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Introducing Clinuvel Pharmaceuticals Limited (ASX:CUV)

Matt Brazier — Tue, 11 Sep 2018 23:09:02 +0000

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.

MedAdvisor (ASX:MDR) Is Growing: FY 2018 Results

Claude Walker — Mon, 03 Sep 2018 09:02:37 +0000

The highlight of the recent MedAdvisor (ASX:MDR) annual results for FY 2018 was undoubtedly the fact that revenue from continuing operations reached $6.6 million, some 50% higher than last year. To the company’s credit, they highlighted this operational number as well as the more flattering $7.4 million in revenue, once you include R&D grants. It made a statutory loss of $4.5 million.

However, at this stage in the company’s development I find it much more useful to look at the cashflow excluding R&D grants. As you can see below, the company is trending in the right direction but growth is not particularly fast.

Importantly, the company said “the development costs will increase in FY19,” because it “will progress the technology integration into its US partners’ systems in order to begin entry into the US market as well as preparing for entry into the UK market.”

Perhaps the best bit of news in this report was that we saw a solid half-on-half increase in both patient engagement clients and patients per pharmacy, as you can see below.

This is good news because increasing patients per pharmacy suggests that PlusOne is adding increasing value for its clients -- eventually that will bring rewards. One of those rewards is through selling patient engagement programs, which are a key way the company monetises its user base. Importantly, this half on half growth in core metrics came without the benefit of an acquisition.

One hesitation I have with MedAdvisor is that costs are quite high. However, the good news is that the company has about $10.5 million in cash on the balance sheet thanks to the investment by EBOS Group (ASX: EBO). I own shares in both companies.

I estimate MedAdvisor can make it through 2019 without needing to raise capital again, even despite increased costs. However, it is increasingly important that we see strong organic revenue growth in FY 2019, or else the spectre of a dilutionary capital raising at low prices will arise. This growth will rely on recently signed agreements with TerryWhite Chemmart (TWCM), Zest and HPS.

One way in which MedAdvisor makes a beneficial contribution to society is by helping pharmacies increase the amount of services they provide. For example, “The Flu Program, launched by MedAdvisor, resulted in the near-doubling of flu shots recorded by its pharmacies. PlusOne recorded over 100,000 flu shots.” This outcome is win-win-win for pharmacies, patients, and MedAdvisor, since “the increased capabilities also enabled MedAdvisor to increase its subscription fees by ~20% during the year.”

Looking forward, there is lots going on at MedAdvisor. It needs to keep improving PlusOne, whilst simultaneously launching into the US. Many companies have found international expansion to be much harder than predicted, so the short term outlook might be a bit disappointing: these things often take longer than management think they will. Unfortunately, the company has had a tepid response to its feature that allows patients to re-order scripts remotely.

On the bright side, if the company can leverage its software into international markets there is a genuine possibility that it will be worth multiples of its current market capitalisation in a few years. There’s no doubt that this strategy has risks, but it seems absolutely worth trying.

Zooming right out MedAdvisor is essentially a play on the fact that this kind of sensitive data -- in the right hands -- can be very valuable at driving outcomes for business and patients alike. For example, “MedAdvisor has… assessed from the de-identified data of 1.3m patients on chronic medications in Australia that Australians only take their medications 54% of the time.” Their system makes it easier for Australians to ensure supply of medications, which is a positive in my book.

Leading pharmacy brands using the PlusOne platform include Discount Drug Stores, Blooms, Good Price Pharmacy Warehouse, Amcal, Optimal and TerryWhite Chemmart. As it improves, with time, MedAdvisor can create sticky long term relationships with these businesses who are themselves fairly defensive. The company is investing in its engineering team so as to continuously improve the offering.

There’s no doubt MedAdvisor is a fairly high risk investment. I have a small holding in my portfolio and I intend to hold on to it for now (but I'm not planning to buy more, either). I’m a little concerned about what the bottom line will look like in FY 2019, but I continue to believe this is one company well worth watching and I remain optimistic for the long term.

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Disclosure: Claude Walker both owns shares in MedAdvisor and EBOS Group at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Zenitas Healthcare Ltd (ASX:ZNT) Takeover & FY 2018 Results

Claude Walker — Mon, 03 Sep 2018 01:49:24 +0000

Community-based healthcare roll-up, Zenitas Healthcare Ltd (ASX:ZNT), released its results as well as news of a takeover proposal on Friday in chaotic fashion. The stock went into a trading halt before the market opened amid reports of an offer to acquire the company in the Australian Financial Review. It then traded in two short intervals following the release of its annual report but prior to confirmation of the takeover bid. Anyone who sold their shares during these periods would be pretty angry given the stock was trading around 10% to 15% higher following the crucial news. The ASX should reverse all trades that took place before the offer was announced.

But it’s not particularly good news for those who managed to hold onto their shares either. The takeover proposal is an all cash offer for $1.46 per share adjusted for a final dividend of 1.5 cents. This equates to an enterprise value (EV) of roughly $122 million.

Management did not provide guidance with today’s results, preferring instead to wait until the company’s AGM on 23 November. The only problem is that shareholders are due to vote on the Scheme Implementation Deed in mid November. Shareholders will have to make a decision on whether to sell without any profit guidance for 2019.

Management did provide pro-forma figures which assume a full-year contribution from various acquisitions executed during the year. These are revenue of $130 million and earnings before interest, tax, depreciation and amortisation (EBITDA) of $19 million. The company delivered organic EBITDA growth of 7.3% in 2018 and if we assume a similar performance in 2019, then EBITDA will be over $20 million. After minority interests of $4 million, it seems reasonable to assume that the business is on track to generate over $16 million of EBITDA for owners in 2019.

Therefore, today’s offer implies an EV/EBITDA multiple of 7.5. I think this significantly undervalues the business. According to management, there remain plentiful opportunities for the company to continue to buy up private allied, primary and home care businesses at between 4 and 6 times EBITDA. These would provide terrific returns for investors if, like the businesses Zenitas has acquired to date, they are not only acquired on such high earnings yields but are also growing 5% to 10% organically each year.

Underlying historical figures demonstrate strong growth in earnings-per-share (EPS) suggesting that the strategy is working well. Underlying figures strip out various “one-off” acquisition related costs and should be taken with a pinch of salt but are the best information available.

The graph below requires a little explanation. I calculated a proxy for EPS using the underlying EBITDA figures provided by the company less depreciation, non-controlling interests share of profit and interest.

I did not adjust for tax because Zenitas’ tax rates have fluctuated from half to half. For example, it earned a tax credit in the second half of 2017 and incurred an 18.4% charge in the first half of 2018. I could have applied a 30% tax rate to all periods but since the non-controlling interests are stated after tax, this could also potentially distort the picture. Clearly, tax is a real cost that reduces shareholder profits and the following chart is intended to provide a sense of the underlying trend rather than absolute figures.

The data point for the first half of 2019 is my estimate based on pro-forma run-rate figures provided by Zenitas.

This impressive EPS momentum is not the result of using excessive leverage given the company remains conservatively geared. Net debt is around $12 million versus the pro-forma EBITDA run-rate after minorities of $15 million. Indeed, Zenitas has recently secured a new $68 million facility with NAB replacing an existing arrangement with Westpac thanks to the strength of its balance sheet. This will provide further funding capacity for acquisitions.

Zenitas is now reaching a scale where it can potentially harvest cross-selling synergies across its national network of home, primary, allied and mobile healthcare providers. The trend towards community based care is also still in its infancy.

Yet despite Friday’s takeover proposal arguably undervaluing the company, it has received the backing of the Zenetas Independent Board Committee (IBC). Two board members were unable to recommend the offer due to conflicts of interest (hence the need for the IBC). One is Jonathan Lim, the Managing Partner of Liverpool Partners who are part of the takeover consortium. The other is Zenitas Chairman, Shane Tanner, who is an upstream investor in one of the entities managed by Liverpool Partners which proposes to acquire Zenitas shares.

One member of the IBC, Dr Jonathan Seah, is also chairman of China Medical & HealthCare Group (CMHG) which owns 10.9% of Zenitas. It seems unlikely that CMHG will submit a counter proposal given he has given his support as part of the IBC which unanimously recommends the offer.

There are unlikely to be other bidders either. A caller on Friday’s conference call highlighted that the Scheme Implementation Deed specifies a window of 10 working days in which to receive any counter proposals. This means any other potential suitors would have limited time to carry out due diligence.

I suspect that the scheme will go ahead, but intend to hold for a couple more weeks to at least find out if a competing bid emerges. The only reason I may not hold to cast a vote is if I need to free up capital for other opportunities. I will not sell within 2 trading days of publishing this article.

Note from Claude: I would not be buying shares at the current price, since the most likely outcome is that the company is taken over at a measly 2.8% premium to the current price. There is some possibility of a higher bid, but the way this has been structured leaves me without confidence that the company is taking the optimal approach. In my opinion it would be better if there was a vote on the scheme after giving guidance in November. I will not sell within 2 trading days of publishing this article -- but I am very likely to sell for at least $1.40, some time after that (albeit not immediately).

Ultimately, this is a somewhat decent outcome for investors; and the thesis for investing is drawing to a close.

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

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

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

Author: Fabregasto

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

Background

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

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

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

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

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

The company operates two distribution channels:

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

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

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

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

Accelerating growth into FY19 and reported FY18 results

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

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

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

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

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

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

FY19F and management performance rights

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

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

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

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

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

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

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

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

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

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

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

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

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

Looking beyond FY19: dare to dream

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

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

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

Small cap volatility

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

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

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

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

Note from Claude:

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

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

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

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

MNF Group (ASX:MNF) FY 2018 Results: No Synchronous Bloom This Year

Claude Walker — Tue, 28 Aug 2018 23:45:53 +0000

MNF Group (ASX:MNF) yesterday released its results for FY 2018. Unfortunately for shareholders, they were the least pleasing results I have witnessed from this company. Fortunately, the long term investment thesis remains in place.

The headline numbers saw revenue growth of 15% to $220 million and net profit drop 2% to $11.9 million. Earnings per share -- uncharacteristically -- fell short of guidance, coming in 16.25 cents for your full year. You can see the longer term view, below:

I would not want to discourage management from making long term decisions for growth, but I cannot deny it is clearly disappointing to see earnings per share in the second half fall below 8 cents. This is a substantial half-on-half drop of 20%. Incidentally, that is about how much the share price fell, yesterday. The guidance miss is probably the driver of the share price fall.

Of course, as shown by the purple part of the column on the right, the company had already warned the market that earnings would be lower than one might have hoped. The reason for the lower earnings was the investment in Pennytel.

Pennytel And Residential Retail Services

Pennytel is the new consumer facing mobile reseller. It sells the Telstra network to baby boomers in regional Australia. While I think this is a smart strategy; leveraging the better network and targeting the ‘low data usage’ crew, but the plan is off to a slow start.

The most unfortunate aspect of today’s update was that the Pennytel plan isn’t going as well as hoped. However, I think that the project could still pay off very well even while it falls short of expectations. You can see what the company originally hoped, below:

Yesterday on the conference call, the CEO said that the uptake was around half as fast as had been hoped -- and the marketing team is learning. However, I need to clarify whether that ‘half’ was revenue or services. Conservatively, I’ll assume services.

In that case we can assume that there were over 4,000 services. That’s far from ideal, but it is also worth noting that the company is likely achieving a lower ARPU than what it had modelled.

For example, I took this top screenshot in February 2018, and the bottom one yesterday:

The original business case was based on achieving 250k mobile subscribers by June 2020. I would say there is close to zero chance of that happening without a major increase in projected costs. Having said that, the company has clearly already reacted. It has merged Pennytel with its existing domestic business and consolidated costs.

The report said that the “Residential sub-segment is expected to cost the company approximately $0.5m at EBITDA level as the customer acquisition run rate increases.” Given that this sub-segment contributed about $3 million in gross margin in 2018 (albeit shrinking), I estimate that the company is now budgeting about $6 million to get Pennytel to breakeven, rather than under $4 million. I think that will be hard to achieve, but I also think that there’s a good chance the end result is reasonable, even if nowhere near as good as hoped. This may be a case of aiming for the moon -- missing, but still making it through the clouds.

I have focussed here on the problem area of domestic residential, but the domestic small and medium business segment is the largest contributor to the segment and it is growing. So too is the recently purchased conference call business. Meanwhile, MNF Enterprise is moving to a more recurring revenue model -- all this means that the domestic retail segment was flat, despite the ‘residential’ segment being a drag for now.

Domestic Wholesale -- The Jewel In The Crown

Moving on to happier subjects, the core domestic wholesale business managed to increase its customer numbers over the last six months, after consolidation reduced partner numbers in the first half.

This segment performed extremely well overall, with gross profits up 15%, and a sharp increase in iBoss SaaS customers, as you can see below:

This is the more positive story that the market was focussed on when various small cap funds were talking up the stock. Presumably those same funds have sold or are selling, now that the narrative has changed. Many small-cap funds are more momentum players than long term holders, which is fine; but their prognostications should be taken with a massive pile of salt -- if they are talking about a company, they are probably selling it.

This business grows organically each year and the plan is to replicate it in Singapore. I’m in favour of the plan.

Global Wholesale -- Below Expectations

Global wholesale was largely responsible for the gross profit miss. The company had predicted it would make $72.3 million but in the end made $69 million, some $3.3 million short. The fact that this translated to a net profit miss of just $400,000 actually suggests that the company scrambled to find savings -- and fair enough.

The culprit in this uncomfortable spot was the global wholesale business which saw margin compression in the second half. As a result, the second half was actually weaker than the first half, by around $25,000. The year on year growth was 16%; so you could probably forgive them for thinking it would keep growing. The reality is that they made less transaction-based revenue than they thought they would.

Over time, the company is selling more of the software-as-a-service style products, into this segment, so it should become less volatile.

Where To From Here?

This was a tough year for MNF Group. In part, that’s because it reinvested in growth, and in part because the global wholesale segment disappointed. Its cashflow looked bad due to the unwinding of a massive payable sum, received in 2016. Look to the huge cashflow in 2016, if you are concerned by the outflow this year.

Capital expenditure remained within reasonable levels, once again suggesting that the company owns good assets that allow high ROIC growth when combined with the expertise of management and employees.

Touching on employees for a moment, I was pleased to hear that the company had managed the consolidation of its residential operations without forcing redundancy on anyone. The fact that this was a priority for the company shows good sense. Companies that are ambivalent about letting people go in tough times will lose more employees to competitors in buoyant times.

The company has moved to address its one segment that is in structural decline. It is always easier on the financials to just let declining business spin off cash, without investing. I am glad that MNF has decided to stay active in the retail space, since it enhances its ability to serve wholesale customers, and leverages tools it builds for its wholesale customers.

This bad year for MNF saw gross profit growth of 17%. The average half-on-half earnings per share growth rate, in the last 4 years, is over 10%. If you narrow that to 3 years, it is still 8.9%.

Either you think it’s game over for MNF Group or you think they will show grit and resilience and continue to build this business.

If the former, sell. If the latter, then I think that we may see some good buying opportunities arise.

Personally, I think that this remains a quality company and -- although it is a large position for me -- I retain an appetite to buy more shares. I think that FY 2019 is likely to be another tough year but we should see improved statutory results in FY 2020 as the Pennytel and Singapore plans become profitable. This could be further delayed if the company makes a big push into NBN. Therefore, short term focussed investors are unlikely to stick with the stock, and sentiment could turn pessimistic.

As a result, I will be looking to buy more shares in MNF Group around $4.15 - $4.65 , all else being equal, at least 2 business days after publishing this post. Keep in mind I already have shares, so I'm going to be patient about the price I have to pay to buy more. I would not rule out paying a higher price if I feel like it, later on, but I am not in any rush.

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Disclosure: Claude Walker owns shares in MNF 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

Matt Brazier — Mon, 27 Aug 2018 10:16:39 +0000

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

Matt Brazier — Sun, 26 Aug 2018 05:18:56 +0000

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.

Sticking With Nanosonics (ASX:NAN): FY 2018 Results

Claude Walker — Wed, 22 Aug 2018 12:38:40 +0000

Disinfection specialist Nanosonics (ASX:NAN) has delivered an 11% drop in sales and a 60% decline in pre-tax profit for the full year ending June 30, 2018. That’s a big decline, but these headline numbers mask what’s really going on.

In the first half, Nanosonics sales were down 17%, a result that was attributed to a particularly strong prior period in which a major distributor undertook a large restocking. The previous corresponding half also benefited from a one-off tax benefit to the tune of $10m.

So it was always going to be tough besting 2017’s full year results. That challenge was made more difficult as distributors and customers delayed orders in anticipation of the Trophon 2 unit, which is being launched this month (earlier than originally anticipated). That left sales growth flat, half on half.

While I’m generally sceptical of excuses for lacklustre sales growth, this issue was flagged back in April when the company first received FDA approval for the second generation Trophon device. Very clearly, in fact.

Another factor is that an increasing number of units are being sold under a Managed Equipment Services (MES) or Rental basis. This greatly reduces the upfront revenue received, but is offset by much greater recurring consumables costs over the term of the agreement (it also lowers the barriers to purchase).

As for the much larger drop in profit, that’s explained by a significant ramp up in costs. For the full year, operating expenses were 15% higher, with the 4th quarter costs almost 44% higher than those expensed in the first. In the current year, management expects costs to come in at $53m, a further 24% jump on last year’s level. Around $13m of this is slated for R&D.

The rationale for the increased operating costs is that they are expanding their headcount to accelerate sales and product development, as well as funding the move into new regions -- a perfectly sensible thing to do as an investment in future growth, but one that doesn’t always work out. Plenty of fast growing hopefuls have misstepped with poor cost control (e.g. catapult).

Given the demonstrated efficacy of the Trophon product, it’s rapid adoption in leading markets, regulatory tailwinds and the advantages of being a first mover, this seems a justifiable move by Nanosonics. But it's something to watch.

What’s core to the bull case on Nanosonics is that the installed base of Trophon devices continues to grow at a sufficient rate. Each machine creates a very high margin recurring revenue stream (I estimate at least 75%) -- one that can be expected to last around five to seven years, with a high rate of retention at the end of the period.

To that end, we saw a 25% boost to the installed base, with a commensurate increase in revenues from consumables. There were 3580 new Trophons in use at the end of June 2018, 90% of which came from the US. That’s down on the 4030 adds in 2017 and the 3880 added the year before that (again explained by deferrals relating to Trophon 2).

With expanded sales resources, new regions and plenty of runway ahead in existing markets, it's not hard to imagine the installed base to grow by at least 4,000 units per year for the next few years. That’ll be supported as the replacement cycle ramps up; at present around 20% of the fleet is five years or more old.

Nanosonics has previously said that each unit generates around $3000 in consumable sales per year. On the numbers provided in the latest results, that number now looks closer to $2200 (that’s a rough estimate; different sales models, a shifting maturity profile, and different regional pricing make it difficult to know exactly).

But as newer units ramp up and as the sales mix shifts towards MES and rental models, we can expect consumables sales per unit to rise. That’s especially true next year when the new agreement with GE kicks in -- one that will see a “material increase in both consumable sales and margin in North America as of and beyond July 2019”.

Altogether, Nanosonics could be churning out at least $75m per year in high margin recurring revenue by 2021. Likely another $30-40m or so in capital sales (when accounting for FX rates), and still with a lot of potential for expansion. That’s before you assume revenues for any new product releases (they are hoping to have one or two new products by the end of FY2020).

Importantly, Nanosonics remains debt free, is cash flow positive and has $69 million in cash. It seems extremely unlikely that they will need to raise capital to pursue their growth plans, and should get a high return on retained equity.

I’d go as far to say that the business is as close to recession proof as you can get, at least for the consumables sales. Moreover, it has very little exposure to the domestic economy.

So I’m not too concerned at all by the latest results. In fact, the business’ prospects remain as attractive as ever.

That being said, adjusting both operating costs and unit economic assumptions have led me to lower my fair value estimate.

I reckon Nanosonics is worth around $2.80 per share (down from $3), though that could prove too conservative if sales growth accelerates (and visa versa!). Check out my forecast on Strawman.com for more.

Despite the very high quality nature of earnings and exciting growth potential, shares in Nanosonics are trading on more than 17 times sales. The PE is 183. Growth needs to be extremely strong to justify these multiples. And, if there are any speed bumps along the way -- as there often is -- we could see some pretty significant swings in market price.

I’ve learnt the hard way that you shouldn’t be too fussy on valuation when it comes to high quality businesses, and I’m very much in Nanosonics for the long term. So despite my view that shares are now above fair value, I’m not tempted to sell just yet.

We could easily see shares jump much higher in the short term given current market conditions (who knows?!). But I wouldn’t be tipping any new money into the business at these levels.

A patient investor will likely get a better buying opportunity in the future. If and when that occurs, and assuming the installed base continues to grow as expected, it’s an opportunity to be pursued with gusto.

I will not trade shares within 5 days of publication of this report.

A note from Claude: I’m very glad to have this fine coverage of Nanosonics from Andrew. I note he has made detailed forecasts available. While I may make slightly different assumptions around the numbers, I think his is a high quality and thoughtful analysis. Andrew bought Nanosonics well before I did, but we both bought more at around $2.50. Like Andrew, I am not buying at current prices. And like Andrew I plan to hold my shares at current prices. I will not trade shares in Nanosonics within 5 days of publication of this report.

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

Windlab (ASX:WND) Building A Business: HY 2018 Results

Claude Walker — Tue, 21 Aug 2018 23:00:30 +0000

As a developer, operator and owner of wind farms, Windlab Ltd (ASX:WND) is at the forefront of the transition towards renewable energy. So how does Windlab stack up as an investment?

Results

On the surface, today’s results are unimpressive, with revenue down 65.6% to $1.8 million. The loss-per-share (EPS) was 2 cents and the net loss after tax was $1.3m. Cash flow was weak too, with an operating cash outflow of $4.8 million and free cash outflow of $4.0 million. The company’s funding position remains healthy with $8.3 million cash, against $2.9 million of debt. There is also $92 million of borrowings held by the Kennedy Phase 1 project special purpose vehicle (SPV). The SPV is 50% owned by Windlab and the debt is non-recourse to the company.

Founded in 2003, Windlab is a young company and until 2012 it was purely a developer of wind farms. Development involves taking a project from inception up to the point at which construction is ready to start. It can take three to seven years to develop a project and success typically means the project acquirer pays the developer a development margin. This fee is often multiples of the cost of the development process. This means that development revenue is lumpy and the fact that none of Windlab’s projects reached financial close during the first half of 2018 is reflected in today’s results. In the second half of the year the 100 megawatt (MW) Lakeland project should reach financial close, and so the full-year result will probably look much healthier.

Zooming out, there is more evidence of progress, hinted at by the uplift in recurring income during the half.

Since 2012 Windlab has been maintaining an equity interest in some of its projects beyond the development phase. It has done this primarily by converting some of the development margin it earns into equity rather than receiving all cash on financial close of certain projects. Normally it receives a third of the development margin as cash with two thirds remaining invested depending on the attractiveness of the project. This generates a share of profit once a farm is operational following construction (which usually takes 12 to 24 months), and makes up part of the recurring income base in the chart above.

The other main contributor to recurring income is asset management fees earned during construction and when the project is operational. Importantly these are independent of wholesale energy prices which affect project profits. The company aims to provide asset management services for its own projects as well as on behalf of third parties. Unlike profit share, this element of recurring income also has an associated cost. Historically, gross margins have been slim although improving; 10% in 2016 rising to 20% in 2017. In the first half of 2018, asset management fees made up 61% of recurring income. This is likely to fall as more company owned projects come online.

The chart above is based on my guesstimate of how recurring income may evolve over the next couple of years. It has been crudely constructed based on incomplete information and includes contributions from only a handful of Windlab’s ongoing projects. These are West Coast One, Coonooer Bridge, Ararat, Kiata, Kennedy Phase 1 and Lakeland.

This chart uses the same imprecise data and adjusts for cost of sales associated with asset management revenue (contribution) to give a sense of when the company may become profitable on a recurring income basis. It assumes gross margin will improve to 25% in 2018 and again to 30% in 2019 and 2020; and that overheads will rise to $7 million and then remain steady.

A Robust Strategy

Windlab’s business is built upon its superior ability to prospect for wind projects due to its proprietary software, Windscape. Originally developed at CSIRO, Windscape can be used “to map vast areas of any country for wind speed, time of day and direction at a resolution of 100 square meters or better”. This is superior to the conventional approach to prospecting of using wind maps which have a resolution of between three and ten kilometres.

The following chart demonstrates how this technology ultimately translates into a competitive advantage for Windlab.

Capacity factor is an efficiency measure which compares the average power generated by a wind farm with the rated peak power of the wind turbines. Windlab developed the top two performing wind farms by capacity factor in Australia in 2018, Coonooer Bridge and Kiata (the red, above).

Superior intellectual property does not necessarily translate into a valuable business but in our opinion Windlab’s management are well on the way to achieving this. The company has progressively moved up the value chain from consultancy, to development and more recently to operations and ownership. As highlighted previously, this reduces the risk of relying on lumpy on-off development margins which can dry up during times of industry turmoil.

By converting development margin into ownership interest Windlab also leverages its investment in a project. It initially invests between $2 million and $5 million over a number of years to develop a project. It then realises several times this amount upon financial close with 30% paid in cash which usually more than covers the original cost. It invests the remainder into the project which typically yields a minimum of at least 8%.

As a hypothetical example, assume Windlab develops a project costing $3 million. It then plans to realise seven times this amount at financial close: $21 million. It takes $6 million as cash, providing a 100% return on the original investment, and then invests $15 million at a 10% internal rate of return yielding approximately $1.5 million in recurring income. These are fantastic economics.

It doesn’t always work out like this though. Firstly, not all projects are going to reach financial close and it is too early to work out what proportion do, given Windlab has only developed a small number of projects so far. Also, development returns are not always so high. For example, Coonooer Bridge Wind Farm cost $2.5 million to develop and realised a development margin of $2.7 million in cash and a 16.3% equity interest which Windlab later sold down to 3.5% for $2 million.

As well as being vertically integrated, Windlab’s business is geographically diversified with a growing number of projects underway in Sub-Saharan Africa, key projects in Australia and a small number in North America. Africa poses additional financial risks so the company looks to exit projects completely at financial close, rather than retain an equity interest (in most cases). The continent is potentially a highly rewarding place to do business due to rising incomes and poor energy coverage. The provision of renewable energy with its low operating expenditures can help these countries provide lower cost electricity, in the long term.

Within Australia, management has been savvy in targeting North Queensland to develop its main projects. In Queensland most energy is generated in the south east and so the Queensland Government currently subsidises the additional cost of supplying energy to the rest of the state through the Community Service Obligation (CSO). The total cost of the CSO in 2015/16 was $498.4 million. Windlab will help to reduce this cost through its Lakeland and Kennedy projects.

Queensland is also desirable because most of its energy is generated by aging coal power stations that will need replacing in coming years regardless of the fact they are bad for the environment. It also has excellent solar assets combined with scarce wind resources in close proximity to the electricity network which plays to Windlab’s strengths. Unlike wind, solar does not generate power at night and so the two are complementary and Windlab has the ability to identify and best exploit the wind resources that do exist.

Big Kennedy: A Big Deal?

The Kennedy project is a two phase project in North Queensland. The first phase is a 58 MW hybrid solar, wind and battery project 50% owned by Windlab and currently under construction. Proceeds from last year’s IPO of around $25 million have been primarily used to retain a joint interest in Kennedy Phase 1. The combination of wind, solar and battery power is a novel approach which aims to address the well publicised inability for renewable projects to provide base load power due to fluctuations in output.

If Kennedy Phase 1 is successful then there is a good chance that the 100% Windlab owned 1,200 MW Kennedy Phase 2 will be developed which will have a similar design. If this happens then the financial consequences for Windlab will dwarf those of any project that the company has previously been involved in. The company aims to earn a development margin of $250 thousand per MW which it has achieved in recent years earning margins of $260 thousand per MW from Coonooer Bridge in 2015 and $490 thousand per MW from Kiata in 2016. We don’t know if a similar development margin would apply to Kennedy Phase 2 but if so, achieving financial close on this project alone would make Windlab’s current market capitalisation of under $100 million appear attractive.

There are good signs that the project will proceed though the timescale is unclear. Firstly, in June 2017 the Queensland Government unveiled its “Powering North Queensland Plan” which includes a proposal to build a 500km transmission line that would connect to Kennedy Phase 2. However, it has only committed to providing equity funding for 30% of the project to date.

Secondly, upon signing an offtake agreement for Kennedy Phase 1 with Queensland Government owned CS Energy, Windlab announced that it had also “entered into a priority offer arrangement which affords CS Energy a first right of offer to negotiate a contract to purchase some or all of the electricity, LGCs, or other green benefits generated by Kennedy Phase II”.

Regulation and Other Risks

Regulatory uncertainty caused by government inaction or flip-flopping has the potential to derail the nascent renewable energy industry. This is no more apparent than in South Africa where the company holds a number of projects.

The Renewable Energy Independent Power Producer Procurement Program (REIPPPP) is the process by which renewable energy projects are provided with offtake agreements in South Africa. Following a number of successful rounds, the state utility company Eskom has effectively halted the progress of the REIPPPP by refusing to sign new purchase price agreements (PPAs) until the government gives it more control over price negotiations during the process. In 2016 Windlab impaired all of its South African projects to zero recording a charge of over $4 million due to this impasse which remains in force today.

There is the potential for trouble here in Australia too. The renewable sector has received heavy investment in recent years in large part thanks to a government scheme called the Renewable Energy Target (RET). The RET sets a target for Australia to source around 23.5% of its electricity demand to be from renewables by 2020. This is enforced in part through Large-scale Generation Certificates (LGCs) which can be created and then sold by accredited renewable power generators. The RET requires that an electricity retailer must buy the certificates to satisfy their renewable obligations each year or they get fined $93 per LGC for any shortfall.

Although the RET target peaks in 2020, it remains in place until 2030 which means that renewable energy producers will continue to earn additional revenue from the sale of LGCs until this time. The price of LGCs, which are traded in a secondary market, fluctuates and is likely to decline beyond 2020 as renewable projects continue to come onstream but demand from retailers remains static. The current price of an LGC is around $77 per MWh which is a lot given it is similar to the spot price of wholesale electricity.

If the price of LGCs falls significantly or if they are not replaced with an equivalent mechanism after 2030 then the attractiveness of investing in renewables diminishes. We think that it is likely that the scheme will not be replaced. However, it is also likely that historical subsidies of fossil fuel generators will also fall.

Countering this is the falling cost of building renewable projects due to greater efficiency from scale and technological advancements. In Windlab’s latest AGM presentation, it states that reliance on LGCs is no longer critical and although figures vary depending on the source, beyond 2030 (when the RET ends) it seems likely that renewable projects will be viable without any form of subsidy. This is likely in the absence of subsidy for competing technologies.

The renewable industry may also benefit from the fact that states have far more aggressive targets than those set by the RET and have the power to effectively bypass Federal Government by issuing PPAs for new projects.

There is also the issue of reliable base load power. It is true that renewables must be competitive on price after allowing for battery storage costs to ensure that energy is supplied to the grid when it is needed. Windlab’s Kennedy project is aims to solve this issue through a hybrid of wind, solar and battery storage. Further, as electric cars and smart metres gradually spread, there will be a degree of distributed power storage and demand side management. If we put an optimistic hat on, there is plenty of room for growth.

Another risk is the likely long-term deflationary impact on wholesale electricity spot prices given the incremental cost of generating renewable energy is close to zero. In my view this is something that will take many years to play out because of the way spot prices in the National Energy Market (NEM) are set.

Each energy supplier bids the quantity and price of their electricity in five minute intervals. The bids are then stacked by price in ascending order and matched with demand. The highest bid within the stack required to satisfy demand then sets the price for everyone. So it is the marginal bidder that sets the price.

Renewable providers can bid zero given their incremental cost of production is zero. Coal power stations also bid low because it is expensive for them to shutdown and restart production if their bids are not successful. Meanwhile, gas power stations bid the highest because they are relatively easy to shutdown and startup and gas is more expensive than coal.

Given the energy mix is dominated by fossil fuels today, it follows that fossil fuel power stations will remain the marginal bidder for many years. Ironically, it is actually good for owners of renewable energy projects if government policies delay the transition to renewable energy as it will ensure that prices remain higher for longer.

When renewables eventually dominate energy generation, we expect wholesale prices will reflect the cost to building and funding projects, thus eroding returns. We think there will always be value in identifying and designing the best projects, though. So if Windlab can maintain its competitive advantage then it should continue to realise healthy development margins.

Verdict

There is no doubt that Windlab is a risky company to invest in given all of the factors which lie outside of the company’s control. But with a project pipeline totalling more than 7,400 MW spanning dozens of projects and a strong financial track record it looks like it offers a decent risk reward profile to us at current prices. The stock is on my (Matt) watchlist and I may purchase a small parcel of shares in the future although not before five full trading days after this article is published.

Note from Claude: Matt did the vast majority of the work on this piece (though I assisted) and I am very proud to have it on Ethical Equities. I have followed Windlab for many years, including before it was listed publicly. I have spoken to the CEO and find him to be intelligent. I will wait five days after the publication of this report, and then I will consider buying a small amount of shares in this company. It is certainly hard to value but I consider it an interesting proposition and whether I do buy, or not, I will follow its journey.

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

Kip McGrath Education Centres (ASX:KME) FY 2018 Annual Results

Claude Walker — Sun, 19 Aug 2018 20:00:57 +0000

The tutoring company Kip McGrath (ASX: KME) released its results on Friday showing a continuing implementation of its long term strategy. It’s steady as she goes.

Net Profit after Tax (NPAT) has grown by 41% to $2.0m. The company has done this amidst a flat revenue of $13.7m (more on that below). This represented an expansion of NPAT margin from 11% in FY17 to 15% in FY18. More impressively, this was not a 1 year trend. Kip McGrath has consistently grown its margin from 2% in FY12.

Behind this steady increase in margin lies a change in the business model of Kip McGrath over the years. They have become less a labour-intensive business, to a more capital light franchise operator. The journey started 8 years ago when they first trialled the Gold Franchisees model.

The Gold Franchisees model is where the head office takes care of the back office functions such as running a marketing program, managing the accounts, and doing the payroll. There is a win-win between the franchisees and the company, since this model frees up their time to teach, while the head office takes a larger cut of the revenue.

As they continue to convert more franchisees into Gold Partners, they will capture a larger proportion of their franchisees’ revenue. Gold Partners numbers continue to rise, increasing by 16% to ~267 centres globally. They are now in the latter part of the journey to convert the franchisees to Gold Partners. In Australia 76% of centres are Gold Partners and the UK, 60%.

On top of their Gold Partners program, Kip McGrath has done a number of things to help their business going forward. They have increased national advertising campaign over TV, radio and digital. Management has said that these national campaigns have shown encouraging results and are a lot more effective than their previous local advertising. Furthermore, they have released an online booking system in Australia and NZ (with UK releasing in August) that enables parents to book in a free assessment directly. These initiatives continue to increase the quantity and quality of leads, with leads up 25% globally in FY18. Management will continue to push these initiatives forward, especially on the advertising front, planning to double their spend in FY19.

Kip McGrath’s push in using technology to tutor students over the internet has continued. They are now delivering over 1500 lessons per month, the same as they were six months ago (but up on last year). The company benefits from online tutoring by taking a cut of the money spent on each lesson.

Cash generation was strong, with a net operating cash flow of $5.2m, up 65% from FY17. This has enabled Kip McGrath to pay a fully franked dividend of 2c, taking their FY18 dividend total to 3c. Free cash flow was $2.2 million, slightly higher than profit.

Part of the reason Kip McGrath was so cheap for so long is because the company has been changing the way it accounts for revenue. Instead of booking the entire price paid as revenue to the company, then paying the tutor through ‘direct costs of student lessons’ they just book their share as revenue.

As a result, gross profit, shown below, is the most appropriate metric to measure top line growth. As you can see the first half is typically weaker than the second half, but the long term trend is up.

The market has woken up to Kip McGrath’s capital light business model. I was aware of all this, yet twiddled my thumbs and hesitated to buy over a few cents when it was in the 30c range. I kick myself over that decision. At its prices now, (68c as I write this) it appears to be fully valued. While management has said that they “expect revenue, profit and profit margins to continue to grow”, I am not sure how much further they can grow. They had a lot of tailwinds from the Gold Partners conversion, but that is towards its tail end. Their advertising and online tutoring are showing promise, but I am not sure that they can grow their revenue significantly.

With UK revenue representing ~50% of their total revenue, they may benefit from a weakening AUD. However they have also used all their historical tax losses, which will see them paying a higher tax rate.

Nonetheless, I have to give credit where credit is due. Management has (and is still) successfully implemented a good long-term strategy. They changed their strategy in 2010 when they scrapped their ill-fated venture into business education. Now, with their current strategy my only request to management is this: make sure your franchise and Gold Partners model creates a true win-win situation for your end customers (the parents and kids), your franchisees, your employees and your shareholders. Only through such a situation would Kip McGrath be able to prosper long in the future. Don’t go down the route of other franchise models, where the head office’s interest reign supreme.

Disclosure: I don’t hold any shares in Kip McGrath. For more of my writings, you can visit my personal blog on wyldestreet.com

A note from Claude:
I assisted with the analysis above and I broadly agree with Mark. However, I own shares in the company and I am a little more bullish, and actually had a bid in to buy shares at lower levels, not long ago (it did not get filled).

I think Storm McGrath will treat stakeholders well. I note the family may consider selling some of their shares at some point. If they do sell any, I hope they inform their shareholders of their reasons, which may be quite legitimate. They have held steadfastly throughout the hard times.

I am glad they have started getting traction with online tutoring but I note all the growth came in the first half: I’ll be looking for that to improve over the next half, or I may have concerns. The main reason I would change my view is if they did an acquisition. If this company sticks to its knitting then I would be pleased to remain a shareholder. Even after taking some profits a while back, this is a 6.1% position for me. However, I am not a buyer at today’s price. I consider the stock worth watching, as a potential opportunity, since it does tend to drift down on low volume.

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Disclosure: Claude Walker owns shares in Kip McGrath Education Centres. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Catapult International (ASX:CAT) FY 2018 Results

Claude Walker — Sat, 18 Aug 2018 12:36:50 +0000

Athlete performance monitoring company Catapult International (ASX:CAT) today released its annual report for FY 2018 -- with little for shareholders to smile about.

Losses for the year blew out to a massive $17.3 million, down from $13.6 million last year. A veritable explosion in pay to employees more than explains the difference, with expenditure on salaries and the like up $10 million (or 35%) to $38 million. And that's before you consider the increased occupancy expenses, partially related to a brand new office.

The only bright point was that revenue was up around 25% to over $76 million. I would have thought a company earning this kind of revenue should be able to make profits, so it's very confusing that lost over $17 million over the last 12 months. The company itself commented that "Control over labour and travel expenses remains important to overall organisational productivity given these items accounted for approximately 71% of total operating expenses in FY18".

Shareholders must recall that directors Igor Van De Griendt and Shaun Holthouse sold over $9 million worth of shares between them in January this year at $1.55, after the end of the financial half year, but before the company reported those results. The stock price plummeted when those results were released on February 22. According to the table below Igor Van De Griendt received $407,032 in total remuneration for 2018, and Shaun Holthouse received $336,551.

In the same financial year that they sold stock and received this remuneration, the share price of the company dropped over 60%. Since July 2016, the company has raised capital at $3, then $2, then $1.10. All those who bought those shares in those offerings are now sitting on a paper loss at $1.08. The remuneration report seems to suggest that those two directors will be paid less in the current financial year. However, the chairman Adir Shiffman looks set to receive $300,000 for his services in FY 2019, just as he did in FY 2018.

Importantly, Catapult books costs associated with rental wearable units through its investing cashflow. In 2018 "the Group wrote off rental units with a net book value of $137,290". They also depreciated the existing fleet by $2.3 million but added over $3.1 million, suggesting that charge will rise in the future. There was also $1.5 million in share based remuneration expense. These factors partially explain why cashflow is stronger than statutory profits.

Having said that, it is certainly positive that the company has produced positive operating cashflow, which was $6.4 million for the year. However, free cashflow was negative at -$9.6 million.

Catapult does not make it easy to calculate the number of elite units sold each half or quarter, anymore. However, they said the subscription mix 57% of total units sold and we can see that 5,330 subscription units were sold during the year. This implies about 9350 units for the full year. The company has stopped reporting unit sales quarterly. Therefore, in the chart below, I've assumed that quarterly sales equal 50% of half yearly sales and used the data from the first half to estimate the third and fourth quarters.

I regret having overestimated this business (sorry), and I am tempted to sell my shares just to be done with it. The reality is I made a bad call and I lost money for my readers. I've lost a lot of sleep over the years since I said the stock was a buy.I apologise unreservedly for the error.

While my first mistake was to call it a 'Buy' my second mistake was not to fix the error as soon as the evidence was there that I was off the mark.

I should have been more skeptical, and I should have found the article where the Chairman said 'I feel the excitement around wearables is just general activity fracas and may or may not turn out to be a real market'. And then I should have changed my view to Sell as soon as it became apparent they would invest heavily in that space.

I take some heart, however, that annual recurring revenue grew over 16% to $53.4 million. This is a $200 million company with net cash of over $25 million.

Overall, I remain uninspired by this investment. It has become more of an experiment in psychology and an example that I too am capable of bagholder psychology. However, my thinking is that hypothetically you could fire the board, and some of management, and cut a lot of costs out of the business, and probably achieve margins on 15% quite quickly, albeit without growth. Assuming that the company can maintain revenue of just $50 million in that scenario (which seems conservative given actual revenue was over $75 million), then you could quite plausibly have a company making $7.5 million in profit. If we assume multiple of 10 times earnings then that would probably give us a bottom end price where a financial pirate surely willing to step in to salvage what they may.

The playbook would be to take it private for a low price, dress it up nicely, and then sell it back to public market for perhaps 20x earnings in a few years (having added leverage).

Therefore, I would certainly not tell anyone to buy this stock.

Looking towards a more optimistic outcome, in the hands of more shareholder friendly management, I could see continued revenue growth (adding at least $10m per year) and some cost reductions. In that scenario we could probably have a company making some decent profits in 5 years, which is probably the sort of path that management are implying they are aiming for.

The company says they are "on track to generate positive cash flow at the Group level by FY21." This seems like a low bar given the various dynamics at play that mean cashflow is stronger than profits. It reminds me of "aim for the stars, hit the moon" -- only -- "aim for the toes, hit the ankle".

Probably the most bullish comment in the whole presentation is that they expect "double digit percentage growth in ARR". This reminds me of another company -- Appen (ASX:APX) that expected double digit growth and blew it out of the water. But when Catapult says it, I can't help thinking they mean closer to 10% than 50%. We'll see, I guess.

Even assuming 10% growth, we should see ARR go from $53.4 million to $58.8. At current prices that would put it on 3.4 times recurring revenue. It therefore could not be more evident that the market is rating Catapult as perhaps one of the lowest quality recurring revenue companies on the ASX. I don't believe that is true, so I'll probably keep ~~bag~~holding my shares until the stock trades on (at least) 5 times ARR. However, I'd like to emphasise the point that I really might sell my shares in this company. I may sell without advanced warning: so consider this notice of my utter non-commitment to hold on.

I will however commit to hold on for another week past this very ambivalent post. But psychologically it's hard to justify deploying capital into a company I'm so uninspired by. Mathematically I think it's probably the right decision, but it's hard to say. I'm definitely unsure about this one.

Feel free to vote here to tell me what you think I should do.

Since I have been rather negative about these results, I guess it's only fair to but the other side of the story. I've not had much success getting Catapult management to talk to me (surprise, surprise) so here's what I got for you:

Very proud of Joe Powell, Mark Hall and the team for their achievements in 2018. It’s a wonderful achievement.
Side note: Interesting to hear the different questions on our growth story from institutional investors, often very dependent on where they are based geographically. https://t.co/Y1ILS6G0SX

— Adir Shiffman (@adirshiffman) August 16, 2018

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Disclosure: Claude Walker owns shares in Catapult International. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Energy Action (ASX:EAX) Improving: FY 2018 Annual Results

Claude Walker — Fri, 17 Aug 2018 04:10:08 +0000

Author: Mark Susanto

The CEO of Energy Action (ASX:EAX), Ivan Slavich, continued to put runs on the board in 2018. The energy management consultancy reported the following, yesterday:

Operating NPAT up 3% to $2.6m

Statutory NPAT up 46% to $2.6m

EBITDA up 21% to $5.7mOperating cash flow up by 92% to $6.9m

Revenue decreased by 5% to $31.2m

Net debt reduced by $3.1m to $3.8m

Fully franked dividend of 4c

A Turnaround Story

The turnaround story here is not too uncommon. Energy Action once had a nice little business which was capital light and high margin. Under the old management, the business committed major unforced errors; ‘di-worsification’, neglecting their existing technology, and taking on too much debt. Theirs was a misguided strategy, as we publicly and correctly predicted it would be.

Cue the new management, who do some things right, such as keeping costs under control, marketing their existing business and not acquiring low margin projects businesses.

Keeping costs down is doubly important because they are not experiencing top line growth in most of their businesses. We can see this when we drill down on the main segments. You can see the revenue of each segment, in the chart below:

The Procurement segment

Energy Action helps their client purchase energy through structured products, tenders and the AEX auction. Revenue grew by 15% to $9.3m for the year. Their number of AEX auctions was largely flat, while the number of electricity tenders grew by 18% and gas tenders declined by 22% due to tightness in the market

Contract management and reporting segment

In this segment the company provides services for bill validation and network tariff review. Revenue declined by 9% to $15.1m for 2018. Sites under management has declined due to the loss of a a large, yet low margin contract for 3,100 sites.

Project and advisory services (PAS) segment

Here, the company provides energy project and consulting work for buildings and organisations. Revenue declined by 15% to $6.6m in the last year. There was an active decision here to focus on higher margin consulting work and move away from lower margin supply & install project work.

Despite the top line decreasing by 5%, EAX has increased its margins due to tight control on costs and the move away from low margin project work. Management has said that they will continue to reduce costs through Business Process Outsourcing (BPO) and automation.

The cash generating capability of the business was in full show in this report -- this was the first time they have had positive free cashflow to firm (FCFF) in several years. Without any more deferred consideration payments from past acquisitions weighing on its books, Energy Action has drastically improved its conversion of EBITDA (earnings before interest, tax, depreciation, amortisation) to cashflow. , Indeed, it boasted an EBITDA to cash conversion of 121%.

Another nice thing is that there are no further “one-off” costs that plagued the statutory profit in the years prior to Mr Slavich’s tenure. You can see this in the chart, below. The yellow is the statutory profit, the blue is the profit excluding certain very real costs.

This is not to say that there hasn’t been any restructuring this year. In fact, the company restructured their sales business into a regional sales model, created a product manager role for Energy Metrics, and moved the PAS business to a consultancy arm under a new general manager.

At the current price of 86 cents, I think the stock appears cheap on the following ratios;

However, there are a few things to watch out for. The biggest problem is the lack of revenue growth.

The procurement business, which is the only business that experienced revenue growth this year has done so on the back of average $/MWh doubling over the past 4 years. This is while the number of successful AEX auctions has declined by ~30% over the same time period. If the price of electricity declines significantly in the next few years, I would expect their business to be impacted.

In the contract management business we consider the sites under contract with Energy Metrics to be a key metric, because these services earn higher margins. The number of sites served by Energy Metrics has dropped about 16% over the past 4 years. This was on top of the aforementioned loss of significant contract on the lower margin software.

One concern I have is that the slowing sales may be reflective of some structural headwind that I haven’t managed to identify. If that’s the case, the business could struggle to improve, even once the ship is in order.

Management clearly sees these challenges and they are tackling them head on. Their focus for 2019 is to increase revenue. They will refresh Energy Metrics and develop new procurement products & services. These efforts may mean an increased level of capital expenditure, especially in terms of software development. You can see how spending on software has been increasing, below:

Finally, on 6 August, management flagged a strategic review to consider “various strategic options available to the Company to maximise value for its shareholders…[including] the potential sale, joint venture or merger of the Company with or to another organisation.” They expect this to be done in 6-12 months’ time.

I believe the company is an interesting investment proposition.

Claude tells me he is disappointed to read about the strategic review, since he thinks it is a waste of money. However, he is pleased with how current management are addressing the challenges facing the company, and he will continue to hold his shares.

The author, Mark Susanto owns shares in Energy Action and will be holding for the time being. He may sell in the future if something better comes along but will not sell for at least 2 full trading days following the publication of this article.

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Disclosure: Claude Walker and Mark Susanto owns shares in Energy Action. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Pro Medicus (ASX:PME) Keeps Growing: FY 2018 Annual Results

Claude Walker — Wed, 15 Aug 2018 21:20:31 +0000

Radiology imaging company Pro Medicus (ASX:PME) released its results for the 2018 financial year this morning. These results provide further evidence that this truly is a hidden gem of a company.

The headline revenue growth of 16% to $36 million was in line with the high expectations the market has of this stock. Meanwhile, the statutory profit of just over $12.7 million was assisted by currency tailwinds in the second half. My preferred measure of company profitability is profit adjusted for currency impacts, which was just under $12.6 million in FY 2018. Management continue to demonstrate their integrity by reporting metrics consistently, rather than picking the most favourable metric in any given report.

While the annual underlying profit was strong, I was particularly pleased to see a very strong second half, as you can see below:

Click to enlarge

Of course, long term shareholders take special note of the North American side of the business, since that is where we hope to see fast and sustained sales growth. As you can see below, the second half produced record revenue from the US, and the half on half growth rate rebounded to over 26%.

Click to enlarge

Importantly, shareholders must note that -- across all its divisions -- Pro Medicus receives both implementation and transaction (or licensing) revenue. Implementation revenue is earned as the company installs its systems, whereas the recurring transaction revenue comes over time as the clients uses the product.

In the first half there was less implementation revenue than there was in the second half of 2017, so we saw a slight drop half on half. It's great to see revenue rebound in the second half. That growth has allowed the company to achieve an EBIT (earnings before interest and tax) margin of over 47%. The management team seem proud of this fact and justifiably so.

The loss of key management, board members, and many other long-serving employees remains a key risk to this business. I was therefore pleased to read that the new long term incentive scheme includes a broader base of management and staff. As a reminder, the co-founders of this company -- Sam Hupert (the CEO) and Anthony Hall are both on the board, and control more than 50% of the shares betwixt them. As an aside, Pro Medicus my data (as you can see below) suggests there is low institutional ownership for a company of its size. I believe it is notable that the company's success has made a big difference to many ordinary people who have placed their faith in the team.

Commentary around qualitative business developments was positive in this most recent report. They have not lost any opportunities from their pipeline in the last six months, which is definitely good news. One of the signs that the company retains technology leadership is that it does not lose many contracts. On that subject, the CEO commented that "we believe we still have a 12 to 18 months lead, if not more. It’s not just the technology but also our proven ability to implement in less than a quarter of the time of the industry standard that gives us the edge”.

Therefore, it is also significant that the company can boast that "we are still either on, or ahead of schedule with all our implementations”.

Operating cashflow was flat at $13.9 million, in large part due to an increase in receivables (and a smaller decrease in payables). The large increase in receivables (over $2 million) was because Pro Medicus "pre-agreed to a deferred payment scheme for two clients in order to fit into their budgetary cycles." That is appropriate.

Free cash flow came in at $7.7 million after $6.2 million expenditure on R&D. This cost has grown slowly and sensibly over the years and I am more than willing to back the team that has already created so much value. However, it's well worth noting that expenditure is about $1 million more than depreciation and amortisation, so we'd expect that line item to rise in future periods.

This performance allowed a 50% increase to the (small) dividend. The balance sheet is rock solid with over $25 million in cash.

The Future

There are many indications that the company will continue growing. Some degree of growth is already locked in. For example, the majority of the revenue from the Primary Health (ASX: PRY) contract is expected in FY 2019. Each implementation is different, but there is certainly a lag time between winning a big contract and booking revenues for it. You can see the big contracts that they've announced in the last couple of years, below:

Click to enlarge

The company aims to expand the use case of its core Visage Imaging technology and it has recently made its first sale of its Open Archive product. If the latter follows the pattern of the former, that may open up the possibility of further sales in the next couple of years. That would be a real positive, since the Open Archive product has real potential to make a meaningful contribution to the company.

Looking further into the future the company continues to work with academic institutions to maximise the long term potential of the Visage Imaging platform. This product should be able to incorporate machine learning tools as those technologies develop.

I own shares in this company (my largest single position) and I intend to continue to hold all of them.

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The Author of this piece, Claude Walker, owns shares in Pro Medicus. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

1300 Smiles (ASX:ONT) Stays Steady: FY 2018 Annual Results

Claude Walker — Tue, 14 Aug 2018 06:32:13 +0000

Dental aggregator 1300 Smiles announced a decent set of results today. Here are the highlights:

Over-the-counter revenue up 9.6% to $55.8 million (this includes revenue earned by the self employed dentists that 1300 Smiles provides services to).

Statutory revenue up 8.8% to $39.3 million

Dividends up 4.3% to 24 cents or a trailing twelve month yield of 3.6% based on the current share price.

Earnings-per-share (EPS) up 5% to 32.2 cents

Net profit after tax (NPAT) up 5% to $7.6 million

Free cash flow was $0.2 million compared to $3.6 million last year as the company ramped up its acquisition activity.

Operating cash flow was up 18.2% to $10.4 million

Net cash of $0.3 million

The following chart shows the relatively steady upward trajectory of the company over recent years barring the blip in 2013/2014 which was impacted by the withdrawal of the Chronic Disease Dental Scheme (CDDS). Note there is also a clear seasonality to the business with H1 typically stronger than H2. (Click image to view).

To be honest I’m a little disappointed with these results. I expected more growth given the company acquired five practices during the year on top of the five purchased in 2017.

The following chart shows the revenue contribution of the five acquisitions completed in 2018 split out from the total and the total revenue for 2017.

Clearly there is not much in the way of organic growth in 2018. In fact, the current year should have been boosted by the acquisitions made part way through 2017 so it looks as if the pre-existing business shrank. In particular, two orthodontists which settled on 30 June 2017 would have contributed nothing to 2017 and were expected to generate more than $2 million of revenues a year according to an ASX announcement dated 27 June 2017.

I would like to do a similar analysis for 2016/2017 but I can’t find a breakdown of the revenue contribution for the acquisitions completed in 2017 in the that year’s annual report.

I have some sympathy with the lack of organic growth. The company acquires when times are tough in order to take advantage of low prices and so it stands to reason that the group’s pre-existing businesses would also show some strain at these times. I expect organic growth to return as conditions improve and corporate activity tails off.

1300 Smiles remains a good quality business run by effective capital allocators as shown by the consistently high returns on capital it generates as per the following chart. Note the slump following the CDDS termination and recent declines on the back of the current acquisition spree.

I define return on capital employed (ROCE%) as earnings before interest and tax (EBIT) divided by the average of opening and closing net assets less cash plus debt.

One are worth exploring is the joint venture in Dentist Members Australia (DMA) that was disposed in the year for $400,000. 1300 Smiles previously owned 33% of the company with two other unnamed equal owners (given it is a joint venture rather than a minority interest). Presumably one of the other shareholders is Daryl Holmes as DMA is listed as a related entity in the Directors Remuneration Report.

Dentist Members Australia offers a voucher system to help patients spread the cost of treatment into manageable chunks. The business generated $1.2 million of revenue in 2017 up 30% on 2016 and 1300 Smiles’ share of profit was $88,000. Although this is immaterial in the contexts of the groups current revenues and profits, it hints at a promising beginning for the venture and it would have been good to receive an explanation for the disposal from management.

The nature of the disposal was also noteworthy given it was done through a vendor finance loan provided by 1300 Smiles at a fixed interest rate of 2% compared with in excess of 5% for all of the other loans receivable to the company.

Perhaps I am nitpicking and the bigger picture is that I expect revenue and profit to grow in 2019. This is because of full-year contributions from 2018 acquisitions as well as the Noosa one completed in July 2018. Also, the nine chair facility recently opened in Morayfield should add revenue, if not profit.

At the same time there is the potential for the company to realise synergies from the recent acquisitions improving profit margins. With a PE (price-to-earnings) ratio of around 20 times, the stock looks fairly valued to me given its track record of growing through all types of business environments.

I own 1300 Smiles shares and will be holding for the time being but may sell if something better comes along (I will not sell for at least 2 full trading days following the publication of this article).

As for Claude, he informs me he is content with these results and will continue to hold his shares.

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The Author of this piece, Matt Brazier, owns shares in 1300 Smiles. Claude Walker owns shares in 1300 Smiles. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

GBST Holdings (ASX:GBT) 2018 Annual Results

Matt Brazier — Tue, 14 Aug 2018 02:35:46 +0000

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.

Capilano Honey Ltd (ASX:CZZ) Takeover: Annual Results

Claude Walker — Mon, 13 Aug 2018 00:00:42 +0000

Honey producer and distributor, Capilano Honey (ASX:CZZ) today announced its annual results for the 2018 financial year, as well as a takeover offer priced at $20.04 per share.

Total sales were up around 3.5% to $138 million and profit was up over 15% to $9.8 million on last year's weak result (assuming you exclude a capital gain). However, profit was flat on the 2016 result, indicating a weak growth trend at best. As you can see below, the company has not been successful at growing exports in recent years.

In keeping with recent performance, inventories increased and cashflow was weak, with the company achieving breakeven for the year on a free cashflow level. Thus, while these results were acceptable, they were not particularly positive.

Takeover offer

The interesting news today is that there is a takeover offer at $20.06, as you can see in the announcement below:

This looks like a reasonably good deal for shareholders, since it realises the strategic value of the assets. If the new buyer can accelerate sales to China as planned, they should get the better end of the bargain, but perhaps rightly so. With shares set to open at about $19.50, there may be a small arbitrage opportunity, but that's not something I would bother with. Overall this is a satisfactory end to an Ethical Equities story that started with this post:

Will Capilano Be A Sweet Investment?

I think we can answer in the affirmative.

The Author of this piece, Claude Walker, does not own shares in Capilano. 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

Matt Brazier — Thu, 09 Jul 2015 12:40:18 +0000

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...

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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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Rectifier Technologies (ASX:RFT) and the Anatomy of a 300% Gain (And Counting)

Claude Walker — Sun, 05 Jul 2015 06:12:44 +0000

You didn't think it was me who was buying the Australian rectifier manufacturing company Rectifier Technologies (ASX:RFT) at a price of 0.002, did you?

No -- I'm not that good. But I can vouch for the fact that my good friend who goes by the name of Imran Khan was. And it wouldn't be the first time that I could have blind followed him to a multi bagger, either (not that I recommend blind following anyone, ever). So I'll just get out of the way, and let you read about how he makes a micro-cap multi-bagger investment...

-- Claude

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I first came across Rectifier in 2013 – it wasn’t pretty. Rectifier was trading at two tenths of a cent, had over a billion shares on issue and carried a poor financial track record. Behind the scenes, however, some interesting developments were taking place.

Rectifier was continuing to migrate its manufacturing operations from high cost Melbourne to low cost Malaysia.

During 2013, Rectifier announced a significant product distribution arrangement with a Chinese counter-party (who shortly thereafter became Rectifier’s second largest shareholder), and separately, another sales contract in excess of $1m.

In late 2013, the major shareholder of Rectifier sold down a large portion of its shares at a significant premium (in excess of 100%) to the current share price.

When Rectifier reported their results for the 6 months to 31 December 2013, I was pleasantly surprised to see it report a profit (albeit small) for the first time in a number of periods.

While the market initially welcomed the result, the enthusiasm quickly waned and traders moved on to more exciting targets. Many days, and sometimes weeks, passed without any Rectifier shares trading, and the Rectifier share price continued to languish as a penny dreadful. I continued to place low ball bids, picking up small amounts of Rectifier stock here and there.

If you looked hard enough though, there were signs that, little by little, Rectifier was moving in the right direction.

In April 2014, the company announced the sale of its non-core UK operations in order to reduce debt and focus its attention on Asia Pacific operations.

In June 2014, it announced it had won two Victorian awards for the research and development, and sustainability, features of an innovative new rectifier product, and;

In August 2014, it advised it had secured approval to sell their new rectifier product in China.

This culminated in Rectifier Technologies announcing a positive NPAT result for the 12 months to 30 June 2014 of $576k.

This still wasn’t enough for the market. The poor liquidity saw traders get bored and long term investors lose patience. In January and February 2015 I acquired my final parcels of Rectifier shares at two tenths of a cent – the same price as my initial purchase approximately 18 months earlier.

In late February 2015, leading up to its half-year profit report, all of a sudden stock liquidity began to pick up. Reasonable sized parcels were trading hands and crossings of stock were taking place. After the market closed on Friday 27 February 2015, Rectifier reported a normalised EBITDA for the 6 months to 31 December 2014 of $473k and positive operating cash flows of $633k. Rectifier mentioned that they were continuing to develop new products and increase sales, including in the fast growing and ‘sexy’ electrical vehicle charging market.

Bang.

The following Monday saw Rectifier open at 0.5 cents and by the following week had reached 1.1 cents. A major re-rating was taking place. Shares most recently closed at 0.007, and have traded as high as 0.011.

The investment case in Rectifier continues to improve. In June 2015, Rectifier announced they had signed a contract to manufacture a customised rectifier for an Australian customer, which was expected to deliver in excess of $3.5m over 3 years.

This was followed by Rectifier, for the second year in a row, receiving an award in the Victorian i-Awards for Rectifier’s new high efficiency electrical vehicle charger rectifier – further evidence of the success of Rectifier’s research and development efforts.

While the Rectifier share price continues to be volatile, the days of Rectifier Technologies at two tenths of a cent would appear to have passed.

The "RFT journey" -- as I think of it -- is a good example of micro-cap investing. Some of my key take-outs from this investment could also apply micro-cap investing more generally. They are:

There are some genuine diamonds in the rough opportunities on the ASX – one needs to look hard to uncover them. By the time they become popular ‘names’, the easy money has usually been well and truly made.

Position sizing is always important if you want to sleep well at night. This is particularly the case with illiquid, non-dividend paying, micro-cap stocks with less than stellar track records. The beauty of investing small amounts in a basket of such opportunities, is that it only takes one stock to really come good to generate over-sized portfolio returns.

Following a stock closely over a long period of time puts you in a very good position to see the incremental steps a company has taken to get where it is today; rather than just viewing a company purely as what it is today (for a growing company, the 'how' is more important that the 'what').

Illiquidity can work in your favour – poor liquidity can scare away many potential investors who would otherwise be competing with you for stock. As far as selling is concerned, liquidity events do happen - most stocks won’t stay illiquid forever.

Disclosure: Imran Khan (the author) holds Rectifier Technologies shares. Claude Walker (introduction only) also owns (a very small holding) of Rectifier Technologies shares. Nothing on this website is advice ever. It is a place to share stories and discuss investing in ethical companies.

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Is 1300 Smiles Limited (ASX:ONT) the best stock for ethical investors?

Claude Walker — Sun, 12 Oct 2014 12:47:40 +0000

I won't be posting much research on this website for a while, so it's fitting that I bow out with a public note on 1300 Smiles Limited (ASX: ONT).

But first, let me declare my bias. I like Dr Daryl Holmes, the CEO, on a personal level - he seems like a trustworthy person, and not just because of the exceptional value he has created for shareholders.

One CEO I quite like has a private driver whisk him away from the AGM - taking two beers for the road. Another has his own super yacht. But 1300 Smiles has a CEO who catches the train to meetings with bankers and speaks proudly of the charity boat he has helped fund and also helps staff as a dentist. As with Australian Ethical Investments Limited (ASX: AEF), not only are 1300 Smiles shareholders automatic philanthropists, but the profitable activities of the company help build a better society. That's because the company's strategy is to make dentistry services accessible to the widest possible segment of society, by keeping costs low.

It's the personnel - all of them - that make this company great, but shareholders and patients are also conspiring to support a good cause, because 5% of the ongoing payments received from all new members in the 1300 Smiles $1-a day Dental Care Plan are donated to YWAM Medical Ships. This ongoing funding will assist YWAM to address critical oral health problems in some of PNG’s most remote and vulnerable communities.

And before I touch on my recent chat with Dr Holmes, we should take a quick look at his best yet annual letter to shareholders. I particularly recommend his soap-box moments - they are essential to understand the numbers.

But first, here's my favourite bit (click image to enlarge):

Update 27/11/2014 -- The company has kindly included an updated graph of the Dental Care Plan Members in the AGM address by Dr Daryl Holmes (which I suggest you read).

And of course, we shareholders should always keep an eye on this important metric (click image to enlarge):

I met with Dr Holmes recently for a coffee and we covered a few different topics - nothing you can't find for yourself. However, I will give some of my impressions.

It seems possible debt might come into the mix again, now that the company is running a bit low on cash, after the excellent BOH Dental acquisition. As you might have guessed from past history, the company would consider taking alone if the right opportunity to acquire presents before cash is replenished. Dr Holmes attitude towards debt seems not to have changed.

On the subject of acquisitions, once you talk to Dr Holmes in person you can really see that he's still happy with the BOH acquisition - certainly, it appears we have brought on board some of the foremost talent in the industry. Even when some of the older dentists retire (and this goes for multiple practices) there seems to be top performing younger dentists ready to fill their shoes.

Like me, Dr Holmes is pleased with the recurring revenue generated by the Dental Health Care Plan, although we do take some credit risk with that one - a fact often forgotten in good times. Nonetheless, the inspired program is bringing in millions of dollars a year already, and it hasn't even been running for long! Shhhh....

As for valuation, well, I'm not in the mood to share, but I will say I am considering entering the market again myself (as a buyer, if this current sell-down spreads). We shareholders remain stubbornly attached to our holdings.

Possibly the biggest single reason for that is the top-notch capital allocator running the show. Buying a share in 1300 Smiles is giving your capital to Dr Holmes and his team to allocate it as they see fit. History shows that they buy and run dental practices profitably, with an eye to community wellbeing, and charitable hearts. At current prices, the dividend is superior to a bank account if you take into account franking credits, and I expect it will grow over time. I would rate the chances of shareholders being treated poorly as low.

One thing I thought was interesting is when asked about the company's investment in Dental Members Australia, Dr Holmes simply said it was an opportunistic bargain. The way I see it, if he keeps gradually expanding his circle of capital allocation competence, shareholders will probably do very well over time.

Thanks for reading everyone, but we're out of time.

The Author owns shares in 1300 Smiles. Nothing on this website is advice, ever. This post is for entertainment (and for my own reference!)

Please do follow me on twitter @claudedwalker.

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More evidence that Cochlear Limited (ASX:COH) is an ethical investment.

Claude Walker — Mon, 08 Sep 2014 11:44:37 +0000

When I came into ethical investing I knew people would have different ethics. But if there was one company I thought thought we could agree on, it was Cochlear Limited (ASX: COH), a company builds hearing aids as well as generating good profits for shareholders.

But since The Intelligent Investor argues Cochlear might be unethical, I thought I'd post a video of a kid getting hearing from a hearing aid. I wonder if people at Cochlear sit around thinking, "let's build less hearing aids, and put the price up." Somehow, I doubt it, but if you work at Cochlear, please let me know!

Watch a seven week old get his first hearing aid, here.

(and props to the person running the Australian Ethical Investments facebook page – disclosure, I hold shares in Australian Ethical)