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Big opportunities for small cap investors in IPOs and secondary placements

Big opportunities for small cap investors in IPOs and secondary placements

2021 was an exciting year for initial public offerings (IPOs) and placements. 55 companies with an offer price greater than A$20 million made their debut on the ASX during the year. Up a staggering 62% from the year before! Secondary placements experienced a more modest increase, up 6% from 2020.

Most equity capital market (ECM) activity took place in the small cap end of the market. Providing a material opportunity for institutional small cap managers like Firetrail to add value for their investors.

In this article, we analyse the success of small cap IPOs and placements in 2021, provide key takeaways for investors, and what to expect in capital markets in 2022. We conclude that corporate activity will remain elevated in small companies throughout 2022. Creating meaningful opportunities for investment managers willing to do the work to identify the best opportunities.

 

IPOs and placements outperformed in 2021

 

It wasn’t just the sheer number of IPOs and placements that broke records in 2021. Together, new ASX-listings raised a total of A$12 billion! Among them were a record number of billion-dollar floats, such as APM, SiteMinder and PEXA.

On the first day of trading, these IPO companies outperformed the market by an average of 20%. However, we did see this outperformance moderate by the end of the year.

We saw the inverse occur in the market for secondary offerings. Average day one performance hovered around 10.1%. While calendar year performance rose to 15.4%! The total amount raised by secondary offers was A$37.7 billion.

But that doesn’t seem like an accurate reflection of performance from a market perspective.

 

Careful stock selection is critical

 

If we adjust for the size of the raise, the story changes. We see big declines for first day and calendar year performance for both IPOs and secondary placements. Suggesting that the relative performance is skewed by a handful of big winners.

In the IPO space, performance was dominated by a few key players. DGL, a chemical manufacturing and storage group, and Trajan, an analytical science and devices company, experienced greater than 100% returns in the calendar year.

To account for this asymmetry, we took the median performance for the calendar year. The median return for IPO stocks was just -4%. Providing a more accurate reflection of capital market performance.

Clearly, an ability to pick winners is key to harnessing value from corporate activity. The chart below compares the relative performance of IPOs that raised more than $50 million. While average performance was strong, there were more losers than winners.

Through deep fundamental analysis, Firetrail were able to pick the winners this year. The median return from our IPO participation was 18% for the 2021 calendar year (shaded in grey in Figure 1).

Careful selection is also key for managers trying to maximise returns from secondary placements. In 2021, we saw a wide dispersion in results.

The best returning secondary issuances were in companies in need of balance sheet repair. The average placement in this category delivered 33% excess. In many instances we observed that the ‘raise’ was already priced in by the market. Hence recapitalisation was the catalyst to refocus the market on business fundamentals.

The market also rewarded companies raising capital to grow organically far more than M&A. Raisings for growth dominated the market (Figure 3). In contrast, there were few M&A bargains in 2021 due to intense competition for assets. Many companies were willing to pay listed multiples for strategic acquisitions.

 

Opportunities will remain elevated in small caps in 2022

 

ECM events are a consistent source of opportunity and strong returns for small cap investors. Access to these opportunities is key, and the Firetrail team have a strong track record of leveraging our corporate relationships and fundamental expertise to access attractive corporate opportunities for our investors. Since the inception of the Firetrail Team’s Small Companies strategy in 1998, previously the Macquarie Australian Small Companies Fund, these events have contributed an average 20% of the total excess returns, or ~3% p.a.

Looking ahead to 2022, low interest rates and high valuations will continue to encourage companies to raise capital. We expect ECM activity to remain elevated and to continue delivering material opportunities for small cap investors like Firetrail.

 

Conclusion

 

2021 was a year of frantic ECM activity and we see no sign of this abating as we move through 2022. As small cap investors, we are excited by the opportunity and potential returns offered by IPOs and secondary placements in the coming year. Our experience shows that meaningful returns are out there if managers are willing to do the work to find them!

 

This article is prepared by Firetrail Investments Pty Limited (‘Firetrail’) ABN 98 622 377 913 AFSL 516821 as the investment manager of the Firetrail Australian Small Companies Fund ARSN 638 792 113 (‘the Fund’). This communication is for general information only. It 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. 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 before doing so. Past performance is for illustrative purposes only and is not indicative of future performance. Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371 (‘PFSL’) is the product issuer of the Fund. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) ABN 22 100 325 184. The Product Disclosure Statement (‘PDS’) and the Target Market Determination (‘TMD’) of the Fund is available at www.firetrail.com. Any potential investor should consider the PDS before deciding whether to acquire, or continue to hold units in, the Fund.


Whilst Firetrail, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness 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, PFSL and Pinnacle 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. This disclaimer extends to any entity that may distribute this communication.

The information is not intended for general distribution or publication and must be retained in a confidential manner. Information contained herein consists of confidential proprietary information constituting the sole property of Firetrail and its investment activities; its use is restricted accordingly. All such information should be maintained in a strictly confidential manner.

Any opinions and forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future.

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. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.

This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Firetrail.

Firetrail: Green by name, going greener by nature!

Firetrail: Green by name, going greener by nature!

Can we be sure that we are removing the same amount of carbon dioxide from the atmosphere as we have emitted as a business? That was the simple question we looked to answer as we approached our business carbon neutrality this year with the same rigour as our stock analysis.

In the process of measuring emissions, researching offset projects, and then purchasing offsets, we were surprised at what we found. Not only is carbon offsetting a largely unregulated industry, but most carbon offsets don’t even remove carbon dioxide from the atmosphere! Read on to find out how Firetrail enhanced our carbon emissions offsetting process for FY21. By doing our homework, and focusing on what matters, we strived to ensure Firetrail genuinely is a carbon neutral business.

 

Step one –  measure the emissions

 

Firetrail expanded the scope of our emissions estimation process this year to include assessments on:

  • Electricity usage
  • Staff commutes and taxis
  • Waste/water/paper/gas usage Flights and hotel stays
  • Supply chain costs, including cleaning, software, and catering, and
  • Working from home emissions when government restrictions were enforced, such as lighting, computer usage and heating

We worked in collaboration with Pinnacle, who have engaged in offsetting their business emissions for the last few years and achieved Climate Active Carbon Neutral certification for their FY20 emissions. Pinnacle also released their inaugural Corporate Sustainability Report in FY21, including details on their carbon inventory assessment, which can be found here. Firetrail’s calculated carbon emissions for FY21 were 134 tonnes of carbon dioxide equivalent. A breakdown of the contribution to total emissions is provided below.

There are a couple of anomalies to highlight in the emissions for the past year. The Covid pandemic continued to impact daily life. This meant that business travel was virtually non-existent for the Firetrail team. We expect business travel to increase as border restrictions (both domestic and international) are eased, and as such expect that this portion of our carbon emissions will increases substantially in the future. We also avoided major lockdowns for the majority of the team in the July 2020-June 2021 period. However, we expect working from home emissions will be a feature of the FY22 carbon emissions due to the extended lockdowns at the beginning of the period. We admit our measurement process is not perfect, and estimation methods are evolving and improving over time as we get access to better data. Where relevant, we erred on the conservative side through this process. Firetrail will look to enhance our approach as we continue in our offsetting efforts in the year ahead.

 

A tonne of carbon is not a tonne of carbon

 

Once we calculated our total business emissions, we began the search for an appropriate way to offset them. The atmosphere cannot tell the difference between a tonne of carbon dioxide removed from the atmosphere and a tonne of carbon dioxide emitted into the atmosphere. It doesn’t care how, or where this is done. It’s all one planet and its all the same. But when it comes to offsetting, this isn’t the case! What really matters to us is ensuring that if we are offsetting our emissions, that we are genuinely removing carbon dioxide from the atmosphere.

Source: Bloomberg

Carbon offset markets are evolving rapidly. Despite this evolution, less than 5% of carbon offsets are actually removing carbon dioxide from the atmosphere. These methods are Afforestation and Reforestation, and Carbon removal technologies (the far-right columns in the graph above). Most offsets still are firmly in the ‘prevention’ bucket, i.e. they are potentially stopping carbon from entering the atmosphere. The big question here is whether most of these projects would have gone ahead anyway.

The efficacy of the two biggest sources of offsets is questionable:

  1. Renewable energy projects. The logic here is by building a solar farm or wind farm, you would displace energy that previously came from a fossil fuel source and should earn credits for it. There is no due diligence however on whether this occurs. Secondly the projects would have likely gone ahead anyway given the lower cost of renewables development. Fortunately – most voluntary carbon credit schemes are now starting to disallow these forms of credits.
  2. Avoided deforestation. Best described as “Unless you pay me, I will chop that forest down”. It’s very hard (if not impossible) to prove whether the trees would have stayed anyway. In many cases the land is protected by covenants or planning restrictions also. And even if the trees do stay – it’s just status quo for the atmosphere!

Of the two options which genuinely offset carbon emissions:

  1. Carbon removal technologies are very expensive. For the fee of 960 Euros (AUD ~$1,500), Climeworks will suck 1 tonne of CO2 out of the atmosphere. Read more here.
  2. Forest planting is a far lower cost option. As a tree grows, about half its mass is carbon, formed by breathing carbon dioxide in from the atmosphere. In Australia, the cost is ~$20 for this – depending on land prices.

To ensure that offsets pass the pub test, offset projects should be a) a project that is not the status quo and b) truly reduces carbon in the atmosphere.

 

Investing in the Flanders Carbon Project

 

Our science based, fundamental approach led Firetrail to purchase offset units from a Queensland native vegetation regeneration project called ‘The Flanders Carbon Project’. The project is subject to independent audit as well as review by the Clean Energy Regulator. Once we purchased these Australian carbon credit units (“ACCUs”), we cancelled them in the Australian National Registry of Emissions Units, so that no one else can buy them. Doing this and avoiding any double counting means the offsetting is real. At $33 per tonne, the cost of doing this was more than double the cost of other carbon offsets we investigated.

The Flanders Carbon Project is situated in the southwest Darling Downs region of Queensland. Vegetation is growing and removing carbon dioxide from the atmosphere on land which was previously intensively overgrazed. The Flanders Project is spread over 32,000 hectares, and in FY21 140,976 tonnes of CO2 will be removed from the atmosphere. From an Australian national emissions perspective, the reforestation of Queensland is also critical. During the 2000s the rate of land clearing (destroying plants) was adding almost 100 million tonnes per annum to Australia’s emissions. This process is now reversing through projects such as the Flanders project and reforestation – this can be seen in the dark green line below. Excluding this Australia’s emissions reductions are minimal (ex-Covid impacts).

Source: Australian National Greenhouse Gas Inventory

 

Conclusion

 

Firetrail are dedicated to playing our part in creating a positive future environment for all our stakeholders and continue to make significant progress in our approach to responsible investing and sustainability. Our journey to carbon neutrality was an eye-opening experience this year, as we enhanced our methodology on not only emissions measurement, but choice in offsets. Carbon markets are certainly evolving, and our advice would be to do your due diligence when embarking on your carbon offsetting endeavour! We are very happy to share more on what we have learnt thus far and hope to keep developing our knowledge through engagement with our clients, portfolio companies and peers.

Please reach out if you would like to hear more.

 

This article is prepared by Firetrail Investments Pty Limited (‘Firetrail’) ABN 98 622 377 913 AFSL 516821 as the investment manager of the Firetrail Australian Small Companies Fund ARSN 638 792 113 (‘the Fund’). This communication is for general information only. It 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. 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 before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.

Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371 (‘PFSL’) is the product issuer of the Fund. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) ABN 22 100 325 184. The Product Disclosure Statement (‘PDS’) and the Target Market Determination (‘TMD’) of the Fund is available at www.firetrail.com. Any potential investor should consider the PDS before deciding whether to acquire, or continue to hold units in, the Fund.

Whilst Firetrail, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness 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, PFSL and Pinnacle 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. This disclaimer extends to any entity that may distribute this communication.

The information is not intended for general distribution or publication and must be retained in a confidential manner. Information contained herein consists of confidential proprietary information constituting the sole property of Firetrail and its investment activities; its use is restricted accordingly. All such information should be maintained in a strictly confidential manner.

Any opinions and forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future.

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. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.

This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Firetrail.

Monthly Insights | Two COVID-19 trends no one is talking about

Monthly Insights | Two COVID-19 trends no one is talking about

Two interesting trends have emerged from the pandemic. Australians are having more babies and they are swapping out their city lifestyle for the beach and bush. In contrast to short term phenomena such as the hoarding of toilet paper, these shifts have potential long lasting implications for the economy and listed companies. In this article we discuss these two trends and the opportunities they have created for companies in the Firetrail Australian Small Companies Fund.

 

COVID baby bump or boom?

When large mortality events occur including diseases, earthquakes and wars, birth rates decline and on average, reach a trough some nine months later. As shown in Figure 1 below, this pattern holds for events such as both World Wars and the influenza outbreaks of 1918. Following an initial drop, fertility tends to rebound. Birth rates begin to recover ~11 months after an epidemic and then increase in the subsequent 1-5 years.

The end of World War II sparked one of the biggest baby booms of the 20th century. Could we be at the start of a post-COVID generation? Estimates by academics regarding the post-COVID birth recovery vary widely. The Institute for Family Studies notes that COVID has the potential to boost births over the next four years by anywhere from 0.3% to 40%. We admit this is a wide range to draw a conclusion from just yet. However, recent trends in birth rates and anecdotal evidence provide reason for optimism:

  • The number of babies born in NSW public hospitals during the June quarter was the largest on record. A total of 19,113 births were reported, an increase of 9% on the prior year. This is a significant upswing compared with the declining fertility rate over the last 10 years.
  • Prior to the pandemic IVF volumes had been increasing gradually over time. But in FY21, 98,290 IVF cycles were recorded, up 29.3% compared to FY20 and the highest figure on record.

The increase in IVF volumes has benefited portfolio holding Monash IVF. During FY21, Monash recorded a 40% increase in new patient stimulated cycles and there are no signs of a slowdown. New patient registrations in 2H21 were up 8% compared to 1H21, and up 35% on 2H20. ~70% of patient registrations are converted into patient treatments within ~3-6 months.

COVID-19 has sparked a behavioural shift amongst Australians. Restrictions on travel and a greater focus on family, health and wellbeing is resulting in a re-direction of priorities. While it is still early days to call it a baby boom, recent birth rates and trends IVF trends indicate we are at the onset of a baby bump. 

Looking beyond the headline impacts of escaping the city

For decades the lack of job opportunities in regional areas has seen many Australians relocate to capital cities. Then the pandemic hit. The sudden shift to working from home has made a tree change or sea change possible and more attractive for many Australians. ABS data shows net migration to regional Australia is the highest since records began two decades ago. In the 12 months to March 2021, net migration to regional areas increased 87.1% year-on-year. The impact of demand for housing on prices in regional towns has been widely publicised. Digging beneath the headlines, second order impacts are more interesting and perhaps even more important.

Demand for products and services across some industries increase as more people move to regional areas. Regional houses are larger and hence require more bricks to build and more lights to illuminate. For listed companies with strong brands, regionalisation has created an avenue to expand store footprints, increase sales, and grow market share. Portfolio holding Beacon Lighting is capitalising on this opportunity. It plans to open three additional regional stores this year including Ellenbrook (WA), Butler (WA) and Melton (VIC). The City of Melton, where Beacon Lighting is expected to open a new store in FY22, is one of the fastest growing areas of Australia. 11 new suburbs have been proposed to be added to it! In 2020, the city recorded a population increase of 4.6%, more than double the increase for Greater Melbourne which grew at 1.6%.

Increased sales in regional areas often come hand-in hand with supercharged margins. This is a direct result of limited competition and lower costs of doing business. A key cost line for many retail companies is rental expense. Bendigo is over 150km away from Melbourne CBD. Looking at recent advertised rents, it is ~50% cheaper to rent a large retail space in Bendigo than it is in areas close to the Melbourne CBD like Southbank. Going regional also comes with less competition from smaller niche retailers that often compete on price. Regionalisation has created an opportunity for companies like Beacon Lighting to increase sales, grow market share and generate better returns on a per store basis.

 

Conclusion

There are many interesting phenomena that have emerged from the pandemic, many with direct and lasting implications for listed companies. Restrictions on travel and a refocus on family has contributed to a spike in birth rates and IVF volumes. The sudden shift to working from home has driven many Australians away from the cities to regional areas. The baby bump (or potential boom?) and regionalisation trends have created an opportunity for many companies in the Firetrail Australian Small Companies Fund.

 

This article is prepared by Firetrail Investments Pty Limited (‘Firetrail’) ABN 98 622 377 913 AFSL 516821 as the investment manager of the Firetrail Australian Small Companies Fund ARSN 638 792 113 (‘the Fund’). This communication is for general information only. It 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. 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 before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.

Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371 (‘PFSL’) is the product issuer of the Fund. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) ABN 22 100 325 184. The Product Disclosure Statement (‘PDS’) and the Target Market Determination (‘TMD’) of the Fund is available at www.firetrail.com. Any potential investor should consider the PDS before deciding whether to acquire, or continue to hold units in, the Fund.

Whilst Firetrail, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness 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, PFSL and Pinnacle 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. This disclaimer extends to any entity that may distribute this communication.

The information is not intended for general distribution or publication and must be retained in a confidential manner. Information contained herein consists of confidential proprietary information constituting the sole property of Firetrail and its investment activities; its use is restricted accordingly. All such information should be maintained in a strictly confidential manner.

Any opinions and forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future.

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. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.

This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Firetrail.

Monthly Insights | A breath of fresh air for investors looking for global growth

Monthly Insights | A breath of fresh air for investors looking for global growth

August 2021

ResMed is a $50 billion medical device company that specialises in the treatment of sleep-disordered breathing and other respiratory illnesses. It is a market leader in the production of cloud-connected medical devices.

ResMed’s share-price has performed strongly in recent months, largely in response to a product recall by its main competitor Philips. Notwithstanding its near 40% rise, we believe ResMed remains a compelling investment opportunity with substantial valuation upside. In this article, we explain why.

 

ResMed 101

The most common illness treated by ResMed products is obstructive sleep apnoea – a condition in which sufferers stop breathing involuntarily for extended periods during sleep. It occurs because the muscles that support the soft tissues in the throat temporarily relax, narrowing or closing the airway such that breathing is cut off. Sleep apnoea can seriously inhibit regular functioning and is related to high blood pressure, heart attacks and daytime fatigue.

ResMed manufactures continuous positive airway pressure (CPAP) devices to assist patients with sleep apneoa. These devices send a steady flow of oxygen into the nose and mouth during sleep, keeping the airways open and allowing normal respiratory function. The CPAP device involves a machine and a separate respiratory mask, see figure 1.

Less common but equally debilitating is chronic obstructive pulmonary disease (COPD) – a lung disease that causes obstructed airflow and predominantly occurs in smokers. ResMed produces cloud-connected ventilators to treat COPD, depicted in figure 2.

 

A large addressable market with low penetration

ResMed’s addressable market is large, growing and predominantly unpenetrated. ResMed assumes a total addressable market of 1.5 billion people based upon the following estimates:

  1. Sleep apnoea – 936 million people with sleep apnoea world-wide – whether that be obstructive sleep apnoea, central sleep apnoea or a combination of the two.
  2. Chronic obstructive pulmonary disease (COPD) – 380 million people.
  3. Asthma – 340 million people worldwide. While asthma cannot be cured, its symptoms can be managed using ResMed devices.

While we think ResMed are overstating the opportunity by capturing cohorts with very mild symptoms, we do agree that the opportunity is very large.

Using a bottom-up approach, we estimate the sleep apnoea addressable market to be 401 million people, as reflected in the figure below:

ResMed believes penetration currently sits below 20%, which means more than 80% of the large addressable market is up for grabs.

Putting it together, we see significant growth for ResMed’s end market, driven by:

  • Population growth – more people in the world
  • Obesity growth – continued growth in obesity and prevalence of sleep apnoea
  • Penetration – awareness and treatment growing from current <20% levels

 

An opportunity to increase market share

ResMed’s key competitor in CPAP devices is Philips. In June 2021, Philips voluntarily recalled a range of products, including their legacy CPAP range.

The recall was driven by deterioration of the sound abatement foam used in Philips’ first generation DreamStation CPAP flow generators and several of its other devices. In total, it expects to repair or replace ~3.5 million devices over the course of 12 months.  The withdrawal of Philips from the market presents a significant opportunity for ResMed to dominate new CPAP flow generator installations over the near term while Philips is busy replacing its existing fleet.

Factoring in the impact of the recall, we expect a 10% increase to ResMed’s share of new patient demand in the first half of fiscal year 2022. Moving into the second half, as the impact of chip shortages lessens and ResMed is able to lift production, we see this share increasing further to 72%. There is the potential for even greater upside if ResMed can negotiate a lift in chip supply earlier than anticipated.

This trajectory does however depend on the pace with which Philips returns to market and begins servicing new patients. Currently, Philips expects to be out of market for twelve months, but their market share loss could last longer. Cochlear provides a useful case study – when it initiated a product recall in 2011, its market share remained depressed for almost ten years, showing a long-term impact on market structure. Even after Philips returns, we believe some of ResMed’s market share gains will remain.

With mask sales also likely to benefit as more new patients purchase ResMed devices, we see total revenue growth for ResMed in the mid-teens for at least the next two years.

 

Cloud-based care delivers increased efficiency and a better user experience

ResMed began its venture into cloud-based health informatics with the purchase of information technology group Brightree in 2016. It has since continued to add to its technology offering with the purchase of several other software providers, most recently Snapworx and Citus Health. These acquisitions provide ResMed with a substantial suite of digital solutions across a number of types of out-of-hospital care.

As shown in figure 4 below, the integration of Brightree services into ResMed products has substantially improved patient adherence rates.

We see scope for ResMed to continue to integrate its SaaS business more closely with healthcare providers over the medium-long term, driving significant value and improved retention.

 

Conclusion

ResMed is a market leader in the production of CPAP devices with a proven capacity to attract and retain a large customer base. We consider ResMed well-positioned to capitalise on the short-term market disruption caused by the Philips recall and to strengthen its leadership position over the medium to long term. Given this, we believe it remains undervalued by the market. ResMed is a holding in the Firetrail High Conviction Fund and the Absolute Return Fund.

 

Disclaimer:

This document is prepared by Firetrail Investments Pty Limited (‘Firetrail’) ABN 98 622 377 913 AFSL 516821 as the investment manager of the Firetrail Australian High Conviction Fund ARSN 624 136 045 and the Firetrail Absolute Return Fund ARSN 624 135 879 (‘the Funds’). This communication is for general information only. It 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. 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 before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.

Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371 (‘PFSL’) is the product issuer of the Fund. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) ABN 22 100 325 184. The Product Disclosure Statement (‘PDS’) of the Fund is available at https://firetrail.com/products/firetrail-australian-high-conviction-fund. Any potential investor should consider the PDS before deciding whether to acquire, or continue to hold units in, the Fund.

Whilst Firetrail, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness 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, PFSL and Pinnacle 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. This disclaimer extends to any entity that may distribute this communication.

The information is not intended for general distribution or publication and must be retained in a confidential manner. Information contained herein consists of confidential proprietary information constituting the sole property of Firetrail and its investment activities; its use is restricted accordingly. All such information should be maintained in a strictly confidential manner.

Any opinions and forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future.
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. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.

Monthly Insights | Lendlease stock story

Monthly Insights | Lendlease stock story

July 2021

One of the most compelling opportunities on the ASX today

Lendlease is one of the most compelling opportunities on the ASX today. While all the attention has been on Lendlease’s (now sold) engineering business and COVID impacts, the significant progress made in a key area of shareholder value creation over the coming years has been overlooked.

Lendlease is a global leader in property development and investment management. Their expertise and reputation in property development has seen the development pipeline grow to over $110 billion today.

In this article, we explain why we believe Lendlease presents a compelling investment opportunity and why a strategy to accelerate its highly sought-after developments has the potential to unlock value for its shareholders.

Lendlease 101

Lendlease operates across three business segments:

  1. Property Development – Partnering with large capital partners to design and develop high quality precincts in key gateway cities around the world.
  2. Investment Management – Management of these property assets on behalf of large capital partners such as pension funds, insurers, and sovereign wealth funds for a recurring annual fee.
  3. Construction – The construction of both external and Lendlease projects.

Why is Lendlease undervalued?

Lendlease began reporting cost overruns and issues at its engineering projects in 2017. Several issues within the division such as tunnelling in North Connex, construction delays at Melbourne Metro and the recent provision on completed legacy projects has resulted in losses of almost $1 billion. A poor experience for Lendlease and their shareholders.

In late 2019, Lendlease sold its Engineering business to Spanish firm Acciona. We believe that the Engineering business has been a major reason the firm’s financial underperformance, in addition to the large valuation discount applied to the total business by the market. Exiting engineering has created an opportunity for Lendlease to simplify its business and focus on Property Development and Investment Management.

More recently, due to COVID, Lendlease has had to pause the development of some of its major urbanisation projects. Property sectors like Office have seen a slowdown in tenant demand which has negatively impacted near term earnings. However, the outlook for planning approvals and capital partners has improved. At its recent operational update, Lendlease announced the approval of its residential tower at One Sydney Harbour, secured an investment partner at the Innovation District development in Milan, secured an anchor tenant at its third office tower at Melbourne Quarter, and sold 100% of the development for $1.2 billion to a Korean pension fund.

Beyond some of the recent challenges, the acceleration of the development pipeline looks very promising. As development of major project’s accelerate, we see upside to Lendlease’s Property Development and Investment Management segments. Which we explore in further detail below.

The potential upside?

1. Accelerating the development pipeline

Lendlease’s reputation and property development expertise has resulted in significant growth in their development pipeline across key gateway cities including Sydney, London and Chicago. Over the last three years, project wins have accelerated, and the development pipeline has grown from $71 billion to over $110 billion. Importantly, many of these projects have been secured with large capital partners, reducing the capital intensity and sharing the risk involved in major developments. Lendlease’s capital partnership model also allows them to leverage their strong relationships with large investors and institutional partners to accelerate future projects.

The development pipeline features several high profile and highly sought-after developments in key gateway cities such as:

  1. The $21.5bn Google project in San Francisco partnering with Google for the next 10 to 15 years to redevelop the tech firm’s land holdings into mixed-use communities including office, retail, residential and hospitality.
  2. Silvertown Quays in East London which includes a mix of office, 3,000 residential units across build-to-sell and build-to-rent and retail space.
  3. The Exchange TRX in Kuala Lumpur which comprises of over 2,000 residential units and 122,000sqm of retail property plus a hotel.

Lendlease also specialise in build-to-rent projects. These projects involve the development of major residential projects on behalf of long-term capital partners which are then leased out to provide a recurring income (yield) for the investor. Build-to-rent makes up 21% of the current development pipeline and Lendlease are seeing significant growth in the asset class due to undersupply of housing in cities like London, New York and Chicago.

Lendlease’s broad pipeline of highly sought-after developments have secured future earnings for the firm. Beyond the near-term challenges, Lendlease is well placed to grow future earnings by leveraging its capital partnership model and development expertise.

2. Growth in high-quality investment management earnings

As property development projects are completed, a large portion of these assets are managed by Lendlease’s Investment Management business. Upon completion, capital partners like superannuation and pension funds can outsource all management activities to Lendlease for a recurring annual fee (usually a % of the value of assets).

Today, Lendlease has $36 billion in Funds Under Management (FUM) which is expected to grow to over $80 billion in the coming years. In our view, Investment Management could account for around 50% of earnings in the next five years (compared to an average of 31% over the past five years).

Investment management businesses generally trade at a premium to reflect the stable, recurring nature of their earnings. As seen in Figure 2., Lendlease currently trades at a discounted valuation to peer asset managers such as Macquarie (MQG) or Goodman (GMG). As FUM grows (Figure 3) and Investment Management becomes a larger part of Lendlease’s earnings, we expect the Lendlease valuation to re-rate to reflect the higher quality mix of its Investment Management earnings, and the sale of its problematic Engineering business (which generally trade at a lower valuation multiple).

Conclusion

Lendlease is a global leader in Property Development and Investment Management. With a development pipeline in excess of $110 billion and growing FUM in its investment management business, Lendlease is a compelling investment opportunity currently unloved and undervalued by the market. Lendlease is a holding in the Firetrail Australian High Conviction Fund and Absolute Return Fund.

 

Disclaimer

This insight is prepared by Firetrail Investments Pty Limited (‘Firetrail’) ABN 98 622 377 913 AFSL 516821 as the investment manager of the Firetrail Australian High Conviction Fund ARSN 624 136 045 and Firetrail Absolute Return Fund ARSN 624 135 879 (‘the Funds’). This communication is for general information only. It 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. 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 before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.

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Monthly Insights | A new player unlocked in the (i)Game?

Monthly Insights | A new player unlocked in the (i)Game?

June 2021

Aristocrat is a A$27bn company operating in the gambling and entertainment industry. It sells and leases physical slot machines (Gaming), and produces online games played predominantly on mobile devices (Digital). Firetrail invested in Aristocrat in April last year because we believed the business was adequately fortified to negotiate the short-term pressures presented by Covid and that it would emerge from the crisis in a much stronger competitive position.

More than one year on, and despite sitting above where it was trading relative to the market pre-Covid, Aristrocrat remains a top portfolio holding in the Firetrail Australian High Conviction Fund for three key reasons:

  • Its strengthened position in Gaming post-Covid and our expectation of continued market share gains;
  • The upside opportunity offered by entry into the nascent iGaming industry;
  • Its conservative balance sheet position, with less than 1.0x gearing in September 2021

 

US gaming is booming

Aristocrat’s US Gaming business has been a success story for over a decade, consistently producing the best performing slot machines and gaining share from other incumbent operators. However, nothing could shield Aristocrat from the fact that when casinos are shut, gaming revenue goes to zero (as it is earned either from the outright sale of slot machines or as a share of machine revenue).

During this ‘peak-Covid’ period, Aristocrat used its strong balance sheet to position itself to benefit when casinos reopened. Specifically:

  • Casino customers were offered financial and operational support;
  • Temporary pay cuts were enacted to minimise redundancies; and
  • R&D teams were maintained at full capacity to ensure a strong game pipeline.

This enabled Aristocrat to hit the ground running as casinos opened back up over the second half of 2020. With the US economy brimming with stimulus, and some other entertainment/travel options remaining inaccessible, casino revenues have since gone from strength to strength. Incredibly, even though some restrictions are still in place and a reasonable number of casinos remain closed, Mar-21 and Apr-21 casino revenues were 10% and 24% above pre-Covid levels, respectively.

Covid has driven a greater focus on optimisation of slot layouts, which has further skewed floor share and revenues towards Aristocrat’s machines. As shown below in Figure 2, Aristocrat gained an additional ~2% share of the US leased game market between Dec-19 and Mar-21. Even though it now owns more than 1/3 of all leased machines in the US, we believe its high level of R&D investment versus peers will underpin continued share gains from here.

iGaming plays to Aristocrat’s strength in content

iGaming is a term that refers to online casino gambling, or more simply, casino games like slots and blackjack that can be played on a mobile phone. It is currently generating annualised industry revenue of ~$3.5bn across six states in the US, with potential for more states to follow, albeit at a slower pace than online sports betting. Given Aristocrat’s strength in land-based casino content, there appears to be a latent opportunity in iGaming, but how significant could it be?

New Jersey has the longest history of iGaming. It was legalised in the state in 2013 but really only took off after online sports betting started in mid-2018. It has now grown to be ~30% of the size of the land-based casino market by revenue.

Somewhat surprisingly, iGaming’s recent success does not appear to have come at the expense of land-based casinos. Over the period leading into Covid, New Jersey’s land-based casino revenue was growing at ~20% (versus 6% across the USA) despite the fact that iGaming was growing at 70%. It is still early days in most other states, but benchmarking the US to Australia on gross gaming revenue per capita suggests that there is room for both the land-based and online casino markets to grow in the US.

A more difficult question to answer is what parts of the value chain Aristocrat would like to target in this market. Early evidence suggests that superior land-based content does translate to the online world:

“170% more GGR per game on slots recognised from US casino floors vs unknown international slot games” – US iGaming platform provider, GAN.

It thus appears likely that Aristocrat’s content will have high monetisation potential in iGaming. It could pursue a strategy of making its content broadly available to the whole iGaming market, or pursue a more narrow segment of the market and tie it to a platform offering to capture a greater share of the value chain. We think iGaming has the potential to add up to 10-15% to group EBIT over the next 3-5 years, and would give Aristocrat leverage to a high growth, recurring revenue market. We remain tuned for further developments.

Conclusion

At Firetrail, we believe Aristocrat is well positioned to continue to consolidate its competitive position in the US gambling and entertainment industry beyond its strong post-Covid recovery. We anticipate that high levels of R&D will underpin continued market share gains. Furthermore, entry into the iGaming industry provides a latent upside opportunity, which we believe will grow alongside, not at the expense of, the land-based market.

Aristocrat is a key position in Firetrail’s high conviction portfolios.

 

 

This paper was prepared by Firetrail Investments Pty Limited (ABN 98 622 377 913, AFSL 516821) (Firetrail). It is general information only and has been prepared without taking account of any person’s objectives, financial situation or needs. It 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. Any persons relying on this information should obtain professional advice before doing so. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. This document may contain information contributed by third parties. Firetrail does not warrant the accuracy or completeness of any information contributed by a third party. Any views expressed in this document are opinions of the author at the time of writing and do not constitute a recommendation to act.