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Ellerston Overlay ASF
PERFORMANCE REPORT March 2015
The investment objective of the Ellerston Overlay ASF (Fund) is to provide investors with a return that
outperforms the Benchmark over time. The Fund aims to achieve this by investing in a concentrated
PERFORMANCE
February
portfolio
comprisingREPORT
of no more
than 30 2014
ASX listed securities and where possible, enhancing returns or
preserving capital through the use of Derivatives and shorter term trading strategies. The concentrated
portfolio of securities will comprise at least 75% of the Fund and will be aligned to the portfolio of the
Ellerston Australian Share Fund (EASF).
Ellerston Overlay ASF Performance
Gross
Benchmark
Excess
Net
1 Month
(1.01%)
(0.06%)
(0.95%)
(1.10%)
3 Months
10.86%
10.33%
0.53%
10.58%
FYTD
11.34%
13.08%
(1.74%)
10.47%
12 Months
13.06%
14.13%
(1.07%)
11.93%
3 Years p.a
14.94%
15.82%
(0.88%)
13.69%
Since Inception (p.a)
16.70%
17.00%
(0.30%)
15.36%
Returns are calculated using the Fund's redemption price and are net of fees and expenses. Returns are also calculated on the basis that distributions are reinvested.
Returns of the Fund may include audited and un-audited results.
The benchmark is the S&P/ASX 200 Accumulation Index. Past performance is not a reliable indicator of future performance.
Since Inception is 4 January 2012.
Market Commentary
After coming close to breaching the 6,000 point barrier several times during March, the local S&P/ASX 200
finished largely unchanged (-0.06%) by month end, printing its strongest quarter (+10.3%) in 24 years to end at
5,891. Global markets sold off initially as speculation around an imminent rate hike in the US mounted.
Subsequent more dovish-than-expected commentary in the Fed’s March statement alluded to a delay in the
much-anticipated rate hikes, which ignited a relief rally midway through the month and caused global indices to
reclaim some lost ground. Despite this, the MSCI World index (-1.57%), the S&P500 (-1.58%) and the FTSE 100
(-2.5%) all ended lower. Europe, as measured by the Euro Stoxx 50, outperformed (+2.7%), led by Germany’s
Dax up 5%, with QE purchases kicking off from the outset, as did Japan with the Nikkei 225 posting a 2.2% gain.
Chinese shares were the clear outlier during the month, with the Shanghai 300 rallying 13.4%.
Ellerston Capital Limited
ABN 34 110 397 674
AFSL 283 000
Level 11
179 Elizabeth Street
Sydney NSW 2000
Tel: 02 9021 7797
Fax: 02 9261 0528
[email protected]
www.ellerstoncapital.com
APIR Code: ECL0012AU
At a sector level, Materials (-4.5%) lagged, whilst Banks (+2.5%), IT (+2.6%) and Healthcare (+2.1 %.)
outperformed. Excess supply in commodities markets overshadowed a cyclical bounce in China. Even with the
Chinese equity market rising strongly on the back of continued policy easing, ongoing supply concerns weighed
on the iron ore price, with the spot market falling another 12% and ASX Resources (-6%). FY16 consensus
earnings for the Miners were cut by circa 11% during the month, despite having already been revised down by
over 35% during calendar 2014. The resource sector now trades in line with the broader market at 15.8x 2016
PER.
Having stabilised for a month or so, renewed A$ weakness to fresh 6 year lows (now approaching 76 cents vs.
the USD) again supported the offshore earners (+3.6%) which have delivered strong returns (+17% CYTD).
Stocks in Australia with >50% of revenue from US/Europe now trade at an average forward PER of 22x. The
best performers in this category for the month included Aristocrat (+13.3%), ResMed (+13%) and Ansell (+10%).
Conversely, the worst $A sensitive performers included Alumina (-12.7%), BlueScope (-12.7%) and TWE (4.6%).
This month WBC, CBA, ANZ and NAB added the most points to the ASX200 index, while BHP and Woolworths
were the biggest detractors.
Domestically, the RBA left rates unchanged at 2.25% in early March, commenting that domestic growth was
continuing at a “below-trend” pace. In China, PBOC governor Zhou Xiaochuan stated that growth had slowed “a
bit too much” and that policy makers had scope to respond with interest rates and other quantitative measures
following a below-trend February growth print of 6.3% y/y. Long-term bond yields fell in both the US and
Australia, with the yield differential continuing to narrow to 35bps, the lowest gap in 15 years.
Major company news.
Corporate activity accelerated during March, with capital management, takeovers and equity raisings all
featuring prominently.
Orica and Boral announced on-market buyback programmes.
IINet (+34.6%) and PanAust (+31.3%) both received takeover bids from TPG and Guangdong Rising H.K.
respectively. TPG will pay $1.4 billion for IINet via a scheme of arrangement in an all cash deal for $8.60, a 31%
premium, subject to ACCC approval. PanAust received an unconditional takeover bid at $1.71 per share from
GRAM, a 39.6% premium to the previous close. GRAM already held 22.5% of the issued capital and had
approached the company previously at a higher price.
Macquarie Bank raised $500m in new capital via a primary placement to partially fund the acquisition of a
US$4bn aircraft leasing portfolio from AWAS Aviation Capital and Chevron announced the sale of its 50%
interest in Caltex to domestic and global investors at $35.00 per share in a $4.7 billion block trade.
Additionally, BHP Billiton released the details of its de-merged vehicle South 32 (the ex-four pillars spinoff) and is
expected to start trading on May 18th. Cost-out is a likely driver of value creation, with $100m p.a. of pre-tax cost
savings identified and a very low gearing level of 5%.
Sudden management changes also featured with CEO departures of Ian Smith from Orica, Greg Shaw from
Ardent Leisure and Bernie Brookes from Myer. MYR’s share price plunged 27% following its shocking 1H15
result where gross margins declined further to 30 bps and the company lowered profit guidance to a range of
$75m to $80m for FY15.
Sirtex (-41.5%) was the worst-performing stock this month after its Sirflox liver cancer treatment trial massively
disappointed and did not show any statistically significant improvement in overall progression-free survival.
Ellerston Overlay ASF – Monthly Newsletter
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Performance
Despite delivering a -1.01% return for the month of March vs. the benchmark of -0.06%, pleasingly the
March quarterly return of 10.86% outperformed the benchmark of 10.33%, which was the best first
quarter for the Australian share market in over 24 years.
Key contributors to performance during the month included Aristocrat (+13.3%), Adelaide Brighton (+8.1%), and
RedMed (+13.0%) as well as not owning any Fortescue (-20.3%) or OilSearch (-10.5%).
Key detractors to the performance were overweights in Medibank Private (-9.4%), Rio Tinto (-9.0%) and
Graincorp (-4.7%), as well as not owning any ANZ (+3.7%), CBA (+1.6%) and NAB (+1.7%) which all rallied
during the month.
Stocks Held
-0.62%, MPL █████████████████████████
-0.43%, RIO █████████████████
-0.37%, GNC ███████████████
-0.20%, NUF ████████
-0.18%, BPT ███████
█████████████████████████████████████████████ ALL, 1.14%
███████ ABC, 0.18%
██████ RMD, 0.15%
█████ TAH, 0.12%
████ GWA, 0.09%
Stocks Not Held
-0.24%, ANZ ██████████
-0.17%, CBA ███████
-0.11%, NAB ████
-0.08%, MQG ███
-0.06%, BXB ██
███ FMG, 0.08%
███ OSH, 0.06%
██ ORG, 0.06%
██ SRX, 0.06%
██ STO, 0.06%
Activity
During the month we strengthened the Fund’s existing position in Super Retail Group (SUL). The last year has
been difficult for the company, characterised by multiple earnings downgrades caused by a number of factors,
both internal and external. Externally, the Leisure division has been hurt by broader economic weakness
associated with the resources downturn, especially in Queensland. Internally, operational problems associated
with the roll out of its new SAP computer system within the Sporting division and below budget performance at
Ray’s Outdoors and FCO in New Zealand have constrained profitability. The market has treated management’s
poor execution in an unforgiving fashion, leading to a massive de-rating, with the shares now trading at a
25% discount to market, its largest relative discount in over 5 years.
15.0
REL PER (%) (+1 StDev) : 4.24
5.0
$13.79
$13.23
-5.0
Ave REL PER (%) :-7.04
$12.3
-15.0
$10.81
REL PER (%) (-1 StDev) : -…
-25.0
$9.37
-35.0
Jun
09
Nov
09
Apr
10
Sep
10
Feb Jul 11 Dec
11
11
Source: Goldman Sachs
Ellerston Overlay ASF – Monthly Newsletter
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May
12
Oct
12
Mar
13
Aug
13
Jan
14
Jun
14
Jan
15
We are convinced that most of the issues facing the company were temporary and now behind them and are
very encouraged by recent trends evident in the latest interim result. In particular, there has been a marked
improvement in sales momentum with LFL (like for like) sales at all 3 divisions turning upwards. This positive
momentum has continued into the second half, with period to date Auto LFL’s +3.5%, Leisure +6.5% and Sports
up an impressive 9%. Commentary is also suggesting that gross margins have improved, a very powerful
combination for any retailer.
We are also pleased that definitive action was taken on the underperforming FCO and Ray’s formats at the cost
of a $27m provision. FCO in New Zealand, which we estimate was losing ~$5m pa, will be exited. Ray’s will be
repositioned and five of the loss making stores closed quickly. The teething problems associated with the new
systems instalment also seem to have been largely resolved.
As a result, post FY15 being a reset year for earnings, we believe the stage is set for the company to
deliver strong 20% plus growth in earnings in FY16. This will be driven by modestly better sales (helped by
cycling relatively weak comparables), much improved operational performance, removal of drag of loss making
operations (at FCO and Rays) and the initial benefits of the significant $100m+ investment the company has
made in its supply chain (these benefits will flow much more into FY17 and beyond).
Trading at an FY16 PER of around 15 times with expected earnings growth of over 20%, we believe that
Super Retail Group is fundamentally very cheap and mis-priced. We would expect the company to be
materially re-rated over the course of the next 12 months as the market gains comfort and sees further
confirmation that management are executing well and that the earnings recovery is gathering pace.
During the month we made a start and commenced buying Orica (ORI) for the first time since inception.
This follows events over the past few weeks that highlight turmoil within senior management ranks and a lack of
judgement from the Board. In our view, this is totally unexpected for a company and franchise of ORI’s
standing. Orica is the largest provider of commercial explosives and blasting systems to the mining and
infrastructure markets (spending 5 times its closest Australian peer on R&D), the global leader in the provision of
ground support in mining and tunneling and the leading supplier of sodium cyanide for gold extraction.
Orica has been unloved by the market given continued question marks over its CEO, volume and margin
weakness in Australia (particularly on the East Coast) driven by a combination of reduced strip ratios, mine
closures and/or mothballing. At the same time, the market has also been concerned about the potential threat of
new entrants into the ammonium nitrate market, which could create an oversupplied domestic market.
The stock is currently trading on 11.9 times FY16E consensus estimates, representing a 38% discount to
the S&P 200 Industrials (ex Financials & REITs), with a free cashflow yield approaching 7.5%. Despite the
macro headwinds and mining companies continuing to “squeeze” their service providers, we believe the discount
is too excessive and that the margin/volume decline is already factored into the stock at current levels. We note
that industry peer Incitec Pivot with 70% of earnings coming from explosives and 30% coming from
fertiliser trades on a PER of 15.5 times for FY16E or a 35% premium. We also observe that the level of short
interest in the stock is at 10.9% and ORI has sadly become another “crowded short”. This creates an opportunity
for investors with a longer term investment horizon and those who block out the short-term noise.
Controversial CEO Ian Smith recently departed Orica, as the Board wanted “a new leader with a different
management style”. The Board has appointed Non-Executive Director Albert Calderon, a highly regarded former
executive at BHP Billiton as Interim CEO. This should offer stability, operational continuity and minimize the risk
of further distractions. His priority will be the ongoing implementation of the company’s broader strategy. Under
the new “capital light model”, capex for Orica is expected to decline sharply over the coming years, as Burrup AN
(the last of the large capital projects), is expected to be completed by the end of calendar 2015. This, coupled
with an improvement in operating cash generation and the benefits of their transformation initiatives, should drive
a big lift in free cash flow generation.
We believe the market may be underestimating the potential benefits stemming from the leadership change, the
cost out program and a recently announced $400m share buyback. ORI recently initiated a review of its
expenses and productivity measures to improve its cost base encompassing efficiency, asset management
capabilities, customer focus and commercial agility. As a result of this comprehensive review, the company
announced the implementation of its Transformation Project, targeting a pre-tax gross benefit of $200-250m by
Ellerston Overlay ASF – Monthly Newsletter
4
FY16. Importantly, the company reiterated that the transformation program remains on track, with expected
benefits in FY15 of $140-170m.
The company’s balance sheet has been further strengthened post the sale of the Chemicals business, with
gearing at 33%, comfortably below ORI’s target range of 35-45%.
Our conservative valuation of Orica is $23.50/share, utilising a 14.5x FY16 PE multiple, which is struck at an
undemanding 20% discount to the S&P 200 Industrials (ex Financials & REITs).
Following on from last month, we continued to strengthen the Fund’s newly acquired holdings in Treasury
Wines and QBE Insurance and funded these purchases by taking profits in Adelaide Brighton Cement
(+8.1%) and also in Nufarm, which spiked during the month. We were able to take advantage of the intra-month
highs in NUF, 50% above our recent entry levels.
Strategy & Outlook
Following an exceptionally strong start to the new calendar year for Australian shares and the fact that the equity
market continues to enjoy further multiple expansion, we are becoming increasingly nervous. As a result, we
have lifted the level of protection in the Fund via the purchase of Index Put Options where volatility remains
relatively low. This way we are not capping any further potential upside capture if our caution is unwarranted.
This remarkable strength has led many investors to conclude that valuations (having already “normalised” over
the last year or so), are now excessive. There is no question that the strong performance has been
predominantly driven by PE expansion, a trend that has left many investors questioning the sustainability of
valuations. However, returns decomposition analysis for the Market ex Resources actually shows that earnings
momentum on the whole still remains a positive (albeit very modest) contributor.
Ellerston Overlay ASF – Monthly Newsletter
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Market PE Ratio and Earnings
120
100
80
% yoy
X
24
Market EPS Growth (lhs)
PE ratio average of low inflation era
PE rises ahead
of earnings
20
14.4
16.5
60
40
16
12
20
-2
0
-20
3
8
IBES
f'casts
4
11
0
-40
0
1988
1991
1994
1997
2000
2003
2006
2009
2012
2015
Source: IBES, S&P, Datastream, Citi Research
The market needs to consolidate these gains and we would not rule out the prospect of a short term pull
back. The RBA ignored ongoing softness in key domestic economic data and despite the futures market
increasing the prospect of an interest rate cut to 75%, the RBA surprised the market and kept rates on hold at
2.25% during its April 7th meeting. The RBA appear genuinely concerned by the rampant growth in certain
pockets of the housing market (particularly in Sydney) and also paid extra emphasis on falling export prices and
therefore the terms of trade.
So while a rising tide has seemingly lifted all boats, there remains a broad range of return and earnings
momentum experiences across the market. There is a long list of stocks where positive EPS change has been
the primary driver of outperformance over the last 12 months. There are also stocks that have run very hard on
little more than valuation uplift and where earnings momentum is still negative. These stocks are the most at risk
of significant de-rating should forward EPSg expectations not be achieved.
The single biggest active position in the Fund remains Aristocrat and given the stellar performance of
the stock, we have recently re-tested our investment case.
In the first week of March we visited Aristocrat’s (ALL) key markets in the US, specifically Oklahoma and Las
Vegas. Oklahoma is the home of VGT, the $1.3bn acquisition made by Aristocrat last year and also the 3rd
largest slot machine market in the US behind Las Vegas and California. Oklahoma casinos are operated by
Native American tribes and under Federal laws allow them to operate games in a tax free way. The suppliers of
these machines have tactically programmed them using the bingo gaming structure. This is legal and provides
customers with an almost identical experience to traditional Las Vegas style casino slots.
Under these guidelines, VGT operates 20,000 machines within the Oklahoma state and continuously takes a
share of the daily winnings, generating estimated EBIT of around US$135m. What was evident after meeting
management face to face, was that VGT games were unquestionably the best performing and most popular,
offering customers the highest return of any slot machine we have ever seen anywhere. The VGT machines
were an essential ingredient to the slot floor dynamics and experience. VGT’s strategy as an early mover in this
market was to provide substantial and ongoing support to the Native American tribal operators as they
developed their businesses. Additionally, VGT doesn’t sell machines outright, instead offering the machines on a
revenue share basis.
For Aristocrat this model is especially attractive, as it provides a high quality and recurring revenue stream with
direct exposure to consumer spending. It is no longer dependant on the casino operators capex decisions and
the historical “replacement cycle”, lowering earnings volatility. If customers spend more money due to increased
confidence, employment or even lower gas prices, then Aristocrat reaps the benefits.
In 2014, Aristocrat’s recurring revenue was 42% of total revenue, delivering a significantly higher EBITDA margin
than the company’s overall 34% EBITDA margin reported during that period. We believe this proportion of
revenue will grow to over 50% in 2015. On top of this growth, the revenue stream is almost exclusively in USD,
Ellerston Overlay ASF – Monthly Newsletter
6
providing direct exposure to the improving US economy and regional gaming markets that are showing positive
trends. In total, the US now accounts for over 65% of group earnings.
Since our trip, the investment thesis has continued to play out with the stock up 13.3% during the month of
March alone and has returned an impressive 61% for the rolling year to March. This was helped by the
company investor day on March 24th which went some way to illustrating ALL’s focus on the importance of
recurring revenue.
Aristocrat has considerable earnings momentum - we think EPS will climb from 21c in 2014 to over 50 cents in
2017.
Over the next 3 years, we believe Aristocrat will have EPS CAGR of 40% versus its industrial peers of 9%, and
despite this the company is trading at a forward PE discount of around 15%, even after the recent share price
Other than the detailed changes articulated in the activity section, our strategy remains as per last month.
Ellerston Overlay ASF – Monthly Newsletter
7
Core Holdings
Active Sector Exposure*
Aristocrat Leisure
Medibank Private
Beach Energy
Rio Tinto
20%
15%
10%
BHP Billiton
Tabcorp Holdings
Graincorp
Treasury Wine Estates
IAG
Westpac Banking
5%
0%
(5%)
(10%)
(15%)
Asset Class Exposures
Effective Cash
100.0%
Utilities
Grand Total
Telecommunication Services
18%
Real Estate
Effective Cash
Other (inc Index Hedges)
(15.5%)
Materials
Short Option
Information Technology
0%
Industrials
Long Option
Health Care
97.5%
Financials
Equity
Energy
Net
Consumer Staples
Exposure (% NAV)
Consumer Discretionary
(20%)
* Active sector exposures are determined by subtracting fund sector weights from
benchmark weights. Positive percentages represent over-weight sector exposures
relative to benchmark and negative percentages represent under-weight sector
exposures relative to the benchmark.
Size Comparison Chart vs ASX 200
0.0%
0.0%
Active
0.0%
ASX 200
0.0%
0.5%
9.7%
5.9%
10.9%
20%
16.9%
7.0%
35.9%
40%
41.1%
60%
15.6%
Portfolio
30.2%
80%
0.5%
66.3%
Size Comparison Chart vs ASX 200
0%
21 - 50
-40%
-30.5%
-20%
Ellerston Overlay ASF – Monthly Newsletter
51 - 100
-10.0%
Top 20
8
101 - 200
201 - 300
Ex 300
About the Ellerston Overlay ASF
The Fund aims to achieve its performance objectives by adopting a fundamental
“bottom-up” investment approach to stock selection whilst delivering additional
income where possible, through option strategies.
Because of the nature of the strategy, at least 75% of the Fund’s exposure is aligned to the portfolio of
the Ellerston Australian Share Fund.
The Investment opportunities for the Fund are identified by analysing and understanding the factors
affecting (amongst other things): business model, industry structure, management team and overall
valuation.
Ellerston Capital typically favours businesses that can sustain high returns or improve their return on
capital and looks to invest in businesses with a market value below the value we attribute to them.
Benchmark weightings do not drive our stock decisions; our approach is totally benchmark
independent.
Fund facts
Strategy Funds Under Management
$675 Million
Funds Under Management – Overlay ASF
$46.5Million
Application Price
$1.1062
Redemption Price
$1.1007
Number of Stocks
21
Inception Date
4 January 2012
Note: Unit prices reflect Class A only.
DISCLAIMER
This newsletter has been prepared without taking account the objectives, financial situation or needs of individuals. Before making an investment decision about
the Ellerston Overlay ASF (Fund) you should read the Fund’s Information Memorandum dated 11 January 2012 which can be obtained by contacting
[email protected] and obtain advice from an appropriate financial adviser. Units in the Fund are issued by Ellerston Capital Limited. This information is
current as at the date on the first page. The inception date for the Fund is 4 January 2012.
This material has been prepared based on information believed to be accurate at the time of publication. Assumptions and estimates may have been made
which may prove not to be accurate. Ellerston Capital undertakes no responsibility to correct any such inaccuracy. Subsequent changes in circumstances may
occur at any time and may impact the accuracy of the information. To the full extent permitted by law, none of Ellerston Capital Limited, or any member of the
Ellerston Capital Limited Group of companies makes any warranty as to the accuracy or completeness of the information in this newsletter and disclaims all
liability that may arise due to any information contained in this newsletter being inaccurate, unreliable or incomplete.
Past performance is not a reliable indicator of future performance.
Ellerston Overlay ASF – Monthly Newsletter
9