October 2024 Update

Ignoring my own advice

The portfolio fell 3.83% in October underperforming the All Ords Accumulation, which fell 1.33%. Since inception, the portfolio is up 65.8% against the All Ords Accumulation at 25.3%.

The biggest drag on the portfolio was once again Close the Loop (ASX:CLG), down 19.0%, bringing our loss on the position to 43.7%, we will discuss this further below. Other detractors were EVZ Limited (ASX:EVZ) down 9.4%, Environmental Group (ASX:EGL) down 8.5%, Scidev (ASX:SDV) down 7.0%, and Gentrack (NZX:GTK) down 6.9%. Both EVZ and Scidev released quarterly reports during the month. In the case of EVZ, operating cashflow was weaker than we expected as the company completed a major project but started others elsewhere. The completed project led to growth at the topline, however this wasn’t reflected at the bottom line due to the mobilisation on other projects. The result was a small cash burn. The recent contract wins should see revenue remain elevated, however what we need to see is a return in margins from the current 1.8% to the pre-Covid c. 3% range. If the company can do that, then we could see NPAT of $3m plus against an Enterprise Value of $11m (that is a big if). It remains a small position for us.

Source: Company filings, author’s calculations

The other quarterly was from Scidev, and the shares actually rose on the back of the report but finished the month down after a previous decline. We had trimmed our position earlier in the month. As we had noted last month, it had become our third largest position on the back of a strong advance. At the end of September, we were up 79% on our purchase four months earlier. We discussed the reasons for this rise here:

September 2024 Update

On the positive side, the top performer for the portfolio was Scott Technology (NZX:SCT). This was despite an ordinary full year result driven by second half weakness. Revenue fell slightly as did EBITDA.

Source: Company filings, author’s calculations

NPAT also fell, down on the first half and well down on the prior corresponding period.

Source: Company filings, author’s calculations

Underneath the headline numbers there were some contrasting narratives. Essentially the company has three core divisions, two of these are firing and one is not. Materials Handling, which manufactures robotic palletisation systems for production lines, is growing strongly, particularly in North America. Revenue in this division rose 35% with North American revenue up from $8.4m to $33m.

Source: Company Filings

Their Minerals division also saw strong growth, with revenue up 19%. This growth was driven by sales of automated modular sample prep systems to Mineral Resources (hopefully their recent issues don’t impact this moving forward), and continued sales of their automated energy transfer system with Caterpillar. The energy transfer system essentially automates the charging connection for electric vehicles. Both of these growth drivers are recent product developments.

Source: Company Filings

Source: Company Filings

The negative driver of the result was their Protein division where revenues fell 35%. They blamed macro conditions for this decline. Despite the fall in revenues, the company is producing some interesting products. Their BladeStop product is the largest component of this division currently, however they have recently started to roll out their automated chicken trussing machines with Costco in the US. Potential future upside comes from the Beef Hide Palletiser which they have recently developed.

Source: Company Filings

Despite the weak 2^nd half, Scott Technology ended the month as our best performer. They initially sold off on the result, however the announcement of $30m in new contracts for the Materials Handling division pushed them back up. The new contracts included the first order for their new NexBot Automated Guided Vehicle.

We made a few minor changes to the portfolio over the month. We trimmed some Scott Technology (we still maintain a small position), and as mentioned above we also trimmed Scidev due to the high weighting it had become. The proceeds were put into a new small position in Connexion Mobility (ASX:CXZ), and after a few months of watching and doing nothing we increased our position in Close the Loop.

Close the Loop continued to fall in October. This was on the back of a Shaw and Partners research note that downgraded growth assumptions and pushed the impact of the proposed debt refinance back to FY26. The debt refinance assumption is most likely fair, as apparently there are substantial break fees on the current facility held through a private credit provider. The current effective interest rate on the debt backed out from the financial statements is 11.2%. A 3% reduction in this rate would reduce the interest burden by c. $2.5m. The issue is that will not be realised this financial year.

We have been back over the FY24 result several times and can see two primary issues. Firstly, the Packaging division was very weak.

Source: Company filings, author’s calculations

The resource recovery division led by ISP Tek Services offset this leading to a flattish result. The second issue is the increase in Net Debt.

Source: Company filings, author’s calculations

This Net Debt increase came about despite Operating Cash flow conversion of $31m. This reflected a 71% cash conversion relative to EBITDA and the company expects similar conversion going forward as the company grows its working capital in line with higher revenues. The drags on the cash balance were the high interest costs mentioned above, an earnout payment related to the ISP Tek Services acquisition, capex and increased lease costs.

The good news is that the earnout payments are over and won’t repeat. Although there is a convertible note due in a few years that converts at 74 cents, at this stage this would have to be repaid (there is also a 2^nd note that wouldn’t be converted above 74 cents offsetting this so no matter what happens $7.5m will have to be repaid…) Aside from that, interest costs should come down in FY26 and capex / leases will be reasonably stable. This brings us down to growth; can the company grow its OCF from here. With that in mind, the company is opening a facility in Mexico to handle increased North American volumes and a new facility in the Middle East. It is also expanding its Circular Planet initiative (i.e. print cartridge recycling) into new European geographies. So, it is not standing still.

If we re-examine the two issues above, starting with the debt. The debt is not really a concern with OCF coverage greater than 3x and Net Debt to EBITDA of c. 1x. The rise in the 2^nd half was a surprise but this shouldn’t repeat given there are no more earnout payments. However, given the refinancing discussion above, it may take until FY26 to see a meaningful reduction as one-off refinancing costs will impact this year. This brings us to growth and valuations. The current market capitalisation is $95m, but it is important to note that you need to look at this on an Enterprise Value basis. The EV is $136m which puts it 5.3x NPATA or c. 7x Free Cash Flow. If the growth incentives above lead to meaningful growth in earnings, then the shares are unequivocally cheap. Short-term question markets remain around the packaging business and there has been some suggestion they could sell this to repay debt. The major long-term risk is the large reliance on one customer (HP); however, the contract has recently been renewed for three years so that is a conversation for another day.

We wrote about momentum earlier this year:

June 2024 Update

At that time, we recognised Close the Loop as a name where we were ignoring that factor. The negative momentum in the share price has accelerated since the result, and we have held out from doing anything until now, where once again we gone against our own advice. The company holds its AGM on November 21^st and we are hopeful that some clarification around the financial outlook can improve the markets opinion on this one. 

Finally, the new position we added was in Connexion Mobility. Connexion is a very small software company. Their software focuses on Fleet Management and is used in the US across 4000 General Motors (GM) dealerships.

The company has grown in recent times with a step up in revenue and profits during the June 2023 half. This was when GM agreed to expand the use of Connexion’s platform to all its “Courtesy Transportation Platform” participating dealerships. Essentially managing the courtesy vehicle fleet for GM in the US.

Source: Company filings, author’s calculations

The recent increase in profit and cashflow has flowed through to the balance sheet.

Source: Company filings, author’s calculations

With this balance sheet strength, the company has been buying stock back aggressively, having repurchased 187m shares between 1c and 2.8c. At the AGM, shareholders provided approval for this to continue. Currently the company has a market capitalisation of A$19m, has close to US$5m (A$7.5m, the company reports in USD) in cash and investments on the balance sheet, and made a profit of US$1.9m last year (A$2.9m). Outside of the step change in June 2023, growth has been hard to come by, however at the current valuation, you are not paying for much. If the company can upsell further add-ons into GM or add other dealers, then earnings can grow. The other avenue of growth could be M&A, an area the company has openly stated they are exploring opportunities.

 Just a friendly reminder that none of the above is investment advice, it is factual commentary on a portfolio run by the author.