Ophir Asset Management Level 26, Governor Phillip Tower One Farrer Place SYDNEY NSW 2000
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Ophir Asset Management Level 26, Governor Phillip Tower One Farrer Place SYDNEY NSW 2000 Dear Fellow Investors, Welcome to the May 2018 Strategy Notes – thank you for investing alongside us for the long term. Due to a fairly intensive travel schedule through the back end of April, we took the decision to delay our monthly ‘Strategy Notes’ to a little later this the month. We hope you enjoy the updates. Strategy Notes – From Auckland to Omaha With an investment mandate that allows both Ophir Fund’s to invest in Australian and New Zealand-listed equities, it is not surprising that New Zealand is one of the more frequently visited international destinations for the investment team. Prior to heading to the US for an extensive trip later in the month, we took the opportunity in April to also touch base with a number of existing NZ-based portfolio holdings in addition to a handful of exciting emerging companies that the nation is now beginning to produce with some degree of regularity. In many ways, the NZ-listed company space has proven to be a happy hunting ground for the Ophir Fund’s for some time and we certainly enjoy the innovative and motivated entrepreneurialism that seems embedded in many management teams in businesses across the Tasman. The ‘tyranny of distance’ facing emerging Kiwi companies quite often works in their favour as founders and management teams are required to think about product scalability and global expansion opportunities far earlier in their company lifecycle than in perhaps other regions. With fairly limited opportunities in the domestic market (the entire population of New Zealand is ~300k less than that of Sydney’s), any budding entrepreneur with a desire to grow a meaningfully- sized business will almost automatically be crafting that idea with global growth goals in mind. We like this natural inclination and desire to expand offshore as it almost immediately sets the success bar higher for businesses and encourages management teams to take intelligent risks early on in their growth journey. Of course, this doesn’t mean there is a dearth of very large companies in NZ that have built significant businesses servicing the domestic populous – indeed the top ten largest companies (as measured by total profit) are dominated by a collection of businesses that generate the bulk of their revenues onshore. In a similar vein to the Australian large cap experience, the majority of these businesses also represent fairly ‘older world’ businesses models entrenched in the more mature stages of the company lifecycle. Of the top ten (Fonterra, Spark New Zealand, Air New Zealand, Ryman Healthcare, Kaingaroa Timberlands, Auckland Airport, Transpower New Zealand, Z Energy, Meridian Energy and Mercury NZ), four essentially operate as majority state-owned enterprises, one is a listed dairy farming co-op, another an unlisted timber plantation and another a national chain of petrol stations. While certainly not a ‘high-growth’ collection of businesses, it is interesting to note that a good number of domestic-facing NZ businesses actually achieve higher EBITDA margins and better overall returns on capital than their listed Australian counterparts. This is primarily a reflection of the broadly smaller market size and the fact that the region tends to sit fairly low on the priority list for foreign companies looking to aggressively disrupt existing offshore markets. In our view, this geographical moat will not last forever, however, and a number of businesses in the larger end of the NZ market that have effectively been ‘over-earning’ versus global peers in recent years will likely experience some competitive pressures in the years ahead. Like Australia, however, scratching below the surface of the larger listed company names has uncovered some wonderful examples of entrepreneurial drive and global innovation – with many small NZ companies in recent years rapidly expanding to become far more substantial in size. While we are limited in our own investment universe to those businesses that are publicly-listed on the NZX, we can only be impressed with the speed in which New Zealand’s start-up community has rapidly developed into a globally relevant destination for local and international venture capital. According to a recent report from the NZ Ministry of Business, Innovation and Employment, more than NZ$875m in capital was raised in 2017 by New Zealand-based businesses across the private equity and venture capital space. Early stage capital commitments tend to favour higher-growth opportunities and it has been the burgeoning Kiwi tech sector that has proven to be the key attraction for foreign capital in recent years. From barely rating a mention only a decade ago, technology now sits as the country’s third largest export (behind tourism and the dairy industry) with the NZ tech industry contributing over NZ$10bn in combined revenue in 2017 and employing more than 40,000 people. 3-Year Revenue CAGR (%) - Selection of High-Growth NZ Companies Source: NZ Ministry 0f Business, Innovation & Employment No event could perhaps be more symbolic of the heights to which the emerging and start-up environment in New Zealand has reached than the pending first commercial rocket launch from NZ-based start-up Rocket Labs – expected sometime toward the end of June this year. Started in 2006 by New Zealander Peter Beck as a company focused on developing smaller, lower-cost satellites for the telco, mapping and space research industries. The business has developed a pilot rocket (in their manufacturing site in Auckland) entirely powered by engines that are constructed by 3D printers that are expected to provide customers with the opportunity to deliver smaller commercial payloads into orbit. With the business already commanding a private valuation in excess of US$1bn prior to achieving first revenues, the potential for the business to meaningfully grow from here is enormous. Keeping true to their New Zealand heritage, the launch of the company’s 17- metre tall ‘Electron’ rocket won’t occur at the more familiar launch pads of Cape Canaveral or Kennedy Space Centre, but from a private launch site in the Hawke’s Bay on New Zealand’s North Island. Across the listed space, we have been fortunate enough ourselves to have shared in the success of a small number of NZ-headquartered businesses and currently retain four holdings in NZX-listed companies across the Ophir portfolios today. While no longer NZX-listed, cloud accounting software developer Xero (XRO), for example, is a business we have written fairly extensively about in previous Letters (you can access it here) that has continued to experience a terrific rate of growth as their global sales strategy begins gains momentum. From humble beginnings in founder Rod Drury’s Wellington apartment in 2006 (the business didn’t operate from a formal office premises until 2007), the company now commands a NZ$6bn market capitalisation with over 2000 staff worldwide and 1.4m subscribers across 180+ countries. In its breakout year in 2008, the firm was thrilled to announce to shareholders annual total revenues of $134,000 – ten years later and the business now generates over $100,000,000 a quarter. While the business is no longer a ‘small cap gem’ lying undiscovered across the Tasman, the considerable market capitalisation of the business isn’t symbolic of a business that has reached peak growth, in fact far from it. While the initial core markets of Australia and New Zealand are certainly maturing (i.e. they are still experiencing overall growth however the rate of that growth year-on- year will slow from here), the business at a group level will still record overall subscription growth for FY18 in the order of ~30%, with a similar amount of growth expected for the 2019 financial year. Expansion into global territories will be the primary driver of growth from here, given the business remains in the early stages of market penetration in the much larger US and UK markets. The UK experience, in particular, has been highly encouraging to date with subscriptions to Xero’s product growing +47% on the prior year. We expect to see a continued acceleration in net subscription additions (i.e. growth increasing at an increasing rate) as market share increases and overall brand awareness expands. Xero Net Subscriber Additions by Geography (‘000’s) Source: Evans & Partners Pleasingly, the business looks set to benefit from some regulatory tailwinds in the UK in FY19 that will require all businesses with revenue >£85,000 to lodge tax returns electronically. While the overall impact at this stage is hard to quantify, we are reminded of the incredible surge in license sales experienced by Australian accounting software provider MYOB through the 1999-2000 period following the announced introduction of the GST in July 2000. Winning the UK, in our view, will be critical for the business on a five-year view as it essentially provides a sound capital base to then attack and grow into more international market opportunities – potentially Canada, Singapore, South Africa and Malaysia. Perhaps more importantly, the business has now reached the crucial stage of moving from loss making to first profitability, effectively enabling future organic growth to be funded by its own free cash flows. While the journey has taken ten years to reach cash flow breakeven, the subsequent uplift in equity value of the business over the period again provides a wonderful example of the incredible competitive advantage that businesses with a supportive shareholder base enjoy. Sacrificing near term profit or dividends for longer term growth optionality hasn’t historically been an easy sell for Australian or NZ-listed management teams and it is encouraging to see shareholder patience being acutely awarded.