I strongly believe that 12 months ago very few investors would have made even the slightest suggestion that the ASX-200 Index would post 11 months of gains in the financial year, with only September 2020 producing the single negative monthly return. I am a firm believer that no matter what edge any successful investor may believe they possess, at certain stages they will simply be the beneficiary of good fortune. In my opinion, FY21 was one of those years when the wind was at many investors’ backs. Even so, I firmly believe that the patience we have shown as an investment team and remaining true to our investment philosophy, have played the most critical part in delivering the strong performance over FY21.

Today, we live in a world where interest rates have never been lower. Across the globe, central banks have flooded markets with liquidity through numerous initiatives, and federal governments have resorted to fiscal stimulus initiatives to drive investment over the short and medium term. This has been very apparent in Australia.

This backdrop has created an excellent environment for asset prices, which includes listed companies. The nuance to the above is that the type of company that the market perceives to benefit over the long term has shifted. As such, we have seen a sharp rebound in valuations for businesses that for the prior 3–4 years have generally been overlooked by many investors. Industries in which these businesses operate include financials, building materials, consumer discretionary and construction/engineering services to name a few.

All NAOS portfolios were a beneficiary to some degree of the events mentioned above in FY21. In saying that, I am a firm believer in the NAOS investment philosophy of investing with a long-term focus in industrial type businesses that:

• operate in growing industries;
• have a clear and increasing moat;
• are run by proven and aligned leaders;
• generate excellent free cash flow; and
• are disciplined and proven allocators of capital.

FY21 may well have been the year when the BRI strategy achieved the scale and momentum that it has desperately needed since listing some four years ago. There were three key events that occurred over the course of FY21 that assisted in driving the total return to over +55% for the financial year.

The first of these events was BRI’s successful application for the NSW Government Bushfire Recovery Grant. This grant was established due to the devastating bushfires in the 2019/20 summer period. As a result of this grant, BRI will receive $10 million to assist in the consolidation of its two manufacturing facilities into one facility at its Grafton operations. We believe BRI will emerge from this process as a more capital-efficient and predictable business. As a result of this manufacturing consolidation, the working capital unwind could prove to be significant. Subsequent to the relocation, BRI should receive additional proceeds from the sale of its Wagga Wagga land holding. Once this process has completed in FY23, we believe that the total improvement in the cash position of the business could be greater than $16 million.

The second key event for BRI was the completion of its largest acquisition to date – Timberwood, for an enterprise value of $24 million. Timberwood is a distributor of premium-grade timber panelling products and will provide BRI with much-needed scale within its core distribution segment. In addition, Timberwood distributes premium-quality, higher margin products that can now also be sold through BRI’s wider distribution network. This acquisition highlights the large-scale opportunity for BRI to continue to grow its trade-focused distribution network as it operates within a highly fragmented industry and one that has a high level of baby-boomer ownership, with limited succession options.

The third key event has been the stimulus programs introduced by federal and state governments over the past 6–18 months, which have generally been very beneficial for the wider housing sector. We believe this will lead to sustained demand for building products associated with the building of new homes and the alterations of existing homes. We also believe that in the longer term, this heightened activity will flow through to large infrastructure projects (which we are already seeing), as well as multi-residential projects. An uptick in both of these market segments would also be beneficial for BRI and its growing national network. 

After many years of persistence, refining its strategy and adapting to the ever-changing finance industry, the COG management team has begun delivering on a strategy that works for its customer base as well as its shareholders. For FY21, we believe COG should deliver a group NPATA of approximately $20 million, compared to just over $9 million in the previous year.

More importantly, the quality and composition of the earnings has changed significantly for the better. We now view COG more like an insurance broker-type business as opposed to a typical finance business. The earnings generated from COG’s broker operations accounted for >70% of the group’s earnings and importantly, the balance of earnings, which are derived from lending, is generally via Westlawn Finance. Westlawn is run via a capital-light model, meaning it does not rely on COG’s own balance sheet funds but on capital raised via the debenture program.

In the past year we have also seen digital online powerhouse REA Group (ASX: REA) successfully take over Mortgage Choice (ASX: MOC), which was Australia’s largest mortgage broker network. We think this highlights the strategic value in building large-scale distribution networks within the financial services industry. While this is difficult to do, COG has been able to achieve this.

Looking forward, we expect COG to take advantage of its existing customer relationships and look to offer more essential products, such as business insurance and equipment/vehicle insurance. In theory, if you can provide critical financial arrangements for assets that allow your customers to operate their businesses, then the same should apply for the insurance of these assets, which can be completed at the same time as the financing. If COG can execute on this insurance opportunity, we believe the potential could be more than double that of the existing finance broking business and also provide a more recurring nature to its earnings profile.

Since the inception of the NSC Investment Portfolio, BSA has always showed potential. However, due to internal and external factors, this potential has either not been realised or it continues to be deferred until the following financial year. Unsurprisingly, FY21 was no different; however, as we exit FY21 and move into FY22, the potential for BSA does look more promising.

To the management team’s credit, it did secure a new contract with the National Broadband Network (NBN). Under this contract, BSA has managed to secure the largest percentage of market share in what could be a long-duration and large-value contract. Following this success, BSA also secured a significant contract with Telstra Corporation (ASX: TLS), which also has potential to be of long duration and reasonably significant from a revenue standpoint.

It is our understanding that a significant majority of the executive team has changed under the new leadership of CEO Tim Harris, whom we hold in high regard. It will be imperative that BSA finally proves to the market that it can grow organically and achieve a respectable margin. Furthermore, BSA will need to be more cognisant of inorganic growth opportunities that would not only diversify the revenue base, but also bring scale that the business desperately needs to offset the fixed-cost nature of its corporate overhead, as well as further driving margin growth and potentially, further innovation.

Since the inception of the NSC Investment Portfolio, MNF has been a core investment and at times the largest investment in the portfolio. Over the course of the latter part of FY21, we made the decision to significantly reduce our holding due to a number of factors that we felt did not fit with our investment philosophy, including the following:

• In our opinion there has been a history of poor capital allocation, which has included significant investments in new business segments such as Pennytel (~$3 million EBITDA p.a. investment) and acquisitions such as Conference Call International. One of these was sold for a nominal amount and the other is now part of an ongoing strategic review.
• A $50-million placement was also completed approximately two years ago. In our view, these placement funds have not been used to execute on any significant growth strategy to date.
• The potential for significant investment in further expansion into South-East Asia, which may depress earnings for ~24 months. There has been little clarity provided on what the expected return would be on this investment.
• The potential for further competition in the very lucrative Australian market, which we believe has seen very little in the form of quality competition for the last 3–5 years. The Australian market has been MNF’s cash engine.

MNF remains a very high-quality business with an excellent customer base and global growth potential. With a share price that has largely been flat over the last approximately four years, in our view the level of investment that MNF has made has not generated a sufficient return. The fifth year may well be the year that this changes and we hope it does, as MNF has the potential to be a market leader over time.

Technology-type companies have been some of the best-performing companies since COVID-19 as many of them have been the benefactors of the expedited transition to a more digital world. With the recent rotation out of higher growth, technology-type investments into more value-type investments, NSC has invested into a new core investment in what we believe to be a value-type software company called Gentrack Group Ltd (ASX: GTK).

GTK is a technology services provider to utilities and airport operators and was established in the 1980s when New Zealand deregulated its power markets. Today GTK has approximately 50 core customers across three main geographies: New Zealand, Australia and the UK, who are supported by over 300 internal engineering staff at GTK.

More recently GTK has undergone significant change, with a completely new executive team from the CEO down, as well as a new chair. From an earnings standpoint the business has also experienced a significant amount of change, in part due to internal execution issues as well as external issues such as regulation change in the UK for utilities providers, which has affected some of their customer base.

The reasons we are attracted to the GTK business are relatively simple. It is a business we have followed for over five years as it has a high-quality customer base. Over 75% of its revenue base is recurring in nature and, in theory, is growing. Many of the new executive team have worked together previously and have a good track record in running technology-focused businesses that solve the problems of very large organisations through innovative solutions.

Under the new team, GTK has reintroduced a move to fully expensing all research and development spend, which we view very favourably, the cash-flow generation has largely been sound, and its balance sheet stands in a healthy net cash position. 

As is the case with a majority of our long-term investments, this particular investment will likely not be a smooth ride and does carry a degree of risk. Even so, we believe the risk is more than outweighed by the potential return. The returns will come if management can continue to grow the sticky revenue base, consistently grow margins, and reinvest the subsequent increased free cash flows into further improving its software, as well as inorganic opportunities that fit the strategy. If this can be achieved, the valuation multiple uplift applied to GTK could potentially be significant. 

It is impossible to provide an accurate prediction as to how a portfolio of investments will perform over a 12-month period. Even so, I believe it is important to provide a general outlook to our fellow shareholders detailing our level of comfort with the current NSC investments, their potential, and any catalysts that may occur in FY22.

We believe that the current portfolio has a significant amount of unrealised value and the current trajectory for a clear majority of these businesses is where it needs to be. Some are benefiting from strong short- to medium-term industry trends, e.g. Big River Industries (ASX: BRI) and COG Financial Services (ASX: COG), while others, e.g. BSA Limited (ASX: BSA), need to capitalise on potential opportunities and increase their scale in a realistic timeframe, both organically and via acquisitions.

For NSC, there could be numerous catalysts that may have a material effect on the portfolio return in FY22. The key and most realistic catalysts in our view would include Over The Wire Holdings (ASX: OTW) achieving an organic growth rate of 10–15% at the revenue line with stable to growing EBITDA margins, and Big River Industries (ASX: BRI) capitalising on the industry tailwinds as well as sourcing another logical acquisition comparable to that of Timberwood. In addition, if COG Financial Services (ASX: COG) can provide greater transparency around the potential of the group to grow its insurance broking earnings and the current trajectory of this earnings stream, this would, in our view, command a higher valuation multiple.

FY21 was an excellent year from a pure return point of view, but we are under no illusions and believe that you are only as good as your next year’s returns. We believe the NSC Investment Portfolio has a compelling balance between risk management (protection against permanent capital loss) and long-term returns, despite its highly concentrated portfolio.

As always, the entire team at NAOS would like to thank all our fellow shareholders for continuing to be shareholders in NSC and we also welcome all new shareholders who joined the register in FY21.

If you have any queries, do not hesitate to speak directly with me or any member of the team.

We look forward to continuing to provide you with regular updates throughout FY22.

Kind Regards,

‍

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