© 2024 First Samuel Limited
The Markets
This week: ASX v Wall Street
FYTD: ASX v Wall Street
Note: not all clients will hold all of the securities we discuss.
To provide a more complete investment picture, we will continue to provide some updates on the prospects of our portfolio companies as gleaned from our coverage of the ASX Reporting Season:
- Mineral Resources (MIN)
- Seek (SEK)
- 360 Capital (TOT)
- Emeco (EHL)
Mineral Resources (MIN FY23 result)
Mineral Resources is one of the most innovative, diversified mining companies in the world. It operates mines for iron ore and lithium (think EV batteries), an energy business as well as providing other value-added mining services. It brings the sort of innovation and value creation that should be a template for other Australian resource companies.
Its financial performance was impressive too, delivering revenue growth of 40%, EBITDA growth of 71% (cash conversion 100%) and 90% growth in EPS and DPS. This was driven primarily by a lift in the price of spodumene, a mineral from which lithium is extracted, as well as a lift in the iron ore price.
Mineral Resources: Continued progress in FY23, with significant new investment being made
Source: Company reports
However, a flagged uplift in capex of ~50% in FY24 (from $1.7bn to $2.5bn) has some elements of the market concerned about cost overruns and project timing in order to meet volume targets. Softening iron ore price expectations amongst consensus has seen the company recognise significant impairments in parts of their portfolio too.
Mineral Resources: Areas of caution for the broader market
Source: Company reports
The ‘consensus’ institutional investor in the market has a more conservative appetite towards expansion and balance sheet gearing than we do. This is in part a function of the longer-term horizon that we take towards managing money and our propensity therefore to not manage to quarterly performance metrics.
What the market said:
• “MIN FY23 revenue, Ebitda and underlying NPAT was 1-10% better than expected and up strongly YoY driven by buoyant lithium prices. Statutory NPAT of A$244m was 65% weaker than our forecast after MIN reported a A$552m post-tax impairment in relation to its iron ore division. The full year dividend of A$1.90 (final dividend of A$0.70) was 3% higher than our forecasts and the dividend was 90% stronger YoY.
• Operating cash flow and capital expenditure were both better than expected, which drove the free cash outflow of A$406m to be materially better (71%) than expected. The net debt position of A$1,855m was 26% better than our forecast.” (Macquarie)
Seek (SEK FY23 result)
SEEK is a relatively new portfolio position. We’ve taken advantage of share price weakness since reporting its FY23 result to find a suitable entry point.
SEEK is the market leader in Australia in online employment services, which provides it with significant pricing power. It’s network also extends into another nine markets throughout Asia and Latin America. SEEK also has minority investments in businesses in China, Korea and a number of other countries.
The company also operates several other businesses including SEEK Learning, which helps connect people with quality education opportunities, SEEK Business, where businesses and franchises can be sold and SEEK Volunteer, Australia’s largest single source of volunteer opportunities.
Figure 3: A dominant presence in the Australian employment market
Trading performance
SEEK’s FY23 result was met with a little disappointment by the investment community. Job ads in Australia were at lower volumes than the record levels of 2022 (post-Covid employment recovery).
Seek: Softer job ad volumes in Australia in calendar 2023
Source: Company reports
Seek: Asian job markets have been softer too
Source: UBS, Company reports
Outlook
We believe that the business retains significant pricing power in its core markets, which will drive healthy revenue growth even if underlying job ad growth is modest.
While the company has enunciated a stretch revenue target of $2bn by 2028 (FY23 $1.2bn), the market has been anticipating that a key thrust of the opportunity for rising cashflow/returns may come via a stronger emphasis on efficiency, after heavy levels of expense growth in recent years. Instead, the company is intending to supplement product price increases by investing and growing its way to achieving platform synergies and earnings growth.
What the market said:
“Guidance disappointed, though we think is mostly in estimates now. The key source of upside risk for the stock is likely the yield outlook particularly in ANZ. Valuation is attractive as well given the relative performance against CAR/REA”. (Macquarie Equities)
TGP (360 Capital) and TOT (360 Capital REIT) FY23 results
TGP (360 Capital) is a long-held, but small position in clients’ Australian Equities sub-portfolios. Within 360 Capital’s corporate structure, the head company also owns a 24% stake in the 360 Capital REIT (TOT), a traditional real estate investment trust.
Clients also own the 360 Capital REIT (TOT) in Property sub-portfolios.
The 360 Capital Group created a significant amount of value in several completed deals in recent years, notably the purchase and sale of the Irongate and PMP assets. At the beginning of 2022, the group had significant cash and maximum optionality.
Unfortunately, in our view, the deals completed in FY23 have not been the same quality, nor did they demonstrate the same insight into market conditions. The net result has been a reduction in the net asset value in TGP to $0.78 per share from more than $0.90 a year earlier. The stock is at a further discount to the net asset value.
Part of the reduction in net assets is due to high dividends in FY23, including an 8c special dividend; the remainder of the fall is due to declining asset prices in its key investments.
These investments, including those of TOT, are facing weakening conditions. In the case of TOT, exposure has switched from cash and property debt towards mixed-use office and health assets.
In the case of TGP the increased exposure has been to a listed investment (15% stake) called Hotel Property Investment (HPI). The change of direction of both companies saw purchases that we wouldn’t ordinarily support. However, and this is the critical issue, history shows us that all assets are trading assets, and all deals that in one year appear “half-baked”, end up creating some value in the next. The chart below shows the evolution of the A-REIT index, and the deals completed by 360 Capital.
Figure 6 – 360 Capital (TGP) – History of profitable transactions since listing
Readers and clients may recall that our Australia Equities sub-portfolios have no direct exposure to property assets, and our Property sub-portfolios contains a very large cash position waiting for new opportunities in response to the expected flux in the property market.
Within this context, we feel it is important to have exposure to management teams that share this view and can also capitalise on future opportunities. We thought it worthwhile repeating the vision 360 Capital has for the Australian market.
- Commercial real estate conditions are expected to continue to weaken in FY24
- Interest rates are expected to peak late 2023, but potentially remain elevated placing pressure on under-capitalised fund managers
- Both LVR (loan-to-value ratio) and ICR (interest coverage ratio) pressures building
- Rental growth expected to continue with inflationary pressures
- Construction costs are going to limit supply, maintain rental levels needed
- Real estate with long secure cashflows expected to weather storm
- Bifurcation of assets going to playout as tenants, investors, financiers gravitate to new buildings
- Secondary asset values expected to fall quicker, usually owned in constrained capital structures
We agree with most of the above and are interested in how to position for such conditions. 360 Capital suggests it has responded accordingly.
- Exited all non-core assets/operations from the Group through a simplification strategy and no legacy issues to deal with, allowing the Group to focus on opportunities as they arise
- Investing across debt and equity gives flexibility to structure complex opportunities
- 360 Capital’s history of dealing with complex opportunities in a timely order creates deal flow to the Group, which is expected to increase as markets deteriorate
- History of operating and transacting through the cycles over past 17 years gives 360 Capital an advantage over some other competitors
- Flexible funding sources across three ASX listed entities and private capital partners, strong management and Board position 360 Capital well to expand its platform
This perspective should prove value-creating, and along with the likely sale of the large stake in HPI (hospitality), we see a range of value-creating options going forward. The breadth and flexibility of its current exposures are shown below. The left of Figure 7 shows the types of property exposure in the underlying assets, and on the right the components of the net asset value in cents per share.
Figure 7 – 360 Capital (TGP) – Group exposures
Source: Company reports
We will look to both 360 Capital and TOT to make substantive improvements in the coming 6 months.
Emeco (EHL FY23 result)
Emeco is a long-held positon in clients’ sub-portfolios, and the stock price has performed poorly (-8%) since its results release in late August. The stock is now trading at $0.61 cps, a substantial discount to its invested capital.
On balance, we were again disappointed by Emeco’s cash generation.
The company has a large capital base of plant and equipment, $1.45 per share as of June 30th, and only moderate levels of net debt, $0.53 per share, giving a net asset backing $0.92 per share.
Based on the company’s reported returns on invested capital, a significant level of cash per share or cash flow yield should be generated. On top of the returns to its capital base, the company can be expected to generate additional earnings from the service-oriented business it operates. Cash should also be generated on the labour it supplies companies to operate and support its equipment.
Most importantly, Emeco also owns a highly valued parts and services business that holds significant inventory and works not only exclusively on Emeco equipment but also external clients.
So what are the components of operational performance that lead from the capital to cash earnings, and where was the shortfall in FY23?
- The plant and equipment need to be highly utilised; there is no cash generation from equipment stored in a shed in WA. Positive – utilisation was more than 90%, which is a great result.
- The rates at which the plant and equipment are rented out need to generate the expected returns on capital. Positive – Despite some lags between rising costs and contract positions, the overall pricing environment is supportive.
- The cost of the labour that was promised or used to operate and support the equipment needs to reflect the true price of that labour plus a profit margin. Negative – rising wages and some inflexibility of contracts led to higher costs that weren’t recovered.
- The Emeco-owned equipment needs to be serviced for a cost that reflects the underlying value of the equipment as recorded. For example, at a household level, it would be unwise to suggest that your 1971 Datsun Sunny 1200 4-door was worth $8,000 if you knew it needed $15,000 of repairs to get it out of the garage. Negative – the cost of servicing was high compared to the revenue.
- The equipment you have promised the client needs to last the length of the contract without having to repurchase new equipment. Plus, success on one project should lead to growth in new contracts that can be funded by the former. Negative – growth capex was high compared to new projects won.
- Finally, like all businesses, it needs to collect the money from the client once the work is completed. Negative – Emeco had a series of debt debts and client business failures that obliterated its free cash flow. The bad debt identified in the 1H23 was partially resolved, yet two new problems emerged in the second half.
As seen above, despite strong underlying conditions, utilisation and high-level operating income, the cash flow realisation after investing flows was weak. Much of this weakness was isolated in one of the Emeco businesses, PitNPortal, and there has been substantial changes made over the course of FY23. Many of the changes have been prompted by the new CFO, and a realisation by senior management that this acquisition was poor.
The combination of stronger underlying conditions and weak cash generation leads us to examine the other structural factors likely to impact future earnings. The figure below highlights the diversity of income streams from a commodity and geographical perspective. This remains a positive feature of the business.
Figure 8: Revenue mix
Source: Company reports
Our conclusion is that most of the factors which leads to weak conversion can be overcome in FY24. Should such cash conversion not be realised the stock remains a likely takeover or merger target at these price levels.
What the market said:
“We maintain Buy Recommendation; FY23 was hampered by PnP (PitnPortal) and weather impacts through the first half. Business looks to be setting for a stronger FY’24; we are comfortable with the idea of ~$275m EBITDA FY’24 which sees EHL on ~2x FY’24 EBITDA and 5x EV/EBIT while generating cash and deleveraging the balance sheet. Stock is cheap and should trade up, though acknowledge it may take delivery of formal guidance and clean period of operating results to see the stock re-rate”. (Euroz Hartleys)
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.