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

All right. Good morning, everyone. It's just gone 10:00. We should get started. My name is Chris Meyer. I'm an Alternative Director on SEC. I'm also one of the Pinnacle directors and we do all Investor Relations for the company. I'm joined today by Marcus Burns, he's a Director of the company and also one of the founders and portfolio managers at Spheria Asset Management, who is the manager of the company. So we've been doing this for a while now. SEC listed back in 2017. We're now in 2026. So companies coming up for 9 years old. Can you believe it? But every time we do this, we just love having our shareholders listen in to these updates. You're our most important asset. And so we thank you for your time and attention. The good news today is that we have great news to tell you. We have great update. We're very pleased as a Board, and hopefully, you're pleased as shareholders with how SEC has performed. We're most impressed and most pleased with how the share price is now trading at a premium to its net tangible assets. That has been a lot of hard work, frankly, by everyone involved. The Board, I think, has deserved some real credibility for having taken shareholders' interests to heart and implementing a lot of change in the last couple of years to affect that turnaround. And then the manager itself has done a great job over the years of beating the market, beating its benchmark, which obviously helps contribute towards a good experience for shareholders. So we'll spend about 25 minutes. This is a 30-minute webinar. We'll spend about 20, 25 minutes going through a presentation, and then we'll take some of your questions at the end. If you have any questions, please feel free to pop them in the Q&A box, and we'll get to them at the end. Marcus, if you wouldn't mind just scrolling forward to Slide 5, please, where shareholders can see that, just the next one -- sorry, the one before that. Just a very high-level update of the financials of the company. It's a 12-month year-end review. Financials for a listed investment company are not hugely important. It's really the investment portfolio that everyone cares the most about. But as you can see on this slide, the most important thing, I think, for shareholders to take out is twofold. One is the ongoing dividend yield the company has of around 6% cash dividend yield, which is about 8% or so if you include the fact that it's fully franked, you can see that 8.4%. And the second thing is that the balance sheet of the company is particularly strong. You can't necessarily see it from this slide. But for many years now, the company has been earning good profits because the portfolio has been going up, and so there's been some capital gains and the portfolio has been generating some income. And so there's some retained profits that we have. And the company has also been earning some good franking credits that it can now use to pay those fully franked dividends. So we feel very good about the financial status of the company today. Next slide, please, Marcus. I think this is a breakdown of the net tangible asset per share of SEC. At the start of the year is the dark blue bar, at the end of the year is the bar on the right, the other dark blue bar. And you can see it was actually a reasonably uneventful year. Weirdly, the portfolio was actually flat for the year. This shows that it was slightly up, which is a technicality, but essentially, the portfolio was largely flat for the year. And you can see that the expenses are well controlled. We have a very small board. We benefit as shareholders from the scale benefits of Pinnacle and its middle and back office and finance function. And on the right-hand side, you can see in the gray, the gray bar, the big gray bar is the dividend. And so it's sort of a reminder, I think, for shareholders that whenever thinking about the performance of your investment in SEC make sure you also remind yourself that you've got to add back the dividend to the NTA when you think about the NTA growth over time. And so the dividend was really the main event when you look at the NTA movement for the financial year 2026. Next slide, Marcus. This is a performance slide. It's obviously the main thing that Marcus will talk to in his prepared remarks. Marcus, maybe if you go on mute there, I'm just getting a bit of background noise. And what you can see, I think, pleasingly for the company and what the manager has been able to achieve since inception of the company is some very healthy outperformance since inception. If you look at the far right-hand side column there, you will see since inception in November of 2017, the portfolio is up 6.7%. The index or the benchmark is up 5.2%. And so that's outperformance from the portfolio of 1.5% after fees. Now if you know active management, achieving that kind of outperformance or alpha, as we say, is not that easy and so credit to Spheria for achieving that kind of performance since inception. More recently, you will see in the 1 year number, which is sort of in the middle of that table. It has been a more difficult year for Spheria not hugely surprising given what you'll hear from Marcus, which is that the performance of the market has been driven by stocks that often don't have very good cash flow yield, which is the real sort of North Star for the way Spheria invests. So that's not unexpected. But pleasingly, in the more recent past, you can see there in the 1 and 3 months is the market has kind of turned -- we've seen a turn in the market and it's come in the direction of Spheria's portfolio. And so you can see there's some solid outperformance in the more recent past. Next slide, please, Marcus. Which is the dividend slide. And there, you can see, really, I think it's worth spending a bit of time on this because the main feature of SEC in the last little while has been our commitment as the Board to really turn Spheria from being a company that is really striving to deliver capital growth to one now that we fully expect to be able to deliver that capital growth, but also high levels of income for shareholders. And you can see that on the top right-hand side. That's a chart of the dividend history of SEC since inception. Probably the most relevant line is the dark blue line, which is the yield. So taking the dividends of the company paid out in the year and dividing it by the net tangible assets per share of the company, and that's including franking. So you can see back in 2018, the very first financial year of the company, deals, including franking was about 3%. It rose to around 5% over the next few years. And then really back in 2022 is when we started to create much more of a focus for SEC on income and distribution. And we started off by increasing the dividend payout ratio. And you can see that's when the dividend yield jumped to about 7%, including franking and we also started paying out the dividends more frequently. So we started with quarterly distributions back in 2022. And then more recently, you can see as we've hit those 8% franking yields, we've improved the payout ratio even further. And so we're now paying out dividends and our stated 1.5% per quarter or 6% per annum from a cash basis, which translates to about that 8% to 8.5% if you include franking. And on the bottom chart, you can see we've not just increased the yield, but we've also increased the frequency of those dividends. We're now paying dividends from as of February this year on a monthly basis. And so our intention is to declare those dividends quarterly and pay them to you monthly. So you should all now be receiving those nice, steady monthly checks into your bank account as of February of this year. Next slide, Marcus, I think is my final slide, which is about the NTA and the trading price of SEC. So what you can see there in blue is the SEC share price. That's obviously the one that's most important to you. The gray bar is the NTA of the portfolio. And you can see for a fair bit of time during particularly 2020, 2021, 2022. The blue line was below the gray line that indicates that NTA discount. You can see that in the orange line, discount of sort of 10-odd percent into 15%. And then what you can see since 2023, really until today is a steady and fairly dramatic improvement in that NTA discount from that sort of 10% level to where we are today, where we're trading at about a 5% premium to NTA. That's probably the most healthy indication of any LIC that shareholders are happy when it's trading at a premium to its NTA. And we think there's a few reasons for that. One is, as I've said earlier, the focus on income, you can see it's -- the improvement in the NTA discount is coincident with when we move a higher payout ratio and a more frequent dividend payout. But we've also improved the transparency of the company over that period of time. We now produce a daily NTA even though the regulation only requires us to do a monthly NTA, we believe a daily NTA provides additional transparency for shareholders. And finally, the manager's performance, as I alluded to earlier, A LIC without a strong manager is unlikely to trade at a premium to its NTA, and so Spheria outperforming its benchmark and therefore, beating the company objectives over the history of the company is also earned the manager that credibility over time. So we're very pleased with this. And obviously, we're very focused on making sure that this continues. But it does set us up very nicely. And with that, I think I'll hand over to Marcus to give us an update on the portfolio.

Great. Thank you, Chris. Appreciate the update, and that's a good run through on the background transparency. So my section is just going through and remind people exactly how we think about investing. And what we do as investors to preserve your capital and to grow it over time. And without spending too long on the basics because many of our investors will know this, but we have a big focus and Matt and I and the team talk about the 3 core things that make our process slightly different to maybe other investors in the small cap space. We obviously want to get great returns for clients and investors. But equally, we're really concern about preserving capital. And to that end, in small cap, we spend a lot of time looking for business that have free cash flow. And so that is a hallmark of how we invest, just comparing those accounting earnings with actual cash that comes through the door into the bank. So our model is based on looking at business that have good cash flow conversion. We also prefer businesses to that low gearing as in low net debt. Again, that might seem fairly obvious, but a lot of business get quite geared during the wrong time of the cycle, and then they're raising money at deep discounts. In some cases, the market cap collapses so quickly that we often struggle to reduce debt materially. So we'd like to not be in those businesses when they're doing the cap raises but maybe come in if there is a cap raise at a very dilutionary level. And then finally, we do value all the stocks in the portfolio. The whole team sits here. Matt and myself included with Excel spreadsheets, and we do our best to try and get a sense of where businesses are and where they're going to be in a couple of years time and do buy these businesses at a lower valuation point. We spend a lot of time looking for inflection points, and I might touch on 1 or 2 names we own in the portfolio that have done particularly well over the last month or 2 that have been effectively going through management transition and changes and inflections that have been positive. And then lastly, and I'll just touch on this. I think the small cap and particularly micro cap space vis-a-vis the large cap space is incredibly under research still and there's a lot of opportunity for us to make money in alpha for clients in micros and smalls. We've kind of gone through, I guess, the performance of the business, of the company since inception. Chris touched on this recently. We've outperformed at the beginning, managed to get 1.5% alpha post fees over the time frame of the LIC. Normally, we would be slightly higher than this. So typically, we end up with 2% to 3% alpha. The last 12 months has been a little more challenged for us, and I'll come on to the reasons for that. And then maybe how we've adjusted to that to give you some sense of how we will be investing going forward, but nothing that's changing materially. Just to give you some flavor, the last 12 months. This is the 12 months performance of the actual underlying holdings we have and which ones have contributed and which ones have not contributed to the return. It might be too much detail for some investors, but just to give you a bit of a flavor of the names that are doing well and having done so well. The chart on the left there shows you is called stock attribution. So the individual stock names that we hold in the portfolio and the ones on the left have been contributors to the performance, ones on the right have been detractors. And I'll come in to -- maybe to touch on a couple of names just to give you a bit of a flavor there. The blue bars are the ones that we actually own in the funds and the red bars are the ones we don't own and -- we don't own, so they will either contribute or detract depending upon their relative performance. I might call out Sims Metal there is one that's been a very strong performer. Sims is a great cash flow business. It's very cyclical. It's a metal recycling business based in Australia and largely North America now. The reason it has performed really well is the cycle has improved a bit in terms of base metal recycling. The business has gone through a bit of a transition selling asset in Europe, which has degeared the balance sheet substantially. So now it's a good cash flow business, albeit cyclical, very low gearing. It's had a tremendous run as they have a business called Sims Lifecycle Recycling, it's basically recycling computer chips out of data centers. And that has gone through a real boom as memory prices have gone through the roof. And so they're making incredibly good returns at that component of the business, which is gone from being roughly 10% of the earnings to close to 40% of the earnings of Sims over the last 12, 18 months with that improvement in memory prices. So the stock has performed very well. We've trimmed back the holding there, still retain a holding that's been reduced. L1 merged with Platinum last year, performed extremely well on the back of the merger, and we've since divested that holding for us. And then Imdex is the mineral sector, Imdex, Deterra, Boss is the mineral sector. Imdex is mining service business, Deterra is a royalties business on iron ore Mining Area C with BHP, which has gone through a bit of recovery, pays very good dividends. On the negative side, Healius, IRESS, and Supply Network and TechnologyOne, maybe worth just touching on those briefly. Healius is an incredibly -- well, should be a very valuable business, gone through a challenging time. It's the #2 blood testing or plasma testing business in Australia. It's gone through a challenging time as wage inflation expanded faster than they've been allowed to raise prices. It is #2 business in Australia in the space with roughly 25% to 30% market share, a lot of revenue the cost but the cost base is too high, so they need to do restructuring in order to improve margins, which we think they can and should do plus it is very likely to be a beneficiary of consolidation in that space as well. So share prices have been challenged over the last 12 months. We retained a holding and still think there's a tremendous amount of value if they can trim costs and potentially merge. IRESS has gone through -- it's going through a management change. We've put in the new CEO into the company there. It's stabilizing revenues, it's improving margins, it's now trading on low multiples. Balance sheet is also very degeared. But the revenue update recently was fairly disappointing. So the stock got sold off on the back of the results, although the actual EBIT and net profit was actually pretty strong. So remains a holding for us. And we think that the new management team is doing a really good job. Supply Network has been a long-term holding for us, a very, very well-managed company and has just gone through basically flat to sideways performance for the last 12 months on very little news really. The top line has grown materially, still taking market share and still translating that earnings -- the revenue growth into strong earnings. So these performances are basically up a point in time. And then lastly, Bapcor, TechnologyOne and Bapcor is a retailer going through a restructuring. I mentioned earlier that we like to buy businesses that, in some cases, go through a period of restructuring or a new management change. Bapcor did a series of acquisitions, which geared the company up. We weren't shareholders for many, many years and they did a capital raising about 2.5, 3 months ago, which we took in. So that materially degeared the business, gave them some scope to restructure the company and they're now in the process of improving earnings by basically tightening up the inventory, trimming costs back, and then I think there probably will be some asset sales at Bapcor, their recent numbers were showing, I guess, business is stabilizing. And so the stock has rerated materially from sort of $0.45, $0.50 up to almost $0.70 $0.80 a day. So that's been a good turnaround story for the firm or for the SEC shareholders and is contributing materially currently in the portfolio. On the right-hand side, I won't go into too much detail other than say that materials where we've been underweight gold largely has been a net negative for the relative returns. Late last year, so around October, November last year, we bought into 2 gold names. We have Capricorn and Bellevue Gold, both in the funds. So we're about 4% weight in gold directly in addition to the mining service names, we have like Imdex and C79, which we'll talk about briefly. So we do have exposure to minerals and materials. We still remain underweight gold, but we have some exposure to a couple of key names there that, again, look like decent quality assets to give us some exposure to this base in case gold price continues to rally from here. And IT has gone through basically transitioned as people digest AI and the threats that AI might bring to software companies. TechnologyOne went through a bit of a sell-off late last year, earlier this year as people were concerned about AI threat to companies like TechnologyOne, since that period, the stock has recovered materially as people start to realize that AI is both a threat and an opportunity for these guys as stocks like TechnologyOne actually integrate AI into their customer offering. So it helps them increase the code base, the speed of their code base update and also allows them to add AI features to the client base, which they're currently looking to charge additional revenue streams on. I won't dwell too much on this slide other than to just show you current holdings there, Supply Network Perpetual, Fletchers, probably worth drawing out that we're overweight energy at the moment. So we have exposure to 1 or 2 oil names in the fund and also some coal. So New Hope Coal is a material position for us. Materials, we're still largely underweight, but it's not a huge underweight, vis-a-vis the index. And then maybe just worth calling out the consumer discretion position, which is -- so the blue bar is our current weight and then the yellow -- the orange is the index. We're currently quite overweight consumer discretionary of that 23% weighting, roughly 5% is in Supply Network, which, as I discussed earlier, is a bus and truck supplier to the independent mechanical chain. So not -- in our view, not particularly discretionary. If you take that out, we're probably -- we overweight the space, but less so. All the view there is bottom-up. So the names we have like Universal Store are driven by really high-quality underlying businesses rather than a view on consumer per se. I'm going to touch on these 2 quickly, just to maybe explain and bring life the investment process for investors who are interested in this. The chart on the right there really is probably the most important one. And one we hold very dear and central to our process. We are comparing 2 things on that chart. The free cash flow before interest and tax, so just effectively free cash flow before tax with the reported EBIT number. And we'd like to see a strong reconciliation there, unless there's a particular good reason why it may not be reconciled. But generally, it's high, we're running at 96% for stock like Universal Store. So they're a very good generator, in other words, it converts a lot of accounting earnings into cash flows. On the left-hand side there, you can see that it's managed to grow our business very strongly through pretty challenging cycles. So it hasn't exactly been a boom time for consumers over the last 5 or 6 years. You can see that Universal Store has managed to grow revenue over 12% over that period of time. And almost every single year is growing its like-for-likes across the 3 major banners they have, Universal Store, Perfect Stranger and CTC, which is a brand they acquired back in 2023, like-for-likes have grown strongly. So very fair dividend yield every year. Great cash flow conversion still fairly mature as a retailer. It's got 123 stores currently, it's rolling out about 10% new stores every year. So we should get revenue growth of somewhere between 10% and 15%. That's translated to earnings growth of 15-or-so percent and a dividend of roughly 5%. So we're getting almost 20% return out of that stock per annum since it IPO-ed in 2021. And then just to give a bit of a different flavor here. I mentioned earlier, we have exposure to minerals by a couple of holdings, but also by mining services, one stock we have, which is -- which we think is particularly interesting is Chrysos Corporation. And basically, it's -- gold sampling is going through a material change globally from fire assay to PhotonAssay and this technology came out of the CSIRO and then listed in form of Chrysos Corporation about 5 or 6 years ago. We recently became a shareholder as they've started to go through and when some material share with the major testing companies in the world, like the ALS of the world and the SGS and Bureau Veritas have now adopted Chrysos technology in their labs. And it's despite growing very strongly over the last couple of years, it has a very, very tiny market share of the potential global addressable market. So currently had 44 deployed units, their estimate of the total market was about 610 and it could be materially larger than that, frankly, because they test for gold currently, but they are broadening out the way they do the testing to other minerals, including copper and silver and a few others. So the market size could grow materially beyond the 610 they have said there. And they have a very high margin, high cash flow return on the assets once deployed. It is not actually a strong cash flow producer today, but the contracted nature of this business means once they put a testing unit in site, they've got a 5-year contract with the client, which is typically extended for up to 10 years plus. And it's a really disruptive technology and we're quite excited by this as a medium-term holding in the fund. Just to finish off, if any of you have seen any other presentations we've done recently, we've talked a bit about why we think small caps are fairly cheap versus large. There's been a shift towards passive investing generally across the market. So ETFs and passive markets are growing materially. And then we've seen a lot of larger funds in Australia who benchmarked against the large cap index effectively shift money out of small, which has created a bit of a vacuum in the small cap space and thus the discount, we think. So just looking at the forward PE ratio of the small cap index comparing to the large caps, the top 100 in Australia. We're roughly at 15% discount today, that's despite the move last month where small cap had a material bounce versus large. The discount is still there. And we feel, obviously, with our holdings that we're trading at a discount on a discount. So we think it is a pretty interesting time to be looking at small caps as an asset class. Just to final finish off the presentation. We thank investors for being with us for some -- for the journey so far. We are a very fundamental investor. The team is working assiduously on bottom-up investing. We do a lot of meetings with companies, a lot of modeling to try and find the best ideas for you. We are inherently biased towards businesses that have good cash flow, good balance sheets. There's been an aggressive rotation into resources over the last 12 months, which we've been underweight, which has caused that slight performance. But at some point, we will unwind. And we do have exposure to mining services and some of the better quality resource names. So we are getting some exposure to that space and have been looking increasingly for the good names there that have good asset lives -- good mine lives and sort of tick the boxes. We remain at a discount to what we think the small cap space remains discount are large and the last thing I'll just touch on is I think that M&A is going to be an increasing factor down here. So that discount is encouraging. Foreign activity, private equity firms and large corporates are coming down here. There were 5 takeovers announced in the last month, stocks like Steadfast, Perpetual and RWC all had bids over the last 12 months -- sorry, the last month and somewhere between a 30% and 50% bump to the share price at the time. So plenty of activity going on. There's a small cap -- a micro cap announced this morning as well. We are typically an overweight beneficiary of takeovers. And so we feel the portfolio is pretty well positioned for that if that continues to eventuate and roll out. So with that, I might hand back to Chris for any questions.

Great. Thanks, Marcus. Thanks for that update. We do -- we have a few minutes for questions. So again, if you do have any questions you'd like to ask, please type them into the Q&A box. Maybe Marcus, just one quickly from me, having heard you at the Pinnacle Summit today. On the M&A theme, are there any sort of macro factors that you think still could act as a catalyst, I'm thinking particularly the interest rate environment, that could act as a bit of a catalyst for increased M&A in the type of companies that you're investing in?

That's a good question, Chris. So yes, there are, probably. I mean the major ones there would be 3 major drivers, obviously. One is interest rates, clearly. If rates stabilize or decline, that's a real positive for takeover activity clearly because the cost of financing has reduced. If rates continue to squeeze a bit higher, though, that is a bit of a negative, just to be frank with analyst with investors. So if rates continue to peak higher, that is a marginal negative for the takeover situation. And I think the other secondary issue is a foreign exchange of Australian dollar, which has been rising. So that is probably a small negative as well. If Australian dollar stabilizes, declines, that means it's cheaper for foreign companies to come in and buy Australian assets. So they like rates falling or rates stabilizing at a fairly weak currency would be 2 positives, I think. Other than that, I think obviously, global. The global situation means that a place like Australia that are relatively stable vis-a-vis other countries where things are changing or America has a less relationship, I think, make them harder for people to buy in those jurisdictions. So that probably favors Australia, I think, from a macro point of view as well.

And we actually see, Marcus, in Pinnacle anyway in the private equity landscape that Australia is very much on the map of these large private equity firms looking for investment opportunities in the Asia Pacific region, particularly given China sort of "uninvestable". And so I think as you mentioned, a lot of those M&A targets have been targeted by private equity firms, haven't they?

Yes. Flush with cash need to deploy. And many of the companies, the U.S.-based ones, particularly like Australia because the jurisdictions until our recent budget has been considered pretty stable.