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

All right. Hello and good morning, fellow shareholders. It's 10:00. We should probably get this webinar underway. Welcome to the Spheria Emerging Companies Limited Half Year Results Presentation. That's the 6 months to December 2023 or the first half of financial year 2024. My name is Chris Meyer, I'm with Pinnacle. I'll be the host of today's webinar. I'll also run through some of the company slides. I'm an alternate director on SEC. Pinnacle, as most of you probably know, does a lot of the Investor Relations for SEC. And we're also a minority shareholder in Spheria Asset Management. Joining me today is Matthew Booker. Matt has done the last few of these webinars. He is the portfolio manager of the SEC portfolio. He's also a company Director on SEC and a co-founder of Spheria Asset Management. Good morning, Matt.

Thank you Chris.

Good. Okay. So first of all, the slides we're looking at today are available in a number of different places. We'll run through them today. But in case you don't happen to have the screen in front of you and you want to grab it somewhere else. You can jump on the ASX under the ticker SEC, you can also pop on to the SEC website and you can find it in there. If you are on the dashboard, you should also be able to see the slides in front of you. The disclaimer slide, really just to let you know that we will talk, or Matt, in particular, we'll talk a bit about some stocks in the portfolio. He's not intending to give personal financial advice at all. These are not topics for your personal portfolio. We don't know your personal situation, so please do not take this as a personal financial advice. And the agenda today is pretty simple. We'll run through some of the results and some of the things we're doing at the company level to try and reduce the NTA discount where we have some pretty good news for you. Matt will run through a portfolio update and then we'll flick over to our audience for any questions. If you do have questions, please type them into the Q&A box at the bottom of your screen, and we will get to them at the end of the session. So in terms of our company update, this is Slide 5, for those of you who aren't following on screen. Just to remind you, and it's probably the best way to frame the results is there's really almost twin objectives for the company SEC. We want to grow your capital, and we want to produce some income. And you can see, if you look at the results for the 6 months to December 2023, that both of those objectives were matched. The company outperformed its benchmark by 2.8%. For the 6 months, it grew by 9.2%. So there was a nice healthy capital growth. And coincidentally, it has also outperformed its benchmark by 2.8% since inception, which is if any of you understand active fund management, you'll know how difficult it is to outperform by that level. So kudos to Spheria for that performance. And on the income front, we did switch to quarterly dividends about 2.5 years ago. We carried on with that in the 6 months that we're reporting here and we delivered $0.56 for the 6 months. If you annualize the 12 months up until the end of last year, SEC is on a dividend yield of about 5.4%, excluding franking or 7.6%, including franking, which is a pretty attractive yield for Australian small cap shares. We also announced a proposal, and we'll cover that a little bit later to exchange shares in SEC for units in these various Australian small companies fund if SEC fails the NTA discount test at the end of the year, and I'll cover that a little bit more on a future slide. Just in terms of the NTA change, it's always helpful to look, this is Slide 6 at how the NTA has moved over the 6-month period. And I guess, starting the period at close to $2.20, ending the period at $2.34. This is pretax NTA. You can see that light blue is really the movement of the portfolio. So that's the capital growth and the sort of, so it's the movement of the market plus the managers outperformance, that's driven that. And then the larger of the gray bars at $0.055 is the dividend we paid during the 6 months. So that obviously comes out of the NTA, but it's part of the old return as a shareholder. So quite a nice graphical way of seeing the objectives of the company being capital growth and income. Just to drill down a little bit further on Slide 7 on performance so as I said earlier, the company does aim to outperform the ASX Small Ordinaries Index. The manager Spheria has done so since inception. It also did so over the 6 months under review and what's pleasingly for the Board, in particular, but I'm sure for you as shareholders is how consistent if you now look at the 1 year, 3 year, 5 year and since inception, that outperformance has been very good and very steady. So again, well done to Spheria. Matt will talk a bit more about where that performance came from when he gets to his section. On the income front, the other objective, as I said, we did move to quarterly distributions back in September quarter 2021, so we're well underway now with a bit of a track record of establishing these quarterly distributions. It's one of the benefits of LICs is the ability to pay regular fully franked dividends, and we are using that ability of the company structure to do that now for shareholders. We think it's been well received. We're targeting a 5% dividend yield per annum of post-tax NTA. It's obviously a lot higher if you include franking closer to 7%, and it's higher even still, if you reflected as a percentage of the current share price. So we think that the income appeal now of SEC is starting to attract a new category of buyers, and it certainly has contributed, we think, to this chart, which is the NTA discount chart. And here, you can see in the orange line at the bottom, while SEC did struggle for probably a couple of years back in 2021, 2022 with the discount to NTA in the high teens region. We think the combination of strong performance, which is really the blue line, the NTA -- sorry, the gray line, which is the NTA, and that distribution profile I showed on the prior chart has driven a fair bit of the narrowing of the NTA discount. And then, as I said earlier this year, we announced the conditional proposal to convert SEC into an active ETF or units in the Spheria Fund. And that conditional proposal is basically if that orange line is not less than 5% on average for the fourth quarter of this year. So 2024 -- so from the 1st of October to the 31st of December, if that discount on average is wider than 5%, then we will undertake a scheme of arrangement to exchange shares in SEC for units in that Spheria Australian Small Companies Fund. It's an identical strategy to SEC, so there should be no change for shareholders in terms of the underlying portfolio. All that would change as you move from being invested in LIC, to invest it in either an unlisted fund or an exchange traded fund and actively managed ETF. So more on that, I think, later in the year, but I think the fact that there is a solution, if you like, if the discount is too wide at the end of the year has also evolved shareholders to want to own more of SEC and that has helped narrow the discount, as you can see on that chart. So that's it from me. Matt, I'm going to hand over to you, if you don't mind, if you can take us through what you're seeing in the markets and with the portfolio in particular.

Thank you, Chris. This slide is unchanged. We put it in every year. Our process is unchanged. We are looking for highly cash-generative companies. We are very fundamental investors. We do valuations. I think we have a degree of conservatism in what we do. We're looking for companies, I guess, with less gearing. It's not always the case, though. I mean, there's in some cases, in environments where companies get sold off because of the gearing, and the company has good underlying fundamentals, but it's over geared, and we do play those situations as well, but they tend to be a small part of the portfolio. We're also looking to buy companies at a discount to valuation. The valuation is key to what we do and underpins our process. We're often looking for inflection points in companies. They go through temporary periods of underperformance, and that can be an opportunity for us often is the case there's changes in management or industry structure, which are appealing to us and provide the opportunity for us to get involved in the situation. So we're very opportunistic. We're very valuation-driven. We do believe the small caps and micro caps are under researched and we think our research efforts can deliver alpha over the long term. It is very inefficient outside of the larger companies in our view, and it's getting more inefficient. I think the focus, you can see globally is on big companies, big tech. And I guess the small caps have been, have really lost their way in terms of getting attraction from investors. Moving on to the next slide. You can see the portfolio performance over the, since inception. I think you can see -- I guess, since the start of 2022, it's been pretty challenging in the small cap space. The market's going through, it's going through a down period, and it's kind of oscillated around that sort of down trend. There was the big sell-off in kind of mid- to late 2023. And often is the case, you get that capitulation and we saw the capitulation, I think it was in October, and you've seen the rally out of that capitulation point in time. But -- so there's been a big bounce out in the small cap space. I think I'll talk about this later. There's still, it is very much lagging in terms of valuations. If you look at the valuations for some of the large cap companies versus small cap, there's a big disparity there. But you can see the performance we've had in the last few months. Hopefully, we can continue that performance going forward. We do think there is inefficiency down the market cap spectrum. Next slide is in terms of stock attribution. I'd like to say we don't get everything right. We're not perfect. I guess we've had some good performers over the past year, and we've had some bad performers. The good performers have fortunately outweighed the bad performers in terms of negative attribution. We owned Appen. We believe there was a good business there. However, I guess, customer concentration got that business in the end and losing the Google contract in our view, has put it in a very difficult position. So we exited Appen at a loss, which was unfortunate, but we have had significant gains elsewhere. On the positive side, Bravura Solutions is a company that we recapitalized in January, and we made some significant changes to the Board and management team as one of the biggest shareholders of that company. And we've seen the company bounce back from recap of $0.40 to trade at $1.30 or within about 12 months. So you can see that when we get things right, we can make a lot of money sometimes is the case we do get things wrong. I think at the back end of the year, we saw a number of takeovers in the small cap space. We're a beneficiary of that. The week before Christmas, we had 4 takeovers in the fund, which was quite positive for performance. Next slide, please, Chris. In terms of our top 10 company holders, you can see the companies there. Adelaide Brighton is undertake over. That's our second biggest holding. Link Administration is also under takeover. So those positions quasi-cash. And then you can see our biggest position is Iris. So it's a technology company that's going through a transformation program. It is a difficult transformation, but we think there is addition by subtraction in that business as they sell weaker assets that have more strategic value to other players that will create value, and they can focus on their core products, which I think have been effectively undernourished for many years under previous management. But we've had some good performance in some of those names and a few of them have detracted as well. I think if you look at our sector exposures, you can see that we tend to be overweight consumer-facing sectors. I think the reason for that is our cash flow focus, consumer-facing companies tend to have significant cash flow generation where we're underweight is energy and resources historically and generally speaking, it's hard to find good cash flow generative resource and energy companies in the small cap space. Anything decent moves into the top 100 or top 50 and that does make it difficult for us to find exposure to those names. But we've found a few names, but we generally underweight those sectors where we think there is something interesting at the moment is the real estate sector. So the Property Trust. I guess the market is kind of factoring in interest rate cuts towards the back end of this year. And I don't know if that's right. But if that is the case, real estate and property trust will do better going forward. We've seen a lot of the retailers rally on that premise. So there's a bit of a disconnect at the moment, and we think our REITs look interesting at the moment. Next slide, please. In terms of the portfolio. We do have a mix of growth and value companies. This company supply network is a company that most haven't heard of. We have owned it for a long time. We think it's a growth company dressed up on a value multiple. And if you look at the business, it basically is taking market share in the truck and bus aftermarket spare part market. It's got probably over 20% share of the bus aftermarket spare part market and it's got probably teens market share in the truck market. So there's significant room for the company to grow and to take share. Some of their competitors are really struggling to grow and are losing share and supply network is taking that share. It's got 25 branches across Australia and New Zealand. It generates fantastic cash flow, as you can see on that chart, top left there, cash flow versus the earnings before interest and tax. It generates high returns. So every dollar, it's reinvesting is at a higher rate. They're getting $0.58 from every dollar invested. So that's a very buffet-like company. It's had 10-year growth in the top line of 14% per annum, and 20% at the EBIT line per annum. So a fantastic growth story. You would think the company would be trading on 50x to 100x in the small cap market, but it's only on 22x, so we think growth company on value multiple. It's a company that we like. And if we can continue to reinvest at that rate and take market share, we think there's significant room for the company to grow its share price further. Next slide, please. In terms of key themes, I think if you look back at late last year, we had a number of takeovers in the portfolio. Obviously, there's foreign players looking at the market down here and finding companies that have strategic positions that they can't replicate and the currency is very low. So we saw a couple of foreign companies into the market and make significant takeovers in the small cap space. I guess that's emboldened the market itself and also what we've seen, I guess, is a very narrow rally in some of the very high PE names. Now the question is what happens going forward. And I guess we need to prognosticate a little bit. And I think that narrow rally in some of those growth names could broaden out, which should be very positive for small caps and for our portfolio. The other, I guess, scenario is that those high PE names, which we have related to, I think, nonsensical levels do fall. But either way, I think we get relative outperformance going forward based on where we currently are. If you look at results season, yes, I actually think results were pretty weak, but they were well guided and the expectations were very low. And where a company was popular, the scenario was the company would report earnings and maybe slightly beat or hit expectations and the stock would rerate to even higher levels. So you had companies like [indiscernible], which is a fantastic retailer in the furniture market, which had -- I think earnings were down 30%, but the stock moved to all-time high. So you've seen a significant re-rating in terms of the multiple for that business. On the other hand, unpopular companies that met expectations or missed slightly were just -- were dealt with pretty harshly by the market. And we think there's opportunity in that segment. Valuations are appealing down there. In some cases, I think it's just going to take management and Board change to turn these companies around. And we're being more proactive on that front. We are a bigger, smaller cap fund now. And we think we need to act in the best interest of our clients and shareholders, and we are taking a very proactive stance in terms of some situations where companies, we believe, have been run very poorly for significant periods of time. In terms of what we're doing at the moment, we're sitting on quasi-cash in those takeover situations and we're rotating out and recycling that money into opportunities that have popped up during reporting season. We're not trying to take too much of a macroeconomic view. We're just looking bottom up and finding good value out there, and we think that will position us for good returns going forward from here. So [indiscernible] I'll thank everyone for their support, and I'll open up to Q&A, please.

Right. Matt, thanks very much for those comments. And again, well done on a good 6 months. We know it can never be taken as a given. It's difficult to outperform a market these days, but you guys have done great. We do apologize. I believe there have been some tech issues with people who are dialing in just in terms of navigating to the actual screen. So if that's impacted your viewing experience. We do apologize. We'll make sure we send a recording of this webinar to anyone who may have struggled. There have been a couple of questions, Matt, and I'm sure it's been impacted to some extent by those tech issues. But there's 2 questions here that I have. One is from Amanda. She's -- she just wanted you to elaborate a little bit more on the earnings season more in terms of what it's telling you, if anything, on the state of the economy, if you could maybe comment on that?

Yes, it's hard to be general. I guess, I think the consumer-facing companies, so retail and anything facing the consumer has been very tough. Like I said, [indiscernible] earnings down but stock re-rating to all-time highs. We saw that, I think, across sort of the retail sector where they were popular companies. We saw that sort of dynamic where a retailer was unpopular. I guess, it came out and met expectations or the result was worse. As I said, they were harshly dealt with. I think unfortunately, commodity prices have fallen a lot, and that's going to impact the Aussie economy. It's been very buoyant for a long time, and we're seeing a lot of the commodity prices fall substantially and costs have risen. So that's going to be a difficult, I think that's going to be a difficult environment for mining service companies and many of the resource companies as well are going to go through significant challenges as they struggle to generate positive cash flow and unfortunately, have debt. So we're being very cautious around the mining service space. I guess moving on to sort of industrial companies, the economy I think is weaker than what people think. And I think the effect of mortgage rate increases is playing through the economy. I guess there's some industries where there is pricing power, and they've been able to protect themselves by raising prices, but volumes, I think, are going to soften off. So building materials, for example, where you've seen some M&A actually, I think volumes are going to start softening, but price rises, I guess, might compensate for that downside in volume. So, it's different across different sectors, different industries, but I definitely think the macroeconomic conditions, it's deteriorating. I think it means that they will be cutting rates maybe towards the end of the year. But often is the case before the rate cutting cycle, markets can go through some challenges.

Matt and then the second one, and maybe I'll take this one to give you a break. It's from George who says, thanks very much for the quarterly dividends. It's a welcome change at SEC. What -- can you give us a feel he asks for the strength of the balance sheet ability to support the dividend? And I'll talk about the balance sheet, Matt, but maybe you want to, if you can, afterwards, just talk about the yield you're getting on the underlying portfolio of stocks in the SEC portfolio that purely -- because obviously you're paying a dividend from a LIC, it's sort of a function of 2 things. One is how strong is the LIC's balance sheet and in particular, the profits reserve and the franking credit balance in order for it to pay fully franked dividends from the LIC SEC. But obviously, a significant chunk of the income and the franking credits that SEC receives comes from a portfolio of shares that Spheria manages. So I'll cover the first piece, which is to say that at the end of December, I think we disclosed this in our results presentation. We didn't have a slide on this, but the franking credit balance of SEC, which is always the sort of overriding constraint, it's the biggest handbrake, if you like, in terms of your ability to pay a fully franked dividend, much more so typically than profits reserves. But the fully franking balance we announced was equivalent to a dividend of, a fully franked dividend of $0.22 per share. And if you remember that chart I showed -- which showed that the quarterly dividends that we have been paying have been in the region of $0.025 to $0.03 a quarter. So $0.22 -- $0.025 to $0.03 a quarter means we've probably got about $0.08 quarters or 2 years worth of franking credits cover to service the dividend at the current levels. Matt, maybe if you could give listeners a feel for the dividend yield of the portfolio?

Yes. And I'd like to work, I think if you look at the trailing dividend yield for the portfolio, it's around 3.75% over the last 12 months. And so that's a real figure. I guess, forecasts are always estimates. I think at 3.75%, I guess we're buying highly cash flow-generative businesses. They do pay dividends. In some cases, we get specials as well. But I think that yield is fairly sustainable on the portfolio. Obviously, it's not the yield that this paid out on SEC, but as Chris said before, we do generally generate capital gains as well because we are, because we do our valuation discipline in what we do, we tend to be selling into strength and I guess, buying into weakness and when we're selling into strength, we're realizing some capital gains in the portfolio. So then that does obviously give a boost in terms of tax paid and income generation in the fund.

Great. Thanks, Matt. There's a couple of stock-specific questions here. The first one, I actually don't know which company this is. It's a ticker, but recent increase in holdings of SWM, if you could explain why?

Yes, Seven West Media, we think, yes, look, everyone's focused on structural issues facing, I guess, free-to-air TV. I guess that has seen the stock price fall to some degree. I think also it's just the cycle. Media budgets have been compressed. The economy is weak, as advertising budgets compress, therefore, there's less revenue paid to Seven West Media. We've seen that through most of the media verticals. So Seven's not alone. I think the good thing about Seven West is they've, they've got significant content and good content. They've got the AFL digital rights, which will -- which they'll get next year. So they'll have full exposure to digital rights of AFL and they've never had that before. And that critical content is protected under anti-cycling law. So there are some reasons that free-to-air is advantaged, and I think we'll maintain strategic position, I guess, in the industry. The stock -- the balance sheet has improved dramatically over the last few years. They've -- they paid off a lot of debt. They put the company in a good position. They've taken out a lot of costs over the last couple of years. They've been prepared for this downturn in advertising and they're going to come out the other side stronger. They're spending good money investing into their digital platform as well, 7plus. They've got significant audiences through that. 7plus could be a huge platform for them to grow going forward given they can tailor advertising to their particular customer. So I think all is not lost in free-to-air TV. The companies are morphing. They're getting, they're becoming more digital, they're becoming more savvy with what they do. I think the markets from the [indiscernible] there, and we think there's significant upside over the next 2 years as the industry turns around cyclically and as they grow their digital streams of revenue.

Matt, thanks for that. Paul asks about Insignia similar question, what's the thinking there? Do you still like it?

Insignia, we, unfortunately, as I said before, we do make mistakes, we've exited Insignia at a loss. We think the outlook for the business is pretty challenging. Bringing various platforms together from a number of acquisitions is a task that we think is too complex. And is too challenging, particularly with a fairly weak balance sheet. So it's one that we've got wrong. We do get things wrong. I think if you look at our success in the past, so on average, we do better than we get more right than wrong.

Okay. Matt, I think that's all we have. So, and probably bumping up against the 10:30 time limit. So again, apologies if any of you had any tech issues. We will get you a copy of this and we'll also drop it up on the SEC website. But thanks. I mean, firstly, for your shareholding, we really do take every shareholder very seriously, and we thank you for your support. We hope you've enjoyed a much better run, both in terms of performance but also share price appreciation of SEC and that the dividend is something you're also enjoying. I speak, I think, on behalf of the Board and saying that we've tried really hard to listen to shareholders and address some of your concerns with regard to the NTA discount. So -- we are certainly very pleased to see it narrowing, as I'm sure you are, and hopefully, that continues. And Matt, again, thanks for your time and well done on another good set of...

Thank you. Thank you. And we're very focused as a team on performance. Like I said, I think there's a lot of inefficiency out there, and I think we will do pretty well over the next few years in terms of performance. Thank you for your support, everyone. We do appreciate it. And hopefully, there's good times ahead for the product.

Take care. Have a great day.

Thank you. See you.