Was it Really Transitory?

It felt like the term most frequently used (and often misused) during the last 12 months was ‘transitory’. However, as investors persisted through FY23, the use of the word gradually declined to the point where it seemed to have almost vanished from everyone’s vocabulary. FY23 taught us an important lesson: certain macro movements and events, such as inflation, interest rate rises, labour shortages and even wars have proven to be anything but transitory. None of the aforementioned factors have shown any signs of reversing soon. The graph below illustrates that valuation compression has not subsided, and the recent stabilisation of price-to-earnings (P/E) valuations for industrial businesses within the S&P/ASX 200 can be attributed more to the slowing or declining earnings of these businesses rather than stock prices moving higher.

S&P/ASX 200 – Valuation (Price to Earnings)

The actions of the Reserve Bank of Australia (RBA) in raising interest rates to combat persistently high inflation has resulted in lower risk, or risk-free investments, providing increasingly acceptable returns for investors, particularly when compared to numerous equity investments. When this tightening cycle commenced in FY22 there was a noticeable shift among investors, who began reassessing their overall exposure to equities due to the availability of alternative, risk-free returns, and equity markets consequently experienced declines, especially in sectors with inflated or irrational valuations.

Over the last 12 months, interest rate rises and inflationary pressures have continued to generate the most headlines, and their impact has extended into the wider economy, with the effects keenly felt by the consumer, businesses and asset prices. Labour shortages also continue to be a significant challenge in the post-COVID environment, with many businesses desperate to hire staff, as shown in the graph below.

Job Vacancies – Australia

These various factors have led to a significant increase in uncertainty around the earnings trajectories of many listed businesses, particularly retail and consumer discretionary stocks. Towards the end of FY23, several companies provided trading updates confirming that the current macro environment was now adversely impacting their operations in a significant manner. Such examples included retailers Universal Store Holdings (ASX: UNI), Michael Hill International (ASX: MHJ), City Chic Collective (ASX: CCX), Dusk Group (ASX: DSK) and Baby Bunting (ASX: BBN).

Arguably, the investing environment we face today was last experienced more than a decade ago. During that period, interest rates offered a reasonable return, businesses with negative cash flows were not valued on revenue multiples, and economic cycles occurred. Admittedly, economic cycles can bring with them short-term pain for investors and businesses alike, but they can also bring extraordinary opportunities. The two following graphs highlight how depressed the current opportunity set is within emerging companies. The first graph compares the price performance of small-cap industrial businesses relative to their larger peers over the past three years, highlighting that small-cap industrials have underperformed their larger peers by 20% on a peak-to-trough analysis or by 10% over the three-year period.

When we review the data over a longer period (in this case, since June 2001 as shown in the second graph below), the underperformance is significantly more pronounced, with the discount of emerging industrial businesses to their larger counterparts at its widest level, even when factoring in the global financial crisis (GFC) and the tech wreck period in the early 2000s. Price movements can often be indiscriminate, but one thing the share price movements of emerging businesses taught us during both the GFC and the COVID-19 pandemic, was that investing in quality, proven and well-funded businesses during such times can yield fantastic returns. Another important lesson learned is that picking share price lows is a futile exercise, especially when investing in large dollar amounts, and while there may be short-term pain in some cases, we firmly believe the long-term gains will be significantly outsized for many emerging businesses.

S&P/ASX Small Industrials Relative to S&P/ASX 200 Industrials – 2020 to 2023

S&P/ASX Small Industrials Relative to S&P/ASX 200 Industrials – 22-Year History

Events of Significance

In my experience of over 16 years in investing, one thing that has become abundantly clear is that share price movements are typically the culmination of a series of prior events related to the business and accompanied by a considerable amount of hard work. With this in mind, I highlight below several events that transpired in FY23, which, in our view, have the potential to generate outsized shareholder returns in the coming years.

MitchCap Secures $270 Million in Financing

As the first unlisted investment in NCC, we have high hopes for MitchCap and to date, we remain highly impressed with the management team of the business and are very positive on the outlook for the business over the long term.

Profitably growing a financing business is never an easy task and in today’s higher interest rate environment, it has clearly become much harder. In our view, the fact that MitchCap has secured a substantial financing package (inclusive of senior debt, mezzanine financing and equity), demonstrates the strength of the business model and highlights the growth opportunities that lie ahead. This financing package (with $275 million of lending facilities – up from $150 million) provides the business with the financial scale to continue to grow its network of dealers (marine, caravan, RV and agricultural equipment) aggressively. For context, MitchCap was founded in FY19 and as at the end of FY23, it now has over 250 dealerships nationwide and 50 original equipment manufacturers (OEMs) on its network. To enable MitchCap to continue on this growth trajectory, a growing funding capability is required to enable the business to service both existing and new customers without compromising the customer experience. We believe this new financing structure gives the business ample capacity to increase dealership numbers to approximately 600 over the next two years, and solidify its position as Australia’s leading provider of commercial distribution financing, excluding auto dealerships.

Financing businesses are not for every investor due to the inherent credit risk involved, but we believe MitchCap ticks many of the boxes we look for in a business within this sector. It deals with business customers, offers an essential service to its customers, has implemented best-in-class asset tracking, and operates in a field with limited competition. While we are sure FY24 will not be all smooth sailing; the key metrics of the business should continue to point in the right direction. Over time, we believe MitchCap has the potential to establish itself as an industry-leading financial services player, generating significant recurring cash profits.

COG Financial Services Novated Leasing Expansion

In March 2023, COG Financial Services Limited (ASX: COG) completed its acquisition of Paywise, a Western Australia-based salary packaging and novated lease provider. As part of this transaction, COG also entered into an agreement with workers compensation provider EML Group, to acquire 18% of the combined COG novated leasing and salary packaging business.

Following the acquisition of Paywise, the novated leasing segment of COG will now account for over 20% of the group’s earnings, while the remaining earnings will be derived from finance broking and aggregation, insurance broking and funds management. This acquisition provides the novated leasing division of COG with the necessary scale, technology and personnel to compete in an industry that has become highly concentrated and dominated by players like Smartgroup (ASX: SIQ) and McMillan Shakespeare (ASX: MMS). Given the concentrated nature of the industry, we believe there is ample room for further competition. Additionally, with EML Group now a minority owner of the group and a customer base consisting of government departments, corporations and unions, which could all potentially benefit from a novated leasing product, it opens up numerous additional opportunities for COG to pursue.

Another key strategic aspect of this acquisition for COG is our belief that Australia is on the verge of a period of high churn as businesses and consumers transition to electric vehicles (EVs), as shown in the graph below. This is due to the significant technological advancements we have seen in EVs, together with recently announced government subsidies for people who acquire an EV (below a specific amount), through novated leasing. The graph below outlines the small but increasing percentage of EVs as a proportion of total vehicle sales. Furthermore, in a recent (May 23) SIQ presentation, the company stated that in Q1 CY23, ~24% of all quotes were for an EV, compared with ~2% for the corresponding quarter in CY22.

Electric Vehicles as Percentage of Total Vehicle Sales

While we do not envisage novated leasing ever accounting for more than 50% of COG’s earnings profile, it adds valuable diversification to the business. Similar to the other divisions within COG, it operates with relatively low capital requirements, has highly repetitive processes, and is exposed to favourable industry trends.

Saunders International Limited – Acquisition of Automation IT and Significant Project Wins

For at least the last three years, it has felt like a transformational year for Saunders International Limited (ASX: SND), and while FY23 may not appear to be as decisive, we still believe it was a year where SND continued its transition into a diversified contracting business of substantial scale.

SND has continued to expand its operations in the automation of control systems by acquiring Automation IT, a Queensland-based company. Prior to this acquisition, we estimate that SND had approximately 20 engineers dedicated to automation services. With the integration of Automation IT, this division will now have over 50 engineers and is projected to contribute more than 15% of SND’s EBIT in FY24. Only two years ago, this division within SND was non-existent so it is testament to the capabilities of Managing Director Mark Benson and his team, who have been able to effectively scale this division in SND with minimal capital investment. Longer term, this division should continue to grow at a significant rate as there is increasing demand for these skills from clients and industries, including the Department of Defence, health care, data centres and property developments. We believe small and medium-sized project work is dominated by unlisted business Sage Automation, but with SND’s increased scale and advantage of being a well-capitalised, publicly listed business, it should in theory provide a genuine competitive threat.

Another noteworthy development for SND during the year was its ability to secure contracts of greater scale and refill its order book as the substantial Caymus contract ($165 million) winds down. Among the notable contracts secured by SND are the storage tank work for the new Western Sydney International Airport (valued at $44 million), and the BP Kwinana Renewable Fuels Project (valued at $42 million). While both contracts are much smaller than the Caymus contract won in 2022, they still represent the second-and-third largest contracts that SND has ever secured. SND has also continued to diversify its earnings by securing a wide variety of contracts across tank construction, bridge work, tank maintenance, automation and plant shutdowns. Although FY23 may not have panned out perfectly, in our view, it was still a pivotal year if SND is to reach its ambitious targets over the next 3–5 years.

FY23 Notable Investment Portfolio Contributors and Detractors
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Contributors

Big River Industries Limited (ASX: BRI)

BRI has been a fixture in the NCC Investment Portfolio for approximately seven years. At the time we first invested, BRI was a business with revenue of $120 million and less than $9 million of EBITDA, operating across nine sites. Based on FY23 market expectations, revenue is expected to exceed $450 million and EBITDA >$50 million, supported by a disciplined acquisition strategy and organic growth. BRI has expanded its presence to 26 sites throughout Australia and New Zealand. FY23 has seen BRI benefit from a number of factors, including price inflation, scarcity of supply, and increased demand driven by government stimulus, which assisted the business in achieving record margins in the first half of the financial year.

From an industry point of view, newspaper headlines have done a good job in painting a negative picture for mortgagors and house builders across the country given the RBA’s record pace of interest rate rises. However, as the Housing Industry Association (HIA) graph below shows, there is a structural shortage of housing in Australia. This shortage is forecast to remain for the next decade, thus providing a significant tailwind for both BRI and the broader construction industry.

Estimated Supply & Demand Balance – Total Dwellings Australia

In our view, the returns provided to shareholders thus far have been driven purely by earnings growth and increased dividend payments rather than a re-rate in the company’s valuation multiple. BRI currently trades at a price-to-earnings (P/E) multiple of less than nine times, which we consider to be a modest valuation for a business of BRI’s current scale and the growth potential that exists within a fragmented market. Over the longer term we believe BRI has the potential to be a a $1 billion-revenue business with EBITDA of >$100 million, and as this transformation occurs (and liquidity improves), we anticipate the valuation multiple to re-rate accordingly, similar to what occurred in an adjacent industry with a comparable business, Reece (ASX: REH).

Saunders International Limited (ASX: SND)

Over the past three years, SND has been the largest contributor to NCC’s Investment Portfolio performance, and FY23 maintained this trend, albeit at a more moderate level. We anticipated FY23 to be a year of consolidation and project execution for SND, considering its recent rapid revenue growth together with the expected completion of the largest contract ever awarded to the company, the $160 million project Caymus contract.

However, FY23 had its challenges for SND, as highlighted by the termination by convenience on project Caymus, which was at an advanced stage of completion. While it is disappointing that SND will not be able to complete the project as initially intended, it demonstrates SND’s ability to successfully tender, win, and execute large engineering, procurement and construction (EPC) contracts.

Despite the setback, SND has managed to secure two significant new contracts valued at over $40 million each. This has helped maintain a relatively stable order book value, even after the loss of the remainder of project Caymus. Additionally, management has focused on diversifying the company’s revenue streams, both organically and through acquisitions, as exemplified by the acquisition of Automation IT late in FY23. As a result, we believe the percentage of group earnings related to automation services will be close to 20%, compared to 0% just two years ago.

SND, like many contracting businesses, faces challenges such as labour shortages, client contract demands, and variability in raw material prices. However, the demand environment remains extremely strong, and if projects require high-level specifications and cost-effective completion, we believe SND will continue to secure its fair share of profitable work.

Detractors

Associate Global Partners (ASX: APL)

As a distributor of both equity and debt investment management products, given the current investing environment it is no surprise that APL was a negative contributor to the NCC Investment Portfolio in FY23.

The significant increase in cash rates that has resulted in the availability of genuine risk-free alternatives for investors, contributed to Funds Under Management (FUM) falling organically by –37% from their peak in Dec 21, but this decrease was offset somewhat by an acquisition late in FY23. As with all funds management businesses the cost base is relatively fixed, so the effect on free cash flow is significant as revenue falls.

While market movements and investor sentiment to equities are beyond APL’s control, we believe a number of positive strategic events that occurred in FY23 position APL well when market sentiment turns. The first of these was the partnership with Woodbridge Capital, an investor in first mortgage secured debt investments within Australia and New Zealand. Over the past five years there has been a surge in the number of debt-focused fund managers, with several notable success stories such as Qualitas (ASX: QAL) and Metrics (part of the Pinnacle Group, ASX: PNI). APL already partners with a first-rate global manager in WCM International, so it is imperative that as it expands its product offerings to encompass debt, Australian equities and alternatives, it partners with top-tier managers that it can then cross-sell to its investor base. We believe the partnership with Woodbridge is a step in the right direction to executing on this strategy. Secondly, APL acquired a small fund distribution business that focuses wholly on institutional clients (as opposed to APL, which is solely focused on retail and wholesale clients). The acquisition will not be financially material but it does add a capability to introduce funds to institutional clients, if required, and provide a complete offering. APL has faced a long and challenging journey thus far, but when the demand for equities returns, there is great potential in owning a fund manager, especially one on the cusp of scale.

BTC health Limited (ASX: BTC)

Over the past two to three years the smallest sized companies have proved to be the biggest handbrake on the performance of the NCC Investment Portfolio, with BTC being the epitome of that. Despite having positive attributes, such as exposure to favourable industry dynamics in healthcare equipment distribution, a CEO who has created significant value in his previous roles, and a management team with substantial equity ownership, BTC has not lived up to expectations. FY23 further emphasised this underwhelming performance.

One of the key issues with BTC has been the slow expansion of its product portfolio, leading to a high level of concentration risk with a single large product manufacturer. This risk became evident when the manufacturer decided to discontinue supplying these devices to the Australian market, affecting BTC and other distributors.

We have taken swift action, although not as quickly as desired, to protect the remaining value of our investment by seeking the appointment of NAOS representative Brendan York to the BTC Board, which has led to significant changes at BTC. The ability of the BTC team to restore value for shareholders remains to be seen, but we remain confident we will maximise value for our shareholders over the next 12–36 months, and conclude what has been a very disappointing investment.

FY24 Outlook

As we move into FY24, the prevailing sense of uncertainty has led to very little conviction among the investment community as well as many business leaders. In our experience, uncertainty generally leads to lower valuations, especially for emerging businesses. However, when taking a step back and applying a small dose of objectivity and rationalisation, it becomes evident for a number of areas within the economy that while the wheels may indeed slow, they will continue to turn. Over time, it is not unreasonable to expect that these sectors will regain momentum and, consequently, valuations will also increase.

I use this analogy as we want all our investments to be exposed to industries that will grow over time, as we have found this not only greatly reduces the risk of entering into a poor investment, but also increases the probability of the investment generating outsized positive returns over the long term. We believe many, if not all, of our core investments have exposure to industries with significant tailwinds that include:

• shortage of detached housing and multi-residential dwellings (Big River Industries);
• reducing the infrastructure project backlog (Saunders, COG Financial Services & Big River Industries);
• overhaul and renewal of Australia’s Defence infrastructure (Saunders International);
• transition to renewable energy products (BSA Limited);
• continued investment by SMEs to transition to modern systems (Ordermentum).

One other thematic we also believe will come to the forefront over the next 12–18 months, will be the advantage public businesses will have relative to their private counterparts given the challenging macroeconomic conditions that are likely to persist. Numerous industries are dominated by private businesses that have founders from the baby-boomer generation. Many of these founders will be approaching decisions regarding succession or potential expansion opportunities. Both pathways can be fraught with financial risk and a level of uncertainty, which can lead a founder to seek the sale of an entire business so as to provide certainty to all parties involved. SND, COG, and BRI have already made strategic acquisitions in this regard, and we expect them to continue pursuing such opportunities. Furthermore, we expect some of the other core NCC investments to pursue similar opportunities if they make financial and strategic sense.

FY24 may well prove to be another turbulent year for emerging equities, but we remain steadfast in our commitment to providing our shareholders with exposure to businesses that are led by capable and aligned management teams, are not overly reliant on capital, maintain strong balance sheets for financial flexibility, and have significant exposure to industries with long-term growth potential. We firmly believe the long-term future of all of our investee companies to be bright, and although the next 12 months may see further share price volatility, we fully expect these businesses to emerge from FY24 in improved strategic and financial positions.

Lastly, I want to address a key factor that has been a significant drag to NCC’s investment performance over the past 12–36 months: the exposure to very small businesses with a market capitalisation of less than $50 million. Even with the best intentions, these businesses often lack the personnel and financial resources to withstand various negative factors that can significantly impact the long-term prospects of a business such as delays, economic factors and regulatory changes, to name but a few. While they may successfully address these challenges, the time it takes to achieve a favourable outcome is often too long and the subsequent opportunity cost for NCC, too great. As a result, we will look to significantly reduce our exposure to the very smallest businesses in the market and instead, focus on businesses with a market capitalisation of approximately $100 million or more, of which the majority of the NCC Investment Portfolio currently comprises, as this is where we have historically been able to generate solid returns over the past decade.

The entire team is acutely aware of the trust you have placed in us to manage your capital and we greatly appreciate your ongoing support.

Kind regards,

Sebastian Evans
Managing Director and Chief Investment Officer
NAOS Asset Management Limited