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Bought KME

Just a note to say I've bought KME at 32c. Full write up to follow

Mobile Embrace Drops a Bomb

I was in the process of preparing an update on Mobile Embrace when they dropped a bomb that slashed 42% off the market cap in one afternoon.

Some of the update I prepared involved trying to assess what the FY17 results might be. Given my goals for this website are for complete honesty and disclosure I will provide the numbers I had calculated. I was anticipating revenue of around $80m with NPAT of approximately $7m (1.8cps). At the share price on November 16 of 25c I was indicating this was good value (a forward P/E of 14 among other things).

Given my purchase price of 30c for the example portfolio the downgrade (that I will go into below) is obviously disappointing. Had my new analysis been available I would not be a buyer at 30c. The valuation would be too stretched for my liking given the risks.

However, that is history and all we can do is assess the situation in front of us. We are talking about a share price of 14.5c and updated information. The investment proposition as it stands is now completely different to yesterday.

There are two things I would like to reiterate before carrying on.

1.      Trust in management is a very important part of investing. MBE management have performed well to date in my opinion. I have no specific reason to believe this is the first in a string of negative updates, but there are countless examples of this elsewhere in the share market. In this case I give management the benefit of the doubt. However, I will be watching very closely at what plays out over the next few months.

2.      A growth company should never be judged on a single set of financial results. As stated above, it is possible that this is the first in a string of negative updates. We cannot judge this yet. In the future we will be able to look back and see whether this is a blip on the growth radar or the beginning of the end. As stated above, management gets the benefit of the doubt this time.

 

MBE have guided the following:

H1FY17

Revenue  >$28m

EBITDA >$2m

FY17

Revenue >$70m

EBITDA >$8m

Their commentary around the lower than expected first half revenue discussed compliance changes relating to Australian DCB impacting their processes. This had a negative effect on customer acquisition and impacted their marketing spend. To be honest, I was unimpressed with how they explained it. Their release was confusing and didn’t entirely make sense. However, they are on record saying it is a one-off issue. They appear to be well on the way to a return to business as usual.

 These issues have impacted revenue and EBITDA by $3.8m and $1.7m respectively. This really is an inconsequential amount provided it is in fact a one-off issue.

 

We already knew the Australian DCB market was becoming saturated for MBE. My previous analysis had only factored in 20% revenue growth for FY17.

 

Now onto the good news. The international DCB expansion appears to be going well. Q2 revenue is expected to come in at around $2.5m and the Q4 “exit run-rate” is expected to be >$5m. From these numbers I am assuming approximately $12m from international DCB revenue in FY17. That compares to less than $5m in FY16. $12m equates to 35% of FY16 DCB revenue and 20% of total group revenue. That is beginning to show some promise.

 

The increase in international DCB revenue comes at a cost. The announcement indicated customer acquisition costs are expensed on a monthly basis. Therefore, this impacts short term EBITDA numbers with the payoff occurring in the following periods.

 

Marketing

The marketing channel has been experiencing good growth over last year. Marketing accounted for almost 50% of revenue in FY16. It is obviously a very important part of the business in its own right, but the DCB hiccup highlights the importance of diverse revenue streams. I am assuming 30% growth from the marketing operations for FY17.

My financial estimates following managements guidance:

Revenue - $72m (up 20%)

EBITDA – $8.5m (down 10%)

NPBT – $5.2m (down 25%)

NPAT - $3.9m (down 20%)

EPS – 1.0cps (down 20%)

 

The expenses and marketing costs given the expansion are difficult to estimate. I have estimated a modest increase to most expenses, hence a negative impact of the profit figures. The company has guided >$8m EBITDA, so my profit figures may be a little bit on the low side. I am happy with that given the circumstances.

Management would most likely have budgeted for slightly more revenue growth and therefore over allocated  marketing budget. Hence the lower profit for FY17 even though revenue will increase.

 

I would normally look more closely at operating cash-flow. Given the above this is very difficult to estimate. FY16 had OCF of $6.3m. I am assuming something around $5m this year as a ballpark estimate. The key point is that it is likely to remain well in the positives.

At the current share price of 14.5c the forward P/E ratio using my estimates is around 15. For a growth company with positive OCF, money in the bank and negligible debt that is very attractive. International DCB is trending very well and the marketing business is growing. It is only the (significant) Australian DCB business that has suffered a setback. If international DCB is successful then today’s announcement is simply not important going forward.

 

The critical investment decision is whether the issue is a one-off or a sign of things to come. I am currently satisfied that, given the valuation, other revenue streams and management’s track record, the investment proposition offered at 14.5c is a good one. I purchased more today at 14c.

The Trump Effect

Well that was unexpected. Then again so was Brexit. Both events were a good reminder that, as investors, we need a plan for such situations. This plan should obviously be relatively developed beforehand...

The Trump election result was a great example of what can happen if your focus is on the short term. At one point in the afternoon US stock futures were down 5% and the NZ/Aussie markets followed suit and closed down more than 3%. Overnight the US markets actually ended up closing up 1%! Following this the local markets regained the previous days losses at the opening bell. That is seat of your pants stuff!

If you weren't well prepared you could quite easily have found yourself selling during the carnage only to watch the market rise again while you are sitting on the sidelines.

There are many reasons why I am a long term investor rather than a trader. The above is one very good example that backs this up.

Most commentators predicted negative sentiment in the markets if there was a Trump victory. Initially that was the case, but a day later if you saw the stock indexes you would have assumed Clinton won. It shows just how difficult it is to anticipate market movements.

Now I'm not saying the market won't suffer due to the Trump victory. I am simply using the last day or so as an example to discuss my investment philosophy.

In the long term volatility (by itself) does not matter. It only matters if you want to buy or sell stocks at certain times. Volatility to the downside offers good buying, and vice versa. If you take the opposite approach of selling when the markets get scared then you crystallise losses and risk missing out on the upside. Most volatility in the market is unrelated to company fundamentals, therefore it does not make sense to act on it.

If a company has fundamentally changed then the above does not apply. Sometimes you have to sell when everyone else wants to too.

A watchlist of pre-researched stocks is always a good idea. That means when volatility does strike you can act straight away.

Further to the above, I am a believer in selling a fundamentally strong company if it becomes too overvalued. This means I can reallocate my capital to companies that are more likely to increase in the mid-term. I always continue to monitor the valuations the companies I hold in case they move into this category.

Grit your teeth and close your eyes

Well, it turned out to be famous last words (at least short term) with respect to PRO and MBE bottoming out. That said, my conviction is unchanged and I will continue to hold. 

Now that I am considering turning this one year project into something more long term I will attempt to write updates more regularly. I will look to write updates on new companies I am looking into as well as updates of companies I currently hold. I will also start writing about companies I hold outside of the 20k portfolio.

In general the market has retreated in the last month. That explains a lot of the negative SP action in that period. I never like to speculate on the reasons behind short term SP fluctuations as I don’t think it is beneficial and is often based on human emotions or outside forces. With that said, here is an update on the companies I hold:

PRO

The SP of PRO has been struggling ever since they lowered guidance earlier in the year. The market punished PRO for this and it has been sitting around the $1 mark ever since. Last week they announced their Q1FY17 revenue and provided a general update. Revenue came in at $3.1m (PCP $4.5m, but that included a large one-off sale of $1m). They also reaffirmed that Q2 and Q4 are their best periods, so this is a good result.

Once again, the market showed it wasn’t happy. I have dug a little deeper into the numbers to try and understand where things are at.

I have assumed the following growth rates for each division: 15% SNARE, 40% eMite and -30% Legacy. I am forecasting the following:

H1FY17

Revenue – $7.6m (down 5% from $8m)

NPBT – $2.3m (down from $2.57m)

FY17

Revenue - $16.5m (up 13% from $14.6m)

NPBT - $4.6m (up 23% from $3.75m)

NPAT - $3.2m (up 33% from $2.4m)

OCF - $5.5m (up 12% from 4.9m)

OCF less income in advance $4.2m (up 17% from $3.6m)

EPS – 5.0cps (up 32% from 3.8cps)

OCF/share – 8.7cps (up 13% from 7.7cps)

OCF less Income in advance/ share – 6.6cps (up 16% from 5.7cps)

Dividend per share 4.5cps (up 13% from 4cps) 

I am not suggesting for a moment that the above figures are particularly scientific. PRO have already proved their earnings are lumpy and therefore relatively difficult to predict.However, they do give insight into whether or not PRO is a good investment at this point. I have only looked at FY17, but I am satisfied their products will remain in demand going forward. I expect FY17 onwards to potentially be significantly better. Using the above figures we can apply the following valuation methods at the current SP of 82.5c:

P/E (TTM) = 22

P/E (FY17) = 17

Dividend yield (TTM) = 4.8%

Dividend yield (FY17) = 5.5%)

P/OCF (TTM) = 11

P/OCF less income in advance = 14

Summary going forward

Using the above metrics I am happy with the valuation of PRO. The headline P/E ratio makes it look a bit expensive. However, looking a bit deeper at the cash earnings (mainly removing amortisation of intellectual property) the valuation looks pretty cheap. Not to mention a 4.8% dividend yield on a growing tech company!

PRO have two quality products (SNARE and eMite) and they are currently smoothing their sales processes to maximise these. I believe this will start showing some pretty good results from FY17 onwards. I also expect them to be on the lookout for another acquisition once they are satisfied with how they have shaped the business with SNARE and eMite.

MBE

The MBE SP is suffering from market uncertainty. We haven’t heard anything on revenue since the FY16 results. This has made the market to fear the worst. We have received a snippet into the overseas revenue growth from DCB which is now >$600k/month and growing. I believe this figure has been significantly depressed due to the devaluing of the pound post Brexit (it was 520k/month in January pre-Brexit).

The AGM is coming up at the end of this month and the market will be expecting a good update from management. I believe management are doing a good job. Revenue growth going forward will be hard to predict due to the saturation of the Aussie market coupled with the ramping up of overseas revenue. However, it you believe in the business model there is no reason to sell unless overseas proves fruitless. We can't make this call yet.

I am working on an estimate for FY17 which I will upload in the next week or so.

MOY

MOY continues to find gold and expand its mineral resource and ore reserves. Recent results have shown the huge potential of their tenements. Valuation isn’t particularly cheap, but there is upside from the gold price (which looks to have resumed its uptrend) and from further exploration.

Current FCF looks to be close to $40m before exploration expenses. This is about 5cps.

WPG

Over the next year they look likely to ramp up production once Tarcoola is given the go ahead. Solely based on this I expect a rerate of the SP. However, they have significant exploration upside also. 

They could be looking at 70k ounces per year for a FCF of $20m+ or 3cps. This is using conservative costs. There is also the exposure to the gold price. I will look to expand on WPG again in the coming weeks.

Portfolio as at 26/10/2016

Portfolio as at 26/10/2016.

It's been a bad month or so for the portfolio. However, I have confidence in the companies and will continue to hold. MBE and PRO especially have potentially bottomed out recently and I remain confident in the fundamentals going forward.

Update/FRM

The 20K portfolio is currently fully allocated. It is possible I will transfer funds between companies, but until any significant rerates occur I don’t anticipate making any changes. This doesn’t mean I’ve just been twiddling my thumbs though. I have still been doing research in the background, so I thought I would use this as a forum to provide some thoughts on other companies I own or am considering.

 

As I think I mentioned right at the beginning of this blog – I am a long term investor. Short term positions are not my strong suit. However, I attempted to use fundamental analysis to choose the companies most likely to appreciate in the short term. Some of these have gone well, while others have hit some bumps along the way. I still hold these because I have confidence in their long term potential. That means I can easily see the timeframe of this challenge rolling over to be more indefinite. I will still attempt to actively manage the portfolio to ensure the funds are put to use as best they can be. That way companies like PRO will have the time to reach it’s potential.

 

Anyway, back to the companies.

 

Farm Pride Foods (ASX:FRM) is a company I have held for a few months. This perfectly demonstrates my inability to time the market as it swiftly proceeded to correct. It did allow me to average down and I am now fully loaded. The current SP is $1.75 and I've now added it to this portfolio. The company sells eggs and egg related products. This is very boring. However, they are exposed to the market-shift to free-range products and they are continuing to increase their exposure by building new facilities. They have recently paid off essentially all of their debt and are making lots of cash.

 

Financial Highlights for FY16:

Revenue - $93.6m (up 3%)

NPAT - $8.2m (up 58%)

OCF - $13.7m (up 49%) (25cps)

EPS - 14.7cps

 

Trailing PE – 12

Price/OCF – 7

 

Catalysts for FY17

·         New free-range facilities coming online, will increase revenue by 15% once operational – NPAT by more

·         Cash building up in bank – possible dividend or acquisition

·         Growing population, growing egg consumption, market-shift towards free-range

·         Valuation is very reasonable – multiple expansion likely

 

Today marks the day of the AGM. There will hopefully be a good update on operations. I decided to put my thoughts on the line and post this before the AGM. I will update anything following the AGM if required…

PS - full disclosure - I have read a broker report on FRM in the past, but I wrote the above based on my own thoughts using only the FY16 report