NAOS Emerging Opportunities Company Limited (NCC) Earnings Call Transcript & Summary

Good morning. My name is Sebastian Evans, I'm the Chief Investment Officer of NAOS Asset Management. Welcome to what is the Second Quarter Update for the Financial Year 2024. I always keep thinking it's still 2023. Obviously, capping off and giving a little bit of a summary on what's been a pretty volatile and dynamic quarter. As you would know, all of the -- as we do all the time, the presentation material was sent around. It's also on the ASX. If you're not sure where you can find it, so if you go into NCC, NAC or NSC, you'll be able to download it in the next few minutes. If you do have any questions, as you know, I always try to -- always do answer everyone's questions. So feel free to use the chat box on the right-hand side of the menu. If that doesn't work for you, my colleagues will see an e-mail. If you write an e-mail to inquiries@naos.com.au and they'll text me through the question, and I'll answer it. I've already answered quite a few questions via e-mail already. So if you do forget, don't hesitate to just e-mail me a question directly. Moving along, clearly, the disclaimer. I'm not going to read that to you. As you would have known by now, we tend to refer to a number of investments in a number of businesses, both public and private. Don't treat it as cost pool, do your own homework and seek your own independent advice, whether it's tax, financial advice or whatever else may be. This is all very general in nature. For those of you who do not know NAOS, this slide's chart gives you a little bit of the summary. This is going into my -- I think, it's my 17th or 18th year now. We launched our first IPO in 2013. It feels like on an eternity ago. But what we do has not really changed over that journey. We focus on investing in emerging companies. So generally, the smallest or the more illiquid part of the market, both public and private. That remains what we do in our core belief today. We have 3 LICs and 1 private investment funds roughly represent or invest funds on behalf of 7,000 shareholders or investors, which is obviously clearly a privilege, and I work alongside 9 very talented individuals. And clearly, you'll see down the bottom right there that directors and staff are some of the largest investors across all the LICs. I don't own a share outside of the NAOS LICs. All of my investable funds are held within NAOS. So when we're performing, clearly, we all benefit and when we're underperforming, like we clearly have done so over the past few months, it hurts us just as much as it hurts everyone else. Next slide, please. Why we believe we're a little bit different? I know people have seen this slide before, but just gives you a flavor of how we go about our investing and execute on that philosophy. So we have 15 core investments. We're very concentrated. One of our largest investments, the CEO will be speaking today, Peter Loimaranta, who is the CEO of MaxiPARTS. We're privileged to have him give a little bit of time in his day to run through the industry that MaxiPARTS are exposed to. We sit on, when I say we, NAOS, as a representative on 7 Boards. So we are quite an active investor. We're not an activist. We consider ourselves long-term supportive shareholders. And you can see that the average holding period is now more than 6 years, it's probably closing in on 7 years. So generally, we have a holding period of at least 7 years. In some cases, it's probably closing in on 10 or 11 years for some of those longer-term investments. But they are small businesses. They generally make roughly $25 million in pretax or EBIT earnings. Next slide. And then finally, the reasons not to invest with NAOS. I'm sure many of the people on the call could list these for me. As I said, we're concentrated. That implies we will generally have a very high level of volatility. Generally, our returns bear no correlation to the small ordinaries or our index because none of our investments are actually within the small ords. So you would see that over the past 3 months, our returns have been completely different to that of small ords. We have an industrial focus, so we don't invest in resources or very early-stage businesses. They are small businesses, though. And we are ESG aware, so we focus on our businesses providing a positive impact to all stakeholders. And then finally, as you would know, some LICs can trade at premiums or discounts. But for us, it's the most sensible investment vehicle because of the way we can stream our fully franked dividends, but also the way we can invest in illiquid businesses in a concentrated manner. We wouldn't be able to do that in a unit trust structure. So to the money slide, I'm sure most people would be referring to or looking at. If I was to summarize Q2 quite bluntly, word that probably comes to mind is just frustrating. To put it in context, October was extremely strong for us. I think all the funds were at least 6% ahead of the index, and that reversed through November and December. And the reason why that reversed through November and December is many of you would have realized that the index went on a tear -- a very positive tear, and you've seen markets now move to record -- all-time record highs, driven by some of the comments that I'll touch on in the following slide. And what that really means for us and what we've seen now for years, this is probably the third year we're seeing this. Small cap and micro cap stocks are not really turning investor attention because people are very focused on liquidity. The way markets are moving, markets are focused on macroeconomic events. People are risk adverse, so they want liquidity. And what that means is when certain comments are made and macro events occur, people look for the most liquid stocks, whether it's up or down. And what we've seen over the past 3 months now, if you include January is, the liquid stocks are running, and they're running very, very hard. And we're not seeing the smaller stocks in the market catching a bit. And I'll give you a few slides in this presentation to show you how big that discrepancy is. Like if you look at the smaller stocks in the Emerging Companies Index, they were down on average 30% through calendar year '23, which is obviously a big difference to the 10% or so that the ASX100 returned over the same period of time. Next slide, please. So just a quick summary. I'm not going to read this word for word. But as I said, Q2 was very volatile. The all ords returned including dividends, 8.7%. But when you look at the fact that November and December returned roughly 12.6%. That shows you that the first month of that quarter was significantly negative. So it really shows you that November and December were awfully strongest months we've seen in a long time. Really due to the fact that inflation globally has started to come down and come down at a fairly rapid pace. And what that ultimately means is investors or speculators, economists, whatever you want to call them, expect interest rate cuts now to be significant through calendar year '24, which is obviously providing support for stock markets globally. Domestically, a comment that I think is worth touching on is overseas migration here was a record 518,000 people welcomed into the country, and that is really providing a floor under the economy from a demand perspective. But if you were to remove that, the underlying demand we would see in Australia is actually quite a bit softer. And that's why GDP only just managed to stay positive at 0.2%. But if you took migration out of that, it would have been very much negative. As I'll touch on, interestingly, earnings expectations for '24 and '25 remain very depressed. So even though the market is up roughly 14% over the last 3 months, what we expect from an earnings perspective is actually negative to flat growth over the next 18 or so months. And then finally, the other thing we have noticed, and we continue to see is corporate activity is ever present in this market. So what we consider to be the smart money around, so people who can take a long-term view, keep some of these businesses private, take them off the public markets, where public scrutiny and I suppose, subjective valuations, they're putting their money to work. So Link Administration, Pacific Smiles, I call it, Adelaide Brighton, Pact Group, Chemist Warehouse, a takeover of Sigma Healthcare, there's been a lot of corporate activity. So people clearly believe that public valuations are not taking into account the long-term prospects of some of these businesses, and therefore, they're willing to take them private. Next slide, please, Angie. This slide here really touches on the second -- or third last comment that I made. And this looks at how earnings, I suppose, expectations change through a year. So you can see we've got the earnings expectations for every year since 2001. And what you can see is generally, most of the time maybe 3 or 4 years, earnings expectations start high and they finish low. In the case of 2023, as you can see there, expectations for growth is actually negative. So we're negative 5% from an analyst's perspective. But even so, share prices are on the rise. So that's really telling you that returns for shareholders are going to be driven by valuations. And that's something we speak about internally. I'll throw Peter under the bus here unfortunately and say, well, if you believe MaxiPARTS is going to earn x next year, it's on a PE of 11%, whereby some of its peers are trading mid-teens at least. So yes, we believe we can get a good return out of MaxiPARTS assuming that, that valuation gap closes. Even though the earnings growth of MaxiPARTS is not going to be 40% or 50%. It's going to be something a lot less than that. And that's really the market we're in. The issue we're seeing though in microcaps is those PE valuations are just not changing. If anything, they're going backwards, and it's proving extremely frustrating for us. But as I said, when I went through the GFC and a few other periods of time, when it does reverse, it reverses in a very significant way and share prices go up the elevator and they can be up 20%, 40%, 50%, 60%, 80% in a very short period of time, just due to valuations being rerated. Next slide, please. This is, I think, also extremely powerful slide. And I don't think people probably appreciate what the market is pricing in. These 2 charts just look at -- one looks at a rate cut or the history of rate cut cycles and the other one looks at what the market is pricing in. So on the left-hand side, you can see the last 3x interest rates were cut significantly. You can see in the blue column, the number of rate cuts that occurred, the duration of those rate cuts and obviously, the total rate cuts. So you can see generally that the amount of rate cuts is significant. It generally happens in quite a short period of time, and they go on for quite a while. They are quite consistent. If you look to the right-hand side, you can see that in the U.S., this is not Australia, a bit in the U.S., you can see that what the market is expecting. This has changed slightly because the Fed obviously met last night. You can see that basically from May onwards, the market is expecting -- in regards to futures the market is expecting an interest rate cut every month from May to December. So you can see that you have 6 rate cuts obviously in 6 months from May to December every time that they meet, they don't meet every month is significant. And I don't think a lot of investors actually appreciate that. But that is why a big part of the reason why the market, the U.S. market especially, has reached record highs because it's telling you that they expect a very favorable macro backdrop as interest rates come down and come down significantly. Next slide, please Angie. And this slide, I appreciate, it's probably slightly complicated. But again, I think it's very important for the time that we're in. This looks at market expectations of rate cuts relative to what the 18 Board members on the U.S. Federal Reserve expect. So the red dot or the orange dot is what interest rates the market is pricing or futures is pricing in. So you can see in 2024, the market expects rates to be 4% in the U.S. and then 3.25% and then 3.25 in '26. The dots are all the Board members and what they expect. So you can see that the market in 2024 is well ahead of what the Federal Reserve expect or all the members expect. Again in '25, you'd say the market again is ahead, maybe just but is definitely ahead. But then further out, surprisingly, the market is actually quite a bit higher relative to what the U.S. Federal Reserve expects. So what we're trying to get across here is we are saying the market is extremely aggressive when it comes to interest rate expectations around cuts over the next 12 to 18 months relative to the Federal Reserve and even the Board here. So it will be very interesting to say, we saw last night the market is down 1.5% today because the Federal Reserve were actually more constrained when it came to rate cuts in the commentary around rate cuts and they categorically said don't expect a rate cut in March. So they expect the market to be very volatile. It is pricing in a lot of rate cuts. So if they don't occur, I would expect volatility to remain very elevated. Next slide, please. Just quickly touching on calendar year '23, just to give people a bit of a summary, I know we tend to forget about the year that was, we move on to January pretty quickly. So the small ords underperformed quite significantly to the ASX 100. The ASX 100 returning 12.6%, the small ords 7.8%. The same was, especially in the U.S., technology stocks just ripped all year. So the NASDAQ returned at staggering 44%. The S&P 500 24% and then the smaller stocks in the U.S., the Russell 2,000 returned just 16.9%. 16 9% sounds a lot, but in the context of 43.4% it's obviously a significant underperformance. Plenty of corporate activity. And the thing that was interesting was the corporate activity and some very well-known, long-established names, Invocare, the largest provider of funeral services; Blackmores, people would know the vitamin healthcare brand; Estia aged care; Costa Group, the berries; Adelaide Brighton, Pendal and Link. So corporate activity really ramped up. And the interesting thing was that the market actually hasn't been -- hasn't replaced a lot of these names. I think there were very few of those, one notable IPO last year. Yet if you look at the amount of names that came off the ASX, it shows you how -- I suppose the lack of depth in the ASX, we're starting to see. There are fewer and fewer quality businesses that remain on the ASX in our view. Liquidity was king. Illiquidity was not king and clearly, that's why we underperformed so significantly. And the other thing is there was very little correlation in my view from -- within industry. So some businesses in retail, some did much better than others. As I said, Kathmandu or KMD brand had a very poor trading update. There's businesses like Premier and Nick Scali. We've seen that across a number of other industries, such as the one that MaxiPARTS is in, which we've seen 3 trading updates from the 3 peers. So no rhyme or reason, really it comes down to a lot of execution and management capability. Next slide, please. And for me, this is probably the money slide out of all of the slides in this deck today. And this looks at the calendar year '23 performance of 3 indices, the S&P 100, so the 1 -- top 100 businesses, the small ordinaries which is our benchmark. But believe it or not, there are a lot of big businesses in the small ords. Keep in mind that these are based on liquidity, you get into an index based on liquidity and then the emerging companies index, which again actually has some big businesses in it, but we would argue is more relevant to our benchmark or our portfolio. And you can see there, at the end of the year, the 100 did [ 12% ] as the Emerging Companies Index, which did negative [ 2% ]. So you got underperformance of roughly negative 14%. And you can see, based on our returns, there were very similar to the emerging companies index. So the market is telling you, it's focused on liquidity, that's where the bid is. That's where people are focused on, but that will change eventually, as people become more comfortable, there's more stability or clarity on where the macro environment is going to head over the next 2 or 3 years. Next slide, please.. And then moving on to our guest speaker today, obviously, at all our webinars, most of our webinars. We like to get a guest speaker really coming from the horse's mouth, so to speak, from our investee companies. We run a very concentrated portfolio. So it's more important people hear from the CEOs and executives when they hear from me. We're very privileged to get Peter Loimaranta to present today. Pete runs MaxiPARTS -- has been at MaxiPARTS, I don't know the number of years, I'm going to say circa 15 years, I'm sure Peter will correct me. And more recently, became CEO of MaxiPARTS as it was -- as they divested their what was a trailer manufacturing business. We've built up a large shareholding in MaxiPARTS. We own roughly 19%. I got to know Pete and his team very well. So with that, I'll ask Peter to come on and present and run through the industry dynamics that he's seeing. In regards to questions, Pete, we'll be able to take questions at the end of the presentation, but I will just make one small comment. MaxiPARTS provided a trading update yesterday or the day before. So if any of the questions, please are not related to that trading update until MaxiPARTS release their full -- their half year result, I would appreciate it. So over to you, Pete, and thanks again for taking the time to present.

All right. Thanks, Seb. So look, today, I'll certainly focus on what we think some of the underlying drivers are of the commercial vehicle parts market as well as some of the trends that we've seen over time. So if we just jump through to the next couple of slides. Thanks, Angela. Look, this statement might sound ideally simplistic, but generally, the more freight that gets moved around Australia by road, the more vehicles there are I mean quite direct effect, the more replacement parts that get sold. So that link between freight movements, vehicle movements and replacement parts probably as strong as it's ever been. So certainly over a number of years that compliance and regulatory environment that a lot of our customers operate in as transport operators has significantly improved. So the ability to push out services, not replace broken parts has disappeared. So there's a very strong link back to the road transport [ task ]. If you look at the table, you can see that it's been fairly consistent over an extended period of time and has seen some consistent growth that's come through. And that growth and consistency happens through various larger macroeconomic cycles. Those trends of consistency and growth expected to continue through as Australia continues to develop business and the economy. Although we might end up with some individual customers, and we might have some individual stores that have larger exposures in the end markets. On a national basis, there is a wide variety of economic drivers contributing to the road freight task. It includes retail, essential service markets, mining, manufacturing, agriculture and construction. So all of that exposure to a variety of end users is what we believe has driven a real consistency in the growing the freight task within Australia. We jump through the next slide. So the freight task is obviously the key driver. There are other influences. Our view is the other influences are significantly smaller. But if I look at the top right graph, and look at the number of commercial vehicles operating in the market. And we can see generally, it's reflected the growth in the freight task. So although there has been a number of changes in vehicle dimensions and carrying capacity over the time, generally, we've seen the commercial vehicle part increase in line with the freight task. One, we always get asked question, what is the age or the average age of the truck fleet. So Australia certainly has what would be considered an average age of fleet that is older than in a lot of developed world, but as we can see, even though there's been some minor fluctuation still has been fairly consistent over time. And from a parts point of view, certainly, an older truck has a bigger pull-through than a brand new truck. But a lot of the parts that get supplied into the marketplace is really driven by usage as opposed to age. I guess, another key question we always get is more around the bottom right-hand slide in terms of what's the mix of the commercial vehicle market doing and is it changing? So as you can see, the different types of commercial vehicles have all seen growth. What's not surprising, I guess, is as we're seeing home delivery and online shopping increase, the light commercial rigid truck is certainly growing at an accelerated rate compared to some of the other models. But nothing of a material movement that has changed with the dynamic of the commercial vehicle parts market in the short term. So, I guess, that the summary there is freight task is a key driver. Demand pull-through has never been as closely aligned as it is today. So if I just touch on some other trends that we've seen in the industry over time. The first one I'll talk about is industry consolidation. So there has been some industry consolidation over a number of years of larger transport operators buying up some of the smaller operators. What's also happened is the consolidation spend. So a number of years ago, larger fleets operated, basically in isolation, it's workshop will do their own thing. Although there's some exceptions, one of the larger customers is really focused on consolidating their spend and looking to get consistency of suppliers and a reduction in suppliers. So although there is very few exclusive relationships, there's certainly been a push to reduce the number of suppliers the larger customers deal with. And that certainly helped supply like MaxiPARTS that operate on a national basis and being able to provide a consistent service and option on a national basis. In terms of suppliers or competitors, which is where MaxiPARTS sits in the transport industry, once again, there's been consolidation of which MaxiPARTS has played a part in. There has been consolidation of the mid-tier and a number of smaller parts operators. So we are in a market now where there are 3 larger national competitors. There are still a range of localized small competitors and then there's the traditional truck OE part service capital equipment distribution model that has various structures and ownership forms around Australia. Next trend, I guess, I want to touch on is, the aftermarket product range itself and what we've seen in the growth both in volume as well as acceptance over time. So that acceptance and growth obviously, was partly driven by operators looking to reduce the cost base of their operations. But I think more importantly, it's been driven by an increase in the quality of the aftermarket alternative compared to what it was 10 or 15 years ago. That improvement in quality is really being driven by 2 different assets. One, the manufacturers themselves wants to improve prices and consistency. And then you've also got the distribution now pretty much dominated by larger corporate players who have a lot of structured process around how they develop, select supplies, which has driven an improvement overall. That said, we still see a wide range of use and demand from different customers. We one of the guys where a customer generally wants a full OE replacement system or for aftermarket. What we're seeing now is a lot of that customers want a more customized approach where, as an example, they might want a novel part solution for their braking equipment, but they're happy to have an aftermarket alternative on shock absorbers. So we certainly have a multitier product structure and approach for a range of different product groups in the range, and that allows us to customize our offering to the market as a whole, but also to specific customers that we deal. Finally, I don't think it would be appropriate as much as I'd like to that we get through talking about trends and not talk about alternative powered vehicles. It's obviously extremely topical. So at this point in time, we've seen very little market impact or very little penetration of the alternative powered vehicles in the commercial space. Where it has happened, it's certainly at the lighter end, more than home delivery, grocery market. When will that change? We know it will change, when it will change, would probably be more driven by how that industry overtakes or overcomes some of the initial challenges, which are really based around the initial cost of the vehicles, the operating range of the vehicles, the support and the infrastructure and their impact -- the wide impact of those vehicles limiting carrying capacity, which therefore limits some of the applications. At the heavy end, there's still a range of different developments being done by different people around electric options, hydrogen options. We do expect to see more trial units and prototype units coming into the market over a couple of years -- over the next couple of years, but certainly, we don't see any dramatic impact or change in the near term to the market. When it does change, and what do we see from a parts point of view, there will be a shift in demand in some of their historical ranges that has volume increase. So away from things like filtration and oil as electrical sort of picks up. Certainly, in the early adoption, given the new technology limited volume, we think the supply of the newer parts linked to the alternative will probably go back through the truck OEs, along with servicing. But as market scale increases, we think there'll be a natural [ dip ] in the distribution options that are available for the new technology and that will include development of aftermarket alternatives, and we think longer term markets have probably bounce back yet to somewhere as a dynamic like we see today. So hopefully, that's provided a small insight into commercial vehicle parts market. And as Seb said, I'll certainly hang around and can answer any questions at the end of the session.

Pete, I might just ask 2 quick ones before you get to the end just to[indiscernible] if that's fair.

Can you comment on like some of your clients have moved from OE parts to aftermarket parts sort of their feedback on that transition and have they ever moved back to OE? Or do they just slowly transition more and more to aftermarket parts?

Look, you occasionally have customers with bad experience and people tend to make their decisions on experience. So [indiscernible] far away we think the experiences people have nowadays are better as I said, that quality improvement has certainly improved over time. So there's not a dramatic gap in quality of new and aftermarket parts. We certainly think having larger distribution partners like ourselves, who customers feel confident and stand behind a product and if it's an issue. If it does come up, it gives them confidence to move. But as we said, we certainly see customers a lot more specific. They might want to have an OE solution [ on parts ] which is critical for them in their safety mechanism, but a shock absorber, et cetera, then they're happy to have an alternative solution. So a lot of products, we have an OE solution that we offer, and we have an aftermarket solution and we will let the customer drive that approach.

And I should really know this, but maybe for everyone else. And out of your customer base or your revenue profile, what would be the split between like large -- those large multitruck customers sort of like family mom and dad operators?

Yes, in terms of the quantity of customers, we have a big tail, it's 12,000-odd customers, so certainly the quantity of customers [ tail ] and the overall value sits there by default, but certainly larger fleets or medium-sized fleets have certainly been a growing area. It's now sitting up in the mid-teens slight number of their total revenue base. We then also have other parts, resellers, other trailer manufacturers, independent workshops [indiscernible] a fairly diverse customer base.