Merry Xmas

Dear Readers

Thank you for your continuing feedback and patronage.

It has been an interesting year, to put it mildly. Given the number of exploding landmines eg VET, SGH, ACO, SPO, DSH, CAJ, and countless of others I cannot now recall, our risk management verging on paranoia continues to protect us.

The COF saga has now been wrapped up. With 72% acceptances, I think the takeover from TetraTech is very likely to proceed. This has been a rollercoaster ride, with a very important lesson of being focussed on valuation, paying attention to things that really matter, which in the case of COF, is the International Development division.

Another saga, namely SCD, also wrapped up during the year. Once again, a low entry price saved us from grief. SCD presents another interesting case study on risk management, on how things could go wrong, and in this case, management with a large voting stake choosing to make the company "go dark."

It is also pleasing to start Xmas with a nice profit guidance from UOS today, being $128m compared with $84m last year. The Fort Knox balance sheet with super astute management continues to protect our investment. We look forward to many more good years with the Kongs.

We are also looking forward to the future with management of SSM. A pleasant belated Xmas present in the form of a big contract with the nbn, together with contracts with Origin in rolling out solar panels and residential battery storage, and with continuing mobile capex war between the big telcos, it is going to be smooth sailing ahead with massive tailwinds.

We also could not possibly not mention Mr Alf Moufarridge and his team at SRV. Well done, and may the cash continue to flow ever more.

Have a safe and merry Xmas, and a Happy New Year. We expect 2016 to be another interesting year. In particular, we are getting ready our popcorn to watch the resulting fireworks in the clash of Slaters versus Maurice Blackburn class action.  As they say, he who lives by the sword dies by the sword.

Enjoy and Prosper,
Yours One-Legged

Letter to Uncle Charlie- part 1

Hi Uncle Charlie

I hope that this email finds you in good health.

As you know, I have recently graduated from university, and despite Mom and Dad's misgivings, I have managed to be gainfully employed for the past year. I am being paid peanuts by my employer (what's new?), barely enough to cover my rent and nothing much leftover for any drinks or holidays. Given the prices of Sydney properties, I think owning my own swanky pad in Surry Hills will be forever a distant receding dream.

In any case, I got paid a bonus this year so I have about $5000 of spare cash. As I have cancelled my romantic Paris trip with my girlfriend due to the recent sad events there, I won't be needing this cash in a hurry. I was thinking of putting it in a fixed deposit, but interest rates are so low at the moment. My Dad suggested putting it into superannuation, but forget about that! Like I won't get to touch the money for another 45 to 50 years till I turn 65 or 70. Seriously, another one of Dad's wacky ideas.

I was just talking to a friend the other day, and he suggested that I buy some shares. He told me to buy shares in some biotech company, the name of which I cannot recall at the moment. He said that it is high risk because they are not making money yet, but the science is tremendous, and if things go well, I can easily double or triple my money, maybe even 10 times if things go well.

As you know, I am no sucker. I know stuff about shares. I can only lose $5000 maximum, but if I win, I can win $10,000, maybe even $50,000. Sort of like heads I win, tails I don't lose much. I reckon in life, you got to be in it to win it. In any case, high risks equal high returns, and I am young, so I can afford to take this risk.

I was thinking that since you have told me you also dabble in shares that you might be interested in this share. I still cannot remember the name, but I will ask my friend if you are interested. Please do not forget to shout your dear nephew a drink if you win big on this.

Your faithful nephew,
Peter

Reporting Season 2H15- part 2

Just a few glossary terms:

CAGR= Compound Annual Growth Rate

EBITDA=Earnings Before Everything Bad
EPS= Earnings per share
EV= Enterprise value (derived by adding debt on top of MC)
FCF= Free Cash Flow
MC= Market Capitalisation

NPAT= Net Profit After Tax
OCF= Operating Cashflow
HY= Half Yearly Report

FY= Full Year Report

17 August 2015

AZJ FY out. NPAT $600m. $1b in FCF. Trading at 13x EV/FCF.

TTI earnings guidance. Might be a good develeraging play? At this point in time, cashflow not enough to allay burdens of the debt.

SLX cash down to $50m. Lots of promises for over a decade.

CMI $30m in cash and $23m in franking credits. Returning capital.

18 August 2015

ONT FY out. Revenue (statutory) up 15%, and OTC revenue up 23%. NPAT up 32% evidencing margin expansion and synergies. ROE=22% up from 17% is a healthy indication of capital allocation skill, which is critical in a roll-up. Trading at PE 23x which is a bit pricey. Cashflow about $8m.

19 August 2015

SEK NPAT $315m, FCF $280m. MC=$4.4b, implying earnings CAGR of 5% for 10 years. Guided NPAT down for FY16.

TWE still at 3-5% ROE.

IMF FY out. Win loss ratio declining. CEO holds no shares. Spreading out to UK, Asia, USA will incur more costs. On balance sheet, net cash of $80m plus investments of $99m. NPV roughly $320m versus MC of $280m. Not enough MoS.

20 August 2015

ICS FY out. NPAT is $1m which exceeded their guidance. OCF is $1.4m, FCF is $1.1m. Company cash is $1.2m, total cash is $2.6m, evidencing some float. 30% increase in revenue, with 43% increase in EBIT, evidencing scaling. Normalised NPAT is $895k. Meaning nearly $550k in the second half, annualised to more than $1.1m for FY16 due to expansion of latest big clinic customer.

UOADB HY out. 10% increase in net asset during last 6 months. That will do! Nearly MYR$900m in the bank.

SCD FY out. NPAT just below $1m, OCF flowed $1.2m back, and ended up with cash of nearly $7.4m in the bank, plus property worth $3.2m less $2m mortgage=$1.2m. Total cash and property net of debt is $8.6m.  MC just under $9m. Service component of $7.2m is now larger than product sales of $6m, and both generated similar NPAT. Product sales only improved slightly, but service revenue went up $1.2m.

21 August 2015

GNG FY out. Revenue up, but margins went down to about 10% operating margins. Oil and Gas division made a loss. Over $40m of cashflow bloated cash balance to nearly $65m, however, about $20m of the cashflow came from squeezing working capital. Work in hand is solid with $220m booked for FY16. However, margin crimp and the oil/gas division remains a concern.

PME FY out. Only $3m NPAT. OCF of $4m ($7m before tax payment) gobbled up by $5m of R & D. Pipeline looks good, cash balance is still healthy at $12m. Next half year should receive a boost from the pipeline, estimated at about $10m for full year. This should underpin a valuation around $150m to $200m. Waiting for re-entry points.

LGD FY out.  Management doing a good job in view of difficult trading conditions. There is possibly a treasure buried within the larger business that has yet to be noticed by the market. Debt is of slight concern, so will need OCF exceeding $10m next year. Based on management comments of synergies and costs savings from the new acquisition, should not be too difficult to achieve.

JIN FY out. $16m in company cash. Player numbers up. OCF at $4m gobbled up by R & D investments. MC=$38m.

IIN FY out. $200m underlying profit with $570k spending on network/carrier costs. TPM will slash a chunk out of this post merger. Figured TPM should be hitting about $500m underlying profit post merger.

24 August 2015

NEA FY out. Revenue=$23.6m, which means second HY revenue=$12.2m versus first HY revenue=$11.4m. This is only 7% growth half on half, meaning Australia is starting to plateau. Australia made $14.8m EBIT, USA lost $4.5m EBIT, and corporate cost a whopping $9m. First USA commercial sale of $11k revenue, but spent over $11m in the US. Speculating that NEA should have piggybacked on Musk’s satellite system- option still open. Guiding to “runrate” of $28m to $32m by Dec 2015 instead of the previous $30m to $50m. Crowther continued with statements of expectations of significant revenue growth, but provided very scant details of how he was going to achieve this, especially since he is now in the USA.

25 August 2015

SRV FY out. Revenue up 15% to $277m (9% in constant currency). NPAT up 27% to $33m, OCF=$60m. Occupancy= 79%, margins= 14.8%. 145 floors. $114m in cash. Depreciation =$18m. ROE=15%. The cashflow is real, as SRV does not capitalise anything other than costs for new floors or floor expansions.

26 August 2015

SPZ FY out. Still burning cash and making losses. Although there is recurring revenue, the business model does not show any compelling customer lock-in.

CTE FY out. Investments continue to eat into NPAT. Cashflow second half has suffered consequently. Revenue has increased, but not as much as expected given investments last year.

UOS HY out.

27 August 2015

RHT FY out. Ferriscan profits improved modestly to $700k, which is slightly disappointing given the AUD/USD tailwinds. Statutory profit is slightly illusory due to government grants.

FLT FY out. TTV up from $16b to $17.6b.  Revenue as percentage of TTV dropped slightly from 14% to 13.6%. Overseas business generated over $100m of EBIT vs total EBIT of $340m. Corporate net cash is over $500m. Watching UK closely.

VOC FY out. OCF $42m lower than expected.

VED FY out. FCF $80m, EV over $2b. Implied CAGR 15% for 10 years. Nope.

REF FY out. 1800Reverse revenue of $6.8m meaning second half revenue= $3318 v $3472. NPAT $2m. OCF=$2.4m. Cash at current date is $7.6m. 1 cent fully franked dividend declared. Franking bank is now nearly $6m.

FID FY out. NPAT $4.6m. $12.3m in cash, 5.5 cents ff dividend. $6.5m in OCF. $57m MC is attractive. It is nice when a share priced for no growth shows actual growth. In such cases, the investor gets the growth for free.

SDI FY out. Most importantly, Brazilian GMP approval has been obtained. Revenue up at $68.6m, NPAT lower at $6.2m due to higher tax rate. Debt reduced, equity up from $52m to $58m. $7m OCF. $60m MC is attractive on various measures.

AWN FY out. Numbers looked horrible, but underlying numbers and strategy are sound.

28 August 2015

SGH FY out. Gain on Bargain Purchase line entries boosted NPAT. Cashflow is again anaemic, and WIP continues to balloon. ROE is poor despite increasing debt. Even assuming $100m of FCF next year, current enterprise value of $1.7b is challenging in terms of valuation.

ICU FY out. Revenue up, small profit before $1m of one-off expenses. Underlying PBT is $1.2m. Positioned for a strong year ahead. EBITDA for last 6 months is $1.2m. Headed for over $2m of EBITDA in FY16.

TCN FY out. NPAT $2.1m. $4.3m of cash in hand. Mixed outlook. FCF $1.1m, with another $1m stuck in working capital and $1.3m loan to Statseeker. Div=0.49 cents. MC=$19m is reasonable.

31 August 2015

AMA FY out. Revenue up to $95.7m, with EBIT up to $14.4m, hence EBIT margins maintained at 14.6%. Balance sheet is strong with net cash of $30m since capital raising. OCF is $7.8m, and FCF is $6.5m. Dividends increased to 1.7 cents ff. Very positive outlook.

Wait But Why

I have recently came across a really good blog named Wait But Why.

Their most recent article is on SpaceX, link below.

http://waitbutwhy.com/2015/08/how-and-why-spacex-will-colonize-mars.html

All their postings/articles are worth a serious read and reread. The Tesla article is specially mentioned here.

Reporting season 2H15- Part 1

Okay folks. Another reporting season is now upon us.

Just a few glossary terms:

CAGR= Compound Annual Growth Rate

EBITDA=Earnings Before Everything Bad
EPS= Earnings per share
EV= Enterprise value (derived by adding debt on top of MC)
FCF= Free Cash Flow
MC= Market Capitalisation

NPAT= Net Profit After Tax
OCF= Operating Cashflow
HY= Half Yearly Report

FY= Full Year Report

4 August 2015

FFI FY out. NPAT of $2.1m. OCF of $3.6m. Food operations trading conditions difficult. Land on balance sheet is $18m les $3m borrowings= $15m. MC=$33m. Food business valued at $18m, about 9x, fair. Dividend 11 cents fully franked, a very good yield.

10 August 2015

COF FY results out. Underlying EBIT is over $20m, net debt $62m. Trading at 2x MC/EBITDA and 5x EV/EBITDA. International Development continues to prop up everything. Early signs of improvement in infrastructure work for Geosciences. Project Management also improved.

11 August 2015

DMP FY out. 40% NPAT increase. A 10 bagger missed.

COH FY out. NPAT $145m up 33%. FCF is similar. Guided FY16 to $165m-$175m. Market cap of $5b implies 30% CAGR for 10 years. Priced to near perfection and more.

GXL FY out. 6.5% ROE. NPAT ($22m) and cashflow ($15m) mismatch. Net OCF not enough for PPE expenditure ($40m). Debt ballooning out to $262m.

BOL FY out. Wages over 50% of revenue. Equity is $198m.

RKN HY out. Trading at 10x FCF annualised. Not priced for any growth.

12 August 2015

ICS- PIE increased holdings again.

CSL FY out. NPAT=USD$1.38b. OCF=USD$1.36b. R & D=USD$462m. Debt=$2.2b. MC=$44b, EV=$46b.

CAR FY out. $100m OCF, MC=$2.6b, EV=$2.8b. Implied CAGR 20% for 10 years.

REA FY out. NPAT $210m, FCF $190m, MC=$5.6b. Implied CAGR 20% for 10 years.

SSM FY out. Revenue=$411m, EBITDA=$25m, NPAT=$11.7m, FCF=$32m, debt is gone. Fixed comms and mobile comms carried the whole group. Increased dividend to 1cents ff. ROE is weighted down by large goodwill component, however ROTC is very good. Guided an increase in FY16 together with an action plan.  Risk of customer concentration (40% revenue from Telstra) being addressed via diversification of customer base in mobile, and into new areas such as street lighting and residential battery. Lots of ticks for CEO.

13 August 2015

SRX FY out. 69% NPAT increase, zinger shot the lights out. A sad 10-bagger missed.

ASW FY out. Steady as she goes. Capital light business spitting back cash, plus a nice cash holding and a Sydney property on the balance sheet. Special dividend and final dividend. Hampered by size and lack of scale. However, it is performing admirably compared to CPU which reported a drop in NPAT, a big debt load, and under all sorts of pressure.

14 August 2015

TWD FY out. NPAT up 27% to $6m, Revenue up 17% to $95m. Results achieved despite election delays in Qld market and delays of land registration in NSW market. VIC market still in establishment phase. Guidance for an even better year for FY 2016. Cashflow lower than NPAT due to inventory buildup. Insane ROE, but very high payout ratio and exposed to housing sector.

Xero: A Review

Introduction

XRO has generated plenty of headlines and opinions in recent times. The ever erudite and brilliant Mr John Hempton gave us a very good introduction here. 

It is not too difficult to find online reviews from users' perspective. Here is one. 

There are also plenty of articles on XRO posted on the Motley Fool Australia. Just Google the search term “Motley Fool Xero” to access all of them. To save you some reading, I can tell you folks that there are all unanimously bullish.* Herewith an example, and another example. 

The XRO expansion story

XRO's CEO Mr Rod Drury was recently reported in the press lamenting that the financial community in Australia does not understand the XRO story. In a nutshell, XRO's management call to arms is that this is a land grab, and they are spending money to tie down "real estate", which means massive cash outflow now, in return (presumably) of untold riches in the future.

Proponents of XRO's management vision points to Amazon as a leading shining example. They are also fond of pointing out valuation disparities between XRO and similar plays in the new fangled cloud/SAAS/software/technology area in the USA such as SalesForce. 

Any person who has experienced the dotcom boom in the 90s can instantly identify this familiar refrain. Don't look there (earnings, cashflow), look here (users, revenue, eyeballs, clicks, etc). Moreover, we are also blessed with generous people such as David Einhorn sharing their ideas publicly. In this presentation (which is an excellent read on its own), David warns us that such peer comparisons make an assumption that the valuation of peers are reasonable. And thus, we could again hark back to days of the dotcom boom where inflated/insane prices are used to justify even more insane prices. We are also reminded of the real estate story in Australia at present, but let's leave that aside for the moment.

The bull case proponents are also quick to point out the involvement of marque investors in XRO such as Peter Thiel. Yours truly one legged is then immediately reminded of the Sino Forest scandal. 

Dissecting the Bull Story and a comparison with Intuit

In his excellent book "Competition Demystified", Mr Greenwald presented us with compelling stories of why it is usually not a good idea to take on an incumbent in an established market. He cited the case of Kodak versus Polaroid in the area of instant photography. More importantly, Mr Greenwald explains that an incumbent, with its entrenched customer base and its size, usually has the advantage of scale in a price war. For example, marketing cost per unit of sale is lower when spread out over a larger base, or R & D costs per unit of revenue is lower.

So with that in mind, we now turn to XRO's assault on Intuit in the USA. We expect that, eventually and inevitably, this battle will be fought out globally.

The Salient Metrics

There are 5 salient metrics that are relevant to the battle, and the ultimate fate of XRO and Intuit.

The first is revenue. Revenue is self-explanatory. This is how much your customers are paying you.

The second metric is selling costs. Also known as marketing and advertising, it is useful to consider the framework espoused by Sanjay Bakshi in this excellent article in relation to GEICO's customer acquisition cost.  I can see the logic in applying a similar argument to XRO, namely that the marketing spend is a customer acquisition costs. If so, one can strip out marketing costs each year and capitalised it, and amortise it over 83 to 95 months, which is the length of stickiness of customers as presented in XRO’s presentation here.  Doing this allows us to see a clearer economic picture. As at 2015, XRO's marketing spend is a whopping 75% of revenue.

Unfortunately, at this stage, capitalising/amortising XRO's marketing spend is not much help, since the total of R & D, costs of revenue, and administration expenses are barely covered by revenue. 

The third metric is R & D. In a software business, this is an absolute necessity just to stay relevant and to stay in business. Accordingly, be wary of software companies that insist on capitalising their R & D spending.  As at 2015, XRO's R & D is 54% of revenue, bearing in mind that the relevant metric for MSFT and Google is about mid teens.

The fourth metric is costs of revenue. This is the same as costs of goods sold, which is a variable cost that is incurred every time XRO makes a sale.  The costs of revenue of XRO as at 2015 is about 30%.

The fifth and final metric is administration. These are the overheads required to do business, and as at 2015, XRO's admin expenses is 20% of revenue.

Intuit's metrics

These are Intuit's metrics for 2014:

Revenue is USD$4.5b versus NZD$143m for XRO.

Cost of revenue is 15% versus 30% for Xero.

Marketing is 28% of revenue versus 75% for Xero.

R & D is 17% of revenue versus 50% for Xero.

Admin is 10% of revenue versus 20% for Xero.

These figures paint out a stark picture in relief on the realities of fighting an entrenched incumbent on its own turf. The four major metrics totalled 70% of revenue for Intuit, and 175% for XRO. You can now see why Intuit is just spewing out cash, whereas XRO is just burning through its pile.

XRO's road ahead

To be fair, the market is big enough for both XRO and Intuit. It is unlikely that the online accounting software market will transition towards a winner takes all scenario. There will be a place for both, and especially if smart people could design a software that is capable of porting data from XRO to Intuit or vice versa. It is also reasonable to assume that XRO could achieve parity in terms of scale once it has achieved a critical mass of users and revenue, and that such critical mass may only need to be a small fraction of the total multibillion dollar market. 

Therein lies the opportunity, if XRO can achieve Intuit's scale.

If XRO can achieve a critical mass at one quarter of Intuit's revenue, say USD$1b revenue and achieve a scale similar to Intuit, then it should be rolling back $250m of EBIT per annum, which will easily justify a market cap of USD$3.5billion to USD$5billion. However, this would probably take a minimum of 5 years.

Daunting Task

The task for XRO is daunting. Current revenue of NZD$150m needs to grow to USD$1billion. Whilst XRO may have caught Intuit napping in terms of cloud solutions a few years back, Intuit is now clearly awake and fighting back, with all the luxury and advantages of an established incumbent in its home market.

If one looks through user reviews and forums, it appears that both product offerings are similar in terms of functionality, if not aesthetics. In other words, XRO is not offering a compelling new proposition. This is not a story of the iPhone/itunes sweeping the world, nor is it a story of Google. There is nothing "disruptive", to coin a tired old term, or at least it is no longer such since Intuit started its cloud offering.

At present, XRO is getting $1 of sales for every dollar of marketing spent. Intuit is spending 17% of revenue on marketing and is keeping pace with XRO in the cloud/online user growth numbers. The pricing for both products are similar, hence putting XRO at a disadvantage due to lack of scale. Due to its large user base, Intuit’s selling cost should be even lower if they can develop a feature allowing for easy portability of data from a desktop environment to the cloud. However, XRO is currently fortunate as Intuit did not appear, as yet, to have perfected this feature. But this is only a matter of time.

To get to USD$1billion of revenue, assuming optimistically that every dollar of revenue requires only 50 cents of marketing (as opposed to $1 currently), XRO will still need to spend close to USD$500m.

XRO only has NZD$210m in the bank.

The other problem is penetration of USA market. USA is not homogenous with a central taxing authority such as Australia or New Zealand. The USA market is characterised by state based laws and regulations. Penetrating each state requires software modification peculiar to each state. Intuit already has a massive head-start, and even if on equal footing, Intuit has massive scaling advantages to match XRO dollar for dollar on R & D. As far as user feedback is concerned, software features are currently head to head, however, we understand that XRO is not available in quite a number of states. This puts XRO at a disadvantage, as perhaps evidenced by increased of R & D to 54% of revenue versus 17% for Intuit.

For XRO to come good on its business model, perfect execution is required. For that to happen, we need to start seeing evidence of metrics trending towards Intuit's metrics, whilst keeping up revenue growth at the same time. This will at least indicate that XRO's disadvantage in scale is being narrowed towards complete elimination, allowing it to compete on parity. In its latest financial, XRO's costs of revenue started reducing from 35% to 30%, which is a good sign. However, this was counterbalanced by R & D increasing from 49% to 54%.

Conclusion

Despite a share price dropping from $40 to $15, it is still sobering to be reminded that XRO is still capitalised at over AUD$2 billion. It has a high hurdle to overcome, and not enough of an upside to justify the risks assumed. My assessment at this stage is that at current prices, this is a bet with a negative expected outcome.

*Edit: in the interest of accuracy, there is a rare dissenting opinion here.

Disclaimer: Not advice. Posts contain, where applicable, my opinions or my interpretation of facts. I am also not able to guarantee that the facts I rely on are accurate. Please seek independent financial advice. I do not hold any XRO shares, but this may change at any time.

Giverny Capital Annual Letter 2014

Another year, another letter from the good folks at Giverny.

To quote:

"Since 1996, our companies have increased their intrinsic value by 983%, or close to an eleven fold increase. Meanwhile, the value of their stocks has increased 1094% (including dividends but without currency effects). On an annualized basis, our companies increased their intrinsic value by 13.4% and our stock returned 13.9% per year. The similarity between those two numbers is not a coincidence (my emphasis)."

Giverny Capital Annual Letter 2014.

We are now on the final straight for the full year reporting season on the ASX for FY2015. May the odds be always on our side.

Yours One Legged