OC Premium Small Companies Mandate commentary for the month ended September 30, 2016.
OC Premium Small Companies Mandate – Performance review
The OC Premium Small Companies Mandate enjoyed a strong start to the new financial year returning 9.1% for the September quarter as the market shrugged off a host of global economic, political and geo-political concerns. This was ahead of both the S&P/ASX Small Ordinaries Accumulation Index and the S&P/ASX Small Industrials Accumulation Index which each returned 8.5% for the quarter. The Mandate has returned 23.5% p.a. for the past five years, which is well ahead of both the S&P/ASX Small Ordinaries Accumulation Index and the S&P/ASX Small Industrials Accumulation Index which have returned 5.3% and 13.5%, respectively, over the same period.
There was limited new stock-specific news in September and the investment team was busy meeting with the management of current and prospective holdings post the August reporting season. Our best performing stocks for the quarter were, unsurprisingly, companies that released solid FY16 results and provided positive commentary about their future earnings prospects. These included Webjet Limited (WEB, +63.6%), Ardent Leisure (AAD, +47.3%), MACA Limited (MLD, +37.7%) and Mineral Resources (MIN, +33.2%). Altium (ALU, +42.6%) was also a stellar performer for the Mandate, but we sold the position as it reached our share price target.
[drizzle]Webjet (WEB) – as discussed in August, WEB announced a result that exceeded market expectations driven by an outstanding performance from the B2C (business to consumer) division where TTV margin accelerated in the second half as a result of strong operational leverage brought about by continued market share gains. However, the result itself was somewhat overshadowed by a £21m deal signed in its hotel business which provides hotel inventory to travel agents. The deal with large UK-based travel company, Thomas Cook, involves WEB taking over Thomas Cook’s 3000 hotel supply contracts and in turn, WEB entering a minimum fiveyear deal to supply these hotels, and its other hotels, to Thomas Cook. This provides WEB’s B2B (business to business) division a material step change in scale, as well as directly related financial benefits (not material until FY19), providing us greater transparency on continued high EPS growth into the future for the company. The company continued its strong share price performance in September and, although we have trimmed our holding, we remain attracted to its capital-light business model and strong long-term growth prospects.
Ardent Leisure (AAD) – continued to re-rate in September following the sale of the Goodlife health clubs and the Hypoxi weight loss businesses. The gyms had been seen as an ongoing headache with business transformation underway in order to combat the increasing prevalence of cheaper 24-hour small format gyms and the sale was seen as representing a fair price. The full-year result in August appeased market concerns, with solid performances across all divisions particularly in bowling, which is benefiting from a number of initiatives introduced from the US Main Event business. The sale of the lower returning health club business will allow management to redeploy that capital into the high growth, but capital hungry, Main Event roll out in the US. With the sale of the marinas business still tracking to management’s schedule, the company is now in a strong position to accelerate the roll-out of Main Event, which is a quality business that has achieved very high returns on invested capital.
Mining services companies, Mineral Resources (MIN) and MACA Limited (MLD), were among our better performing stocks in the quarter reflecting the improved outlook for both businesses and the sector in general. MIN and MLD are highly regarded operators who ought to continue to benefit from increasing activity in the coming years as the commodity cycle rebounds. Both companies currently earn the majority of their profits from crushing, screening and processing ore for quality clients across a number of different commodities and mine sites. Both have a strong reputation among their clients and typically operate under long-term contracts. Importantly, both MIN and MLD have strong net cash balance sheets that position them well to weather any commodities downturn.
Scottish Pacific (SCO, +18.8%) – an IPO the Mandate participated in early in the quarter, was another strong performer. SCO operates in the debtor finance market primarily in Australia where it is a top three provider of debtor finance solutions with 20% market share, but also with a presence in New Zealand and the UK. Debtor financiers, such as SCO, provide financing to SMEs to bridge the cash flow gap between their expense cycles and the collection date of their receivables. SCO has a number of key characteristics we believe will make it a solid contributor to the portfolio over the longer term, including its scale and competitive position, which will provide it with a meaningful cost advantage, a large distribution network, which should underpin its growth, a solid track record in credit assessment and an experienced management team led by industry veterans with combined decades’ experience in the sector.
On the negative side of the ledger, Vocus Communications’ (VOC, -26.0%) share price has performed poorly since August. We see the main catalysts for this recent underperformance as a confluence of events including: i) senior management turnover with the resignation of pre-merger Vocus CEO (and post-merger executive director), and the subsequent sell-down of his substantial shareholding and the resignation of the CFO, ii) market concerns around the amount of acquisitionrelated activity over the past 18 months including recent broker questions about the accounting treatment of one-off acquisition-related costs and 3) competitor TPG’s recent FY17 guidance downgrade which cited increasing margin pressure in an NBN world.
Our team has been vigilant in assessing each of these concerns and we remain a comfortable shareholder, albeit we acknowledge the risk profile of the stock has increased with the management turnover and the high level of M&A activity. In a merger of this size, senior management turnover is inevitable as synergies are extracted and required skill sets necessarily change. Current Managing Director (ex M2 Telecommunications MD), Geoff Horth, is an industry veteran and is held in high regard by our investment team. He is backed up by an experienced senior management team that includes M2 Telecommunication founder, Vaughan Bowen. While M&A activity has been elevated, the telecommunications landscape has changed rapidly and the combined Vocus, M2 Telecommunications and Nextgen businesses have a mix of assets that will allow the company to be a key player in an NBN world. While integration risks remain our key concern, we note the management team’s outstanding pedigree in M&A over a long period and we are comfortable with their acquisition accounting which is consistent with their past approach.
On the question of margin pressure under NBN, we note some clear differences between the TPG and Vocus businesses. Simply put, there are different economics in an NBN transition for TPG where margins were higher to start with due to their high proportion of subscribers using on-net DSL services (i.e. where TPG owns the equipment in the local phone exchange and delivers the service from there at high margin) compared to Vocus that offers predominantly low-margin