Thursday, December 20th, 2018
As an aggregate basket of stocks, ASX-listed small-caps have continued their downward spiral in recent weeks. The Small Ordinaries Accumulation Index has now fallen by about 13.1% in the financial year to date, largely reflecting growing macroeconomic concerns. In some cases, the selling pressure has only been augmented by disappointing company-specific developments. This provides the context for recent small-cap sub-portfolio changes within the StocksInValue Model Portfolio, with recent volatility providing a degree of opportunity.
Austal is an Australian shipbuilder and global defence prime contractor which designs, constructs and sustains some of the world’s most advanced aluminium commercial and defence vessels. ASB has designed, constructed and delivered more than 300 commercial and defence vessels for more than 100 operators in 54 countries worldwide. Established in 1988 and listed on the ASX in 1998, Austal has grown to become the world’s largest aluminium shipbuilder.
Figure 1. Austal snapshot
Source: ASB ASX Presentation
ASB is Australia’s largest defence exporter and the only ASX-listed shipbuilder. Austal delivers iconic monohull, catamaran and trimaran commercial vessel platforms – including the world’s largest trimaran ferry and multiple defence programs such as the Littoral Combat Ship (LCS) and Expeditionary Fast Transport (EPF) for the United States Navy.
ASB has shipyards in Australia, the United States, Vietnam, China and the Philippines and service centres across key geographies. Austal’s USA shipyard was established in late 1999, and is the largest non-government employer in Mobile, Alabama, serving as the centre of manufacturing for the Littoral Combat Ship (LCS) and Expeditionary Fast Transport (EPF) programs for the US Navy.
ASB is well positioned to deliver strong earnings growth over the medium term as a result of three key factors: (i) Steady revenue growth and material margin improvement in its core US Defence business, (ii) Strong growth in recurring support and maintenance revenues, and (iii) A solid rebound to profitability in ASB’s Australasian business.
ASB’s US Business
ASB manufactures Littoral Combat Ships (LCS) and Expeditionary Fast Transport (EPF) vessels for the United States Navy out of its Alabama facility. ASB is one of only two manufacturers of the LCS program, along with Lockheed Martin. Over time, given a strong ‘learning curve’, ASB’s margins have materially improved. Essentially, ASB’s specialist shipbuilding workforce are becoming more efficient over time, resulting in a reduction in labour hours per vessel and increase in delivery velocity. Half on half EBIT margins have improved by ~2.5 percentage points over the past two years, noting that just a 1% increase in margin represents ~$13m in EBIT growth (+20% on FY18 EBIT).
Figure 2. Labour hours per vessel
Source: ASB ASX Presentation
Strong growth in recurring support and maintenance revenues
ASB provides naval, government and commercial operators through-life capability management and vessel support services, including crew training and instruction, vessel servicing, repairs and maintenance, integrated logistics support, vessel sustainment and information management systems support.
ASB’s support business is increasingly providing a strong baseline of recurring revenue. Typically, 10% of the capital cost of a vessel is allocated to annual maintenance programs, with the OEMs best positioned to provide services. As ASB delivers more ships, particularly LCS, this component of ASB’s total group revenue becomes more prominent. Support revenue is therefore forecast to approximately double over the coming three years to $400m, representing an EBIT contribution of between $24m and $28m per annum. Given an average ship life of 25 years, this effectively becomes a growing source of recurring revenue.
Figure 3. ASB Sustainment Revenue
Source: ASB ASX Presentation
Solid rebound to profitability in ASB’s Australasian business
ASB management have forecast a rebound to profitability in its Australasian business in FY2019 and beyond. This guidance is underpinned by increased Australasian defence expenditure, a strengthening global passenger transport market and a subsequent improvement in global demand for high-speed ferries. In isolation, this represents a ~$10m turnaround in EBIT (FY18 vs FY19).
ASB is one of only two global manufacturers of high-speed catamarans and is thus well placed to absorb growing demand for not only global fleet expansion but a significant phase of fleet replacement. This is occurring at a time when ASB has successfully invested in expanding manufacturing capability in lower cost Asian jurisdictions (highlighted on slides below).
Figure 4. Global High-Speed Ferry Replacement Market
Source: ASB FY2018 Presentation
Figure 5. Manufacturing Capacity by Geography
Source: ASB FY2018 Presentation
We have initiated with a portfolio weight of 2.0%, which we believe balances the growth opportunity articulated above and the risks inherent with such an investment. Risks include contract risk, execution risk and associated margin sensitivities, strong customer bargaining power (the US Government) and currency risk.
Macquarie Telecom (MAQ)
Macquarie Telecom (MAQ) is a specialist provider of enterprise cloud and telco solutions to Government and medium to large enterprises in Australia.
We like the business because it is well-run, has a strong local brand and experiencing healthy demand for its services. Historical returns on reinvestment are strong, particularly in the Hosting business. In our view, MAQ’s reinvestment pipeline is not fully captured in the Model Portfolio entry price of $21.04 (as at 7 Dec).
At its inception in the early ’90s, MAQ’s offering revolved around Telco services where the company acted a value-added reseller of voice, mobile, data and colocation products. Soon after listing in 1999, MAQ added Hosting operations between 2001 and 2003 with two data centres in Sydney (CBD and Macquarie Park) and one in Canberra. Benefiting from the trend of business IT resources migrating offsite, the Hosting segment grew to become MAQ’s primary earnings driver and now contributes around two-thirds of Group earnings before tax, depreciation and amortisation (EBITDA).
We believe MAQ’s team led by founders David and Aiden Tudehope is high calibre as reflected in the Group’s industry-leading Net Promoter Score of +70, which represents ‘excellent’ customer loyalty, and position with the hosting market as a specialist in cybersecurity and customised hybrid cloud.
This half MAQ announced a major development plan to almost quadruple capacity (in terms of Mega Watts – MW) across the data centre portfolio over 45MW, via an expansion of the Macquarie Park campus from 10MW to 43MW. The initial capital expenditure for the shell will be $75m-$80m, the bulk of which will be incurred across CY19. We estimate that investment in the project will total over $400m, which will be spread over several years.
In late June MAQ signed a wholesale supply agreement with NBN Co, which will enable the provision of MAQ’s telecommunication and data services such as SD-WAN to businesses across Australia, including regional areas. First customers are expected in 2Q19. The deal is a significant growth opportunity for the Telecom segment, which has been mostly flat in recent years.
At its November AGM MAQ guided to first-half EBITDA of $25m to $26m, in-line with expectations.
Jumbo Interactive (JIN)
In other news, Model Portfolio holding Jumbo Interactive (JIN) provided some relief from the market turmoil with a very positive operational update.
JIN upgraded full-year earnings forecasts by 28% and now expects to deliver earnings of $20.5m for the full year. Comparing favourably to FY2018 profit of $12.1m and prior guidance of ~$16m, new guidance implies that JIN expects to deliver earnings growth of 69% for the year. We estimate JIN to hold over $60m cash (no debt) and on an ex-cash basis still trades on about 19 times earnings, an undemanding multiple relative to JIN’s growth profile.
Indicative of the operating leverage increasingly evident in the business, JIN’s first-half forecast profit of $11.8m nearly matches the full 12-month profit generated in the year prior.
As one of just two online retailers of official lottery tickets in Australia JIN’s long-term growth is underwritten by an increasing percentage of ticket sales made online, which currently stands at about 20% of the total.
The upgrade was largely thanks to changes to Powerball odds in effect since April. Essentially the odds of winning lower-tier prizes improved, however, the odds of hitting the jackpot have lengthened substantially from 1 in 76.7 million to 1 in 134.4m. This results in more winners (in number) and larger jackpots.
As a result, the fiscal year started with 11 consecutive large jackpots including a record $100m jackpot in August, which likely had a material effect on sales.
Also, during the half JIN signed its first ‘Powered by Jumbo’ customer in the Mater Foundation, with revenues expected from FY20. Powered by Jumbo is a new business line that markets JIN’s internal lotteries management system as a product to charities and governments on a global basis. JIN will generate revenues as a percentage of total customer turnover, which is a multi-billion-dollar addressable market.