Post Results--Examining the tail--PXA MIN CKF DMP SHL IEL DDR

 EXAMINING THE TAIL—PXA DMP RMD IEL DDR SHL MIN

Almost all of my top 10 holdings are clear of significant issues with maybe valuation being the main point of conjecture. These investments represent a large proportion of the funds deployed. There is also a tail these are small or middling positions as launching pads to potential further investment but with current issues that may preclude investors from becoming overly excited about them. Therefore, they have potential attractive upsides. The underlying business should be sound and the issues short term. These holdings can be upscaled if the issues are indeed ST, however, not all will turn out favourably.

How are these going? This is not an in-depth analysis but an overview of the short-term issues, are these issues becoming better or worse?

Pexa (PXA)

My thesis here rests with the Australian business being a natural monopoly, that appears intact. Secondly, Australian success can be repeated in the UK. Success in the UK remains elusive but there are positive signs. The undertaking has taken longer and the investment continues to mount. The success in getting the UK banking major Natwest to onboard the exchange is a major positive but does not ensure success. The progress since the new UK head has been positive. The main issue has been the ability of PXA to coordinate agents, banks and government offices without explicit government support. It highlights the difficulty of creating a network.

PXA has generated $283m in FCF over the last 3 years, of this $186m has been reinvested internally including the UK, and another $131m in acquisitions with most in the UK to assist the initiative there. That means all FCF and some debt have been utilised in the expansion.

The UK market is 2.5X the size of the Australian market so the “prize” is large. PXA commented that $127m has been invested into the UK and for an A$2.4b company that is not overly large but is being expensed and has a large call on FCF as described.

Finally, I have been critical of the C-suite since the listing with the UK initiative appearing to hit unforeseen issues and with their acquisition spree into loss-making digital applications at top prices. With the announced retirement of the CEO and the CFO long gone, there is an opportunity to appoint an expert in what is required. We watch with interest.

The bear case would entail, a long costly and ultimately failed UK initiative. Despite the huge industry gains of implementing the exchange, there is a chance of failure. When are the losses enough and when is it clear they have failed? For investors, that is the difficulty here. Ultimate failure in the UK would mean you are left with a profitable monopoly in Australia with a value around current levels, IMO, at this point the downside is not great.  

ND stabilised over the year, stabilisation is a good description of the whole year. An interesting aside is that the float was able to offset the extra interest strain, a very welcome outcome.

Dominos (DMP)

The end of C19 brought about issues for many of the C19 winners. Broadly these can be described as operationally gearing up during the boom times, only to be exposed to a high cost base as demand normalised. Overall, the experience was profitable but heavily skewed in the C19 period with poor or no returns afterwards.

Although there is certainly a C19 overhang for DMP it is also mixed. Parts of the business have recovered while others are still suffering. The differences appear to be strategic blunders and poor execution. For DMP these rest with two businesses being France (est) 12% of stores and Japan 26% of stores. For a company to carry 38% of stores (in aggregate) underperforming is unsustainable for a growth business. The problems appear quite different with huge and unsustainable store expansion in Japan and inconsistency and lack of execution in France. Japan remains a huge reset with 7-8% of stores to be closed and the growth reinitiated with a more profitable and sustainable expansion planned. The French business appears to have let franchisees run their show, which produced a lack of pricing and menu consistency making company-wide coordination and synergies difficult. The positive is that there remains a profitable core in each market and Japan will benefit from the concentration of sales across fewer stores. New CMOs have been appointed in both markets.

DMP runs a franchise model. That is built upon the franchisees earning returns large enough to incentivise new store openings. Group-wide franchisee profitability is $97K with a target of $130K. Variations around these averages can be expected to be large. The operational leverage both up and down is stark as we have seen the downside in the last couple of years.

The balance sheet appears to have stabilised, so becomes less of an issue, as long as profits show a positive trend.

After several disappointments, the market will likely want to see clear evidence of progress and have marked the business down heavily.

 

Sonic Healthcare (SHL)

Another business that has been impacted by the C19 cycle. SHL was a huge beneficiary as testing exploded across its markets. NPAT margins doubled for two years over C19 but now are well below the PreC19 levels. SHL appear to be carrying the extra costs of the C19 times, and given the extreme profitability during C19 are perhaps duty bound to remain open for business with current volumes much lower. Additionally, it can be expected that governments are not keen to give attractive price rises, for a time anyway. The largest customers in various countries are governments and they largely set prices.

Overall SHL's performance over C19 cannot be faulted. They responded by supplying testing, producing larger profits which cleared their balance sheet and allowed for acquisitions as the world exited C19. The question is where the NPAT margin and ROE end up. SHL has never been a large excess ROE company but has added assets consistently above its cost of capital. The question is in the normalised post-C19 world does SHL recover to the previous margins and ROE and drive profits higher from the newer acquisitions? I can't see anything structurally to impede this outcome. The negative is that the natural rate of ROE is not overly attractive just good.

Mineral Resources (MIN)

I am not a big investor in resource companies, mainly because accurately forecasting commodities is very difficult. MIN has a proven ability to add value mainly through its mining services division, which continues to be excellent and secondly, investing in a counter-cyclically in its commodity investments. Although that strategy remains, it has been overshadowed by establishing two large mining operations, one in iron ore and one in lithium. These are major investments, with lithium-producing output and iron ore (Onslow project) yet to reach production.

Lithium is not a commodity that I know a lot about. The cost curve, from what I can see, is not too bad with a steep rise for about half of world production. That means it should be apparent to producers who should mothball operations in a cyclical downturn. Are we seeing a cyclical or structural downturn? That is the big question, I am in the cyclical camp but with not a great deal of conviction.

The iron ore operation is in the process of deploying billions of dollars to create a low-cost long-life mine. Tempting fate, MIN has invested a vast amount and is now committed to finishing the project. We have seen this before. Peak debt coincides with a sudden drop in the commodity price. For some companies, this has been an existential threat. Is it for MN? The increased nervousness may be justified. Unlike other companies we have seen in this position, MIN has a profitable services business, although FCF is well below EBITDA, and the sale of the road infrastructure was critical.

MIN's future is now much more tied to the iron ore price and the lithium price. Where will those prices be in one year, or five years are particularly important as MIN needs to de-gear. Such is the life of commodity investors and why these companies can't be a large part of the portfolio, IMO. I would feel much more confident playing the cyclical recovery if debt was not involved.

The scary scenario is iron ore at $70/t, which is possible, where most participants make a reasonable (not spectacular) return. That would mean the debt payback is very extended.

IDP Education (IEL)

IEL is a leader in its field and has a history of profitable growth in a large and growing market. I have not been a shareholder in the past as the valuation was high given the underlying risk that the business was exposed to government policy. Maybe that was too conservative in the distant past, but is the current issue.

The investment case revolves around the sustainability of the model over the long term. Governments are involved through immigration and visa policy which opens up some difficult political issues, like the end of globalisation, xenophobia, the impacts on social conditions in the end markets, etc etc. The flip side is that the education of mainly Asian students in mainly Anglo-Saxon democracies has become a large and lucrative industry for the democracies.  The issues to consider are whether we are heading down a path of ever-increasing restrictions on student movement or a cyclical adjustment that will revert to secular growth rates.

The business has shown leadership and proved the franchise's strength through strong pricing and market share gains in these difficult times.

We can see that during C19 student numbers understandably declined but student numbers bounced back strongly. Together with the local market hardships of higher interest rates and inflation brought negative political responses to the high student numbers, fanning the flames. Even as I write I can see the lack of logic in this argument, so it is a political issue. My base case is that we see a reversion to secular growth as the political intensity declines with interest rates and inflation.

Resmed (RMD)

One of the best quality companies listed on the ASX. A leader in its field, a large and growing market, exceptional returns on investment and hugely cash flow generative. Arguably, in the local market, RMD has the best GTM in medical devices. RMD is an aggressive and focused company. The issue has been the potential existential threat from the new weight loss drugs.

The initial fears of the new drugs obliterating RMD’s business appear to have passed. RMD to their credit, and unsurprisingly, to some extent have produced data that supports mutual growth. We are still in the early stages of this story.

Over time the world will most likely evolve where weight loss drugs are cheap and accessible, how RMD business adapts to these changes is still unknown and the resolution will likely be long-dated.

Collins Food (CKF)

CKF is the operator of the KFC franchise and is a steady grower with positive but limited growth prospects. Like with DMP, both struggled after the C19 frenzy, but the difference is that CKF is an owner of the assets while the DMP model is more franchise-based. That means the upside and downside are greater with DMP and depend on management execution to a greater degree.

There is not too much wrong with this business but has a modest ability to reinvest making it a stable grower and will likely not attain the valuation upside some other stories will.

Dicker Data (DDR)

An IT reseller of hardware and software to enterprises and SMBs. The business is (or has) been founder-led and has a history of reasonably good growth and returns. The IT industry is growing but exhibits some cyclicality. The business does not offer any significant IP but is driven by scale efficiency and relationships with suppliers and customers. Large operators such as MSFT are confident that they can get their products to customers efficiently. Therefore DDR plays an important role in the industry but is reliant on understanding where client demand will develop, maintaining good relationships with suppliers and sourcing the correct inventory. They are very well versed in this, although there is some evolution involved. The business is attractive but lacks the IP-driven barriers of others, so an efficient middleman facing some cyclical issues.  

TWO NEW POSITIONS

I have initiated two new positions in stocks which were dealt with harshly during the result season Jumbo Interactive (JIN) and PWR Holdings (PWH). (Very) Briefly, these two founder-led (for what that is worth) businesses have a history of profitable growth and high returns on invested capital. Both had issues with their last results but don’t appear structural. The share price falls put them into the buy zone for me. For PWH a manufacturer of specialised motor parts, it will depend on the value of their IP in their products. The OEM market is a killer and although they are thankfully diverse continued success is based on ongoing outstanding product development. Something they have done in the past. JIN is a tech company with a specialisation in digital lottery and associated gaming products. Although embedded in Australia, much of the growth appears to be reliant on overseas expansion. The company has some large targets they are contemplating with international growth. Of course, the progress here will be hard-fought and long-dated, but they have a history of some success in riding the digitalisation of this cottage industry.

 

Conclusion

One of the investment market phenomena that has become clear maybe post-GFC, is that the market has become much less comfortable in carrying stocks with issues, almost regardless of valuations. Conversely, the market appears to pay extraordinary valuations for those companies without issues. Maybe the enormous growth of momentum investing has something to do with that. It is an observable result, but the reasons are debatable. With that in mind, we see apparent value sitting there until it is de-risked and then the revaluation can be surprising. That means there is often a small window when the de-risking occurs and being full weight at that time is the game involved in the current market. How good am I at doing this? Well I have to get better, it's the game. Trying to rationalise why the market can't see value for so long and then fall incredibly in love with the same company is the observable occurrence, rationalising its existence is moot, and using the phenomena to your advantage is the critical factor.

I am writing this to clarify my thinking on each case and to be critical in thinking about these positions. We can see the companies bunching in certain stories with strong leaders facing industry issues, more average companies facing cyclical issues and some others facing short-term issues.

Writing this I realise that I have a long tail, and although that is ok it is not great and some rationalisation of the holdings (as well as a few not covered) is appropriate! That does not cover my even smaller list of speculative holdings which include, AD8 (new), DSE, EOL, BOT, BVS, CCP and TRJ which could be rationalised as well, lol.

To be clear my main mistake in this area of investing is waiting for the market to realise the value I see, sometimes for years, and then selling on the initial pop, only to see the SP rise much higher, as the market loves the derisking and momentum players enter. Must remember that lesson when you are right add more, don’t realise the gain too soon. 

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