Good afternoon,

ASX200 was flat again last week, still around that 6200-mark. Ansell (ANN, +3.4%) and Mayne (MYX +3.4%) pulled the Healthcare sector higher, while large-cap oil OSH (-4.3%) and WPL (-3.4%) dragged energy lower on the back of Woodside announcing weaker than expected sales volumes from the Northwest Shelf.


Podcast

After a couple of client requests, I’m starting a podcast with our new starter, Jordan Travers. You might remember we did a couple of videos with Jordan a while back  (see it here). Jordan has joined to learn the fundamentals of finance and investing after developing a keen interest over the last 6-months or so. The format/inspiration has been Jordan’s daily barrage of questions and the chat’s we’ve had, which we reckon others could probably benefit from. So, if you have any questions on finance, economics or investing,send them through, and we will do our best to cover it.


Woodside (WPL)

Reading a bit of detail however, and having worked in the business of commodity sales in a prior life, this lower realized sale price was merely a function of what ships sailed before 30 June, of those boats ships, which were priced DES or FOB (with freight included or without) and what products were sold during the period. Very normal stuff. We used to have boats ‘slip’ into the following financial year reasonably regularly (I used to try and avoid this as it affected our bonus pool!) but with weather, fickle and demanding customers, strikes at ports or rail companies, vessel/train availability, maintenance issues, you lose scheduled days very easily.

Long story short, this is noise. None of this is relevant for the longer term investor, and Woodside continues to operate with exceptional efficiency, and I see no reason why return on assets won’t continue to trend from 4% to top of peer group 8% over the next 5 years provided the global economy continues to recover, and oil prices don’t collapse. Woodside is in my mind, the most defensive way to gain energy exposure on the ASX, offering a strong balance sheet (10% gearing), 4-5% dividend yield and some growth potential should the politics around tolling on the NWS be resolved (as I expect) and Browse basin is unlocked.

Source: Macquarie Research


The Data Exchange Network (DXN)

This game is about trying to buy under-loved, under-appreciated things before everyone else and then selling them when the world wakes up to it. However, every day, most investors want to talk to me about stocks the world has already woken up too, they want to talk about ‘the news’.

DXN isn’t in the ‘the news’. It’s been in the AFR once (from memory), it’s only owned by a handful of very long-term institutional investors (Ellerston, Mutual Trust etc.) and the management team and there’s no broker who’s short-term incentives of higher commissions and pending corporate fees trying to ‘ramp’ the share price.

Instead, you’ve got a business run by high calibre people who could be doing a myriad of other high paying things with their time. They have a product that’s IP protected, proven, and operates in the top growth section of one of the highest growth sectors on earth. I’m expecting these guys to make some powerful waves over the next 6-months as they bring online 2000-racks worth of co-location data centre capacity in Sydney and Melbourne, start producing revenues which at forecast utilisation will generate c.40% NPAT margins.


What does quality mean?

“I only buy quality companies.”
“I only buy blue chip shares.”
“I only buy the top stocks.”

I only wish the people who used these catch cries provided a glossary of terms with their statements. It’s meaningless without one.

How do I define quality? For mine, it’s a combination of how the business sources revenue, it’s ability to increase prices, control costs and sustainably expand its market share. Each of these characteristics is measured in a variety of ways, but I’ll provide some examples to give you a flavour:

  • “How the business sources its revenue” – a high percentage of reoccurring revenue relative to total revenue offers investors certainty. Contracted fees, high barriers to exit or change, sticky customers all make for high valuations as it mitigates the risk of revenue going backwards.
  • “The businesses ability to increase prices” – if a company can increase price whenever it wants, without losing any customers, that’s a pretty good sign that business is going to keep winning as their customers keep buying despite the cost impost.
  • “Control costs” – if a company can grow, that’s great. But if it can grow without spending any more money on staff, power, water, raw materials, that’s the better!
  • “Sustainable expansion of the company’s market share” – if you can beat the competition, without investing as much money in your business as the competition, your shares will be worth more than the competition. I love companies that are spending less on capital but generating more in profits than their competitors. It highlights brand dominance, diligent cost control, likely margin expansion (eventually) and probably repeat customers if not reoccurring revenues.

Breville (BRG)

Breville is an excellent example of a quality business.

It sources its revenue by selling kitchen appliances to consumers all around the world. Appliances that have a natural life (you use them for a while, and then you need a new one), appliances that have technological and utility improvements every year (new features, styles, colours and applications). As populations grow, as the middle class emerge, as homes become larger, we buy more and more of Breville’s products.

These products importantly, have the Breville logo on the front which ‘stands’ for something. It’s a brand. A brand like “Nike” or “Mercedes Benz”. Would you prefer to own some blender with no brand on it or a Breville? Do you trust Breville?

This trust, this customer life-cycle, these repeat purchases, this brand, coupled with technical expertise, supply chain control and distribution dominance make Breville worthy of a premium valuation. They can increase prices, manage costs and grow their market share.

Let me show you, first sales per annum. They’ve growth at 7.2% compound annual growth rate (CAGR) for the last 5-years.

Then let’s have a look at EBITDA margins. Looks a pretty safe bet to assume they are going to be above 16%

And finally, return on assets (ROA). After a period of exceptional returns, seems like a sustainable level 12-13% is reasonable.

Despite all this quality and a consistent track record for growing earnings, for the first time in a long time, we can by this stock on a reasonable PE ratio of 20-21x.

And just in case you weren’t sure how rare just a company is. I screened for businesses on the ASX who over the last 5-years have:

  • Earned an average of at least 10% return on assets
  • EBITDA margins of 15% or better and
  • Sales CAGR above 5%
  • Dividend growth above 0%
  • EBITDA growth above 5%.
  • Over a $300m market cap
  • All without issuing any equity

The list is below, with current forecast EV/EBITDA multiples.

It’s no surprise then that BRG recently made Macquarie Quant analytics list of high potential for positive earnings surprise during this upcoming reporting season. They found that earnings surprises are persistent with the businesses that have surprised many times in the past, like BRG, are likely to do it again.

BRG reports 16 August.


Ups & Downs

Much to my hatred, Afterpay (APT) has gone nuts. Continued acceleration of transaction volumes and revenue has investors pumped up about their prospects in the US. Chatting with a friend during the week, who’s an M&A lawyer, he reminded me that in the world of business, there are “unlimited opportunities for profitless growth”.

As much as you probably don’t care and you just want to buy stocks that go up, buying things that are unsustainable and speculating on things that are unlikely, is not a good investment process and won’t result in anything better than chance, minus costs, for the average client.

If you’re a fund manager or Afterpay shareholder reading this, perhaps you can explain to me precisely what Afterpay’s current arrears and bad debts are? I’d like to know what APT’s EBITDA margins are (not the reported EBTDA “profit” **cough cough**) and I’d also like you to explain to me how their credit-check free decision engine works. I’d also ask while you are counting your profits what you think of APT’s level of disclosure is like and whether you know many other high quality, transparent, sustainable businesses that report so little detail of their operations to shareholders… I’d just like to know.

CIMIC (CIM) (the old Leighton’s) put out a decent H1 performance, revenue, profits and dividends up. Still can’t justify 20x earnings for a contractor though.

Asaleo Care (AHY) revised its earnings guidance and put out a pretty weak set of numbers for H1 last week, share price subsequently ravaged, 40% down. CSR (CSR) down on a Goldman Sachs SELL recommendation, citing peak earnings. Elsewhere China stocks BAL, A2M got clipped.

Have a good week,
LL