Read the previous week’s Investment matters.
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Background
ASX reporting season
Most companies with an accounting year-end date in June select August as the month to report their full-year results. We’ll provide updates in Investment Matters over the next few weeks. Here’s a snapshot of results reported in the week just past for stocks held within clients’ Australian shares sub-portfolios.
Many companies reported this week, and we will return to those not discussed in September. Amongst the more prominent portfolio positions not covered today, we note our overall view and market impact below.
| COMPANY | FIRST SAMUEL VIEW | CHANGE SINCE RESULT |
|---|---|---|
| Perpetual (PPT) | Negative | -3.8% |
| Nanosonics (NAN) | Positive | +15.5% |
| Johns Lyng (JLG) | Negative | -30.7 |
| BHP Limited (BHP) | Neutral | -0.8% |
| Bega Cheese Limited (BGA) | Positive | +9.4% |
| Steadfast Group Limited (SDF) | Positive | +1.0% |
| Aurelia Metals (AMI) | Positive | -3.1% |
| Wesfarmers (WES) | Negative | -4.1% |
| Catalyst Metals (CYL) | Positive | +5.6% |
| IGO Limited (IGO) | Positive | +1.3% |
| Mineral Resources (MIN) | Negative | -8.1% |
| Australian Clinical Labs (ACL) | Positive | +9.4% |
| TZ LIMITED (TZL) | Positive | -4.0% |
| 360 Capital (TGP) | Positive | +1.7% |
| Metals Acquisition Corporation | Neutral | -5.0% |
The Market
Worley (WOR)
First Samuel View: Positive
Market reaction since result: +8.7%
Worley’s stock has underperformed the broader market since the Dar Group sold a significant stake in the company in April 2024. However, the full-year FY-24 result released on Tuesday demonstrated that the company continues to perform exceptionally well.
We have taken the opportunity to add to positions both at the sell-down and since. Worley is one of the top 20 stock holdings in clients’ Australian shares’ sub-portfolios.
The graphic below shows a snapshot of financial performance. It highlights 14% growth in revenue (“Aggregated Revenue excluding Procurement”), 24% growth in operating earnings (“Underlying EBITA”) and a 27% growth in after tax profits (“NPATA”).
The financial results were impressive, as was how it generated them. Margins earned on work completed continued to improve, and the guidance for margins in FY-25 surprised the market and us to the upside. Cash generation remains exceptional, and the structural advantages its global workforce enables, and which Worley continues to leverage to advantage, has meant costs remain under control.
After following this company for almost 20 years, it is pleasing to see Worley less exposed to cyclical pricing pressures on the revenue front and on costs less exposed to fixed and increasing labour prices. This provides more confidence in the stability of its margin outlook.
We believe that, along with Macquarie Bank on the financing side, Worley is one of the few ways to profit from the scale of work required for the energy transition.
The chart below shows how much of Worley’s work in traditionally “dirty” industries such as Energy and Chemicals is now related to a transitional or renewable versions of the former workflow.
Sources of revenue – movement toward transitional and renewables focus – FY24
Source: Company reports
Other exciting features of commentary provided by management included the CEO noting that “competitive intensity is the lowest it’s been in 35 years,” “employee attrition rates continue to fall,” and the “pipeline of work is still healthy and growing.”
Given the company’s financial strength and the growth prospects of its industries, we would expect it to engage in M&A. Smaller bolt-on acquisitions would be preferred. Still, the company suggested that target valuations are high.
The only concerning feature of the results presentation was the value of the Worley backlog of work to be done. Some project modifications, scope decreases, and a $200m project cancellation reduced the backlog for the first time in many years. Whilst not a red flag, future revenue doesn’t follow perfectly from future backlog. The issue did raise many questions with management, and we will be more closely watching it in the coming months.
Sources of revenue – movement toward transitional and renewables focus – FY24
Source: Macquarie Bank and Company reports
What they said:
“Clean result with strong cash flow and no restructuring costs. Macro uncertainty, but low double-digit EBITA guide better than feared.
Strong balance sheet to gain greater focus with 1.5x gearing (vs up to 2.0x target) creating balance sheet optionality.” – Macquarie
Inghams (ING)
First Samuel View: Negative
Market reaction since result: -21.2%
Contract risk strikes chicken
The Ingham’s result last Friday was a mix of
- Moderate current performance – reasonable sales in FY-24, good pricing for Chicken (see chart below) and adequate cost control with an improving outlook.
- Guidance for next year’s earnings that was a slight disappointment – in the order of 5% lower than market expectations.
- The dramatic impact of a new Woolworths supply contract –
- Management flagged a new multi-year supply agreement for Australia with Woolworths, leading to a phased annual volume reduction.
- Despite management downplaying the impact, noting a negative volume impact in FY-25 of 1-3%, the market had difficulty processing the news as cautiously optimistically as management portrayed, leading to very large falls in the share price.
We tend to share the management team’s cautiously optimistic view of the impact with management, that is, the change will likely be only slightly negative in the medium term. In fact, management noted to us in a post-result meeting that a similar experience in New Zealand three years ago has been net beneficial in terms of prices received, ability to win alternate supplier contracts and the ability to manage variable costs in response.
The structure of the chicken meat industry is highly concentrated, both in terms of processing suppliers (especially at a state level) and in terms of major clients (supermarkets, fast food retailers etc).
Where supply is concentrated, and supply chains involve high levels of exclusivity, there are increased risks regarding biosecurity and the continuation of supply. A supermarket or fast-food retailer could be without supply in the case of disease or industry disruptions, and they could lack supply simultaneously as a competitor continues to sell chicken. This could lead to significant dislocation.
Woolworths cannot risk having no chicken, when Coles still does have chicken. But the same holds for Coles. We suspect this risk, the experience of covid, and the ongoing risk around bird flu, combined with growth in the demand for chicken, has led Woolworths to look for change.
However, the drivers for change are very different from the change’s impact.
The chicken meat industry in Australia is very well-behaved, and changes to supply chains that see lower levels of exclusivity need not lead to lower prices or volumes for any or all of the existing producers. Supply may reorganise, all clients supply will be more diversified, and all processors will have more clients.
Stock markets with a short-term focus need more certainty than real-world conditions can sometimes provide. We suspect this is the case for Inghams’ share price reaction. Inghams could not paint a picture of reorganisation with certainty; competitively, it would have been unwise to do so before it is in place.
Other than the contract news, we were pleased with the result. Continued investment in efficiency and capacity initiatives is positive. Delivering productivity benefits through automation and expanding capacity to grow volumes sustainably is consistent with our goals. Both are expected to deliver margin improvement.
Clients will note that following the share price fall, the company is trading near our original purchase price and 20% higher than lows. Consistent with our trading strategy, we sold a substantial proportion of our position at levels 30% higher than current prices. We will likely rebuild our position.
What they said
“We have a Buy rating on Inghams. The shares have been sold off, given the shock news about the Woolworths volume reduction. However, as time passes, we expect a clearer understanding that the drop is simply Woolworths diversifying its supplier risk, nothing more sinister about industry volumes or Ingham’s customer relationships. Nevertheless, it will take time for investor confidence to rebuild. We expect further updates about customer wins and clarity on the Woolworths contract will be positive share price catalysts.” – MST Marquee
Earlypay (EPY)
First Samuel View: Positive
Market reaction since result: +5.5%
Our long-held, now relatively small position in EarlyPay, the invoice financing company, delivered a pleasing set of results this week.
After a potentially profitable takeover was thwarted during covid, it is fair to say that Earlypay has been a disappointing holding. But in 2024, we will have a fully aligned management team and a potentially simplified and more focused operational focus.
With First Samuel clients owning around 14% of the company, we remain keenly focused on it. Either the ASX-listed COG Group (20%) or a trade buyer is likely the likely long-term owner of the assets, so we remain patient.
However, Earlypay is a very small company listed on an ASX market that has lost interest in small companies. The lack of focus on smaller companies and recent lower returns for tiny companies are cyclical features of markets. Trends in focus and returns will reverse, but not soon.
Until then, we are imploring the very few small companies that remain in the portfolio to improve their operations and increase their financial sustainability in anticipation of strong markets.
The highlight of the Earlypay results, apart from the strong level of normalised earnings generated, was the company’s strategic improvements. These include:
- Acquisition of selected assets from Timelio, a former well-funded competitor, is now fully complete
- The disastrous RevRoof transaction, which marred operations for 12-16 months, is now recovered and resolved with no outstanding exposure
- The team has made ongoing improvements to risk management processes and portfolio rebalancing in line with risk appetite
The result
The numbers were generally in line with our expectations, with the 2nd half of FY-24 exhibiting similar trends to 1H-24. The company retains a subdued appetite for growth.
This subdued appetite is partly the result of former missteps and partly likely a response to an uncertain economic environment. Weakened appetite, for either reason, doesn’t reduce the long-term value of the business, but at some point, the business needs to either grow or return capital to shareholders.
Interest margins and credit quality were pleasing in an uncertain environment.
The upside from Group refinancing, reducing the cost of the money Earlypay borrows to lend to its clients, has been completed with lower costs and better flexibility—the change was not quite as transformative as we could have envisaged, but it was positive, nonetheless.
The Timelio acquisition is okay and wasn’t expensive.
Clients should note that Earlypay has a Net Tangible Asset (NTA) backing of 15 cents per share. With the stock trading at only a minimal premium to NTA, there is limited risk to the company’s underlying value.
So Earlypay is “cheap” at the current share price on an NTA basis, and the company is also cheap with respect to future earnings and the potential for dividends.
Earnings per share are likely to be 2.5 to 3 cents per share in FY-25 and FY-26; hence the stock is attractively priced at less than seven times earnings. Depending on the growth trajectory, there is also capacity to generate a dividend yield of around 8-10%.
FY-25 will be the story of balance sheet optimisation and turning on the growth drivers.
If either is successful, the stock should trade towards 10-11x earnings, with an upside closer to 30c per share. Should the company generate sustainable and profitable revenue growth, we anticipate a merger or corporate takeover would make the most sense for patient shareholders.
Client portfolio exposures
Source: Company reports
We also appreciated the final part of the EarlyPay presentation. There was a focus on innovation which outlined the development of new “channels-to-market”. Embedded payments are a growth option we look forward to seeing progress on in the coming months.
What they said:
“The focus now is on resuming growth at acceptable risk, ultimately driving the share price..” Henslow Research
Ventia (VNT)
First Samuel View: Positive
Market reaction since result: -1.6%
Ventia is the leading outsourced services provider in Australia. Its services include cleaning, routine and emergency maintenance (prisons), meal preparation (e.g. defence), and coordination of responses in emergency situations.
The company operates across several levels of government (federal, state, and municipal) and companies with expansive infrastructure asset bases, such as Telstra.
Result in short
The company delivered solid revenue and net profit growth of double-digit proportions, along with good cashflow generation. While the stock had run quite hard into the result (we had begun to selectively take some profits), a result meeting expectations for the half as well as an upgrade of full-year earnings guidance by 2% was nonetheless met with a sell-off of almost 7% on the day of the result.
Market growth supported by industry tailwinds
Ventia is exposed to several attractive thematics that underpin growth in revenues and build scale economies within their business. These include
- A rising number of infrastructure assets as services are enhanced and rolled out (e.g. NBN)
- A growing population base (increased use of Gov’t assets and need for routine maintenance)
- An increased demand for services to be outsourced as Government and large companies variabalise their cost base and take advantage of economies of scale
- Megatrends such as energy transition and digitisation requiring ongoing capex spend and assistance from companies to prepare
Source: Company reports
Continued bid success underpins future growth
Source : Company reports
Along with favourable industry dynamics providing an underpin to services’ demand, Ventia also has demonstrated an ability to retain business at a higher value as well as win new business.
Ventia is a capable provider of services and continues to invest in technology to keep track of workflow and measure returns. This information becomes a reinforcing mechanism for improving organisation efficiency, operating performance as well as being useful to drive new business wins. That in turns drives increased scope for investment in technology, equipment and people in order to continue to win share.
What they said: “Tough crowd”
“VNT is building a track record of consistent performance relative to expectations. We believe this is underpinned by a number of favourable operating characteristics. Contract structures are skewed towards lower-risk cost reimbursable (21% of revenue) and schedule of rates (70% of revenue), which supports VNT’s ability to deliver a stable EBITDA margin profile (between 8.0% and 8.5% post FY20). Moreover, with an average contract length of 7 years and work in hand equivalent to 2.5x our FY24 revenue forecast, VNT should have solid sales visibility..” UBS
Woolworths (WOW)
First Samuel View: Neutral / Positive
Market reaction since result: +0.1%
Woolworths remains under significant public scrutiny. News stories abound, and unfortunately, politicians of all persuasions have used Australian supermarkets as headline and sound-grab generators. This scrutiny affects how Woolworths and Coles present financial information and, we suspect, impacts how the businesses are run.
Outgoing Woolworths chief executive, Brad Banducci, said the political pressure on prices – at a time household budgets are constrained by higher mortgages, rents and utility bills – would only end “when the customers are no longer under the cost-of-living pressure.”
The focus on politics, the emphasis on intangible aspects of the business, and extended commentary on the Australian consumer obscured some very important structural aspects of the operating performance.
Our take-aways on the structural factors are:
- eComX, Woolworths’ online business, plus all the value created through digital interactions customers have with the company, including Click and Collect and home delivery, are growing fantastically well. These businesses are now generating sustainable profits.
- There is increasing evidence that eCommerce sales, now 12% of supermarket sales, are beginning to crimp/cannibalise store-level profitability. Considering the vast resources and capital allocated to Woolworths’ physical stores, managing this transition will be challenging for the next 10 years.
- Woolworths NZ business, which faces much more robust levels of competition, is fragile and likely to remain of limited value in the medium term.
- BigW is a weak business that is unlikely to survive in the medium to long term without vast changes in its business model. The changes are possible, but whether the effort and investment will be value accretive remains to be seen. We include very little value for Big W in our assessment of the company.
- Despite the array of challenges, Woolworths’ core business model continues to generate significant free cash flows, and its fabulous capacity to manage gross margin is only getting more powerful. Digital engagement, customer loyalty programmes and the gamification of app-based client interaction are all margin enhancing. When combined with power they maintain over suppliers the capacity to manages challenges is high.
As an investment, the challenge in valuing Woolworths, especially at these elevated price levels, means we must combine:
- strong fundamentals, and market power that has allowed Woolworths to sustain and grow margins
- political forces to limit this power
- a future where the supermarkets’ business must manage headwinds from cannibalisation of store revenue by a growing eComX business
- the strain on capital of a business which needs to continue to invest in stores and online at the same time
We suspect that, on balance, Woolworths is slightly expensive in the short-term.
Risks of cannibalisation rising
According to MST Marquee numbers over the past five years, Woolworths’ market share has risen by 1.05%. Its online sales have increased 331% over that time frame, with store sales only up 20%. Considering inflation has been rising faster than that amount, Woolworths stores are selling less than pre-covid. On a per-capita basis, in-store sales are falling despite Woolworths growing market share.
During this period Woolworths has still be able to generate profit growth, with the start-up losses from eCommerce now behind them. In FY-24 the margin generated from eCommerce was positive and growing steeply. The margin remains less than half of the in-store margin.
Woolworths online growth – eCommerce now making money
Source: Company reports
However, this success is a two-edged sword going forward.
Woolworths’ pursuit of online is now potentially risking overall margins. In FY-24, store profits were flat; in 2H-24, profit margins fell by 19bp for stores. This margin reduction was despite increases in gross margins across the business (higher prices, mainly due to less promotional intensity).
Improvements in working capital continue to mitigate the cash impact of Woolworths’ challenges, including those from the poorly performing NZ and BigW assets. Keen readers will remember that one of the features of Woolworths’ business is its negative working capital position.
Suppliers pay for all of the inventory in Woolworths stores and Distribution Centres. How? Woolworths has, over time, reduced the amount of inventory it holds to 30 days of sales (shown below). This requires a fantastic level of scale and dramatically efficient supply chains.
On the flipside, Woolworths’ payables days are now extended to 44.6 days, meaning that on average, they pay for the goods 15 days after selling them. When sales are measured in the tens of billions, improvements in net working capital can be very large indeed.
The secret sauce of Woolworths keeps improving – inventory and payable days
On balance: More challenges and a high share price
Woolworths is a great business and its ability to now generate sustainable earnings from its online business reduces the risks for future online growth.
But the degree to which this success is beginning to cannibalise in store profits could be problematic. Considering the tailwinds of post-covid spending, an inflation spike, and the spike in supply of migrant workers are all passing pressures are likely to rise.
We are likely to continue to reduce our holdings in Woolworths.
What they said: ‘Woolies needs the X factor, move to Underweight’
“ We expect Woolworths shares to drift lower as sales trends remain sluggish and free cash flow generation is limited. We reduce our target price from $32.90 to $32.20 per share, largely driven by earnings downgrades along with lower long-term margins in Big W and New Zealand Food. The near-term share price risk is the ACCC inquiry into supermarket prices, which is likely to create negative sentiment in the next month.” MST Marquee
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.