Portfolio Performance for the 6 Months to August 22 2019

The portfolio produced a positive net return of +46.2% for the 6 months to 22/8/19 taking the annualised net return since inception to +44.8%. As I’ve added a new international stock, the performance figures are now also reported net of gains or losses arising from changes in currencies.

The standout stock was Afterpay (ASX: APT), which rose +43.5% in the 6 months and has driven the returns. 3 new positions were also added being Electro Optic Systems (ASX: EOS), Blackwall (ASX: BWF), and Pinduoduo (NASDAQ: PDD). EOS was added at a net average price of $3.29 (up +41.2%), BWF was added at a net average price of $0.84 (up +17.5%), and PDD was added at a net average price of AUD$33.13 (up +36.7%).

As usual, the information below isn't intended to be read as investment cases. Rather, they are just thoughts of mine I want to put down. 

Afterpay

There have been numerous key events within the last 6 months including: the launch of Clearpay in the UK, AUSTRAC, a $300m capital raise and founder sell down, key retailer wins and customer growth acceleration in the US, Visa’s entry into the Buy-Now, Pay-Later (BNPL) space, the introduction of Klarna’s ghost card, CBA’s USD$100m investment in Klarna and their announcement that they’ll be coming to Australia, and the list goes on. I believe the AUSTRAC investigation and Visa’s announcement to enter the BNPL space together have been the chief drivers of the volatility experienced over the last 6 months. AUSTRAC’s investigation has meant that Afterpay is subject to an audit in respect of its Anti-Money Laundering (AML) and Counter Terrorism Financing (CTF) compliance. The actual outcome of this is unknown but given the direct worst case scenario is a sanction of $21m per contravention of the Act ($42m in total for 2 breaches), I’m comfortable with bearing this risk. The big unknown from my perspective is that if they were in breach, what other ramifications could that lead to beyond the direct maximum financial sanction. In other words, would this put Afterpay back insight of ASIC and if so, what could that lead to?

In terms of competition, I’m still of the view that the competition especially in the US is exaggerated. The term Buy-Now, Pay-Later gets thrown around as an umbrella term and many of these “me-toos” are in fact very different to Afterpay. Many will charge either an account fee, interest, other charges, or some combination thereof. Most (if not all) don’t have the simplicity and transparency of the Afterpay business model – which in my opinion has been one of the major drivers of its success. Google Trends data below shows the relative popularity in search terms of Afterpay and some key competitors in the US. As can be seen, Afterpay remains the clear leader. This is in light of Klarna’s recent big marketing campaign “Shop Like a Queen”. The campaign promoted the ghost card which allows shoppers to use the service on any site (or so they claim). What this effectively means is that they are providing the service for free. When I first read about the ghost card from Klarna’s press release, I was very skeptical of this. My interpretation of it was that because they couldn’t compete directly with Afterpay in the US, they had to offer their service for free to gain traction. Fast forward a few months, and I think another reason for launching the ghost card was to artificially boost their customer growth numbers for the purpose of their recent USD$460m capital raise. At some point, they will have to monetise the userbase. Given that Klarna is a bank, my inclination is that they will in some form monetise the user base directly and perhaps charge a reduced merchant fee. This reactive move by Klarna in my opinion is a testament to the strength of Afterpay’s management team and the strong brand they have developed. 

Similarly, as can be seen in the Google Trends chart below, within a matter of months, there has been a strong convergence between Clearpay (Afterpay’s brand name in the UK) and Klarna. I think it’s important to bear in mind that this was achieved with less than 100 active merchants at the reporting date (the average would be much lower). This compares to Klarna who have been in the market for several years and have many more merchants than Clearpay.  To me, this is one of the strongest signals of the strength of the business and Afterpay’s ability to expand into new markets. Over time, this will become apparent in the financials. 

Many brokers have assumed linear customer growth in the US. For example, at the time of writing, a recent broker report shows that they assume the US business adds a net of ~2.5m customers per year in both FY20 and FY21. But this is not how this business works, rather, growth is exponential (not linear). The most recent US Press Release proves this nicely, with customers up ~250,000 per month in the US between Jun-Jul 2019 vs ~130,000 per month between Jan-Feb 2019. Therefore, I believe there is substantial upside risk to the customer numbers in many of these broker reports. Over time, as I believe they will continue to grow the customer numbers, the brokers will be forced to upgrade leading to a re-rate.  

The direct key drivers of revenue growth being number of active users, frequency of purchase, average order value and the merchant margin are all tracking along nicely, and I am extremely pleased with the progress. While I continue to monitor the market acutely, with each passing day, I grow more confident that this business will become a household name across the globe and that the best years are still ahead of us. 

Electro Optic Systems

EOS operates in the space and defence markets. They make advanced weapon systems predominantly for the military and develop tracking systems for orbiting satellites and space debris.

The company’s core competency is the development of Remote Weapon Systems (RWS). RWS are essentially weapons that can be attached to various vehicles allowing the weapons to be used remotely – i.e. the gunner isn’t manned on the gun, rather, it’s operated nearby or within the vehicle. The weapons business has an order backlog of over $600m and is tendering for projects which in combination are worth more than $2.5bn with existing customers. Only a small amount of that $2.5bn has to land in order for future earnings upgrades. 

The space business currently generates minimal revenues, but this has potential to be a substantial part of the business over time. Management estimates the market to be worth over $2bn over the next 10 years. The theme behind the space business is appealing. There is currently $900bn of space assets (and growing). EOS’ space technology allows satellietes to track debris and avoid collision which is an increasing threat and legacy based detection is increasingly becoming insufficient. EOS has been in the research side of the space market for over 20 years. They have developed advanced technology which is potentially now at “mass commercialisation”. For example, space communication is mainly by microwave technology which is limited to a bandwidth of about 500GHz. This is expected to hit capacity within a few years, leading to a need for higher bandwidth. The EOS satellite is the only optical communication satellite capable of testing transmit-receive bandwidth of 20THz in space (Evans & Partners, 2019). The company’s advanced technology places it well ahead of the competition. My numbers don’t factor in much upside in this side of the business, but once again, if only a small amount of the market is landed, there is potential for earnings upgrades down the track. The margins in this division are high, and so as this division grows, margins are expected to expand over time.

What initially attracted me to this business was simple; the business was forecast to grow revenues in excess of 40% in FY20, and was trading at about 11x earnings (after adjusting for unrestricted net cash). It was simply just too cheap. A recent upgrade to earnings (and the subsequent rise in the stock price) means that the company now trades at just under an FY21 EV/EBITDA of 9x. On face value, this may seem cheap as it’s got a secured revenue stream with real potential for meaningful upgrades down the track. However, at the end of the day, it’s still a contracting business and so a multiple re-rate much further than this seems unlikely. Rather, the main driver will have to come from the company landing contracts and growing its space division (and therefore margins). Both drivers I believe are achievable and, in my opinion, the risk-reward remains compelling. 

Blackwall

Blackwall is a property funds management company that operates 3 distinct but complimentary businesses. Blackwall Asset Management is a development and management business that acquires commercial real estate for incremental returns. Wotso Worksapce is a co-working business that earns the bulk of its revenue by leasing out desks. The investment segment (~$30m) holds a strategic ~$16.2m in Blackwall Property Trust (ASX: BWR), with the balance deployed opportunistically to further enhance the other 2 operating businesses. 

While the funds management and investment business together contribute towards a large part of the NTA and revenues, the expansion of Wotso is where I believe the bulk of the uplift will come from. Management have indicated that the total network will have 6,700 desks in by FY19, up from 1,400 in FY16. The bulk of the sites are yet to reach maturity (generally after 3 years), meaning that latent revenue remains with overall occupancy estimated to be at ~50%, compared to the average of ~95% for mature sites. Upon maturity, revenue per desk is estimated at $4,750 with an EBITDA margin of 20-35%. In other words, there is potential for $25-30m of revenue using current desk rates. However, given the strong surge in supply, I’ve brought down the average rate per desk and occupancy rates, as despite having some immunity (expansion is CBD focused, whereas Wotso’s  are in the suburbs), I believe there will be rate pressure across the board and maintaining the 95% gets more challenging. I’m a believer that the co-working market will continue to grow in popularity. Moreover, co-working represents less than ~2.5% of assets in Sydney and Melbourne which compares to ~7% in New York, providing further upside via increased penetration rates.

The recent sale of the Bakehouse Quarter in Strathfield also means that with the cash infusion of $110m in total (split across BWR and BWF), the expansion of Wotso is likely to continue and so too will the recurring management fees from asset management.

With NTA of ~$0.49 per share (which isn’t needed to operate the two other businesses), the geographical expansion of Wotso, increase in utilisation rates over time as newer Wotso sites mature, and the sale of the Bakehouse Quarter and the associated uplift in cash and NTA, I believe there is strong potential for the shares to move higher from here.  

I will introduce Pinduoduo in another post.

Thank you for reading.

Performance figures are annualised and the figures are quoted net of fees and expenses, gains/(losses) from changes in foreign currencies, but before taxes. All positions are long positions. Inception date is 22/02/2014. This article is general advice and is not intended to be personal advice. Before making any decisions, consult a licensed professional.