Cadence Capital Limited (CDM) Earnings Call Transcript & Summary

Ladies and gentlemen, welcome to Cadence Capital Limited's Year-end Audiocast for June 2022. As you can see from the first slide, we've ended the year down around 3% against a market that was down 7.5%. Over the -- since inception period, you can see that we're up around 12% against the market up around 6.6% and nearly double the market's performance over that period of time. The top contributors to performance during this financial year were Whitehaven Coal, TMC The Metals Company, Newhope Coal, Upstart Holdings, DigitalOcean Holdings and Asana. And the largest detractors for the period were Resimac Group, Bed Bath & Beyond, Nitro Software, Peabody Energy, Betmakers Technology and Sofi Technologies. You will have seen by now that we've declared a final dividend of $0.04 fully franked per share, bringing the year's total dividends to $0.08 per share. This is a 60% increase on last year's dividends. Our annualized dividend yield is around 9% fully franked. And when you gross up for the franking, it's around 12.9% based on the share price of around $0.885 at the date of the announcement of the dividend. I think the shares are trading around $0.92 today. The ex date for our dividend is the 17th of October 2022 and payment date, the 28th of October. There will be no DRP for this final dividend as the company's share price is currently trading at a discount to NTA. You can see in this slide here that we paid 117.2 cents of dividends to date since inception. When you include the franking, that's around 166.4 cents per share. You can see the top 20 shareholders on the next slide. And every month, you should be able to get a copy of the top 20 shareholders in our monthly newsletter. You can see a well-diversified portfolio here with lots of liquidity, as we've been outlining for many months now and also an increase in short exposure, which is important in this period. There's also a spread of domestic and international shares in that top 20 list. The next slide shows a portfolio composition at the 30th of June in a different format, showing you market capitalizations, again an indication of liquidity. And you can see how much of our portfolio has a market capital greater than $1 billion or AUD 500 million to AUD 1 billion. We are also currently holding very high levels of cash and have increased our short exposure. The liquidity, if we were to put it on a weekly basis, we could get out of 98% of the fund within 1 week. You can see obviously that this change in portfolio has been occurring as the year has progressed, of course, puts us in a very strong position at the moment, holding high levels of cash, short positions and very good liquidity. The next slide is a slide that I wanted to include in a bit more detail compared to some of the last audiocasts that I've been doing. And this is really a 220-year interest rate chart. Importantly, I'd like to say that this is not a prediction. Predicting interest rates is obviously a very difficult thing to do. And there are many people employed full time to do this for a living. I'm merely wanting to line -- outline here what has been happening to interest rates. You can see that I source this information from a Bianco Research L.L.C., and what I have done is added trend lines to this interest rate chart, which is very interesting over long periods of time. You could see the red trend lines show interest rates falling from the 1850s, around 12%. Towards the end of the second World War, interest rates were around 2%. Then from the end of the second World War until the mid-1980s, we saw interest rates go up from around 2% to 14%. And then more recently, you've seen interest rates fall from 14% to 0%. I'm talking U.S. interest rates here. They're different in different parts of the world, but U.S. [ never went ] into negative interest rates. Why I'm showing this is that we have now seen potentially a change in the longer-term trend where interest rates have gone from 0% to a number much higher than 0%. And this trend line that I've drawn here in green, drawn the trend line out to 2060, which is 40 years from now, I've got to the midpoint of interest rates over 220 years of around 8.5% to 9%. So why am I showing this to everyone and why am I thinking about this is simply to point out that the environment you operate in with interest rates is a very important one. In an industry of rising interest -- in the environment where interest rates were rising from the 1940s to 1980s, we saw a certain type of asset perform well. Then from the 1980s to 2020, say, we saw a different type of asset performing well. And then we may see a different style of assets and different style of investing performing well going forward. And so as I've been outlining in some of my telephone conversations with people, this change in trend for interest rates could be a very important change in trend. And of course, it's a very long-term trend. We like to look at equity trends in terms of 7.5 years or 10 years or 12 years, these trend lines that I've drawn here are 40- and 50-year trend lines. So then what can we say about this increasing rate trends on the next slide? Well, of course, what I've just outlined is that they are very long duration trends. Interest rates went up from 1945 until the '80s and then fell from the mid-'80s until 2020. And obviously, since bottoming out, interest rates have been going up for the last 2 years. And obviously, in this environment, it's important to focus on what assets can perform well in an interest rate rising environment. So the first thing to say is whilst having just indicated that this is not a prediction is that if this interest rate trend and upward trend does persist over the next 40 years, obviously, interest rates will be a lot higher than they are now. As always, very few people have predicted interest rates would rise as quickly as they have. And almost certainly, very few people will predict interest rates will go up much higher. It is only a very, very few people who benefit to predict that interest rates will go up and is not a popular trend to suggest that interest rates will continue to go up. So it's unlikely that you're going to be reading or hearing much commentary on interest rates going much higher. They simply will just go higher, if they're going to go higher on trend. Turning now to 2 core positions within the portfolio, which have operated independently of rising interest rates, those -- that is the energy positions and in particular, coal positions within the portfolio. The first position I'd like to talk about is Whitehaven Coal. Obviously, we know that coal prices are at record highs, and coal is required to produce energy in nearly all aspects of our lives. For many reasons, there has been underinvestment in fossil fuels in the hope that green energy can replace those fossil fuels. And this underinvestment, combined with recent events in Russia and Ukraine have obviously led to coal shortages and great demand for the coal that Australia produces. Currently, Whitehaven is trading at around a PE of 3 this year and 2 next year based on current coal prices and cash earnings, which have obviously exploded, making Whitehaven fundamentally cheap. Put another way, Whitehaven has operating cash flow yields of 32% this year and around 45% next year and a very cheap price to earnings growth ratio. Coal and energy prices are generally cyclical and using the Cadence process, we obviously like to add to coal positions when they are going up and sell them when they roll over. WHC has met and continues to meet our fundamental and technical criteria. In a similar vein, the following slide talks to the Newhope Coal position. Again, Newhope is experiencing exploding coal prices and record coal prices. Newhope's trading on similar multiples of around 3.2% this year and 1.9% next year and as we experienced the same explosion in its earnings. Newhope has operating cash flow yield of 28% this year and even higher around 58% next year and a very cheap price to earnings growth ratio. Again, coal prices are cyclical and it's the Cadence process that have got us into this position when it was cheap and added to the position on the way up. And obviously, we'll be selling that position on the way down. Newhope continues to meet our fundamental and technical criteria as does Whitehaven. Coal stocks may not always be cheap and pay large fully franked dividends, but they are currently very cheap and currently trading and paying large fully franked dividends. I'd like to now turn to Jackson and Charlie to take you through a number of additional positions within the portfolio.

Thanks, Karl, and good day, everyone. My name is Charlie Gray, Portfolio Manager here at Cadence Asset Management. Today, I'll touch on 2 positions in the portfolio, one short and one long. Turning to the first slide. Graincorp, GNC, which is a short position in the fund, is Australia's major soft commodity trading business. We've seen profitability soar in the past 12 months on the back of a confluence of positive factors. Record East Coast volumes and record wheat basis has been the major 2 drivers. I'll explain what basis is in a second. But we've seen the stock go from something that was hated when it spun out from UMG, the demerger from United Malt Group, where UMG was really the stock that everybody loved and thought it was very high quality. And GNC was meant to be the underperformer or the low-quality business. In fact, GNC has been a much better performing stock. Since then, it's over doubled. And really, that's being driven by the significant upswing that we've seen in agricultural conditions, and we've seen analysts upgrade forecasts and recommendations across the board. And now they -- it's a consensus buy. So importantly, this basis trading profit is the spread between the Australian wheat price and the international wheat price. And Graincorp is now able to take advantage of this by buying domestically and really being the only place that Australian farmers can sell to. And given there was a surplus domestically being able to offer a low price to Australian farmers, they have no other way to get it out and then be able to take that grain, store it and then sell it into the international market where there was actually a significant deficit. And international prices were very, very high because of a, North Hemisphere conditions being quite poor and b, obviously, the Russia-Ukraine conflict, which created a supply chain constraint there. So this basis trading profit is not disclosed by the company, but we believe it could account for up to 1/3 of FY '22 profit. So a very significant number. Now this isn't recurring. This has really been a moment in time where this margin has gotten very, very large, and we expect that this will normalize over the next 6 to 18 months. This is really the first catalyst we see of the short trade. And then longer term or medium term, if you look at the agricultural cycle, it's obviously a cyclical industry inherently, and it's been very favorable in Australia over the past year or two. So while we don't know what's going to happen next year in this industry, eventually, it's going to go into a downswing, and the volumes and earnings on that basis will also normalize. So if we look at it through the cycle or a normalized level of earnings, Graincorp is trading around 20x PE. This is nearly double historical averages. So while we don't know the exact timing, we see that the share price could go back to where it started around $4 to $5 over time. We started a short position as the stock rolled from its highs recently in June and as the buyback was close to completing, and we've seen the stock trend a little bit lower as this gap between the international price and the domestic price in Australia has also closed right down now as Northern Hemisphere conditions have improved, and we've started to see more flow of grain in the Northern Hemisphere and also as the buyback is now completed and finished. So turning to the next slide. The next stock is ResMed, RMD, which is also trading on the ASX. This is a trading position. ResMed is the global leader in medical devices for respiratory conditions, particularly the CPAP machine, which you may have heard of. Importantly, demand for these devices is uncorrelated to economic conditions. It's rather driven by the long-term structural trends in an aging demographic and increasing respiratory issues, whether it's obesity or other health problems in adults. Why this is interesting now, we believe, is 2 main things. Firstly, the main competitor, Philips is expected to be out of the market for at least FY '23 as it completes the recall of its respiratory products. There were some issues with this last year. And number two, really, most importantly, ResMed has not been able to take full advantage of this, given the chip supply constraints that we've seen over the past 6 to 12 months. You need a chip to go into their CPAP device, which they haven't been able to fully source. And we've seen in the recent U.S. results season, the semiconductor companies are coming out and they're talking about their forward projections of volume and capacity, and they're saying that they're going to ramp up to the end of the year and that this supply situation should improve by the end of calendar 2022 and into 2023. So ResMed should be able to benefit from this. Also, ResMed's new product, which is a cloud-connected device, doesn't require a chip, and it's begun the rollout of that product as well. Feedback from industry participants, including a couple of major distributors for this product think quite positive. So we think that, that rollout is going well. We believe there's upside to consensus earnings expectations as ResMed builds their sales momentum over the next 6 to 12 months. We see the company growing at around 20% on a PE of around 30x for a peg of 1.3x. This is around 10% growth higher than market expectations. And from a trading or technical perspective, we've seen the stock trend higher short term and break out of its recent downward range that it established over the past 6 months and resume its longer-term uptrend. So now I'll hand to Jackson to touch on another theme we're seeing in the portfolio.

Hi. My name is Jackson Aldridge, Portfolio Manager at Cadence Capital. Today, I wanted to talk about a short across an industry, that we've seen a number of companies have extreme share price movements. And we think the fundamental drivers of the industry are starting to wane, and I guess that the industry is the shipping industry. So the shipping and logistics industry experienced, I guess, a never-seen-before surge in freight rates. I pulled up a chart here. You can see the freight rates have effectively gone up 600% over the period of COVID or ensuing COVID. And we think it's due to a number of things across the demand and supply dynamic, as it always is. So I guess the problem -- I wanted to touch on the problem and then to see where it is now and get an understanding of where the industry is going. So I guess on the problem, as I said, as always, it is the demand and the supply. So on the demand side, I guess, we're all spending huge, huge, huge amounts, the consumer was going nuts. There was stimulus packages. There was record low interest rates. And I guess as well that because of the lockdowns and because of the border restrictions. It was a huge surge to goods and not services. So there was, I guess, an above-trend demand for goods. And right at the start of COVID and kind of over the ensuing months, retailers did everything they could to get rid of inventory. Inventory was seen as a bad thing. You didn't want to get stuck with it because we didn't know what the consumer was going to do. We didn't know the governments were going to step in the way they did. So initially, retailers effectively flogged off the inventory as quickly as they could at discount prices, et cetera, and then quickly reversed course realizing, "Oh my God, there's this huge demand surge. We need as much inventory as we'd get." So they rushed to get as much inventory as they could. So again, there was this huge demand for goods to be moved around the world and physical goods versus service-oriented goods. And just a statistic is the -- typically, in America, between Long Beach and Los Angeles, they handle about 40% of containerized freight. And in the year from '20 to '21, their volumes were up 16% in terms of how many 20-foot containers they processed. That's huge. Like typically, it's been flat to kind of up 1% or down 1% and then to go up 16%. So that shows you the amount of physical goods that was being trafficked around. And then I guess on the supply side, there was issues with port congestions, labor shortages, reduced port operations because of COVID restrictions. And I guess the major pain point that people don't really understand in this industry is a large majority of the actual container fleet is leased out of Asia. And one of the stipulations that they have is that the container boxes have to be sent back to Asia. But as goods were shipped to America or shipped to Sydney out of China, which was operating at full speed at that time, our ports were either locked down or effectively at way below capacity. So there was this huge buildup of containers. So a huge amount of supply was out of the market. As China was operating and the world was demanding goods, a large chunk of the supply side was just sitting in these ports. So you're seeing this strain on supply, this push in demand and effectively, what it led was prices took off 600%. So I guess I wanted to touch on how it's going now and what the effect has been lately. In relation to the demand component that I'm talking about, it's the opposite now. Interest rates are going up. Mortgage rates are going up. GDP is declining and we're talking about a recession. Freight rates, which is a market kind of indicator, they've kind of been talking about through May and June, their volumes are down 10, 15 -- 10% to 15%, specifically 11% in the last 4 weeks alone. We talked about retailers wanting inventory and needing inventory and talking about the strength of the consumer. But in March -- sorry, in May, the Logistics Managers' Index reported that warehouse capacity is at an all-time low. So effectively, there's all this inventory sitting in warehouse. And we've heard it from major retailers, Target, Walmart. Big, big retailers, global retailers are talking about excess inventory, and now they're actually doing the other way and have to discount inventory to clear it. So there's an inventory problem. So there's not that pull anymore from retailers. There's not that pull anymore from consumers on the demand side. So you're seeing excess highly kind of elevated inventory levels. And then on the supply side, I guess, with the port congestion that I was talking about, just the best thing we can go is our statistics at the moment. Even as late as January in 2020 in L.A., there's about 110 container ships sitting offshore waiting to take containers back to Asia. That reduced to 45 in late April. So the backlog is clearing. And then I guess, this other point here I've got is that the containers sitting idle in ports in Los Angeles and -- sorry, Los Angeles, throughout COVID, were typically sitting there for 9-plus days. That's kind of the industry standard for sitting around idle for an extended period of time. So that's actually reduced by 52% since October '21, but remains highly elevated compared to normal. So there's still further reduction in that as backlog clears. But what it's telling us is that the ports are starting to get more efficient and people are back to work, and we're clearing this excess backlog of effectively empty containers that can't get back to China to ship goods around the world. And then the third or the next component of supplies is additional capacity. Like any kind of cyclical upswing in price is always a supply reaction. And in this industry, there has been just in early '22, there's been a 10% capacity uplift. And just to give an understanding of how much they're spending and how much more will come on, 2 of the largest U.S. container businesses, Triton and Textainer have spent roughly $5 billion in CapEx just last year, and that equated to their CapEx -- cumulative CapEx from 2013. So you can just see the extent of the supply side reaction. So effectively, supply is coming into an industry that demand is falling and just simple economics should suggest there's downward pressure on the underlying freight price. And just to touch on a company-specific, Textainer, I mentioned before, we have a short position on this business. Revenue growth for these businesses is pretty simple, it's driven by high leasing rates or low leasing rates, utilization and fleet expansion. So over the COVID, we saw the leasing rates go up. We saw utilization rates go to all-time highs, and the companies were expanding into this demand period. It reverses the other way, and these businesses have high leverage because they have a huge amount of fixed costs. And so on the upside, the profit works and then on the way down as we're seeing leasing rates come off, utilization rates come off, the expansion is done for these companies. So effectively, now we're going to see the earnings -- what's going to happen to the earnings, I guess. And I guess for Textainer is operational costs, they had a pretty significant one-off benefit. And the point to my thing about leverage is as you've got more utilization, you get more benefit out of your operating cost line, and it becomes much more efficient, but it works from the other way down. So as you can see here, roughly 17% of the NPAT uplift was just through kind of these operational efficiencies of having more utilization. And then from a free cash flow perspective, they spent the $1.6 billion of CapEx last year. Ex dividends, ex buybacks, the company actually was negative $1.3 billion of free cash flow. So sure, they've spent a lot of the money to participate on the upside now, potentially if freights stay where they are. But that's the big question mark that we're talking about. And just to show the scale of the leverage that this company has received is pre-COVID, they did about $1 of EPS with very little growth. And now post-COVID, there's about -- they just printed a $5.62 number last year. The market is expecting $6-plus in '23 and '24. I just don't see how that's going to happen as it's a cyclical business, right, and we've explained the drivers of how the supply has reacted. And you can see that, as I showed in that first chart, the freight rate is coming off quite quickly, and we expect that to somewhat normalize over the next kind of 6, 12, 18 months. So that's kind of my pitch on Textainer. And then I've mentioned a couple. We have a couple of these shorts on. We're looking at a couple of these. There's DAC, ZIM, Triton, as I mentioned before, Star Bulk Carriers. There's a number of these businesses that are going to experience the extreme negative leverage, negative operating leverage that we've spoken about. So I'll now pass on to Karl to finish up the presentation.

Thank you, Jackson and Charlie. Turning now to the outlook for the year ahead. Obviously, last year, we saw significant changes in trends across the market. We've seen interest rates, inflation, energy prices and commodity prices change significantly over the last 12 months. And this has led to very different types of stocks performing well in 2022 versus the similar period in 2021. And we were just reflecting when putting this presentation together on just how much expectations have changed in the last 12 months. We wrote 12 months ago that the RBA said rates will remain at around 0% until 2024. And now the big banks' economists expect them to rise to around 3% by the end of 2022. We've seen that the market and households are currently experiencing rising mortgage payments, increasing energy bills and food costs and face a very different year ahead compared to the recent years of stimulus and an inverted commerce free money that has existed within the economy. While this will obviously create significant headwind from many businesses, it will also lead to opportunity for others. I hope that we've outlined for you a number of core positions within our portfolio that represent opportunity to make returns in this environment. And we will continue to focus on implementing the Cadence process of finding those cheap and core positions or the real expensive core positions and going long or short those positions and adding to our positions following these market cycles. This has obviously served us well to date and we believe will continue to serve us well in the future. As we've outlined earlier in this presentation, we are holding high cash levels, and our liquidity is at almost an all-time high being able to liquidate nearly over 90% of the portfolio within 1 week. Ladies and gentlemen, thank you very much for listening to the year-end audiocast. And as always, if you have any questions, please do not hesitate to get in contact with us. Thank you for your time.