Reading Capital letter to investors for the month ended May 31, 2016.
For the month of May 2016 the fund yielded a 2.7%, net return to Investors, against a +0.7% for the Tel Aviv 100 index. Starting in 2016, Reading Capital Aleph Fund returned a positive 8.1% (net to investors) against a negative -4.8% for the TA100.
Since we have English speaking investors and we intend to diversify our investor base outside of Israel, I’ll be writing our letters to investors in English from time to time. It is also a self-improvement session since we usually read a lot in English but don’t get to practice writing much. Please bear with us and our grammar\spelling mistakes as we go along.
A short introduction to our new readers: Reading Capital is a concentrated, long biased fund that primarily invests in Israeli-related companies. We use a bottom up approach. Most of our time and effort is dedicated to finding exceptional ideas and once they are identified, we invest heavily in those rare birds.
In the following pages we’ve written a summary detailing the thoughts behind a few of our largest positions: Taldor, Sapiens &Tadiran. Hopefully, this will help you understand our thinking mechanism, in general, besides getting introduced to the ideas themselves.
We hold 14 equities that amount to 83% of our portfolio and 17% cash. This is not an unusual cash reserve, as we historically hold about 20% of assets in cash. Currency break down: 83% in ILS, 16% in USD and less than 1% in others. Our 5 largest positions constitute 44% of the portfolio and our 10 largest – 75%.
Chart 1 shows the cumulative results vs. Tel Aviv 100 index (Israel’s main index):
Reading Capital – Relative performance
We compare ourselves mainly to the Tel aviv 100 Index (TA100) and also to the global equity index, the iShares MSCI (Ticker: ACWI).
Please see in the following pages short write up about 3 of our largest securities
Taldor (M.Cap – 72M$)
- Taldor is an Israeli based company providing its customers with a handful of IT, software, hardware, infrastructure and communication solutions. The government and financial sectors are responsible for more than 60% of the company’s revenue.
- This customer mix, combined with the nature of Taldor’s mission-critical solutions, induces high stability in revenue. Demand for products and services is recurring and the relationship with the customers is long lasting.
- Management seems to be promising. A newly appointed CEO with extensive experience of more than 15 years at the helm of Yael group – one of Israel’s leading system integration companies.
- Although the sector grows at a GDP+ rate, Taldor is priced at a single digit P/E ratio of 9 (based on our outlook for this year). Moreover, 2016 is expected to be accompanied by sustained growth, due to delays in government tenders originally intended for 2015.
- On top of the expected growth, the Israeli IT sector is recovering from lowered profitability of the IT companies (Taldor. Malam, Ness) that specialized in fixed cost contracts, mainly governmental, between the years 2011-2013. As ness was acquired by Hilan (IT competitor) the others accepted more rational pricing.
- The storyline is simple in this case: long-term stable revenue and upcoming profitable growth. Yet still, the single digit cash flow multiple is not reflective of the given circumstances and possible bonuses.
- Bonuses can be found in:
- Potential acquisitions ahead. The local IT sector is perhaps the most M&A-rich sector in Israel, fueled by significant advantage to scale, relatively low margins and the limited size of the market. Smaller private companies often sell for low single digits multiples, allowing for both risk-aversive and value-creating acquisitions to be done. For instance, just this December Taldor purchased XGlobe, a hosting service provider, for a mere 5.5 multiple. Operational leverage is expected to boost profitability even more. Eventually, each merger taking place accelerates the consolidation cycle of the entire market, since it enhances the ability of the bigger participants to reduce prices and lowers existing margins even more.
- Taldor is not immune to this phenomenon itself. Larger competitors might view the company as quite a bargain, as they can eliminate almost half of OpEx and “see” the company at 6x Operating income. From our understanding, it is only a matter of time.
Reading Capital – Sapiens (Ticker: SPNS, M.Cap – 580M$) – Dual listed
- A global provider of software solutions for the insurance industry, replacing the insurance legacy systems and creating a sticky, wide moat, mission critical new software company.
- We’re usually drawn to single digit P/E’s but SPNS P/E ratio of 20 and EV/EBITDA of 10 (2016E) comes on the back of a very high quality company in a unique business. A breakdown of the revenue by quarter (Left chart) in the past decade demonstrates the systematic growth of ~17% in the last 5Y accompanied with an operational leverage (right chart). Growth is based on extremely long-term customer relationships, recurring revenue and operational excellency in an endless global market with a 11K insurance companies and addressable 25B$ market.
- The company simply has a metaphorical crosshair on its back, when it comes to private equity shooters. The balance sheet is cash rich, carrying a total net financial asset of 100M$ – 17% of market capitalization.
- An important element is the fully owned subsidiary named Decision. Its enterprise software allows businesses to transform their inner logic into a centrally controlled strategic asset in the shape of Decision’s software. We can name a wide range of optimistic valuations for Decision, as it grows even faster than sapience and has clients such as JPM and Barclays. The company is still heavy on OPEX though, due to the early stage of its business life (high S&M => negative OP). Although we are patient, it is interesting to note that sales are estimated at more than 20M$ and comparable enterprises are trading for 5 times Sales. This gives us a price range between 50-150M$. Although I hate to use the sales multiple, there is no other practical way of estimating it.
- Leaving the cash balance and Decision aside, Sapience trades at an EV/FCF ratio of 18.1, 13.9, 11.7 for the next three years. In this case particularly, we have a clear visibility to the future, as 85% of each year’s sales are pocketed on January 1st, due to sustainable recurring revenue.
Reading Capital – Tadiran (M.Cap – 110 M$)
- The company was established in 1989 as an importer and distributer of various electrical appliances – air conditioners, refrigerators, washing machines and other white goods. In 2015 Tadiran made a strategic decision to focus solely on the growing and profitable air conditioning business, due to destructive competition in other segments.
- In parallel with importing ACs from the global leading manufacturer GREE, Tadiran also produces central air conditioners in Israel. Both products are marketed under a fully owned brand (“Tadiran”) that is familiar and appreciated by most consumers in Israel (1st place in customer satisfaction survey, 2013).
- This valuable mixture of importer-manufacturer allows Tadiran to offer a “one stop shop” to its customers (business & commercial), shortening lead-time and allowing for locally required product adjustments.
- Alongside Tadiran, the second dominant player is Electra – operating with a similar business model while also owning retail floor, dedicated to electrical appliances, unlike Tadiran. This pair commands a combined market share of more than 80%, approximately equally split, whereas the next largest player holds about 10%.
- Management wise, Tadiran is owned and operated by Moshe Mamrod, with a personal stake of 74% in the company. Throughout the years, Mamrod has led Tadiran through strategic acquisitions and decisions that created exceptional value to shareholders, multiplying the market cap by more than 5 in the past decade.
- Going forward, we still have much value creation to expect. The stock is trading at a humble P/E ratio of 8.7, based on historical 2015 results. This, without taking into account the future revenue soon to be delivered by a long-term government concession to improve energy consumption in 11 different hospitals.
- Also, as a result of significant growth during the past year (19%), the company successfully renegotiated contracts with its supplier, lowering the price purchase per unit. This last improvement (Q4) was barely visible in the company’s annual report for 2015, since the prevailing seasonality of the AC business shifts most of the revenue to Q2, Q3. This summer is expected to be even more profitable than the last one, being an all-time profit record in itself.
- Tax- the company has some net loss carry-overs from the past (discontinued operations), which are recorded as tax assets and are expected to materialize so that no tax will be actually paid in cash, more or less, up to 2019.
- Summary: We estimate this owner-operator company traded at a 8.5 P/E and 5.3 EV/FCF on 2016 with bonuses coming from Hospitals energy efficient program coming to effect 2017 & ~10% holding in Enverid, a successful energy efficient startup.
Reading Capital See full PDF below.