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

I will do an update on the company, some of the financials, will fly through that because I'm sure the main event that you're all dining in for is to listen to Matt give us his views on the market. So that's the rough agenda for today. If you do want to get today's slides, please look on your dashboard, you should be able to download them there. If not, you can hop on to the ASX and under the ticker SEC, you will find the slides or go on to the company's website itself. We will take some questions at the end. [Operator Instructions] The disclaimer is pretty standard. We're really not here to give you personal financial advice. We don't know your personal circumstances, so please this is just general information and a company update, not stock-specific tips. As I said, the agenda today is a company update, portfolio update from Matt, and then some Q&A. So straight into the company update. This is a snapshot of the results that we posted a couple of weeks ago for the company. The company is in very good shape. It's made a good profit for the year and the portfolio was up 9.6%, and we declared $.093 of dividends, which translates to a pretty healthy yield of 4.9% on the NTA and 7% if you include franking. So that's a pretty healthy dividend for a small cap company. We also commenced the buyback during the year, and we'll give you a little bit more on that in due course as part of our capital management initiatives to close that discount to NTA. If you do look at this waterfall slide, it's basically in dark blue, the NTA at the start of the period in July of last year and the NTA at the end of the period on the 30th of June this year. You can see in light blue, always within [ LIC ], the primary driver of the NTA change tends to be the performance of the portfolio. And so you can see a pretty healthy return of $0.21 from the portfolio during the year and subtracting from the NTA is the dividends that are paid and so there you can see $0.087 of dividends were actually paid to shareholders through the year, resulting in a period-end NTA of $2.20, if you round it up. And so important that shareholders remember that while the NTA -- the NTA is always reduced by the dividends paid. So never really -- you should never really look at your NTA today and compare it to the NTA when you bought and think that maybe the return hasn't done anything because you've always got to factor in dividends to your total return. On the topic of dividends, what's really relevant from this slide is, as a Board, we decided about 18 months ago to move to quarterly distributions and quarterly dividends, and you can see that on the chart. The September 2021 dividend was the first one we paid as a quarterly dividend. And we've paid quarterly dividends ever since then. So the one we've just declared now for the end of June this year was the eighth quarterly distribution for the company. And not only are we paying quarterly distributions, but we've since the June dividend of this year, increased that quarterly target to 1.25% of the post-tax NTA for the company at the end of the quarter, and that is up from the 1% target before that. So the company is targeting 5% of its NTA per annum. That's as -- obviously, as a percentage of the NTA. And if you reflect that as a percentage of the share price, that yield is a fair bit higher given the share price of the $1.90 is at about a -- or low double-digit discount to its NTA. Dividends since IPO, about $0.43. So about 21% of the IPO price paid out as dividends again, an important indication, I think, there of the amount of return that shareholders have received from income. Manager doing very well. We'll hear a little bit more from Matt on this a little bit later, but you can see there for the year under review, outperformance of about 1.2% against its benchmark. But I think really a standout has been the 3-year performance where you can see the company portfolio has done 13.5% against its benchmark of 5.2%, so high performance of 8.3%, really quite remarkable performance from Spheria in what has been a reasonably difficult market all around. If you look final -- at this final slide for me before I hand over to Matt. We did this for the first time in this results presentation because we wanted to just take a step back, often -- because companies report so often, you often lose sight of the picture since IPO. And so we thought, given it's pretty much a 5-year-old company, it was worth just zooming out a little bit and giving shareholders a feel for what the returns have been like since IPO. And so a similar waterfall chart to the annual results chart, but this one instead is since IPO. So it's a 5-year chart. And you can see, at IPO, the NTA was about $2 per share. We ended the period at the end of June at $2.20. Those are the 2 dark bars on that chart. And probably the most interesting bar is that first bar on the left-hand side, the light blue bar, where you can see that the benchmark produced in the region of $0.40 per share. But the actual portfolio outperformance, so this is where the manager of Spheria has actually outperformed its benchmark or outperformed the market, contributed about another $0.35 per share. So very important to recognize that for any manager of the -- like the significant contribution that can come from portfolio outperformance and certainly Spheria has done a good job of achieving that for SEC to date. Second thing worth pointing out, as I said a little bit earlier, is the dividend, so about $0.40 of dividend since IPO. It's a significant number, and you must always consider that when thinking about your total return you received from the company since you invested in it. And then finally, the buyback. So I did mention that a little bit earlier. We have started the buyback again. One of the reasons why the buyback should be attractive to shareholders, but certainly is a consideration for the Board is that it is accretive to the NTA to buy back shares when the share price is at a discount to its net tangible assets. And that has been the case every time we've done a buyback for SEC. And so you can see there, the buybacks we've undertaken for SEC since its IPO, and we've really undertaken 2 buybacks, one in 2021 and the other one is live at the moment, has added about $0.035 to the NTA per share for the company. So it is financially accretive for shareholders. All right. That's more or less it from the company update. Matt, I'll hand over to you to give us an update on the portfolio.

Thank you, Chris. I'll get straight into our process and many of you heard our process before. Our focus is cash flow. We're looking for highly cash-generative businesses and CapEx does come into play when we're looking at these type of companies. We're also taking a long-term view, so trying to determine, I guess, what the sustainable long-term earnings and cash flow of the business is, and we do a lot of work around industry structure. I guess within that, companies can be underearning or overearning and that can be an opportunity both ways. Obviously, if a company is underearning, and we believe we can earn more, there's potential to make quite a bit of money out of it. The flip side is, if something is overearning, obviously, we try not to be there in the first place, but it can mean that if we are there, that we're selling that business. But we look at companies through that lens. We try and keep an open mind. We definitely believe just because the business is challenged or there's issues with the business, doesn't mean it's not an opportunity. And often, we find opportunities and challenges at inflection points, can be a change in management, can be a change in strategy, it can be a shift in the industry structure. So very focused on changes in businesses and changes in industries as a potential entry point into a business and potentially an exit point as well. We do believe the market is highly inefficient and we're seeing that at an extreme at the moment. I think we saw the same thing pre-COVID and into the early part of COVID where there was significant valuation inefficiency. So we've got the same dynamic playing out now and that gives us a significant opportunity. Move on to the next slide. In terms of performance, yes, I think you can see -- I spoke a bit about this prior to COVID, it was a challenging period for us in terms of relative performance. I guess that COVID period presented opportunities for us, and we did rotate the portfolio aggressively to take advantage of that dynamic at the time, and we've generated significant alpha coming out of that COVID downturn. That's continued for a multiyear period now. But again, I think we're again facing some challenges, I guess, in the market, and that is an opportunity in itself. But good relative performance over the last 3 years. I'll talk a bit about reporting season has been a difficult period for us, but I think there's opportunity in those challenging periods. In terms of stock attribution, it might be hard to read that slide. It definitely is hard to read for me. But our biggest contributor last year was Nitro Software, which ironically was our worst performer in the previous period. And Nitro Software was subject to take over last year, and it was subject to 2 acquirers bidding aggressively for the company. We hold a significant stake in Nitro and we were able to leverage that position in determining, getting a better outcome for all shareholders, and obviously, including ourselves. So that was quite a good opportunity. It was a company that we like the long-term prospects for, but we're willing to give up those prospects given the price that was paid at the end I think the takeover started at, I think, $1.55 or thereabouts and ended at about $2.20. So we did pretty well out of that one. Also, we had some good performances across the portfolio last year. Smartgroup did well for us. It recovered strongly after being sold off. And then we had some long-term positions, which did well for us. So Monadelphous, Blackmores, which was subject to takeover was taken over by Kirin. A2B, which is the old Cabcharge business, which is in a bit of a turnaround at the moment and also benefiting from obviously the reopening out of COVID, but that did well as well. And supply networks, which is something I'll touch upon later, performed, continues to perform well. We did have some disappointments last year. City Chic was definitely a disappointing period. It had a disappointing period. I guess City Chic had been a strong performer for us in the past. We've reduced our position in the majority, but we reentered the company last year, and we had -- I guess, there was a bit of a disappointing outcome there. We do believe the prospects of the company have improved. Link Administration also was a little bit disappointing for us as well during the period. Unfortunately, there's a bit of a left field event with that business, and they lost a significant customer, but we believe that the potential risk to the rest of the business is quite low. But moving on to the next slide, Chris. That was our top 10, I think, at the end of July. So you can see that IRESS was one of our top positions. Clearly, it had a poor result. And so it has fallen considerably since that result. We think the dynamics for the business remain robust. However, there was some overpromise on cost out in the business and management credibility has taken a significant hit. We don't believe that's changed the merits of owning the business. We just think it's pushed out, I guess, the opportunity set there in terms of earnings upside. Adelaide Brighton had a good result. The stock had rallied into that result and has sold off since. But we think the prospects have definitely improved Adelaide Brighton. Vista Group had a fairly weak result, but we think the prospects are good as well. But yes, that was sold off as well. Bega had an in-line result and has traded pretty well. InvoCare is being taken over -- has been taken over and we are reducing our holding in that and rotating into other opportunities at the moment. In terms of sector positions, we've had tendered -- have a bias to the consumer space. The consumer space is obviously highly cash generative. Also, there's been a lot of pressure there. So valuations are very compressed, and we think there's a lot of opportunity in that consumer space. We do note, though, that the consumer classification is a bit nefarious in that InvoCare, for example, fits into the consumer discretionary space when clearly, it's not a discretionary type product. But that is obviously moving out of our portfolio. Flight Centre is also -- so travel has caught up in that consumer space. And I think there's different dynamics with the travel space versus the broader sort of consumer discretionary exposures in there. Moving on to the next slide, please. Just a company that I think has flown under the radar for many years, and we've been a long-term investor in, and we just wanted to break out something different because we often talk about names that are known, we broke -- this is a company that's not as well-known, supply network. Its brand is multi-spares and if you're not in a truck mechanic or you're not a bus mechanic, you wouldn't know the brand. But this company has carved out a strong market position. It's the #2 player in the aftermarket parts industry in the Australia and New Zealand market behind Berson. Berson has acquired its #1 position. This company has grown organically to be the #2 player. It's got 24 branches across Australia and New Zealand. It's got a strong history of cash flow generation. It's reinvesting its cash flow at a high return. You can see the ROIC on the top right chart there is the ROIC is currently over 50% and you can see the earnings growth the company has had on the left chart. Significant earnings growth, significant revenue growth and significant cash flow generation in the business. If we extended that out to fiscal year '23 because they've just produced their results 2 days ago, we haven't updated our numbers fully yet. Their earnings have grown from $30 million in fiscal year '22 to $40 million in fiscal year '23. And that is all organic growth. So they haven't bought any of that growth. It's all organic and historically, it's all been organic as well. And the company, if you -- when you get down to the bottom line, it's trading on a 23x P/E multiple. It's got net cash. It's never raised capital, except at the outset when the company was originated. And it's growing at -- it's grown at nearly 20% per annum over the last 10 years. But it's a company we've had a long-term position in. We don't often talk about it, but it's grown from a microcap company to a small cap company, and we think the prospects remain strong. I mean its market share would be double digit in the -- probably a low double-digit sort of percentage market share. It's got the potential to grow to 20%, 30%, potentially 40% of the market, and you can see the returns that would be generated from growing organically to that size in the market. But that just gives you an idea of what -- some of the things that we don't often talk about. Just in terms of what we're seeing now, we're mostly through reporting season, it has been very volatile and more volatile, I think, than most reporting seasons. It seems to be a very twitchy set of investors in stocks in our space. Any small disappointment in the stock has led to a pronounced impact on the share price. And in some cases, I guess that might be warranted. But in most cases, I think it's been a massive overreaction. And that overreaction is what we're preying on. We're finding opportunity in that. And as I said, we're rotating some of the portfolio, some of the takeovers that have occurred in our portfolio, and we're rotating that cash into those positions as we think there's a long-term opportunity in some of these situations. We do think the market is repeating past cycles. It's natural human behavior for that to happen. And you can see that there's a flight to safety and the flight to safety is growth. And that's happened over the past probably 6 to 12 months. You've seen that rotation back to growth companies after they were sold off aggressively. The dispersion now between growth and value is like -- is at an extreme, and we've seen this in the past where that eventually that something breaks and there will be a catalyst for that commodity prices have retraced, but we're still seeing significant speculation, particularly in sort of the lithium type names. A lot of the lithium names that we look at are not producing, and there's still significant market cap attributed to those companies. It feels a bit like the after-pay, the buy now pay later space from 3 years ago where, I guess, the speculation was right there despite the actual product losing its tenure. Inflation appears to be stabilizing. There's talk that interest rates have peaked. I think that could be a catalyst for small caps coming back into demand because at the moment, they're kind of on the nose. But definitely, inflation has peaked, although there are some structural issues, I think, we're facing in the economy with higher energy prices and tightness in the labor market, which is continuing. It is softening, but it is structural to some degree. I think we're positioned in a diverse set of companies. We own companies that, in some cases, challenged, but the valuations are compressed and I would call them more valuation turnarounds. And then we own companies that we think are reasonably priced growth company. So we own companies like SNL and Breville and Premier Investments. So good sort of growth companies at more reasonable prices. And so we think we've got a good diverse set of companies in the portfolio. I do think there will be a catalyst for convergence in valuations, some of the extremes that we're seeing now are just too extreme, we've got companies out there which are perceived as high-growth companies that actually have been acquiring a lot of their growth and they're on 100x PEs. And then we've got companies in our portfolios on single-digit PEs, where there is potential for growth or where there is potential for turnaround in earnings as the economy recovers. So we won't know till down the track, but I think we'll find out in hindsight, there will be a convergence. I think potentially M&A in the space will trigger that convergence. We've seen takeover activity today in the small cap space with one of the companies we don't own bid at a significant premium. I think there's a 78% premium for one of the companies today. But I think maybe that's the trigger for some sort of turnaround or also interest rates peaking and potentially coming off would be, I think, constructive for the small cap space. So we'll open up for questions.

Great. Thanks, Matt. We do have a couple of questions here, and I'll get to them shortly. If you do have a question, please feel free to type it in the box there. We've probably got 5 or so minutes to handle some questions, so we've got plenty of time. Matt, maybe I mean, you spoke about M&A in the small cap space and you touched on it being a difficult earnings season in general. There's a question here around the reporting season. So it seemed a bit more brutal than most in terms of immediate price reaction, including some of the SEC holdings. Can you discuss why this is the case? What has caused the brutal price reaction with some of these companies during earnings season. What's your view.

I wish we knew. It's hard to ascertain some of the movements seem significantly over the top in our view. It seems like the market has become more short term. I think there's a lot of fear out there with the economy and a lot of fear and I think a lot of naivety in the market that you can make money quick. I think with the growth space, I guess, the growth complex doing so well, I think there's a pursuit for quick short-term wins. And if the short-term win is not there, then it's a quick exit. And it has been pretty brutal for a number of names. I think there's been a few mentioned in the presentation today with IRESS selling off pretty aggressively. And to some extent, that was -- I think that was fair and reasonable. I think it was just the degree of the selloff. Now it's become -- the register is quite open. It's a very strategic asset, and there's potential for M&A with that company. It doesn't have the protection of a high multiple anymore for what is a very strategic business. So I think that one is heavily overdone, but management did overpromise. And I think I guess the reaction is quite brutal when you overpromise and underdeliver. Small caps reactions can be quite brutal, but I think no one is over the top. Adelaide Brighton had a big runoff into the result. And I think the selloff was more sort of buy in rumor sell in fact. I think the underlying business has definitely improved. The industry, the cement and concrete industry returns are improving, and Adelaide Brighton will get dragged up with that. And some of the other reactions, look, Appen was, to some extent fair. I mean they're trying to pivot the business away from deep learning to generative AI assurance-type services, and that is a bit of a leap of faith. I mean it's -- we're backing management to do that. They're communicating a good strategy, but we haven't seen the returns to date. And I guess the reaction to that, the revenue decline there was quite savage, but to some extent, fair, I guess. But I think long term, they can pivot the business. And then some of the other reactions here, I think, have been over the top, I guess, Smartgroup had rallied strongly into the result. And I guess there was that buy in rumor sell in fact to kind of thing. But yes, it is -- small cap is that way. I mean that way inclined, you can get big moves in companies. And when they go for you, it's fantastic when they go -- it goes against you, it's hard to take. But we know that these sort of windows present opportunity, and we've seen that, like I said, pre-COVID and in that initial period in COVID and that's -- we tend to make good money out of these periods, and we think we'll make good money again. And I'm not sure what will be the trigger. I suspect there'll be M&A. We don't rely on that. We want these businesses to be turned around. But I do think the risk reward in a lot of these companies is heavily skewed to the upside and there will be a trigger. But like I said, we'll only know in hindsight what that trigger is.

Matt, and what about the consumer? Dave asks, what has the earnings season told you about the shape of the Aussie consumer?

Yes. Well, it's patchy. So some companies are really struggling. So City Chic is struggling. It's demographic has been hit hard. So it's a mom with a mortgage, and she's not spending as much on herself. She's spending on the kids. And so her spend for herself has fallen away. There's other companies that are exposed to the housing sector, which is struggling, where sales are down. So the Temple & Webster and those sort of companies, their sales are demonstrably down. [Indiscernible] sales are down. They're weak there as well. So those sort of companies are struggling, but then there's shoe sales continue to do well. So Accent Group, for example, teenagers and the younger generation are still replenishing their shoe supplies. And so those kind of companies are doing well. But it really is very patchy. It's hard to discern. I guess the ones that come out of this downturn and get to the other side, we'll make a lot of money. It's just a matter of getting to the other side. And City Chic gone through hell and back. But I think they're coming out of that period of -- it was pretty much technically insolvent. I think they're coming out of that. The balance sheets built back up. They've got net cash on the balance sheet. They'll be able to invest in inventory. That is going to really change the complexion of the business going forward, the ability to invest in new products and to roll out new products to that customer base.

And travel?

Look, travel, I think, is peaking. And we -- 3 years ago, we recapitalized Flight Centre. And I was kind of straw had some winter at the time, and we recapitalized at $7.50. The stock is now trading at $21 at the time. Everyone thought probably we're crazy, but we made a lot of money for our clients. And we've been winding back our position in Flight Centre, we don't own as much as we did 6 months ago. We think travel is probably peaking, affordability is becoming an issue. The government denying Qatar Airways flying into the market has kept prices high for flights. It's going to be a big impediment for the consumer going forward. So we still like travel, but we think we're coming to the tail end of that rally. And we think there's opportunity to rotate out of travel into other consumer exposures and also into other businesses where there's opportunity from a valuation perspective.

Okay. There's a question here from Tim, Matt. Maybe I'll take it to give you a bit of a break. It's about other than the share buyback, what other strategies will be implemented to get the share price closer to NTA? So Tim, and I guess everyone, generally, closing an NTA discount is really you're trying to drive more buyers. I mean, at the moment, many LICs are trading at big discounts, I think, because sentiments towards general equity risk appetite is low. And so there's a bit of a buyers' strike and -- but our job as the Board and as the manager is to really try and drive new buyers. And so we spend a lot of time obviously talking to potential new buyers. And so the first thing I would say is just getting out there and spreading the good story about here's an opportunity, I think, for you guys to buy the discount. The second one is -- and it's linked to driving new buyers is performance. There's a very strong correlation between LIC that traded at closer to the NTA and investment performance. It's somewhat surprising to us, I guess, that SEC hasn't had such good performance is not trading closer to its NTA because certainly, the manager is doing its job in terms of outperforming its benchmark. So as long as the performance continues, I think there's a good chance that new buyers get attracted to the company. We've significantly improved the transparency. So you probably know that many LICs only produce monthly NTAs. We actually have a daily NTA on SEC, I think it really helps shareholders to determine the value of the portfolio on a regular basis, so you don't have this sort of disconnect between what's happening in the market and what's happening with the NDA. We also produced the top 10 holdings in SEC whereas many NICs or small cap managers on to be their top 5. So transparency, I think you can give us a big tick. Capital management is the stuff that is probably the level that the Board can pull, which certainly the SEC Board is not afraid to use particularly when there is a deep discount to NTA. And that's why we put the buyback in place. We will be very aggressive with the buyback when there's a disconnect between the share price and the NTA because that's the time when it's the most accretive to shareholders for us to buy back shares. And the second one is dividends. The one benefit of an LIC and that probably doesn't get for credit enough for it is the ability to pay regular fully-franked dividends. And so we decided to move to quarterly dividends, as I said, about 8 or 9 quarters ago, really with a view to trying to produce regular fully-franked dividends on a steady sort of rate for shareholders. And it's -- while the discount at the moment is higher than we would like, when we announced those capital management initiatives the discount was kind of 18%, and they've got all the way back to 8% to 9% a couple of weeks ago. I don't think the Board will sit still if the discount is in some double digits. So it's something we discuss a lot and we are aligned with you. We are shareholders ourselves. And so we will continue to consider other initiatives to close that discount if the current ones don't work. All right. I think unless there's any other final questions. We're on the 11:30 mark. We did promise we're trying to get you out of here by 11:30. So I think, Matt, all that's left for me to say is thank you for your time and certainly a great job on managing the portfolio. And to shareholders, thank you for your time and interest in dialing in today. You will get a replay of this probably by the end of the day in your inbox. And as I said at the start, if you would like to get the slides from today, your best bet is either to jump on the SEC website or on the ASX and just type in the ticker SEC, and you will find in there from this morning. So thanks very much for your time again, and have a good rest of your day.

Thanks for your support. Thank you.