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

All right. Hello, and good morning, fellow Spheria Emerging Companies' shareholders. It's 11:00. I think we should get going. Welcome to the first half FY '23 results presentation for the company and portfolio update. My name is Chris Meyer. I am an Alternate Director of the company, also run Investor Relations for the company on behalf of Pinnacle, who is a strategic shareholder in Spheria, the manager of the company's portfolio. Joining me today is Matt Booker. Many of you will know, Matt. He's the cofounder of Spheria Asset Management and also the manager of the SEC portfolio. Just a reminder that today's webinar will be recorded and you will be sent to replay. In case you want to refer back to anything. The slides we will go through today will not only be up in front of you on the screen as Matt now will click through it. But we will -- you can also find them on the ASX, which we put up on the ASX this morning. In case you don't have it in front of you Matt. If we can just refer to the slide numbers. So those who are following on the phone but aren't necessarily looking at the screen can follow the presentation. At the end, we will take some questions from shareholders. So please if at any time during this webinar you feel like you want to ask a question, just drop it in that Q&A box you should see on your dashboard, and we will endeavor to get to that at the end of the presentation. You also should find a few useful links on your dashboard, including this presentation as well as how to access the website for the company. So, without further ado, I'll cover off on the company update. Matt will do the portfolio update. We should aim to get you on of here in about half an hour or so. So just going first through to the disclaimer slide. If you can please just quickly cast your eye over that. I think the main thing to take away here is that neither Matt nor I are giving you a personal financial advice. We don't know your personal financial situation. So please don't take any of Matt's stock ideas and stock tips for your personal portfolio. As I said, we'll start with a company update you a portfolio update and then take some questions at the end. In terms of the company update, I think the main thing to call out here is the company is in excellent shape. It made a bit of a profit in the first half of the financial year, the 6 months to December last year. If you remember, those of you who have been invested since IPO, the company really has 2 primary objectives. The one is to outperform the benchmark for its portfolio to outperform the benchmark. And pleasingly, as you can see on that slide, the portfolio has actually outperformed its benchmark by about 2% per annum after fees since inception. So that's an excellent result. Well done to Matt and his team. And the second thing is to produce some income for shareholders. And again, we have a few slides on that coming up, but it's been a big focus of the company and the Board, and we're pleased to have declared $0.043 worth of dividends in the 6 months under review, which if you take it, if you gross it up for franking and take it as a percentage of the share price at the end of the year is about a 6.8% dividend yield. So, an attractive income-producing company. In terms of this waterfall chart, you'll see we started the financial year with a pretax NTA of $2.09. It closed the year at $2 just a little over $2.12. So, an increase for that period, much of it driven by that light blue box, which is the performance of the portfolio that obviously added to the NTA. The dividend we paid at $0.043 per share comes out of the NTA, although obviously adds to shareholder returns. I think the other thing worth noting is that the post-tax NTA quite strangely at the end of the financial year was above its pretax NTA. That's not a typical situation for a listed investment company, but it is because there were some assessed losses or deferred losses, I should say, on the tax front. That has actually normalized this calendar year. And so, at the moment, both the pretax NTA and the post-tax NTA more or less the same. I actually had a share in front of me at about $2.24 per share. So again, the NTA has risen quite nicely in calendar 2023. As I mentioned, dividends is an important part of what we're focused on in the company. This slide really indicates that if you look at that chart at the bottom, we have now paid 6 quarterly distributions. We are doing it at a rate of 1% of the post-tax NTA per quarter, so 4% per annum. And as you can see in that chart, it's been in a reasonably steady rate of between $0.20 and $0.25 per quarter. So, we think this is important. It's an important component of shareholder returns. In fact, you can see there, since inception or since IPO, the company has paid out just over $0.38 per share or about 19% of the IPO price. So, a significant component of the total return for shareholders since IPO. And then also, if you think about a listed investment company, one of the merits of a lick is that it can pay fully franked and smooth dividends. And so essentially, what we have decided as a company is to use that LIC structure to better target income for shareholders. I covered off on the performance, but I think it is worth just quickly noting here that particularly over the last 3 years, but since inception, Matt and his team have managed to outperform the benchmark. It was a, I guess, tougher 6 months, although the portfolio was up, the benchmark was up a little bit more. So, on a relative basis, a tougher quarter, and we'll hear from a tougher 6 months, and we'll hear from Matt about that now. But I think what's quite impressive is that, that 5-year period since inception has been a particularly volatile period in the market. It's been good for growth stocks for part of it, bad for growth stocks for another part of it. And so that style shift is something that Spheria has been able to navigate and has been able to produce returns for shareholders above the stated benchmark. So ,with that intro, Matt, let me hand it over to you, and you can give us an update on the portfolio.

Thanks. Excellent. Thank you, Chris, for that introduction. Let's move on to Slide 10. Most of you have probably heard about our process before. We're very focused on cash flow and sustainability of those cash flows when we look at a company, and we do a lot of work on industry structure as well, just to make sure there is that sustainability element to the cash flow because, obviously, that's critical. We have a DCF model basically, and that's how we arrive at the valuations. Ideally, we're looking for companies with less debt. It's not always easy to find in the small cap space. There is an element of gearing in the businesses, and that's operational and debt as well. And ultimately, we're trying to buy the discount evaluation. That has gotten easier in some ways with the fall in markets over the last 12 months or so. However, there's been a lot of earnings pressure. So -- we're very focused on what is the sort of long-term sustainable earnings for a company. And we believe that the markets, I guess, will write themselves over time. We're often looking for inflection points in companies. So sometimes we're buying turnaround situations. Sometimes, there's a change in management, and that's the opportunity. Also, industry structures changed. So, a competitor goes out the back door and the industry structure improves for the remaining participants. So very focused on inflation points. And we do believe the market is under research. A lot of the research is very superficial from elements of the market. So, we find that we can really dig in and add value through examining financial reports, talking to competitors, talking to management in some cases, -- there is definitely inefficiency in the small cap space. And that's where we -- I guess, we exploit that opportunity in terms of doing the research that many don't. Moving on to Slide 11. We have generated goods outflow over time. So good relative performance in the product. You can see the green line. There were some challenging periods going back when the market was high growth, high momentum, given we're a traditional investor that is a difficult market for us to generate relative performance. We've had good relative performance coming out of the COVID period. Obviously, that stabilized at fairly high levels. And it has been a bit more challenging in recent months, as Chris pointed out. and has been hard to get absolute performance in the past 12 months or so, the markets have obviously been under a lot of pressure with the withdrawal of monetary stimulus and rising interest rates, that just makes a difficult environment. And now you're seeing a lot of the economic impact. So first, we saw the impact on the stock market. And now we're seeing the impact economically on households and on earnings basically. We're seeing a lot of earnings pressure out there in this reporting season. But we think that provides the opportunity in the longer term. Just moving on to stock attribution. So, I just give you an idea of where we generated relative performance on a stock basis over the past 12 months. You can see our outperformance has been concentrated in Monadelphous Group, which is a mining service company MWA provides engineering services in that market. Obviously, the commodity market is very strong. So, there's strong demand for Monadelphous and they're one of the premium players in that engineering construction space. Another one that's been surprising is Horizon Oil, we owned Horizon Oil for probably 7 years since we started the business. And it had some challenges early on, but it's really paying significant dividends and generating huge cash flow at the moment. It is an oil producer that has a really strong oil producing business in Beibu, which is New China off China, and it has some assets off New Zealand as well, but highly cash flow producing assets. And Nitro software, which is currently undertake over with 2 bidders having now at the business, we've obviously quite a bit of press, but we've extracted , we think, a fantastic return out of that through basically voting down one of the proposals and allowing the other party to come in over the top. So that was a great outcome. If we didn't vote against that scheme, none of the shareholders would have got the increase, which we've seen in the last week or so. And then on the negative side, [indiscernible] has hurt us. CCX is a retailer. It expanded into the U.S. market. It has a fantastic presence in the domestic market. We originally bought in around $0.70 probably 4 or 5 years ago. And we sold most of our stock out at $5 to $6. It has fallen precipitously from $5 to $6 after facing a number of challenges with its core business, particularly in the U.S. And the stock is currently around $0.50. We've cycled back in too early. So, we bought in around $1.52 on the downswing, and now it's fallen down to about $15. The company is trying to manage down its inventories. It's not an easy process, given demand is very soft out there, particularly in the U.S. But we can see the company getting through this process in the next 6 to 12 months and returning to past operating levels in the medium to long term. What has also hurt us is not only much in the way of energy and coal stocks have hurts on not only white have coal has really hurt us. Some of the hip names have rerated again, and that's been difficult for us. So, ProMedica, for example, service. And then we've seen significant de-rates I guess, in consumer-facing companies. So, at lake Brighton, which is a building materials company. Here, they're in everywhere, which is a media company, #1 radio stations in Australia, both regional and metro. So, it's been a bit of a difficult market in terms of derates in terms of anything that's sort of consumer-exposed but we think there's upside going forward if you can look through the cycle. Moving on to Slide 13, can see our top 10 holdings. We release these every month. So, there's nothing, I guess, new in that. We've been long-term shareholders in Blackmores, InvoCare, Flight Centre Iris, all of these names we felt for a long time. We're not a high turnover fund. We try and take a long-term view on companies. And we think we own some very good companies here. There are some challenges within those companies, particularly execution-wise, there's been some management issues in a couple of those names that I just mentioned. And we've been pushing hard to get better outcomes for shareholders. And that might see some change in management teams and directors over time. And I guess you've seen that in the past few years with us being a bit more activist in terms of our holdings. If you look at the chart on the right, you can see we are very underweight materials, which is effectively resources, commodities exposures, and we are very underweight energy, as I discussed before. And that has been challenging because those sectors have done particularly well over the last 12 months. Despite that, we've generated some positive relative performance in the fund relative to the benchmark. So, it has been a difficult market just from a sector perspective. We also are overweight consumer discretionary. However, if you look at the construct of that, a big chunk of that relates to Flight Centre and InvoCare. We think Flight Centre is obviously more disposed to travel spend within that, which we think will over index over the next few years, given what's transpired in that space over the last few years. And in [ Macae ], we don't think is being classified correctly. We don't believe that is consumer company, it's a very stable type business given that it's exposed to the death rate in the in the population. But you can see where we're underweight and where we're overweight. I guess, as I said, there's been some headwinds for us given our underweight towards commodities. Moving on to Slide 14. I kind of alluded to Flight before, it is one of our bigger holdings. We are seeing a significant turnaround in the share price in recent months. I think the market is getting more optimistic on the outlook for travel spend. As we've been thinking it will over index in our view. The company has taken out significant cost in their leisure business with nearly half the store base being shut down during the COVID period. The balance sheet has improved demonstrably in the last 18 months or so. And we believe in the next 12 months, the balance sheet will continue to improve as the cash flow comes in upfront from clients who have paid out on the back end to suppliers. We also think the biggest issue they're facing at the moment is just the lack of capacity in the market, and therefore, there's been pressure on commissions, which are being received. We think capacity is coming back online. Obviously, with China reopening late last year, we think there'll be more Chinese capacity coming online and just broader capacity in the airline industry will be very beneficial for commissions, which obviously drives profitability at Flight Centre. But there's a big turnaround coming there. The costs are our revenues going up, and we think gross margins will go up as well. So, we think the outlook for flights is improving dramatically currently. Moving on to Slide 15. I guess one of the exposures we do have in the commodity space is Deterra Royalties. It was spun out of Iluka several years ago. And I think it's kind of one that's fallen by the wayside. I don't think people talk about it a lot. It is one of the highest quality exposures in mean commodity space. It takes sort of 1.2% royalty from basically the HP's main mining area, which is Mining Area C. There's a 50-year plus mine life there. It is an annuity stream type business. There's very little cost in taking that royalty into the bank account. So. it's a high cash flow producing asset. There is leverage to the iron ore price, clearly. If the iron ore price goes up, the receipts are obviously higher for the group. Obviously, if the iron ore price falls, they're lower. So, we take a long-term view of iron ore at about USD 75 with a TWD 75 dollar versus U.S. currency, and we believe the company is worth well in excess of $60. So, we think there's significant value in Deterra, and we think it's a good way to play resources at a low risk -- from a low-risk perspective. In terms of outlook on Slide 16, it has been very challenging. I think you need to look forward and the share market is always 6 to 12 months in advance. And I think we think inflation is somewhat peaking outside of wages at the moment and even wages are probably peaking as well. So, there'll be less -- we think less upward trajectory in interest rates. We think interest rates are starting to peak in the next probably 3 to 6 months. And if we can look through this period of earnings, I guess, degradation, I think there's opportunity by good long-term sort of valuation led opportunities. The growth momentum narrative has collapsed. However, some of the tech companies are still living in the past. We're talking to a lot of the companies and they're love to take headcount out, reduce cost. And they think that the market is going to supply capital that they can continue with their operating businesses running at losses. That's not sustainable. These companies need to take headcount out. We think there's good opportunity now popping up in the tech space. And we think the management teams and the boards will start listening to some of the more value-orientated managers like ourselves that will push for significant cost restructuring in these companies. We think there's over exuberance in the mining space, particularly in the lithium market. We've been talking about it for a while. The lithium price has come off pretty sharply. We just don't think it's sustainable at these levels. The cost of lithium battery in a car is a big component of an EV. If the price of EVs escalate, people won't be able to afford them. So, I think it's almost circular that we think the lithium price will come off. We do think there's a long-term story there. We just think that in the short term, the lithium prices exceeded anything that is sustainable. We think the balance sheet for most of our companies are in good health. I think this downturn in the economy will clean out many of the weaker competitors, and that is an opportunity. The risk, I guess, in small cap is there's a lot of operating leverage in businesses, a lot of fixed cost. And with the cost inflation, cost basis have gone up and you're seeing the compression in earnings and margins at the moment playing out. But we think there's opportunity within that. We think M&A could pick up. We've seen that with Nitro in the last 6 months. We think there will be more M&A from private equity. And also, the balance sheet of any of the major companies in the market are very significantly very strong. So, we think some of the bigger players, which are lacking growth in the market will look to buy growth. And so, we think there's a positive outlook for M&A. It has been very quiet for the last 12 months, but we think that will pick up in the next 6 to 12 months, particularly if interest rates peak and funding markets remain open, which at the moment, feels like it's moving that way. So broadly, we're positive. We think there's opportunity. We think valuations there and think there's long-term earnings sustainability in companies that the market's just not seeing. And we'll open up for questions then.

Okay. Great, Matt. [Operator Instructions] We do have a couple in already. And maybe, Matt, to kick one off here with this slide up. Amanda asks, do anything from the reporting season that we've just been through that, I don't know, confirms or conflicts with your outlook here?

This reporting season has been mad, like I've been through a lot over the last 20 years in terms of reporting seasons. This one seems like the silliest any sort of negativity in the result, any negative delta in the result in terms of earnings outlook or earnings that's been dealt with in a serious way, like, I mean, you're seeing share prices pummeled. So, the de rates are just significant. But that -- I think that's providing opportunity. Are we learning anything from this? I think we're learning that there's a lot of money out there, which is being led around by, I believe, momentum type strategies. I think there must be quantitative strategies, which are at play, which is driving us focus on earnings delta. And I think that actually is an opportunity. I think you've got to be contrary, you can find opportunity in that sort of -- in the downside in the share prices. I mean if you get share prices to discounting just locating from valuation, that's an opportunity in the long term. But the market is just so excess in infatuated with earnings momentum at the moment and all the momentum is negative. So, it's manifested in a lot of downside in the share market during reporting season.

Matt and David asked a pretty good follow-up here, which is, at least in his view, and I presume he's asking for your view on this is large caps during this reporting season have widened margins, the blue-chip stocks, whereas in the small-cap space, he's saying there's been some pressure on margins, why would now be a good time to invest in small caps rather than large caps.

Well, I think large caps have hugely outperformed over the past year. I think the it looks at the valuation relative recently. But I would assume that the large caps are trading at a significant premium to reflect that defensibility of earnings and large caps tend to be more defensive in these downturns. And that's -- I have looked at a lot of large-cap results in the last few weeks, been very focused on our own space, but if that's what's transpiring, Yes, I get that. But also leverage works both ways. So obviously, there's a lot of pressure on the downside now in the economy. That will abate and there'll be pressure to the upside and the operating leverage works to the upside. So small caps from here will probably lead the market, I would think, given what's transpired over the last 12 months in terms of valuation and in terms of earnings sensitivities, I think there's -- logically, I think small caps will lead the way out of this downturn. But how long is downturn last is anyone's question, I don't know when the relief valve will happen on interest rates, but talking to some of the companies. We were talking to a [ Kiwi ] company a few days ago, and they pointed out that the RBNZ said that rates would peak at 5.5% this year. And in the last release, they raised rates by 50 bps, and they're saying now that about 55% will be the ceiling. So, it feels like rates are starting to top out and expectations that things are going to peak in the next few months, and that will be good for small cap companies. But I don't want to get too caught up in the macro. I mean it is obviously important to us in the short term. And I think it just -- it provides opportunities, I believe. And that's the way we've always played it. I mean any sort of share price dislocations are an opportunity in our view. And we're a very value-focused investor. And I think over time, that's played out with us generating good performance.

And Matt, I suppose you've been investing in small caps for quite some time and your experience do small caps tend turn to lead or lag a market on the way out as the [ Conocos ]...

There's no doubt they leave the market, and you'll see super normal returns on that in that scenario. No doubt about that in the last -- the GFC, even the tech back 2000, 2001, it was the same thing. It was just -- I guess, it was debt by 1,000 cuts on the way down. But the rally out was just so significant out of those 2 points in time, it overrode I mean the performance made was just off the charts. So, I think we're in that scenario. It feels like we're in the death by 1,000 cuts stage of the cycle, but we'll get through that. No one knows when the bottom will be, but when you come out of it, it comes out so much harder and you can make multiples of what you put in.

Matt, do you want to take this one on Sydney chicken and asks, are you still confident there how they run out of money. Yes, a question about the balance sheet strength of steady sheet.

That's a good question. Will they run out of money? It's a very difficult environment. I mean the latest update, 17% sales decline, the first 7 weeks was pretty terrific from our perspective. And I guess the issue is they're discounting aggressively to move stock. So, their volumes are up, but their prices are down, and that's a big reason for that delta in sales. They have in that first 6 months, obviously moved a lot of inventory and the balance sheet situation, although it hasn't improved dramatically. The net -- the operating cash flow, free cash flow dynamics were reasonable in the first half. If those trends feels like they've got momentum. If those trends continue, I believe they'll amortize the debt over the next few months, and they'll be in a position where they'll be net cash by 30 June. But it is it is treating the needle. They are walking a fine line at the moment in terms of their balance sheet position. And it is a bit precarious given the softness of the consumer, particularly in the U.S., I mean, the U.S. market is very soft in saying that the U.S. is a big market. If you want to move $30 million of stock, you can do it. There's many avenues to market. I think given the depth and breadth of that U.S. market, I think they can achieve what they're talking about. And we spoke to a competitor yesterday to CCX, and they mentioned just this that they believe they'll be able to move the stock and that people just don't understand how big that U.S. market is. So yes, it's a fine line that we think they're pushing hard. They're going on the right path. The worst-case scenario is, I guess, they look to raise money. I don't -- I'm hoping they don't go down that path because it would be highly dilutive...

Okay. There's one final here from Samuel. Maybe I'll take it just on the balance sheet of SEC. You ask what's the update on the franking balance and the confidence that the company can support. Its distributions. Samuel, just look at the results announcement, we did actually publish the franking balance at the end of December. It's basically equivalent to about $0.26 per share of dividends that are available to be paid out of the franking balance. So given we're paying dividends at a rate of somewhere between $0.02 and $0.025 per quarter and we can afford a $0.26 per share dividend with the current franking balance. That's about in round numbers, 10 quarters or 2.5 years' worth of dividend cover. So, the balance sheet is in good shape. And I think some of it comes from the fact that Spheria themselves invest in cash flow generative small-cap companies, which themselves pay healthy dividends. So, the company is not relying on capital gains to generate their franking credits or their retained profits in order to pay out dividends. So, we feel very comfortable with the current level of dividends of SEC. Thanks for the question. All right, if there's no more questions, we are just up at that 11:30 mark as the clock behind you, Matt, tells me. So I think with that, we'll say thanks very much to all of our shareholders. We hope that the latest quarterly dividend that hits your accounts, I think, on the 3rd of February, was well received, and we wish Matt and his team all the best in producing some else between now and when we speak to you next. Thank you very much for your time, Matt, and thanks to shareholders for listening in.

Yes. Thank you, shareholders. Thanks, Chris. And yes, hopefully, we can generate some absolute returns rather than just relative.