Ellerston Australian MicroCap Fund (ECL0984AU) Report & Performance

The Ellerston Australian Microcap Fund delivered 1.73%, underperforming the Small Ordinaries Accumulation Index which finished up 3.54%. During the month, the RBA paused interest rates and announced the replacement of RBA Governor Phillip Lowe with Michelle Bullock. Bond yields rose slightly as the market changed its expectations that rates may remain at peak levels for longer. Looking more specifically at stock news, M&A remained elevated as Costa (CGC AU), best known for avocados and berries, received a bid at $3.50 per share while UMG Group (UMG AU) entered a scheme Implementation deed at $5.00 per share. We have also seen capital raises pick up at the smaller end of the market as companies look to bolt on growth to their current base.

In July, the market digested a lot of stock specific news flow with in full swing and companies pre releasing their full year results. This saw many of the travel names upgrade guidance or provide positive trading updates-Flight Centre (FLT AU) up 23% : Corporate Travel (CTD AU) up 17% and Siteminder (SDR AU) up 44%. While retailers like KMD Group (KMD AU) and Michael Hill (MHJ AU) cited softer trading is continuing. Resources updates were a mixed bag with the lithium names struggling.

RPM Global (RUL AU) was a strong performer, delivering 10%. This was on the back of the company providing an update on its FY23 software sales and guidance. RUL reported that it now has A$126m in pre-contracted, recurring, non-cancellable software revenue which was up 32% on the prior year. Total Annual Recurring Revenue now stands at A$55m. FY23 operating EBITDA, before once-off management incentives, is now expected to finish at A$15m, which compared to the company’s guidance of A$13.8m. We continue to see RUL as a high-quality play, noting its blue-chip customer base, its profitability, and the share buybock it is currently undertaking. RUL remains a high conviction position for the fund.

One of our top performers for the month of July was MMA Offshore (MRM AU), which finished the month up 14%. This price move was on the back of a +15% upgrade to consensus when guidance for FY23 was issued that would see EBITDA between $66-68m. The trading update also implied that momentum is likely to continue. MRM’s vessel utilisation over 2H23 was 79%. We believe this is very impressive given that three of their larger vessels were in dry dock for much of the third quarter of the year when compared to S their 71% utilisation from 2H22. This update was a strong indicator of the leverage that can come through with this business, and we believe this cycle is still some time from the peok ate with day rate and utilisation still ramping up rapidly. We hold this as a high conviction our portfolio and still see significant upside from here.

The Ellerston Australian Microcap Fund delivered 2.11%, outperforming the Small Ordinaries Index whichfinished flat at 0.03%. This was the second month in a row where large cops outperformed small caps. In June we saw the RBA hike rates by 25bp, May monthly CPI beat expectations, both of which contributed to further consumer weakness. We saw a number of consumer discretionary names continue to drift on the back of negative sentiment and consensus estimate downgrades. M&A activity remained elevated with PointsBet receiving multiple bids for its US business, while Perenti bid for DDH1.

Qoria Limited (QOR AU), formally Family Zone, had a strong month finishing up 40% on the back of two positive announcements. QOR is one of the only global providers of digital safety and student wellbeing solutions. Its services look after over 13m students; 5m parents and 24k schools globally. QOR’s share price was supported by its trading update which reported that its ARR was at +$95m before entering its seasonal strong quarter while its fixed costs remained stable, producing gross margins of +80%. The group also outlined the pathway to EBITDA profitability and 20% EBITDA margins over the next 24 months. QOR also announced a new debt facility which should help clean up the group’s capital structure and remove the doubt of a further capital raise. We don’t have many stocks in the portfolio which are loss making, however, when we see a business that has the ability to take market share globally and a line of sight to cashflow breakeven we are happy to invest.

We only recently wrote about Fleetwood (FWD AU},but once again it contributed strongly to this month’s performance with the stock rallying 26% on the back of an additional contract with RIO which can generate a further $100-120m in revenue over a number of years. Our attraction to FWD has always been around the operating leverage that the Searipple village can deliver to earnings. This asset over the last 10 years has been heavily written off on FWD’s balance sheet given the historic downturn in accommodation requirements around Karratha. However, over the last few years, even though occupancy had remained low compared to historical averages, it has been a solid cash producing asset. We believe that as more projects are launched around the Karratha region, this asset can once again start printing —$30m+ of EBIT which is more than the entire business is generating currently. We believe further contracts on top of its already announced contracts should see o continued re•rating to the FWD share price.

The Ellerston Australian Micro Cap Fund outperformed the Small Ordinaries Index by 0.14% in the month of May. The market was weighed down by noise around the US debt ceiling and closer to home, fears around higher inflation and rising interest rates. In May we also saw weakness in Small Resources with the index down over 7% with coal, gold and copper names all being hit. On the flip side we saw a strong rally in tech names on the back of the frenzy in AI sparked by NVIDIA’s 2Q trading update in the US.

May can be a mini reporting seasons with numerous conferences taking place which can require companies to provide trading updates. We entered May being very cautious around consumer facing names and anticipating a wave of downgrades. Early trading updates in May were a mixed bag with Media exposed names being hit heavily while large cap retailers such as Super Retail Group and JB Hi-Fi weathered the storm slightly better. However as the month progressed, a number of domestic retailers began providing negative trading updates, with consumer conditions markedly tougher post the Easter period.

The Ellerston Australian Micro Cap Fund outperformed the Small Ordinaries Index by 1.0% in the month of April. The market rallied in April partially based on the Reserve Bank of Australia (RBA) pausing interest rate rises (we note RBA moved rates by 0.25% in May),the anticipation of a softer landing and signs that global inflation was on a downward trajectory. We continued to see M&A appear with Kirin bidding for Blackmores and Wesfarmers/API bidding for Silk Lasers to name two.

More importantly, we saw at the smaller end of the market, fundamentals return. By this we mean catalysts and changes in earnings once again drove share price movements. The quarter was filled with news flow as companies got a handle on their 3Q results, and many cleansing the market before conference season kicked off. Turning to the portfolio, three stocks that had a strong April were Helloworld Travel (HLO AU); SmartPay (SMP AU) and Fleetwood Limited (FWD AU). We first bought into HLO in 2021 when it sold its corporate travel division to Corporate Travel Management (CTD AU) for $175m ($100m cash + $75m in CTD scrip).

While the transaction removed an earnings stream for HLO, it fundamentally changed the balance sheet of the business. HLO has benefited from the opening of borders and the recovery of leisure. This was clearly demonstrated in April when the Group provided a 3Q trading update, materially upgrading EBITDA guidance (+31-36%) to $38-42m (from $28-32m). This is the second upgrade that HLO has pushed through this year and there is further scope as guidance implies a weaker 4Q despite this usually being a seasonally stronger period. With Management being major shareholders and a balance sheet, which is ready to undertake M&A we believe HLO remains materially undervalued.

The Ellerston Australia nMicro Cap Fund outperformed the Small Ordinaries Index by 0.42% in the month of March.lt was a roller coaster ride for small caps with the index being down over 5% mid-month before recovering to close-0.72% on the back of a wave of takeover offers. From a macro point of view, March was one of the more interesting months that we have had in some time. We saw the failure of multiple US banks with Silicon Valley Bank (SVB) having some direct contagion into the Australian market. We also saw the rescuing of Credit Subse by UBS. Unlike previous periods of financial distress, regulators were on the front foot which appears to have stemmed any broader contagion.

March also saw a wave of M&A. In the Industrial space we saw all cash bids for United Malt from an industry player and Invocare, which was trading near COVID lows, be pounced on by private equity. In the healthcare space, Estia Health received o credible bid from Bain Capital while Australian Clinical Labs made on opportunistic scrip bid for Healius. The most dramatic impact to small cops in March was Albemarle’s bid for Liontown – a lithium explorer. Liontown holds a reasonably large weight in the index and was also heavily shorted, which resulted in the stock rallying more than the bid price. It also had a chain reaction sending other lithium names soaring. Ultimately this dynamic resulted in the Small Resources Index finish up 6% on the doy and 5.57% for the month (vs Small Industrials which finished down 3.0194 We think M&A will remain a large thematic goingforward.

We remain cautious of broad-based EPS growth across the market. This, coupled with rising interest rates and the push and pull of inflation/rate expectations, leaves us of the belief that we are back in a stock-pickers market. We continue to look for companies that can grow revenue and navigate inflationary pressures through the current period.

The Ellerston Australian Micro Cap Fund finished the month up 0.1% outperforming the Small Ordinaries Index which finished down 3.7%. The market gave back some of its gains from January weighed down by Resources, Healthcare and Energy. Statistically, reporting season disappointed the market with more companies missing consensus estimates which resulted in net downgrades across the board. However, what we would say is the drivers of the earnings downgrades were very much inline with our expectations and what we have been discussing in these newsletters over the last 6 months. We saw higher wages impacting costs bases; we saw rising interest rates impacting net interest costs; and we saw inventory levels that couldn’t be cleared or if they were cleared, with the use of discounting. The mixture of all these issues meant that cash balances have diminished (or debt has increased) and management discussions around price rises, “right sizing” and re-considering their capital allocation policy were front of mind.

This reporting season highlighted the markets grapple with what are the right multiples for businesses with an uncertain earnings trajectory. On one hand we had GUD Holdings which supplies aftermarket parts up 28% verse a Temple & Webster an online retailer down 38%. While there are many differences between these two names, most simply we have defensive retailer verse an expensive cash burning retailer. This dichotomy played out across the market with a rotation back towards defensives over the growth/ risk shift we saw in December and January. Two companies which reported a reasonable result in February whose valuations over the last 6 months have come back into more agreeable territories are DGL Group and Aussie Broadband. DGL group (DGL AU), a provider of diversified services within the chemical manufacturing, warehousing, distribution and environmental services, closed the month of February up 20%.

The share price ran throughout the month in anticipation of the H1 FY23 results, which was released on the 28th February. DGL demonstrated strong revenue growth of 52% on the prior period, driven both by acquisitive activity in the half as well as strong organic growth. Cash flow conversion, which had been an issue in previous results, came in very strong for H1 FY23 at 108%. The result was accompanied by an upgrade to the guided EBITDA range, from $70-$72m to $71.5-$73.5m for FY23, and was coupled with guidance to strong underlying cash flow conversion of 90-95%. We hold DGL as one of our core positions and look forward to a strong half in which DGL continues to leverage their specialised solutions in the chemical manufacturing and logistics space.