Dear fellow shareholders,

For the financial year ending 30 June 2024 (FY24), the NCC Investment Portfolio fell by –26.49%, compared to the Benchmark S&P/ASX Small Ordinaries Accumulation Index (XSOAI), which increased by +9.34%. This was the worst financial year return of NCC in its 12-year history and brings Investment Portfolio performance since inception to +5.28% p.a., outperforming the XSOAI return of +5.09% p.a. over the same time period.

I want to be very clear and acknowledge that this performance is not an acceptable return, and heading into FY24, we did not think producing such a poor result was even a remote possibility. My fellow Directors and I, many of our staff, and our extended networks and families are some of the largest investors in the Company, so this underperformance hits home in a profound way.

As I will elaborate in this letter, I firmly believe the current share prices of many of our core investments do not truly reflect their long-term value. We remain steadfast in our view that the true value of these investments are significantly higher than where they stand today. Throughout the year, we have spoken with many sources to stress test our investment thesis for each of these investments. Those sources have overwhelmingly corroborated our viewpoint regarding long-term value. As an investor in emerging companies, we expect that these businesses should be able to substantially grow their earnings per share (EPS) over time, and frankly, most of our core investments have not hit our internal growth hurdles this financial year. However, this is not to say these businesses will not be able to grow EPS to substantially higher levels in FY25 or FY26. If this occurs and the macro environment becomes more favourable for such businesses, we believe the re-rate to fair value will be significant.

We believe we are business owners, and our investing mentality should be aligned to this. That is why we will often seek board representation on the companies we invest in, through a NAOS representative. At present, a NAOS representative sits on the board of eight of our investments, which we believe helps to support their respective executive teams, and ensure they are taking the right steps to achieve their long-term strategic goals. If they successfully execute, this should lead to maximised shareholder value over the long term.

Has The Market Structure Changed Investing Forever?

Earlier in the year, highly regarded US-based investor David Einhorn gave an excellent analysis on what is moving markets today, particularly on the changing structure of the market.

He argues that a significant portion of investment capital in the market either cannot assess valuations due to a lack of training, does not care about valuations (i.e. passive index funds or exchange traded funds (ETFs)), or intentionally ignores valuations in favour of price-focused strategies (i.e. technical or quantitative strategies).

Einhorn illustrates this with an example of two companies both having a fair value of $1 billion. If one is undervalued by the market and has a market capitalisation of $500 million, and the other is overvalued with a market capitalisation of $2 billion, a market capitalisation-weighted index fund investing $5 will allocate $4 to the overvalued company and only $1 to the undervalued one. This leads to the overvalued stock receiving disproportionately more investment, causing it to outperform, while the undervalued stock underperforms.

This issue is compounded when new investments into index funds come from redemptions from active managers who had previously allocated more to undervalued stocks. When money is withdrawn from these active managers and reinvested in index funds, the undervalued stock faces net selling, and the overvalued stock sees net buying, driving their valuations further apart.

The rise of passive investing over recent years has seen several trillion dollars redeployed in this fashion, which in Einhorn’s words “has fundamentally broken the market”.

Looking at the ASX, the Commonwealth Bank of Australia (ASX: CBA) would be the prime example of this in the domestic market. As at 30 June, CBA shares were trading at $127.38, just below their record high. The share price has increased by +26.2% over the last 12 months and inclusive of dividends, has delivered a total shareholder return of +31.7%, markedly higher than the S&P/ASX 200 Accumulation Index FY24 return of +11.4%. Where the increase in CBA shares ties in with Einhorn’s comments is in relation to its EPS growth. FY24 EPS is expected to decrease by –1%, then looking ahead to FY25, consensus estimates are forecasting earnings growth to be negative again, around –3%. As such, CBA currently trades on a price-to-earnings (P/E) multiple of 21.9x, and given the decrease in EPS for FY25, this will increase to 22.7x.

Based on these metrics, I would argue the investment case for CBA goes against many of the fundamentals of investment analysis, such as looking for businesses that can provide sustainable EPS growth, as well as seeking businesses that do not require an ever-increasing amount of capital to achieve this, which leads to a reducing return on equity (ROE).

Commonwealth Bank – Share Price vs. EPS

Commonwealth Bank – Key Metrics

So, why is the price of CBA shares at a record high? When considering the current macro environment, one that is more conducive to low credit growth and increasing bad debts, this appears illogical. However, let us not forget, CBA is the second-largest business on the ASX, by market capitalisation, and a highly liquid one. It has provided investors with a relatively stable stream of dividends and in theory should continue to do so. If you have exposure to an ETF that seeks to provide exposure to the ASX 100, Australian financials or even large, listed businesses in Asia, chances are CBA will form part of that exposure. As these ETFs continue to increase in size and popularity, many of them will continue to acquire CBA shares regardless of price and/or value.

Interestingly, when looking at global banking peers, CBA would rank fifth most expensive in terms of valuation. This is out of 120 banks with a market capitalisation greater than $85 billion (e.g. ANZ Group has a market capitalisation of $86 billion).

Looking to the S&P 500 in the US, a notable trend that has been occurring for some time now is that the market breadth (or the number of stocks moving up versus those declining) has been decreasing at an ever-accelerating rate. Despite this, the S&P 500 has already set 30 all-time highs so far in CY24. The S&P 500 recorded a gain of +22.7% in FY24, but as we can see from the chart overleaf, the major contributors to this performance were five of the so-called “Magnificent 7”, namely NVIDIA, Microsoft, Amazon, Alphabet, and Meta Platforms. Due to their already large market capitalisations given their substantial returns, we estimate they have contributed >95% of the S&P 500’s FY24 return.

S&P 500 vs. Magnificent 7 - FY24 share price return

While this may seem like a bubble, we believe it is in fact hard to justify current prices as such when we look at the current earnings and EPS% growth of each of these businesses. As an example, NVIDIA has a P/E of 50x but its forecasted EPS is expected to grow ~120% for CY24, which will see the P/E halve. For Meta, the current P/E is 25x with forecasted CY24 EPS growth of +30%. When you then overlay the average market capitalisations of the Magnificent 7 of $2.2 trillion with their average cash balances of US$32.3 billion, you can argue the current valuations are justifiable. The trends these businesses are exposed to are high growth in nature, generally scalable (globally) and have a market dominance that gives them a high level of pricing power. All these characteristics are very hard to find in one business, let alone seven.

EPS Growth Expectations – Magnificent 7 vs. S&P 500

So, what does all of this mean for investing in emerging companies, especially those outside the resources and technology sectors? The answer is not simple. In very basic terms, investment in such businesses needs to be attractive relative to all other investment options. In a world where we have mega-tech businesses, significant expansion of private credit (non-bank lending) and more speculative investments such as venture capital, various options are available to all investors.

For investors in emerging companies, returns are driven by three key outputs:

• earnings per share;
• the valuation multiple applied to these earnings; and
• dividends.

If an emerging company is unable to grow its earnings at a reasonable rate, then the valuation multiple applied by investors to these earnings will reduce. For example, if earnings remain flat, and the P/E multiple falls from 12x to 9x, this will lead to a 25% reduction in share price. Investors will then be reliant on dividend yields for any return.

In the current environment, many investors focus on short-term news flow and extrapolate these findings. For many businesses with cyclical attributes, this had led to significant downside share price movements. I would argue this becomes self-fulfilling, as falling share prices result in smaller market capitalisations, and often, reduced liquidity, as investors move up the liquidity curve. This in turn makes it less attractive for the company to remain a listed business as the valuation premium reduces (or evaporates), leading to an inability to raise funds and further reduced liquidity for shareholders.

At NAOS, we continue to believe investing in emerging companies that have a clear moat, are run by proven and aligned management teams, coupled with a long runway of growth in favourable industries, will ultimately yield strong long-term results. Economic cycles will impact earnings in the short term, but in our view, it is important to remember many large and successful businesses, such as Reece Ltd (ASX: REH), have experienced periods where their share price flatlines or even falls (especially in their early years). Acquiring shares in times such as these can yield tremendous results and we would argue such opportunities exist today.

Events of Significance for Investee Companies in FY24

Given the FY24 Investment Portfolio performance, it is easy to assume there were no significant events that may lead to strong shareholder returns in the upcoming year. However, in our view, there were a number of notable events that could shape the respective businesses for many years to come. They have not yet led to a change in the share prices of these investments, mainly due to their minimal impact on short-term profitability, but in our view, significant potential upside exists.

BTC health (ASX: BTC)

Strategic Investors and Eurosets Distribution Agreement

After what can only be described as a tumultuous three-year period for BTC, the business had some positive news flow and what appears to be the start of a new chapter. The company welcomed three new strategic investors (all of which are related), collectively representing a ~15% stake in the business, along with the appointment of a related party as the new Head of Finance. The three businesses all operate within the medical device space and either design, manufacture and distribute their own products or distribute third-party products. With these firms as shareholders in BTC, it opens up opportunities for BTC to partner with them to identify and commercialise medical devices into the Australian market via a distribution agreement with BTC. In our view, the major shortcoming of BTC to date has been its inability to scale via either acquisition or organic opportunities, such as licensing other medical products or organic revenue growth.

The medical device space is dominated by large players such as EBOS Group (ASX: EBO) and historically, it has been challenging for BTC to convince manufacturers of medical devices who require a distribution partner in Australia that BTC is the low-risk choice. This deal provides BTC access to numerous medical devices with no upfront cost, an aligned partner via equity ownership, and a royalty agreement that has the potential for those royalties to be converted into BTC shares. If BTC can prove to the market that a number of these devices can penetrate the Australian market and drive profitability for BTC, it will go a long way to restoring confidence in management and the business. We believe this is a sound first step, and working with a strategic partner possessing significant industry experience means the future looks significantly brighter for BTC.

Ordermentum Pty Ltd (Unlisted)

Acquisition of Foodbomb and Funding Secured

Ordermentum has been an unlisted investment within the NCC Investment Portfolio for over two years. In early FY24, Ordermentum completed the acquisition of the wholesale food marketplace business Foodbomb, while completing a financing round of both debt and equity of ~$16 million.

Ordermentum is a B2B order management technology platform that connects hospitality venues (cafes, restaurants etc.) with food and beverage suppliers from whom they purchase their goods. Over 40,000 hospitality venues and ~850 suppliers, many of which sell coffee, dairy products and baked goods, all use Ordermentum to manage a critical business process. This forms Ordermentum’s core offering and has seen the business grow significantly over the past 3–5  years. As we can see from the graph opposite, it took Ordermentum ~6 years to see $1 billion transacted on its platform; the most recent $1 billion took <9 months.

Ordermentum - Cumulative Gross Merchandise Value (GMV)‍

Source: Ordermentum

An area of opportunity for significant growth is the breadth and depth of Ordermentum’s supplier category offering. It has a very strong pedigree in categories such as coffee, dairy and baked goods, but is still building its strength in fresh produce categories (fruit and vegetables, meat, poultry etc.). This is where the acquisition of Foodbomb makes strategic sense, as it combines the strength of the Foodbomb supplier base in fresh produce with Ordermentum’s strength in other categories.

This is of significant importance because if management can increase the number of supplier trading relationships (TRs) per venue (e.g. coffee supplier = 1TR, coffee + bread + poultry suppliers = 3TRs) from ~1.5 per venue to just ~2.5–3, the revenue uplift is significant but with minimal operating expense increase. We estimate an average venue may have ~10 different TRs, hence the opportunity to further accelerate network growth underpinned by increasing supplier quality, size and category diversification, is a realistic one.

Number of Trading Relationships on Ordermentum Platform

Over the past 12-24 months, Ordermentum has been adding a third pillar to the platform alongside its core competencies of ordering and payments. This is in essence a marketplace that showcases an array of food and beverage suppliers to potential venue customers. It allows choice for venues looking to change supplier and/or add further suppliers/produce to their service offering; for example, suitable new bakery suppliers for a specific cafe. Importantly, it does this without cannibalising existing supplier/venue relationships, and therefore, does not diminish the integrity of the platform. If venues are made aware of new products that could be of use to them, this is a subtle way for Ordermentum to increase the number of products sold to each venue over time.

From a supplier’s perspective, Ordermentum acts like a salesperson by showcasing their brand and produce to a far greater pool of potential venue customers, some of whom may have previously been unobtainable. For the supplier, this can drive sales growth for their own businesses. For venue operators, it saves them time and effort in understanding which suppliers offer what products, and provides access to new suppliers as well as new product categories. The food and beverage market is a highly fragmented market, so for a supplier to gain exposure to ~40,000 Ordermentum platform venues is highly valuable, and in our view, more effective than just adding more outbound salespeople.

The Foodbomb platform is a marketplace offering as well as a sales channel for some enterprise-style suppliers, such as large national food distribution businesses. These suppliers are well versed in transacting with customers via a marketplace-style offering, and many of those customers are large hospitality groups that require large volumes of fresh produce. We believe that as a supplier, you would be willing to sacrifice more of your margin to a platform that not only saves your business time and creates efficiency, but also acts as a sales engine and boosts revenue. Therefore, if Ordermentum can effectively combine its own marketplace offering with Foodbomb and further scale this third pillar, the effect on its own revenue line will be significant. We believe we are starting to see the early signs of success occurring.

Saunders International (ASX: SND)

Acquisition of Piping Solutions

It was another productive year for SND, during which it completed the acquisition of Piping Solutions (PS) for an initial payment of $13 million on a debt-free, cash-free basis plus an earn-out payment up to $7 million. PS was established in 2004 and today employs ~100 people, and in FY23, generated $3.6 million of EBIT on revenue of approximately $41 million. Importantly, the transaction was 50% funded from SND’s available cash, with the vendors taking the balance in SND scrip. In our view, this is a very positive outcome for SND as it demonstrates the belief the vendors have in SND’s strategy, particularly considering the illiquid nature of SND shares.

We believe PS will be a highly complementary offering for several key reasons including:

• Complementary Offering and Skillset – SND initially grew by building large liquid storage tanks, so it makes sense for them to offer their clients a more complete solution that includes both the tank and all associated piping elements. PS and SND have worked together on several contracts, highlighting their complementary capabilities. PS fabricates and installs steel-piping solutions and offers complete maintenance programs for existing steel-piping infrastructure. One major project that PS has recently completed was the ~11 kilometres of sophisticated steel-piping infrastructure at Western Sydney Airport, which connects the fuel storage facilities to all the refuelling points at terminal berths, in a safe and compliant manner. The acquisition of PS will allow SND to retain more of the revenue from contracts, rather than subcontracting out these specialised skills.
• Exposure to Defence – Over the past few years PS has gained significant exposure to contracts awarded by the Australian Government Department of Defence, representing approximately ~40% of PS’ revenue. It currently has a contract at RAAF Base Tindal, and provides fuel installation and maintenance services to six other defence sites. SND has been on a multi-year journey to gain the credentials and expertise required to tender directly on large defence opportunities, and the acquisition of PS further enhances this strategy, as well as building out a strong portfolio of successfully completed defence projects.
• New Energy Markets – SND has been building out its capability to ensure a successful entry into new energy markets, and PS accelerates this progress. These markets include areas such as hydrogen, green hydrogen and biofuels. Many green energy technologies being developed will require not only storage mechanisms but also distribution, and potentially, refining infrastructure. PS, with its recent collaboration with the Scaling Green Hydrogen Cooperative Research Centre (SGH CRC) and its diverse client base, strengthen SND’s position in these evolving markets. Some of PS’s clients are shown in the pie chart below.  

In our view, FY24 was a successful year for SND, and the current share price does not fairly reflect the progress made. Management has been able to rebuild its order book post the completion of the $160-million Project Caymus work it won in FY22. SND completed the acquisitions of Automation IT and PS. From what was originally a specialist tank construction and maintenance business, SND is now well on its way to becoming a multidisciplinary contracting business that can deal directly with Tier 1 clients and offer unique solutions few other contractors can, on a self-performing basis. We are also seeing a number of new contracts that fit with this enhanced capability, including the underground piping infrastructure alongside the fuel storage farm and processing facilities for Western Sydney Airport, as well as the $44-million liquid storage facility in Pelican Point, South Australia.

Big River Industries (ASX: BRI)

Acquisition of Specialised Laminators

During FY24, BRI announced the acquisition of Specialised Laminators (SL), a distributor and manufacturer of specialised panels mainly for use in a commercial environment, which has been operating since 1977. The business was acquired for an initial payment of $10 million, split 70/30 between cash and BRI scrip. Using a crude 10% EBITDA margin against its $27 million of revenue implies the business is being acquired on an EBITDA multiple of 3.70x. This was the first acquisition completed by new CEO John Lorente, and in our view, highlights one of the key attributes of our BRI investment thesis; namely the opportunity for consolidation in a highly fragmented market that is dominated by baby boomers with limited succession options.

We believe this acquisition has a high level of strategic merit for BRI. The products distributed, and, in some cases, manufactured by SL, are of a more specialised and customised nature compared to typical laminates and veneers. The products are used in commercial applications, for example, coffins, boats, recreational vehicles and public bathrooms and amenity areas. With BRI now growing to 26 distribution sites across Australia and New Zealand, this extensive network provides SL with a unique platform to market and stock its product across the entire BRI network.

BRI’s network, predominately via its panels division, serves thousands of commercial clients and joiners/cabinetmakers, all of whom are potential customers for SL’s unique products, although they may currently be unaware of them. Additionally, BRI’s acquisition of SL enhances its capability to develop new products to meet market demands and innovate to a level where there are fewer competing products. These products can then be effectively marketed and distributed throughout BRI’s entire network, further strengthening its value proposition.

The decorative panels market in Australia and New Zealand is one that is not well understood by the wider market and we estimate that post this acquisition, the total panels market that BRI has exposure to is worth approximately $2 billion in sales annually, comprising a mix of high-value and lower value products. The two major players in the space are the family-owned Borg, and Fletcher Building (ASX: FBU), which owns the Laminex Group. Both companies primarily focus on manufacturing rather than distribution, particularly when dealing with smaller commercial clients. BRI has the ability to cater to these smaller commercial clients and also offer a national network with a wide range of BRI products, including specialised veneers and panels. In our view, this gives BRI a unique moat and a long runway for growth, both organically and via M&A.

FY25 Outlook

There is no doubt that being an index-unaware active manager with a focus on emerging companies has never been more challenging. Despite this, we fundamentally believe and remain steadfast in the belief that investing in emerging companies, with a long-term and concentrated portfolio structure, can lead to substantial positive returns.

I would argue the current share prices applied to most, if not all, of our core listed investments factor in no earnings growth or even negative growth over the long term. However, as history has shown us, extrapolating a current earnings profile can prove to be a misguided approach, when earnings are either depressed (and also valued on low earnings multiples), or at inflated levels (and also trading on lofty earnings multiples). This can explain why large amounts of variability can affect a company’s share price over time.

In our view, three key factors will dictate the returns of the NCC Investment Portfolio over the next few years.

Firstly, economic conditions will change, and these changes may have significant impacts on some of our key investments, such as Big River Industries (ASX: BRI) and MitchCap. For BRI, an increase in the supply of new housing will provide a significant tailwind, whereas for MitchCap, a friendlier economic environment will allow its customer base to hold increased inventory levels, which should drive higher turnover of stock, leading to increased revenue for MitchCap.

Secondly, businesses will need to continually innovate and refine their strategies to ensure they meet their customers’ changing needs, and we are confident our investments are nimble enough to execute successfully in this regard. We also do not believe that many of our businesses reacted as effectively as they could have in 2H FY24 from an efficiency perspective.

In FY25, they will need to ensure they are being as efficient as possible to maximise the value of their asset base, particularly if cost rationalisation activities have occurred in response to the more challenging economic climate of late.

Thirdly, as listed companies, they also have the clear advantage over their private counterparts in being able to use their listed scrip to acquire businesses that bring with them a compelling strategic offering. Potential opportunities for strategic M&A activity are also likely to increase given the depressed valuations across many emerging companies.

There is no doubt that the above factors come with a significant amount of execution risk. However, due to the recent investor exodus from emerging companies, in our view, the valuation multiples currently applied to many emerging companies have not been as depressed for 10 or even 20 years. Consequently, when these businesses grow their earnings base at a rate even slightly above market expectations (e.g. >5%), we would argue the re-rating of these businesses has the potential to be significant. As we have seen over the past 12-24 months, when a listed business remains undervalued over a significant timeframe, then there is a real possibility the company will be acquired and delisted. In 2024 alone, within the building materials sector, three of the largest listed businesses saw takeovers, namely Boral (ASX: BLD), Adelaide Brighton (ASX: ABC) and CSR Limited (ASX: CSR), all of which had been listed since the 1960s.

We also believe that in most cases, the people who run our core investments are highly aligned, highly motivated and highly capable. This also gives us great confidence that the strategies are being implemented with strong fundamentals behind them and a high level of energy to achieve the outcomes in a desirable timeframe. While some may argue that executives/management teams have a poor ability to judge what fair value is for their respective businesses, we would argue that these same people have a deep understanding of the long-term strategic value of their respective businesses.

In conclusion, we are striving for improved returns following the recent unsatisfactory performance. We take full responsibility for these results and remain committed to restoring value and delivering long-term performance.

My fellow NCC Directors and I continue to increase our shareholdings, and NAOS has also recently committed to reinvest up to 15% of its annual management fee into acquiring NCC shares on-market.

The entire team at NAOS is acutely aware of the trust you have placed in us to manage your capital and we greatly appreciate your ongoing support.

If shareholders have any questions, please do not hesitate to contact me directly.

Kind regards,

Sebastian Evans
Managing Director and Chief Investment Officer
NAOS Asset Management Limited 

What are the main issues you face around safety for your employees?

As the Managing Director and CEO of Saunders, my foremost commitment is to the safety of our employees, subcontractors, and the community. Working within various high-risk industries across diverse locations in Australia brings about distinct challenges, especially in standardising safety practices amid varying regional regulations and client demands.

For example, all states and territories now follow the same work, health and safety (WHS) regulations, except for Victoria, which has not implemented them yet. Additionally, we work with clients who have their own company rules based on US or European standards, and these rules vary between different organisations.

Could you provide an overview of Saunders’ approach to ensuring safety across its project sites?

To address these complexities, we prioritise robust planning, proactive execution and effective communication. Our integrated management system ensures consistency in safety and compliance across our diverse operational environments.

Our safety approach centres on “Zero Harm”,  reflecting our highest commitment to safety across all operations; it is our promise to our people and their loved ones. From initial proposals and planning through to construction and ongoing maintenance, we employ a comprehensive safety management system that exceeds regulatory standards. This includes using the Hierarchy of Controls methodology to identify and mitigate hazards at every stage.

Our Health, Safety, Environment and Quality (HSEQ) management systems have been certified to meet the  ISO 45001 standard, and has also been accredited by the Office of Federal Safety Commissioner (OFSC). These achievements highlight our dedication to safety and qualify us for the highest standard under the Australian Government Building and Construction WHS Accreditation Scheme.

Do you have programs in place to mitigate risks?

We have implemented robust programs and initiatives to mitigate risks and foster a strong safety culture across the organisation. One key initiative is Together for Safety, a safety training program aimed at developing safety leadership skills and fostering a safety-oriented culture over the next five years. Additionally, we have recently introduced a company-wide “Two Hours for Safety” session every Thursday for all operational management teams. During this time, all personnel are dedicated solely to safety activities.

We roll out monthly safety themes to address high-risk areas, and our executives and board members conduct regular site visits. These initiatives actively engage our teams and empower our workforce to take ownership of safety at every level.

How do you measure performance in this area? What have you achieved?

Enhancing our safety culture, actively managing operational risks, and consistently reviewing WHS Standards are foundational to our safety performance strategy. We employ key indicators such as safety observations, inspections, and Total Recordable Injury Frequency Rate (TRIFR) to track safety performance, delivering monthly reports to leadership.

In FY24, we achieved a strong safety performance, with a TRIFR12 metric of 1.35 as of June 2024 (based on one million hours worked). This represents an 83.9% decrease from 8.39 in June 2023. This significant decrease demonstrates our tangible progress in improving safety outcomes.