This week we look at two more unloved securities, CIMIC (CIM. ASX) and Service Stream (SSM.ASX). Both of them have been perhaps less than pleasant experiences for long-standing shareholders. With that in mind, is it potentially a good time to buy? After all, both of them sit in a strong thematic (i.e. infrastructure and commodities).
CIMIC Group (CIM.ASX)
This is one company that most Australian investors would be familiar with (or at the very least its predecessor, Leighton Holdings) and not for the right reasons. Governance issues, most recently including bribing the then Deputy Prime Minister of Iraq to secure a pipeline contract, have certainly raised some red flags. This has also been exacerbated by construction project issues, boardroom politics and slowing demand in the mining services segment. The last of these is potentially where we see the most upside and why CIMIC is even on our radar; we remain of the view that (despite the last week’s price action) we are very much in the infancy of a multi-decade bull cycle in commodities which will undoubtedly see a pick up in demand. This is also not mentioning the increased investment in infrastructure globally. To give some context, CIMIC’s last guidance indicated that they have a pipeline of relevant future tenders to the tune of $475bn AUD (up from $285bn AUD).
Moreover, despite the definite red flags regarding governance, CIMIC does have a reputation of a strong balance sheet and an ability to undertake large scale contract-mining and construction projects that create an effective moat when moving to tender. Substantial economies of scale allow the company to take on multiple projects and diversify across market cycles, though this could have been executed better in my opinion. Breaking down revenue as it currently stands: 65% Engineering and Construction, 25% Contract Mining and 10% Services and Property Development.
Author: Sid Ruttala
We continue to see substantial upside given the pipeline in Australia (Eastern Seaboard) and across the Asia Pacific region (where they still operate as Leighton). At the current run rate, the business has already been awarded work in hand up to $10.4bn in Australia for 1H21. To put this into context, the full year of 2020 was $6.6bn. In my view, we will continue to see this pipeline grow, especially coming out of lockdowns as governments look to stimulate growth. On a more strategic level for the business, some key catalysts to come will be the potential divestment or listing of their services arm, Ventia (the brand that does the asset management and maintenance). Returning once again to the reflation thematic, the business’ cost of financing and their debt issuance in the European markets has seen them reduce their cost of financing from 2.2% to 1.9%; given that a significant portion of this is fixed (especially the longer term Eurobonds), any uptick in inflation should again act as a transfer to the shareholders.
On the negative side, CIM’s 50% sale of Theiss, now the largest contract mining services provider on the planet, was potentially a bad move despite the rhetoric around “introducing a partner to “support growth and diversification”. Never has anyone of reasonable business acumen come to the conclusion that the sale of a business to a hedge fund would be conducive for longer term growth. The other 50%, by the way, is now effectively owned by Elliott Management (i.e. a Paul Singer outfit). Singer is the man termed by the New Yorker as the doomsday investor, a rather apt elucidation in my view.
Arriving at the numbers, revenue came in at $1.7bn and NPAT at $208m, an apparent decline of 34%. However, stripping out the Theiss numbers (due to the sale), first half numbers were actually higher by about 1.5%. Furthermore, CIMIC has maintained NPAT guidance for 2021, $400-430m AUD, and our view is that this remains on the conservative side. Assuming that this is the case, one could easily see a medium term catalyst for a re-rate on the underlying security. I make this call based not only on the unwinding of the Covid impact (delay in contract awarding) but also on the additional pipeline assuming a conversion rate in line with their historic trend. Using that as a scenario, my expectations are that NPAT will come through marginally higher than guidance at $440m AUD.
Importantly for the dividend starved investor and assuming that they keep the current payout ratio of circa. 63%, it implies a dividend yield of 4.3%.
Red Flags & Risks: The biggest red flags with CIMIC, despite their engineering capabilities, strong balance sheet and scale, are the consistent governance issues. Company politics almost always seem to get ahead of them and there doesn’t seem to be a coherent strategy for longer-term growth. It’s the classic case of a good brand, product and technical capabilities with bad optics and overall management. The focus on PPP (Public Private Partnerships) is the right move but one hopes that they don’t repeat history with how they go about this aspect of the business.
My Expectations: Cheap! Especially given the broader thematic around infrastructure and the segments CIM operates in. Despite the less than stellar performance in the share price, our fair value estimate is about $35 AUD… the potential for 70% upside.
Dividend Yield: 4.3%, assuming a price $20.30 AUD.
Service Stream (SSM.ASX)
It has been a rather eventful year so far for SSM; rather cringeworthy for the shareholders but we are of the view that at these levels it makes for an interesting investment proposition. The share price having lost close to 50% since the beginning of the year in a bull market leaves us quite certain that long term investors aren’t happy campers. For those of you unfamiliar with the business, SSM engages in asset life-cycle services to the utilities and telecommunication sectors. That’s another way of saying they design, construct and maintain much of the infrastructure that you see around you, from your broadband to your gas connection. Given the nature of the industry they operate in, scale is potentially the most important factor in terms of long-term sustainability as well as consistently locking in longer term contracts.
On the first count (i.e. scale), the business has a history of acquiring in order to diversify, initially with Comdain in 2018 which has contracts across water and transmission. More recently, SSM has managed to get their hands on the entirety of the services division of Lendlease. Herein lies the problem with the recent price action. We will start by saying that we could see this situation being handled substantially better. It started with a leak from the AFR before shareholders got to find out and price action that saw massive selling pressure preceding the announcement. It was almost as though someone knew that there was a cap raise on the books… But now let’s have a look at the deal itself. The business will now acquire 100% of the services segment with an EV of $310m. Accounting for debt the purchase price is $295m and it would’ve bought out the business at an EBITDA multiple of 6.9x. Management guidance indicates that post-acquisition synergies should lead to a strong EPS accretion of about 30%, a rather nice target for the shareholder to think about.
So, does this make sense? In our view this further diversifies the business revenues, away from just telecommunications and utilities, to now broader capabilities in specialist design and construction. Not to mention a customer base which includes some of the largest public and private sector clients in Australia. Overall, it was done at a reasonable price and makes a great deal of sense from a strategy perspective. Personally, I would love to see them make a play for Ventia (mentioned above) which would make the group a force to be reckoned with but that is perhaps a pipe dream as the addition of Lendlease should keep the business busy for a while yet.
Returning to the bread and butter of the business, we like what we see. The contracts are reasonably long in duration and the business should have greater diversity in customers following the Lendlease acquisition. On the teleco side, their most important agreements are the NBN Unify and the Telstra field operations which are cumulatively worth $1.3bn AUD over an 8 year period. On the utilities side, the business has continued to secure contracts, the most recent being SEQ Water and NSW Operations.
Getting into the numbers, first half EBIDTA of $40.2m AUD and strong cash flow generation with working capital remaining at 1.3% of revenue. The business also maintained its payout ratio which, in retrospect given the acquisition, may have been a little on the ambitious side. Though Covid put a dampener on revenues, especially in the telecommunications segment with delays in client procurement, we should see continued recovery throughout 2021 with perhaps the exception of NSW. Interestingly, the acquisition of Lendlease should see combined revenue now at $1.7bn AUD and EBITDA of $120-125m AUD (management guidance). On the flip side, the company would have added close to $123m AUD in debt, manageable if things go according to plan.
Red Flags & Risks: The biggest risks come from the integration process and their ability to retain existing customers as well as find cost outs. Continued Covid related risks also persist, especially in NSW now, which does place stress on the telco segment.
My Expectations: When one considers the business’ current market capitalisation in comparison to the forecast group EBITDA, we think that SSM could be exceptionally cheap. We don’t expect payout ratios to stay within the current 50-60% range for another 12-24 months but, at the current share price, the investor will potentially lock in a yield of 10-12% over the longer term.
Dividend Yield: The most recent dividend was 0.025c per share but post-acquisition we expect (perhaps hope is more appropriate) that further distributions will be delayed for the year. After that, and using the current share price of 90c, a yield of 10-12%.
For those of you looking to get in, it may be worthwhile to hold out for below the SPP at 90c.
As markets across the globe continue to test record highs – whether it’s equities, property or even these new fangled digital assets that very few people seem to understand – many think there are very few modestly priced opportunities out there. This week we will be talking about a corner of the market that, ironically, hasn’t received any attention. Here we are referring to the media sector and will be looking at three small caps, two of them NZ based, that few would be looking at.
Author: Adam Wolf
These three companies have flown under the radar and might now be starting to look like attractive investments. All three of these companies are strengthening their balance sheets and will have opportunities to create value through capital management.
Sky Network Television (Dual Listed: SKT.NZX & SKT.ASX)
Sky Network is a broadcasting company based in New Zealand. They provide pay television services, media streaming services and, more recently, broadband internet services. Sky Network is essentially New Zealand’s Foxtel (those of you familiar will recognise the hardware, below) , providing people access to TV shows and, most importantly in New Zealand, rugby coverage. Over the years SKT has done everything but create shareholder value but we now see a possible turning point. They have made big changes to their management team, strengthened the balance sheet and have a significant cross selling opportunity.
Source: Sky
Sky Box
Sky box is NZ biggest pay television service with 566k customers. To get a Sky box you need to be a Sky starter member which costs $26 a month, from here you can stream these channels on any device and can add more channels, such as sport. Like Seven West Media (SWM.ASX), Sky Sport had rights for the Olympic games and provided a much more comprehensive coverage compared to free to air coverage; this would have been a big tailwind for Sky box customers, specifically increased sales of the sports package. Sky Sport also has exclusive rights for All Blacks and Super Rugby games, a huge draw card in NZ. Sky also became the owner of global streaming app Rugbypass which has a reach of over 40m people a month.
Source: Sky
Broadband
Sky Network’s latest venture has been establishing a broadband service to provide households across NZ with high quality broadband. The broadband offering is a big value add and a huge cross-selling opportunity. The pricing structure will favour existing Sky customers at $80 a month. SKT is aiming to provide broadband to at least 8% of Sky box customers; if they achieve this it will add approx. 53m of ARR to SKT (that’s using conservative estimates). Sky made a strategic partnership with Vocus New Zealand to provide the internet network, with Vocus providing technical expertise and the network backhaul.
Improving Balance Sheet
Earlier this year SKY retired $100m of debt using existing cash reserves; this will increase bottom line earnings by about $5m. They have also been divesting assets. They sold their OSB assets (outside broadcasting) and are in the process of selling two out of three of their site buildings located in Mt Wellington, a smart move given the shift to working from home. These divestments should build a decent net cash position on SKT’s balance sheet.
Personnel Changes
SKY has changed up their management team, something that can really turn a business around especially in the microcap space. They have appointed Keith Smith to the board. Smith is chairperson for Goodman Group (GMG.ASX), one of the best performing REITs on the ASX. They have also appointed the Chief Commercial Officer, Sophie Moloney, as CEO. In addition, they have appointed a new Head of Investor Relations while Andrew Hirst has stepped into the interim CFO position as they look for someone permanent. Sky is in need of a big turnaround and the company looks to be heading in the right direction after these executive changes. They are now heading into a significant net cash position and are now debt free; the new management team should have a strong balance sheet to create significant shareholder value.
Capital Management
Given that Sky should be entering a huge net cash position, management will have some important capital management decisions to make and, with FY21 results released at the end of the month, we should have more clarity as to what they will be doing. We see a share buyback as the best way to return capital to shareholders, as opposed to dividends, given the share price is close to an all time low. Sky could retire a significant amount of shares for a small consideration. At a share price of $0.15, Sky can buy back more than 10% of the shares on issue for less than $30m.
Thesis
Sky has been unloved but we can see SKT being a great turnaround story. They have a fresh management team and, after they finish divesting their property portfolio, they will have a huge net cash position which can be used to drive the share price through share buybacks. They are currently sitting on an EV of around $230m (this does not include the sale of their OSB and property assets) and their guidance for FY21 is approx. $170m EBITDA which would put them at an EV/EBITDA of circa 1.35x, a figure that seems too good to be true for most investors. Another key development is that SKT has received a number of approaches around potential transactions. Sky has appointed Jarden as an advisor for these matters and we wouldn’t be surprised to see some corporate action here given how cheap SKT shares are at the moment.
Seven West Media (SWM.ASX)
Seven West is a national multi-platform media business based in Australia. SWM has had a great first half of 2021; they won 12/24 weeks for total viewership and this doesn’t include their Olympics coverage. SWM secured the rights to broadcast the 2020 (2021) Tokyo Olympics, Paralympics and the Winter Olympics in February next year. SWM has been shoring up their balance sheet and, on the back of the lockdown and Olympic tailwinds, we believe they are well positioned to deliver significant shareholder value.
Source: SWM company filings
Olympics
SWM has been a big beneficiary of the recent lockdowns. They had the rights to broadcast the Olympics, which will be the biggest digital event of the year, and with so many people in lockdown the Olympics were drawing in huge viewership. As well as this, brands are investing more in TV advertising as a result of lockdowns. They grew their 7 Plus user base from 6.4m to 9.2m, a 43% increase. On the back of this user growth, SWM will have the opportunity to run targeted advertising campaigns as well as maintain the user base with more sporting events to come. In February next year Seven will be broadcasting the Winter Olympics which, while not as big as the Summer counterpart, will have another bumper effect on 7 Plus users.
Google and Facebook Deals
SWM has recently signed deals with Google and Facebook. The agreements bring the premium news content Seven produces from newsrooms across Australia to Facebook and Google. In their most recent trading update SWM said they expect their digital earnings to contribute $60m of EBITDA for FY21; with these deals in the bag they should add around $60m of incremental revenue in FY22.
Capital Management
Seven have been focusing on cutting costs, reducing debt and divesting non core assets. They achieved a $35m cash saving from the Olympics, existing content agreements and Cricket Australia. They have been retiring huge amounts of debt ($195 m in the second half to date) with more repayments to follow, substantially reducing their interest payments. They have reduced Net Debt from over $400m to approx. $275m. SWM have sold their WA newspaper business, Pacific newspaper business and their Osborne Park facility for $75m. SWM have strengthened their balance sheet position significantly and can now start to think about returning capital to shareholders, whether that’s through dividends or share buybacks remains to be seen.
Source: SWM company filings
Thesis
SWM have been a big winner from the latest lockdowns and benefited significantly from having Olympic coverage, growing their user base substantially. They have the winter Olympics next year and the Ashes at the end of the year to hopefully retain users. The management team have been very conservative and are focused on reducing net debt. SWM will soon be in a position to resume paying dividends and pursue M&A opportunities. They are trading at an EV/EBITDA of circa 4x. When compared to NEC (as above), Seven West looks like a far better opportunity with more upside.
NZME (Dual Listed: NZM.NZX & NZM.ASX)
New Zealand Media is one of the biggest media companies in NZ. They boast the number one newspaper and have huge market share in all aspects of media including news, audio brands, radio stations and real estate publications. This company has been a quiet performer that has slipped under the radar. Yes, the newspaper industry is dying but NZME have been monetising their digital assets and gaining digital subscribers to more than compensate for this.
Source: NZM company filings
Real Estate – OneRoof
Unlike Australia, NZ has no truly dominant online players in property listings. NZM’s OneRoof is the number one residential listing site in Auckland, it has the potential to replicate the Australian success of Domain and REA Online in the NZ market. OneRoof is NZM’s hidden gem; they have been doubling their revenues. 89% of NZ residential properties for sale are listed on OneRoof. NZME are aiming to provide a complete property destination and are targeting an EBITDA margin for this segment of 15-25%. A business like this would typically trade at much higher multiples than what their parent NZM is trading at.
Source: NZM company filings
Strategy
As mentioned, NZM’s print business is declining (as expected) but they have been aggressively cutting costs to maintain margins through a workforce restructure. NZM are in the process of selling their ecommerce platform, GrabOne, which could push them into a net cash position. They are focusing on converting their customers to digital subscribers which is not only cost effective but gives them an opportunity to add value. They are growing their audio brands and realising their opportunity to become the leading property listing platform in NZ through OneRoof. Their strategy doesn’t require any significant capex but if a value accretive acquisition opportunity were to come about they will consider it.Dividend PolicyNZME intends to pay 30-50% of Free Cash Flow in dividends subject to being within its target leverage ratio and having regard to NZME’s capital requirements, operating performance and financial position. The target Leverage Ratio of 0.5 to 1.0 times rolling 12 month EBITDA. NZM’s leverage ratio was 0.6x in H120 and we expect it to be within the range in FY21, allowing NZM to resume paying dividends. In CY2020 NZM’s free cash flow was around $40m (excluding government grants); if they were to pay 30-50% of this in dividends, their yield would be 6-10%.
Thesis
The thesis here is fairly simple. NZME are the market leader in news coverage in NZ, they have huge market share in all areas of media and are best positioned to be the market leader in residential home listings through OneRoof. They run a very profitable business, recording $67m of EBITDA in CY20. They have over 2.4m digital monthly users but only around 50k are monetised. Assuming they execute their strategy in growing digital customers and monetising them, they look like a steal in the current investment climate. They are trading at an EV/EBITDA of about 3.1x (which will be lower once they have sold GrabOne) with a Free Cash Flow yield of 21.5%, they present a great value opportunity and are likely to resume dividends this financial year.
All three of these media companies are cash generative companies going through structural changes and are focused on strengthening their balance sheets. Through good capital management decisions these companies can create significant shareholder value. The market will take time but it will get it right.
Disclaimer: SWM and NZM are both currently held in the TAMIM Australia All Cap portfolio.
This week we start a new series. One focusing on something many Australian investors place great value in: dividend yield. To start off we look at Origin (ORG.ASX) and AGL Energy (AGL.ASX), both of which have proven to be rather painful experiences for the shareholder in recent years. Which brings us to the question, is it perhaps time to buy? Especially when considering the relative valuations of the businesses in both a historic context and comparison to the broader market.
Origin Energy (ORG.ASX)
The Origin business can be put into two categories, the first is energy retail while the second is generation. Both of these have faced significant headwinds in recent years. On the retailing front, much like the Telcos, the competitive pressures and decreasing cost margins have posed significant threats to the earnings of the sector overall. While Origin has historically managed to grow earnings since the initial demerger from Boral back in the early 2000s, this was primarily through the acquisition of previously state-owned entities and a regulatory environment characterised by privatisation. With the domestic market now consolidated and about 20% of market share, the business faces saturation and a dilemma in growing its top line. The much needed catalyst came in the form of upstream and the arguably more profitable generation. It has developed the Australia Pacific LNG Project (APLNG) – a joint venture between Origin (37.5%), ConocoPhillips (37.5%) and Sinopec (25%) – in the Bowen and Surat basins. Although this remains the likely future driver of growth, spot markets continue to be volatile and, with increasing regulatory intervention and a confrontational attitude given domestic gas shortages, the far more lucrative export business has a way to go.
To sum up the critical points, ORG operates in a complex and competitive environment that 1) has seen diminishing margins across its core retailing business; and 2) in the segment that is key to providing future earnings growth, is seeing volatility and an increasingly hostile policy environment. So with that context in mind, let’s dive into the numbers
Author: Sid Ruttala
Management has confirmed that FY22 is a trough in earnings and should see some recovery. Within the generation business, higher than expected input costs, including coal and gas prices, have hurt the bottom-line (i.e. higher than anticipated fuel costs) wish was compounded by substantially lower wholesale prices (i.e. Covid related). EBIDTA is likely to come in at $450-600m AUD (note the wide range) though FY23 is likely to see a rebound assuming that wholesale prices stabilise. This result is also somewhat mitigated by the APLNG which in fact benefits, as could be expected by higher spot prices, with sales volume coming in slightly higher than expectations although I personally continue to be disappointed at the realised price at $55USD/bbl. Conservative but nevertheless could’ve been much better. The business’ Net Debt/EBITDA, even taking into consideration the APLNG dividends at 3.4x, continues to cause concern (a hangover from the acquisitive phase).
On the positive side, much of the negative has been offset by consistent business customer wins, strong EBIDTA to cash conversion and stable customer account numbers (a vital metric in our opinion). Looking at CAPEX, the business has been delivering with APLNG CAPEX at record lows and a dividend to ORG of approx. $265m AUD.
So, with all that in mind, why do we think this is a buy?
Simply put, the price and defensive attributes of the business make it a great allocation for the portfolio. Firstly, the energy retailing business, despite its low margins, has defensive attributes and scale matters. With a relatively stable market share (i.e. stable customer account numbers), this becomes a cost-out story with future growth predicated on upstream. Moreover, in comparison with its other significant competitors, ORG is (comparatively) not as encumbered with legacy coal assets, which makes it more palatable for institutional investors. Based on current share prices, it implies a dividend yield of 4.4% with further upside assuming payout ratios of more than 50%. If the company should meet its own targets, it implies that shareholders investing now should have locked in a close to 8% yield by 2025.
Red Flags & Risks: The wholesale electricity business continues to see margin pressures and volatility along with further risks in the policy environment. Though much of the noise has subsided, the possibility of export restrictions being placed on local producers cannot be ruled out. We are also likely to see continued impairments across its legacy generation assets.
My Expectations: A patience game and dividend growth story. My expectations are a fair value target of $6.50 AUD per share assuming opex reduction targets are met as well as continued recovery in the wholesale markets, which we see as improving over the medium to longer term.
Dividend Yield: 4.1%, assuming a price 4.37 AUD
AGL Energy (AGL.ASX)
AGL has certainly been on shareholder’s minds in recent years and not for the right reasons. The share price continues to be in free fall and the CEO’s departure in the middle of a critical juncture with the demerger of the business certainly does not help the optics. Like ORG, AGL has been hit across its retail divisions and by downward pressure on wholesale prices. Add to that increased uncertainty around its coal assets and the embattled company has what might be termed a perfect storm. Nevertheless, it has been on our watchlist, not least given the relative valuation (and this is even taking into account the broader discount that the energy sector seems to be trading at across the ASX).
Similar to ORG, AGL’s growth has historically been underpinned by acquisition as opposed to organic (the most recent acquisition being Click Energy). However, with the market stabilising, much will be contingent upon management delivering upon cost reductions and the handling of legacy generation assets. AGL has relied upon low-cost coal to date and, unlike ORG, relies upon those assets for a disproportionate amount of its generation (84% coal based). While the proposed demerger of coal assets from the retail and renewables division should theoretically benefit from a management and strategy perspective, there is a great possibility that it may in fact be value destructive given the risk of duplication.
Continued regulatory and policy uncertainty potentially make it an investment for the more adventurous. Under current estimates, we are likely to continue seeing declines in earnings over the next 24 months (approx. 7% p.a.) and the shake up of the C-Suite at such a critical juncture does not help the situation.
Examining the numbers, underlying EBITDA of $926m, representing a decline of 13% with NPAT down even further by 27%, the disconnect being higher depreciation expense and impairments. On the positive, what has been pleasing is that the business has continued to grow the total number of services to customers by 246,000 to 4.2m and has seen an increasing take up of its broadband and carbon-neutral products. So, having said all that, why do we think it is worth considering as a buy?
Simply put, the price. This is a classic reflation trade as we see stabilisation in the wholesale market coming out of Covid. In addition, and despite the negative numbers which are likely to continue into the immediate future, the market may have overreacted with the share price declining close to 60% over the last twelve months. Within the domestic market we continue to see a space for coal at least in the short-term and, given the current pipeline of renewables, we are likely to see choppy supply-demand numbers. Assuming even the worst case scenario, our fair value estimate stands at $12 AUD per share.
What has been particularly concerning however is the lack of management’s clarity around future strategy and even the payout ratios. They initially announce a 100% of NPAT payout ratio and then reneging by going to 75% and announcing a DRP fully underwritten which effectively raises $300m AUD in equity. Poor form, especially when one considers that they had previously embarked in share buybacks at $19 AUD per share.
Red Flags & Risks: On top of the existing messiness within domestic energy markets, and as mentioned, much of the risk comes from uncertainty around management of the business at such a critical juncture. With coal assets so unloved we could very well see further shareholder dilution with traditional banking institutions unwilling or unable to underwrite further developments.
My Expectations: We will probably see the security bottoming out at $7 AUD per share before consolidating. This implies a P/E of less than 10x and a dividend yield of 9.11%. We are likely to see this stabilise and much will be contingent upon management realising their OPEX reduction targets (not helped by the changes in management). It would, in our view, be unfortunate for the current chairman and interim CEO to continue on in those roles, we would prefer an outsider with a fresh perspective come onboard.Dividend Yield: 8.57% assuming a share price of 7.44 AUD and a normalisation in payout ratios back to 75%.
Final Thoughts – Both ORG and AGL remain cheap, AGL more so. For us, we continue to own ORG with AGL being on the watchlist (we would need to see a clear strategy from management and, more importantly, a leader).
This week we will be writing about two of the heavyweights on the NASDAQ, Amazon (AMZN.NASDAQ) and Alphabet (GOOGL.NASDAQ). While these stocks are always in the headlines, we believe there are parts of these businesses that are stuck in the shadow of their parent company and aren’t getting the attention or credit they deserve and, as such, any value when it comes to the market. GOOGL and AMZN are best known for their search engines and marketplaces but what people may not see is that they are both making transformational advancements in the autonomous vehicle industry.
Author: Adam Wolf
Autonomous Vehicles
Autonomy or automation has been pulled forward several years due to the pandemic and yet it remains an area the media largely ignores, similar to electrification about eighteen months ago. The technology is ready, has been developed and undergone plenty of trials (for those watching the Olympics, autonomous vehicles are being used to transport the athletes within the village). And now there are catalysts for change with, amongst others, labour shortages and efficiency improvements. Additionally, 94% of US car crashes are caused by human error so by removing these mistakes through fully autonomous vehicles, lives can be saved. There are still a lot of boxes to tick before autonomous vehicles are used at scale though. This includes things like road-side infrastructure connectivity (a space we are actively investing in) as well as some minor obstacles such as weather conditions but we believe autonomous vehicles will be a multi-trillion dollar industry and, just as people refused to see motor cars being widespread in the early days of the 1900s, we are seeing a similar situation with autonomous vehicles.
Alphabet (GOOGL.NASDAQ)
Google (we’ll use “Google” for familiarity’s sake) has been a strong performing stock recently (up 50+% YTD). The company makes most of its money from search and display ads and the like but other investments, such as YouTube and cloud tech which are growing at fast rates, are starting to drive profits too. While Google is one of the most covered stocks on the market, this is the same market that still isn’t giving them proper credit for subsidiaries like YouTube. Google at its core is starting to prioritise investments for long term value creation and they are accordingly starting to invest heavily in AI. The segment of Google that we believe is a real hidden gem, obscured by the shadow cast by the behemoth that is Google as a whole, is Waymo.
YouTube
Quickly touching on YouTube, Google bought the company in 2006 for $1.65bn USD. Since then, YouTube has become the second most popular website in the world. That $1.65bn is probably a small figure compared to what YouTube would attract if it were spun off today. YouTube is a unique asset in the sense that their business model is extremely tough to copy and anyone that tries to compete with YouTube can simply be copied or absorbed. Another feature of YouTube is that they can scale their service (add more users) and hardly increase their costs in doing so. The key revenue drivers for YouTube are its premium subscription service and Google Ads. YouTube-displayed ads currently account for around 10% of Google’s revenue.
Source: Visual Capitalist
Waymo
Waymo was first founded in 2009 as “Google’s self driving car project”. Waymo have developed the software that operates autonomous vehicles using, amongst other things, lidar systems and sensors. Since launch they have already achieved Level 4 autonomy. This means they can operate vehicles with full autonomy but with a few restrictions, such as weather and road conditions. Last year they launched Waymo One, a fully driverless ride-hailing service. This is an operation that means anyone in Phoenix with the Waymo app can hail a fully autonomous ride at the tap of a button. Competing with the Ubers and taxis of the world isn’t all Waymo is doing, they currently have a few segments to their business. They aren’t just looking to drive people, they are also looking to grab a piece of the commercial market through trucking, postal services and pizza delivery. Waymo was an early mover in the driverless car space and has made a lot of progress already having tested autonomous vehicles in 25 cities across the US. More recently, Waymo launched Waymo Via which is developing an autonomous trucking solution (directly addressing a pressing issue in the current environment given the US’ truck driver shortage).
Source: Waymo
Waymo recently raised $2.5bn USD to further develop their technology and we think a lot of this will be used to progress Waymo Via. Waymo has also already established partnerships with Volvo, Nissan and Renault to name a few and these partnerships will be used to test how autonomous vehicles will be used in Japan and France.
Source: Business Insider
Context: Aurora
There has recently been news of fellow autonomous tech company Aurora going public via a SPAC deal at a valuation of around $11bn. They are a fair way behind Waymo in terms of their capabilities (e.g. they haven’t reached Level 4 autonomy yet) and they have no existing operations, having only been founded in 2017. These kinds of deals show that the sector is beginning to heat up while also highlighting what Waymo could be worth as a stand-alone company. Given how far behind Aurora is and the extent of Waymo’s existing operations, it is certainly well north of $11bn.
Amazon (AMZN.NASDAQ)
Jeff Bezos recently rocketed off into space but Amazon’s stock price has stayed grounded the past year while the S&P has climbed higher and, over that timeframe, Amazon has continued to grow and innovate. Amazon is essentially a bundle of lots of different businesses with different margins, their profits are being driven by Amazon Web Services (AWS), but they also have other segments that are emerging like their advertising business. Amazon’s ‘Advertising & other’ (see below) revenue segment contains a lot of the revenues generated from their subsidiaries and we believe portions of these investments are misunderstood and aren’t priced in.
Source: Benedict Evans, Feb 2021
Automation
Looking at Amazon, there is a huge opportunity to inject further automation (not entirely in the mobility sense either) into their business model, notably the e-commerce side. It will be a step function change in terms of their cost structure. Logistics is by far Amazon’s biggest expense. Any opportunity they get to automate anything, whether it’s picking within the warehouse, moving a package from warehouse to warehouse with autonomous systems, or anything along that front is going to be a step function change in their operating profit. We think that this development is something that the market is not paying attention to whatsoever. And that’s just one aspect of the business.
AWS
The other big aspect of the business is obviously AWS, their profit centre. AWS is providing on-demand cloud computing platforms and APIs to individuals, companies, and governments, on a metered pay-as-you-go basis They’re not getting credit for this business whatsoever and, in terms of it fitting within our mobility theme, Cloud solutions/technology in general is something that fits perfectly within the first pillar of sharing and connectivity, we consider it the network layer. Cloud infrastructure is critical, particularly as we talk about edge computing, and having vehicle to vehicle, vehicle to infrastructure, basically just low latency connections. As Cloud scales, Amazon is obviously the leader there. All of the Cloud players – Amazon, Microsoft, and Google – have autonomous efforts. They know that autonomy is going to be huge and, simply put, having Cloud in house when you also have autonomy is a significant advantage.
Source: Statista
Zoox
In 2020 Amazon acquired Zoox for approx. $1.3bn USD. Zoox is an autonomous vehicle company looking to reinvent personal transportation. Like Waymo, Zoox will provide mobility as a service in dense urban environments; they will handle the driving, charging, maintenance and upgrades for their fleet of vehicles. Riders will simply pay for the service. This is a key difference between these new autonomous solutions and the Ubers of the world. Amazon is a unique and growing company that uses its vast platform to disrupt any new business it enters; we saw what happened when Amazon bought Whole Foods, Walmart and Target took a big hit in market value. We can see them having the same impact in the autonomous driving industry. Zoox is something Amazon is getting negligible credit for. And that’s understandable. They’re a bit further behind in terms of the competition. But in terms of the opportunity set, it’s a massive one. And that’s not to mention anything else that Amazon has going on whether it’s pharmaceutical or Amazon Go, which is basically automation and something that we believe they’re going to probably license out over time and it will become a very high margin product.
Regulation
A risk that is commonly spoken about regarding the FAANG stocks is the perceived regulatory risk. There has been talk that regulators will step in and break up the Amazon’s into smaller entities, such as spinning off the AWS business, but so far it’s been a losing battle for lawmakers as they haven’t been able to force any of these changes yet. However, if Amazon or Google were to be broken up, we believe they would become more valuable as the market prices the spun off entities properly. It is relatively common for excellent companies with many different segments to be undervalued.
Thesis
Both Google and Amazon are pioneers in their respective fields but we believe these businesses are misunderstood and the market isn’t giving them enough value for their subsidiaries that would be worth a lot more as stand alone businesses. Both AMZN and GOOGL are investing in long term plays that create value for shareholders, e.g. AWS and YouTube, but we think their autonomous vehicle investments, Waymo and Zoox, may be their best ones yet.
Rewinding back to the early 2000s, Amazon was spending hundreds of millions of dollars on capex to build out AWS for years. It was a massive expense, very capital intensive and a huge drag on free cash flow. All the corporates, their potential competitors, thought they were crazy. They didn’t understand it, so they ignored it. And so, for years, they allowed AWS to take a huge lead in a multi hundred billion dollar plus market with literally no competition. Fast forward to today and it’s a business probably worth about a trillion dollars and Amazon is the clear leader of the pack. That’s how we expect these autonomous units to be viewed, big cash drags that are given negative to no value. Today, Google is given no value for Waymo. One day the market will catch up and quickly recognise how transformational it is.
Disclaimer: AMZN & GOOGL are held as a long positions in TAMIM’s Global Mobility portfolio. The TAMIM Global Mobility strategy seeks to to capitalise on the ongoing $7 trillion autonomous and electric vehicle revolution.
Ahead of his webinar next week (register here), Robert Swift takes a brief look at the state of the world and what it means for the investors out there.
Instead of some precautionary monetary tightening, for which we pleaded, we got an additional stimulative policy aka a large pro cyclical fiscal boost of up to $6 trillion (Yes, TRILLION) some of which may go on productivity enhancing investment. The combination of fiscal and monetary stimulus in the USA is now at a level not seen since WW2.
US fiscal and monetary policy has only been as coordinated during WWII
Source: GFD, Deutsche Bank
Not surprisingly this is having inflationary consequences and these are now getting harder to conceal from the ‘great unwashed’ with hedonic pricing and ‘transitory’ arguments. The more geeky should also concern themselves about how big the output gap actually is in the USA. Large output gaps tend to mean one can be relaxed about inflation in periods of easy money and loose fiscal policy and vice versa. Those in favour of this extraordinary stimulus argue the output gap is large. Recent studies from the Congressional Budget Office would indicate the opposite and that we should be concerned if we don’t change course soon by tightening money. Essentially there is a lot less room to manoeuvre; time is running out if we wish to avoid inflation or stagflation.
Inflation is unlikely to be transitory and we have invested as such. Add in temporary(?) supply chain problems from Covid, permanent supply chain changes from National Industrial Policies (aka a dismantling of the global trade just in time system), and the supply side reductions caused by the “Green Revolution” and now hot weather, wet weather and not enough wet weather, and we will see the commodity complex, both hard and soft, on a strong upward trend. Wages are going up too and so we are looking at quite a well-entrenched bout of inflation and inflationary expectations. This will have consequences for companies with stretched balance sheets, and for those companies who provide goods and services with elasticity of demand and high fixed costs.
Companies can either take the inflation in input prices as a hit on margins and keep retail prices where they are, and/or they can raise retail prices and try to preserve margins. We believe that the latter is more likely. Prepare for persistent inflation. If we’re wrong and it’s the former, prepare for lower returns and profit growth from equities. Neither is particularly great for equity markets and the discount rates that will be applied to future earnings and dividends.
Consequently one needs to invest in companies with quality balance sheets, low elasticity of demand for their products, and not in danger of being targeted for regulation.
The Biden administration has recently introduced a potential 3rd policy tool in its attempt to generate sustainable economic growth, where sustainable means a reduction in wealth inequality, wage growth relative to profit growth, and a reduction in corporate pricing and employment power (monopolies and monopsonies). This policy tool is the use of anti-trust legislation to break up ‘Big Tech’ and more recently an Executive Order directed at the rail roads, and has been accompanied by the appointment of Big Tech critics to the Federal Trade Commission which oversees policy toward protecting consumers.
The FTC is a bipartisan federal agency with a unique dual mission to protect consumers and promote competition
While the USA dithers about monopoly power and is “putting out the (inflation) fire with (fiscal) gasoline”, elsewhere in the world a set of policy makers is acting in a more orthodox manner by moving counter cyclically to reduce the build-up of inflationary expectations consequences; squeeze moral hazard out of its financial system; and prevent monopoly power from building early by applying regulatory pressure. Yes, and ironically, it’s the Chinese who seem to be doing what the “Imperialist Running Dogs” used to do? It is a topsy turvy world when the Chinese adopt the capitalist play book?.
Namely:-
Be countercyclical in monetary and fiscal policy – China 1 USA 0
Let owners of the risk capital be at risk – China 1 USA 0
Prevent state sponsored monopolies and encourage competition such that capitalism serves the consumer – China 1 USA 0
Some of the regulations seem somewhat draconian, capricious and counter-productive and we have been somewhat caught in our portfolios by the severity of the Chinese regulatory crackdown. We own Ali Baba (9988.HKG) and some collateral share price damage has been seen in other large Chinese dual-listed companies such as Ping An (601318.SHA, 2318.HKG). On the other hand we are underweight Tech in our global portfolios; own none of the likely targets of the FTC in the USA and so from a portfolio perspective are underweight this risk. Additionally and crucially, any increase in regulation is typically aimed at large companies and not smaller ones. As at end July, 6 USA stocks constituted about 25% of the market. We won’t get badly hit by any USA legislation against large “Tech”. Our portfolios have a substantial underweight position in the risk factor known as ‘Size’. Small is (once again) beautiful?
We will shortly be running a risk based analysis of the inflation protection properties of the listed infrastructure stock universe. There isn’t a lot of long term data on this and much of the promotion of listed infrastructure as an inflation hedge is opinion. Fair enough, but we’ll do an ex ante risk analysis of the properties of these stocks and publish shortly!
We would also suggest investors consider Asian and Japanese smaller companies. Inexpensive, improving governance, and operating in an environment of prudent macro-economic policy, we believe prospective returns look very good. We have managed a portfolio successfully for four years here and have many more years’ experience than that in Asian and Japanese equity markets.
The Origin business can be put into two categories, the first is energy retail while the second is generation. Both of these have faced significant headwinds in recent years. On the retailing front, much like the Telcos, the competitive pressures and decreasing cost margins have posed significant threats to the earnings of the sector overall. While Origin has historically managed to grow earnings since the initial demerger from Boral back in the early 2000s, this was primarily through the acquisition of previously state-owned entities and a regulatory environment characterised by privatisation. With the domestic market now consolidated and about 20% of market share, the business faces saturation and a dilemma in growing its top line. The much needed catalyst came in the form of upstream and the arguably more profitable generation. It has developed the Australia Pacific LNG Project (APLNG) – a joint venture between Origin (37.5%), ConocoPhillips (37.5%) and Sinopec (25%) – in the Bowen and Surat basins. Although this remains the likely future driver of growth, spot markets continue to be volatile and, with increasing regulatory intervention and a confrontational attitude given domestic gas shortages, the far more lucrative export business has a way to go.
AGL has certainly been on shareholder’s minds in recent years and not for the right reasons. The share price continues to be in free fall and the CEO’s departure in the middle of a critical juncture with the demerger of the business certainly does not help the optics. Like ORG, AGL has been hit across its retail divisions and by downward pressure on wholesale prices. Add to that increased uncertainty around its coal assets and the embattled company has what might be termed a perfect storm. Nevertheless, it has been on our watchlist, not least given the relative valuation (and this is even taking into account the broader discount that the energy sector seems to be trading at across the ASX).
