the South Austraian facility during the year which should enable the company to both grow sales and enhance margins. Cash at 30 June was $2.2 million offset by $2.9 million of financial liabilities, slightly up on the net debt position a year ago of $0.5 million.

Underlying earnings before interest, tax, depreciation and amortisation margin (EBITDA%) improved from 16.0% to 21.6% demonstrating operating leverage as overheads rose by less than gross profit.Underlying gross margin (GM%) improved slightly to 47.4% from 46.3% last year. Underling figures exclude a $0.3 million inventory impairment in FY 2018.

All three divisions performed well with services revenue up 11.3% to $11.2 million, products revenue up 62.8% to $9.1 million and a technology sale for $2.4 million compared to none last year. The second half of the year was an improvement on the first half, but only because of the technology deal. Both services and product revenue were slightly down half-on-half. A noteworthy achievement was breaking into the US market with steel mill rolls. Management said, “The steel mill roll market in the United States alone is estimated to be well over fifteen times that of Australia, and Australia steel mills provided $285k revenue in 2019 (and growing)”

The technology sale during the year included $1.95 million of equipment and a further $0.4 million of consumables. The customer is under contract to continue buying these consumables from Laserbond and they could be worth $1 million per year albeit at relatively low margins. In addition, the customer will pay a utilisation based licence fee estimated in the hundreds of thousands of dollars per year falling straight to the bottom line. Another technology sale is planned in 2020 and two per year from 2021.

Based on these results Laserbond trades on a historical enterprise value to earnings multiple of under 20. The outlook remains positive for the company with double digit sales growth forecast for the Services and Products divisions at similar profit margins to FY 2019. Longer term the company is targeting $40 million of annualised revenue by 2022.. Today’s results have proved that operating leverage exists within the business and so an almost doubling of sales could translate into even higher profits. This is without the impact of technology license fees which will start to flow from next year. Whilst half on half revenue excluding technology was slightly lower and there is a decent chance that the coming year will be one of consolidation, I think Laserbond shares remain good value over the long term and I will be holding on to my shares.

Disclosure: Matt Brazier and Claude Walker both own shares in Laserbond at the time of publication, and will not sell for at least two days.

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Addendum from Claude

Matt has covered Laserbond very well for Ethical Equities, quite publicly.

But newsletter subscribers were quite clearly told we liked the stock back in October last year, when we sent them this:

So even if you're not ready to become a paid subscriber to Ethical Equities, I do believe there is a lot of value in the Free (albeit infrequent) Newsletter.

Over The Wire Holdings Ltd (ASX:OTW) Full Year 2019 Results

2019-08-17T00:32:25+00:00

Over The Wire (ASX:OTW) Full Year Results FY 2019

Telecommunications and IT services provider Over the Wire released its full-year results today. The headline figures were very strong:

Revenue up 49% to $79.6 million
Net profit after tax (NPAT) up 83% to $10.1 million
Earnings-per-share (EPS) up 64% to 20.7 cents
Dividends up 30% to 3.25 cents
$0.4 million of net debt down from $6.2 million

Unfortunately, these numbers do not tell the whole tale because they include $4.1 million of other income. This relates to a reduction in deferred consideration payable for Comlinx, a business acquired in the first half of 2019. This means that Comlinx is not performing as originally hoped. Comlinx contributed $11.1 million of revenue in FY 2019 at a 32% gross margin, dragging down the group average to 51% from 56% in the prior year.

Comlinx generated $16.1 million of revenue and $3.2 million earnings before interest, tax, depreciation and amortisation (EBITDA) in 2018 as a standalone entity. Revenue for the 8 months since Over the Wire acquired the business was $11.1 million, in line with the prior year. CEO Michael Omeros said that payment of the deferred consideration depended on Comlinx achieving significant growth in 2019 which did not materialise. In addition, Comlinx margins slipped from around 35% to 32% primarily as a result of a higher proportion of lower margin hardware sales during the period.

To Over the Wire’s credit, unlike most of its peers the company has never split out integration costs from its figures despite being a regular acquirer. Having done two substantial acquisitions during the period it is likely that this also hurt profitability. Michael said that the company has always presented statutory numbers which is why the $4.1 million of other income was not excluded in the charts above. Regardless of the presentation style, I was expecting a better underlying performance from the business and it seems the market agrees with me as the shares are down over 12% since prior to the release at the time of writing.

Over the Wire is more than a garden variety roll-up. It is also growing organically, although this contribution is decreasing on a percentage basis. In the FY 2018 presentation the goal was to achieve organic growth of 20% each year and this has been reduced to 15% in today’s slides. Furthermore, in the HY 2019 release management declared that the company was on track to deliver in excess of 18% organic growth for the full year and the final result was 13%.

In the chart below I chose to display EBITDA rather than earnings because Over the Wire incurs a significant amortisation charge as a consequence of the acquisitions it has completed and this ought to be excluded in order to assess the true performance of the business. I omitted the $4.1 million of other income which inflated this year’s result and I used a simple average of the opening and closing shares on issue for each period rather than a weighted average. As you can see, despite purchasing both Comlinx and Access Digital in the first half of 2019 the business has been unable to improve EBITDA per share.

Over the Wire spent $4 million on capex in 2019 and a similar amount is forecast for next year. Based on underlying second half 2019 EBITDA of $8.5 million I estimate the free cash flow run-rate of the company is $9 million. Its enterprise value is $210 million at the time of writing, a hefty 23 times this figure. I’m not sure that the company is a sufficiently high quality business to justify such a valuation as it is particularly hard for roll-ups to maintain per share profit growth as they become bigger. Another challenge facing Over the Wire is that 70% of its revenue is derived from providing increasingly commoditised data and voice services. I sold my shares as I believe that at the current price of $4.08, there are better places to invest.

Disclosure: The author, Matt Brazier, has recently sold shares in OTW and will not trade shares for at least 2 days following the publishing of this article.

For early access to our content, join the Ethical Equities Newsletter.

Access to our paid Ethical Equities Supporter membership subscription is available, but only by request.

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

Laserbond: Impressions From A Site Visit

2019-05-22T07:02:22+00:00

Laserbond (ASX:LBL): Guidance, Thesis Update And Site Visit

This is the third time that we have covered Laserbond. We first introduced the company in October 2018 and also reviewed the HY 2019 results.

Introduction

Last week I visited Laserbond’s Smeaton Grange facility and met with CEO Wayne Hooper and Financial Controller Matthew Twist. Wayne and Matthew were open, friendly and generous with their time. I spent three and a half hours on site, spending time in the company boardroom and having a tour of the shop floor including the R&D laboratory. The factory is more like a workshop as much of the work done at Smeaton Grange is bespoke services such as reclamation. The 5,400 m2 premises contains 2 laser systems and a High Pressure High Velocity Oxy Fuel (HP HVOF) thermal spray setup, but the majority of the space is used for machining.

Business Segments

Laserbond has three divisions which are Services, Products and Technology.

Services is where customers send their existing parts to Laserbond to be repaired or improved. The company has been offering services since it was founded in 1992 and it remains the largest segment by revenue. Services do not always involve extending life or using Laserbond’s proprietary technology and around 60% of group revenue is derived from laser cladding.

There is little in the way of competition for the Services business . Being close to the customer is critical as lead times dictate cost. There are a few small companies around the world that specialise in laser cladding, but they typically do not have a presence in Australia. The advantage of location is one reason why Laserbond is looking to expand geographically, but more on that later.

The Products division is the fastest growth area and manufactures parts which undergo laser cladding to extend useful life. Customers are mostly OEMs and Laserbond relies on two such customers for 46% of its total revenue. Laserbond provides OEMs with differentiation for their own products, which mitigates customer concentration risk.

Own brand products are yet to take off. There was a false start with the DTH Hammer released in 2015. The product has struggled to gain traction because it is only superior to cheaper Chinese alternatives in the harshest environments. Also, the DTH Hammer is designed for the Drill and Blast industry which is fragmented and so hard to sell into.

A more recent product, Composite Carbide Steel Mill Rolls, looks more promising. It lasts three times as long as competing parts, but is more than three times as expensive. Despite this, it saves customers money through reduced downtime. The product is currently used in Australian steel mills and is undergoing testing at five sites with a major US customer. The US steel industry is 15 times larger than Australia and so these steel mill rolls have the potential to become a significant contributor to revenue.

Correction thanks to Gregory Hooper, CTO and founder:

"Our Composite Carbide Steel Mill Rolls are lasting more than 5 times longer than competing parts and are less than double the price. This development would be regarded as step-change within the steel industry and addresses a costly wear issue that has been a problem for many decades. The manufacturing of our Composite Carbide Steel Mill Rolls utilises our Patent Pending Laser deposition method."

The current strategy for the Products division is to develop products where laser cladding provides an obvious advantage over existing alternatives. This could mean that the product range becomes thinly spread across a range of geographies and sectors instead of addressing a specific industry. In turn this may improve revenue diversification, but could also mean that fewer economies of scale are attainable. For example, the company would constantly need to break into new industries and its sales and marketing teams may remain unspecialised.

The Products division is perhaps more likely to encounter competition than Services as manufactured parts can be more easily distributed internationally. For example, Caterpillar carries out laser cladding internally on some of its products. Laserbond generated just $2.6 million in export sales last year and so the division is still too small (and will remain so for some time) to attract the attention of such competitors.

The company also licenses its laser cladding technology overseas, involving a large upfront fee for equipment and ongoing license fees of around $200 thousand per year for training and support. I had wondered if this could hurt Laserbond’s competitive position in the long-run, but learned that the company does not give away all of its knowhow when it sells a technology package. It is constantly innovating in any case and so the technology it sells becomes outdated over time.

The first technology deal was with a Chinese company and involved Laserbond receiving an ongoing percentage of the customer’s sales, but this has translated into little revenue to date. Management has learned from this and the latest sale, which was to a UK multinational, is based on hours of usage which can be monitored by Laserbond remotely.

Economic Moat

I believe Laserbond has a sustainable competitive advantage because of its R&D capability. It was the first to introduce HVOF to Australia in the early 1990s and created its first laser cladding system in 2001. Laserbond has improved that early laser setup significantly, both in terms of efficiency and quality, and still manufactures its own systems today. The reason it originally decided to manufacture its own equipment was because it was too expensive to buy it ready made. New entrants would have the same problem today. They would either have to go through years of learning to develop a similar solution in-house, or pay the likes of Laserbond to provide them with one at much greater cost and which would need upgrading over time.

The three colours in the pictures above represent different elements. The improvement from the left panel to the right panel typically represents a doubling of useful life for a product. The breakthrough was developed by Laserbond in 2014 and patents are still pending. The company believes its laser cladding technology is the best in the world.

The other element of Laserbond’s moat is its expertise of knowing which solution to apply in each application. For example, spray surfaces are a good solution for corrosion, but do not stand up so well to wear as there is no metallurgical bond. Alternatively, some materials cannot be welded as heat from the process breaks down their qualities.

Laserbond has demonstrated and refined its expertise over many years developing strong relationships with customers in the process. Some of these customers are now willing to buy products from Laserbond because of this shared history. These relationships are critical as Laserbond’s products are usually more expensive than alternatives and so customers would probably not buy them unless they were convinced of their superiority.

As laser cladding is not necessary or even desirable in many cases, it may not make sense for a large equipment manufacturer to simply copy Laserbond’s technology and apply it to all their products. This could benefit Laserbond as it may leave exploitable gaps in the market which are too small to interest larger competitors. In this way, Laserbond could become a niche parts supplier to various industries over time. Added to this, selling spare parts is an intrinsic part of the business model of some manufacturers. It is not in their interest to significantly extend the life of such parts.

Historical Performance

Laserbond has achieved remarkably consistent sales growth over the years despite generating most of its revenue from the mining sector. This is for two reasons. It is growing relative to the broader industry and it is exposed to mine maintenance and not mine construction. Indeed, customers are perhaps more likely to look at extending the life of equipment during tough times rather than replacing it.

You can see below how revenue (the blue) has grown steadily over time, while profit before tax has swung around a bit.

Between 2013 to 2016 the mining industry contracted sharply coinciding with Laserbond’s expansion into South Australia and with it moving into a much larger facility in NSW. Consequently, operating costs increased substantially at a time when revenues plateaued impacting profitability.

Such volatility is also caused by a low base effect and so as Laserbond grows profitability should become more stable across the cycle. However, Laserbond is and will remain a business with high fixed costs, which must invest in advance of expected growth and so profitability will remain bumpy.

Various exceptional items relating to the upgrade of the Cavan laser rig and the recent UK technology sale are included in working capital at 30 June 2018 and 31 December 2018. Excluding these, in the first half of 2019 the average working capital to annualised sales ratio was 26.5%, its lowest level since the first half of 2015, as can be seen below.

26.5% is still high and it is clear from breaking working capital down into its constituent parts that receivables is the main contributor. As can be seen below, receivables days have averaged around 3 months over recent years. This is a long time to wait to get paid and may say something about the balance of power in Laserbond’s relationship with its large OEM customers.

Outlook

Over the past couple of years, revenue growth has been strong and this looks set to continue. Currently, the company is experiencing a shortage of machining staff and has had to turn away some business for which it could not guarantee sufficient turnaround times. A lack of skills locally has led the company to source employees from overseas. It has experienced significant delays in doing so due to the recent government transition from the 457 to the Skilled Migrant visa program. Hopefully, this is a one time only event and such delays are not repeated in the future.

The above chart is taken from the latest investor presentation and includes forecasts from FY 2019 onwards. Horizontal lines mark $5 million increments and so the FY 2022 forecast is $40 million. In the context of the above figures, it is worth considering that Laserbond’s revenue visibility is limited as its sales cycle is only a few weeks long and the company has a missed forecasts in the past.

The following chart was taken from the 2015 Annual Report and includes forecasts at the time.

As you can see below, these targets haven’t yet quite been reached, and it has taken a couple of years longer than anticipated. The main reason for the lag is that the DTH Hammer product did not take-off as hoped.

From July 2016 the Products division includes OEM products (previously in Services). Jan-Jun 19 figures are based on the mid-point of FY 2019 company guidance.

Aside from missing revenue targets, there is also a risk that focus on growth comes at the expense of returns. The company has publicly stated that it is looking to expand geographically, either through an acquisition or a greenfield site. Strong sales growth means funding is tight and so such a move would likely be accompanied by a capital raising, as was the case when Laserbond expanded into Queensland and South Australia. However, if geographical expansion happens, it would probably only require a small raising.

The company has expanded into Queensland and South Australia previously. The Queensland expansion was via the ill-fated acquisition of Peachey’s Engineering in 2008 and later disposed of in 2013. A number of unfortunate events unfolded following the acquisition of Peachey’s. A family tragedy impacted the long-standing manager of the business, it was dependent on work from Rio Tinto which scaled back operations in the area and the LNG boom caused high wage and rental inflation.

The South Australia expansion has been much smoother. Laserbond opened a greenfield site in Cavan in 2013, towards the end of the mining boom. Although this meant that growth was slow in the first couple of years, it gave the company the opportunity to develop valuable R&D significantly improving the performance of its laser cladding technology (as per the coloured images from earlier in this article).

Laserbond recently replaced the laser at its South Australia operation. The new unit cost around $0.5 million and its installation has led to a reduction of around $100 thousand per year in energy costs. In addition, production output has doubled. Further improvements will come from the installation of a second laser in the next couple of months. The two lasers will be controlled by a new robot system, allowing one person to operate both lasers whilst reducing downtime. Similar opportunities exist to upgrade the two lasers in NSW, where there is also the opportunity to add a third. Such investments promise excellent returns on investment.

Clearly, there exists spare capacity within existing facilities. Smeaton Grange currently operates on two shifts rather than three and as stated above could take another laser. A second laser is about to be installed in Cavan. The fact that the company is looking to add another site despite an apparent surplus of spare capacity may say something about the wealth of sales opportunities that lie ahead. It may also be related to a buoyant share price.

Valuation

Laserbond’s share price has roughly doubled since listing in 2007 at 20 cents. Grossed up dividends represent a further 6 cents to give a total return of 130% in just over 11 years, or 7.6% compounded per year. This is a decent performance, but I own Laserbond shares because I am expecting better returns in the future.

If management’s FY 2022 forecast is achieved then today’s share price of 40 cents, representing a market capitalisation of around $40 million, will appear cheap. Assuming 12% net profit margins, the stock would be trading on a FY 2022 price-to-earnings (PE) multiple of 8 assuming minimal dilution between now and then.

UK listed Bodycote is the global market leader in heat treatment, dwarfing its nearest competitor. Like Laserbond it offers surface engineering technologies such as HVOF, but crucially does not currently offer laser cladding. Neither does it have operations in Australia.

Bodycote generates strong returns on capital, also experiences stable revenue combined with lumpy profit and trades on a mid-teens forward PE multiple. Laserbond trades on a similar multiple and is growing much faster than Bodycote so is arguably relatively undervalued.

Conclusion

I remain a supporter of Laserbond as it has many features that I look for in an investment. Management are entrepreneurial, long-standing and their interests are well aligned with shareholders. Laserbond’s R&D capability provides it with an economic moat and it has few competitors. Although the business is exposed to the mining cycle and dependent on some large OEM customers, it is becoming more diversified. The company is undergoing rapid sales growth and management has an abundance of excellent capital allocation opportunities.

There is a risk that the mining sector turns down in the near term and takes Laserbond’s profits (and share price) with it, as happened in 2012. But it is also possible that the company achieves its sales targets over the next few years and richly rewards investors in the process. In the first scenario I will probably sell my shares and look for an opportunity to re-enter when conditions improve. Otherwise, I intend to keep hold of my shares as long as the company continues to improve and the share price remains sensible.

Disclosure: Matt Brazier and Claude Walker both own shares in Laserbond and will not trade for at least two full trading days following publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

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Why I'm Long Bigtincan Holdings Ltd (ASX:BTH)

2019-05-09T04:54:33+00:00

Why I'm Long Bigtincan Holdings Ltd (ASX:BTH): Cracking America

Update 3/7/2019

Please note: The author of this piece, Matt Brazier, has decided to sell his Bigtincan Holdings for the following reasons:

It is too dependent on Salesforce.
It has too many competitors.
It is not sufficiently cheaply priced.
The tech sector in general is rather hot.

The original piece remains below, for those who are interested. I do not hold it either.

-- Claude

----- ---

Bigtincan is a SaaS company that sells sales enablement software to medium and large enterprises. Sales enablement software improves the performance of sales, marketing and customer service teams by helping them work seamlessly together. In the process it creates valuable information which management can use to make better decisions.

At its core, sales enablement software helps marketing teams distribute content to sales people. The internet and modern computers have facilitated the creation and storage of huge amounts of information across numerous applications. This is problematic for salespeople, who want to maximise the time they spend selling to customers, as finding relevant content is increasingly time consuming. Bigtincan’s software, Bigtincan Hub, solves this problem.

It provides a “single source of truth”. All sales content can be accessed from Bigtincan Hub preventing the need to search through multiple applications.
It has a clean, clear and user-friendly interface.
Marketing departments can ensure only up-to-date content is available to sales teams through built-in version control.
Marketing teams can “push” the best content directly to end users.
The best performing content is automatically provided to sales people and content gaps are automatically identified, ie sales opportunities lacking effective content. This provides feedback for content generators (marketing).
Mobile first design and offline capability means that travelling sales people can reduce office time.

The way that Bigtincan Hub recommends content to users is based on ontologies, a technology developed by Contondo which Bigtincan acquired in 2017. Ontologies organise and describe the relationship between data. For example, they are used in Bigtincan Hub to divide sales content into useful categories such as customer industry, opportunity stage and location. The technology labels content automatically providing relevance ratings from one to five for each piece of content for each sales prospect. Gap analysis highlights prospects where no relevant content exists to assist content creators.

Bigtincan Hub collects data and provides analytics to senior management. It records which content is used by who, for how long and when. The platform also records when content is received by customers and cross-analyses it with sales success measures to reveal which content is effective at different stages with different types of customers.

In mid 2018 Bigtincan acquired Zunos, a micro-learning and gamification software company. This brought learning and on-boarding (the process of bringing new sales people up to speed) capabilities to the platform. Micro-learning means that training material is chopped up into small chunks and delivered continuously. Gamification involves the use of virtual rewards and scoreboards to encourage learning. These conceptual tools are a flexible and time efficient way for users to learn.

Content creation and editing capabilities allow marketers to make content within Bigtincan Hub and sellers to tailor it to customers on-the-fly.

Bigtincan Hub also provides communication tools such as chat, call and video. These can be used by sellers to share content which they find useful.

An expanding set of features means Bigtincan Hub is increasingly embedded into the workflows of its customers’ sales, marketing and customer service personnel. In addition, Bigtincan targets large organisations with many thousands of end users and it would be complicated and expensive for these customers to switch solutions. Therefore, as with other software companies sharing these traits, it is difficult for competitors to steal Bigtincan’s customers.

Customer retention has historically been in the 80% to 90% range which is similar to Xero (ASX:XRO) and is further evidence of customer “stickiness”. Perhaps one would expect a higher rate than this given Bigtincan serves larger organisations than Xero and, as argued above, switching costs increase with customer size. Also, large companies are less likely to go out of business which reduces a source of churn. However, Bigtincan defines retention conservatively as it does not net churn against growth in existing customers unlike some peers. This is not because Bigtincan experiences little growth from existing customers. Most customers are large organisations and so typically roll out the solution bit by bit to ensure a smooth transition and also to try before they (fully) buy.

Retention has fallen over time, but remains high. It would be concerning if it continued to fall in the future.

The company has significantly raised prices in recent years and is currently rolling out even more expensive versions of Bigtincan Hub targeting specific industry verticals. As you can see below, gross profit margins are high and have risen over time.

The sales enablement software market is young and growing. As outlined above I suspect Bigtincan is able to defend itself from competition and so should be able to ride the industry wave and ultimately deliver high returns to shareholders. It is possible that switching costs reduce over time, but that has not historically been the case in other segments of the software industry. Furthermore, Bigtincan’s content recommendation engine improves with time and so a customer would need to train a new set of algorithms to work optimally in order to switch solutions. Nonetheless, it is something I will be watching out for.

Bigtincan generates 90% of its revenue from the US. Competing successfully in the US shows that Bigtincan is a world leader in sales enablement. Even highly regarded and locally listed Xero is struggling in the US.

As you can see below, monthly recurring revenue has grown strongly in the last few years.

*The first half of 2019 includes contributions from Zunos and FatStax of approximately $380 thousand based on information provided at the time of the acquisitions.

And this has translated into increasing statutory revenue, as you would expect.

*The first half of 2019 includes contributions from Zunos and FatStax of $1.1 million. Organic revenue growth was 39% over the prior corresponding period.

Strong revenue growth and multiple industry awards including the 2017 CODiE award for Best Sales Enablement Platform suggest that Bigtincan Hub is among the better solutions in the market. A roster of blue-chip clients including Fortune 500 companies like AT&T, Merck and Siemens hints at the same.

CEO David Keane told me that Bigtincan is one of four key players in the sector, the others being Seismic, Showpad and Highspot. Seismic has the largest market share while Highspot reportedly doubled revenue last year according to the 2018 Gartner Market Guide for Digital Content Management for Sales. David said that Highspot focuses more on inside sales ie office bound sales people rather than mobile sales which is where Bigtincan specialises.

David told me that the key advantage Bigtincan has over many of its competitors is that it owns the entire technology stack. He argued that this is important because it gives Bigtincan greater control over data and more flexibility to respond to technological developments compared to relying on third party platforms. For example, he showed me how it is possible to open, edit and present Microsoft PowerPoint files from within Bigtincan Hub rather than having to use PowerPoint itself. This enables Bigtincan to automatically capture the data associated with such an interaction which would otherwise be lost.

David is a serial entrepreneur having founded Veritel Wireless which grew rapidly to become one of the largest fixed wireless providers in Australia before it was acquired by BigAir Australia (formerly listed on the ASX). The other co-founder, Steve Cohen, passed away in late 2017 shortly after the company listed.

David is passionate about Bigtincan and focussed on continually evolving the company’s technology to meet the needs of sales people. During a video call, he enthusiastically showed me various cutting edge Bigtincan product features including augmented and virtual reality. This is reassuring as continuous investment in innovation is necessary for a software company to remain competitive.

There was a mix-up in the organisation of our call which I later found out was my fault. Consequently, David was driving to from Boston to New York when I phoned unexpectedly at 6pm. Not only did he take my call, but he returned to the office and gave me a product demo, spending one and a half hours in total with me. This says something about his commitment towards Bigtincan in my view.

There are three negative and seven positive Bigtincan employee reviews on Glassdoor. The positive reviews all seem to be written by sales people, while the negative ones all complain about the sales team overpromising product features to customers. I thought this may explain Bigtincan’s slightly disappointing churn and could be related to the fact that the sales team is primarily located in Boston whereas operations and product development is in Sydney. David said that he did not think either was the case, but that the issue was the result of teething problems typical of an immature fast growing business.

I also asked David about the typical reasons that a customer leaves. He said that often it is because the person within an organisation championing Bigtincan leaves, internal budgets get cut or customers think they can build the product themselves. At this point I thought that David may be unwilling to acknowledge the company’s flaws, but perhaps everything is as benign as he seemed to suggest.

Bigtincan has made a number of what look to me like savvy acquisitions since listing. The first, Contondo, was acquired in late 2017 and provided Bigtincan with the ontology technology described earlier. The second was Zunos and it added training features based on micro-learning and gamification as well as tier one clients including American Airlines and SonyPlastation. Finally, Fatstax brought with it the ability to create high quality and user friendly digital catalogues fed directly from a customer’s ERP system. This technology is useful to businesses with a large number of complex SKUs explaining why Fatstax has a strong customer base in the manufacturing vertical.

Bigtincan incurs little capital expenditure (including intangibles) and so operating cash flow is a decent proxy for free cash flow. As can be seen below, the company is still burning cash.

Following an ongoing rights issue at 42 cents per share, closing May 10, Bigtincan should have over $20 million in cash by my estimates. I believe the company could reduce discretionary investment to become profitable if it was unable to raise more capital in the future. It is pleasing that the company is raising funds through a rights issue this time around because this is fairer to all existing holders than only using an institutional placement.

Based on comparisons with other enterprise software businesses, Bigtincan could achieve a 20% after tax profit margin at maturity. Annualised recurring revenue (ARR) was $21 million at the end of December 2018 and since then the company has been awarded two new multi-year contracts with a combined value of $10 million. Assuming ARR is now around $25 million, net profit would be $5 million at a 20% margin.

After the retail offer is completed, the company will have a market cap of about $132 million at a share price of 51 cents, implying an enterprise value of circa $112 million. Revenue is forecast to grow 40% this year (albeit assisted by acquisitions). Previous years have always seen organic revenue growth of more than 30%. $112 million seems like a reasonable price for such a fast growing business with many high quality features.

Disclosure: Matt Brazier owns shares in Bigtincan and will not trade for at least two full trading days following publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

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Note from Claude: While I do not own Bigtincan shares I may purchase some in the future, but not for at least two days after this article is published.

Dicker Data Ltd (ASX:DDR) FY 2018 Results: Record Revenue

2019-03-01T00:24:17+00:00

Dicker Data Ltd (ASX:DDR) FY 2018 Results: Record Revenue

IT distributor Dicker Data released a typically solid set of full-year results yesterday. Revenue rose 14.4% to $1.5 billion, net profit before tax was up 16% to $46.2 million and NPAT improved 20.5% to $32.5 million. A one-off tax credit assisted the NPAT result. You can see below how the improved profit was ultimately a product of record half-year revenue.

Net debt increased 21.3% to $103 million (1.9x EBITDA), operating cash flow dove 70.5% to $12 million and free cash flow tumbled 73.2% to $10 million. Cash flow is volatile in this business because of high working capital (inventory plus receivables less payables) requirements combined with skinny operating profit margins (3.1% in FY 2018).

This means a relatively small percentage move in working capital over a period can overshadow profit and play havoc with cash flow. Over time these moves balance out, assuming working capital remains under control. And this has been the case to date, as you can see below.

Even though working capital is well managed, additional working capital is still required to grow revenue. Therefore, cash flow will fall short of profit whilst Dicker Data grows which is what happened this year even though working capital/revenue fell.

Despite its inconsistent cash flow and respectable growth profile, the company pays substantially all of its profits out as dividends each year. It does this by using debt to finance its working capital position. Total dividends for FY 2018 rose 9.8% to 18 cents representing a dividend yield of 5.5% at current prices.

Although working capital requirements are high, fixed asset requirements are relatively low and so Dicker Data generates a high return on capital (27.6% in FY 2018) and a very high return on equity (41.9% in FY 2018). However, return on capital will moderate over the next couple of years as the company upgrades its warehousing facilities for a cost of around $55 million.

Dicker Data is run by founders David Dicker and Fiona Brown and has provided outstanding returns for shareholders since listing at 20 cents in 2011. The annualised return for those lucky enough to have held since then is approaching 50% including dividends. Including dividends, the stock has returned about 24% since we chose it as our Preferred Dividend Stock for November 2019 in our hidden report for subscribers.

This impressive result is partly due to the lean capital structure described above, skilled and shareholder aligned management and tailwinds in the IT industry. Another factor is a scalable business model which offers customers an ever growing range of IT vendors and products.

The stock trades on an EV/NPAT multiple of just shy of 20 or a P/E multiple of 16 which is reasonable given the quality of the company and secular IT growth trends.

Note from Claude: I have little to add to this other than to remind readers that the founders own most of the business and management incentives are well aligned with shareholders. I thought these results were good.

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Disclosure: Matt Brazier does not own shares in Dicker Data at the time of publication. Claude Walker does own shares in Dicker Data 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.

Clinuvel Pharmaceuticals (ASX:CUV) Profit Growth Continues: H1 2019 Half Year Results

2019-02-27T00:02:49+00:00

Clinuvel Pharmaceuticals (ASX:CUV) Profit Growth Continues: H1 2019 Half Year Results

Rare genetic skin disorder drug developer Clinuvel Pharmaceuticals released its half year results yesterday. Revenue increased 27% to $9 million, NPAT jumped 189% to $4.1 million and EPS spiked 183% to 7.5 cents. Operating cash flow rose 80% to $7.2 million, free cash flow was up 76% to $7.1 million and the company had $42.8 million in cash with no debt.

Costs reduced 3.5% to $5.7 million compared to last year with incremental revenue falling straight to the profit before tax line. Gross margins are close to 100%, marketing costs are minimal and other overheads are well controlled.

Such economics are possible because the company’s only revenue generating drug, SCENESSE, is highly effective, well tolerated and the only approved treatment for the rare skin disorder erythropoietic protoporphyria (EPP). The frugality of management is a secondary factor.

Favourable foreign exchange movements contributed 9% of the total 27% improvement in revenue in the period.

On first glance it may seem that the stock is massively overvalued given it has a market capitalisation of $1.2 billion yet generated only $9 million in revenue during the half, growing at around 20% on an underlying basis.

However, there are a couple of mitigating factors. The first is that the business is very seasonal. Scenesse is mainly administered in advance of the three warmest seasons in the year. As the drug is only currently approved in Europe, this period falls into the second half of the financial year as can be seen in the charts below.

The second factor is the potential for FDA approval for SCENESSE, opening up the US market. In my view this is likely given the large and growing body of real world evidence generated since the drug was approved in Europe in 2014, showing that it is safe and effective.

The company received a boost in this regard on 9 January 2019 with the news that the FDA has set a Prescription Drug User Fee Act (PDUFA) date of 8 July 2019, evaluating the SCENESSE® New Drug Application as a Priority Review.

Clinuvel shares are up around 30% since I wrote this report back in September and I no longer own shares in the company on valuation grounds. In particular, I believe that profits could fall off a cliff when the company loses exclusivity for treating EPP with afamelanotide in around a decade’s time. This is far from certain and for those interested, there is a discussion of this issue in the comments at the bottom of my original write up.

Note from Claude:

I have not sold any shares in Clinuvel, and while I may adjust my position size in due course, I have no current intention to sell out of the stock. I differ from Matt because I think there could be enough growth to justify the risk of losing exclusivity for afamelanotide. Clinuvel has a head start in terms of marketing and manufacturing expertise. I do, however, agree that there is a real risk of over-valuation if the market underestimates this risk.

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Disclosure: Matt Brazier does not own shares in Clinuvel at the time of publication. Claude Walker does own shares in Clinuvel and will not trade them for at least two days after the publication of this article. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Laserbond Limited (ASX:LBL) HY 2019 Half Year Results: Planning Pays Off

2019-02-24T01:11:09+00:00

Laserbond Limited (ASX:LBL) HY 2019 Results: Planning Pays Off

Surface engineering company Laserbond reported great results on Friday. Revenue was up 45% to $10.5 million as guided in January, but EBITDA exceeded guidance of $1.8 million coming in at $2.1 million and up 293% from last year. NPAT was up 635% to $1.2 million, operating cash flow jumped from $0.2 million to $1.8 million and free cash flow improved from $0.3 million to $1.8 million. Unusually for a manufacturer, investing cash flows were positive, although at least $0.5 million of expenditure is planned for the second half.

Turning to the balance sheet, cash of $2.8 million exceeds $2.5 million of financial liabilities. This was an improvement from a net debt position of around $0.5 million at the end of June 2018. Such cash generation is impressive in light of the strong growth the company is experiencing and enabled a substantial increase in the interim dividend from 0.2 cents to 0.5 cents.

The products division was the key driver of growth in the half with revenue up 103% to $4.8 million and also saw an improvement in gross margin from 42.5% to 49.6% due to efficiencies of scale. Growth is expected to continue with the company recently winning its first orders from a US steel manufacturer at the end of last year for its Composite Carbide Steel Mill Rolls.

Meanwhile, the services division recorded revenue growth of 17% to $5.7 million and is also expected to continue growing. Furthermore, gross margins are expected to return to historical levels of around 50% in the next 12 months, up from 45% for the first half.

The technology division registered no sales in the half but the company incurred some costs related to a $1.8 million order with a UK multinational that will flow through as revenue in the second half. Management are confident of securing further deals in future.

In light of all the above, my 2019 forecasts (included in the charts on the original writeup) look achievable. $22 million of revenue implies a repeat of H1 plus the UK technology sale. EBITDA of $4.3 million is just over double the first half result.

At Thursday’s closing share price of 38.5 cents, Laserbond is trading on an EV/NPAT in the mid teens using my EBITDA forecast for 2019 and adjusting for interest, depreciation and tax. History shows that Laserbond’s profitability can be volatile and so you could argue the company is fully valued at this multiple. However, I would point to the long-term revenue growth trajectory, the talented Hooper brothers who founded and still run the company, and the minimal share dilution that has occurred over the years.

Profit is unlikely to keep growing in a straight line from here and consequently there will probably be better opportunities to pick up some shares. But there may not, and if you believe in the long-term future of Laserbond then the shares are not particularly expensive at these prices.

I hold Laserbond shares and intend to continue holding while the growth story remains in tact. Assuming it does, I will be looking for an opportunity to add some more shares on any significant price weakness.

For those interested, this piece I wrote last year provides further detail on what the company does and its history. However, since writing that article, Laserbond’s share price has risen almost 100%.

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Note from Claude: Regrettably I did trim my position in Laserbond prior to these results, after the strong share price appreciation. That seems to be a mistake I make pretty often, and I'll put it down to the fact that I haven't followed the company very long, and I was trying to be too cute on valuation.

These results came in above my expectations. This is a very promising start to our coverage of Laserbond (all Matt). I will keep an eye on the share price and should there be a sell-off as a result of wider market malaise, then I would consider Laserbond a prime candidate for accumulation. So far I've been really impressed with what I've seen and if, as we increasingly believe, this is a good quality business run by honest and competent management, then they could achieve a lot in the long term.

Disclosure: Matt Brazier and Claude Walker both own shares in Laserbond at the time of publication, and will not buy or sell for at least two days after publication of this article. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Webjet (ASX:WEB) H1 2019 Half Year Results: B2B Soars

2019-02-21T02:22:16+00:00

Webjet (ASX:WEB) Profits Soar In H1 FY 2019

Online travel agent Webjet announced excellent results today and the shares are up more than 20% in early trading. Total transaction revenue increased 29% to $1.9 billion and revenue rose 33% to $175.3 million. EBITDA leaped 42% to $58.0 million and NPAT was up 59% to $31.8 million. EPS rose 48% to 31.5 cents and the interim dividend edged up from 8 cents to 8.5 cents.

This growth was assisted by the acquisition of Destinations of the World (DOTW) during the period as well as a full six months contribution from JacTravel acquired in the prior corresponding period. Stripping out the effect of acquisitions, revenue was still up an impressive 21%.

The balance sheet remains strong with $159.5 million held in cash excluding client funds and total debt of $212.9 million, which is more than comfortable in light of the profit figures above.

On the surface, cash flow was weak with operating cash outflow rising 80% to $26.1 million and free cash outflow before acquisitions up 47% to $40.1 million. However, the disparity between cash and profit can largely be explained by a one-off payment to suppliers of $53 million relating to 2018 expenditure. This was flagged back in August and there was a corresponding higher than expected cash inflow in the second half of 2018.

After taking this into account, profit roughly matches cash flow but there are also acquisition related reconciling items so the picture remains clouded. Such opacity in the accounts is typical of most acquisitive businesses and is an additional risk that investors in these types of stocks must bear. Also note the company has previously had conflict with its auditors, so it’s fair to say that it is hard to follow the accounts - there is some risk here.

The main driver of growth is the B2B division, WebBeds, which was founded six years ago and now constitutes well over half of the company’s EBITDA on a pro forma basis. This business provides hotel inventory to travel agents and tour companies acquired directly from hotels and from other aggregators.

In order to achieve scale management has aggressively acquired competitors. This has greatly improved the choice of higher margin direct inventory which it can offer clients as well as assisting with geographic expansion. WebBeds is now the second largest player in a highly fragmented sector.

With scale has also come improved margins and the company upgraded its long-term guidance of 8% Revenue/TTV, 5% Cost/TTV and 3% EBITDA/TTV to 8%/4%/4% by 2022.

Shorter term, WebBeds expects an uplift in sales in FY 2020 when it begins to recognise revenue on inventory sold to Thomas Cook. An agreement signed in 2016 involved Webjet acquiring Thomas Cook’s hotel inventory and providing inventory to Thomas Cook’s customers. As part of the deal, Webjet does not earn revenue on inventory provided to Thomas Cook during the transition phase which ends this year.

The slower growing B2C division consists of the Webjet online travel agent (OTA) and New Zealand based Online Republic. Webjet OTA recorded a good result with flight bookings growing 4.1% or three times the broader market. Online Republic saw a modest decline in bookings and TTV but an improvement in margins. Notably, EBITDA from the B2C segment was lower half on half, pointing to weak consumer spending. Here lies the risk in the cyclicality of the business. If Australia falls into recession, then EBITDA from the B2C segment will probably continue to decline.

Thoughts on valuation

As a result of the incremental revenue from Thomas Cook, a full-year contribution from DOTW and growth opportunities in Asia, the company is guiding at least a $40 million improvement in EBITDA in 2020. This is up from current 2019 guidance of $120 and after adjusting for capex and tax I estimate the stock is trading on a forward EV/NPAT of around 23.

Given guidance of further improving margins in the WebBeds business in the medium term and MD John Guscic’s confident statement in today’s conference call that there will still be plenty of growth potential in the B2B division in ten years time, the stock looks good value even after today’s rise.

The only thing that would hold me back from buying shares in Webjet today is where we are in the business cycle. Global economies are weakening with Italy in recession. Meanwhile, the outlook for the Australian economy continues to deteriorate with house prices sliding.

The B2B business is growing strongly enough that it would probably be relatively unaffected and so I can’t imagine earnings going backwards but there is still scope for disappointment in the next couple of years.

However, for those that are happy to ride the cycle I think that today’s price represents a decent long-term entry point.

A note from Claude:

My thesis for buying Webjet, as outlined in Episode 10 of the Three Wise Monkeys podcast, was that the B2B business had hit profitability and we were at an inflection point as operating leverage would take hold. This turned out to be absolutely correct and has driven a 30% share price rise today. However, the weak B2C results show that Webjet is not immune from macroeconomic factors, even as it continues to win market share. So I am no longer a buyer of Webjet shares. For now, I will continue to Hold.

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Disclosure: The Author of this piece, Matt Brazier, does not hold Webjet shares. Claude Walker does own Webjet shares and will not trade in Webjet shares for at least two days after publication of this article. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

LaserBond Limited (ASX:LBL): Scratching Beneath The Surface

2018-10-25T21:50:17+00:00

LaserBond Limited (ASX:LBL): Scratching Beneath The Surface

LaserBond Limited (ASX:LBL) was founded in 1992 by engineer Gregory Hooper along with other members of his family. Brother Wayne Hooper, also an engineer, joined the company in 1994 and the two still run it today. Gregory is responsible for much of the technology the company has developed over the years and Wayne is focused on business strategy and operations.

Edit (30/10/2018): The Hooper family collectively owns around 47% of the company.

Essentially, Laserbond uses various techniques to strengthen the surface of heavy duty equipment such as mining drill bits and steel mill rolls. Initially the company was focused on, and developed, its own techniques for thermal spraying. That is where semi-molten droplets of a coating material are sprayed at high velocity onto a substrate material. Since 2001, Laserbond has become a world leader in laser cladding technology which involves bonding a surface material to a substrate using a high power laser. This produces a metallurgical bond and unlike welding is done at low heat minimising damage to the materials. The company also does heat treating, machining and welding.

Laserbond has three operating divisions: services, products and technology. The services business is reclamation work where customers wish to extend the life of equipment. In many cases, Laserbond treated equipment can last more than twice as long. The products division makes new equipment for either OEMs or under Laserbond’s own brand name. These products are designed to last much longer than competing products that have not undergone a similar surface engineering process. Finally, Laserbond manufactures laser cladding rigs which it sells overseas to customers in non-competing industries along with ongoing training and maintenance.

In all cases, Laserbond saves its customers money by extending equipment life at a fraction of the cost of replacement. Although its products are a little more expensive, their lifespan is often multiples of alternatives. The techniques are also environmentally friendly because they use a tiny amount of energy compared with manufacturing new products.

Considering 75% of Laserbond’s revenue is sourced from the mining sector, the business has been surprisingly resilient since listing in 2007. On an organic basis revenue has grown steadily, from $2.6 million in 2003, to around $20 million this year. Even during the mining downturn between 2013 and 2015, revenue was flat whilst most mining services companies suffered steep declines. This suggests customers aren’t willing to cut their expenditures lightly.

Organic profit before tax, excluding non-cash write-downs, has been less consistent, although the company has been profitable every year other than 2016, when it made a small loss. Between 2013 and 2016 Laserbond moved to a new larger manufacturing facility in New South Wales, established a greenfield operation in Adelaide, and invested heavily in staff and capital equipment, ahead of expected growth. All this affected profitability.

Many small and growing businesses experience such profit volatility until they reach a scale where incremental investments become insignificant relative to profits. You can see how this has played out with Laserbond in the image below:

The 2019 figures in the charts above are my estimates and all data excludes contribution from an ill fated acquisition of Peachey’s Engineering made in 2008, and disposed of in 2013. The idea behind buying Peachey’s was to provide a beachhead in Queensland where Laserbond could roll-out its laser cladding and thermal spraying services. The services business is dependent on proximity since the equipment is expensive to transport (products only require a one-way trip).

Laserbond paid $3 million upfront for a business that was expected to deliver $1.4 million in earnings before tax. The trouble was that it was heavily dependent on Rio Tinto’s Alcan aluminium refinery in Gladstone. Shortly after Laserbond acquired Peachey’s, Rio scaled back its aluminium business impacting revenue. At the same time, the Gladstone LNG plant was under construction putting upward pressure on wages for skilled tradesmen and Peachey lost some of its best employees.

When I spoke with Wayne Hooper, I asked why the company was still considering acquisitions following this experience, and given that the greenfield expansion into South Australia had gone so well. He said that lessons had been learned and the next time they will make sure everything is right. We will see, but in any case, it is an acceptable risk since acquisitions are not the core strategy of the company.

Wayne made a comment during our conversation that I thought underscored the innovative nature of Laserbond. When I asked about the risk of selling technology packages overseas and, how to ensure customers continue to pay licenses, he said that customers will need years of support to properly learn the techniques. On top of that, Laserbond manufactures the cladding systems themselves out of necessity, because when Wayne and his brother first started getting interested in laser cladding, they couldn’t find a company to supply them with the setup they wanted.

Clearly, there is significant key man risk in the business but this is something that management is aware of. This is part of the reason for the ongoing staff recruitment. They have hired an R&D manager with a PhD from Germany and continue to broaden the management team.

I think that Laserbond may be at an inflection point. Historically it has been a niche services business focused on reclamation with obvious limits to scalability. But in the last couple of years it has established the products division which has the potential to grow significantly and yield economies of scale over time.

It hasn’t been entirely smooth progress so far. The company’s down-the-hole hammer products have yet to take off and Wayne said this is because Laserbond doesn’t currently offer the same range as competitors. This is being addressed through a collaboration with Boart Longyear and the University of South Australia which should yield a variety of products that Boart may potentially distribute in the future.

The addressable market for Laserbond’s surface engineering techniques is vast since they can be applied to virtually any piece of heavy equipment. The large manufacturers currently don’t really use the techniques and so Laserbond’s competitors are mainly small innovative services operations like itself. Even after a recent run-up in share price, Laserbond is capitalised at just over $20m with minimal net debt. This compares to recent guidance of at least $1.8 million earnings before interest, tax, depreciation and amortisation (EBITDA) for the first half of 2019. The future looks bright, although there may be a few more bumps in the road along the way.

Note From Claude:

I greatly appreciate Matt contributing this research into Laserbond, in which we both own shares. In some ways, it reminds me of Kip McGrath Education Centres (ASX:KME), because it is a tiny, family run company that seems to be heading in the right direction. In my experience these kind of companies often fall off the radar of most investors, completely, so the observant and patient investor has the chance to buy shares at attractive prices.

If Laserbond is actually a good quality business, then there will probably be plenty of upside over the long term at current price of 23 cents per share, with a (growing) dividend yield of 2.6%, fully franked. However, I would consider a yield of 3% - 4% to be my target price to buy shares.

But the real value is in following along with the story, because a company this size will almost certainly be forgotten, at times. At those times that I will be looking to buy in my target price range, with a patiently set limit order. The other time I like to buy tiny companies like Laserbond is if there is some sort of good news but the market is slow to react. Both scenarios are worth watching for, in my view.

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

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Disclosure: Matt Brazier and Claude Walker both own shares in Laserbond at the time of publication, and will not sell for at least two days. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Introducing Clinuvel Pharmaceuticals Limited (ASX:CUV)

2018-09-11T23:09:02+00:00

Introducing Clinuvel: A New Ethical Equity For September

Clinuvel Pharmaceuticals (ASX:CUV) is a profitable and growing biopharma company. Its drug, SCENESSE (afamelanotide 16mg), is used to treat erythropoietic protoporphyria (EPP), a rare genetic disease characterised by severe intolerance of the skin to light. SCENESSE is approved in Europe and is in the final stages of gaining marketing access in the US. I believe the stock represents good value based purely on the potential for SCENESSE in Europe. US approval would double the addressable market for SCENESSE and Clinuvel has a pipeline of other compounds and indications.

Clinuvel Background Information

The scientific basis of SCENESSE originated at the University of Arizona Cancer Centre in 1987 with the development of a synthetic hormone designed to protect the skin. Clinuvel (or EpiTan as it was called then) acquired the technology and listed on the ASX in January 2001 with the aim of developing a tanning product, Melanotan.

Current CEO, Philippe Wolgen, took the helm in 2005 and the board appointed the late Dr Helmer Agersborg as Chief Scientific Officer (CSO) at the same time. The pair switched the company’s focus towards addressing light-related skin disorders including EPP. The main accomplishment of the company to this point was to develop a sustained release delivery mechanism, improving both efficacy and reducing side effects.

In 2010, afamelanotide was added to the list of drugs reimbursable by the Italian National Health System for EPP and in 2012 two leading Swiss insurers agreed to reimburse the drug. Clinuvel finally received full European approval in 2014 following the longest ever regulatory review by the European Medicines Authority (EMA). In June 2016, the first EPP patients received the drug under the approval. A New Drug Application (NDA) was submitted to the US Food and Drug Administration (FDA) in June 2018.

Clinuvel Intellectual Property

SCENESSE

SCENESSE, or afamelanotide, is a synthetic version of the alpha-melanocyte stimulating hormone (α-MSH) which naturally occurs in the body. Skin cells release α-MSH when subjected to ultraviolet radiation (UVR). Once released, the half-life of α-MSH is a few seconds, which is sufficient time to reach and stimulate other skin cells called melanocytes which then produce melanin. Melanin is a dark brown pigment which causes tanning and protects the skin from sunlight.

SCENESSE differs from α-MSH in that it is 10 - 1,000 times more potent and has a half-life of 30 minutes. The drug is further enhanced by Clinuvel’s patented controlled release delivery mechanism which involves injecting an implant about the size of a grain of rice under the skin. This doubles melanin density levels and reduces side effects compared to daily liquid injections of afamelanotide. The effects of a single implant last around two months.

Side effects of SCENESSE include nausea and headaches which may be experienced by more than 10% of people. Diarrhoea and vomiting, abdominal pain, drowsiness and decreased appetite may affect up to 10% of people.

EPP

EPP is a genetic disease which is estimated to affect between 1 in 75,000 and 1 in 200,000 people and is more prevalent in fair skinned people. Sufferers do not produce sufficient ferrochelatase, an enzyme which converts protoporphyrin IX into heme B. Consequently, abnormally high levels of protoporphyrin IX accumulates in the blood and skin. Protoporphyrin IX undergoes a chemical reaction when exposed to sunlight which causes severe pain, swelling and scarring of the skin. Many EPP sufferers avoid the sun altogether, including light from windows, with severe psychological consequences.

SCENESSE is the only approved drug for treating EPP and is currently only approved in Europe. Over two decades, more than 1,400 patients have received more than 4,500 doses of the drug in clinical trials and post approval. Clinuvel closely monitors the safety profile of SCENESSE in order to maintain marketing permission for the therapy from the EMA. More than 95% of patients treated with SCENESSE continue treatment beyond the first year and some in Switzerland have been receiving treatment for more than a decade. The drug works and has proven to be safe up to this point, so US approval is a real possibility.

Clinuvel’s development pipeline includes a paediatric (for children) formulation of SCENESSE for EPP.

Vitiligo

Vitiligo is a more common disease than EPP affecting between 0.1% and 2% of people and is a second potential indication for SCENESSE. The cause of vitiligo is unknown and the disease is characterised by patches of skin losing their pigment. It is more noticeable in people with dark skin and can cause sufferers to be stigmatised. One of the main treatments currently available is UVB therapy, where patients are exposed to controlled quantities of UVB light.

Clinuvel has undertaken two Phase II clinical studies of SCENESSE in vitiligo.

The first was an open-label study conducted in the US comparing SCENESSE plus UVB therapy against UVB therapy alone. 54 patients were enrolled with half assigned to each treatment arm. 41 patients completed the study and the extent of repigmentation in those receiving SCENESSE was significantly greater than observed in the control group. A follow up study showed that depigmentation did not reoccur in patients who received a combination of SCENESSE and UVB therapy.

Only 75.9% of patients completed the US Phase IIa study with 13 withdrawals, including five who failed to complete the study “due to the intensity of pigmentation experienced”. It would appear there is real potential, but with the possible drawback that the drug makes the unaffected skin darker.

A second double-blind (meaning that neither the patients nor those running the trial know which patients are receiving the drug) study is ongoing in Singapore that was initiated in May 2014. Promising preliminary results were released in December 2015 for the seven patients who had completed the study up to that point, with an additional patient withdrawing consent. A further 13 patients were enrolled under “an expanded open‐label protocol” with completion of treatment expected by February 2016, but Clinuvel is yet to publish these results.

A more rigorous vitiligo study is planned in the US following FDA approval for EPP.

The above images are of two different patients in the US Phase IIa study. Note the change in skin tone in the unaffected areas for the patient receiving the combination therapy.

The vitiligo progress seems encouraging but the following question remain unanswered:

The pilot Phase IIa trial in the US was originally supposed to be double the size with half the study conducted in Europe. What happened to the European part?
Why were only 8 patients initially enrolled into the Singapore study given the prevalence of vitiligo?
Why haven’t the final results from the Singapore trial, including the 13 additional patients, been released given the final treatments were completed in early 2016?
The five month follow up to the US study showed that depigmentation did not reoccur in those patients treated with the combination therapy. Does this mean that vitiligo sufferers would only require a single course of treatment if SCENESSE is approved? In comparison, EPP patients must receive the treatment on an ongoing basis.
Why did almost 25% of patients drop out of the US study?
Does SCENESSE further darken the dark parts of the skin as well as the light patches in vitiligo sufferers?

Topical Delivery

Clinuvel has been developing topical products in the background over the past couple of years under a joint venture with Biotech Lab Singapore, called Vallaurix. Early this year the company purchased the rest of Vallaurix and it is now a 100% owned subsidiary of Clinuvel. Two publicly disclosed products are under development, CUV9900 and VLRX001, and in a letter to investors in January 2018 chairman Stan Mcliesh stated that “Clinuvel will launch its premiere non-pharmaceutical product lines under private label”. It is unclear what the long-term strategy is here but perhaps it includes creating a topical version of SCENESSE to target light patches of skin in Vitiligo sufferers.

Recent Patents

Clinuvel holds patents for treating sufferers of central nervous system (CNS) disorders including Multiple Sclerosis (MS) and Alzheimer's Disease (AD) with α-MSH analogues (such as afamelanotide). It has also filed a patent in August 2018 for using α-MSH analogues to treat xeroderma pigmentosum (XP), a rare genetic disease where sufferers have a decreased ability to repair DNA damage. The company holds other patents for targeting inflammatory disease such as inflammatory bowel disease (IBD).

EDIT: The US patent for CNS disorders was rejected and others for inflammatory disease have not been issued either. Apologies for the initial oversight.

Scientists in Italy conducted a study published in 2015 indicating that afamelanotide induces cognitive recovery in Alzheimer transgenic mice. The authors suggested “MC4 receptor agonists (of which afamelanotide is one) could be innovative and safe candidates to counteract AD progression in humans”.

Clinuvel Competition

SCENESSE has been granted orphan status in both the US and Europe for treating EPP. Therefore, Clinuvel has exclusive marketing rights for seven years in the US and ten years in Europe post approval. SCENESSE was approved in 2014 in Europe and so exclusivity will expire in 2024.

SCENESSE is also protected by patents. These cover the controlled release delivery mechanism of SCENESSE and the use of alpha-MSH analogues to treat phototoxicity. The key patents were lodged in the 2000s so Clinuvel should remain free from competition in the XPP market at least until the late 2020s, unless another drug is developed.

Beyond that, it is possible that generics will emerge given Clinuvel currently earns between €56,000 and €85,000 per patient per year for SCENESSE. Clinuvel is required to monitor safety and prevent off-label use to retain marketing approval in Europe and this may provide a barrier to entry. Another could be the difficulty in achieving clinical equivalence given the complex delivery method of SCENESSE.

I have come across two companies besides Clinuvel that are actively developing Melanocortin 4 (MC4) receptor agonist drug candidates, Palatin Technologies and Rhythm Pharmaceuticals.

Palatin is developing Bremelanotide to help restore sexual desire in premenopausal women with hypoactive sexual desire disorder (HSDD) and has completed Phase III trials. The drug is very similar to afamelanotide and, like afamelanotide, originated in the University of Arizona.

A researcher at the University of Arizona accidently discovered the potential for MC4 receptor agonists to treat sexual dysfunction while developing the tanning drug, melanotan-II, that Clinuvel later acquired. He mistakenly self-administered twice the dose of melanotan-II that he intended and experienced an eight hour erection, nausea and vomiting!

Rhythm Pharmaceuticals is developing setmelanotide to treat genetic causes of obesity and has completed Phase II trials in two indications.

Clinuvel Market Potential

Between 1 in 75,000 and 1 in 200,000 people suffer from EPP and the disease is more prevalent in those with fairer skin. SCENESSE is priced at between €56,000 and €85,000 per patient per year and currently the recommended maximum number of treatments per year is four. Each treatment lasts for two months so the maximum revenue each patient could generate is €120,000 per year, assuming a treatment costs around €20,000.

Orphan drugs are usually more expensive than non-orphan drugs but SCENESSE seems pricey even for an orphan drug. A European study done in 2011 found that annual prices for orphan drugs ranged between €1,251 and €407,631 with a median cost of €32,242.

The UK National Institute for Health and Care Excellence (NICE), which decides which drugs are made available under the National Health Service (NHS) seems to agree. It has decided not to recommend SCENESSE as it did not meet its health-economic criteria. Clinuvel plans to appeal the decision but given the company has a uniform global pricing policy, it is quite possible that no agreement will be reached.

Although SCENESSE is costly for payers, I think it is important to recognise that orphan drugs need to command high prices in order to attract capital to develop them in the first place. This is because of the following reasons.

By definition orphan diseases affect a small number of people and so represent a small market opportunity for drug companies if prices are low.
High prices are temporary in most cases as exclusivity and patents only last a set number of years after which generics can enter the market.
The chances of getting a drug approved are low (less than 10% according to some statistics). The returns generated by individual companies need to be viewed in the context of the industry as a whole.
Drug development is not cheap. Clinuvel has raised $150 million in external capital to date.

Clinuvel successfully negotiated pricing with the German National Association of Statutory Health Insurance Funds (GKV-SV) in 2017. Including Germany, patients have been treated with SCENESSE in six EU countries plus Switzerland.

There are 328 million people living in the following European countries: Finland, Ireland, Norway, Germany, Sweden, Belgium, Switzerland, Italy, Netherlands, Austria, Spain and France. These are wealthy countries and there is a good chance that EPP sufferers living in them will have access to SCENESSE. The majority of these nations also have high populations of fair skinned people who are more likely to suffer from EPP. Assuming the lower end of both the prevalence range for EPP and price range for SCENESSE, these countries represent a $150 million revenue opportunity. The opportunity could be as much as $600 million assuming the high end of the ranges. Including the UK, the figures are $180 million and $721 million respectively.

US approval could be up to 24 months away but may happen much sooner if SCENESSE receives a priority review. The decision will be made after Clinuvel has provided additional documents requested by the FDA. The US effectively doubles the addressable market for SCENESSE.

The total revenue opportunity for EPP is between $330 million and $1.32 billion assuming UK reimbursement, FDA approval and consistent pricing,. The market for Vitiligo is bigger than EPP should Clinuvel achieve FDA and EMA approval.

Clinuvel Financials

Clinuvel earns very high gross margins (>90%) and has a relatively low fixed cost base of about $10 million per year. The company has reached profitability and future revenue growth will largely fall to the bottom line.

Clinuvel has $36.2 million in cash and no debt.

The business is seasonal with revenue weaker in the first half of the year. This is because SCENESSE is primarily sold in the lead up to spring, summer and autumn in the Northern Hemisphere.

Clinuvel Executive Team

CEO Dr Philippe Wolgen was a promising ~~soccer~~ football player in his youth but instead chose to train as a craniofacial surgeon before becoming an equities analyst. Under his watch Clinuvel has regularly missed commercialisation and regulatory approval deadlines, but this is typical of early stage drug companies.

Clinuvel’s share price closed at $3.35 on 27 November 2005, the day before Dr Wolgen was appointed, and is now $18.34. He is jointly responsible for switching Clinuvel’s focus from developing a general use tanning agent to targeting rare genetic disorders, which has proven to be a successful strategy. He owns 5.4% of Clinuvel.

Chairman Stan McLiesh is the former general manager of pharmaceuticals at CSL Limited and joined the board in 2002.

Recently appointed non-exec director Dr Karen Agersborg is the daughter of former CSO Dr Helmer Agersborg, who passed away in 2012.

Board member Willem Blijdorp purchased $13.6 million worth of shares for $10 per share in July 2018.

Conclusion

Clinuval’s share price has risen sharply in recent months and is up more than more than 20% since I started researching this article. The company’s current market capitalisation of $880 million is reasonable given the potential of SCENESSE for treating EPP in Europe excluding the UK alone ($150 million to $600 million revenue opportunity). It is likely that US approval will follow, effectively doubling the company’s addressable market. Success with Vitiligo would more than double it again.

I intend to buy a small number of shares in the company, but not for at least two full trading days following the publication of this article. I think the key risk is the prospect of generic competition around ten years from now, but I would hope that the company has been successful in launching other products by then. Delayed safety issues are another risk, but given some patients have been taking the drug for more than a decade I think this risk is low, albeit potentially company destroying.

Note from Claude: I’d like to thank Matt for prioritising this work. This company looks promising to me, and I may buy some shares, after reflecting. However, I will wait at least two trading days to do so.

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Disclosure: Matt Brazier and Claude Walker do not own shares in Clinuvel at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Nearmap Ltd (ASX:NEA) FY 2018 Results

2018-08-27T10:16:39+00:00

Vale Mike King -- I wish you lived to see this 10-bagger (for you). So many spiffy pops for you my friend.

Nearmap Ltd (ASX:NEA) released its results for FY 2018 last week and reported an increase in both revenue and losses.

Revenue rose 32% to $54.1 million with annualised contract value (ACV) up 41% to $66.2 million. ACV can be thought of as the revenue run-rate at year end and the fact that it grew faster than revenue bodes well for the future. This growth was driven by a combination of more subscriptions, which increased 13% to 8,863, and a boost to the average revenue per subscription (ARPS), which increased 25% to $7,473. It seems to me that the business is in its infancy given it has an estimated less than 1% share of the expanding global aerial imaging market.

The other side of the ledger looks less appealing. Rising costs meant that net loss after tax more than doubled from $5.3 million to $11.0 million and loss per share deteriorated from 1.4 cents to 2.8 cents. Cash from operations swung from a cash inflow of $3.7 million to a cash outflow of $2.7 million, while free cash outflow increased 89.8% to $12.2 million. The company remains debt free but its cash balance shrank from $28.3 million to $17.5 million during the year.

As a shareholder in Nearmap I am comfortable with the terrible set of numbers in the previous paragraph. This is because the vast majority of the expenditure represents investment in growing what (I believe) is a very high quality business. Nearmap has low incremental cost of sales, 100% recurring revenue and sticky customers. These economics are reflected in the financials of the more mature Australian operation which generated $26.7 million of cash in 2018 and heavily subsidises the US operations, which burned through $22.7 million. An additional $14.8 million was spent on corporate costs and group investments.

Generally speaking, cost of sales for Nearmap consists of the cost of taking aerial images several times a year, stitching them together, storing them and maintaining an online platform where customers login to view them. Pure software businesses often have both fewer and lower direct costs than this, but are similar to Nearmap in that the incremental direct cost per sale is very low. Furthermore, Nearmap’s high capture costs may actually work to its advantage in that they provide a barrier to entry for would-be competitors.

This means that for Nearmap, gross margins are low to begin with, as is the case in the US business. But margins become very high at maturity, as seen in the Australian business. Indeed, gross margin % in the US increased from 12% to 27% in 2018 while it was steady in the Australian business at 94%.

The value of subscription businesses is dependent upon customer retention and in this regard Nearmap scores highly. A particular highlight of the 2018 results was the reduction in churn, which is calculated as a percentage of revenue, from 10.2% to 7.5%. This alone increased portfolio lifetime value (LTV), which is ACV multiplied by gross margin % divided by churn, by 37%. Of course, churn will fluctuate over time and so LTV is inherently unstable.

LTV does not account for indirect costs -- but it is a useful proxy for tracking value creation over time, in my opinion.

Another cause for optimism is that the company’s heavy investment into the US, over recent years, appears to be bearing fruit. ACV more than doubled rising from US$5.3 million to US$12.9 million during the year and as can be seen above, the region is tracking ahead of Australia at the same stage in its life.

There are two key things of note in the chart above. Firstly, since entering the US market in the first half of 2015, the company has consistently spent more cash than it has generated. Secondly, there is a seasonal pattern to cash receipts, with the first half being weaker than the second half.

Management commented several times that operating cash flow for the second half of the year improved compared to the first half. Given the seasonality this is is misleading and does not necessarily imply an improvement in performance. The prior corresponding period (2017 H2) is a better comparator, and both operating and free cash flows worsened on this basis. However, they also said that the company is expecting to achieve cash flow breakeven in 2019.

The sales team contribution ratio (STCR), which is the ratio of incremental ACV to sales and marketing costs, increased from 90% to 114% in 2018. This metric is useful because each dollar of ACV has an expected life of more ten years based on current churn rates. The improvement for the year suggests that Nearmap may be realising scale benefits from its sales and marketing function.

Nearmap has recently added Oblique and Panorama imagery to its platform and is now developing 3D content. Obliques enable subscribers to measure the height of features and Panorama provides the viewing of an area from any angle. Already, $9 million or 13% of group ACV relates to Oblique or Panorama product features which is further tangible evidence that management are spending money shrewdly.

Nearmap is continuously expanding the range of products and tools available on its imaging platform which enhances the company’s competitive advantage.

Nearmap’s other source of competitive advantage is its growing historical database of images, which spans several years of multiple captures per year across most of the populated parts of the US and Australia. The company has recently announced that it is expanding into New Zealand which will add to this asset and further diversify the business.

For a while I had reservations about Nearmap because of its executive remuneration. In particular, I felt that the non-cash component was excessive and unfairly diluted shareholders’ interests. Today, executive remuneration remains high but the non-cash component has fallen in the past couple of years. Total remuneration should continue to fall as a proportion of revenue as the business grows and I think that management are executing well so am happy for them to be well rewarded.

I do have one major concern with my investment in Nearmap. Its current market capitalisation is over $700 million and so for investors to realise significant further gains I think that the company will need to become a quasi-monopoly in the US aerial imagery market. I think there is a good chance of this happening because of the clear superiority of its product and how difficult it will be for others to catch up given its competitive advantage.

However, investors in Nearmap should keep an eye on competition as well as potential substitutes such as satellites and drones. My current view is that neither satellites nor drones pose an immediate risk. Satellites are expensive and struggle to achieve the same clarity due to atmospheric interference and cloud cover. Nearmap has the option of switching to drones if and when it becomes preferable to use them over light aircraft.

It is somewhat reassuring that CEO Rob Newman also seems confident about Nearmap’s competitive position. He said,

“With our unique technology and business model which no other aerial imagery company globally has been able to replicate at scale, Nearmap is well positioned to execute on our vision to become the world’s leading provider of subscription access location intelligence.”

I do think that Nearmap is priced for perfection though, which means the downside risk is large should the company disappoint. I will not be selling my shares whilst the momentum in the stock remains, but should sentiment turn (as evidenced by a falling share price) then I would probably sell. However, I certainly will not sell for at least two trading days following the publication of this article.

Note from Claude:

I have clearly previously under-estimated the value of the new features Nearmap was adding. Arguably, this company has plenty of room to run: it could easily become a $1 billion company. However, one relevant question is whether they will raise capital again on that journey. I think they might. For that reason I am a little cautious here. It’s hard to value the shares in 10 years time if you have no clue how many there will be.

While the business is supposed to reach breakeven next year, that does not mean it will not raise capital again. Therefore, although I will definitely be keeping some of my Nearmap shares, I am actively looking to sell more of my Nearmap shares (I already sold around 20% of my original holding at $1.50, announced prior here). I will wait at least 2 trading days, and then I’ll probably sell around 20% of my current holding -- but only if (and when) I like the price.

Either way, it will remain one of my larger holdings.

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

Adacel Technologies Limited (ASX: ADA): FY 2018 Results

2018-08-26T05:18:56+00:00

Provider of systems and services for air traffic control (ATC) training and air traffic management (ATM), Adacel Technologies Limited (ASX:ADA) released its results for FY 2018 on Thursday night.

Revenue rose 25.0% to $53.1 million, net profit after tax (NPAT) fell 9.5% to $8.4 million and earnings-per-share (EPS) was similarly down 9.1% to 10.64 cents. Operating cash flow jumped 75.7% to $8.6 million and free cash flow rose 71.2% to $8.1 million thanks partly to a $3.8 million tax refund.

Cash was down 23.4% to $12.5 million following the payment of $9.5 million of dividends and $2.0 million spent on buying back shares during the year. The company announced a final dividend of 2.5 cents as well as a special dividend of 5.0 cents bringing the total dividends declared in the year to 9.5 cents versus 11.75 cents last year, or a yield of 5.6% at current prices.

While NPAT and EPS both fell compared to 2017, underlying profitability actually improved. This difference is due to tax with a $1.4 million tax benefit recorded in 2017 compared to a $1.8 million tax expense for this year. Profit before tax (PBT) improved 29.8% to $10.2 million although this is still below the 2016 peak of $10.8 million. The company has available tax losses in Australia and tax credits in Canada in addition to $3.9 million of deferred tax assets on its balance sheet. These have an estimated value of $11.8 million and $10.1 million respectively and should reduce tax payments in future years.

Adacel typically generates more than two thirds of its revenue from North America with much of the remainder originating outside Australia. Therefore, the business is exposed to currency fluctuations and in particular the relationship between the Australian and US dollars. The Aussie has weakened around 8% against the US dollar in the past year and a continuation of this trend would be good news for Adacel’s Australian investors.

The company generates lumpy one-off revenue from the sale of its systems as well as recurring service fees once a system is installed. As the base of installed systems has grown over the years, so has the defensive quality of the business.

Note the chart above shows the tight cost control on display with overheads lower today than they were in 2015. This also highlights the scalability of the business.

As can be seen above, the stable services business now comfortably covers overheads and Adacel is far less dependent on the contribution from system sales compared to before 2015. Come the next recession, the company’s profit is not going to fall off a cliff, as was once the case.

It was good to see the services revenue return to half-on-half growth, after a weak first half.

Adacel’s investing cash flow history provides further evidence of fiscal discipline. The company expenses almost all R&D investment and tangible fixed asset requirements are minimal. The ability to generate strong free cash flow enables Adacel to pay attractive dividends and is one of its best qualities from an investor point of view.

Systems

Intensifying competition has eroded the gross margin percentage of Adacel’s Systems division. It was 27.9% in 2018 down from 34.8% last year and is expected to continue falling in 2019.

This may not be as bad as it seems. Increasingly it is the services side of the business that drives performance and so discounting the price of systems to win business may be worth doing in order to realise more lucrative service revenue later on.

The company is looking to mitigate the lumpiness of revenue in its Systems division by broadening its product range including offering small footprint land-based ATM systems as well as the oceanic based systems for which it is known. It is also investing in R&D to expand the product range of its ATC simulator business.

Services

The Services segment represents the recurring revenue side of the business and is higher margin than Systems as can be seen in the charts above.

Last year, Adacel was impacted by the loss of a portion of a contract for support services it provides to the US Federal Aviation Administration (FAA). The company has formally protested this contract award and has halted delivery of software support pending the outcome which has further reduced revenue. This dispute drove a 5% fall in Services revenue in 2018 and in Friday’s investor conference call management revealed that the judge overseeing the case dismissed Adacel’s claim. The company has 30 days to appeal the decision.

The above contract loss was partially offset by growth in the separate and existing FAA Advanced Technologies and Oceanic Procedures (ATOP) contract. This is Adacel’s largest and longest serving contract dating back to 2000 and it generated service revenue of around $12 million in 2017. In September 2017 the company announced that the contract had been expanded with annual revenue increasing by 20%. Only 11% of this contract extension was delivered in 2018 and so it will contribute to growth in 2019.

It is worth noting how dependent Adacel is upon the FAA, although this risk is somewhat offset by the huge investment the civil aviation authority has already made in the company’s systems. If the company can reconcile its differences with the FAA then it is easy to see how Services could realise some growth in 2019, especially considering recent System wins.

Room to Climb Further?

In this piece which I wrote for Ethical Equities back in July 2015, I said:

“Putting it all together, Adacel is trading on a conservative forward enterprise value to free cash flow multiple of about 7x right now. It is by no means a perfect company because it is exposed to economic cycles, has a poor history and has powerful customers. However, it seems that Adacel has put its past behind it and that looking ahead conditions will be much more favourable.”

Fast forward to today and Adacel trades on a historical enterprise value to PBT multiple of 11.9. I am not sure if the outlook is as rosy today, as it was back then. In the prior article, I used PBT as a proxy for free cash flow because of the company’s available tax losses and credits. The PBT figure used in the previous calculation was my estimate for 2016 of $6.0 million, which turned out to be wildly conservative given the actual result was $10.8 million! For context, the 2015 PBT result was $5.9 million.

The share price closed at 60 cents on the day that my original article was published and the stock is trading at $1.715 at the time of writing giving a capital return of 185% in just over three years. Roughly half of this performance can be thought of as being driven by multiple expansion with the other half due to PBT growth. In addition, the company has paid 18 cents of unfranked dividends representing an income return of 30% over the period.

For the record, I bought my shares for 59 cents in May 2015 and sold them for $1.60 later that year. This was a pleasing result but it turns out that I sold much too early given the share price peaked at over $3 in 2016.

Adacel directors David Smith and Silvio Salom (also the company’s founder) sold 4.7 million shares between them in the second half of calendar year 2017 for at least $2.60 per share. These trades were well timed given the share price today is around 35% below those levels. It is worth paying attention to insider trading activity.

I do not consider that Adacel’s stock represents anywhere near as attractive a prospect today as it did back then. This is partly because it is now trading on a higher earnings multiple, but more importantly there is less visibility of future growth for the company. In July 2015, Adacel had just announced roughly $120 million of new contracts in the preceding few months. In contrast, I estimate the value of contracts announced in FY 2018 is less than $60 million.

Having said that, Adacel remains a reasonably priced decent quality business and although I am not tempted to buy shares right now, I would be fairly content to hold if I did own some in the absence of a superior opportunity.

Note from Claude: I think this is a very insightful write up, and I value Matt’s work here. I largely agree with his conclusions except for the fact that I’m a little more optimistic given the strong cash flow of the business. The company has been buying back shares and paying out dividends so it does seem to want to share that cashflow with shareholders. That’s not as common as I’d like.

Second, I could certainly envision this company being significantly bigger in a few years. Ultimately, however, I am concerned there has not been enough investment in software development and I do not hold shares myself. I would not rule out purchasing some, especially on share price weakness, but I’m not in a hurry.

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Disclosure: Neither Matt Brazier nor Claude Walker own shares in Adacel at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

GBST Holdings (ASX:GBT) 2018 Annual Results

2018-08-14T02:35:46+00:00

It has been a tough couple of years for GBST Holdings Limited (ASX:GBT) since their former CEO Stephen Lake stepped down in 2015 and this year was no different. Revenues rose just 0.3% to $88.3 million and EBITDA (earnings before interest, tax, depreciation and amortisation) was up 1.7% to $12.2 million.

NPAT (net profit after tax) was down 11.4% to $6.2 million and free cash flow was $3 million, down from $9.2 million last year. The stock trades on a trailing twelve month dividend yield of 2.4% at current prices.

GBST’s results are messy so it is difficult to know which metric to look at to understand business performance. I believe that EBITDA is the best of a bad bunch of choices for the following reasons:

- Shares on issue have risen by less than 1% over the past two years so an earnings based metric is equivalent to an EPS (earnings-per-share) type calculation for the period.
- Similarly the debt structure of the company is largely unchanged with cash falling slightly from $11.7 million to $11.4 million and no debt in either year.
- The company has a falling amortisation charge related to legacy acquisitions which boosted profit before tax by $1.5 million this year compared to last.
- Tax and finance charges are erratic year-to-year. For example last year the company recorded a tax credit of $2 million versus a $1.5 million expense this year.

Despite all of the above, EBITDA is not perfect. In particular it does not account for the fact that last year the company capitalised just $1.2 million of R&D costs compared to $7.3 million this year so arguably this year’s results are even worse. Furthermore, it expensed less R&D this year compared to last, $7.7 million versus $9.6 million.

The reason for the hike in R&D spend is due to a major multi-year investment drive begun when current management took over in 2016. The project is expected to be partially one-off in nature with ongoing maintenance spend estimated at $6 million to $8 million but not before next year when investment will ramp up further.

A page in the presentation (click to enlarge) accompanying today’s results summarises what this money is being spent on. As a technology company I personally don’t think it is correct to quarantine such spend since it seems it is mostly to maintain the competitiveness of existing products and is therefore a business-as-usual (BAU) cost (although I acknowledge that the cost is likely to reduce in future).

A look at historical revenue trends further supports the view that the R&D spend is a defensive move.

It looks as though GBST could have finally turned a corner in the second half of 2018 although the EBITDA result does not include the additional $7 million of capitalised R&D spend.

The trouble is it is very hard to know what future years will look like. The company separates its revenue into lumpy project related Services income and recurring License income. However, recurring revenue has taken a hit recently as a couple of major GBST lost a couple of major clients in Australia underscoring the company’s customer concentration risk.

A couple of wins in 2017 could indicate improvement in 2019 as License fees flow through. These include Investec Wealth & Asset Management who are in the top three wealth management firms in the UK by assets and who are now using GBST’s wealth management product Composer. Then there are a couple of distribution deals in Japan and the US done in 2018 for the company’s capital markets product Syn~.

The fact that management have elected not to provide guidance underscores the uncertainty as does the fact that the company hired a new CTO, CFO and Head of HR in the 2018 financial year. Then there is the profit impact of the adoption of the new accounting standard AASB15 although this is not expected to be significant.

With a market capitalisation of just shy of $150 million I think that GBST looks fully valued given the company’s lack of growth in recent years and no guarantees going forward. There are better opportunities out there in my opinion.

I do not own GBST shares and I would Sell GBST if I did.

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The Author of this piece, Matt Brazier, does not own shares in GBST. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Adacel Technologies Limited (ASX:ADA) is an emerging microcap offering a good risk-reward ratio

2015-07-09T12:40:18+00:00

Ethical Equities is proud to present this report by the rampaging Fire Bull, who is himself an emerging micro-cap investor displaying good risk-reward ratio. I would happily have this guy manage my cash.

We're lucky to have him present one of his favourite investing ideas right now (though I hasten to add, like me, he can and will change his mind on new information, so please don't rely on anything you read on this website, ever.) It's all about education.

Now, without further ado...

---- ---- ---- ---- ---- ---- ---- ---- ----

At the outset, I’d just like to say that I gained much of my understanding of Adacel from reading posts on the HotCopper thread. In particular I owe thanks to ambitious.1, Stweeve, Fibonarchery, vfrioni, Ormond, imran khan, peterdoobes, CapitalH and anyone else that I may have missed. Some of this material is likely to have come from what I have read on the forum, although I have verified all research independently. Adacel Technologies (ASX:ADA) is a market leader in the supply of air traffic control training systems, particularly in the United States. It also sells satellite based air traffic management software and voice activation technology used in planes, drones and simulators.

For a small company, Adacel has a fairly extensive product offering which needs to be understood to appreciate the full potential of the company. Here are the key product categories it sells along with a short description on each.

ATC Simulation & Training

This is the core division of Adacel’s business and products range from small mobile training systems to Adacel’s flagship MaxSim product, a fully immersive training simulator. The products incorporate Adacel’s voice recognition technology which increases realism and helps students learn aviation phraseology.

Air Traffic Management

Adacel’s Aurora, is satellite based air traffic management software that can automatically detect potential air collisions before they happen. This reduces workload for controllers and has environmental benefits as the system can help optimise flight plans to save fuel whilst a plane is airbourne.

Voice Activated Cockpit

Voice Activated Cockpit enables the pilot and the aircraft to effectively talk to each other, freeing the pilot’s hands and eyes to perform other tasks. Adacel offers a similar solution for controlling drones.

Air Traffic Control in a Box

Using Adacel’s speech recognition technology, Air Traffic Control in a Box provides automated air traffic control training for pilots and drone operators, which is preferable to using human controllers.

The financial history of Adacel is weak; the company has generated just $8 million of free cash flows in total over the last ten years. However, it is the future and not the past that matters and such a poor track record is precisely what provides the opportunity to buy the stock at a bargain price today.

The company has struggled in recent times because governments around the world stopped spending money on its products after the GFC. This is now changing, as economic conditions have improved, and outdated systems desperately need replacing. Yes, this is a somewhat cyclical business.

In 2013, Adacel’s revenue was $31.3 million, the lowest it has been in the past ten years. In the previous three years, from 2010 to 2012, no significant contract wins were announced which probably explains why 2013 was the low point. However, the company still managed to deliver a small profit before tax in 2013 of $0.9 million.

This is significant for two reasons. Firstly, since the start of April 2015 Adacel has announced more than $120 million of new contracts, which implies that revenue will be much higher in the next couple of years. Secondly, Adacel is now a much better run operation than was once the case. For example, in 2010 the company made a loss before tax of $3.0 million on revenues of $46.4 million. I think this improvement in profitability is down to management, but more on that later.

Air traffic is forecast to grow over the long term as people from developing countries get richer and start travelling abroad. Also, drones are expected to become widely used, further congesting the skies, albeit at a much lower altitude. Consequently, more air traffic controllers and more advanced systems will be required and Adacel should benefit in the following ways.

There is a shortage of air traffic controllers currently, and this combined with expected future demand means that more simulators will be needed.

Adacel now has a large base of installed simulators that will require constant maintenance and updates as the skies get busier and the training needs of controllers change (for example, training on drones). This base is likely to get bigger, indicating that revenues will be less volatile in future.

Radar systems will be replaced by more accurate satellite based systems, the kind sold by Adacel.

Adacel’s voice technology can be used to replace human air traffic controllers when training pilots and operators of drones. This product is called Air Traffic Control in a Box and at the end of 2012, a collaboration between Adacel and Israeli drone simulator company, Simlat, was announced utilising this technology.

The same speech technology is used in Adacel’s Voice Activated Cockpit product, which allows the user to control planes and drones with their voice. The product has safety benefits because it frees up the user’s hands to carry out other tasks.

Adacel has a strong partnership with Lockheed Martin and its Voice Activated Cockpit technology is being used in the prestigious Joint Strike Fighter program. The technology will continue to get high profile exposure from this contract as more fighter jets are rolled out.

Adacel’s air traffic management software, Aurora, is sold as part of Lockheed’s overall air traffic control solution. This allows Adacel to leverage off Lockheed’s name to win contracts that it would not be able to compete for alone.

Adacel is not the only company with these types of products, but it is definitely one of the leaders based on its dominant position in the US market and impressive partnership with behemoth Lockheed Martin.

Also, it should be noted that Adacel’s customers are large public sector organisations and governments which, thanks to their size, have considerable pricing power over Adacel.

Thorney Investment Group, a highly regarded private investment firm specialising in emerging companies, owns just under half of Adacel. It has built up its holding over more than a decade which demonstrates commitment. The long-term major presence of Thorney on the share register is potentially a positive, because it increases the chance of the company being run in the interests of all shareholders. On the other hand, it could lead to neglect of retail shareholders in favour of Thorney, should interests become opposed.

Peter Landos, chairman of Adacel since 2012, is also the COO of Thorney and it seems unlikely that the improvement in profitability evident since his appointment is just a coincidence. CEO, Seth Brown, was hired at around the same time as Mr Landos and probably shares some responsibility for the turnaround.

The new management team has focussed on project management discipline and cut redundant costs which has led to the improved financial results of recent years. In addition, it bought the intellectual property for Adacel’s air traffic management system, Aurora, which means the company no longer has to pay royalties or risk losing the technology to a rival.

More recently, Adacel bought Computer Sciences Corporation’s air traffic simulator business. Crucially, this means that Adacel now has systems at more than 95% of schools in the FAA’s Collegiate Training Initiative program enhancing its leadership position in the American market.

In terms of value, Adacel looks cheap. It has a market capitalisation of less than $50 million at current prices and recently announced that it expects to deliver profit before tax (PBT) of $4.5 to $5.0 million this year.

However, it also has $7 million in cash, no debt and the above figures include $0.8 million of genuinely one-off costs related to bad debts owed by the Ukraine government. Also, profits in the second half of the year are expected to be $3.1 to $3.6 million and so along with the recent acquisition and contract wins, I conservatively estimate PBT to be over $6.0 million next year.

Over the past ten years, Adacel has spent a total of just $5.7 million on capital expenditure. Also, the company has $64 million of retained losses on its balance sheet so I expect free cash flows will be similar to PBT for some time.

Putting it all together, Adacel is trading on a conservative forward enterprise value to free cash flow multiple of about 7x right now. It is by no means a perfect company because it is exposed to economic cycles, has a poor history and has powerful customers. However, it seems that Adacel has put its past behind it and that looking ahead conditions will be much more favourable.

Disclosure: Fire Bull (the author of this piece) holds Adacel Technologies shares. Claude Walker (introduction only) does not own Adacel shares, but may choose to buy Adacel shares at some point in the future. Nothing on this website is advice ever. It is a place to share stories and discuss investing in ethical companies.

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