Wednesday, September 7th, 2016
Every reporting season, there a handful of companies which are expected to upgrade their earnings outlook but instead blindside the market with a downgrade. Share price reactions to such paradigm-shifting events are typically dramatic and immediate. Opinions from pundits in the market can be equally strong as they try and understand the magnitude and longevity of the issues facing the company. APO is no exception, being one of the poorest performers of this year’s reporting season and the current subject of intense market scrutiny. As value focused investors, we must beg the question of whether its current price truly reflects its longer term outlook and its underlying quality as a business.
Figure 1. APO Price/Value Chart
The first step in doing so is to explore what drove the downgrade in the first place. If management is to be believed, their original guidance did not adequately account for the disruptive effects of this year’s Olympics. The Games typically shift a significant proportion of ad spend to television from categories like out-of-home, or at the very least discourage spending in other categories. Whilst we accept the logic behind this explanation as self-evident and well-supported by others in the market, it was hardly a black swan event and, we feel, should have been more conservatively accounted for by management.
Yet part of the problem is that industry revenue growth – which will also reflect the impact of the Olympics – is expected to be 9-10% in 2016, above APO’s revised forecast of 6-8%. The most obvious explanation is that APO is losing market share, calling into question its service offering and competitive position. Dig a little deeper though, and another answer emerges. Much of the industry’s growth is being driven by the digitisation of printed (static) billboards and signs which is both opening the category to new advertisers and contracts and directly leading material efficiency gains. Of course, the same process is similarly driving APO’s growth but with a catch. Its production and installation revenues, (an estimated 17-18% of group revenues), is structurally declining as the turnover from static billboards falls. This is a necessary drawback for a company digitising its asset portfolio but was not previously well understood by the market.
Figure 2. APO digital proportion of revenue
Source: APN Outdoor
Also worth noting is that the 18% industry growth achieved in the first half of 2016 reflected a pull forward of revenues from Australia’s protracted Federal Election. Given APO has sizeable New Zealand operations, this was another source of disparity. Finally, transit media (in train stations, etc.) has not been digitised and will naturally grow slower than the industry as a whole in the shorter term.
Critically, what the downgrade does not reflect is any sign of structural headwinds in out-of-home advertising. Industry growth is still strong and is being led by the digitisation of billboards, and the shift in ad spending away from print, radio and TV towards categories like out-of-home. These are the key pillars of our investment thesis and in our view, remain intact. Moreover, we believe out-of-home is a relatively immature segment, which is just scratching the surface of its capabilities in terms of interactivity, targeted content and coordination with mobile media. Meanwhile, cash flow conversion is strong, contributing to a robust balance sheet with gearing of less than 1.0x. This affords APO with future funding flexibility to push growth either organically or through acquisitions.
Figure 3. Outdoor ad spend and share of total spend
Source: OMA, Clime estimates
That being said, our growth forecasts have come down to reflect the long term drag from production and installation revenues. We have also revised our growth estimates for APO’s New Zealand business, though management does expect market share gains going forward. The net result is a reduction in our estimate of forecast profitability (NROE) down from 30% to 27% which brings our twelve-month forward value to $6.25 (currently $5.16). We see tangible value here for patient investors willing to look through the emotional and myopic market response to an unexpected downgrade, a view we have actioned by purchasing the stock with our own funds.
Clime Asset Management owns shares in APO.AX