Bateleur Flexible Prescient Fund 2018 1st quarter report back to investors
1 Bateleur Flexible Prescient Fund 2018 first quarter report back The fund s unit price (A1 class) returned -3.5% for the first quarter of 2018. As comparisons, the JSE All Share Index returned -6.0% inclusive of dividends reinvested, SA government bonds (ALBI) returned +8.0% and cash (STeFI) returned +1.6%. In terms of underlying strategies (table 1), the domestic equity holdings detracted 2.1% from performance as the share prices of both Naspers and British American Tobacco (BTI) declined. The foreign equity holdings detracted 1.0% from performance, the strength of the Rand more than offset the positive contribution from Amazon. Table 1: Attribution by strategy Attribution by strategy YTD % Top contributors Top detractors Domestic equity -2.1% Adcock Ingram Naspers Foreign equity -1.0% Amazon BTI/Reinet Costs net of interest -0.4% Mpact RMI Total -3.5% Source: Bateleur The more constructive investment environment in SA following recent government changes has resulted in a sharp re-rating of many domestic focused large capitalisation shares, including the banks, retailers and several industrial companies (such as Bidvest, Imperial and Barloworld). In many instances, the upward re-rating of these companies (largely driven by foreign buying) is already discounting a much improved economic outlook and no longer represents a compelling investment proposition. In our view, a superior risk/reward investment opportunity exists in the domestic mid-capitalisation space (mainly industrial companies) that do not form part of the MSCI SA index and therefore have not benefited from foreign portfolio flows. Several of these companies have high barriers to entry, lengthy track records of consistent earnings growth, stable management teams, and most importantly, trade on attractive valuations. They also have favourable operating leverage to any upward surprise in SA GDP growth from the current subdued levels. Based on fundamental company specific research, we have increased the fund s exposure to this segment of the equity market over the past quarter. Collectively this group now represents a healthy weighting in the fund. Three of these holdings are discussed in more detail in this report. 1. Mpact Market Capitalisation R4.8bn; Price R28.00 Mpact is the largest vertically integrated producer of recycled paper products in SA (predominantly containerboard and cartonboard). In broad terms, the company collects waste paper at its numerous depots around the country, either from its own recovered paper business or by purchasing from third party waste paper merchants. The recovered paper is then baled at the depots and transported to one of its three mills where it is the primary variable input, along with energy, in the production of recycled containerboard and cartonboard.
2 The finished containerboard and cartonboard reams are then either sold into the market, to third party converters, or transported to Mpact s own facilities where they are converted into corrugated boxes and related products. Mpact s recycled paper business has historically been a profitable business with solid returns on capital due to 1) its dominant market position providing economies of scale 2) being a vertically integrated operator has enabled margin retention, and 3) having high barriers to entry with the substantial cost of putting up a new recycled paper mill deterring new entrants. Mpact also has a plastics business where it holds the number one market share position in SA in PET preforms, styrene trays and plastic jumbo bins. It is also the largest producer of recycled PET bottles in the country although this business is currently loss making as it overcomes start-up teething problems. The plastics business is a smaller part of the overall group with lower margins and has less attractive fundamentals than the paper business. Mpact has the number one market share position in SA in the following products: Source: Bateleur, Company Financials Mpact unbundled from Mondi Plc and listed on the JSE in 2011 in order to pursue its own growth strategy without the constraints of the Mondi group. Chart 1 shows the consistent growth in operating profit and expansion of the operating profit margin between 2008 and 2015, while chart 2 highlights the improving return on capital ( ROCE ) over the same time period. Chart 1: Mpact op. profit (Rm) and margin (%) Chart 2: Mpact ROCE (%) 2008-2015 1000 900 800 700 600 500 400 300 200 100 0 Mpact s operating profit and operating margins improved steadily between 2008 and 2015 2008 2009 2010 2011 2012 2013 2014 2015 Operating profit O/P margin (RHS) 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Mpact s ROCE improved steadily between 2008 and 2015 ROCE (Return on capital employed) 2008 2009 2010 2011 2012 2013 2014 2015 Source: Bateleur, Company Financials
3 In 2016 and 2017 multiple factors contributed to a break-down in the historic earnings growth profile of Mpact (chart 3). This was closely tracked by a sharply declining share price (chart 4). Chart 3: Mpact op. profit (Rm) 2008 to 2017 Chart 4: Mpact share price since listing (Rand) 1000 900 800 700 600 10.0% 9.0% 8.0% 7.0% 60 50 40 Mpact s share price declined sharply in 2016 and 2017 tracking lower earnings 500 400 300 200 100 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Operating profit O/P margin (RHS) 6.0% 5.0% 4.0% 3.0% 2.0% 30 20 10 Mpact share price 0 2011 2012 2013 2014 2015 2016 2017 Source: Bloomberg, Company Financials A major customer of Mpact, purchased an existing mill from Sappi and converted it into a recycled paper mill. This resulted in an initial loss of sales volume for Mpact and a more competitive pricing environment. Secondly, the price of domestic recovered paper (Mpact s major input) increased sharply as a result of increased domestic demand from the new competitor as well as local waste paper merchants exporting recovered paper due to strong global waste paper prices. Thirdly, Mpact undertook a large R765m expansionary capex program at its Felixton paper mill aimed at increasing recycled paper capacity and improving efficiencies through reduced energy consumption. This resulted in a shutdown at its Felixton mill, while the fixed operating costs remained. Finally the sluggish SA economy and drought in the Western Cape (where Mpact is a large supplier of corrugated boxes to the fruit industry) meant that demand was subdued and Mpact could not pass on sufficient price increases to compensate for the increased input costs. With the exception of the drought in the Western Cape that remains, these headwinds have largely abated, and financial year 2018 and 2019 should result in a normalisation of profit margins and a strong recovery in operating profits off a depressed base. The Felixton mill upgrade is complete, and will ramp up to full capacity by the end of calendar 2018. Mpact should enjoy a 20% production cost benefit over its competitors from this project, while there is also strong customer support for the lightweight containerboard produced at the mill. Global waste paper ( OCC ) prices have declined by 43% from their peak in 2017 to current levels of EUR 91/ton (chart 5). This has led to a sharp decline in the price of SA waste paper prices and will have the most material benefit to group operating margins in 2018, and especially 2019, as existing stock piles of recovered paper are depleted.
4 Finally, the SA economy is expected to expand at a faster rate in both 2018 and 2019 (in excess of 1.5%) than in 2017 (+1.3%) which should be mildly supportive of both paper sales volumes and pricing. Despite the substantial expansionary capital expenditure programme over the past three years, Mpact remains highly cash generative. Gearing (debt/equity) is expected to peak at slightly above 54% in financial year 2018, thereafter declining, as total capex requirements are forecast to be in line or lower than deprecation in the next few years (chart 6). Chart 5: European OCC prices (Euro s) Chart 6: Mpact Capex to depreciation (%) 180 160 European OCC prices have fallen 43% since September 2017. 159 254% 204% Mpact s heavy capex investment period is now behind them. Capex to depreciation 140 - - Capex = depreciation 154% 120 100 104% 80 European OCC prices (EUR) 91 54% 60 2013 2013 2014 2014 2015 2015 2016 2017 2017 2018 4% 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018e2019e Source: Bateleur, Bloomberg We estimate that Mpact trades on a forward P/E multiple to December 2019 of less than 10 times, which we view as attractive. The fund continued to add to its existing Mpact holding during the first quarter of 2018. 2. AECI Market capitalisation R14.0bn; Price R117.00 AECI is an explosives and speciality chemicals company based in SA, with regional business in Africa, Southeast Asia, the USA and Australia. The company is a key supplier to the SA mining and manufacturing industries and has been listed on the JSE since 1966. Speciality chemicals contributes 64% of group operating profit, supplying chemicals and related services across a broad spectrum of customers exposed to mining and manufacturing. The bulk of earnings come from higher margin, value added chemicals which are typically customised solutions to end clients, with an added service element which is an important contributor to the economics of the business. For example, AECI subsidiary Nulandis, employs a trademarked process named NuWay to conduct an assessment of the farmer s soil. The objective, utilising science, is to characterise and chart soil, and in in so doing, optimise the farmer s planting, nutritional and chemical spray programmes to save water, increase productivity, promote sustainable soil and grow healthy crops. This value added focus, alongside selective acquisitions, has resulted in speciality chemicals consistent record of earnings growth (chart 7). Over the past 34 years, revenue has grown at an annualised rate of 15.5% p.a., while operating profits have increased at a rate of 15.3% p.a. Since 1983, operating profit has grown every year except for three, illustrating the resilience of the business model. Given the
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 5 consistency of earnings growth, we would argue that the speciality chemicals business warrants a higher rating than what is currently implied by the market. Chart 7: Speciality chemicals op. profit (Rm) Chart 8: Segment op. profit margins (%) 1 400 14.0% 1 200 12.0% 1 000 800 600 10.0% 8.0% 400 6.0% 200 4.0% Speciality chemicals Explosives - 2.0% Source: Bateleur Capital, Company Annual Reports AEL explosives (AEL) contributes 31% of group operating profit, and includes the production of electronic detonators, shock tube initiating systems and bulk emulsions. It provides blasting services and related products that optimise the value extracted at the customers mining operation. AEL is one of the largest explosives manufactures in the world with an estimated global market share of 5-6%*. The bulk of revenues come from SA and the rest of Africa (RoA) with smaller contributions from Australia and Indonesia. AEL has been in existence since 1895. AEL s operating margins (Chart 8 - above) have improved from the 2014/15 lows and is guided to reach 10% in the medium term. The general mining slowdown of 2015, characterised by low commodity prices and weak producer balance sheets, came at a time when AEL completed a number of expansion programs. AEL had to sacrifice margins in order to secure the required volume and support the viability of their customers. Since then, mining activity and commodity prices have improved and certain low margin contracts have been renegotiated supporting a normalisation of operating profit margins. The group recently concluded two acquisitions, Schirm and Much Asphalt, for a total consideration of R4.1bn. At financial year end 2017 AECI s net debt was low at R400m and will remain at comfortable levels post the closure of these two acquisitions. Schirm AECI acquired Schirm from the Imperial group for R1.9bn on a trailing EV/EBITDA multiple of 9.1 times. The business has a footprint in both Germany and the USA and derives the majority of its revenue from agrochemicals and the balance from fine chemicals. *Source: AECI annual report
6 The strategic rationale for the Schirm acquisition is sound, with various synergistic opportunities as listed below: Adding an extra production season in the northern hemisphere (smoothing seasonality) Replacing AECI imports with production from Schirm Reallocating formulation activities to Schirm from SA Expanding AECI s existing product range into Europe Much Asphalt AECI recently acquired Much Asphalt for R2.2bn from a private equity consortium on a trailing P/E ratio of 12.6 times. Much Asphalt is SA s largest supplier of hot and cold asphalt to the road construction industry. Although management are guiding to future growth opportunities through an expanded product offering and expansion into Africa, we are less enthused on the strategic rationale for the transaction. Management argue that Much Asphalt fits strategically with AECI on the basis of the chemical processes utilised in the production of asphalt and road surfacing products. However, a negative is that the acquisition will increase the group s exposure to the more cyclical nature and greater contract risk generally associated with construction activities. Our investment thesis for AECI can be summarised as follows: Return to growth in domestic mining and manufacturing industries We expect both mining and manufacturing production to moderately increase as the SA policy environment improves, aiding sentiment, capital investment and GDP growth. Speciality chemicals the long term, consistent profitable growth track record warrants a higher valuation multiple for this division. Below trend margins Margins in the explosives segment are below trend, we expect this to improve as mining volumes and industry profitability increase, resulting in improved operating leverage. Attractive valuation AECI trades on an estimated P/E multiple to December 2018 of 9.8 times, an attractive rating that is yet to reflect any positive sentiment from the perceived turnaround in SA. In addition, the acquisitions of both Schirm and Much Asphalt should be accretive to earnings. The fund continued to add to its existing AECI holding during the first quarter of 2018. 3. Hudaco Market capitalisation R5.7bn Price R168.40 Hudaco is an importer and distributor of branded automotive, industrial and consumable products. The product range is broad and includes seals, bearings, power tools, automotive parts, security & communication equipment, diesel engines, power transmission products, hydraulics and pneumatics. The ready availability of product is essential to Hudaco s operating model and a key enabler of sales. An additional driver of sales includes product specific technical expertise and the network of specialised branches and distributors throughout SA. Hudaco has 11 consumer related businesses (such as Rutherford / Makita, Miro and Partquip) and 21 engineering consumable businesses (such as Deutz, Bearings International and FHS Filters) which supply the domestic mining and manufacturing industries.
7 Chart 9 illustrates the positive historical relationship between domestic capacity utilisation and Hudaco s operating profit margins. A moderate increase in domestic economic activity will likely result in meaningful revenue growth and margin expansion for the group, but more specifically the engineering services division. The impact of the weak domestic GDP growth environment has been more pronounced within the engineering consumable businesses. Over the last three years revenue in this segment increased by only 3.4% and operating profit declined by 10.0% - providing a low earnings base. Notwithstanding the group s exposure to the constrained domestic mining and manufacturing industries, Hudaco has been able to consistently grow core headline earnings per share at a rate of 8.8% per annum since 2010 indicating the resilience of the business model (chart 10). Chart 9: Capacity utilisation vs. Hudaco margins (%) Chart 10: Hudaco comparable HEPS (Rand) 88% 86% 17% 15% 13.0 12.0 8.8% comparable HEPS growth per annum since 2010 84% 82% 80% 13% 11% 9% 11.0 10.0 9.0 8.0 78% 7% 7.0 76% SA Capacity Utilisation - SARB (LHS) 74% HDC EBIT margin (RHS) 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 5% 3% 6.0 5.0 2010 2011 2012 2013 2014 2015 2016 2017 Source: Bateleur Capital, Company Annual Reports, SA Reserve Bank The group generates high levels of free cash flow (Chart 11) allowing for a healthy dividend policy and the ability to pursue an acquisition strategy without the need to issue equity or take on excessive debt. In addition, the business requires very little capital expenditure to maintain or expand operations. Hudaco s working capital (Chart 12) is key to its operational success and has been tightly managed in order to ensure limited financial slippage.
8 Chart 11: Hudaco cash flow & capex (Rm) 600 500 400 300 200 100 Acquistions (Rm) Capital Expenditure excl. acquistions (Rm) Operating cash flow (Rm) Chart 12: Hudaco working capital (months) 5 Inventory Receivables 4 Payables Net W Cap 3 2 1 0-1 -2 0 2010 2011 2012 2013 2014 2015 2016 2017 Source: Bateleur Capital, Company Annual Reports -3 2010 2011 2012 2013 2014 2015 2016 2017 Growth in earnings has been aided by bolt on acquisitions, where management have proven themselves to be astute allocators of capital. Over the past few years acquisitions have been strategically focused on consumer facing businesses such as Miro (distributor of wireless, networking, VoIP and IP video products) and Partquip (importer and distributor auto parts). This has shielded Hudaco s group earnings from the pressures within the engineering consumable businesses. Hudaco is trading on an estimated 12 month forward P/E ratio of 11.4 times, which is appealing relative to larger industrial peers Bidvest (17.3 times P/E) and Barloworld (13.7 times P/E). The management team, under the leadership of Graham Dunford, are material shareholders in the business and have a respected track record. The fund continued to add to its existing Hudaco holding during the first quarter of 2018. Current fund positioning and conclusion The fund s current positioning (equity exposure of 82.9% and cash weighting of 17.1%) is premised on equity valuations being above trend, the late stage cycle of global growth, and expectations that global monetary conditions will tighten further. Strategy Exposure % Top 5 holdings Domestic equity 68.6% Naspers Foreign equity 14.3% BTI/Reinet Total equity exposure 82.9% Mondi Cash 17.1% S&P 500 Old Mutual Source: Bateleur Capital * As at 23 April 2018
9 The outlook for SA is somewhat different to developed markets in that the interest rate environment should remain accommodative, while the corporate earnings base is low given the below trend GDP growth and policy missteps over the past few years. Unfortunately, SA equity valuations (especially the large capitalisation index constituents) are not compelling and are already discounting an improved economic outlook and corporate earnings recovery. Nevertheless, as mentioned in the body of the report, there are a number of stock specific opportunities held in the fund, predominantly in the SA mid-capitalisation space, that are both attractively valued and positively geared to any rebound in SA GDP growth. We anticipate a challenging period ahead but remain confident in achieving the fund s investment objectives. Kevin Williams Fund Manager James Easterbrook Head: Distribution
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