Bateleur Flexible Prescient Fund—2018 1st quarter report back to investors

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Bateleur Flexible Prescient Fund – 2018 first quarter report back

The fund’s unit price (A1 class) returned -3.5% for the first quarter of 2018. As comparisons, the JSE All

Share Index returned -6.0% inclusive of dividends reinvested, SA government bonds (ALBI) returned

+8.0% and cash (STeFI) returned +1.6%.

In terms of underlying strategies (table 1), the domestic equity holdings detracted 2.1% from

performance as the share prices of both Naspers and British American Tobacco (BTI) declined. The

foreign equity holdings detracted 1.0% from performance, the strength of the Rand more than offset the

positive contribution from Amazon.

Table 1: Attribution by strategy

Source: Bateleur

The more constructive investment environment in SA following recent government changes has resulted

in a sharp re-rating of many domestic focused large capitalisation shares, including the banks, retailers

and several industrial companies (such as Bidvest, Imperial and Barloworld). In many instances, the

upward re-rating of these companies (largely driven by foreign buying) is already discounting a much

improved economic outlook and no longer represents a compelling investment proposition.

In our view, a superior risk/reward investment opportunity exists in the domestic mid-capitalisation

space (mainly industrial companies) that do not form part of the MSCI SA index and therefore have not

benefited from foreign portfolio flows. Several of these companies have high barriers to entry, lengthy

track records of consistent earnings growth, stable management teams, and most importantly, trade on

attractive valuations. They also have favourable operating leverage to any upward surprise in SA GDP

growth from the current subdued levels.

Based on fundamental company specific research, we have increased the fund’s exposure to this

segment of the equity market over the past quarter. Collectively this group now represents a healthy

weighting in the fund. Three of these holdings are discussed in more detail in this report.

1. Mpact – Market Capitalisation R4.8bn; Price R28.00

Mpact is the largest vertically integrated producer of recycled paper products in SA (predominantly

containerboard and cartonboard).

In broad terms, the company collects waste paper at its numerous depots around the country, either

from its own recovered paper business or by purchasing from third party waste paper merchants. The

recovered paper is then baled at the depots and transported to one of its three mills where it is the

primary variable input, along with energy, in the production of recycled containerboard and

cartonboard.

Attribution by strategy YTD % Top contributors Top detractors

Domestic equity -2.1% Adcock Ingram Naspers

Foreign equity -1.0% Amazon BTI/Reinet

Costs net of interest -0.4% Mpact RMI

Total -3.5%

2 The finished containerboard and cartonboard reams are then either sold into the market, to third party

converters, or transported to Mpact’s own facilities where they are converted into corrugated boxes

and related products.

Mpact’s recycled paper business has historically been a profitable business with solid returns on capital

due to 1) its dominant market position providing economies of scale 2) being a vertically integrated

operator has enabled margin retention, and 3) having high barriers to entry – with the substantial cost

of putting up a new recycled paper mill deterring new entrants.

Mpact also has a plastics business where it holds the number one market share position in SA in PET

preforms, styrene trays and plastic jumbo bins. It is also the largest producer of recycled PET bottles in

the country – although this business is currently loss making as it overcomes start-up teething problems.

The plastics business is a smaller part of the overall group with lower margins and has less attractive

fundamentals than the paper business.

Source: Bateleur, Company Financials

Mpact unbundled from Mondi Plc and listed on the JSE in 2011 in order to pursue its own growth

strategy without the constraints of the Mondi group. Chart 1 shows the consistent growth in operating

profit and expansion of the operating profit margin between 2008 and 2015, while chart 2 highlights the

improving return on capital (“ROCE”) over the same time period.

Chart 1: Mpact op. profit (Rm) and margin (%) Chart 2: Mpact ROCE (%) 2008 - 2015

Source: Bateleur, Company Financials

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Mpact has the number one market share position in SA in the following products:

Mpact’s ROCE improved steadily between 2008 and 2015

Mpact’s operating profit and operating margins improved steadily between 2008 and 2015

3 In 2016 and 2017 multiple factors contributed to a break-down in the historic earnings growth profile of

Mpact (chart 3). This was closely tracked by a sharply declining share price (chart 4).

Chart 3: Mpact op. profit (Rm) 2008 to 2017 Chart 4: Mpact share price since listing (Rand)

Source: Bloomberg, Company Financials

A major customer of Mpact, purchased an existing mill from Sappi and converted it into a recycled paper

mill. This resulted in an initial loss of sales volume for Mpact and a more competitive pricing

environment.

Secondly, the price of domestic recovered paper (Mpact’s major input) increased sharply as a result of

increased domestic demand from the new competitor as well as local waste paper merchants exporting

recovered paper due to strong global waste paper prices.

Thirdly, Mpact undertook a large R765m expansionary capex program at its Felixton paper mill aimed at

increasing recycled paper capacity and improving efficiencies through reduced energy consumption. This

resulted in a shutdown at its Felixton mill, while the fixed operating costs remained.

Finally the sluggish SA economy and drought in the Western Cape (where Mpact is a large supplier of

corrugated boxes to the fruit industry) meant that demand was subdued and Mpact could not pass on

sufficient price increases to compensate for the increased input costs.

With the exception of the drought in the Western Cape that remains, these headwinds have largely

abated, and financial year 2018 and 2019 should result in a normalisation of profit margins and a strong

recovery in operating profits off a depressed base.

The Felixton mill upgrade is complete, and will ramp up to full capacity by the end of calendar 2018.

Mpact should enjoy a 20% production cost benefit over its competitors from this project, while there is

also strong customer support for the lightweight containerboard produced at the mill.

Global waste paper (“OCC”) prices have declined by 43% from their peak in 2017 to current levels of EUR

91/ton (chart 5). This has led to a sharp decline in the price of SA waste paper prices and will have the

most material benefit to group operating margins in 2018, and especially 2019, as existing stock piles

of recovered paper are depleted.

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Mpact’s share price declined sharply in 2016 and 2017 tracking lower earnings

4 Finally, the SA economy is expected to expand at a faster rate in both 2018 and 2019 (in excess of 1.5%)

than in 2017 (+1.3%) which should be mildly supportive of both paper sales volumes and pricing.

Despite the substantial expansionary capital expenditure programme over the past three years, Mpact

remains highly cash generative. Gearing (debt/equity) is expected to peak at slightly above 54% in

financial year 2018, thereafter declining, as total capex requirements are forecast to be in line or lower

than deprecation in the next few years (chart 6).

Chart 5: European OCC prices (Euro’s) Chart 6: Mpact – Capex to depreciation (%)

Source: Bateleur, Bloomberg

We estimate that Mpact trades on a forward P/E multiple to December 2019 of less than 10 times,

which we view as attractive. The fund continued to add to its existing Mpact holding during the first

quarter of 2018.

2. AECI – Market capitalisation R14.0bn; Price R117.00

AECI is an explosives and speciality chemicals company based in SA, with regional business in Africa,

Southeast Asia, the USA and Australia. The company is a key supplier to the SA mining and

manufacturing industries and has been listed on the JSE since 1966.

Speciality chemicals contributes 64% of group operating profit, supplying chemicals and related services

across a broad spectrum of customers exposed to mining and manufacturing. The bulk of earnings come

from higher margin, value added chemicals which are typically customised solutions to end clients, with

an added service element which is an important contributor to the economics of the business. For

example, AECI subsidiary Nulandis, employs a trademarked process named NuWay™ to conduct an

assessment of the farmer’s soil. The objective, utilising science, is to characterise and chart soil, and in in

so doing, optimise the farmer’s planting, nutritional and chemical spray programmes to save water,

increase productivity, promote sustainable soil and grow healthy crops.

This value added focus, alongside selective acquisitions, has resulted in speciality chemicals consistent

record of earnings growth (chart 7). Over the past 34 years, revenue has grown at an annualised rate of

15.5% p.a., while operating profits have increased at a rate of 15.3% p.a. Since 1983, operating profit

has grown every year except for three, illustrating the resilience of the business model. Given the

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Capex to depreciation

European OCC prices have fallen 43% since September 2017.

Mpact’s heavy capex investment period is now behind them.

- - Capex = depreciation

5 consistency of earnings growth, we would argue that the speciality chemicals business warrants a higher

rating than what is currently implied by the market.

Chart 7: Speciality chemicals op. profit (Rm) Chart 8: Segment op. profit margins (%)

Source: Bateleur Capital, Company Annual Reports

AEL explosives (AEL) contributes 31% of group operating profit, and includes the production of

electronic detonators, shock tube initiating systems and bulk emulsions. It provides blasting services and

related products that optimise the value extracted at the customers mining operation. AEL is one of the

largest explosives manufactures in the world with an estimated global market share of 5-6%*. The bulk

of revenues come from SA and the rest of Africa (RoA) with smaller contributions from Australia and

Indonesia. AEL has been in existence since 1895.

AEL’s operating margins (Chart 8 - above) have improved from the 2014/15 lows and is guided to reach

10% in the medium term. The general mining slowdown of 2015, characterised by low commodity prices

and weak producer balance sheets, came at a time when AEL completed a number of expansion

programs. AEL had to sacrifice margins in order to secure the required volume and support the viability

of their customers. Since then, mining activity and commodity prices have improved and certain low

margin contracts have been renegotiated – supporting a normalisation of operating profit margins.

The group recently concluded two acquisitions, Schirm and Much Asphalt, for a total consideration of

R4.1bn. At financial year end 2017 AECI’s net debt was low at R400m and will remain at comfortable

levels post the closure of these two acquisitions.

Schirm – AECI acquired Schirm from the Imperial group for R1.9bn on a trailing EV/EBITDA multiple of

9.1 times. The business has a footprint in both Germany and the USA and derives the majority of its

revenue from agrochemicals and the balance from fine chemicals.

*Source: AECI annual report

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Speciality chemicals Explosives

6 The strategic rationale for the Schirm acquisition is sound, with various synergistic opportunities as

listed below:

Adding an extra production season in the northern hemisphere (smoothing seasonality)

Replacing AECI imports with production from Schirm

Reallocating formulation activities to Schirm from SA

Expanding AECI’s existing product range into Europe

Much Asphalt – AECI recently acquired Much Asphalt for R2.2bn from a private equity consortium on a

trailing P/E ratio of 12.6 times. Much Asphalt is SA’s largest supplier of hot and cold asphalt to the road

construction industry. Although management are guiding to future growth opportunities through an

expanded product offering and expansion into Africa, we are less enthused on the strategic rationale for

the transaction. Management argue that Much Asphalt fits strategically with AECI on the basis of the

chemical processes utilised in the production of asphalt and road surfacing products. However, a

negative is that the acquisition will increase the group’s exposure to the more cyclical nature and

greater contract risk generally associated with construction activities.

Our investment thesis for AECI can be summarised as follows:

Return to growth in domestic mining and manufacturing industries – We expect both mining and

manufacturing production to moderately increase as the SA policy environment improves, aiding

sentiment, capital investment and GDP growth.

Speciality chemicals – the long term, consistent profitable growth track record warrants a higher

valuation multiple for this division.

Below trend margins – Margins in the explosives segment are below trend, we expect this to improve as

mining volumes and industry profitability increase, resulting in improved operating leverage.

Attractive valuation – AECI trades on an estimated P/E multiple to December 2018 of 9.8 times, an

attractive rating that is yet to reflect any positive sentiment from the perceived turnaround in SA. In

addition, the acquisitions of both Schirm and Much Asphalt should be accretive to earnings. The fund

continued to add to its existing AECI holding during the first quarter of 2018.

3. Hudaco – Market capitalisation R5.7bn – Price R168.40

Hudaco is an importer and distributor of branded automotive, industrial and consumable products. The

product range is broad and includes seals, bearings, power tools, automotive parts, security &

communication equipment, diesel engines, power transmission products, hydraulics and pneumatics.

The ready availability of product is essential to Hudaco’s operating model and a key enabler of sales. An

additional driver of sales includes product specific technical expertise and the network of specialised

branches and distributors throughout SA.

Hudaco has 11 consumer related businesses (such as Rutherford / Makita, Miro and Partquip) and 21

engineering consumable businesses (such as Deutz, Bearings International and FHS Filters) which supply

the domestic mining and manufacturing industries.

7 Chart 9 illustrates the positive historical relationship between domestic capacity utilisation and Hudaco’s

operating profit margins. A moderate increase in domestic economic activity will likely result in

meaningful revenue growth and margin expansion for the group, but more specifically the engineering

services division.

The impact of the weak domestic GDP growth environment has been more pronounced within the

engineering consumable businesses. Over the last three years revenue in this segment increased by only

3.4% and operating profit declined by 10.0% - providing a low earnings base.

Notwithstanding the group’s exposure to the constrained domestic mining and manufacturing

industries, Hudaco has been able to consistently grow core headline earnings per share at a rate of 8.8%

per annum since 2010 indicating the resilience of the business model (chart 10).

Chart 9: Capacity utilisation vs. Hudaco margins (%) Chart 10: Hudaco comparable HEPS (Rand)

Source: Bateleur Capital, Company Annual Reports, SA Reserve Bank

The group generates high levels of free cash flow (Chart 11) allowing for a healthy dividend policy and

the ability to pursue an acquisition strategy without the need to issue equity or take on excessive debt.

In addition, the business requires very little capital expenditure to maintain or expand operations.

Hudaco’s working capital (Chart 12) is key to its operational success and has been tightly managed in

order to ensure limited financial slippage.

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SA Capacity Utilisation - SARB (LHS)

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8 Chart 11: Hudaco cash flow & capex (Rm) Chart 12: Hudaco working capital (months)

Source: Bateleur Capital, Company Annual Reports

Growth in earnings has been aided by bolt on acquisitions, where management have proven themselves

to be astute allocators of capital. Over the past few years acquisitions have been strategically focused on

consumer facing businesses such as Miro (distributor of wireless, networking, VoIP and IP video

products) and Partquip (importer and distributor auto parts). This has shielded Hudaco’s group earnings

from the pressures within the engineering consumable businesses.

Hudaco is trading on an estimated 12 month forward P/E ratio of 11.4 times, which is appealing relative

to larger industrial peers Bidvest (17.3 times P/E) and Barloworld (13.7 times P/E). The management

team, under the leadership of Graham Dunford, are material shareholders in the business and have a

respected track record. The fund continued to add to its existing Hudaco holding during the first quarter

of 2018.

Current fund positioning and conclusion

The fund’s current positioning (equity exposure of 82.9% and cash weighting of 17.1%) is premised on

equity valuations being above trend, the late stage cycle of global growth, and expectations that global

monetary conditions will tighten further.

Source: Bateleur Capital * As at 23 April 2018

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Payables Net W Cap

Strategy Exposure % Top 5 holdings

Domestic equity 68.6% Naspers

Foreign equity 14.3% BTI/Reinet

Total equity exposure 82.9% Mondi

Cash 17.1% S&P 500

Old Mutual

9 The outlook for SA is somewhat different to developed markets in that the interest rate environment

should remain accommodative, while the corporate earnings base is low given the below trend GDP

growth and policy missteps over the past few years. Unfortunately, SA equity valuations (especially the

large capitalisation index constituents) are not compelling and are already discounting an improved

economic outlook and corporate earnings recovery.

Nevertheless, as mentioned in the body of the report, there are a number of stock specific opportunities

held in the fund, predominantly in the SA mid-capitalisation space, that are both attractively valued and

positively geared to any rebound in SA GDP growth.

We anticipate a challenging period ahead but remain confident in achieving the fund’s investment

objectives.

Kevin Williams James Easterbrook

Fund Manager Head: Distribution

Bateleur Capital (Pty) Ltd

Authorised financial services provider FSP no 18123 — SG109 Ground Floor, South WingGreat Westerford Building240 Main Road, Rondebosch7735 — T +27 (0)21 681 5060 F +27 86 649 1794—

bateleur capital 2018

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