Make it Hot | April 2024 Update
”Do not wait to strike till the iron is hot; but make it hot by striking." – attributed to William Butler Yeats
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THE MONTH | We used the word “oscillate” last month and that continues to be the case - in each of the past four months NAV has moved in the opposite direction that it had in the prior month. This month it advanced 0.53%, bolstered by Adveritas (AV1; +37%) against a backdrop where the S&P/ASX Small Industrials fell 5.1% and the resources sector (in which the Fund does not invest) helped push the S&P/ASX Emerging Companies Index up 2.62%.
SMALL TALK | Since our last monthly update, Fund investors have received a profile of Adveritas (AV1).
OUTLOOK | We doggedly continue to invest based on our view of the potential value of each individual investment. We do not trade based on momentum. That has been a hard path to follow in the past few years when some of the most interesting opportunities are those that have no momentum and the marginal buyer who might once have come into the market based on value/price points is often nowhere to be seen. So an improvement in market activity in April, as highlighted in the “What’s On Our Minds” section of this update, is noteworthy.
We have repeatedly pointed to M&A as the potential path for unlocking value where the marginal buyer in listed markets fails to do so and we noted the following in Small Talk this week:
20 listed Australasian M&A deals so far in CY2024, up from 13 a year ago;
Software has been the most active industry group in CY2024 (no Software deals struck in the same period of CY2023);
The median multiples of CY2024 M&A are 33%-41% higher than the median valuations of ASX-listed micro-to-mid caps.
PORTFOLIO REVIEW
One step forward - the gain in AV1 highlighted on the cover page - accompanied by a step back - Intelligent Monitoring (IMB; -22.5%). Our comments last month about the frustration of not having performed better so far in FY2024 remain relevant. There were positive developments with AV1 that were reflected in its positive price movement. If anything there was positive news from IMB too but it fell anyway.
Digital advertising fraud protection company AV1 showed a substantial increase in cash receipts, generating $3.9m in the first nine months of FY24, compared to $0.6m a year earlier. This growth is attributed to expansion of its customer base but also successful pricing strategies, where threefold rate increases are being pushed through progressively through to December 2024, without significant client pushback to-date. The company is exhibiting cost discipline, with $1.7m in annualised savings extracted in December 2023, and operating leverage as it advances towards cash flow positivity. March quarter cash receipts were up just over $1.1m year-on-year but net operating cash burn reduced by $2.3m to -$1.4m. Annualised Recurring Revenue (ARR) was $4.53m at December 31, up 54% on the prior year. Since then, in the March quarter AV1 said it added ~$1.1m in annualised revenue.
IMB, Australia’s leading security monitoring company since the acquisition of the local ADT business, released its March quarter cash flow report showing $5.25m net operating cash flow for the three months (and $7.4m before interest, acquisition and integration costs). IMB confirmed it was on track for its annualised $31m FY24 EBITDA target. Post month end, IMB then announced an upgrade to that guidance to between $33.5m and $34m. With a market cap of $78m and net debt of $75m, IMB’s enterprise value of $153m is only 4.5x the upgraded EBITDA guidance. IMB has been publicly setting the target of a 10x EV/EBITDA pricing, which we think is a logical ambition. If it were achieved on the current capital structure and guidance, it implies 237% upside to the equity valuation.
Portfolio Changes
We participated in placements for existing holding Adveritas (AV1) and new investment Coventry Group (CYG). We also added to our holding in MedTech company MedAdvisor (MDR; +9%). Remote monitoring tech company Spectur (SP3; unchanged) dropped out of the “Top Nine” table to be replaced by MDR due to both the increased holding and the lift in the MDR share price.
MDR did increase in price but we felt the market still did not fully appreciate the strength of its March quarter cash flow update. Operating revenue for the quarter was up 42%, with 58% growth in the US business, and gross profit was up 49%. While net operating cash flow was -$2.1m, this represented a $10.2m improvement on the same quarter a year earlier, with MDR’s March quarter typically a seasonal weak spot due to the timing of quarterly abatement payments to US pharmacies.
Consensus estimates have MDR doing $118m revenue for FY24 and delivering its first positive EBITDA result over a full year, at $5m, off $69m gross profit. Its enterprise value is currently ~$179m.
WHAT’S ON OUR MINDS
Liquidity in small stocks
The month of April 2024 was the first month in eight that featured year-on-year growth in the value of trade across the ASX’s smaller listings, using the S&P/ASX Emerging Companies Index as a proxy. “One swallow does not make a summer, neither does one fine day,” Aristotle told us. On a twelve month rolling basis, the value of trade in the Emerging Companies Index over the 12 months to April 2024 was still down 13% year-on-year. But the 47% year-on-year increase in the dollar value traded in the month of April was a welcome shift.
Private Market Valuations
We continue to watch private markets slowly adjust to reflect the change in the cost of capital that has occurred over the past two years. Despite marketeers labelling private assets as low volatility, there is underlying volatility in the pricing of private assets and there is correlation with public markets. March quarter data from PitchBook shows that “median Q1 early-stage and late-stage valuation step-ups were either flat or down” and in the secondary market shares were trading at median and average discounts of 37% and 28%, respectively. “The number of flat and down rounds as a proportion of all VC deals expanded consistently since Q1 2022 on a QoQ basis, notching 27.4% in Q1 2024—the highest level in a decade”, said PitchBook. “Common stockholders and early-stage investors face the challenge of highly dilutive terms.”
“Recap” risk and opportunity
Australasian equity capital raising activity was down 8% year-on-year in CY2024-to-date (an improvement since our previous monthly update), following a 6% decline in CY2023 (using Dealogic data in USD). We analysed quarterly cash flow reports for the December quarter of 2023 and found over 230 companies with no more than four quarters of cash funding at hand based on their most recent burn rates (and backing out the R&D tax rebates many received in the quarter). Thus it continues to be the case that businesses are desperate for funding. This is a risk for existing investments that may require capital. It is also an opportunity and an exciting time for investors to apply bottom-up, fundamental research and engage constructively with companies to provide them with capital on attractive terms.
Interest rates & inflation
Interest rates remain low by historical standards (see 700 years of declining rates charted here) and central banks should be keen to get back to something like the Taylor Rule estimate that an equilibrium policy rate is 2% above inflation. The market consensus has shifted in recent months from expecting rate cuts through CY2024 to a view more like the one we have held - that there is not a strong case for reducing interest rates in the near-term. If central banks do walk back rates materially, the implication will be that the economy has deteriorated. Shifting market sentiment regarding the extent to which interest rates could decline from here will influence the market in the short term. As we highlighted here, a quantitative view set out by Fidelity Investments’ director of quantitative market strategy is that the probability of small stocks beginning to outperform again increases by almost 50 percentage points with “the conjunction of rates having peaked and earnings growth having troughed.”
Energy
We see energy as a quasi-currency - if you have energy you hold something valuable and exchangeable. The world is going to need all forms of energy to sustain or further advance standards of living. Dragonfly Fund does not invest in the resources sector directly but we do own and seek out opportunities to participate in the energy economy - through engineering, manufacturing and software or other industrial and technological angles.
Unlisted
A key lesson for us from FY2023 is that it is important when investing in unlisted entities to have some form of influence.
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