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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.

Audinate (ASX:AD8) Q3 2019 Quarterly Cashflow Report

Claude Walker — Sun, 21 Apr 2019 04:02:13 +0000

Just prior to Easter, audio networking protocol (Dante) owner Audinate (ASX:AD8) released its quarterly cashflow report. Receipts from customers were down on the prior quarters, at about $6.2 million, but up 40% on the prior corresponding period. As you can see in the chart below, the third quarter was the weakest quarter last year, so it seems likely that the result was impacted by some seasonality.

The company produced $1.6 million of positive operating cashflow but only about $300,000 if you exclude the government rebate. This lead to negative free cash flow of just under $1.5 million (in its weakest quarter). While I would prefer to see free cash flow breakeven, this level of outflow is acceptable given that the company still has $12 million cash in the bank.

The number of Dante enabled products available for sale increased by 11% over the quarter, to 1,946. This increase of 197 is a really strong result, given that the prior 4 quarters have averaged about 115 new products per quarter. This was explained by a big leap in the number of Original Equipment Manufacturers (OEMs) shipping a Dante enabled product, up by 13, to 241. Again, this was a strong result compared to prior recent quarters -- the last half saw an increase of only 7 OEMs shipping Dante enabled products, while the half before that saw a gain of just three.

This growth in customer numbers could be seen as a strengthening of Audinate’s network effect, whereby widespread acceptance of its Dante protocol support further acceptance. In selling the shares down, upon release of the quarterly, the market has perhaps overlooked this fact.

Having said that, I believe that the market price for Audinate is now far more reflective of its potentially strong market position, despite the fact the company has yet to exercise its (theoretical) pricing power to drive profitability. So while I would not say the opportunity has passed, I cannot deny that as the share price has risen strongly in recent months, the balance of risk and reward has become less favourable.

Nonetheless, I remain a happy holder of Audinate shares.

Finally, Audinate has now produced four quarters of positive operating cashflow and will therefore no longer be required to submit quarterly cashflow reports.

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

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

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

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

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

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

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

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

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

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

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

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

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

Ananda Health

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

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

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

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

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

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

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

Ananda Food

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

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

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

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

Hemp Black

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

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

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

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

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

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

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

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

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

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

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

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

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

Financials & “Valuation”

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

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

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

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

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

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

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

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

Closing thoughts

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

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

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

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

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

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

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

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

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

For ethical investment ideas I back with my own money, join the Ethical Equities Newsletter.

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

Gentrack Group Ltd (ASX:GTK) FY 2018 Annual Results Analysis

Claude Walker — Sun, 13 Jan 2019 19:50:22 +0000

Gentrack FY 2018 Results Review

It's been some time now since the Gentrack Group Ltd (ASX:GTK) FY 2018 annual results were released to market.

I discussed the results in this podcast, but I thought it might be useful to put some thoughts in writing.

As you can see below, growth on operating metrics by segment was fairly muted when you consider the recent acquisitions.

While the business has continued to grow, once you take into account the dilution associated with the capital raising of around NZD$90 million at A$5.69, these key metrics are all down on a per share basis.

Whilst it is de rigueur for investors to focus on per-share metrics based on a weighted number of shares, given that Gentrack is buying strategically and for growth, rather than for multiple arbitrage, I don't think it is particularly useful.

If we (perhaps harshly -- that's me) simply use the number of shares on issue (98,525,216) to calculate per share earnings, then we get just over 14 kiwi cents per share. That's about 13.2 cents per share at current exchange rates.

Put like this, you can see that the stock is still optimistically priced at A$4.80, which is over 36 times earnings.

Now, that means the stock is pretty expensive today, especially considering it fell short of broker analyst estimates, as you can see below.

For this reason, I think that in the short term there is plenty of potential downside. This view is compounded by the fact that on the earnings call the management forecast a tough 2019, with upgrade cycles in Australia unfavourable, and Brexit weighing on the UK business.

Why, then, would I buy more stock?

The Long Term

In my experience successful small-cap investing is all about finding those few multi-year winners, holding them, and preferably adding along the way (or else having a large enough initial position that you remain heavily weighted towards to long term winners.)

Gentrack is a profitable, cashflow positive software company with recurring revenue of about $64 million (all figures in NZD money unless otherwise stated). It has software-as-a-service style revenue of over $50 million, and this figure is growing quickly as it converts its customer base from licensing deals to software-as-a-service deals. Crucially, that process takes revenue and profit away from the near term, and pushes it to the long term.

Not only does this process depress today's profit to the benefit of tomorrow's but it also makes it easier for the company to continuously integrate new products from acquired firms, and cross sell them into the existing customer base.

This strategy makes sense. As an enterprise software company serving large utilities around the world, Gentrack has an important off-the-books asset; the trust of those companies.

The company is leveraging this by acquiring up-and-coming software companies in its space for high multiples. This is actually the opposite of multiple arbitrage, since Gentrack is typically buying companies on a higher multiple than it trades. This is arguably justified because Gentrack is actually trying to add value to the acquired businesses, by integrating and cross-selling their software. To my mind, this compares favourably to a company like Hansen Technologies (ASX:HSN) which tries to buy more mature businesses at a lower multiple. That strategy worked well when the Australian dollar was at multi-decade highs, and enterprise software company valuations were relatively low coming out of the GFC. But it works less well today, as can be seen by Hansen's lack of earnings-per-share growth.

Of course, the comparison is rather moot since the market assigns a much higher multiple to Gentrack -- there's no real edge here.

What I think is my edge in owning and accumulating Gentrack is that it displays the qualities of being a well run high quality stock that can keep growing for many years.

For example, it does not give specific guidance, suggesting it is not a slave to brokers. The chairman participated in the most recent capital raising, at well above current prices, suggesting that there is high level confidence in the strategy and direction of the company. Unlike many software companies, it has been able to grow revenue from $38 million to $104 million in four years, all while paying a dividend. In these heady days of valuing companies on revenue (regardless of the achievable steady-state net profit margins), that's rarer than you might think.

One of the worst examples of the brain-rot infecting software company investors is the apparent assumption that every software company can (one day, at least) achieve net profit margins of 10% - 20%. However, for non-critical software companies with questionable value-add, and a high cost of customer acquisition, this is far from fait accompli. When investors buy stocks like Livetiles (ASX:LVT) or Livehire (ASX:LVH) on valuations of hundreds of millions, they are essentially assuming eventual profit margins which, in my view, are very unlikely to be every achieved.

What Gentrack has, unlike this companies, is the ability to grow profitably for a very long time period. While fund managers might be thinking three or five years ahead, at most, I actually believe Gentrack could still be growing at well above GDP in 15 years, and there is very little chance that that is priced in.

Second, and most importantly, the strategy of buying faster growing unprofitable small software companies is one that only really pays off when you make the killer-purchase. Because humans have trouble understanding (and valuing) exponential growth, and because that growth is always uncertain, it is inevitable that Gentrack will overpay for some of its acquisitions (as is the case with CA+).

However, if Gentrack can pay a fair price for a great software product, then really put a rocket under its development and growth through the application of Gentrack's development teams (and sales department) then one or more of these acquisitions could turn out to be an absolute bargain.

To understand this reality you need to think about what it is like to be a small software company competing against large companies for the business of even larger utilities. It's hard. Very very hard.

You have neither relationships nor (in some cases) adequate access to software developers. You may be dependent on a few talented individuals for the development and upkeep of your product. You can barely afford the salespeople you need, and you're a relatively unproven -- even if you have the best product there is the old adage "you don't get fired for choosing IBM" working against you. For these companies to gain a few million (or tens of millions) in annual recurring revenue is no mean feat -- and its a smart time from Gentrack to buy, in my opinion. At that stage the product is somewhat legitimised in the market.

With over $10 million in cash and the capacity to borrow against predictable cashflows, Gentrack can continue to buy as opportunities arise.

I have kept space to buy more Gentrack shares over the next few years, since I think it may disappoint in a "risk off" environment. But I also increased my holding on the sell-off and I continue to think of the company as a core holding. If the company traded for less than 25 times earnings on poor sentiment I would have an appetite for building a large position. At current prices I think it's slightly undervalued on a long term view.

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Disclosure: The Author, Claude Walker, owns shares in Gentrack at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Readcloud (ASX:RCL) Update On AGM and Acquisition

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

Readcloud: The post-AGM Update

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

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

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

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

Business momentum and trying to understand the cashflow profile

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

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

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

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

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

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

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

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

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

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

Sales update + acquisition of AIET

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Matt Brazier — Thu, 25 Oct 2018 21:50:17 +0000

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Note From Claude:

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

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

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

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