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 opportunity set currently is within emerging companies. The first chart 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 ~40% on a peak-to-trough analysis, or by 15% over the three-year period.

When we review the data over a longer period (in this case since, June 2001) 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 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 has yielded 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.

MOVE Logistics CEO Appointment

In early CY23, Craig Evans was appointed CEO of MOVE Logistics (ASX/NZX: MOV), filling a role that had been vacant since July 2021. We strongly believe Craig’s appointment will play a pivotal role in MOVE’s potential success as a highly profitable and efficient business. Craig Evans had an impressive 34-year tenure at Mainfreight (NZX: MFT), starting in 1987 as a branch manager and eventually being appointed New Zealand country manager in 2015. When Craig announced his retirement from MFT, this excerpt from the MFT Team Newsletter praised his contribution with the following statement:

“Craig Evans, a legend of our business, has announced his intention to finish in the New Year, after 34 years of service with Mainfreight. Craig has played a key role for us across many and various leadership roles, of late leading our New Zealand team. During this time, the business has developed tremendously and is achieving record levels of growth and profitability. Our network intensity and customer reach has increased, with many new facilities built under his guidance.”

Over his six-year tenure as country manager, this division of MFT grew from a revenue base of $563 million with EBITDA of $78 million, to a revenue base of $1.13 billion with a PBT of $137 million (which we estimate implies an EBITDA of ~$165 million). While we acknowledge no individual alone can determine the fate of a business, we believe Craig is exceptionally qualified to lead the MOVE business.

Craig’s appointment builds on the complete overhaul of the MOVE executive team which consists of more than 10 executives with prior experience with the likes of Mainfreight, Toll Holdings and Linfox.

Given that Craig joined MOVE in the second half of the financial year, tangible progress in terms of strategy and financial results for FY23 is yet to be seen by investors. However, we have confidence that Craig and his team will develop a strategic plan that maximises MOVE’s potential for all stakeholders. The details of this plan are expected to be made public early in FY24, providing the market with insight into the growth opportunities and potential improvements in both profit margins and revenue profile for the business.

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, who 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.

MaxiPARTS' Acquisition of Forch Australia

Despite being a standalone business for just two years post the divestment of its trailer business in 2021, MaxiPARTS (ASX: MXI) has hit the ground running on the acquisition front. It started with the acquisition of Truckzone in FY22, and was followed by the recent acquisition of Forch Australia, a distributor of workshop consumables, in March 2023.

While the estimated EBITDA of $2.5 million from the Forch acquisition may not be a transformative deal on its own, it is worth noting that over 80% of the current EBITDA is generated in a single state, Western Australia. As such, we believe there is the potential for significant EBITDA growth as the business expands into other states such as New South Wales and Victoria. We believe there is only a single meaningful competitor to Forch: the Germany-based Würth Group. Based on the public information we could source, this business recorded >$175 million of revenue in CY22, highlighting the opportunity that MXI has with this recent acquisition.

Although MXI may not appear to be a business that has significant earnings growth potential given it is not operating in a high-growth industry, we continue to believe that in a few years’ time, the company has the potential to organically generate EBITDA of ~$35 million, a significant increase on the ~$14 million it generated in FY22. We also expect MXI to have numerous capital management options, as the business should be in a significant net cash position in the next 12–18 months.

FY23 Notable Investment Portfolio Contributors and Detractors
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Contributors

Big River Industries (ASX: BRI)

BRI has been a fixture in the NSC Investment Portfolio since its inception almost six years ago. At the time of our investment, 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 caused by 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).

MaxiPARTS (ASX: MXI)

As mentioned in the above section, MXI’s management has not wasted any time as a standalone business and is laser- focused on maximising the growth potential of the business over the next 3–5 years. In FY23, MXI shares re-rated in a moderate manner, driven by a strong HY result followed by the acquisition of Forch Australia.

From an industry point of view, Australia has one of the oldest truck fleets globally, with the average age of a heavy truck at 16.3 years compared to the European Union (14.2 years), United States (14.5 years) and United Kingdom (7.6 years). While supply chain issues are still affecting the manufacturing and delivery of new trucks to Australia, trucks are being used for longer rather than being retired, and are also being used more, with the number of kilometres increasing steadily since 1985.

An Increasingly Ageing Truck Fleet is Hauling More Freight

Similar to Big River Industries, we believe MXI will demand a significant valuation re-rate as the business demonstrates its ability to scale in a highly profitable manner. Unlike BRI, MXI fortunately has a clear comparable from a valuation perspective, in the form of direct competitor, Supply Network Limited (ASX: SNL). SNL is a business of similar size but with a long history of delivering outsized returns to shareholders in a capital-efficient manner. Currently, SNL trades on a P/E multiple of approximately 22 times, which we consider reasonable for a business of SNL’s calibre, but it is a valuation multiple that we believe, based on consensus, estimates to be over 50% above that of MXI’s.

Detractors

Eureka Group Holdings (ASX: EGH)

In the case of EGH, the warning signs were apparent in FY22, and things worsened in FY23 as margins were eroded when interest costs were not adequately hedged, and the business then completed an equity raising to deleverage the balance sheet and embark on greenfield expansions. As we stated in a number of our previous investor communications, we lost confidence in management’s ability to consistently grow earnings in an accretive manner, and we would argue a lack of transparency and an unsatisfactory capital management strategy has resulted in a poor earnings per share (EPS) profile over the past few years. In our view, a significant opportunity cost existed and as such, we exited our investment and reinvested the funds into other investment opportunities we believed could compound our capital at a higher rate.

MOVE Logistics Group (ASX/NZX: MOV)

While our hopes for MOVE remain high, it is evident the old adage is true: turnarounds always take twice as long and are twice as expensive to implement successfully. These challenges have been compounded by issues in the New Zealand economy, including a severe labour shortage post-COVID, natural disasters, and supply chain disruptions affecting new truck delivery times. Given these headwinds, the revamped management team at MOVE was always going to struggle to deliver improved financial results in the short term.

However, we maintain our belief that MOVE has the potential to become a highly profitable business with significantly greater scale than it currently possesses. The market dynamics appear favourable for MOVE, as one player dominates 50% of the market, while the remaining share is divided among MOVE and three to four players with private equity ownership. With the benefit of hindsight, we made our investment too early; however, this has allowed us to secure a >15% ownership stake in a business that attracts relatively few institutional investors.

FY24 Outlook

As we move into FY24, the prevailing sense of uncertainty has led to very little conviction amongst 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 residential housing and apartments (Big River Industries);
• ageing and more complex trucking fleet(s) (MaxiPARTS);
• completing the infrastructure project backlog (COG Financial Services and Big River Industries);
• supply chain pressures and risk-mitigation strategies (MOVE Logistics);
• transition to renewable energy generation (Gentrack Group).

One other thematic we also believe will come to the forefront over the next 12–18 months will be the advantage that 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. COG, BRI, MXI, and Saunders International (ASX: SND) have already made strategic acquisitions in this regard, and we expect them to continue pursuing such opportunities. Furthermore, we believe that MOVE will also seize on 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.

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