Spheria Emerging Companies Limited (SEC) Earnings Call Transcript & Summary

Good morning, and welcome to the Spheria Emerging Companies half year results shareholder update. My name is Chloe Tilley, and I'm a member of the Listed Products team at Pinnacle Investment Management. Today, I'm joined by Adrian Whittingham, Director of the company; and Matthew Booker and Marcus Burns, the Co-founders and Portfolio Managers of Spheria Asset Management. Over the next 30 minutes, Adrian will cover the half year results for the company, and Matt and Marcus will share their insights into the underlying SEC portfolio and broader market. And finally, we will open the line to questions. I'll now hand over to Adrian.

Thank you, Chloe, and good morning, shareholders. As Chloe mentioned, we are going to run through the highlights on Slide 3 for the half year for the financial year 2020. For the first half, SEC declared a profit of $4.6 million with company performance of plus 4.7%. You can see at the first point, one, and you can see below on that slide, a highly determined performance -- company performance over that period. We're also pleased to declare a $0.03 interim dividend, when combined with the final half of FY '19, provides a yield of 3.9% over a 12-month period. Also, during the half year, share buyback continued and we also made different statement that SEC is very poised to act as a consolidator in the space, and I'll touch on that in a few slides as we go to Slide 4 next, please. When you look at the breakdown of the NTA for that first half, you can see that we start with a pretax NTA at $2.04 as at 1 July 2019 and then end up with a pretax NTA at 31 December 2019 of $2.09. You can then see the components of the NTA through that period, including the portfolio, the performance and also the breakdown of the dividends and also the impact of the accretion from the buyback on the company. When looking at Slide 5 and the dividends throughout the period for SEC, I did mention that we have declared a $0.03 interim dividend. Pleasingly, that is a 50% uplift on the $0.02 that we declared over the previous corresponding period. It also ties in with the final dividend that we paid at the end of last financial year for the half of $0.04, providing annual or a 12-month period, a dividend of $0.07 per share. You can see in the table on the right-hand side, that the ex-dividend date will be the 6th of March 2020. The record date of the following date, 6th of March, and then the dividend payment date of the 20th of March. Looking at the discount to the NTA. I think we have all -- we've communicated very clearly and we've shared the disappointment with the shareholders if the continuing discount has continued, you will note that the buyback had an impact when we first started, when we first put that in place, although, unfortunately, the discount has continued to stay at a level, which we are unhappy with, and I will talk to that as to what we're doing moving forward. Then if you look at Slide 7, the discount for the NTA relative to our peers, we are certainly not alone in this space. It is not just an SEC phenomenon. You can see there the light blue line is looking at Australian small company equity LIC and its average discount. And you can see that over the last 12 months, there have been times when we have been above the average. Obviously, times when we were being below, but they really haven't deviated too much from that average. So at this point, I believe it's in that structural phenomenon since really the start of 2019. It's also something that's been experienced in other areas of the LIC space, of which I am sure, a number of you are well aware of. And look, it is something that we're very focused on, and we would like to see that now over the coming period. And then if I refer to Slide 8, which is the initiatives to close the discount. As I referred, we set aside a on-market buyback of up to $5 million. So far, the company has acquired up to $4.2 million as part of that buyback. It has been accretive to the NTA; however, the discount has continued to be prevalent. So we continue to look at that, although, clearly, we haven't put in place what we will be doing post this period once the buyback has been issued. I think it's fair to say that the buyback hasn't worked. And we remain absolutely focused on capital management, and we will continue to look at what we need to do in this space. The area that we have flagged is that we do believe we are very well placed to act as a consolidator in this space. There are a number of small company LIC not at scale. We have mentioned before that to be at scale, it would be nice to have a market cap of circa $200 million as an example and we will explore our options in this segment moving forward. So I can assure you that all directors of the company are very focused on ensuring that we get a good result for our shareholders and that anything to improve in that -- in this space will absolutely be to the benefit of the shareholders, if there's any consolidation or transaction moving forward. We've also looked at shareholder engagements. We've tried to reach out to a number of major shareholders. We've been participating in investor events in view the -- that the NTA is now weekly. And also the staff, the managers of Spheria Asset Management have acquired shares and they now own more than 750,000 shares in the company. So what I'd like to do now is to hand it over to Matthew Booker and Marcus Burns to talk about performance and how the portfolio is positioned moving forward.

Thanks, Adrian. It's Matt Booker speaking here. Just in terms of the performance last year, it was a very challenging market for us in that it was very speculative market, very growth-driven. We tilted more towards value-orientated companies, and we saw this really work against us. So we did underperform the index last year on a calendar year basis. We did see a better 6 months to the end of 31st of December and you can see that on the top chart where you see the theoretical performance post fees. The bottom table indicates performance post tax, post listing costs, and obviously, post fees as well. So you can see the impact on the NTA performance there, so a very difficult market in that it was very speculative. Obviously, we've moved into a very different market this year where the market was even more speculative in January month and continued into February. Obviously, we've seen a dislocation since. So we're seeing quite a change in the market environment, but we think that there's opportunity abounding in that, and we think we'll get some performance going forward from here, given the valuations are quite attractive at the smaller micro-cap end of the market. Now just looking at it on a graphical type basis. As you can see slide -- on that slide, our performance last year. So the green just indicates our relative performance since inception. And you can see the Spheria performance, the dark color versus the index. So again, it just highlights how, I suppose, positive the market was last year and we managed to keep up this year, as I said, we're seeing a different trend in the market. Now we'll talk about some of the companies that we've invested in to give you an idea of how we're investing.

Thanks, Matt. Marcus here. So first off, what we're going to talk about is City Chic, CCX, which is a small-cap retail that we own in SEC. And really, I mean, the core key factors about the stock we like, we've talked about sometimes before, is that it has all metrics we look for at Spheria. So great cash flow conversion. It's retailer of plus-size women's apparel, a really good history of strong cash flow conversion. The balance sheet is net cash. So even though it has some operating leases, which give it a little bit of underlying leverage, the business still carry cash as a buffer, and that's one of the things we like about that kind of business. It shifted over time from being a pure-store retail format to online. So last year, over 40% of revenues were actually online, which is capital light. And the way the business works, it becomes very attractive for women just to shop online as well as buy at stores because the sizing is very consistent between both forms of purchasing clothing. And then late last year, they made an acquisition of a business called Avenue in the U.S. -- or the online component of a company called Avenue, which had previously done roughly $100 million of revenue, and they paid about USD 16 million. So roughly 20 -- just over AUD 20 million for $100 million of potential revenue and attractive margins on the group. So this kind of stuff we like. It obviously has all hallmarks of what we like and currently is trading about 12x EBIT. The net cash balance sheet definitely serve for, we think, low double-digit earnings growth into medium term. Good dividend payer and great cash flow conversion and we think a very strong niche, which is a kind of business we find attractive and we'll be investing in. Matt?

Just moving on to Asaleo. It's a company we took a position in, in late 2018, early 2019. Obviously, it's been in the headlines lately. It does supply products into, obviously, the hygiene-type sectors. So it owns Libra, TENA and Tork. Tork is obviously a B2B business, which supplies age care hospitals and other commercial entities with products in that -- in the sanitizer space. So if you go into a commercial bathroom, you'll see that they supply most of the product in that bathroom. They're the biggest player in that market. They also have a strong position in New Zealand where they do own few lines of toilet paper and tissues, napkins, et cetera, which they're one of the biggest players in the New Zealand market still. The good thing about Asaleo is they did sell a division probably about 18 months ago, so their balance sheet is in much better shape now. They've kept the core parts of the business, which are growing rapidly and are much more insulated in terms of they have less exposure to pulp prices. So they've got a very strong and less volatile earning stream going forward. They have rebased the earnings, in that they're investing in their product. They're promoting their products more. This has taken a toll on margins, but we think the earnings are rebased, and the outlook for volume growth is quite strong across the business. So we think this is a better business. We think it's going to be a good cash flow generator going forward. It's on 10x EBIT. So it's trading at 33% discount with the parent company, which is based in Sweden. So there's a bit of an arbitrage there. And we think the outlook for growth is quite strong in the short term; obviously, with what we're seeing with the coronavirus still and so in the long term, given some of the demographics for the business.

And just to Matt's point there, when they made the sale of their tissue business in Australia, they really sold off probably the worst part of the business. They handled the most commoditized, most price-sensitive areas that are getting price wars with other peer players and sold it for a good price, got a lot of cash flow and naturally regeared their balance sheet. So as a company we're looking for another shift in strategy and a material change in the balance sheet. We find that attractive, we went back and bought the stock.

Just moving on to the top 10 of our portfolio at 31st of December. What we want to highlight here is that 6 of the companies actually have net cash. So obviously, in the current environment, having a good balance sheet is very important. Four companies do have debt, but they're well-funded in terms of earnings coverage of that debt. So we think we're well positioned to come out the other side. Obviously, we don't know how long the impact of the coronavirus and the impact on the economy will last. But looking at the statistics for the coronavirus, we think that there is the potential here that market is overreacting. However, there will be companies that had called out with stretched balance sheets. So we just -- we are conscious of that. We're going into some pretty difficult times in terms of the economic fallout from quarantining, from all sorts of actions which the government is taking. So this definitely has impacts on the economy, and we understand that. But we think there will be potential to make a lot of money coming out of this. I think Marcus has some thoughts around this.

I think that's right. I mean we -- the strategy we employ is to look for good free cash flow companies. All these businesses have good, consistent cash flow, which would matter in the downturn. Valuations also matter, and I think we're starting to see. So as Matt said early on, in this correction cycle, we saw fairly increment selling across small caps. Over time, though, that should become a little more discriminatory. And so businesses that are real, that have cash flow, that can buy their stock back, that don't need independent financing or -- independent financing from banks or stock market will tread through the cycle better than stocks that are very leveraged or speculative. And so we feel that we're in a good position to go into this and likely to use the opportunity to sort of find new, fresh ideas. So it does present us with a good opportunity to look at the portfolio. I think there are some stocks that maybe oversold, so we kind of think it's a very interesting period for us.

Yes. We think we need to play a medium- to long-term game and not get caught in the short term. And obviously, as I said before, since the risk is around solvency and balance sheet, so we just need to be conscious of that when we're buying into companies. But there's some good companies now that are trading at not all-time lows but lows -- multiyear lows, which are presenting significant opportunities because the companies have actually built good franchises and they've just been impacted by what we think are temporary events. So this is the opportunity out of what is the mess at the moment, especially on -- I think anyone who that takes a long-term view can make money from this point.

Wonderful. Thank you, guys. We now have some time for questions. We've had a number come through already. [Operator Instructions]

I'll direct the first question to Matt and Marcus. It's regarding Class, which is the top holding asset of December. CL1 has recently fallen 35% and the portfolio allocation is more than 5%. Will we be adding to the portfolio? And how does the weighting of greater than 5% sit in terms of portfolio risk management?

We've always said that our maximum weight is 5% active in a stock, and obviously Class is at that limit. It has a strong balance sheet. It's got cash of around $10 million. It generates a lot of cash flow. It's got a very defensive revenue stream and at 99 -- it's got over 99% retention of its customer base. So it's got high predictability of cash flows in the business. They've moved into an adjacency now, which we think represents significant upside potential in the trust market, but they're currently very predisposed to the SMSF market. But there -- basically, their product will be fungible into that trust market with the...

Current channels?

Yes, the development currently being spent on the trust component, which is the tax engine for a family trust. So we think there's significant upside, if you can take a longer-term view on this company. This has a huge potential upside. We've spoken to customers that are piloting the trust product. They're very excited by the features and the productivity benefit they're going to get from it. So we think there's significant growth. The sell-off is an opportunity. The issue for us at the moment is we're constrained by how much we own at the company. We have bought a little bit more in Class, but we are definitely constrained by how much we own in the company.

Thanks, Matt. And Adrian, what's takeover activity in the small-cap space at the moment?

Yes, sure. Thanks, Chloe. Look, we -- it's been said over the last couple of years, frankly, and we don't see that necessarily slowing up, so if we don't take up enough swing, I believe [ in that data ]. So we believe the corporation is still pretty active. Obviously, monetary rates coming down, so as long as banks are going to lend to parties like private equity, we're going to see a lot more activity. Clearly, with the dislocation in the marketplace, stocks are selling off. That makes it more attractive to come in to deploy capital. And see, we stayed advance -- at strong demand for the next 12, 18 months or so. Still very, very attractive. And all of these names that we're buying in as net cash, very attractive cash flow dynamics. Those business we like to buy are carrying some of their revenue stream, so they've become very attractive for companies to take over. So likely to remain elevated, I would say.

Yes. If you look at the private equity space, it raised a lot of money over the last few years. They need to deploy into the market. The market in our view is very inefficient at the moment. There's a lot of valuation opportunity, a lot of good companies around. They need to deploy to get paid. And so as Marcus said, we saw a takeover today, private equity taking out a small player in the micro-cap space. We've had Healius and Village Roadshow, which have had nonbinding, indicative offers from private equity.

And pretty material discounts there, frankly.

Yes. I think people are worried about the funding markets, but you have to remember these guys have significant equity. They can reduce the load of debt in these companies to make the acquisition. And these are good companies that are trading at relatively low multiples, but we think there is a trend, and we think that the trend is towards private equity takeovers, and we think they might be the marginal price setter in the market, given quants and passive have driven this inefficiency. We think private equity might take advantage of that, which would probably suit us.

Thanks, guys. We've seen the market sell off over the fears around coronavirus. How has the SEC portfolio fared? And how do you see this impacting the portfolio in the longer term?

Look, as we talked about, the selling has been pretty indiscriminate. Obviously, there's pockets of the market, which are very exposed. So travel, for example, is very exposed. People are canceling travel plans. Obviously, corporates are canceling travel plans. There are some beneficiaries on the other side as well. So obviously, the tissue makers, toilet paper makers and just the hygiene companies are benefiting from the spend. But at some point, that will abate and there'll be an air pocket, which will be hard to fill for those companies as well. So you can't just extrapolate that going forward. And the other risk is obviously aged care, aged care in terms of the occupancy rates. And sadly, the coronavirus, the fatality rate is very high for people over 60, so that will impact aged care potentially, although we have to understand that Australia is very good in terms of standards of care. And so we're hoping that the impact might be too severe. But that's the kind of risk that we're seeing at the moment from a sort of sector-specific view.

Yes. So in terms of what we're doing with the portfolio, we would be looking at stocks that have solvency issues. So anything that's got a very geared balance sheet that can't withstand a 3- to 6-month reduction in sales or revenue by a fairly chunky amount is likely to go through a bit of a tough period. So we've gone through [ inside of ] the portfolio believing it's those kind of businesses. But to Matt's point, I think no one knows exactly how it's going to play out. Our current view is that it obviously will create disruption to supply chain, to commerce, the way people move around, et cetera. But at some stage, we'll have to look through that and find good opportunities. And so we're trying to position ourselves and what we can do with research to find attractive opportunities on the other side of this current malaise whilst making sure that portfolio is not overly impacted going into what could be a pretty tough period of the economy.

Wonderful. Probably there's time for 2 more questions. What do you -- why do you think Mortgage Choice is a good investment? And has the allocation to cash increased during February?

Our cash levels are fairly constant. We're not going to panic in this market. Mortgage Choice has net cash. You can see in the property market that volumes -- mortgage volumes are going up quite strongly. I think Mortgage Choice had 23% gross growth in its applications on a 6-month sequential basis. So they're seeing strong volume trends in the business. The current sell-off in the share price, we find hard to understand. The company would be trading on less than 10x earnings. We think the outlook for volumes is definitely improving. There's a lot of stimulus being thrown in the property market, and as I said, the property market is holding up really well. The sell-off, I think, is just -- is hard to understand especially when the company is printing at 7% fully franked yield, and that yield will probably grow by double digit this year and next year and potentially more. I think that the population and customers will move more towards the property market away from the share market, given the volatility we're seeing. I think that will just be the trend. I think the market -- the government will try and stoke the property market because they don't have any levers at the moment, and that will be more stimulus for the property market. So the sell-off is an opportunity. Mortgage Choice has about 4 -- 3% to 4% share of the market. We think the market is moving more towards brokers, away from the banks. Brokers bring independent advice to the market. There's less regulatory potential impact on the business now that the Hayne Royal Commission has passed without any change to the industry except maybe more onerous conditions around how advice is provided. So we actually think the outlook for Mortgage Choice is quite strong. The sell-off is a huge opportunity. The risk is quite low in the business. It's got a $55 billion loan book. It's an annuity-strain type business, and the volume growth outlook looks pretty robust to us.

Perfect. Thank you, Matt, Marcus and Adrian. And thank you to everyone who joined us today. For further information regarding SEC or to access a replay of this update, please visit our website, spheria.com.au. Enjoy the rest of your day.