Quarterly Commentary 30 June 2017
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QUARTERLY COMMENTARY 30 JUNE 2017 1 of 15 Q2 2017 COMMENTARY It is often difficult to pinpoint exactly why certain sectors of a sharemarket become cheap relative to others. Even harder is pinning down the catalyst that will bring the valuation pendulum back into a more sustainable position. Hardest of all though is getting the timing right - the point in the cycle when this catalyst will actually take effect. We tend not to obsess about the catalyst or the timing. Instead, we look for the pendulums that are at or near an extreme; those companies or sectors which we think are likely to reward investors handsomely when the pendulum rights itself. SIMON MAWHINNEY, CFA Relative to large companies, Australia’s small capitalisation Managing Director & Chief Investment Officer shares are nearing extreme valuations. Graph 1 illustrates this and plots the performance of the S&P/ASX Small Ordinaries Accumulation Index relative to the S&P/ASX 100 Accumulation Index (the largest 100 companies). Graph 1: Performance of small companies relative to large companies in Australia 1.00 0.90 0.80 0.70 0.60 0.50 Small Companies Relative to Large Companies Large to Relative Companies Small 0.40 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 Source: Iress, S&P/ASX Small Ordinaries Accumulation Index relative to the S&P/ASX 100 Accumulation Index 2 of 15 Q2 2017 Despite the small end of town having rebounded a little from its the pendulum’s shift is determining whether it is permanent or early-2015 lows, it has significantly underperformed over the whether it will return to its swing path. We believe the significant past 20 years and has underperformed the top 100 by 7% in the underperformance of this sector to be temporary. 2017 financial year alone. It has been argued that this is the result of a shift to passive and ETF investing, where it is possible Table 1 shows that, relative to its benchmark, the Australian to replicate 87% of a market’s exposure with the top 100 share Equity portfolio has over three times more (by portfolio weight) positions. It’s not clear – this shift to passive investing is a global exposure to companies outside of the largest 100 shares in the phenomenon but it hasn’t resulted in similar underperformance S&P/ASX 300 Accumulation Index. It is in this segment of the of small capitalisation stocks in other large developed share sharemarket that we see some of the most attractive investment markets. More important than identifying the reason behind opportunities. PMP Limited is one such example. Table 1: Weighting of large and small companies in the benchmark and portfolio Benchmark Allan Gray Shares in top 100 91% 68% Shares outside top 100 9% 32% Source: Iress, weights in the S&P/ASX 300 Accumulation Index and the Allan Gray Australia Equity Strategy PMP Limited It’s been a difficult environment PMP is a printing and marketing distribution company with The past 15 years have been characterised by extreme operations in Australia and New Zealand and annual revenues overcapacity in Australia’s print industry and weakness in PMP’s of A$1.2 billion. (previously core) directories and magazine print markets. PMP’s share price has significantly lagged the broader sharemarket. The company has a national footprint of printing assets which is 50% larger than its nearest rival. Its customer base includes PMP’s difficulties began in the early-2000s, when a slump in retailers, magazine publishers and community newspapers. retail marketing activities resulted in a fall in print volumes. PMP’s distribution assets include Gordon & Gotch, a magazine Aggressive pricing strategies followed as incumbent printers distributor to nine thousand retailers across Australia and New tried to keep printing presses fully utilised. Operating profits fell Zealand, and a catalogue letterbox delivery business with across the industry. To make matters worse, PMP entered this national coverage and a network of over 12,000 walkers. cyclical downturn in the worst possible shape with over $600m in debt making it poorly equipped to withstand the near 50% fall Figure 1: PMP Limited has a large national footprint of in its revenues. printing assets Things outside of PMP’s control went badly. In a desperate effort to unlock much needed synergies in an oversupplied print market, a merger with Independent Print Media Group (IPMG) was sought in March 2001 only to be blocked by the ACCC. Things within the company’s control didn’t go much better. In 2004, PMP doubled the size of its directory printing business increasing its market share of Telstra’s white and yellow pages printing from 50% to 100%. And then in 2007, the Board of PMP rejected a private equity bid of $1.95 to $2.15 and the company embarked on an acquisition strategy in a bold attempt to consolidate an extremely fragmented print and distribution market. Source: PMP Limited 3 of 15 Q2 2017 Survival made the business stronger PMP shares trade at approximately 75 cents today and the entire company is valued at A$450m (market capitalisation plus Miraculously, PMP survived. Regrettably, the portfolio has held anticipated peak debt of $75m). The company expects earnings PMP for some time (refer to Graph 2) but there are several before interest, tax, depreciation and amortisation (EBITDA) of reasons to believe that the PMP of today is a far better company $70m in 2018 and $95m in 2019 as the benefits of its merger than the PMP of yesteryear. Not only has the company synergies with IPMG are fully crystallised. With only $5-$10m significantly reduced its debt and disposed of poorly performing in annual capital expenditure and no expected tax payments for businesses, but the industry structure has improved and PMP some years as future profits offset the significant tax losses of appears to have a sustainable competitive advantage. the last 12 years, free cash flow should exceed $85m p.a. from 2019. For most of the 2000s, the print industry had been highly fragmented with the resulting competitive dynamics all but Does it sound too good to be true? crippling. A series of recent mergers have resulted in the top five printers being consolidated into two players. PMP merged At a little over five times free cash flow, PMP is priced at a level with IPMG (the same merger the ACCC blocked in 2001) in significantly below that of the broader sharemarket. On the face March of this year and in December 2016 the IVE Group of it this is a rare opportunity and it is reasonable to ask how we acquired the third and fourth largest players in the market, might be wrong. Franklins and AIW Printing. PMP now holds a significant We understand there to be three areas of concern. The first is market position in a relatively consolidated industry. that the projected synergies from the IPMG merger will prove elusive. These are a reasonably significant part of the journey to This market position, together with PMP’s vertically-integrated $95m in 2019’s forecast EBITDA (2017’s EBITDA is expected market offering, is a source of significant competitive advantage. to be $31-$34m). The second concern is that the irrational PMP’s portfolio of printing presses and national footprint allow behaviour of the print industry over the past 15 years may not it to provide a flexible and cost competitive offering relative to be over and significant competitive tension between the now its peers. It also has significantly more capacity than its peers top two players may be every bit as damaging as the five large and is best placed to handle the seasonal demand peaks of its players over the recent past. And lastly, that cyclical and customers. The co-location of its distribution facilities and structural headwinds may inhibit the company’s ability to national footprint of printing presses also provides significant deliver its targets. logistics benefits and cost synergies. Graph 2: Portfolio holdings in PMP Limited compared with the share price for the same period 2.50 80 70 2.00 60 50 1.50 40 Holdings (millions) Price (AUD) 1.00 30 20 0.50 10 0.00 0 Jun 06 Jun 07 Jun 08 Jun 09 Jun 10 Jun 11 Jun 12 Jun 13 Jun 14 Jun 15 Jun 16 Allan Gray Australia Equity Strategy Holdings PMP Price Source: Allan Gray. The Allan Gray Australia Equity Strategy includes the Allan Gray Australia Equity Fund and institutional mandates that share the same investment strategy. 4 of 15 Q2 2017 All of these concerns have merit and create an element of PMP has limited exposure to these sectors. Catalogues remain uncertainty but we believe this has been more than reasonably a particularly relevant and effective marketing channel for the reflected in the share price. According to a recent company retail, lifestyle, entertainment, travel and tourism sectors. update, the company has already implemented $40m in annualised cost savings, putting them well on track to achieving The company has never their total planned cost savings. Both of the large printers are been better placed to deal now publicly owned (IVE Group was floated on the sharemarket in December 2015). The degree of accountability that comes with a cyclical downturn with this should foster a culture of commercial discipline not Of all of the concerns, potential cyclical headwinds are probably seen in many years, with the likelihood of irrational competitive the most relevant. Australian households appear to be stretched tension low relative to the past.