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Pro Medicus (ASX:PME) 1H FY2020 First Half Results Analysis

Claude Walker — Wed, 12 Feb 2020 23:32:58 +0000

Over the years, Ethical Equities has written plenty about Pro Medicus (ASX:PME). We received more feedback on that one stock than any other.

Importantly, Ethical Equities is now archived as a website, and exists as a column within A Rich Life, a new periodical covering arts, culture, philosophy and ethical investing.

Happily, if you're interested, you can therefore read coverage of the Pro Medicus (ASX:PME) 1st Half FY 2020 Results on that new website.

- Claude

List of Ethical Investment Funds

Claude Walker — Fri, 08 Nov 2019 02:03:42 +0000

A List Of Ethical Investment Funds In Australia

One of the pleasing developments I've noticed over the last few years is the continually expanding selection of ethical funds available to Australian investors. But unfortunately, some funds could be considered to have much stronger ethical policies than others. For example, AMP Limited (ASX:AMP) has a fund called "The AMP Capital Ethical Leaders Fund".

When the Ethical Advisor's Co-op reviewed the fund, they found that it invested significant amounts of money in fossil fuel companies and -- to rub salt in the wound -- they apparently used their shares to vote against a variety of environmentally conscious resolutions put forward by activists. The reason I think this is problematic is that I believe some investors in the fund might assume that "ethical leaders" would not include fossil fuel companies. But hey, millennials don't make the rules, do they?

In any event, I've enjoyed discovering the Ethical Advisor's Co-op "leaf ratings", and so thought I'd incorporate them into this short list of some of the ethical managed funds available in Australia.

BetaShares Global Sustainability Leaders ETF and the BetaShares Australian Sustainability Leaders ETF

These publicly traded ASX ETF basically apply a fairly stringent negative scan, including avoiding companies that are major financiers of fossil fuel projects.

The Ethical Advisors Co-op gives it 4.5 leaves out of 5.

Australian Ethical Emerging Companies Fund

Australian Ethical launched this fund a few years ago, tracking its benchmark for much of that time, before opening up a solid lead more recently, with a gain of 19.9% in the twelve months to August 2019.

The Ethical Advisors Co-op gives it 4.5 leaves out of 5.

Nanuk New World Fund

This is a global fund in operation since 2015 has handily outperformed its benchmark, generating over 14% per annum for investors.

The Ethical Advisors Co-op gives it 4 leaves out of 5, the best result of any global managed fund, from what I could tell.

Samuel Terry Asset Management

The Top performing Samuel Terry Absolute Return fund recently showed themselves to be very ethical investors! They said:

"During the year, we formalised a previously informal policy of not investing in businesses primarily engaged in the following activities: Thermal coal (i.e. coal for electricity production – coal for steel is not excluded), Tobacco, Gambling, and Lending to poor people at very high interest rates.

We recognise that this policy will not please everyone. Some say that it is not our job as fund managers to make moral judgements with your money. Others say that we should exclude other sectors such as oil production. However, this is the basis upon which we have been investing for some time, so we believe it is time to articulate our policy."

It is not yet rated by the Ethical Advisor's Co-op.

MX Capital

Run by star stock picker Weimin Xie. Avoids companies that are damaging to human society, violation of animal rights, human rights violations, un-remediated destruction of the environment. I invest in this fund.

It is not yet rated by the Ethical Advisor's Co-op.

Personally, I look forward to seeing the Co-op develop their fund rating system further, you can check their list here.

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

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

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

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

Ecofibre Ltd Quarterly Cash Flows and the Quest for Controlled Growth

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

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

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

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

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

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

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

Operational and other developments

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

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

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

Quick thoughts on Valuation and closing thoughts

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

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

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

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

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

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

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

That Time I Got Lucky, Anatomy Of My Pro Medicus (ASX:PME) Investment

Claude Walker — Tue, 08 Oct 2019 22:00:57 +0000

An Ethical Equities Supporter has requested I do more case studies of investments I've made in the past, which I think is good for learning, so here is the first one.

The Process

I came across Pro Medicus because I have two beliefs about the long term future.

Software is eating the world
Healthcare is the best defensive industry

So I was looking for companies that were working in software and healthcare.

I also look for:

Insider buying
High Insider ownership
Profit and dividends.

Pro Medicus in 2013

Made $5 million in profit, market cap of <$50 million.

However, on an underlying basis, only made about $1 million in profit.

The big profit was because it sold its part of its Amira business (which it bought in 2009), for a multi-million dollar profit.

It sold the software, but it kept the team of software developers that built the software -- they were now working on software for the visualisation of large radiology files: Visage 7.

https://www.youtube.com/watch?v=idCQOUHv7Q4

Pro Medicus in 2014

In October 2013, PME made its first sale of Visage 7, worth $4 million.

Then, in April 2014 it announced a 6 year deal worth $20 million. This was the inflection point.

In July I bought shares. In August it reported profit of $1.5 million (ie, an improvement on the year before, backing out Amira proceeds). It had a market cap of about $90 m, plus over $20 million in the bank.

If you adjust for the cash, it was trading on EV to Earnings of about 46 times -- so it was definitely not cheap on the past metrics. It announced another deal in November, worth $8m. CEO said gross margins on these deals would be around 80%.

Importantly, both founders were involved in the business, and insiders were buying shares in the business, despite already controlling over 60% of the shares.

The CEO was willing to take time to explain the business to a little-young-nobody like me. My research indicated that both founders sourced some of their energy for life and work activities, from pride and passion. This is important because if majority owners are motivated only by money then they will not share the spoils of success fairly with minority shareholders.

Looking to the numbers; forward gross margins of around $25m had been won in the space of 1 year of launching Visage 7, while the company's entire enterprise value was around $100m.

It was clear if the company kept winning Visage contracts then it was extremely cheap. While I did of course perform a discounted cash flow valuation, the undervaluation this was extremely obvious, given the material gross profit uplift caused by each new contract, and the fact that the company was profitable already. The only it needed to do to be very undervalued, was to keep winning Visage contracts. The key question was whether it would. Given that it was well publicised the entire healthcare industry was moving towards deconstructed picture archiving and communication systems, there was a technological tailwind driving adoption. Thus, further wins seemed likely.

The Journey Since Then

As the company continued to win contracts and grow revenue, the market begun pricing in further wins. Whereas in late 2013 the price arguably reflected announced wins, rather than future wins, by 2019 the price arguably reflects many future wins, including both Visage and the Vendor Neutral Archive product. In this way, the market has become more optimistic and is now willing to pay a higher multiple of (much increased) earnings. You can see in the chart how I've traded the stock over the years. I still hold despite seeing it as too richly valued -- see here for my lament on why.

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Disclosure: The author owns shares in Pro Medicus.

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

Elixinol Global (ASX:EXL) HY 2019 Stock Analysis

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

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

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

Financial performance 2019YTD

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

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

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

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

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

Significant increase in competitive activity

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

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

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

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

Accelerating global expansion and significant new investments

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

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

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

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

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

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

Closing thoughts = highwire tightrope

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

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

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

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

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

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

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

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

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

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

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

It's Time To Die, Livehire (ASX:LVH)

Claude Walker — Mon, 23 Sep 2019 02:55:49 +0000

Time To Die, Livehire (ASX:LVH)

Livehire (ASX:LVH) is a “talent management technology company” with a market capitalisation of $84 million at the current share price of $0.285. The company has around $35 million in cash which we believe should be returned to shareholders since we believe the business is destined to fail and the business itself is worth nothing, at best.

The Livehire Business Model

We believe Livehire’s core value proposition is to sell companies contact with potential employees. It calls these potential employees ‘talent communities’, but the actual product is simply information about, and access to, those people who make up the ‘talent communities’. Livehire charges its customer about 50 cents per ‘potential employee’ per month, for the right to access information about them, and reach out to them. You can see an example of how this might manifest, from the Livehire Facebook page, below.

Now, the real question here is how Livehire built up its database of potential employees. Indeed, Whirlpool user “Invictus” asked that very question quite some time ago (in 2015).

Perhaps the best answer came from whirlpool user “Antonluigi”, who claims to work for Livehire and happens to share a name with the founder and CEO.

However, while this answer is a lot of fun to read, it doesn’t actually answer the question of how Livehire was able to make the ‘private connection’ to a potential employee, in the first place. In the image below, Daniela from Livehire once explained that a profile is only created once an employee accepts an invitation to join a talent community. But the question remains; how did Livehire get the details of that person which were required to invite them to the talent community in the first place?

Judging from the prospectus, it seems that Livehire makes contact with potential employees ‘on behalf of’ any (client) company to which they had previously applied for a job.

Now, we’re not sure about this, but it seems that once clients have accepted entry into one ‘talent community’, simply by clicking on a link, then their ‘profile’ becomes available for all Livehire’s customers to invite to their own talent community. Now, what sort of information might that profile contain? Let’s look, again, to the prospectus:

We can scarcely believe it's the case, but it seems to us that Livehire has managed to sell access to former applicants back to the very employers they already applied to, for 50 cents per month, all while creating the potential for brand damage for those blue-chip customers (if the posts above are anything to go by).

Questions for Livehire Chairman Mr Michael Rennie

Are all applicants whose information is shared with Livehire by your customers clearly informed that if they agreed to create a Livehire profile, then they would receive personal messages asking them to expose their CVs to other customers of Livehire?

Did they opt-in to receive that contact from Livehire?

Do you check they have opted in or do you simply assume your customers have had them opt in?

Even if your customers such as Tree Of Life and Little Real Estate do pay you $6 per year to access potential employees, how do the economics of this business ever stack up? Why is it worthwhile for customers to pay $6 a year simply to invite 'workers' to apply for jobs?

It’s hard to believe high value employees would willingly be part of this system. What percentage of jobs placed through your talent communities go to employees with a salary over $100,000?

How does this business ever scale? In FY 2018 the company lost over $10 million to achieve revenue growth of around $1 million in FY 2019, during which the company lost over $14 million. With privacy laws only getting tighter, how can you hope to continue to convince employers to provide you with applicants' details?

Under the privacy act, an entity must not collect sensitive information about an individual unless the individual consents to the collection of the information and if the entity is an agency—the information is reasonably necessary for, or directly related to, one or more of the entity’s functions or activities. Does Livehire hold sensitive information within CVs and if so, does it have evidence of express permission to hold that information? Or do you believe that simply assuming that your clients have gained that permission would suffice in this regard?

Livehire often talks about growth in ‘talent community connections’ but how much is your list of potential employees growing, by which we mean the list of email addresses (and or mobile phone numbers) that you can message to invite to join a ‘talent community’?

Finally, would it not be better simply to wind up the company and return what remains of its cash back to shareholders?

Disclosure: the author is neither short Liverhire, nor does he own shares in Livehire .

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

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

3 Investing Mistakes I Made So You Don't Have To

Whitney Higginson — Wed, 18 Sep 2019 05:17:30 +0000

3 Investing Mistakes I Made So You Don't Have To

In 2016 I opened a trading account deposited $3,000 and bought shares in Resapp (ASX:RAP) and Fastbrick Robotics (ASX: FBR). RAP & FBR were companies supposedly spearheading innovation in their respective industries - RAP had developed new technology to diagnose and manage respiratory diseases, and FBR created the world’s first fully automated robotic bricklayer. Over the following months, I watched in horror as the share prices fell and wiped out most of my money.

This certainly wasn’t what I expected, and I didn’t understand what happened.

Faced with a screen of red, I was not only frustrated that I hadn’t made any money on what I believed to be promising investments, but I was also completely discouraged from investing altogether.

When I spoke to friends and family about what happened, I was met with remarks of share trading being akin to gambling.

I cashed out whatever money was left and deleted the app.

I had, in retrospect, just learnt the most sobering lesson of all: investing is not a get rich quick scheme, nor is it as simple or as easy as the financial media headlines tout.*

I returned to the market this year, determined to give it another shot. After a 3-year hiatus I was ready to reflect on the investing decisions I made in 2016: where had it all gone wrong? With the benefit of hindsight, I believe that these are the three mistakes I made back then, and below is how my thinking has since evolved on each:

I got swept up in euphoria

It’s very easy to get overwhelmed by how little you know when you first invest in the market, and to automatically accept that those who write about investing must know what they’re talking about. I mistakenly turned towards the market to guide my investing decisions – using price action and momentum as a signal of quality - thinking that if I followed the crowd I would make a profit because everyone invests with the same goal in mind, right?

What I hadn’t appreciated back then is that the market is much like a storytelling device; when a share price increases, people are telling positive stories about that company and when a share price decreases, people are more negative about that company.

Every investor is making decisions based on their varying knowledge and experience, and we all operate with a level of uncertainty. Unfortunately, every single one of us human investors is wired to be emotional, and thus the market is often driven by irrational fear and greed rather than by calm analysis – even impacting experienced money managers with many years of experience. When people are really positive about the market, they are driven by greed and when people are negative about the market, they are generally selling out of fear. Listening to the market is just about the worst thing you can do as it often traps you into buying high and selling low.

I invested in companies that had favourable coverage and publicity, and a growing crowd of increasingly enthusiastic investors. Some wisened investors say that by the time a company appears in the press the “easiest money” has already been made and that early buyers will use the opportunity to sell at rich prices to the newcomers. At the point where investor frenzy peaks, chances are that even the most optimistic expectations have already been built into the price. So unfortunately, I invested during the All Time Highs for both companies. You can guess what happened next: the price inevitably came crashing down when market sentiment changed.

Listening to the market and not developing your own reasons for investing in a company puts you at risk of not understanding why/when market sentiment changes and leaves you exposed to more irrational decision-making when the market swings. Invest in companies and understand the potential catalysts for future share price upside, not because you think the market is going to go up. Furthermore, as investors, we need to know precisely why we are invested in a stock and what we expect to happen – so that we can be ready to sell if things don’t turn out as expected.

I invested in longshot companies

As a bright-eyed rookie wanting to do some good and maybe help change the world, I was sucked into investing in multiple longshot companies.

The profile of a longshot company is often like this: it is on the brink of solving a big universal problem and the solution is normally complicated beyond measure and impressively innovative. No other company has achieved this before. The longshot company is marketed in a way that grabs news headlines and appeals to our emotions. It makes sense why investors flock to invest in longshots: deep down, we all have this desire to make the world a better place, right?

Longshot companies with new tech/drugs typically have extensive clinical testing, approval & regulation hurdles to pass which can take years. This also means there’s no guarantee the solution actually works, and a long development process can often mean multiple capital raisings which continually dilute long-suffering shareholders. If a long shot company (and its management team) has no established record of innovation or products in market, it’s possible that shareholder funding is not being used in the most optimal fashion and that there may not even be a world changing technology or drug at the end of the rainbow!

I can now confirm: I did not change the world but I did lose money. Unfortunately, changing the world comes at a cost if it doesn’t work out, and it’s often at the expense of the retail investor.

The market values usually companies based on two things: growth and profitability. Longshot companies are normally so early in development that they have neither, and so the market then ascribes a speculative valuation based on potential – which is more fluid than hard science and can be inaccurate by orders of magnitude. This means it could take years for investors in early stage companies to ever see their company begin to generate meaningful profits, and if you happen to buy into one of these longshot companies near a share price peak, it could take years to see a meaningful return on capital. Longshot companies are by definition inherently risky as an investment proposition, especially if you have little understanding of the solution and industry.

Yet it’s hard not to get swayed by the alluring story and dazzling prospectus of a longshot company. FOMO starts to creep in and the desire to be a part of The Next Big Thing (read: it almost never is) takes over any rational decision-making. Some recent examples of this on the ASX include lithium, fintech and payment solutions, and cannabis. When I feel the early stages of FOMO myself, I put the company on a watch list and patiently wait to see a record of earnings. Sure, I might miss investing in the company at a lower valuation, but waiting for earnings minimises risk, protects my cash and allows me to focus on other opportunities in the market. As many people have said, stocks are like buses – miss one and another opportunity will be along shortly!

I didn’t have a clear strategy

There are unlimited opportunities in the market and many different ways of making money. Not having a clear idea of where I wanted to focus my attention and money left me at the mercy of emotional & irrational decision-making every time I checked the share price. I was trigger-happy; ready to buy and sell shares every time a new announcement appeared on my screen. On top of this, I was investing in industries that I had no knowledge or competence in. We all know how that ends.

Investing is an art, and art is all about selection.

Take advantage of what you already know and use this as a starting point to refine your own investment strategy. The beauty of investing is that there is no single ‘right’ way. Finding an approach that compliments your psychology is instrumental in future successes.

The uncomfortable reality of investing is that every single person makes mistakes and loses money. Even the best investors make mistakes, and sometimes repeat the same ones over and over. Part of the challenge is accepting this, and viewing mistakes as learning opportunities.

Self-reflecting on my mistakes is the single most important tool to help me continually refine my own investment process and make more informed decisions. It has added structure to my approach, enforced discipline and helped uncover blind spots.

And hey, hopefully reading about my mistakes and my subsequent learnings can help inform your investment process further.

*In reference to those viral tweets that do the rounds every year telling us we all could have been millionaires by now had we only invested $1,000 in Amazon/Apple stocks in the 90s and held for 20 years though the tech bubble, the GFC and general market swings. So easy, right? As many authors have noted recently, it is very unlikely that there are many original Amazon investors left from the 1990s – given the ~90% share price plunge following the Dotcom crash, it would have required extreme intestinal fortitude and nerves of steel to hold onto your AMZN shares when so much of the financial media was predicting its doom at the time! So I’ve learned to take such articles with a grain of salt…

Disclosure: the author does not own shares in Resapp or Fastbrick Robotics.

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

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

How To Calculate Free Cash Flow And 2 Rules To Avoid The Hype Trap

Claude Walker — Mon, 09 Sep 2019 00:04:20 +0000

I recently shared "2 Rules To Avoid The Hype Trap" with Ethical Equities Supporters. Following those rules requires that investors can establish revenue growth, free cash flow and profit from the primary documents. It is always important to take these numbers from the accounts themselves, because companies will often highlight misleading adjusted numbers in their presentations, not the statutory numbers.

How To Calculate True Free Cashflow

Free cash flow = operating cash flow minus investing cashflow. You can get this information from the cashflow statement in a company's annual report. Let's look at Livehire (ASX:LVH) as an example. Below is their cashflow statement from page 31 in their annual report.

Livehire's free cash flow for FY 2019 is -$9,877,307 -$1,259,530 = $-11,136,837 (the blue boxes). Since that is a negative number, we can surmise that the company has free cash outflow (or negative free cash flow) of about $11.1 million. That means that the company used up $11.1 million in its operations over FY 2019.

Now that is the "pure" or "true" free cash flow number. However, we may wish to make adjustments that would reflect free cash flow without certain benefits or costs that we might consider to be one-off or unsustainable. I've highlighted some such values with the pink arrows. You could also adjust for big changes in the receivables and payables (check the balance sheet for that) or share based payments to employees (check the profit and loss statement for that). Knowing when to make this adjustments can be important for valuation, and can be complex and subjective, but it doesn't matter much for the purpose of this exercise.

How To Calculate Operating Revenue Growth And Ascertain Statutory Continuing Profit

The next step is too look at how much it grew revenue in the same year that it spent $11.1 million. For that, we'll look at the income statement, below, from page 28 of the annual report.

Calculate the operating revenue growth by subtracting last year's revenue from this year's revenue (top blue boxes). In this case, that is: $2,622,814 - $1,650,517 = $972,297. We can then use that revenue growth of $972,297 to calculate a percentage growth rate by dividing the growth amount by last year's revenue, like this: $972,297 divided by $1,650,517 = 0.589086328707914 = 59%. Of course, a revenue growth rate of 59% is neither good nor bad on its own, since it depends on all the context (such as whether it was off a low base, and how much the company spent to get that result).

Finally, it's also important to identify the true profit from the profit and loss statement statement (the bottom blue box). We can see Livehire has a loss of over $13 million.

2 Rules To Avoid The Hype Trap

On the ASX, there are plenty of companies that exist for years, and continuously raise capital. Their businesses are never really going to take off, but they usually have some glossy presentations, a great story about some amazing technology, cannabis-related business model, or mining tenement. Many (but not all) of these stocks (which can eventually fall 90% or more) can be avoided if you follow the two rules below. If you've had less than three years investing experience, or still consider yourself a beginner, then I recommend applying these rules to the vast majority of your portfolio.

Rule 1: Generally only ever buy stocks with positive free cash flow, profit, and growing revenue.

Rule 2: If you break rule one, only do it if the company had at least $10 million in revenue in the trailing financial year.

If I had applied these rules to my investing I would have avoided only a few of my winners, so I don't believe the price of restricting oneself in this way is very high.

Disclosure: the author does not own shares in Livehire (ASX:LVH).

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

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

Appen (ASX:APX) FY 2019 Results Analysis

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

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

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

Figure Eight

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

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

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

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

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

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

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

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

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

1H19 results

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

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

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

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

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

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

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

FY19 guidance vs. Appen’s earnings upgrade history

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

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

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

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

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

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

China’s increasing importance in AI

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

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

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

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

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

Closing thoughts

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

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

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

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

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

_______

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

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

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

Dicker Data (ASX:DDR) HY 2019 Half Year Results Analysis

Claude Walker — Thu, 29 Aug 2019 22:14:38 +0000

Dicker Data (ASX:DDR) HY 2019 Results Analysis

On Friday last week, IT distributor Dicker Data (ASX:DDR) reported its results for the first half of 2019, demonstrating that it remains a great source of funding for its co-founder’s private race track and superfast racing cars.

Plenty of credit must go to the operational team along with the employees more generally, who have shown in this half what they can achieve if the facility is running at close to capacity. Revenue was up about 19% of the prior corresponding period while earnings per share gained close to 50%, thanks to record-breaking margins.

I agree with my friend Tony Hansen that this is partly a demonstration how cramped they are in the current facility and suggests that expenditure on new staff isn't being made as they don't have the room. Therefore, it seems unlikely this NPAT margin will be maintained as the company gears up for another growth leap with its new facility. In any event, you can see how the profit spiked in the most recent half, in the graph below:

Operationally, it was good to see a good rebound in NZ revenue, which was a key target for COO Vladimir Mitnovetski to improve on after the company suffered a set-back there in losing one distribution agreement, a couple of years ago. In my observation this is a team that usually achieves its stated goals.

Free cash flow came in at $13.8 million, which is obviously below profit, due in large part to a massive build-up of receivables. Cynics among us might quite fairly object to this and in my view the worst decision the business has made in the last few years is to offer “by-the-month payment solutions that can be specifically tailored to suit our partners and their customers’ varying needs” which “will be underpinned by DDR’s own balance sheet”. Ironically, I actually do trust CFO Mary Stojcevski to run this program sensibly, but I nonetheless think it increases risk for the company and probably creates a negative narrative that is suboptimal.

Having said that, I would expect nothing less from the board of Dicker Data who seem to do exactly whatever they want and don’t worry too much about what analysts think. Usually, this would be entirely unacceptable but when you take no salary and pay out 100% of earnings as a dividend then you have proven alignment with shareholders so in my view you earn that right. The main ramification of all this is that if Mary or Vlad quits I think I will sell most or all of my shares in a hurry.

Speaking of dividends, the company maintained the 5 cents quarterly dividend, putting the company on a trailing yield of 3.2% at yesterday’s close of $6.66 (someone has a sense of humour with that pricing). I’m forecasting the dividend to increase, with a final dividend to increase for the fourth quarter, potentially by a meaningful amount.

At current prices, I think that Dicker Data is roughly fairly valued. I could see myself selling some shares at around $7, but I’m not in a massive hurry. I’m not sure if I would be a seller at current prices. It has re-rated by well over 100% since I called it my preferred dividend stock for November 2018. I was buying around that time, with my last purchase in January 2019, and I might be more motivated to sell once a tick past the one year holding period.

Potential Upside

This analysis has characterised the extremely strong improvement in margins as unsustainable. I think that is the case, but also note that the company said, it is “moving even more so to becoming a solution aggregator business focusing on strong value added services for our vendors and partners”. This approach should lead to higher margins, so it is possible that the company will actually be able to keep margins above historical levels. This hypothesis is consistent with the multiple on-market purchases of shares by COO Vlad and CFO Mary, over the last year. If it comes true, I will be pleased.

Potential Downside

Dicker Data is gearing up to move to a bigger facility. This is the correct move as it will allow the business to continue growing over time. However, this kind of transition always comes with risks and is likely to depress profit growth, if not profit itself, during the transition period. As you can see in the chart above, Dicker Data has previously depressed its profit when undergoing a transition period in 2014. Keep in mind that the company has net debt of over $100 million, and historically pays out 100% of earnings as a dividend, which necessitates borrowing. In a period of declining profits (but increasing revenue) the company might face some funding difficulties, although I think that reasonably unlikely. The announced sale of the Kurnell property for $36 million will help in this regard.

Conclusion

I continue to like Dicker Data as a business although I am not likely to be a buyer at current prices.

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Disclosure: Claude Walker owns shares as disclosed and will not trade any for at least 2 days after publication of this article.

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

Vista Group (ASX:VGL) HY 2019 Results: Valuation Downgrade

Claude Walker — Thu, 29 Aug 2019 06:00:52 +0000

Vista Group HY 2019 Results and Valuation Downgrade

This morning Vista Group (ASX:VGL) reported its results for the first half of 2019 and they were very disappointing, sending the shares down by about 30% to $3.60 (AUD), at the time of writing. Please note, all currency below is NZD unless stated otherwise.

As a reminder Vista software provides modules for stocking food and drink, mobile ticket scanning, web bookings, loyalty programs, and assessing the performance of specific movie titles. It has a huge global market share, as you can see in the map below.

While revenue did grow by over 10% on the prior corresponding period, to $67 million, that was down slightly on the second half of 2018 (recall that Vista reports on the calendar year). The core vista cinema software did reasonably well, but Movio saw its EBITDA contribution fall back, as did the earlier-stage investments. You can see what I mean in the graph below.

Looking to the bottom line, there was absolute carnage, with a $5 million increase in administrative costs leading to reduced profit (excluding currency impacts), which came in at $4.1 million for the half, down on $5.7 million last year. Probably the most concerning aspect of this result for me is that I would have preferred if management showed more cost discipline. On the call, the CEO called out the “Biennial customer conference” as one reason administrative costs went up, and also seemed to imply that revenue was less than hoped, commenting that, “one of the elements of a business such as this is that the timing of revenue doesn’t always fall exactly as we would like”.

Free cashflow unfortunately went negative, with an outflow of around $3.4 million, due to weak operating cashflow, the derecognition of one partly owned subsidiary’s cash balance, and increased software development expenditure.

One of the issues with Vista Group is that it is on an old software model and not a recurring software as a service model. The company says it has $41 million of recurring revenue during the half. That would imply annualised recurring revenue of around $80 million. Compared to other growing software companies, then, Vista would not seem particularly over-priced after todays share price fall, which puts it on around 8 times hypothetical annualised recurring revenue.

The bigger news from today’s release was that the company will go to 100% SaaS “as fast as we can”. This process will incur substantial short term pain for substantial long term gain. I hate to say it, but it is probably the right move, and the company should probably have done it a long time ago. It is a testament to its business model that it has been able to tie up so much of the market without a proper core SaaS model. The reason for this is a proper SaaS offering will enable it to roll out upgrades to clients much more regularly and cheaply. This in turn will maximise the benefit they gain from the cinema management software.

Conclusion

I have previously outlined why I was holding my Vista shares, and valued them at “about $5 Australian”. Unfortunately, it seems like I was wrong on that valuation, at least in the short term, and I apologise to anyone who relied on it. If I had sold at that price, I’d be 28% better off on the holding. I feel very bad for getting this one wrong.

Having said that, I still think that the company will emerge from this ordeal quite a bit strong. Compared to other entrenched enterprise software stocks, I think it is quite attractively priced. Even so, I am now lowering my valuation to about $3.10 Australian, which means it is not attractively priced at the current price of $3.65.

Over the next week, I plan to sell some of my Vista Group shares, since it is still a reasonably big holding for me, even after getting smashed today. I’m not sure how many I will sell, and I don’t know what the price on offer will be. I think one day shares will be worth a fair bit more than the current price, if they can execute on the business transformation to fully SaaS. However, I believe the time to buy will be once there is evidence they can execute well.

I currently intend to hold at least some shares for the whole journey, or until it becomes clear they will fail on execution. If it looks like they are succeeding, I will try to buy back my shares.

I am very disappointed in this investment, and I think it will be one of my bigger losses this year. However, that’s what happens sometimes on the stock market sometimes. I am nonetheless, very sorry to my readers and listeners.

Disclosure: Claude Walker owns shares in Vista Group and is planning to reduce his holding soon.

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

Nanosonics (ASX:NAN) FY 2019 Results Analysis: Shortsellers Ruthlessly Owned

Claude Walker — Tue, 27 Aug 2019 22:41:56 +0000

Nanosonics (ASX:ASX) FY 2019 Full Year Results Analysis

We joined the Nanosonics (ASX:NAN) journey at Ethical Equities when we published this report predicting a short squeeze last year, when the price was around $2.60. Yesterday, the company, which sells the Trophon device and associated consumables, has delivered a record full year result for FY 2019. That saw its share price spike 32% to close at $6.50. You can hear me outline the (old) short squeeze thesis at around 18min 30s in this podcast.

For the full FY 2019 year increased 39% to $84.3 million, with installed base of the Trophon grew across all regions. As you can see below, the company is continuing to grow revenue strongly, albeit not smoothly, due to changes in selling model and the release of the Trophon 2. It just so happens the second half was an improvement on the first half, in terms of revenue, but not in terms of profit, as you can see below.

Note: This post was supported and assisted by Strawman founder, Andrew Page. I recommend Strawman as the best ASX stock forum available.

As you can see below, the number of Trophon units installed in North America continued its long term climb to reach 18570, with the growth rate steady at about 1500 per half.

Nanosonics has 75% market penetration in Australia and NZ, and is finding much growth there anymore, but on the conference call the CEO said that he sees no reason that the company cannot reach a similar market share in the USA. At current (absolute) growth rates, that implies around 10 years of growth in the US (albeit with a declining rate in percentage terms). So, a long runway remains.

Looking to Japan, the CEO reminded listeners that they do not have guidelines for adoption there (which are required to compel purchasing of high level infection control devices like Trophon.) However, he said, "things should start kicking in very positively from 2021”, which implies he thinks that "the fundamentals for adoption", as he calls them, are falling into place.

On top of that, the company has taken over the distribution of its consumable products in the US from July 2019. That means that instead of selling its consumables through GE for some of its customers, it will sell consumables directly to customers and get a better margin. The impact of this margin uplift is expected to be fully felt in the second half of FY 2020.

Importantly, however, operating expenses grew by around 15% in 2019 due largely to a 27% lift in headcount and an increasing R&D spend. The company said costs would increase significantly in the current year, forecasting $67 million in operating expenses (a 36% increase) for FY2020 as the business readied itself for its “strategic growth agenda”. That includes new products, sales & marketing and business development. We now expect the second product to be announced in the 2020 financial year, and note that this is expected to weigh heavily on profit in the short term.

While the company did achieve record profit before tax and revenue in FY 2019, we note the (significant) exchange rate benefit in these results. Without that, revenue growth would have been 29% instead of 39%. This benefit is unlikely to be repeated and may in fact reverse in future periods, so it would be unwise to build a model based on sustained growth at those levels.

On the call the CEO said that the impact of upgrades to Trophon 2 was “quite minimal during the year… probably sub-100” in the US. That means the capital sales in the US were new installed growth and what they sold to GE into their inventory. This bodes well for the company's prediction that growth in capital sales remains at constant absolute levels. Over 30% of the current installed base is due for renewal in the next two years, and that replacement cycle, even if not well conformed to, should help.

Buy, Hold, or Sell?

Nanosonics is a profitable business with over $72 million in cash on hand. However, after the share price pop yesterday it has a market capitalisation of $1.95 billion, giving it an enterprise value of $1.88 billion. Against that, it produced free cash flow of $2.6 million in FY 2019, putting it on an astronomical EV / FCF ratio of 722. The company is now trading on 22 times revenue, which is pretty phenomenal given it is a medical device maker, rather than the sexiest software stock you've seen.

For contrast, Resmed (ASX:RMD) the sleep apnoeia device maker, trades on around 8 times sales and Cochlear (ASX:COH), the hearing implant company on around 8.5 times sales. For Nanosonics, even if we bullishly assumed 30% revenue growth for five next five years, and some margin improvement, returns from here would arguably be lacklustre.

As I have previously disclosed, I had already begun selling my Nanosonics shares, at lower levels. For the last year or more, I have been holding on to Nanosonics stock because I believed, correctly as it turns out, that the people who had short sold 13% of the company when the share price was under $3 would receive a severe lesson and be forced to cover at higher levels. With short interest now sitting at about 3%, that thesis has largely played out.

As such, I intend to take more profits from Nanosonics after publishing this report. Because I believe Nanosonics is a great quality company, I will almost certainly be retaining a small holding, so that I remain engaged with the business and capable of understanding it properly. I would very much like to participate in another short squeeze of such epic proportions in the future. I'll take an 100%+ gain in about a year whenever I can.

However, I strongly believe that the company is very generously priced at current levels. While the business could continue to perform very well over the long term, and the stock could become even more richly valued, to quote Andrew Page, "should growth not materialise as expected, the downside could be severe." He too, has taken some profits.

Nanosonics is a high quality business that is making the world a better place by reducing the transmission of the HPV virus, among others. That in turn reduces the number of people who get cervical cancer. That is very considerable pain and suffering alleviated. At current share prices, I will be doing some selling for sure, but am unlikely to sell out completely. I will likely sell in only small increments, as I am enjoying the sport of watching to see how ridiculous the price can get, and basking in the glow of what has to be one of the most satisfying short squeezes I have ever seen.

Thanks again to Andrew Page for helping with this article. We recommend you continue the conversation over at the Strawman forum for Nanosonics.

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Disclosure: Claude Walker owns shares as disclosed and will not buy any for at least 2 days after publication (but does intend to sell a few as disclosed).

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

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

Matt Brazier — Mon, 26 Aug 2019 06:52:03 +0000

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

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

Historical listed performance

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

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

Coworking

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

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

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

WOTSO works (though perhaps not everywhere)

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

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

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

The Bakehouse Quarter

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

Insider incentives

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

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

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

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

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

Valuation

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

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

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

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

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

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

Disclosure: Matt Brazier does not own shares in BWF or units in BWR and Claude Walker owns shares in BWF (a very very small position), but not units in BWR at the time of publication. Neither Matt nor Claude will trade either security for at least two days. This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

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

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

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

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

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

Capital raising and key growth initiatives

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

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

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

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

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

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

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

The Dante ecosystem

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

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

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

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

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

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

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

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

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

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

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

FY19 results and illustrative FY20E projections

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

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

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

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

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

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

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

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

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

Closing thoughts

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

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

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

_______

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

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

Pro Medicus (ASX:PME) FY 2019 Results Analysis: Record Profit Yet Again

Claude Walker — Thu, 22 Aug 2019 22:05:06 +0000

Pro Medicus (ASX:PME) Posts Record Results In FY 2019

Yesterday radiology imaging company Pro Medicus (ASX:PME) reported revenue of $50.1 million for the full year, along with profit of $19.1 million, an increase of over 91% on last year. When I reported on the half year results, I noted that it would be hard for the company to grow half on half, since last half was such a strong half. I also expressed my hesitancy about the share price. It turns out I was too conservative, as the stock has gained well over 100% in the intervening period, to close above $30.50 on the day of the results.

The business seems to be doing very well indeed. As you can see below, the company grew profits strongly, half-on-half, in the end. Some of that growth coming from existing customers using the image viewer more. Many clients have signed transaction-based contracts, which mean Pro Medicus benefits if they view more images. However, the company also benefited from on-boarding new clients and receiving the first full year contribution from others.

The Australian business, which is primarily a radiology information system (RIS), showed good growth, largely because it now serves two of the biggest radiology companies, in iMed and Healius Ltd (ASX:HLS), along with other customers. The company had to invest for many years to win this dominant position, but it now enjoys natural growth as its clients themselves are growing.

It was the US business that stole the show, with the viewer product (Visage 7) accounting for the vast majority of the revenue. You can see below how revenue from the US is tracking.

Turning to free cash flow, the company did very well indeed, converting 90% of profit to free cash flow, which came in at about $17.1 million. That lead to net cash of just over $32 million. That puts the company on an enterprise value to free cash flow (EV/FCF) ratio of around 175; an eye-wateringly expensive price! The good news, at least, is that as the company continues to grow, free cash flow should remain strong (or even get stronger) relative to net profit, as accounting changes mean that some payments received up-front will be recognised over the period of the contract on a flat line basis. There will of course be some volatility in cash flows related to capital sales.

While there is no doubt that the stock is not cheap, any more, it also seems clear that the company is of very high quality. For example, it still has minimal salespeople but has only ever lost 4 tenders for its Visage 7 product. This year, it did increase staff numbers, but its investments were in R&D and implementation. This expenditure helps delight customers, if not win them. Over time radiologists who have used Visage become advocates for it when they move to an institution that does not have Visage. Therefore, in my view, the best kind of marketing is continual investment in the product. This focus is evidenced by the fact the company has around 40 software engineers out of a total staff of about 75 globally.

Following on from our sociological examination of the Pro Medicus share price, it seems clear the company is getting a lot more attention now, with several questions from analysts indicating that they were relatively new to the stock. In my view, this process of discovery is a large part of why the share price is so high at the moment.

Longer term, it was pleasing to learn more about the twofold potential for artificial intelligence algorithms on the Visage viewer platform. As the company develops AI applications, it can roll out those improvements with the next update. Some technology will be made available to all users.

However, the company is also encouraging other organisations and people to develop their own diagnostic algorithms for radiology, and make those technologies available for radiologists for a price through the Visage 7 platform. Pro Medicus would take a cut. If the company ever achieves this, it will have profoundly improved the business because it would have positioned itself to profit from the capital (monetary and intellectual) of third parties. This path would result in better outcomes for patients (based on past documented experience of the impact of Visage), and also potential savings for radiologist employers. In the US, radiologists are paid a lot, so anything that improves their workflow is very beneficial. For me, a key milestone in the next few years will be when the company first manages to sell a third party product (an algorithm, essentially) over the Visage 7 platform.

On the call, one analyst elicited some interesting insight into the radiology market over in the USA. According to the CEO, requests for tender amongst radiology groups is in “deep freeze” because there has been so much consolidation in that market. When a radiology group is looking to either buy another, or sell itself to another, it is not an attractive time to change move to a deconstructed PACS system with Visage. Once consolidation dies down in this sector, Pro Medicus should see a pick up in the pipeline selling to these kinds of clients. Longer term, consolidation is a tailwind for Pro Medicus, as the company specialises in large radiology and hospital groups. The reason for this is that their product is expensive, and the product is designed to optimise ROI for large groups; and these are the contracts Pro Medicus tenders for.

Valuation

Notably, one of the difficulties for modelling how Pro Medicus might justify its current $3 billion market cap is that at present the company is focussed on the larger, more attractive end of the radiology market. However, they already are making quite a splash in this end of the market, and it’s not clear how much further they can grow before it simply gets harder to continue to increase market share. From memory, they already have 5 of the top 20 hospital groups. I think they can go to 10, or even 15; but would that be enough to justify the current price?

That is not guaranteed.

One bright spot, however, is that the company’s vendor neutral archiving is continuing to appeal. The CEO said that one day he thinks it could be worth 30%-40% of the imaging business, which would be a significant contribution. At present, it seems there is some potential for them to cross sell the VNA product to customers who already use their viewer, and going forward, it seems more likely they will manage to sell some combined offerings. We’ll need to see growth in the VNA business if the company is to fulfil its potential.

I stand by my recent comment that the aggressive buying of Pro Medicus shares at around $33 by passive index funds is frothy-mouthed accumulation. However, I also think those people who have been short selling the company, many of them since much lower prices, are cruising for a continued bruising. Time is their enemy, because even though the valuation is frothy as it comes, the company continues to improve in quality over time.

I have upgraded my valuation on the back of these results. I think the company is now worth at least $1.5 billion (or a share price of around $15) which has me at a much more conservative valuation than most. Having said that, the main argument for it being worth buying at $3 billion is to understand the company through a gorilla game framework.

If Pro Medicus to become the gorilla in its niche it will need to achieve the following:

Maintain its technology advantage through continual improvements to its Visage and VNA technology (Within its control).
Sell other people’s algorithms over its platform to assist with diagnosis in both radiology and other medical sciences (Partly within its control).
Continue to be able to find clientele who are willing to spend money to make money. Pro Medicus provides strong ROI to its clients, but some (for example, public health organisations) cannot make that ROI because internal process mandate they go for the cheapest option, even when it will leave them worse off in the long term. (Not really within its control).

If Pro Medicus does end up dominating algorithmic radiological diagnosis, in the long term, then I suggest that in fact it will be considered to have been cheap at current prices. While I do not necessarily think the risk versus reward is brilliant at current prices, I maintain Pro Medicus as my largest single shareholding, due to this long term potential. Of course, I do not expect a smooth run, and I will take profits as and when I deem appropriate.

Finally, it’s worth noting that the founders have previously said they would sell 3 million shares each but have only sold 1 million each so far, so we may see a further sell-down after these results. It is very positive that the founders remain committed to the business and I believe that the retention of the team at Pro Medicus (at multiple levels, not just top management) is the most important thing for me to track. It’s truly rare to see a group of people doing such good work and the longer that is sustained, the better for everyone.

Disclosure: Claude Walker owns shares in Pro Medicus at the time of publication, and will not sell for at least two days.

Post Script: Claude's subsequent coverage of Promedicus can be found on A Rich Life

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

Webjet Limited (ASX:WEB) FY 2019 Full Year Results Analysis

Matt Brazier — Thu, 22 Aug 2019 06:40:52 +0000

Webjet FY 2019 Results: The Turbulence Will Soon Be Over

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

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

B2B

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

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

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

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

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

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

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

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

B2C

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

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

Conclusion

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

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

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

Laserbond (ASX:LBL) FY 2019 Full Year Results

Matt Brazier — Tue, 20 Aug 2019 01:07:40 +0000

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

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

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

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

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

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

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

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

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

Addendum from Claude

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

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

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

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

Matt Brazier — Sat, 17 Aug 2019 00:32:25 +0000

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

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

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

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

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

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

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

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

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

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

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

Is Ooh! Media (ASX:OML) Good Value After Its Share Price Crash?

Claude Walker — Fri, 16 Aug 2019 02:11:42 +0000

Back in December 2018, I explained on this podcast with Matt Joass and Andrew Page that I was short a stock called oOh!media (ASX:OML) as a hedge, since it is a poor business that is highly leveraged to the Australian economy.

Today the share price has fallen 25% on a big downgrade to its guidance. Let's take a look at the numbers to see if the short thesis has now played out.

The company has disclosed that it had underlying EBITDA in the first half of $56 million. It claims that over current year it will magically release $16 million in synergies that it has been unable to release in already. Annualising the first half underlying EBITDA, and adding the magical synergies, we get an underlying magical EBITDA for 2019 of a bit under $130 million. This is in line with their guidance of $125 million to $135 million.

Offsetting this, the company has forecast capital expenditure of $55 million - $70 million. Last year operating cashflow was about $70 million against underlying EBITDA of $110 million, so if we are generous we could model operating cashflow of perhaps $100 million in FY 2019. Adjusting for the forecast capex, we thus have an (extremely generous) free cash flow forecast of about $55 million.

At a share price of $3 OML has a market capitalisation of $717 million. It last disclosed net debt of $372 million, so the enterprise value is almost $1.1 billion. Against a reasonable free cash flow forecast of $55 million.

That means the FCF / EV is almost 20.

Even those who were pushing the stock above $4 (presumably) admit it is cyclical, and this guidance at least implies it is on the wrong side of that cycle. I've no doubt in the world that today's buyers are "looking through" the cycle and seeing some magical future where a company with zero moat is able to maintain high margins. Of course, the truth is that there is no shortage of outdoor space for advertising and any exceptional profits accruing to exceptional locations will eventually accrue to the property owners.

Whether or not the Ooh Media share price beats the market from here, I do not see any rational argument that it can provide good risk adjusted returns. The utility of the stock is as a hedge against an economic downturn. It is true that the company is a real business that will probably still be around in many years, but the chances of exceptionally good returns are nowhere near high enough to compensate for the very real risk that investors suffer exceptionally bad returns, based on factors the company cannot control.

In my view he stock is still overvalued, once adjusted for the risk of economic slow down in Australia. As I said at 34 min in the aforementioned podcast: "Ohh Media is a bad stock and I would not own it for anything, Disclosure: I am short".

Disclosure: Claude Walker is short Ooh Media, increased his short position earlier this morning, and will not close his short position (but may increase it) for at least 2 days after the publication of this article.

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

Cleaning Up The Portfolio

Claude Walker — Tue, 06 Aug 2019 00:06:35 +0000

Generally speaking, I try to let my winners run, even if I do take some profits.

Today, with momentum changing, escalating trade wars and Hong Kong in chaos, I'm going to ditch some of my lower conviction positions that I have been umm-ing and ahh-ing about.

We've published on three of those on Ethical Equities, so I thought I should mention here.

I'm going to sell out of Elixinol (ASX:EXL). A couple of quarters ago I said "As a result of this analysis, I can only conclude that in the best case scenario my confidence in the company is now lower than it was, and two days after this post, I intend to sell a significant chunk of my Elixinol shares."

The subsequent results weren't great either, so I'm all out today.

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

I subsequently reduced my position size and now I'm selling out completely on valuation concerns and because this AFR article made it seem like a strange company.

Finally, I will also sell out of Xref (ASX:XF1). When we last covered the stock, I said "While I could imagine myself taking some profits if I find superior uses for my capital, I do believe that this thesis needs longer to play out, and I have held on so far. At the very least, I'm inclined to give the business until the end of the financial year, when we will find out about the all-important fourth quarter sales. " Unfortunately, its most recent results disappointed slightly, so now I'll probably sit on the sidelines.

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