CV Capital Sept 19 quarter update

In my last report, I said that it was a challenging period to find bargains. My definition of a bargain is a stock that has very little downside but has significant upside potential (i.e. low risks and high returns).

Traditionally, an easy way to spot a potential bargain is to look for statistically cheap stocks, these are stocks selling at low valuation benchmarks (e.g. low price to earnings or low price to book value). Although there are many statistically cheap stocks on the ASX, nowadays these tend to be companies which are: (1) operating in sunset industries with declining revenues and earnings (2) undergoing restructuring exercises (3) highly leveraged (4) facing a threat to its business. Stocks like these do not fit my definition of a bargain.

Spotting a bargain on the ASX today usually requires insight which is much harder to achieve than compared to looking for statistically cheap stocks. An example of insight was when we bought Baby Buntings last year (I discussed Baby Bunting in the 2018 annual letter). The stock was trading at around PE of 14x when we bought the shares in June 2018, which is not by any measure cheap. I had some insight into Baby Buntings as I have young kids and frequently visited the stores. Their main brick and mortar competitors were closing down which reduced future competition and at the same time Baby Buntings’ share price had fell 50% from 12 months prior due to both the general retail sector being re-rated downwards and their margins being eroded because of their competitors’ closing down sales. The combination of these factors meant that the risk reward ratio was very good and we took a large position. As of 30 September, the return from this investment is 159%, by far the highest return in the portfolio. Unfortunately, I can’t seem to find these opportunities very often.

It’s probably not that surprising that bargains are harder to spot on the ASX given where we are in the cycle and the existence of many smart investors constantly hunting for undervalued securities.

In relation to searching for opportunities, Charlie Munger has previously said “fish where the fish are” which I believe is very true. Many a time, it is not necessarily the smartest who makes a fortune but the first. Therefore, moving forward I intend to expand our search for bargains in foreign markets with less demanding valuations or where pricing is less efficient. For illustration, I list below a few valuations benchmarks across various markets around the world.

Based on just a few valuation benchmarks, these suggest that there may be better value outside of the Australian market. As an example, I have uncovered some companies listed on the Russian stock market that are trading at low single digit PE multiples with dividend yields in the teens. If we invest in markets like Russia, given the risks involved, my strategy would be to allocate no more than 10% of the portfolio to that country and spread our bets across say 10 securities so that we don’t concentrate our exposure to any single company. I see these markets as both an opportunity and also a potential substitute for cash as their dividend yields are high.

In terms of activity in the last quarter, we exited a position and we entered into a new position.

We fully exited our position in Bounty Mining with a loss of 36%. We were fortunate not to have lost more as we trimmed our position by a third earlier in the year. Coming into this investment, I already knew that mining was a risky game and we invested because I thought the odds were in favour of Bounty given the favourable circumstances. Bounty listed (IPO) in June 2018 at a price of 35 cents or a market capitalisation of circa $120 million and its key asset was the Cook Colliery, a coking coal mine under care and maintenance at the time. Bounty purchased Cook Colliery from Caledon Coal which had gone bust after investing hundreds of millions into upgrading the existing mine infrastructure. So I figured the opportunity was good because:

  1. Cook Colliery had plant and equipment worth a few hundred million which meant that there was no major capital expenditure required to restart operations.
  2. Coking coal prices were trading at $260/ton and at Bounty target production rates of 1 million ROM tonnes, the revenue potential was substantial.  
  3. The managing director at the time was a 30 year coal mining veteran who also had a significant stake in Bounty.
  4. When we invested in November 18, the share price had halved since the IPO. At 16 cents or a market capitalisation of $60 million, I felt it was very cheap relative to their potential revenue and earnings if they could achieve their target production. All that was needed was to mine the coal.  

So why didn’t this investment work out?

The main reason was the challenging mining conditions at Cook. Bounty is still only mining 600 tonnes of coal (far short of their target production) on an annualised basis and the low volumes are causing Bounty to lose money on every ton of coal mined. To fund these losses, Bounty had to borrow from their major shareholder. Although the latest June quarterly report showed that production is on an increasing trend, albeit very slowly, I decided to exit our position because the Company was running out of funds again and the latest funding proposal by the major shareholder was in the form of a convertible note where once exercised would double the ordinary share count and significantly dilute the minority shareholders. So even if Bounty succeeded in increasing production and profitability, minority shareholders were not going to see much of it.

Before this experience, my view was that mining was a very difficult sector for a value investor but now I think it is near impossible territory. The risks surrounding commodity prices, operational and geological risks mean that for an outsider it is near impossible to tell whether a margin of safety truly exists.

On a brighter note, we bought a new position in Link Administration Holdings. Link has a few business lines but the main ones are fund administration and corporate share registry services. They also own a 44% stake in PEXA which is Australia’s premier electronic lodgement network operator (ELNO) for real estate transactions. The share price fell nearly 40% from May to August, (due to a profit downgrade announced at the end of May) which is when we took a position.

When we acquired our position, the enterprise value (total value of the company including its debt) was $3.1 billion which included the value of their interest in PEXA, which was valued on the balance sheet at $715 million. Link’s core businesses in FY18 (excluding PEXA) were spitting out free cash flows (FCF or cash that is available to be paid out to shareholders) greater than $200 million a year and with 80% of the revenues being recurring in nature (due to its contractual nature), this suggested that the $200 million FCF is sustainable. I also believe the revenues from the fund administration business to be relatively sticky because of how they integrate their systems and people into their customers operations. As an example, one of their key clients AustralianSuper has 2.2 million members who are all serviced by Link. Link calculates the balances in their super accounts, handles correspondences and operates the AustralianSuper call centre. It would not be easy for AustralianSuper to migrate the systems and people to a new provider.

In addition, the fund administration and corporate share registry services businesses have large economies of scale benefits. The investment (sunk cost) into the systems and software development cost hundreds of millions and it would be very difficult for a competitor to compete on price as Link is already the market leader in fund administration and has the second largest market share (after Computershare) in corporate share registry services. This means that they can spread the sunk cost across more clients/ members than a smaller competitor or even the super fund themselves (if they wish to DIY) so in theory should enable Link to have a competitive advantage by being the lowest cost provider.

Removing PEXA’s value from Link’s enterprise value implies a $2.4 billion ($3.1b – $715m) valuation for Link’s business. For now let’s assume the value of PEXA is about right. Based on a FCF of $200 million, this implies that the market is valuing the business at a FCF multiple of 12x ($2.4b/ $200m), which is a relatively low multiple to pay considering the quality of the business. Just as a point of reference, I calculated that Computershare, a key competitor is trading at a FCF multiple of circa 24x.

PEXA is very interesting and is potentially the jewel in the crown. PEXA was formed in 2010 to fulfil the Council of Australian Governments’ initiative to deliver a single, national e-conveyancing solution for the Australian property industry. Fast forward to 2019, PEXA has invested millions to develop its platform and is currently the only licensed national ELNO. PEXA has significant market share in real estate transactions in those states where e-conveyancing has been made mandatory. The chart below shows the take up by the states for all types of property transactions.   

PEXA is currently processing 2 million (annualised basis) real estate transactions from a total market size of circa 3.5 million transactions. Once SA and QLD make e-conveyancing mandatory (which is only a matter of time), it wouldn’t surprise me if PEXA’s market share increased to over 90%. On average PEXA charges $60 per transaction so its potential future revenue from e-conveyancing services could be over $190 million. FY2019 financial information presented by Link suggest that the operating expenses are circa $100 million per annum with R&D expenses being significant (>$20 million) in FY2019. This suggests that its operating income from e-conveyancing could reach $100 million once e-conveyancing becomes mandatory across all states.

The e-conveyancing fees are mandated to escalate at inflation (CPI) and growth in construction of new properties should provide strong tailwind for revenue growth. With a largely fixed cost base future price increases should largely flow to the bottom line. In addition PEXA is also developing tools to provide add-on services such as title searches and e-contracts. This provides opportunity to further grow ancillary revenue and earnings.

Although a competitor has emerged (Sympli), I think that it will be very difficult to compete given the first mover advantage (my understanding is that Sympli’s platform is still under development), market share (PEXA already has close to 80% market share in states which have mandated e-conveyancing) and network effect that PEXA commands. The network effect is significant because at the moment, there is no interoperability between the ELNOs and PEXA already has 8,218 solicitors and 149 financial institutions as subscribers. This means that in a property transaction, both the vendor and purchaser’s solicitors have to use the same ELNO.  

PEXA’s average cost of $60 is insignificant relative to the size of a property transaction and since these fees are passed on to the solicitor’s client there is not much incentive to switch to a cheaper provider from the solicitor’s perspective. Once a solicitor learns how to use PEXA’s platform, the human condition generally dictates that he/she would be reluctant to learn a new one.

Link’s carrying value for their stake in PEXA implies a 100% value of $1.6 billion. In my opinion, this does not appear to be a stretch given the monopolistic nature of the business. One potential strategy for Link is to list PEXA in the next 2 – 3 years and by then it is possible that the business could be worth between $2 – $3 billion.

Moving onto the September 2019 quarter results.

Since June, the portfolio has appreciated by 11.2% and we have managed to recover lost ground and pull slightly ahead of the benchmark. A key reason for the satisfactory performance over the last 3 months is the appreciation in Baby Bunting’s shares and given the concentration of our portfolio, movements in our large position have a big impact on the overall returns. CV Capital’s objective is to beat the benchmark over the long term (3 – 5 years) and although we are approaching the 2nd year milestone, I am still not placing too much emphasis on the current performance. The table below shows out performance (before taxes). Our cash position is circa 21% of the portfolio. I’ve added a column to show mathematically how long it will take to double the value based on the current rate of return. It is for illustrative purposes only.

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