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

My name is Chris Meyer. I am part of Pinnacle. We're a strategic investor in Spheria Asset Management, and the manager of the SEC portfolio. We also handle all Investor Relations for SEC company. It's my real privilege to be your host today. I'm joined by Matthew Booker, Portfolio Manager of the SEC portfolio and Director of the company. Matt and I will do a bit of a tag team today. I'll run through the company section. Matt will run through the portfolio, and we'll get you out of here in half an hour. We will take questions at the end. [Operator Instructions] The slides for today, Matt and I will actually run through them on the screen with you. For those of you who are unable to actually view our screen, you can also get the slides on the ASX website or actually on the SEC website, the company's website, and you can follow along, Matt and I will refer to the slide numbers in case you can't see what is up on the screen. A replay of this will also be sent to you at the end of the session, probably sometime today, in case you want to listen back to any of the points that we've made. So, I think with that, let's get off. Shall we, Matt? So…

Yes.

This disclaimer is, if you can just cast your eyes over it, mainly, I think what we're trying to tell you here is that we're not giving you a personal financial advice. We don't know your personal circumstances, so please take these comments as general advice. As I said today, we'll split it up between Matt and I. I'll do the company update. Matt will do the portfolio update, and then we'll head into some questions. So, on the company, it's a bit of a strange one. LICs like Spheria Emerging Companies, STC, have a portfolio of listed securities. Those securities are mark-to-market on a yearly basis.

Yes. Hello. Chris, you dropped out. Can you hear, Chris? Okay. We'll come back to Chris -- you're back now. You just dropped out for a minute. Okay. [indiscernible] on Slide 6 again.

Yes. So on Slide 5 here, you can see -- what I was saying is that listed investment companies like SEC have a portfolio of Australian equities. Those securities are mark-to-market at the end of the financial year, which was June 30, 2022. The markets were down. That resulted in accounting loss. It's nothing to be alarmed about. As markets recover, those losses are extinguished. What's pleasing though from the slide, 2 things. One is the portfolio did outperform its benchmark by 5.5%. It's a pretty significant number, and you'll hear a bit more from Matt about that later. And secondly, the company is becoming a more significant dividend payer. Those of you who've been invested since last year will know that we changed our dividend policy to be quarterly dividends, targeting 1% of the NTA every quarter. That's resulted actually in a dividend yield for the year of 5% cash, 7%, including franking, which is -- I think for those of you who are invested in the SEC for income will agree that, that's a fairly substantial quarterly distribution that's not being paid to you. If you look at the NTA waterfall chart on this slide here, Slide 6, you'll see that we started the year at $2, just shy of $2.60, end of the year at $2.09. The largest contributor to the fall in that NTA was the fall in the portfolio's value. So that's $0.35. We also paid $0.125 worth of cash dividends during the year that includes the final dividend from FY '21 and 3 quarterly distributions that were paid during the financial year. Pleasingly, as markets have rebounded in July and August, the NTA is back up at around that $2.30 level at the middle of August. If you just roll forward to the Slide #7, you can see the dividends. So SEC has always been a reasonably good dividend payer. It is one of the objectives of the company. For the first 3 years of its life, we paid semi-annual distributions. You can see that on this chart at the bottom of the slide. However, in September quarter of last year, we switched to quarterly distributions. We felt like, as a Board, shareholders would appreciate a more regular dividend and also a dividend that was set at a clear level of dividend. And so, we introduced the 1% per quarter of the post-tax NTA distributed every quarter. And you can see that that's now being paid in the last 4 quarters. So we've lived up through that commitment. That's a cumulative distribution for the year of $0.098. As I said, if you take that as a percentage of the share price or the average share price for the year, that's a 5% dividend yield or 7%, including franking. Interestingly, if you summed up all those distributions since IPO which took place in 2017, that's $0.338 of distributions over that -- over the life of the company, which, if reflected as a percentage of the $2.00 IPO price, is about 17% of the IPO price. So, always, I think, when you think about your investment in SEC, don't just think about the return you're getting from a capital growth perspective, but it's important that you also pay attention to the distributions that you've received. Just a final slide from me then on the company's performance before I hand over to Matt. This is a table which shows you, I think, the most important figure to probably focus on there since inception. So SEC is coming up to its 5-year anniversary that will happen in November of this year. So we're at the June period end, a little under 4.5 years since inception. And you can see there the company has outperformed its benchmark by about 2.8% per annum after fees, which is a significant accomplishment by the manager, so well into [indiscernible]. You'll see that on a 1-year basis, 5% -- outperformance were just over 5%. It was a really good year for Spheria. The market is much more -- this kind of market is much more their kind of market. And so, with that, Matt, I'll hand over to you to tell us a bit more about what's going on in the portfolio.

Okay. Thank you, Chris. Just a bit on our process, and most of the shareholders will know how we invest. We're very cash flow focused in what we do, and very fundamental driven. And we believe strongly that cash flow drives company valuations over time. And what we're trying to drive is a sustainable free cash flow generation, I guess, forecast for the business. Given we've got actuals, we should be able to forecast those cash flows going forward. We do a lot of industry work. We look at the company's position in the industry and the sustainability of that position and try to determine that cash flow -- I guess, cash flow cycle for the business. And then, I guess if we find a good, legitimate company with cash flow, then we move on to the next stage, which is valuing those cash flows, and that's a really important component because, obviously, you can find a business that generates free cash flow, but you could pay the wrong price for it. So it's very important that you have a valuation that underpins what you're doing. And without that anchor, you're kind of flying blind in the market. And then we have a number of risk controls. So, obviously, we want to buy it at a discount to valuation, but also we want to buy companies where the balance sheet is sustainable. And that means that the cash flow can support any debt in the business. Ideally, we like companies that have no debt or very limited debt, and that reduces the risk in that business. We always say that you need to keep an open mind, particularly in the small cap market. You get inflection points in businesses and industries. You get changes in management and strategy and shifts in industry structure. And it can take a company that, for example, might be unpopular for whatever reason. But if you do see a shift or a change in the industry structure of the company, you can get a real shift in that company's prospects. So we just need to keep an open mind with these companies in the small cap space. It's not as simple as buying a large cap company, which is very stable. I mean you can find companies that I guess they're at the bottom of the cycle, and you can make a lot of money out of those companies in small cap. The other aspect to small caps is, it is a very inefficient market. It's under-researched. The research can be quite spotty in terms of coverage. There's a lot of turnover at the broking side of the equation, and there is a lot of inefficiency, I guess, in terms of coverage. And we can take advantage of that with our systems and our people and the resources we have, and also, obviously, the experience we have in the team. If you look at portfolio performance, we have outperformed on a relative basis, particularly in the last 2 years. And I think the environment has suited us. I think you have seen changes, I guess, in the market over that timeframe. We -- obviously, we went into COVID and it was a very difficult environment prior to that. It was very speculative. The COVID sort of, I guess, environment, changed market dynamics. You really saw valuations dropped quite precipitously, and that created a huge opportunity for investors. We felt that there would be stimulus that would lift, I guess, the economies and the markets, and that did happen. And there was significant opportunity within that time -- within that set of companies. So we rotated the portfolio pretty aggressively into companies where there was a lot of valuation upside and where we thought the risks were over imputed in the share price. And we made a lot of money coming out of those COVID downturns. And then since what you've seen, I guess, earlier in this calendar year, is a real change in the market dynamics, and that's where interest rates have gone up globally. So I guess the monetary stimulus has been ratcheted down, which has been a much more difficult environment to make absolute returns in. So the economy is obviously [ inburning ] for the last probably 12, 18 months. I guess the Central Bank has been slow, to slow down the stimulus, and now we're facing significant inflation across the global economies. And that can be quite a depressing type outlook. However, the valuation set within that has improved, or the valuation equation has improved dramatically in the last 6 months where you're effectively getting paid to own companies. Multiples are very low in certain names, in certain sectors. People are pricing companies, I guess, off the current conditions and not looking forward, and the multiples, I guess, are getting quick payback on. So there's a lot of opportunity out there. And so, we think it's a good time to invest. You're better investing now after a downturn than at the heights of an upturn. So, I think from our perspective, we have a mantra about buying low and selling high, and I think you're in that low environment at the moment. So there's an opportunity out there. We move to Slide 13. I think we can see the stock attribution for fiscal year '22. It's a bit over the shop. I think you can see that there's a lot of blue on that left side, which means we've had a lot of positive contributors in the portfolio. So we've chosen some good companies over that timeframe, and there's a diverse type of company within that set. You can see we own -- Flight Centre, for example, was a big contributor to performance last year. It had a good share price performance on the back of travel mean reverting across the globe, as obviously the restrictions came off globally. And Michael Hill managed to produce record results in the last 18 months despite having a significant chunk of its network closed for the last 12 or probably the last 24 months. So they're producing record results. Clearly, as the restrictions have come off, they'll have less store closures going forward. So that should -- kind of going forward. But obviously, the market could be a bit weaker. If the economy is a bit softer, that could impact demand. But we think there's enough levers to pull that -- they'll perform pretty well. And they're being priced at the moment, very cheaply. The stock's trading at about 4x EBIT or 4x cash flow, which is pretty crazy, and it's got $100 million of cash. During the period, Class was taken over, and Class, one of our probably bigger positions that we've owned, probably since the inception of Spheria, and it was taken over for a significant premium. And we thought that closed the gap, I guess, to where we thought valuation should be. Look, you could argue that it was relatively cheap in the scheme of tech companies in terms of the final valuation. However, we think there were synergies with the acquirer, and we've retained shares in that acquirer since. And then, for example, you've seen a massive shift in the market. And you can see that Zip Co, a company we didn't own during the period, and it was a positive contributor because we didn't own it, I think it fell from probably $10 or $12 from its highs down to -- I think it got down to $0.50 somewhere in June. So that was a sector we had avoided, and it's turned out favorably for us. And those sort of sectors where you get bubbles forming, there's no profit. There's lots of revenue. There's no cash flow. Yes, you can make paper money out of it, but can you make sustainable returns out of it? And that's the big question mark around those bubble type sectors. And so, you've seen that with buy now pay later, the Afterpays, Zip Cos, the Sezzles, all those names, performs well for a period, and then the bubble burst, and you've seen significant pain in that space. Lithium's going through the same process at the moment. Yes, lithium makes sense longer term. EVs obviously are a growing proportion of automotive transport, and that will continue. However, we think the lithium price is not sustainable at these levels. There will be a supply reaction, and we believe that bubble will also burst. If you look at the names that we can invest in, in this market, most of them don't generate any money. They're explorers. And so, that's a very dangerous type equation to us. So we've made money, I guess, through adverse set of names through the cycle. All those names, if you look at them, generate good cash. Yes, we've lost some outfit during the period owning companies. That's part of the portfolio, I guess, that we're not -- not everything is going to perform well during the period, but there will be a portfolio effect, and some of those loses will become winners the next year. So we'll keep it with our mantra, buying high cash flow companies, and where -- companies where we believe that the valuation makes sense. If you look at our top 10 companies, I guess, we've had some -- if you look at the results season, we've had some disappointment at the result period. Blackmores is one of our biggest positions. We think it's a high-quality business. It's growing its top line at double-digit rates. It's growing in those Asian markets at 30% plus rates into Indonesia, Thailand, and even China is starting to grow again. Australia is back on the growth path. However, the issue we've had with Blackmores for some time is the cost side of the equation. They haven't managed costs well. And unfortunately, this results -- there was no sign of a turnaround, I guess, in that cost equation. The performance on the cost side was disappointing and the margins remained low. So they're currently generating about 10% margins. It's a company that used to generate 20% margins. So if they get back to those historic margins, you could easily double the profit. It's not being priced to generate 20% profit margins. It's being priced for probably low double digits. So there's not much in the valuation in terms of cost execution. But it has been disappointing for us that the management teams have 3 years there now. They've managed to grow the top line, which is good, which is very positive. But they haven't been able to keep a lid on the cost. So that's been a bit disappointing. Of the other companies, we've had a few others report today. IRESS reported their results, and that was a strong result. We think the outlook for IRESS is very good. And we've been investing aggressively into certain products, and they haven't yet seen the revenue benefit, and it's not being priced for that potential growth. And one particular segment of the market we're pretty excited about is the industry fund space where it's a big market. This merger is happening, and there's the potential for software changes in that market. So, we believe that the IRESS products is leading edge, and we'll take market share in that space, and it's not reflected in the share price. And then we've had some good results out of some other companies. Monadelphous reported a strong result yesterday, and Breville also reported a strong result yesterday as well. But it's been a bit of a mixed bag. The reporting season has been a bit all over the shop. I mean, some companies have been able to manage their cost bases and some haven't. But generally, the top line growth is there. So it's more a cost issue for the companies. And whether that's temporary or not is, I guess, the question that will be resolved in the next year or 2. In terms of examples of what we own, I think NZME is a good example of a company that we really like. It was perceived as an old world media asset several years ago. I guess it was going through a transformation, but it wasn't really showing dividends at the time. But what we're seeing now is strong growth in that business. So it's gone from an old world newspaper business, and it's moving to digital subscriptions. It's also moved into the property -- the digital property market. So it owns the second biggest property portal in the New Zealand market, but it wasn't always second. It was third or fourth maybe 3 or 4 years ago. So now it's outright second. And it feels like that market in that terms of that property market is shifting more towards what's happened in Australia with REA domain dominating the market. What we've got in New Zealand is Trade Me, the #1 portal, and NZME not far behind now in terms of audience, in terms of inventory. It's right up there now. And it's a matter of just monetizing that business, and you're seeing strong growth in that property portal side of the business. You're seeing strong digital subscription uptake on the newspaper side, and you're seeing strong digital advertising coming through with the newspaper as well. So it is really transforming from an old world business into a new world business. About 1/4 of its earning -- 1/4 of its revenue is now digital. If you went back 5 years, that percentage of digital revenue would have been in these -- in the low single digits. So it's really -- its report card is starting to tick. It's getting ticked. The company has got no debt. It trades at about 4x or 5x pre-tax free cash flow. To us, it's a company that's in structural growth, and we think the multiple can rerate over time, and we think there's a strong investment case with this company. In terms of outlook, it's been a tough 12 months, as you can see from the performance of SEC and the index. The index was down, I think, nearly 20%. Obviously, we were down less. A little bit disappointing for us. We thought we would have done better during that period, but nonetheless, we outperformed the index. We think there's a lot of opportunity now. As I discussed, balance sheets are strong [ again ]. The economy still remains strong. Top lines are strong. Costs are an issue, but we think those costs will get -- will be under control in the next 24 months. And so, there's a strong valuation argument at play. I guess the growth momentum narrative really dropped away in that first 6 months of the calendar year, but you've seen a bit of a resurgence in that space in the last month or 2. However, some of the results haven't supported that resurgence and you've seen some pretty sharp pullbacks in that space. So I'd be wary of investing in those companies. If they're not producing cash flow, the valuations don't make sense. I think it's going to be a pretty tough environment for the next year or 2. And we look at our portfolio holdings, and the balance sheet, as I said before, are very strong. I think they can stand a downturn. And some of the weaker competitors will get cleaned out, and that will be a pretty good environment once we come out the other side. One of the things to watch out for is just operating leverage in the business, and just having a lot of fixed cost will be an issue. Costs are creeping up, that will impinge margins, and it's going to be a difficult space to navigate, I guess, for those companies that have a lot of operating leverage. But if we look at the businesses we own, we think a lot of the downside is now priced in, and the significant upside from owning these companies through this cycle and out the other side. And generally, you make money when you buy low and sell high rather than buying high and selling low. So we're just continuing to stick with that mantra. And I think it will hold us in good state in what will be a more turbulent environment over the next year or 2. I guess, we can move on to questions now.

Yes. Awesome. Thanks, Matt. We do have a couple of questions. [Operator Instructions] So, the first question, Matthew, is from George, and it's about Adelaide Brighton, which is a top 10 position you showed us there. The question is, it's been in the portfolio for a while. Results have disappointed. Do you apply any top-down filters about things like the outlook for the cement industry? And if so, what -- I guess, maybe what went wrong with Adelaide Brighton?

Yes. It has had a number of poor results, and it's been disappointing. I think one of the key factors in the downturn has been the loss of lime volumes. So the Alcoa contracts, they lost a big part of their volume from Alcoa. It went to an importer, Kemaman, out of Thailand (sic) [ Malaysia ]. Unfortunately, for AWC, that hasn't been a good decision by them because the cost of importing lime has been a major issue in the last year or so. Obviously, there's been supply chain issues. The cost of freighting and shipping has gone through the roof. And so, I think from an economic perspective, there's a lot of regret from moving that volume away from Adelaide Brighton. Adelaide Brighton has actually retained a bigger chunk of that volume than was expected. And I think going forward, there will probably be a review of that situation. So I wouldn't be surprised if Adelaide Brighton secure a bigger slice of that lime volume that they lost, and that would probably be on good terms. I mean having that surety of supply, not having that freight cost issue and supply chain issues from importing, I think is a huge positive. And I think may see the relationship between the companies improved such that there is a renewed contract there, which would be quite positive. The lime business is very -- was very profitable for Adelaide Brighton, and I believe that profitability will return in the next year or 2, if that contract is renewed at higher volume. In the meantime, they've been growing outside of that and diversifying their customer base in lime. But that's just one part of the business that was under pressure in the last few years, and it's contributed to the decline and underperformance in terms of earnings. Cement volumes as a whole have been growing. There was some residential volatility a couple of years ago, but I think volumes in the industry are growing. You're seeing it both on the resi side and the non-resi side. And we think going forward that Adelaide Brighton has built out a very strong exposure, or increased its exposure to that infrastructure side of the market by building out on the East Coast in terms of its aggregates and its concrete business. So I think going forward, they're in a good position to, I guess, harness some of that growth in the concrete industry, which is going to come through. And I don't -- I'm not -- I'm quite positive on the outlook for cement and concrete going forward. Yes, they had a very poor result, but the result was due to cost increases, and some of the cost increases have been dramatic. Obviously, fuel gas prices going through the roof. And there's a lag in terms of the price increases going through and hitting the P&L. So that lag has affected the profitability in the first half. I think the second half will be much stronger for lime. And I think the outlook beyond that is much improved with the investment they've made into that non-resi space.