Archive 2Q 2020 Letter

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Disclaimer: This letter is an archived letter to shareholders of the SaltLight Investment Holding company prior to the formation of the SaltLight SNN Worldwide Flexible Fund. The purpose of this archive to provide a historical narrative of our thinking and how it has evolved over time. We find that writing down our thoughts and allowing the passage of time to judge them are helpful in our learning and improving the art of investing. Results, past investments held and our thinking may have changed.

Dear Shareholder

This quarter shall probably be remembered in the history books as the quarter that the world suddenly stopped. Dispersion amongst our portfolio companies was evident with a standout performance from technology investments and further declines in domestically-exposed businesses.

The portfolio continues to be positioned for resilience rather than blind optimism.

From a firm perspective, I have some exciting news to share at the end of the letter.

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It is worth reflecting on SaltLight’s last quarterly letter where I wrote:

“…the odds in the present situation appear that the chance of a quick economic recovery is small. In fact, there is the stomach-churning risk of a ‘fat tail’ event of a protected economic contraction and indeed, the odds of an Armageddon scenario of a depression are not zero.

There are very few historical playbooks on how to manage risk in a portfolio under these uncertain scenarios. We could be too negative, over-estimate the impact and miss the quick recovery or we could be too optimistic and underestimate the impact with a significant loss to our portfolio’s value.”

The claims of economic Armageddon appear to be unfounded, well, at least if markets movements are to be believed. Global Markets have had one of their best quarters ever!

Time will tell how credible the market’s forecasts will turn out. Many will argue that the actions of central banks and loose fiscal stimulus have raised even the most aggressive ‘animal spirits’.

We should be mindful of the underlying data in deciding whether markets have not got a little ahead of themselves:

  • The IMF projects that global GDP (annualised) is expected to decline -4.9% for 2020[1];
  • Furthermore, the IMF forecasts South African’s GDP (annualised) is expected to decline -8% for 20201;
  • The OECD projects South Africa’s unemployment will be 36% in 2021;
  • South Africa’s debt to GDP is expected to reach 85% in 20211 (it should terrify any future taxpayer that when we started this fund in 2015, the gross debt-to-GDP ratio was 48.9%!)

The last point is a crucial one. South Africa is not alone in its debt-fuelled spending binge. It appears that some US millennials are directing their stimulus cash for day-trading. In the UK, the government is subsidising 50% of their citizen’s Nando’s lunch (dining out and on Monday, Tuesday or Wednesdays only)[2]. Never to be outdone, as most world airlines are teetering on bankruptcy, the South African government has opted to restart the perennially unprofitable national airline from the ashes.

If anything, COVID-19 has exposed the many fragilities in political and economic systems. In my previous letter, I indicated that believe it is more helpful to understand the nature of the system that we’re dealing with. We operate in a complex system that is inherently unpredictable and trying to make narrow forecasts is senseless. Extreme events are not only common; they should be anticipated as the norm.

Modern economic systems have adopted just-in-time supply chains, globalised product manufacturing and concentration in product specialists. A shock to the system has exposed how little resilience we have. Anglo-Saxon economies operate with high levels of corporate and consumer debt with paltry cash reserves. Governments have become the lenders of last resort.

In South Africa’s case, the rapid increase in public debt means that we are now reliant on the ‘kindness of strangers’ until decisive reforms are actioned. Whilst developed economies have record-low interest rates, our relatively higher EM yields satisfy global investor’s need for yield. Seemingly unthinkable only five years ago, it is becoming more recognised that there is a scenario where SA will need some kind of external financial support in the future.

In terms of market performance, it is clear that participants have sought safety in technology companies. South African investors have benefitted tremendously from the dominance of Naspers (Prosus) due to its substantial shareholding in Tencent. Without this giant balloon keeping the index afloat, there would likely be more panic in line with the underlying economic data. From SaltLight’s perspective, we’ve been handsomely rewarded from our investment in Prosus however the ALSI Index currently sits with a combined weighting of 23%[3] of these companies whereas our portfolio weighting is far less than that. Our remaining portfolio is largely exposed to the domestic economy.

Source: SBG Securities

Portfolio Update

SaltLight’s portfolio has broadly responded in line with the dynamics of their business models and customer-base exposure. It is clear that where the portfolio had the pillars of resilience and optionality that I discussed in my last letter; the expected outcomes have largely played out.

Discovery

Discovery has recovered most of its COVID share price declines. It announced in June that it has adjusted its embedded value down by 4.7%[4] on conservative estimates by utilising some of their discretionary margins (these are insurance reserves for scenarios just like COVID-19). Two-thirds of the assumption change is due to COVID mortality and morbidity effects and the remainder of the adjustment is related to economic effects across of all their businesses (e.g. policy lapses). Given South Africa’s low mortality rate, these assumptions could be very conservative, and the assumptions revised downwards in future years. Interestingly, Discovery is projecting a ‘second wave’ of infections in the middle of 2021.

These numbers attest to the resilience of Discovery and, as we expected, the Ping-An Insurance business in China outperformed expectations with new business growth of 42%[5] – despite the lockdown in China.

I should note that we still get this business at zero cost at current valuations. Investors who have been in the market for some time should recall that once upon a time Tencent was a zero-value, fast-growing, China investment inside of Naspers (an ‘old world’ media business).

Developed-market SaaS companies have had a strong rally since March to the point that the median US-listed SaaS company now trades at 13.7x EV/NTM revenue (that’s revenue in the next twelve months; not profit!).

The subscription business model is one of the more innovative models that have been capitalised on over the last decade. In the digital world of almost-zero marginal costs, these companies have incredibly attractive unit economics once a customer has been acquired. As long as the customer is retained, cash hits the bank account like clockwork. The largest ‘capital expense’ to build a SaaS company is the customer acquisition cost (CAC). Cloud providers have been a strong enabler of the business model too; effectively making expensive server infrastructure a variable cost that can scale up according to demand. From an accounting perspective, everything in SaaS companies shows up in the income statement.

A SaaS company’s profitability is determined by three inter-related ‘dials’: (1) rate of user acquisition and (2) margins and lastly (3) retention rates. Investors talk about the ‘Rule of 40’ which is a rule-of-thumb metric to determine what a healthy SaaS company should look like[6]. A successful company should have a ratio of at least 40 (measured by revenue growth rate% + EBITDA margin%).

If the business wants to juice revenue growth through user acquisition, then EBITDA margins will be temporarily lower as the investment is made in sales distribution and channel marketing. Over time, this expensed investment is earned back in future subscription revenue.

If the business wants to rather generate higher margins in the short term, then user acquisition is dialled back a bit. What differentiates an intangible asset SaaS business to business reliant on tangible assets is that these ‘dials’ can be adjusted swiftly; whereas, asset-heavy businesses have physical assets to taper down.  

Cartrack

Cartrack is our only SaaS portfolio company. It has grown revenue by an 18% CAGR over the last five years but has opted to be extraordinarily profitable (48% EBITDA margins). 21% of revenue now originates from Europe and Asia with a very large addressable market.

Interestingly, many of the world’s dominant vehicle tracking companies originate from South Africa. If there is one thing that we have a competitive advantage in, its vehicle theft. The industry has been very successful as insurers have, for many years, offered a discount on insurance premiums if the insured has a vehicle tracker installed. This has enabled our companies to scale in SA and then launch into other markets.

Cartrack will likely have a slower first half however we expect growth will resume trend in the second half. As mentioned, the median US SaaS company trades at 13.7x EV/NTM revenue. Conversely, Cartrack is lumped in with other South African companies and trades at a measly 3.8x EV/NTM revenue. More importantly, Cartrack is robustly profitable and a 14x FCF valuation.

Curro

Curro provided the market with an update at their AGM in July. Over the long term, the thesis for private school education remains firmly intact. However, the range of outcomes in the short-term is wide.

As of June, Curro saw a 0.1% reduction in learners in primary and high school grades. However, they saw an 18% reduction in learners in pre-school grades – unsurprising given it is hard for small children to be taught through distance learning.

My base case is that parents in financial distress will push through until the end of the school year (December in South Africa) and then we could see further declines in learner numbers. However, the government’s recent decision to close government schools again due to teacher’s union pressure might cause parents to think twice. Whilst it is uncertain, it appears that the government current school curriculum could be pushed into the new school year. Private school children will be at a huge advantage if this is the case. 

The key risk for shareholders is the outstanding debt and cash flow pressure. Collections have remained relatively robust with cashflow down 20% YoY from March to June. Management has opted to raise additional capital via rights issue (that we’ll be supporting). Part of the additional capital proceeds will be used to acquire other schools in key locations. According to management, some of these opportunities are being offered at 25%-35% of replacement value. I think this is a valuable use of capital to cease on these opportunities.

At the current price, we’ll be able to deploy additional capital at 75% of the cost of building new schools in the Curro network.

Widening Our Opportunity Set: Launch of Our New Fund

Editor’s Note: This is the SaltLight SNN Worldwide Flexible Fund fund.

I am incredibly excited to announce that we’ll be launching a collective investment scheme in the coming weeks. This process has been ongoing with the support of current and new investment partners.

In my March letter, I indicated that COVID-19 has made pre-February assumptions redundant. Every pre-COVID decision should be retested for the ‘New Normal’.

There are two reasons why SaltLight is walking down this path:

(1) Our domestic opportunity set is declining

(2) Preserving flexibility and structural resilience to our capital

The South African public equity universe has been shrinking over the last few years due to the number of de-listings and buyouts. Furthermore, there has been a trend of ‘growth’ companies migrating to developed stock exchanges where ‘growth’ is rewarded with superior investment ratings. The Financial Mail reported[7] last year that the number of JSE Listings has declined by 26% from a peak of 485 in 2002 to 356 as of last year. Given the valuations of small-cap shares and the increasing regulatory burden, we expect this trend to continue.

According to the Association of Savings and Investment South Africa (ASISA), 65% of the SA domestic collective investment scheme pool (1,107 funds) is chasing the shrinking domestic opportunity set.

Within the high bar criteria for companies in our investment process, I believe that we own what we’d like to own in the ‘New Normal’.

Our current fund structure does not allow us to invest in offshore opportunities due to South African’s exchange control regulations and I believe this could be an inherent risk in the coming years.

Over the last few months, we’ve undertaken the process to register a new fund with the Financial Services Conduct Authority (FSCA) that will be registered shortly. Our approved mandate will allow us maximum flexibility and geographical reach to take advantage of many more opportunities using the same investment process.


[1] Source: World Economic Outlook Update, June 2020 link

[2] Source: HM Revenue and Customer link

[3] Combined weighting of Naspers and Prosus as of June 2020

[4] Adjustment to the December 2019 Embedded Value;

[5] Source: Company. This represents new business for the 11 months to May 2020

[6] There is no science behind this metric and really should be considered a heuristic

[7] Source: Profile: New JSE CEO has a Dream For Transformation, Financial Mail, 31 October 2019 link