Short-term earnings are irrelevant

Company specific variables to consider for survival

Demand for Products and/or Services

We are witnessing huge fluctuations in demand across certain categories. Since 2016 NAOS have compiled a newsletter called CEO Insights that is shared with our investment community on a weekly basis. The newsletter contains a selection of comments made by Company CEO’s, these comments are helpful in providing ourselves and our investor base with a reliable look-through into individual sectors and the overall economy. During the past week, there have been a significant number of company updates which have allowed us to gain important insights into the current impact of COVID-19.

Starting with the beneficiaries, the most obvious seem to be the sellers of consumer staples, in particular supermarkets. Brad Banducci, CEO of Woolworths, recently commented that they “have recorded more sales in the last week than we would in the week before Christmas.” There have also been other beneficiaries, with Telstra CEO Andy Penn noting that they have seen an increase in “demand being seen in the enterprise market for upgraded capacity and mobile broadband in the consumer and small business market.” The demand for streaming services such as Netflix has increased to the point where Netflix have agreed with the European Union to reduce streaming quality to preserve network capacity. The shift to a nation working from home has also benefited JB Hi-Fi who said that they have seen increased demand for “technology products that enable remote working, learning and communication, and essential home appliances for food storage and preparation.”

A further flow on effect comes from the implications of a lower Australian dollar. The Australian dollar recently traded below parity with the New Zealand dollar for the first time since it was floated. When global growth is strong and the Australian dollar is low, it has typically buoyed demand for tourism and education. Obviously, this time around that won’t be the case, but consider the possible competitive benefits for our largest export, being iron ore, which is priced in US dollars and has suddenly become much cheaper for offshore customers to buy.

Unfortunately, however, it appears the businesses negatively affected will far outweigh the beneficiaries. The most obvious initial impact is on the airlines and the travel industries with Alan Joyce, CEO of Qantas commenting that “this is the worst crisis the travel industry has ever gone through.” Regional Express have cancelled all passenger air services with demand expected to “nosedive to around 80% from the 60% we are experiencing today.” The impact has obviously also been felt across the wider tourism market. To put into context how unprecedented the current events are Chris Nassetta, CEO of Hilton Hotels commented “Hilton has been around 100 years. We’ve never closed a hotel that wasn’t going to be demolished or rebuilt. The bulk of our hotels in the major cities are closing as we speak”.

In the retail space, Russell Zimmerman, Executive Director of the Australian Retailers Association noted that “early reports were that revenue across the board was down 30% for March compared to last year”. Given that retailers survive on small margins, it could mean that rent is not paid on time, and as a result we expect to see landlords come under pressure. We have since seen most of the large shopping centre trusts withdraw their earnings guidance. We are also witnessing the first stages of capital expenditure being reduced with two examples of this being Sydney Airport (ASX: SYD) and oOh!media Limited (ASX: OML) both announcing their planned spend would be significantly reduced, along with a number of Real Estate Trusts (REITs).

Recurring Revenue Base and Potential Variability

Over the past 12-18 months we have noticed a significant increase in the number of companies reporting ‘annual recurring’ revenue. The bulk of this has stemmed from newly created companies offering their products on Software as a Service (SaaS) business models, where their clients are charged a subscription fee. An example of this change has been the accounting software space, where Xero Limited (ASX: XRO) offers their accounting service entirely online, meaning easier integration with your accountant and easier compliance with any changes to taxation laws.

Following this significant shift in the revenue model, most of the industry now operates in this way, and we have seen numerous examples of companies adjusting their business model to a subscription-style offering. Not only does this benefit the customer, but also the company as they now have a more predictable revenue stream and they can become more fully integrated with their clients, who are then even more reluctant to switch providers. Pro Medicus Limited (ASX: PME) is another example of a company offering a very sticky subscription-style revenue stream. PME provide a tool for radiologists to view scanned images remotely with extremely high levels of quality. The contract with the hospital usually stipulates a minimum percentage of the total amount of scans each year to be viewed using their technology. The sales cycle is long, but if a client wanted to leave, the switching costs would be very high, and the company estimates the process would take close to two years. This business model should provide investors with a high degree of certainty relating to future revenue streams.

We cannot say when a recovery will occur, but we do believe that a recovery will eventuate at some time in the future. Our focus at NAOS will always be on the stock specific opportunities that are presenting themselves to us at any given time.

To highlight an example of the movements we have seen within our portfolio, Enero Group Limited (ASX: EGG) has seen its share price fall by approximately 60% from its CY20 high. NAOS sold a circa 10% stake in the company just 6 months ago to several larger institutional investors. The business now has a market capitalisation of just $74 million or an enterprise value of just $60 million taking into account their net cash position of $14 million. This is a business that generated free cash flow after all capital requirements of $8.20 million for 1H FY20, which equates to a free cash flow yield of circa 25% on an annualised basis. Even if the revenue base was to fall by 50% and EBITDA margins from 16% to 10%, then the EV/EBITDA ratio would still only be around 4 times. Clearly public relations spend will be reduced significantly in the short-term, but in our view, B2B PR will remain and Enero has a client base that includes some of the largest technology businesses in the world, such as Facebook and Adobe. As such, we believe it may soon be an ideal time for us to start to acquire some of the shares we sold at much higher levels.