Three reasons to own Downer Group

Three reasons to own Downer Group

James Miller, Portfolio Manager

Downer Group is an Australian listed company that designs, builds and sustains major infrastructure assets and urban facilities. The company’s core business activities are backed by long-term contracts (some lasting more than 20 years) typically with Government clients.
To put the scale of this business into perspective, it employs more people than the Commonwealth Bank, BHP or even Telstra.
There are three reasons why we believe Downer is a compelling investment opportunity

1. A high-quality business

When you think of engineering it may conjure up visions of large fixed-price projects and cost blow-outs. In recent times, engineering firms have been doing it tough. RCR Tomlinson went bust, Lendlease lost hundreds of millions of dollars building infrastructure and many other large-scale projects have been disasters.

Downer doesn’t do the mega, one-off, fixed-price projects. They specialise in low-risk, urbanisation projects. Think roads, rail, schools, stadiums, hospitals and power. It’s highly recurring and they have $43 billion of work in hand, spanning up to 30 years.

In our view, these twin tailwinds will drive Downer’s continued growth: 

• Population growth and urbanisation: Creating increased demand for urban infrastructure services.

• Demand to outsource: Particularly from government, to companies like Downer who have the expertise to plan, build and service urban infrastructure projects often at a cheaper price and higher quality

2. An un-demanding valuation

In the 2019 financial year, Downer is set to deliver strong earnings growth. The future years are likely to grow steadily in the high single-digit range, driven by continuing contract wins as well as operational improvements.

Downer’s current share price puts it on a price to earnings (P/E) multiple below the market average, despite the robust growth outlook that is higher than the market. This, in itself, a compelling investment proposition.

In addition, Downer delivers a dividend yield above 4%, backed by high quality earnings and cash conversion of around 90% over the past 7-years.

Why is Downer undervalued in our view? One of the problems is that it has no peer listed in Australia. You need to travel to the UK to find companies who do similar things such as long-term facilities management. Companies like Compass and Serco are both trading on 20x P/E ratios. Downer trades on a P/E ratio of around 15x today.

3. Key catalysts for Downer’s valuation to re-rate

So how does the company trade at a higher multiple to generate capital growth for investors?

We believe there are two key catalysts on the horizon.

Downer is rumoured to be selling their mining services division. It makes up around 13% of earnings but consumes almost 50% of Downer’s capital expenditure to generate those earnings. In our view, a sale of this business over the medium-term would move the company into a more capital light business model which is looked upon favourably by investors.

Secondly, the company currently loses money on the Royal Adelaide Hospital contract. It’s a long-term contract with limited downside (less than 2% of Downer’s market capitalisation). While not overly material, any positive outcome of a renegotiation of that contract in the medium-term would be better than the current situation and looked upon favourably by shareholders.

Conclusion: A high quality business with an un-demanding valuation

In our view, Downer is a compelling investment opportunity because of the quality of the business and exposure to urban services. In addition, the valuation for the business today is un-demanding with strong growth, good cashflow and some potential catalysts for a re-rate. For us, Downer ticks all the boxes.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140. 

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Firetrail believes the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail disclaims all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

The winners and losers of a more sustainable approach to plastics

The winners and losers of a more sustainable approach to plastics

July 2019 – Ramoun Lazar, Equity Analyst

Demand for convenience has seen plastic use multiply and today plastics are fundamental to many aspects of daily life. As consumers we interact with plastics many times a day. Whether it be drinking water from a PET bottle, eating yoghurt from a flexible plastic pouch, or using shampoo from a rigid plastic bottle, the applications are numerous within a modern consumer economy.

Plastics combine unrivalled functional properties with low cost. This has seen plastic use increase 20x over the past 50 years. And plastic use is expected to double again over the next 20 years. So, what are the key challenges for both consumers and producers of plastics in the twenty first century? In this insight, we look at the environmental and social costs of plastic use, the future of plastics and the challenges for consumers and companies in plastics. We conclude that companies offering a technology focus – whether it be shelf life, recyclability, and ultimately less waste dictating terms are expected to be winners from the change to more sustainable plastics use. Whilst companies less adept to change, will be expected to continue to lose market share and may be left behind.

The environmental impact of plastics has been largely ignored… until now!

One third of the 300 million tons of plastics used every year is only used once (single-use plastics). In addition, one third of disposed plastics escape collection systems at a cost to oceans, natural landscapes and urban infrastructure. At present, only 15% of plastic packaging is collected for recycling globally.

Recent media attention on marine pollution including the BBC’s Blue Planet series, has shone a new light on the problem of plastic waste and garnered significant backlash against this convenient substrate. Plastic has become a serious environmental and social issue that warrants attention and action. Policymakers, NGOs, industry and local community action groups have led the initiative to reduce our consumption of plastics.

Are all plastics bad?

Growing awareness of plastic waste impact is now triggering action. Single-use plastics such as plastic straws, bags, cutlery, lids and wrappers are being challenged by policy makers and communities, particularly where a more sustainable alternative is available. The city of Seattle recently became the first major US city to ban single-use plastic straws, with other US states following suit. Chile has approved a nationwide ban on plastic bags, while at home in Australia consumers now pay for plastic shopping bags.

So, should consumers expect further restrictions on single use plastics? Our view is yes. Given the wave of public support we expect more regulatory power to protect the environment against plastic waste. There is little doubt support exists for the view that all plastics are bad and should be banned or replaced by other more earth friendly substitutes. This is possible in some cases, e.g. paper straws replacing plastic straws, and will likely continue to garner favour. However, the phasing out of plastic packaging and plastic consumer products is highly unlikely and poses significant challenges and complications for modern society.

Certain plastics cannot be easily substituted. Some plastics provide significant benefits to consumers and society that can’t be matched by other substrates. In our view, these technologies will continue to gain prevalence. For example, a high barrier film packaging helps improve the shelf life of fresh produce, reduces spoilage and can even extend distribution opportunities. Most supermarket meats and cheese products utilise high barrier films, where the product is vacuum packed, minimising exposure to the external environment. This enables delivery of a fresher product resulting in reduced waste, extended produce life, reduced transport costs and lower carbon footprint.

The benefits of high barrier plastic technology seem obvious, yet a third-party survey by Sealed Air, a major global packaging provider, in the US showed that 40% of consumers aren’t familiar with vacuum packaging features and/or benefits. The same survey also found that once educated on the features of barrier packaging, nearly 90% of respondents acknowledged the benefits of these products to the wider community, while 70% said they were willing to pay more to ensure a fresher more sustainable product is delivered and consumed.

The plastic challenges are multi-faceted and complex in nature. Whilst some plastic technologies can have material benefits to consumers it is clear there is a significant environmental cost to plastic use. Below we look at the response to these challenges from both a corporate and government level as different stakeholders respond to consumer demands to find solutions to the environmental and social costs of plastic use.

How corporations are responding?

Increasingly major corporations around the world are taking their own initiative towards more sustainable business practices. Amcor is a flexible plastic packaging company owned within the Firetrail portfolios. It is the global market leader in high barrier packaging and the world’s largest buyer of resin, the key raw material input in producing plastic.

So how has Amcor been responding to the challenges facing the plastic industry over the next two decades? Amcor was the first global packaging company pledging to develop all its packaging to be recyclable or reusable by 2025. Today, around half of Amcor’s products are fully recyclable. Amcor’s large US$200m annual R&D commitment will focus on developing more recyclable materials wherever they are used, while at the same time also using more post-consumer recycled resin – lowering demand for virgin resources.

The company is also a signatory to the Ellen Macarthur Foundation’s New Plastics Global Commitment (EMF), an organisation that is leading the initiative against plastic waste. The EMF includes signatories from over 400 other companies that include packaged goods, retailing, hospitality and food service companies, raw materials producers, durable goods producers, the recycling industry and investors. Major brands such as The Coca Cola Company, Danone, L’Oreal, Mars, PepsiCo and Unilever are working with other key industry stakeholders to create a circular economy for plastics that starts with packaging. At its core EMF is focusing on the elimination of problematic plastic packaging through re-design, innovation and recycling. The EMF believes approximately 70% of plastics can ultimately be reused or recycled.

Increasingly corporations are responding to the public’s concerns regarding environmental issues such as plastics which is resulting in innovation and change. In our view, governments will likely be the next force to ban highly wasteful and damaging plastic products such as shopping bags and straws as we have seen in some parts of the world. Importantly, governments will also need to invest in the infrastructure to reuse and recycle waste streams to ensure these are in place to support a more sustainable future.

The winners and losers of a more sustainable approach to plastics

Plastics will continue to play an important part in consumer packaging. However, this role will likely be very different to today. Companies like Amcor will continue to benefit from the obsession by consumers on freshness, recyclability, and ultimately less waste dictating terms. Other sectors that may benefit are fibre and aluminium packaging, which is seen as having higher recyclability rates compared to plastic. Companies orientated around recycling should also be winners, albeit we believe this is longer dated and requires government support to improve collection and processing infrastructure, and ultimately returns.

In our view, businesses not adept to change such as commodity style single-use plastic packagers will continue to see share losses and revenue pressures. Producers of virgin materials, such as resins, are also likely to suffer as the proportion of recycled plastics increases over time.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Firetrail believes the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail disclaims all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

 

 

Why high conviction investing requires a long-term mindset

Why high conviction investing requires a long-term mindset

Patrick Hodgens, Managing Director & Portfolio Manager & Kyle Macintyre, Investment Specialist

At Firetrail, we believe that high quality, high conviction investment managers can outperform the index over the medium to long-term. Over the short-term however, even an investor with perfect foresight will have periods of underperformance.

In the article below, we explain the findings from an experiment we conducted to assess the risk and return profile of a high conviction stock picker with perfect foresight. The amazing excess returns generated over the long-term may not surprise you. What might surprise you, is the conviction and long-term thinking required to stay the course and reap the rewards from our ‘perfect stock picker’.

The Warren Experiment: Designing the ‘perfect stock picker’  

For our experiment, we wanted to assess the performance of a perfect high conviction stock picker over the short, medium and long term. To be clear, in order to conduct this experiment our ‘perfect stock picker’ is required to have perfect foresight. That is, they know which stocks will win prior to investing. For fun, we named our perfect stock picker Warren, after one of the greatest stock pickers of our time, Warren Buffet.

For the Warren Experiment, we selected parameters that reflect the Firetrail high conviction investment strategy and style. The key inputs for Warren’s portfolio are summarised below:

  1. Investment universe and benchmark: S&P/ASX 200 Accumulation Index
  2. # of positions held: The top 20 performing stocks in the universe over the period, equally weighted at the beginning of the period
  3. Holding period/rebalance: 3-years, to reflect our own medium-term forecasting and holding period
  4. Time period: 31st December 2000 to 31st December 2018

How did Warren’s portfolio perform over the long-term?  

The long-term results of Warren’s stock selection are unsurprisingly impressive. As the table below highlights, Warren generated 32.8% per annum above the Benchmark over the 18-year period. If you had invested just $10,000 in Warren’s high conviction portfolio, you would have over $4.5m at the end of the experiment. If you invested the same amount in the market, which still provided a solid return of 7.7% per annum over the same period, your investment would be worth $38,000. Due to the power of compounding, excess returns can have a significant impact on return outcomes for investors over the long-term.

The Warren Experiment: Return Statistics

Source: Firetrail Research

Of course, Warren has perfect foresight in our experiment and the portfolio returns are theoretical. So, the incredible performance result is to be expected. In reality, the risk required to generate the above returns would make Warren’s strategy ‘uninvestable’ for the typical investor.

The Warren Experiment: Risk Characteristics

Source: Firetrail Research

The table above highlights the Risk Characteristics of Warren’s portfolio. To put this into context, an average high conviction manager would expect to have a Tracking Error of 3% to 5%. Under normal conditions, the investor would expect to out/underperform the Benchmark by approximately the same range of 3-5% p.a. over the long-term. Warren’s portfolio had a Tracking Error almost 3 times the average high conviction manager. The Portfolio Volatility is also higher than the market. Whilst the theoretical returns in the Warren Experiment are high, so is the active risk taken to achieve those returns.

Long-term vs short-term performance  

To outperform the Index, your portfolio needs to be different to the Index. High conviction investors typically differentiate their portfolios through:

  1. Portfolio concentration: Typically investing in 20 to 40 of their best ideas
  2. Position sizing: Position sizing generally reflects the conviction the investor has in the underlying stock. Higher conviction = larger position size
  3. Risk management: Which differs among investors. Our approach aims for the risk and returns of the portfolio to be driven predominantly by stock selection, where we believe we have an edge (as opposed to macroeconomic factors which we believe are largely binary and unpredictable)

Due to the differences in a high conviction portfolio’s positioning, the performance outcomes can vary significantly from the Index and the average investor. Put simply, if a high conviction investor gets more stock calls right than wrong, they will outperform. Conversely, if they get more stock calls wrong than right, then they will underperform.

In our view, a high quality, high conviction investor should get 60% or more of their stock calls right over the medium to long-term. After all, even Warren Buffet (arguably one of the greatest investors in our history), doesn’t get every stock call right. But an investor who gets 60% or more of their stock calls right should generate meaningful outperformance over the long-term.

However, in the short-term, even an investor with perfect foresight will experience performance volatility. The below chart highlights the significant drawdowns experienced by Warren in our perfect stock picker experiment over multiple short-term periods. Despite getting 100% of stock calls right over the medium-term, Warren experienced 17 significant short-term underperformance periods of 5% or more under the Benchmark.

The Warren Experiment: Short-term underperformance of 5% or more below the Benchmark

Source: Firetrail Research

The largest drawdown Warren experienced was 26% below the Benchmark between June 2008 to October 2008. This drawdown took almost 2 years to recover and raises the question as to whether Warren would have survived as an investment manager post the GFC?

The second largest drawdown was over 12% and occurred during the December quarter of 2018, a period where many active Australian equity managers including Firetrail underperformed. Interestingly, despite the underperformance, Warren’s theoretical portfolio still delivered 45.3% pa over the 3 years to 31 December 2018, 38.6% pa above the Benchmark return over the same period. An impressive result if you were able to maintain conviction and stay the course.

Conclusion: High conviction investing requires a long-term mindset  

Finding a high conviction manager that can deliver excess returns can have a material impact on your returns over the long-term. However, a high conviction approach is not for everyone. It requires a long-term mindset and a belief that your investment manager will get more of their stock calls right than wrong over the medium to long-term.

As our Warren Experiment shows, even an investor with perfect foresight will experience short-term periods of underperformance. These periods of short-term underperformance are painful for investors and investment managers alike. In our experience, high conviction investors that maintain conviction, stay true to their approach and focus on the longer-term will be rewarded over time.

If you would like more information including presentation slides, charts or underlying data from the Warren Experiment for use with your clients, please contact us at ClientReporting@Firetrail.com

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future. The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Firetrail believes the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail disclaims all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this communication is prohibited without obtaining prior written permission from Firetrail. Firetrail and its associates may have interests in financial products and may receive fees from companies referred to during this communication.

Three reasons Baby Bunting is booming

Three reasons Baby Bunting is booming

Eleanor Swanson, Analyst

Baby Bunting is a baby specialty goods retailer with a network of 50 stores across Australia. The company has 12% share of the $2.4 billion of the domestic baby goods market, generating $300 million of sales last financial year. In this article, we highlight three reasons why Baby Bunting is booming, and why it is one of our top picks in the Australian small cap retail sector.

1. Market Consolidation: Bye-bye baby retailers 

During FY18 there was an unprecedented level of store closures in Australia’s baby retail sector. Four of Baby Bunting’s major competitors went into administration including Babies “R” Us and Baby Bounce. The collapse of these speciality retailers has left $138 million or almost half of Baby Bunting’s annual turnover up for grabs. Given that its nearest competitor now has just three stores, Baby Bunting is in a unique position to benefit from the significant consolidation within its sector. We expect the company to capture approximately 30% of the sales from these defunct retailers where store catchments overlap.

2. Store roll-out: Baby Bunting is growing up 

Baby Bunting intends to increase its store count from 50 to 80, with six new stores opening FY19. In December 2018, the company opened its first mall location at Chadstone, the biggest shopping centre in the Southern Hemisphere. Not only will Chadstone be a top performing store, it represents a new opportunity for Baby Bunting to branch out from its big-box, home-centre roots, to a premium retail offering in malls. The mall opportunity is not factored into its current store-roll out plan.  Baby Bunting is one of the few retailers on the ASX with both a store roll-out story and a significant market share opportunity. We expect Baby Bunting to deliver up to 15% revenue CAGR over the next three years.

3. Scale benefits: The big kid on the block 

The size and scale of Baby Buntings’ store network and operations creates a formidable barrier to entry. First time parents wish to see, touch and receive advice on big ticket items such as car seats and prams due to the emotional nature of the purchase. Suppliers are conscious that they need an in-store presence. Given Baby Bunting is the sole baby retailer with a footprint in 5 out of 6 states, it is crucial that a strong relationship with the retailer is nurtured by suppliers. Baby Bunting is therefore in the driver’s seat when negotiating buying terms and product exclusivity deals. Its sheer size means it is also eligible for large volume discounts, which competitors with three or less stores cannot attain. As a result of its market dominance, Baby Bunting can offer competitive pricing and product differentiation, driving in-store traffic whilst expanding gross margins.

Conclusion: The Baby Bunting boom continues  

Baby Bunting presents a rare opportunity to own a retailer that is growing sales and expanding margins.  An unprecedented level of market consolidation in the Australian baby retail sector is allowing Baby Bunting to grow sales and profitability materially in a short space of time. Over the next few years, we expect Baby Bunting’s earnings to double as it continues to benefit from market consolidation, revenue growth and improving scale benefits.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrail.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Hey Earnings, where’s my Cash?

Hey Earnings, where’s my Cash?

James Miller, Portfolio Manager

How can Treasury Wine Estates report cashflow of $27m and profit of $219m? Should we be concerned?

One of the joys of analysing investment opportunities is that every opportunity is unique. In making investment decisions, we look at each company through a slightly different lens. During the February reporting season one of the key issues that arose was the mismatch between cashflow and earnings for many companies.  In the article below we explore why this happens, and how it affects our decision making.

There are three key areas to focus on:

  1. What drives the difference between cashflow and earnings?
  2. When should you be concerned?
  3. How does it affect our decision making?

We conclude that recurring or deteriorating cashflow issues may be symptomatic of a broader issue in the business. In our Absolute Return Strategy, poor cashflow can be a red flag for further research of potential short opportunities.

1. What drives the differences between cashflow and earnings? 

Changes in working capital can often explain the key differences between operating cashflow and earnings. Key drags on cashflow for a company can be:

  • Increasing receivables – a company is yet to be paid from customers
  • Reducing payables – suppliers being paid quicker by the company
  • Increasing inventory – a company is yet to sell goods they have produced

Ideally you have high payables, low inventory and low receivables. The combination means a company is getting paid quickly, for goods you recently produced, and not having to pay your suppliers quickly.

2. When should you be concerned? 

Cashflow is a concern if you believe that the company isn’t going to receive that cash at some point in the future. Two companies that had poor cashflow conversion in the Dec 18 half were engineering firm Worley Parsons and wine exporter, Treasury Wine Estates. Cash conversion is a ratio of operating cashflow to accounting earnings – the higher the better.

We weren’t concerned in February 19 when Worley Parsons announced operating cashflow of $21m versus profit of $98m. For companies with skinny margins and large revenues, such as Worley Parsons, a small move in timing of receivables or payables can have large effects on cashflow. To put it in context, in that 6-month period Worley had ~$2.6b of cash receipts from customers and paid nearly $2.6b in payments to suppliers. Put simply, the scale of the cashflows in and out of the company during the period were large compared to the profit, so a couple of days change in payment timing can make all the difference.

One result that warrants more research was Treasury Wine Estates (TWE). Management went to the effort of explaining that, whilst their 31 December 2018 cash conversion was just 54%, at the end of January this had stepped up to 85%. A possible explanation of changes in cash conversion is the timing of sales. One key question that springs to mind is whether Treasury’s customers have been receiving better payment terms to get sales completed in the half year?

For the contracting sector (think companies like Cimic, Monadelphous and Lend Lease) poor cashflow always requires investigation.  The first sign of a large construction contract encountering problems is often the customer stopping or slowing payments to the contractor until the problem is rectified.  Given that the profit on construction contracts is recognised by a management assessment of completion progress, the profit can be more subjective than the cashflow.

3. How does it affect our decision making? 

Earnings are the key metric we use to assess most companies.  Earnings are far less volatile than cashflow and enable the best comparison for valuation between companies on a timely basis. For example, doing cross-industry comparison, we can compare banks (with very messy cashflows) to resource companies effectively using earnings as the primary metric.

However, understanding a business’s cashflow is also critically important. Typically, a short-term hiccup in cashflow, that is well explained by management, is not a concern.  But recurring poor cashflow, or deteriorating cashflows in certain industries, can be a warning sign.

Summary 

Making investment decisions involves looking at many aspects of a company’s financial position. One critical component is understanding a company’s cashflow. Recurring or deteriorating cashflow issues may be symptomatic of a broader issue in the business. In our Absolute Return Strategy, poor cashflow can be a red flag for further research of potential short opportunities.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrail.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Why WorleyParsons is set to benefit from the oil and gas cycle

Why WorleyParsons is set to benefit from the oil and gas cycle

Blake Henricks, Deputy Managing Director & Portfolio Manager

Worley Parsons is an Australian engineering company that specialises in global oil and gas projects. In this article, I explain why Worley Parsons is set to benefit as the oil and gas investment cycle turns positive. I’ll outline our investment thesis in Worley Parsons, focusing on three key areas.

  1. The oil and gas investment cycle
  2. Cost-out initiatives
  3. Worley Parsons valuation

The article will provide you with a deeper understanding of ‘What Matters’ for Worley Parsons and why I believe it is a material opportunity for our investors.

1. The oil and gas investment cycle 

At the peak of the oil and gas cycle in 2014, oil soared to US$115 per barrel. The subsequent collapse in the oil price to below US$30 per barrel in 2016, resulted in significantly reduced capital expenditure (capex) in oil and gas projects globally, as major energy producers focused on protecting balance sheets.

As shown below, the reduction in oil and gas expenditure significantly impacted Worley Parsons’ revenue, which fell 50% from their peak in 2014.

Worley Parsons Revenue ($AUDm)

Source: WorleyParsons Financial Data

After four years of underinvestment, we believe we are at the bottom of the oil and gas investment cycle. Our research indicates that investment in oil and gas projects needs to return to meet global energy demand. Worley Parsons is set to benefit from the return of the oil and gas cycle. Pleasingly, early indicators are looking strong. Over the past 6 months, Worley Parsons has won many contracts giving us confidence that the worst is behind us.

2. Cost-out initiatives 

Worley Parsons has embarked on significant self-help initiatives over the past few years. A disciplined focus from management has led to a reduction in costs of around $500m since 2016. For a business that made $299m of EBIT on FY18, the cost-out has been material.

In addition, Worley Parsons announced a transformational acquisition of US based Jacobs’ Energy, Chemicals and Resource business in 2018. Jacobs is also a global engineering firm, with less oil and gas exposure. The acquisition provides attractive synergies and strong EPS accretion for shareholders. Importantly, the purchase was conservatively funded and positions Worley Parsons as a market leader in its key categories. Once the acquisition settles, expected early to mid-2019, the purchase provides shareholders with a more diversified, stable earnings profile and gives Worley Parsons the scale and capabilities to bid on some of the largest energy projects around the world.

3. Worley Parsons valuation

Worley Parsons is incredibly undervalued. Today, it is trading close to a market multiple on FY20 earnings, when factoring in synergies from the recent Jacobs acquisition.

The recent 30% fall in oil price in late 2018 and the near doubling of shares on issue has caused the Worley Parsons’ share price to underperform in the short-term. In our view, the market has incorrectly assumed that lower oil prices will cause a sustained lower level of investment in oil and gas projects. Whilst lower oil prices may cause a pause in 2019 capex, investment in global oil and gas projects needs to return over the medium term for global oil supply to keep up with demand. At this point in the capex cycle, Worley Parsons is incredibly undervalued.

Conclusion 

After four years of underinvestment, the oil and gas cycle is turning positive. Worley Parsons is well positioned to benefit as the market leader in oil and gas engineering. In our view, Worley Parsons is significantly undervalued at this point in the cycle. With significant earnings leverage and a compelling valuation, Worley Parsons will be a material opportunity for patient investors.

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