Update No. 204 – 27/02/15

Reporting season is over and I am dealing with the usual last night dump as many of our holdings are customarily last minute reporters. Small firms often are.

After my comments last week, I should be happy that we got a few after close reports, it does allow the market to fully digest the reports content and act in a fully informed way come market open next week.

For reports issued after market allow a proper digesting of the information presented and can potentially save people from acting brashly on a short-term change based on an inappropriate reading of the facts presented.

After close today, we had two particular reports issued with figures that I believe are remarkably different to what the market was expecting. One was remarkably better than expected, but on a thorough reading was probably not quite as good as it looked at first glance. T’other was I believe a good deal worse than the market was expecting, yet upon a thorough review, still leaves the impression the future is very bright (remember investing is a forward looking process). Had these reports been released into the market live, as they are both fairly illiquid stocks, there would likely have been very sharp moves followed by partial returns toward the respective starting points (I say likely as this is a speculation, obviously the market doesn’t always react as I say it will!).

Naturally, the unexpectedly good report was from our second smallest holding and the unexpectedly poor result was from our second largest.

I always think it is best to concentrate on the mistakes, weaknesses and errors, so I will review Dicker Data’s result, which was not nearly as impressive as I was expecting.

In an investor presentation released on 21 July 2014, DDR indicated they expected to generate a pre-tax profit of $30m in FY15, but would incur an additional integration expense of approximately $3m. This was reaffirmed at the AGM, when it was declared that $3.2m in integration costs had been incurred and there were unlikely to be further meaningful costs.

In a first quarter update released 30 October 2014, DDR indicated revenue, profits and EBITDA were all tracking better than expected.

This would lead one to believe that underlying $30m PBT was probably going to be exceeded in the 12 months ending June 30 2015 barring a major deterioration in trading conditions.

The result delivered this evening was an underlying December half PBT of $10.02m. Now traditionally DDR has earned about 61% of PBT in the June half, so if that were to hold, a little over $25.7m of underlying PBT would be the Dec 14/Jun 15 12 month result (this will not be the FY15 result as they have switched to calendar year reporting).

This result is plainly nearly 15% below the guidance issued and that is part of what I would have expected the market to knee-jerk react to if this has been released into live-trading.

The other thing that would (will) likely upset holders is the poor estimation of the integration costs. There has been no further publicly announced update to the $9-10m integration costs guidance. Yet as at 31 December 2014, the integration costs to date have been $14.21m and the report says a further $500k of redundancy costs have fallen into January. With integration costs of $5m greater than expected, there really should have been an announcement to mention this in the intervening period. I am all for the removal of surplus staff and the business will be leaner as a consequence, but it shows a poor understanding of such an integration that costs were so grossly underestimated. This is the first time DDR have undertaken such an acquisition, so I suppose this is understandable, but it really should have drawn a further update to the market somewhere in the last couple of months. When the firm you acquire in the same industry has marginally higher revenues and nearly 4 times as many staff, it should be clear there will be meaningful costs in reducing staff numbers to more appropriate levels.

The result seems to have split revenues roughly down the middle ($252m from DDR & $246m from ED), and gross margin has been lifted due to the extra volume leading to higher rebates, so there has been no negative impact in this area. As such, if the $25.7m was to be the underlying PBT for the 12 month period ending 30 June 2015, roughly half of that is attributable to ED, which means given the final $51.1m paid for ED, the acquisition multiple was about 4x PBT or about 5.7x NPAT, so once the acquisition is fully bedded down, it will have clearly created significant intrinsic value for the shareholders at the time of the acquisition.

EBITDA has traditionally been around 48.3% higher in the second half (prior to the ED acquisition), so if that historic pattern holds, EBITDA for the 12 months ending June 30 2015 will be something like $39.8m. Given the market cap at Friday’s closing price of $1.80 is about $238m and net debt per the report issued tonight is about $119m, the ‘Enterprise Value’ is about $347m. That places Dicker on an EV/EBITDA multiple of about 8.7x, which is certainly not too demanding, especially given around $2.3m of the ‘A’ in EBITDA is not a genuine cost (they will never need to replace this cost whereas most depreciation at some point requires replenishment).

I had expected an EBITDA figure of more like $20m in the December half, so it is unquestionably a disappointment based on what I was expecting. But given they were still incurring some redundancy costs in January, the costs have not yet been fully stripped out and when they do, if they can return their cost of doing business to something nearer to pre-acquisition levels, generate revenues of $1b per annum ($498m in the weaker December half indicates this should be comfortable) of revenues at a 9% gross margin, then the business should generate about $50m or more of EBITDA (as I had been working on as the current run rate). The ‘DA’ in EBITDA will be circa $4m per annum (though the ‘A’ will cease at some point once depleted). The ‘I’ based on the December half appears to be about $8m per annum, leaving about $38m in PBT, with a tax rate of 30% meaning the underlying earning power of the business looks to be about $26.6m. Again, based on the current market capitalisation of $238m, this is a fairly undemanding at less than 9x; based on the EV of $347m, is still only 13x (I will discuss P/EV next week as this is actually my favourite ratio along with P/FCF).

Most businesses that grow their after tax earnings from $6.1m (June 2011) to $26.6m (my estimate in the above paragraph for the period ending June 30 2016) over the course of 5 years would have sought recourse to their shareholders for substantial extra capital. To date, Dicker has only required an additional $4.06m in fresh equity capital to support that growth. If they were to raise say another $60m to extinguish half the debt currently on the balance sheet, I would describe the circa $20m increase in annual after tax earnings was a good return on an extra $64m of capital.

I still suspect Dicker will fall in price on Monday, but provided the costs keep falling over the next few months as the integration is finalised, it appears to be inexpensive at current prices and despite it being the second largest position in the fund, if the price were to become very much cheaper in the near future, EGP might once again be a buyer – Tony Hansen 27/02/2015

EGP Fund No. 1 Pty Ltd. Up by 4.19%, trailing the benchmark by 8.96% since July 1^st 2014. Since inception, EGP Fund No. 1 Pty Ltd is Up by 77.50%, leading the benchmark by 31.45% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1.000 cent per share Franking Credit & 31 May 2014 Dividend of 7.000 cents per share plus 3.000 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}