Disclaimer:
The information provided in this Substack is for informational and educational purposes only and does not constitute financial product advice, investment advice, or a recommendation to buy, sell, or hold any financial products. The content is general in nature and does not take into account your personal financial objectives, situation, or needs.

While reasonable efforts are made to ensure the accuracy, completeness, and reliability of the information presented, no representation or warranty, express or implied, is given as to its accuracy or completeness. All opinions expressed are those of the author and are subject to change without notice.

I am not a licensed financial adviser. You should consult a licensed financial adviser, tax professional, or legal advisor before making any investment decisions. Investing involves risk, including the potential loss of capital, and past performance is not indicative of future results.

The author may hold positions in the securities mentioned and will disclose such holdings where relevant. Any mention of specific securities, investments, or strategies should not be interpreted as a recommendation.

By accessing and reading this content, you acknowledge and agree that the author is not liable for any loss or damage arising from any decisions you make based on the information provided. You are solely responsible for your own investment research and decisions.

I hold a position in B&M European Value Retail.

In May 2024 I wrote an article on B&M European Value Retail (B&M) and why I purchased shares for my own portfolio:

https://substack.com/@myinvestmentjournal/note/p-144547917?utm_source=notes-share-action&r=h29te

Original Thesis Summary

The original thesis was composed of 6 key elements:

1. Successful Adoption of the Dollar Store Model in the UK

When executed well the dollar store format has proven to be a highly successful retail model globally. B&M was the first dollar store in the UK and France to successfully adopt this model to local conditions. This success was evident in:

• Materially stronger margins the comparable UK retailers,

• Margins similar to or greater than successful dollar chains overseas,

• Strong and consistent cash generation,

• High returns on capital.

2. Durable Competitive Advantages

As a result of its successful execution, B&M had developed a number of competitive advantages including:

• Efficient warehouse and logistics network,

• Strong supplier relationships and purchasing power,

• Disciplined product selection with limited SKU’s,

• Low cost flexible store format,

• Relative immunity to online competition due to low average basket size,

• Well established and trusted brand in the UK.

3. Covid Earnings Distortions

I described the Covid periods earnings as abnormal and earnings during this time were not representative of sustainable long term earnings. Earnings were temporarily inflated because B&M was able to remain open while other retailers with similar goods had to close.

I expected post-Covid earnings to normalise. However, it also seemed likely productivity would settle at a higher level than before the pandemic, as many consumers discovered B&M for the first time during this period and continued shopping there after the pandemic.

4. A Long Growth Runway

The thesis assumed B&M continue deploying capital at attractive rates rates of return through:

• Further store expansion in the UK,

• Much longer potential for store expansion in France,

• Incremental productivity improvements driven by greater scale and operational efficiencies.

5. Shareholder Friendly Capital Allocation

I viewed B&M as financially conservative, with:

• A strong balance sheet

• A consistent base dividend

• A track record of returning excess capital to shareholders

6. Valuation Didn’t Reflect Business Quality

Finally I argued B&M’s valuation understated the quality of the business. On multiple metrics:

• It’s valuation was low to average relative to UK peers that were slower growing lower margin,

• Cheap relative to international dollar store peers with comparable or inferior economics.

In short I viewed B&M as a resilient, high return discount retailer with a long investment runway. That traded at a valuation that didn’t account for its quality and long term compounding potential.

What has Changed Since Last Blog Post?

Earnings and profitability

At the time my initial write up was published the price of B&M was 543.6. Today it is 161.6, a fall of approximately 70%.

Over the past decade, B&M has delivered substantial absolute earnings growth from 38.6m in FY2015 to 367m in FY2024, almost a ten fold increase. However, as shown below this is not all smooth.

The impact from Covid is clearly visible. Net income fell sharply in FY2020, before rising well above trend in FY2021 (when B&M was allowed to remain open while some competitors were closed). This created a temporary and unsustainable earnings boost.

Following the peak in FY2021, Earnings have gradually normalised as lockdown restrictions were lifted and consumer behaviour reverted towards pre-covid patterns in both the UK and France. Although B&M hasn’t completely normalised with store and employee productivity as well as returns on capital above 2019 levels, until recently.

If we break the results down in half yearly periods a clearer pattern emerges.

The half year data shows a period of post-Covid stabilisations, followed by a more pronounced deterioration in profitability in recent periods.In the first half of FY2026, adjusted profits before tax declined sharply (this profit measurement is used as it was the only consistent profit metric I could find going back to FY2016). This decline in profitability has occurred despite revenue continuing to grow at a steady pace.

This is because the key driver of lower profits are increased costs and in the first half of 2026 B&M was hit by a number of difficult cost drivers.

1. Increase in Minimum Wage and National Insurance: There was a 6.73% in the minimum wage in the UK as well as an increase in national insurance from 13.8% to 15% all in the same quarter. Given the labour-intensive nature of B&M’s business, this had an immediate impact on costs

2. Wilko Stores: Towards the end of 2023 B&M entered into negotiations to buy 51 Wilko (bankrupt discounter) stores. While these stores were acquired at favourable terms, they required significant refurbishment before finally opening in 2025.

   New stores are typically less productive than other stores in their early months. Wilko locations are often smaller and differently located than B&M’s traditional out of town retail park format, making them less optimised for B&M’s model. As a result these stores have diluted near term profitability.

https://www.bbc.com/news/business-66711168

3. Energy and Other Operating Costs: Consistently higher energy prices in the UK have increased the cost of running stores and distributing goods, adding further pressure to margins.

Together these factors have led to a 30% decline in adjusted EBITDA in the first half of FY26.

This highlights one of the key risks of investing in businesses with low margins such as discount retail. Even when revenues continue to grow, relatively modest relative increases in costs can have disproportionate impacts on profitability. This is operating leverage working in reverse.

The recent cost increases and declining profitability are largely confined to the UK business. B&M’s French Operations continues to grow earnings (although slower than in the past), with adjusted EBITDA increasing from £17m to £18m over the period.

At the time of my original blog post, I expected that while Covid era sales were clearly inflated, post Covid normalisation would leave B&M with a higher sales base per store than pre-Covid. New customers who discovered B&M’s strong value proposition during the pandemic would return. While this has been true in absolute terms the rate of ongoing growth recently on a store like for like basis has disappointed.

Recent results over the past 18 months show B&Ms like for like growth hovering around flat to mildly negative, despite:

• Elevated inflation

• A weak retail environment

• Continued pressure on household budgets, that should in theory, favour value retailers

This matters more than overall revenue growth. Like for like sales are an important driver of operating leverage in retail. When like for like sales stagnate, while fixed and semi-fixed costs such as wages, rent, energy and logistics grow faster than revenue this leads to margin compression. This dynamic has been clearly visible in the latest results, where modest revenue growth was overwhelmed by high cost inflation.

The UK stagnation does not imply a broken business model. The B&M business is still very profitable. But it does require a downward revision in B&M’s UK earnings expectations and a more cautious view on earnings recovery.

The market’s reaction to B&M over the past 18 months has been severe with the stock price falling sharply as profits declined and guidance was reduced. It appears the market has lost confidence in B&M’s ability to deliver sustainable earnings growth particularly in light of increasing cost pressures.

The market’s valuation implies B&M’s business model is no longer sustainable and that B&M has entered a period of structural decline.

The reality presented in the financial results is however more nuanced. Group revenues continue to grow and France, which has not been hit with the same cost inflation as the UK. Gross margins of B&M in the UK remain largely higher or on par with other UK retailers as well as international discounters.

Other UK Retailers

Other Dollar Stores

What has changed is not the durability of the business model, but the operating environment. A combination of flat UK L4L sales, sharply higher labour costs, increased national insurance and elevated “other costs” has exposed the downside of operating leverage in mature retail stores. This is intensified by a wave of new store openings that are not B&Ms normal type of stores and are still in their ramp up phase. The result is a sharp, but highly leveraged, decline in earnings that look worse than the underlying trading conditions would suggest.

However the market’s reaction is not entirely irrational. My original thesis underestimated the possibility of UK stagnation and sensitivity of earnings to cost inflation in a low growth environment and business with high operating leverage. While the selloff may overstate the long term damage, it correctly signals the short term earnings profile.

The question for investors is therefore not whether results have been poor, which they clearly were. But whether the valuation reflects the realistic long term earnings power, or assumes a degree of structural decline not supported by the underlying economics of the business. B&M isn’t the only retailer impacted by these increased costs and so the thing to monitor is whether B&M will be able to pass on these costs in time, returning to its prior margins.

B&M’s Executives

For nearly two decades B&M was led by Simon Arora, who played a central role in building the business from a small struggling regional retailer to the UK’s leading discount variety chain. His long tenure provided continuity, deep operational expertise and strong cultural alignment.

In September 2022 Simon stepped down as CEO and was replaced by Alex Russo, the company’s former CFO. However Russo’s tenure proved short lived, departing less than 2 years later, at a time when the business was already struggling.

Tjeerd Jegen was appointed CEO following Alex Russo. While it is too early to assess Tjeerd’s performance the speed and frequency of B&M’s CEO tenure under Alex Russo contrasts sharply with B&M’s earlier years under Simon Arora.This is particularly important in retail which is an execution heavy business.

Compounding these concerns was an accounting error identified under former CFO Mike Schmidt, requiring correction and further denting market confidence. While the error itself was limited, it reinforced investor concerns around internal controls and governance at a time when trust in management execution was already fragile.

Leadership instability and an accounting error by themselves do not invalidate B&M’s long term business model. However they have clearly undermined shareholder confidence and amplified the market’s reaction to existing issues. All this is especially concerning in a business where management plays such a crucial role in the businesses success or failure.

Is B&M in Structural Decline?

At current valuations, B&M is priced as if it has entered a period of structural decline.

P/E (LTM): ~7x

EV/EBITDA (LTM) ~5x

Price/FCF (LTM) ~7x

These are not multiples you would expect from a UK retailer growing in line with GDP, they are what you’d expect from a business in structural decline.

While recent results and governance issues justify a higher risk premium and lower earnings expectations. The valuation implies a degree of permanent impairment not yet evident in the long term underlying economics of the business.

Although the last half year’s earnings are concerneding, especially the last quarter it is not enough to completely come to the conclusion that B&M is in structural decline. Over the next few quarters B&M results I will be monitoring the following 5 variables and believe that only 1-2 of these returning back to where they were before the most recent quarters would more than show that B&M is not in structural decline:

1. UK Like for Like Sales.

The most important signal to look for is Like for is UK Like for Like (LFL) sales. A business in structural decline typically exhibits persistently negative LFL sales as customers gradually disengage from the proposition.

B&M’s LFL sales have been flat to mildly negative, which is disappointing, but has not been going on long enough to determine it is in terminal decline. If LFL results can stabilise in the 0%-2% range, that would suggest customers still see value in B&M’s proposition and recent weakness can be mostly attributed to external factors and execution issues. Sustained LFL declines would however significantly strengthen the structural decline thesis.

2. Passing on Costs.

Over the past year B&Ms costs have increased faster than revenues, hurting margins. Will B&M be able to pass on these costs and have margins return to where they were? Typically its not prudent for businesses to pass on significantly higher costs all at once, but to pass them on with some lag.

3. Wilko Stores.

In 2025 B&M opened the Wilko stores that they purchased in bankruptcy. These stores differ from B&Ms usual stores in areas such as location and size and are in their ramp up phase. Does their profitability converge to B&Ms standard profitability?

4. New CEOs Credibility.

Tjeerd took over in June 2025 so it is too soon to assess his performance. Since becoming CEO he has initiated a review of customer proposition and operations and begun implementing a ‘Back to Basics’ plan This plan involves

• More competitive pricing (Potentially hitting margins),

• Greater availability of popular items (Customers have been leaving 15% of the time without the item they wanted),

• Reducing the number of SKUs (Too many items complicate the supply chain),

• More exciting promotions (Promotions more recently have become stale).

B&M has said it expects the full impact of this turn around plan to take about 12-18 months.

5. Return on Incremental Capital Trends.

Returns on capital in recent quarters have gone down quite a bit. Largely driven by the increasing costs. One thing to note is that although returns are down they still seem above potential cost of capital for B&M, indicating the business is generating value. Although the question is can they return to the range of previous values?

Updated Growth Assumptions and Valuation

In my last post I assumed a 10%-15% EPS growth rate over time, this turned out to be too optimistic. The issue is not that B&M is structurally impaired and has lost its value proposition, but that earnings are much more sensitive to operational changes and costs than I allowed for.

New Realistic Growth Ranges:

Near Term (Next 1-2 years): Low to mid single digit EPS growth. As the UK business absorbs the cost inflation, the new strategy of “Back to Basics” takes effect and the business gains momentum.

Medium Term (3-5 years): Mid single digit EPS growth. If UK L4L stabilises and margins recover modestly, while France provides incremental growth.

What can provide upside:

• UK L4L stabilises going positive.

• Cost absorption improves, through productivity, pricing and/or better product selection.

• Wilko cohort normalises towards the estate average (or stops being a drag).

• The new CEO gains credibility and regains market trust.

• Returns on incremental capital stop declining

Valuation

Due to the Discounted Cash Flow (DCF) being quite sensitive to cross check it I have used 2 additional valuation methods to obtain a range of values for a bear, base and bull case for B&M . The 2 additional valuation methods are:

1. EV/EBITDA: B&M management explicitly guides the market using EBITDA, rather than EPS or net income. This is likely because EBITDA isolates performance level metrics from capital structure noise such as leases, depreciation and financing.

2. Owner Yield: If we conservatively assume B&M has ended its growth phase how much cash can be returned to shareholders without impairing the existing business.

Bear Case (~£1.6): UK L4L remains weak, cost inflation is only partially offset, and the market retains a depressed multiple because confidence doesn’t return quickly.

Base Case (~£2.7–£3.0): FY26 is the reset year. UK L4L stabilises, margins recover modestly, the company returns to a more normal earnings level (not back to peak). Trust is gradually restored, the stock re-rates to a still discounted but more reasonable valuation.

Bull case (£4+): Execution improves decisively, Wilko stores coverage to average profitability, B&M regains something close to prior earning powers.

As can be seen the valuation currently at £1.6 implies very pessimistic despite the business remaining profitable and cash generative. If UK L4L can stabilise and costs be better passed through, the rerating potential is meaningful.

What I Have Learnt from B&M

B&M has been a very humbling investment. Not because the thesis was carelessly researched, but many things that have happened were outside of what I knew at the time and it exposed this.

This update forced me to separate:

• What went wrong in the business

• What went wrong in my expectations

• What went wrong in how the market reacted

1. Underestimating Downside for Low Margin Businesses

Although I acknowledged discounters have a relatively low margin business model (for which B&M actually has relatively high margins). I underestimated the operating leverage and how asymmetric the downside could be when cost pressures hit. Together relatively small increases in:

• Minimum wage,

• Employer national insurance,

• Elevated energy and logistics costs,

• And drag from newly opened Wilko stores

Together these impacts lead to a 30% decline in UK adjusted EBITDA in a single half. This reinforces that in low margin sectors:

• Revenue growth does not guarantee profit growth,

• Modest L4L weakness can have outsized impacts on profit,

• Cost inflation can overwhelm even disciplined operators.

2. Normalisation Stories Require Tighter Downside Framing

My original article identified that Covid earnings were structurally high and should normalise. However I underestimated the range of outcomes around that normalisation.

In future I will be more explicit about:

• Downside normalisation scenarios,

• How cost shocks can impact earnings

3. Management Stability

Another lesson from B&M is leadership stability during periods of stress. At the time I wrote the article Simon Aurora was stepping down, this should have been a red flag on such an execution dependent business. This is especially the case when the business is still going through its normalisation period post Covid

How This Will Change My Approach Going Forward

• More conservative with greater downside in low margin sectors,

• Explicit modelling of potential cost shocks,

• Greater emphasis on earnings stability in future companies not just earnings growth

• Greater management continuity during periods of change

• Stronger valuation buffers for normalisation thesis.

Final Verdict

Based on my updated analysis I will be holding my B&M stock.

The stock is definitely not priced for growth, and seems to be priced as if the business is in structural decline. However the evidence coming out of the business does not yet support that conclusion. At the same time the near term earnings outlook remains too uncertain to aggressively add would be premature.

This is therefore a situation where valuation supports a buy, but fundamentals visibility does not.

Summary

Why I am not selling

• Gross margins are still high relative to other retailers

• Return on capital remains above cost of capital, even after recent compressions.

• The balance sheet is manageable with no immediate solvency risk.

• France continues to grow earnings and provide geographic diversification.

Why I will not buy anymore

• UK L4L sales remain weak

• Cost inflation has not been fully absorbed

• Wilko stores still subscale and underearning

• Management credibility in process of being rebuilt

• Earnings expectations may still need further downward revision

Disclaimer:
The information provided in this Substack is for informational and educational purposes only and does not constitute financial product advice, investment advice, or a recommendation to buy, sell, or hold any financial products. The content is general in nature and does not take into account your personal financial objectives, situation, or needs.

While reasonable efforts are made to ensure the accuracy, completeness, and reliability of the information presented, no representation or warranty, express or implied, is given as to its accuracy or completeness. All opinions expressed are those of the author and are subject to change without notice.

I am not a licensed financial adviser. You should consult a licensed financial adviser, tax professional, or legal advisor before making any investment decisions. Investing involves risk, including the potential loss of capital, and past performance is not indicative of future results.

The author may hold positions in the securities mentioned and will disclose such holdings where relevant. Any mention of specific securities, investments, or strategies should not be interpreted as a recommendation.

By accessing and reading this content, you acknowledge and agree that the author is not liable for any loss or damage arising from any decisions you make based on the information provided. You are solely responsible for your own investment research and decisions.

I hold a position in Tourmaline Oil.

Executive Summary

North America’s natural gas prices are among the lowest in the world, largely due to the shale revolution, which unlocked vast supplies. These technologies propelled the U.S. to become the world’s largest natural gas producer and Canada to fifth place. However, insufficient export infrastructure has left much of this gas stranded within North America, keeping domestic prices 2-4 times below those in Europe and Asia. Over time, as LNG export capacity expands and new sources of domestic demand develop, this pricing gap has the potential to narrow.

Tourmaline Oil Corporation offers a compelling way to capitalize on this dynamic. Despite persistently low North American gas prices, the company has thrived thanks to its founder-led management team, rigorous cost discipline, and prudent capital allocation. With a deep reserve base, industry-leading operating efficiency, and a consistent commitment to shareholder returns through both regular and special dividends, Tourmaline is positioned to benefit from any normalization in North American natural gas prices. Importantly, even if prices remain structurally depressed, Tourmaline’s low-cost structure and operational strength suggest it can continue to deliver attractive returns to shareholders.

What Does Tourmaline Oil Corporation Do?

Tourmaline Oil Corporation, is Canada's largest producer of natural gas (despite the oil in its name). It produces some oil, but the majority of its revenues come from natural gas products. It is also Canada's fourth largest midstream operator, this involves the transportation, storage and marketing of hydro-carbon products.

All of Tourmaline’s activities take place in the Western Canadian Sedimentary Basin (WCSB) of which it divides its areas of operation into the three regions of:

1. The Alberta Deep Basin

2. The North East British Columbia Montney and

3. The Pierce River Triassic Oil Complex.

The WCSB is estimated to contain approximately two thirds of Canada’s natural gas reserves. Due to decades of conventional oil extraction there is a significant amount of infrastructure, skilled workers and detailed knowledge of the region's geology.

Does Tourmaline have a Moat?

I would classify Tourmaline as having a narrow economic moat. In the natural resource industry it is difficult to have a significant moat. It has a great culture, a large low cost inventory of natural gas and scale. However despite all this Tourmaline still faces intense competition, has little pricing power and requires moderate rates of reinvestment.

Executive and Operational Culture

“There are no shortcuts around quality, and quality starts with people. Maybe shortcuts exist, but I’m not smart enough to have ever found any.”

• Steve Jobs

Tourmaline Oil’s operational culture is one of disciplined execution, deep geological expertise, and relentless cost control—all anchored by an experienced and cohesive leadership team that has built multiple successful energy companies together.

At the core of Tourmaline’s success is Mike Rose and his executive team, who Mike has brought from the two previous Canadian energy firms firms he built and sold with them —Berkley Petroleum (sold for $CAD 1.5 billion) and Duvernay Oil (sold for $CAD 5.8 billion). When he launched Tourmaline in 2008, many key members of his prior leadership teams followed him, forming a tight-knit, high-trust group with a proven track record of value creation and operational excellence.

Rather than chasing growth in unfamiliar areas, Tourmaline focuses on regions within its circle of competence, specifically the Alberta Deep Basin, the Montney, and the Peace River High. Over the years, the company has developed a deep geological understanding of these basins, allowing it to identify high-return drilling locations and bolt-on acquisitions with precision. As CEO Mike Rose once put it:

“Tourmaline has become quite knowledgeable about the areas in which they operate using bolt on acquisition on areas in their circle of competence. The only way to reduce costs while meeting production goals is to really, really understand the rock you are producing. This is an area where TRMLF stands out. When it all comes together, you see it in graphs like the one below. Unit costs drop and production targets are met or exceeded. The fact that the company has done this in all three of the key basins where it operates is significant.”

• Mike Rose

This philosophy has paid off handsomely. Tourmaline has consistently achieved:

• Best-in-class capital efficiency, maximizing production per dollar invested.

• Low operating and administrative costs, even as the company scaled and inflation pressures rose.

• Synergy-driven acquisitions, which not only added inventory but improved overall cost structure and returns.

  

A key hallmark of its culture is discipline in acquisitions. The company only pursues assets that are accretive to its free cash flow per share and meet or exceed the return potential of its existing portfolio. This has allowed Tourmaline to build a multi-decade inventory of low-cost drilling locations, reinforcing its competitive edge.

Culture is not only about financial performance but also about how a company treats its people and stakeholders. Tourmaline’s loyalty-driven leadership has fostered long-term employee retention and consistent execution. In 2023, Mike Rose was recognized as Canada’s Outstanding CEO of the Year, with the award board noting:

“Mike inspires loyalty because he is loyal to his colleagues and his shareholders. He built an extraordinarily talented team that surpasses all forecasts and delivers outstanding shareholder returns. Mike and Tourmaline are truly future-focused, and the company’s environmental performance goals and technologies have made it among Canada’s lowest-emissions producers.”

Publicly traded companies are often criticized for short-termism or bloated cost structures, Tourmaline stands apart. Its operational culture—grounded in geological expertise, disciplined capital allocation, and integrity—has allowed it to outperform peers through commodity cycles while positioning it well for the long term.

Large, Low Cost Inventory

"He who has the lowest costs can survive these commodity cycles, particularly on the natural gas side, the best, and they are self-repairing.”

• Mike Rose (CEO)

A core pillar of Tourmaline’s moat is its multi-decade inventory of high-quality, low-cost drilling locations. In a highly cyclical and volatile commodity business like natural gas, this inventory isn’t just an operational asset—it’s a strategic advantage that underpins the company’s long-term resilience and profitability.

Tourmaline has built this deep reserve base through a combination of disciplined exploration and targeted, synergistic acquisitions since its founding in 2008. As a result, Tourmaline now controls what may be Canada’s most extensive low-cost gas inventory. Based on current production methods and geological understanding, the company has more than 17 years of natural gas inventory that can be developed for less than C$2 per gigajoule (GJ)—placing it well below the industry average cost curve.

This inventory provides multiple strategic advantages:

• Resilience in downturns: When gas prices fall and weaker competitors struggle or shut in production, Tourmaline remains profitable, continues to generate free cash flow, and sustains its dividends.

• Upside in bull markets: During high-price environments, the same low-cost wells yield outsized margins, allowing the company to fund special dividends, buy backs or further acquisitions.

• Capital allocation flexibility: Because it doesn’t need to chase expensive acreage to sustain production, Tourmaline avoids value-destructive deals. It can wait patiently for attractively priced bolt-on, strengthening its long-term economics.

• Strategic independence: A large, self-sustaining inventory shields the company from being forced into overpriced M&A or drilling in marginal zones.

  

In a cyclical industry, cost is survival, and Tourmaline’s vast inventory of low-cost locations ensures it can not only survive but thrive through commodity cycles. This reserve base—paired with geological expertise and capital discipline—forms a durable, if execution-dependent, economic moat.

Scale

As Canada’s largest natural gas producer, Tourmaline benefits from scale across multiple dimensions of its operations.

Being a large producer helps Tourmaline run its operations more efficiently. While most producers aim to drill multiple wells on a single site and share infrastructure, smaller producers often own scattered land positions and depend heavily on third party processing and transport. In contrast, Tourmaline holds large contiguous blocks in its core regions. This allows it to drill many wells close together, build centralised infrastructure it controls and coordinates operations across a wide area. This leads to fewer delays, lower costs per well and greater efficiency.

Tourmalines scale also gives it leverage in marketing and mid-stream partnerships. It has been able to negotiate better terms for transportation and processing and been active in gaining exposure to diversified end markets, including direct US hubs and LNG capacity. Smaller competitors are generally price takers at the well head, but Tourmaline can capture improved pricing. In 2021 Tourmaline signed a 15 year gas supply agreement with Cheniere Energy for use of its LNG facility at Corpus Christi. Owning much of its own infrastructure means it can also better negotiate and plan out bottlenecks.

Finally Tourmalines scale can give it other intangible benefits. These include

• Greater visibility with regulators

• Stronger relationships with partners and suppliers

• Enhanced recruiting power for top technical talent

• Reduced marginal G&A costs by spreading them over a larger production base

While scale doesn’t guarantee outperformance, Tourmaline's ability to translate size into cost advantages and strategic flexibility elevates it above many of its peers. In an industry where volatility and fragmentation are common, Tourmaline can use its scale to reinforce its moat and enabling long term value creation.

Intense Competition

Tourmaline operates in a highly competitive and commoditized industry. This limits the depth and durability of Tourmaline's moat.

Natural gas is a fungible product, which means buyers don’t care who produces it – they care about price, energy content, and location. There is no brand loyalty, no customer lock in and no ability to charge a premium. Like every other producer, Tourmaline is a price taker, competing in a market where price differentiation doesn’t exist.

Adding to this challenge is all the ways Tourmaline uses to gain an operational edge – horizontal drilling, multi-well pads and advanced fracking techniques are widely accessible to all their competitors. These techniques are not proprietary, and service companies like Schlumberger and Halliburton offer similar tools and best practices. While Tourmaline may execute more efficiently than most, its methods can be studied, copied and applied by other operators.

To make matters even more challenging there are few barriers preventing other capital entering the space. Major oil companies, independents and even private equity operators can enter into Tourmaline's core regions if they see attractive returns. The best acreage may already be held, but that doesn’t stop challengers coming in and developing neighboring lands.

Moderate reinvestment

"Go for a business that any idiot can run – because sooner or later, any idiot probably will run it"

• Peter Lynch

Tourmaline must continuously invest in drilling and development just to maintain flat production. Natural gas wells decline rapidly, particularly in their first year, which means the company is locked into a never ending cycle of capital deployment. While Tourmaline executes this cycle better than most, the fact remains: a large part of its cash flow is committed to reinvestment and is not discretionary.

Tourmaline is undoubtedly capital efficient delivering high output per dollar invested – but it is not capital light. Sustaining production and replacing reserves demands ongoing meaningful expenditure. This makes the business model execution dependent, not structurally advantaged. Tourmalines returns are impressive today due to skilled management and operations not because the business can compound with minimal oversight or spending.

This means unlike stronger moat businesses Tourmaline must be more closely monitored for declining operational excellence. Its need for continuous operational excellence limits the durability of its moat and means the management must continue operating hard to maintain it.

It is not a business any idiot could run.

Tourmaline Oil Earnings and General History

Tourmaline was founded by Mike Rose in 2008, a geologist and energy executive with a history of successfully building and selling Canadian energy companies. Before founding Tourmaline Rose had already founded Berkley Petroleum in 1993, it was later sold to Anadarko Petroleum in 2001 for C$1.5 billion. This success was repeated with Rose founding Duvernay in 2001, which was sold to Shell in 2008 for C$5.8 billion. Rose launched Tourmaline later in 2008 bringing with him many trusted executives from his prior two ventures. Tourmaline was founded initially with C$253 million raised from management and eventually IPO’d in 2010 raising an additional C$228 million.

By the end of 2010 Tourmaline was one of the largest property owners in the Alberta Basin. Between 2010 and 2015 Tourmaline completed a number of strategic acquisitions including:

Huron Energy 2012, APL Oil and Gas 2012, Santonia Energy 2014, and Mapan Energy 2015. This helped to establish a contiguous footprint across high quality gas plays.

Tourmaline continued its disciplined acquisition strategy beyond 2015. By 2019 Tourmaline was tied with Canadian Natural Resources for the title of Canada's largest natural gas producer. Tourmaline was able to take advantage of the Covid dip making 2020 and 2021 big years for Tourmaline and its shareholders with five acquisitions including Modern Resources and Jupiter Resources in November 2020. The Modern and Jupiter acquisitions were integrated within months and contributed meaningfully to Montney production within a year. Tourmaline became Canada's largest natural gas producer just as natural gas prices doubled from Covid lows. Tourmalines share price rose six fold from Covid lows between March 2020 and October 2021.

Tourmaline executed its largest deal in July 2021, acquiring Black Swan Energy for C$1.2 billion. This helped the company's daily production exceed 500,000 boe/d of production by 2022. That same year Tourmaline entered an LNG supply agreement with Cheniere Energy to export Canadian natural gas internationally via Corpus Christi starting in 2023.

In 2023 Mike Rose was recognised as Canada’s outstanding CEO of the year. Under his guidance Tourmaline had not only efficiently scaled production, but had also prioritised environmental performance, being one of Canada’s lowest-emission natural gas producers, while maintaining its industry leading cost structure.

Does Tourmaline Make Good Acquisitions?

“But probably our most important criterion is that the business we’re buying has a free cash flow return, or we have a line of sight to a free cash flow return, that’s as good or better than what we have in our base business already.”

• Mike Rose

A high level of growth through acquisition can be seen as a red flag. Decades of empirical research suggest that most mergers and acquisitions (M&A), particularly those involving large public companies, fail to create value for the acquiring firm’s shareholders.

A well-cited study by the National Bureau of Economic Research (NBER) examined major acquisitions by large U.S. firms over a 20-year period and concluded that these deals collectively destroyed more than $200 billion in shareholder wealth for the acquiring companies (NBER, 2003). Similarly, a comprehensive meta-analysis covering 55,000 M&A transactions between 1950 and 2010 found that, on balance, M&A deals predominantly fail to benefit the acquirer, particularly in the long term (Meta-analysis, 2016).

There are multiple reasons why M&A often fails to create shareholder value:

• Executive incentives: CEOs are often compensated based on the size of the company they run. As a result, they may pursue acquisitions to grow the business—even if the economics are questionable—because larger firms often justify higher executive pay.

• Poor price discipline: Acquirers frequently overestimate cost synergies or revenue-enhancing opportunities, leading them to overpay for the target company.

• Integration challenges: Many deals stumble during or after integration due to cultural mismatches, lack of planning, or the departure of key personnel from the acquired firm.

Given this track record, any company that pursues acquisitions as a growth strategy warrants close scrutiny. The quality of capital allocation—particularly in M&A—can make or break long-term shareholder returns.

In Tourmaline’s case, its acquisitions have been funded through a mix of debt and equity. While I explore the company’s balance sheet in more detail later in this article, it’s worth noting here that the balance sheet remains in strong shape. To assess whether Tourmaline’s acquisitions have added value, I focus on per-share outcomes, rather than just headline growth. This is especially difficult in the resource sector, where earnings can fluctuate significantly due to changes in commodity prices.

Below is Tourmaline’s production on a per-share basis, specifically barrels of oil equivalent (BOE) per day per thousand shares. Despite issuing new equity to fund acquisitions, the company has consistently increased production per share—a key sign that growth hasn’t come at the expense of existing shareholders.

Over the past 10 years, BOE/day per thousand shares has grown at an average annual rate of over 9%, and over 7% in the past five years. This suggests that Tourmaline’s acquisition strategy has not only avoided the typical pitfalls seen across the industry but has actually enhanced shareholder value on a per-share basis, even in a capital-intensive and cyclical sector like natural gas.

North American and Global Natural Gas Industry

Tourmaline operates within a North American natural gas market that is structurally different from those in Europe and Asia. While natural gas is a globally traded commodity in principle, in practice it is still highly regional due to the costs and constraints of transportation. In 2025 the price of natural gas at their major trade hubs has been 4-5 times higher in Europe and 2-3 times higher in Asia than in North America.

The price of natural gas in North America is significantly lower than in other major global markets. This disparity is largely the result of the shale revolution, where advances in hydraulic fracturing and horizontal drilling have driven a substantial increase in North American natural gas production. However, the infrastructure needed to export this gas—primarily pipelines and Liquefied Natural Gas (LNG) terminals—is costly, requires extensive planning and regulatory approvals, and can take many years to construct. Thus much of this gas is stuck in North America driving down prices.

https://www.reuters.com/markets/commodities/us-natural-gas-markets-point-steep-price-rise-2025-maguire-2024-09-10/?utm_source=chatgpt.com

TTF - stands for Title Transfer Facility and is the main exchange market for natural gas in Europe, based in the Netherlands

Henry Hub - is the primary exchange market for natural gas in North America.

Brent - Is the primary global benchmark for oil prices

Why is North America Producing So Much Natural Gas?

Following nearly three decades of decline, U.S. crude oil production surged by 159%, rising from 5 million barrels per day in 2008 to 12.8 million barrels per day in 2023—a transformation driven by the widespread adoption of shale drilling technologies. U.S. natural gas production similarly experienced a renaissance, growing by 88% between 2009 and 2023, after decades of stagnation. The catalyst behind both booms was the combination of hydraulic fracturing (fracking) and horizontal drilling, which unlocked vast hydrocarbon reserves in previously inaccessible shale formations.

https://www.voronoiapp.com/energy/-The-Shale-Revolution-Reshaping-the-US-Oil-and-Gas-Industry-2453

While some shale basins were developed specifically for natural gas (such as the Marcellus Shale in Pennsylvania or Haynesville in Louisiana), others (such as the Permian Basin in Texas and New Mexico), were primarily targeted for crude oil. Despite these differing objectives, natural gas production soared across the board for two main reasons:

1. Dedicated Gas Drilling in Gas-Rich Regions:

Regions like the Marcellus and Haynesville were among the most prolific sources of natural gas globally. Their low breakeven costs and high productivity per well made them highly attractive to producers, even at modest gas prices.

2. The Rise of Associated Gas from Oil Production:

In oil-rich basins such as the Permian, natural gas and natural gas liquids (NGLs) are often produced as by-products of oil extraction—a phenomenon known as associated gas. As oil production ramped up, so did volumes of associated gas, even though gas was not the primary target. In many instances, producers flared excess gas when takeaway infrastructure was lacking.

https://www.eia.gov/todayinenergy/detail.php?id=63704

This combination of intentional and incidental natural gas production led to a massive supply glut in North America. Prices at the Henry Hub benchmark fell well below those in Europe (TTF) and Asia (JKM), where gas is typically imported via expensive LNG supply chains. Meanwhile, infrastructure bottlenecks—particularly limited pipeline capacity and LNG export terminals—trapped surplus supply within the continent, deepening regional price disparities.

Gas prices have continued to remain low because in many regions producers had low breakeven so could remain profitable at low prices. In oil regions gas was produced as a bi-product so was produced regardless of the cost of natural gas.

Why are Natural Gas Prices More Regional than Oil Prices?

Crude oil is a liquid under normal conditions, making it relatively easy to store, load, and transport globally using conventional tankers. This ease of movement allows oil markets to be much more deeply interconnected, leading to a relatively unified global price with benchmarks like Brent and WTI.

In contrast, natural gas is a gas at standard conditions, which means that for the same amount of energy, it occupies much more volume than oil. This makes transporting it far more challenging and expensive without further processing.

To enable long-distance trade, natural gas must first undergo liquefaction to become Liquefied Natural Gas. This process involves:

• Cooling the gas to –162°C (–260°F) to condense it into a liquid.

• Storing and transporting it in specialized cryogenic tankers, which are highly insulated to maintain the extreme cold.

• Re-gasifying the LNG at the destination terminal before it enters the pipeline system.

Liquefaction reduces the volume of natural gas by about 600 times, making large-scale international transport viable. Without this process, it would take around 600 ships to move the same energy content as one LNG carrier—a clear illustration of why LNG is essential for cross-border trade.

However, the LNG supply chain is highly capital-intensive and involves long lead times, regulatory approvals, and environmental assessments. Many regions, particularly North America, still have limited LNG export or import infrastructure compared to their production or consumption.

As a result, natural gas markets remain fragmented, with regional supply-demand dynamics and infrastructure constraints driving local prices. This is why different benchmarks like Henry Hub (North America), TTF (Europe), and JKM (Asia) often show significant price differences—even when global energy demand is aligned.

Is it possible for North American Natural Gas Prices and the Rest of the World to Ever Converge?

North America produces an enormous amount of excess gas due to its large shale formations. As discussed above much of this supply is stuck in North America due to a lack of LNG export infrastructure.

Over the coming years, however, substantial new export infrastructure is set to come online. Multiple large-scale LNG facilities—and expansions of existing ones—are under construction, each increasing the volume of gas that can be shipped abroad. By opening more routes to higher-priced markets, these projects could help narrow the price gap. In 2025, European benchmark prices averaged roughly 4–5 times higher than North American Henry Hub prices, while Asian prices were 2–3 times higher. Based on current project timelines, North America’s LNG export capacity is expected to nearly double within the next five years.

One of the most significant developments for Tourmaline is LNG-Canada, Canada’s first LNG export terminal, scheduled to begin operations later this year. Located on the west coast, it will provide a direct outlet for Canadian natural gas to reach Asian markets. In its first phase, LNG Canada will be able to export 1.8 Bcf/d of natural gas, with potential expansion to 3.6 Bcf/d in the future. As Canada’s largest natural gas producer, Tourmaline stands to be a major beneficiary of this new demand channel.

That said, full price convergence with global markets remains unlikely in the near term. LNG exports incur substantial costs—liquefaction, shipping, and regasification typically add US$2–5/MMBtu—and building new capacity is both capital-intensive and time-consuming.

Demand for Natural Gas

Demand for natural gas globally and in North America is likely to increase in the years to come, due to a number of structural trends.

Natural Gas as a Transition Fuel

Natural gas is often seen as a transition fuel in the shift towards cleaner energy. In North America abundant natural gas has made it cheaper than coal for power generation, with utilities replacing coal fired power generators with gas turbines. This not only lowers CO2 emissions, but also produces lower levels of sulphur dioxide, nitrogen oxides and particulate matter improving air quality.

Globally the move to natural gas is often driven by public health and environmental benefits, particularly in fast growing Asian economies where coal is still dominant. While not carbon free natural gas’s lower emissions, public health benefits and ability to complement renewables make it a practical bridge fuel.

Industrialisation and Development

Industrialisation and urbanisation in many countries around the world such as China, India and Mexico is driving significant long term demand growth for natural gas. These countries are experiencing long term economic growth and rising incomes leading to increased energy demand. Natural gas is a key fuel due to its reliability, low cost and lower emissions relative to coal. In particular for regions experiencing air-quality challenges, gas-fired power generation offers a cleaner alternative, helping the government provide energy without hurting public health.

Beyond power generation natural gas increases demand for chemicals and demand for natural gas as a significant feedstock to many important chemicals such as fertilisers, plastics and other petro-chemicals underpinning a modern society.

Data Centers and Artificial Intelligence

Data centers are one of the fastest growing sources of electricity demand in the USA. These facilities power: cloud computing, online computing, large scale data processing and even Large Language Models (LLMs), already consume 2%-3% of electricity. Their electricity needs are expected to rise substantially as the digital economy expands.

Artificial Intelligence (AI) computing, particularly LLMs, has become significantly more energy intensive than past forms of cloud computing, requiring vast amounts of power for both training and inference.

While renewable energy could play a significant role in meeting this demand, the intermittent nature of wind and solar means reliable baseload power is critical for baseload power. Natural gas plants unlike coal plants can ramp up more quickly when renewable output falls short. As AI based data centers multiply, this could create a meaningful new source of natural gas demand in North America.

Tourmaline’s Future Growth

Tourmaline's future growth strategy is largely a repeat of its prior growth strategy and what I have stated above that it has had since its founding. A dynamic combination of exploitation of its current drilling inventory, strategic high return on free cash flow acquisitions, strong cost control and a search for new markets to sell its gas.

As stated earlier Tourmaline has 75 years of drilling inventory and even multiple decades of inventory below the current price of natural gas. This means that Tourmaline doesn’t have to worry about finding new locations to drill to find new natural gas and so can do so only when advantageous opportunities present themselves. In addition, as technology advances and new infrastructure gets built in the region this should lower the cost of current higher cost production areas.

It was also shown earlier that tourmaline has generally made value accretive acquisitions and this rollup strategy is still one that Tourmaline can follow into the future. As shown below graphics from the company’s investor presentations up to 2020 reinforce this trend, showing consistent per-share production growth and a decline in cost per BOE—further evidence of successful, value-enhancing integration.

One potential pitfall of this strategy is generally speaking as companies following a roll up strategy grow in size it becomes harder to achieve comparable growth. This is because companies they acquire need to be larger to make a difference and there are less large companies. When buying larger companies they also tend to be more efficiently priced and so it is more difficult to get good deals.

A fundamental element of Tourmalines strategy is to be the lowest cost producer where it operates. This has been achieved through deep geological knowledge and relentless cost control. Its large continuous acreage allows it to centralise processing and transportation infrastructure, avoiding duplication and lowering per unit expenses. Management also actively benchmarks against peers, implementing new technologies and best practices, to maintain cost leadership, even as inflationary expenses and operational complexity increase. This focus on costs ensures Tourmaline remains profitable throughout the cycle, giving it a durable edge in a competitive industry.

As part of its long term strategy Tourmaline is also working to diversify its end markets and even reduce exposure to the heavily discounted North American natural gas market. In 2023 it signed a 15 year deal with Cheniere Energy, the largest US LNG exporter to export its natural gas overseas, giving it exposure to markets with higher gas prices. Tourmaline as Canada’s largest natural gas producer will also significantly benefit from the completion of LNG Canada later this year. These initiatives will broaden Tourmaline’s markets, improving price and provide more stable and resilient profits over the long term.

Tourmalines Competitors

As stated earlier natural gas is a highly fungible product with consumers unbothered by who they purchase their gas from (provided its not sanctioned). As a result it is a highly competitive industry and Tourmaline operating in North America operates in one of the most competitive low cost environments in the world.

Within Canada Tourmaline competes with a large number of companies for the same assets in the WCSB. Many of these peers, especially the larger ones, share Tourmalines capital discipline, operational efficiency and even low cost production. This means Tourmaline's cost advantage – while industry leading– is heavily contested.

Tourmaline is the largest producer of natural gas in Canada. The second largest producer in Canada is Canadian Natural Resources, who by themselves are quite a well managed company. Unlike Tourmaline most of their revenue comes from oil production in the Canadian tar sands. They also have some production outside of Canada.

After Canadian Natural Resources, the third-largest natural gas producer in Canada is ARC Resources, which is arguably the company most comparable to Tourmaline. Like Tourmaline, ARC operates in the WCSB, with decades of drilling inventory, a strong balance sheet, and a low break-even cost for natural gas.

However, Tourmaline holds several key advantages over ARC. Tourmaline has greater scale, producing more natural gas than any other Canadian company. Second, it is diversified across three core basins within the WCSB—the Alberta Deep Basin, the Montney, and Peace River High—while ARC is more heavily concentrated in the Montney, leaving it with higher basin-specific risk. Most importantly, Tourmaline has demonstrated superior capital allocation and stronger per-share returns over time.

A clear example lies in the companies’ largest transactions. Tourmaline’s acquisitions of Modern Resources and Jupiter Resources in 2020 were made when commodity prices were near cycle lows. Both deals were opportunistic, accretive to cash flow, and increased production on a per-share basis. In contrast, ARC’s merger with Seven Generations in 2021 came later in the cycle, when valuations had significantly recovered, and it was not immediately accretive to cash flow per share. This difference underscores Tourmaline’s more disciplined and shareholder-focused approach to growth.

https://www.canadianenergycentre.ca/canadas-trillion-dollar-rock/

In North America Tourmaline is only the 3rd largest producer. The largest producer in North America is EQT Corporation, who mostly focuses their production in the Marcellus and Utica shales, located in the Appalachian Basin in the Eastern United States. Expand Energy Corporation is the second largest producer, Expand Energy Corporation operates in the Marcellus Formation and Appalachian Basin in Pennsylvania and West Virginia.

In this environment, Tourmalines moat relies on its industry leading cost structure, diversified market access, and continuing disciplined capital allocation. The company's scale, acreage and track record provide an edge for now. But in a commodity market where efficiency is constantly replicated, competition can be unrelenting.

Tourmalines Balance Sheet

Tourmaline has a credit rating of BBB from the credit rating agency DBRS (Morningstar). As of their 2024 annual report Tourmaline has a total long term debt of 1.272 billion, this is slightly above their net profit for 2024 of 1.264 billion and less than half of their 2024 EBITDA of 3.162 billion. Thus Tourmalines seems to have a relatively healthy balance sheet from a debt perspective.

Tourmaline also maintains significant liquidity. It has a syndicated credit facility of 2 billion, which is largely undrawn. Its credit rating also would allow it to raise short term debt. This liquidity position is important should anything unexpected happen, but it also allows Tourmaline to make opportunistic acquisitions. An example of this is in 2020 when the price of oil went negative and the price of natural gas also suffered. Not only did Tourmaline survive but it opportunistically made its largest acquisitions in its history.

Tourmalines Management Team

Michael Rose: Is founder, Chief Executive Officer (CEO) and Chairman of the board at Tourmaline Oil. Prior to founding Tourmaline Michael was founder, CEO and chairman at Duvernay from 2004 to 2008. Michael has a total of 38 years experience in the oil and gas industry. According to online sources Michael has just over 8 million shares in Tourmaline with a total value of 468 million.

Brian Robinson: Is Chief Financial Officer (CFO) of Tourmaline Oil. Prior to joining Tourmaline Brian was CFO at Duvernay and Berkley with Michael Rose. Brian has held a variety of financial roles in the oil and gas industry prior to his current position and has 37 years experience as an accountant. According to online sources Brian has 658,050 shares in Tourmaline with a total value of 38 million.

Earl McKinnon: Is the Chief Operating Officer (COO) of Tourmaline Oil, a position he has held since December 2023. Earl joined Tourmaline in May 2013 as completions manager. Prior to joining Tourmaline Earl held various roles in Shell Canada. According to online sources Earl has approximately 91,299 shares in Tourmaline with a total value of just over 5 million.

Scott Kirker: is Chief Legal Officer and External Affairs. Prior to his current role Scott was secretary and general counsel at Tourmaline since 2008. Before joining Tourmaline Scott was manager of corporate affairs at Duvernay, until its acquisition in 2008. Scott has practised law for 30 years in various capacities.

Tourmalines Valuation

For a natural resource company such as Tourmaline which produces a commodity it can be difficult to produce a straight forward valuation, especially for a general investor. This is due to factors such as:

1. The constant changing and unpredictability of the price of natural gas

2. The highly technical knowledge required to work out the cost of extracting the natural gas from all the various fields

3. The constantly evolving technology for extracting and finding the natural gas

One way the energy industry has developed to value their businesses is using the PV10. This is a calculation of all future oil and gas revenues, net of forecast expenses, and discounted at an annual rate of 10%. To calculate this metric independent reservoir engineers are hired to develop reserved reports for both existing and proven but undeveloped well locations (2P). The report accounts for each well's present production rate, production cost, expenses for reserve development, and its forecast decline rate. Suitable estimates are made regarding the price of natural gas.

Based on the most recent Tourmaline presentation the PV10 as at 2024 for Tourmaline is $CAD 88. This represents a 34% discount at Tourmalines current price of $CAD 57.90 per share. Companies generally trade at a discount to their PV10 value. However Tourmaline is a higher quality energy company and this discount appears higher than warranted for such a company. In addition, for a company like Tourmaline, the PV-10 estimate does not capture its decades of drilling inventory, as it only accounts for reserves classified as proved. Energy companies generally don’t book reserves decades into the future because the process of proving them is costly and unnecessary until development is closer at hand. As a result, PV-10 understates the long-term potential of Tourmaline’s resource base, since it excludes much of the company’s high-quality drilling inventory. Finally Tourmalines management team have a great track record of growing the company beyond its current proven reserves and operational excellence. So there is a greater probability that reasonable assumptions for the industry in the PV10 calculation are conservative for Tourmaline.

Relative to peers in Canada, Tourmaline looks a little expensive. However in general Canadian energy companies seem much cheaper than US energy companies based on the table below.

It is difficult to compare like for like even in Canada with Canadian Natural Resources getting most revenues from synthetic oils in the tar sands and not natural gas. As stated when discussing competitors ARC Resources is the most similar and appears cheaper, but as discussed earlier Tourmalines quality can warrant a premium in its valuation and based on the Next Twelve Months (NTM) earnings and EBITDA, there doesn’t seem to be much of a premium.

Risks Investing in Tourmaline

Commodity Price Volatility

As a commodity producer, Tourmaline is highly exposed to fluctuations in natural gas prices. Unlike crude oil, which is priced on a more global basis, natural gas markets remain regional, meaning local supply and demand dynamics can have an outsized impact on pricing. This regional nature often results in greater price volatility. While Tourmaline’s industry-leading low break-even costs provide some protection, a prolonged period of depressed prices would still materially reduce profitability and limit its capacity to generate free cash flow.

Management Risk

Tourmaline’s long-term success depends heavily on consistent operational excellence and disciplined reinvestment. The company’s track record of superior capital allocation and efficiency has been driven by its founder-led management team, who also hold significant equity stakes. This alignment of interests with shareholders has been a major competitive advantage.

However, a material change in leadership quality—whether through departures, succession missteps, or a shift in corporate culture—could impair Tourmaline’s ability to sustain its performance. While the company benefits from strong underlying assets, well-established infrastructure, and proven operating procedures, these advantages would not fully insulate shareholders from the potential deterioration in long term results caused by weaker leadership. Importantly, the impact of such a shift might only become evident over time, making management continuity a key risk factor. It would be good to see succession planning. For now there doesn’t seem to be any sign of Mike Rose stepping down.

Regulatory and Environmental Risk

Canadian energy companies operate under some of the most stringent environmental and carbon pricing frameworks in the world, and Tourmaline is no exception. Both federal and provincial governments have the authority to impose new or tighter environmental regulations, which could increase operating costs over time. Compared to U.S. producers—who often face less aggressive carbon pricing—this places Canadian companies at a relative cost disadvantage.

In addition, regulatory compliance carries its own risks. Failure to meet environmental standards, whether due to operational missteps or unforeseen events, could result in fines, reputational damage, or the loss of social license to operate. In the most severe cases, environmental incidents can lead to costly remediation efforts and reduced investor confidence.

That said, Tourmaline has a strong track record of compliance and has established itself as one of Canada’s lowest-emission natural gas producers. This not only reduces its risk exposure relative to peers but also positions it favorably in a world where investors and buyers are increasingly prioritizing low-carbon energy sources.

Infrastructure and Market Access

As discussed earlier natural gas is difficult and costly to transport, its value is heavily dependent on access to infrastructure. Unlike oil, which can be shipped globally using standard tankers, natural gas requires pipelines or LNG facilities to reach end markets. If this infrastructure is unavailable, constrained, or temporarily out of service, gas can become “trapped” near the point of production, often selling at a steep discount—or, in extreme cases, at negative prices.

Infrastructure disruptions can have immediate effects on pricing. For example, the fire at the Freeport LNG terminal in Texas on 8th of June, 2022, forced the facility offline for several months. With fewer LNG cargoes leaving North America, domestic gas supply built up, depressing prices at Henry Hub and other benchmarks. This event illustrated how infrastructure bottlenecks can ripple through the market.

Tourmaline is relatively well positioned within Canada, as it owns significant midstream infrastructure and holds firm transportation commitments, providing more reliable market access than smaller producers. Its scale and dependable production profile also allow it to secure favorable agreements with major infrastructure partners. A notable example is its supply agreement with Cheniere Energy, which gives Tourmaline direct exposure to LNG-linked international pricing. Looking ahead, the start-up of LNG Canada in 2025 will further mitigate market access risk by providing a large, direct outlet for Canadian gas to reach Asian markets at higher international prices.

Competition and Industry Dynamics Risks

North America is one of the most competitive natural gas markets in the world. Tourmaline faces competition not only from other large Canadian producers, such as Canadian Natural Resources and ARC Resources, but also from highly capable U.S. shale operators across multiple basins. If competitors were to match Tourmaline’s cost leadership—or if U.S. shale producers were to ramp up supply significantly—this could put downward pressure on prices and erode Tourmaline’s competitive advantage.

That said, Tourmaline has already proven its ability to thrive in this challenging environment. The company grew into Canada’s largest natural gas producer during a period when U.S. shale development was surging and driving down continental prices. Its success in scaling operations under such conditions highlights its resilience and reinforces confidence in its ability to remain competitive, even in a crowded and cost-focused industry.

Currency Risk

Tourmaline reports its results, pays employees, and sources many of its inputs in Canadian dollars, while natural gas is primarily benchmarked in U.S. dollars. This creates an inherent currency mismatch. If the Canadian dollar appreciates significantly against the U.S. dollar, Tourmaline’s revenues—converted from U.S. dollar benchmarks—would fall in Canadian dollar terms, while much of its cost base would remain unchanged. Such a shift could put pressure on margins and cash flow, even if underlying commodity prices are stable.

Conclusions

North America's abundant shale-driven supply of natural gas and infrastructure bottlenecks keep prices among the lowest in the world, while in Europe and Asia, reliance on LNG imports means consumers often pay multiples of North American prices. This regional imbalance has persisted for years, but with LNG Canada set to begin exports and U.S. LNG capacity nearly doubling over the next five years, the foundations are being laid for North American producers to capture a larger share of international pricing.

For investors, Tourmaline Oil represents a compelling way to play both sides of this dynamic. If global and North American prices gradually converge, Tourmaline’s size, low-cost inventory, and long-term LNG exposure mean it will capture substantial upside. If prices remain structurally depressed, Tourmaline’s scale, best-in-class costs, and disciplined capital allocation should still allow it to generate above-average returns and continue rewarding shareholders.

In a cyclical, competitive, and execution-dependent industry, Tourmaline stands out not as a company immune to risk, but as one uniquely built to thrive regardless of how the global natural gas market evolves. For investors looking for both resilience and optionality, it offers one of the strongest ways to gain exposure to the future of natural gas.

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I hold a position in Endeavour Group.

“Stalwarts are stocks to own for moderate growth and relative safety. The best time to buy them is when they're out of favor.”

• Peter Lynch

Executive Summary

Endeavour Group is a classic stalwart: a mature, market-leading business with strong cash generation and defensive characteristics. It operates Australia’s largest alcohol retail and hospitality network, including BWS, Dan Murphy’s, and over 350 hotels. Its competitive advantages stem from national scale, supply chain efficiency, exclusive private label brands, customer data insights, and regulatory barriers—particularly in electronic gaming machines.

While recent results have been weighed down by industrial action, soft consumer spending, and leadership transition, the long-term fundamentals remain intact. Endeavour continues to gain market share, improve operational efficiency, invest in digitalisation, and premiumisation trends. The current valuation reflects pessimism, trading at a meaningful discount to its consumer staple peers.

With a stable 5%+ dividend yield, modest long-term growth potential, and room for multiple re-rating, Endeavour offers a compelling mix of income, resilience, and value. For investors seeking a durable, out-of-favor stalwart with a margin of safety, Endeavour Group deserves a closer look.

What Does Endeavour Do?

Endeavour Group runs Australia’s largest network of alcohol retailers under the brands of Dan Murphy’s and BWS. The alcohol retail business accounts for more than 40% of Australian retail alcohol sales with 1,453 BWS stores and 275 Dan Murphy’s stores. It sells alcohol in stores, online and even drive through, generating 10.2bn in total revenue for the group as well as 685m in EBIT.

* Liquor store drive through in North Curl Curl

Endeavour Group also runs Australia’s largest network of hospitality venues. It has 354 hotels and pubs across Australia providing a range of services including: alcohol, food, electronic gaming, wagering, live entertainment and accommodation. The hospitality part of Endeavour Group generates 2.1 billion in sales and 438m EBIT.

Finally Pinnacle Drinks develops, sources, imports and distributes alcoholic beverages for Endeavours retail and hospitality operations. Pinnacle allows Endeavour to innovate and offer private label products which can enhance its margins and offer its customers exclusive products they can’t get elsewhere.

Does Endeavour Group have a competitive advantage/moat?

Scale

Endeavour Group’s primary competitive advantage lies in its unmatched scale within Australia’s liquor distribution industry. Operating over 1,720 liquor stores under well-known brands such as BWS and Dan Murphy’s, Endeavour has at its disposal a comprehensive nationwide distribution network. This extensive footprint enables the company to optimize its supply chain with low marginal costs and execute synchronized national marketing campaigns.

To efficiently move products from many suppliers to its many retail stores and hospitality outlets, Endeavour has a highly cost-effective supply chain infrastructure, some of which it shares with its former parent Woolworths. This supply chain incorporates significant fixed costs—such as software systems for inventory management, dedicated personnel overseeing supplier relationships, and logistics and distribution infrastructure. By spreading these fixed costs across a vast volume of goods, Endeavour significantly lowers the marginal cost per unit transported. Multiple distribution centers strategically located around Australia also facilitate same-day delivery to stores, hotels, and customers. This capability reduces inventory holding costs and enhances customer satisfaction. Competitors lacking Endeavour’s scale and operational expertise face challenges replicating such an efficient, low-cost distribution system.

Endeavour’s scale also provides substantial operational leverage. The company can invest in larger, more impactful advertising campaigns for its brands. Given its extensive store network and high sales volumes, the marginal cost of these marketing efforts is lower compared to a similar campaign from smaller competitors. Furthermore, Endeavour’s volume of shelf space across Australia strengthens its negotiating position with suppliers, enabling bulk purchasing discounts and additional promotional support.

Finally, Endeavour’s scale empowers it to invest heavily in innovation. Whether improving logistics, experimenting with new store formats, or introducing new beverage types, Endeavour can pilot innovations in select stores. Successful initiatives can then be rolled out across its entire network, achieving greater impact at a lower relative cost than competitors could manage.

Margins tend to be low for retailer types such as Endeavour which sell a large number of low margin goods such as liquor stores or supermarkets. But even so Endeavour's margins outshine those of its key competitors as can be seen below.

Data Driven Customer Insights

Endeavour Group’s national scale doesn’t just streamline logistics—it fuels a significant advantage in customer intelligence. With thousands of daily transactions across its Dan Murphy’s, BWS, and hotel venues, Endeavour gathers one of the largest sets of retail liquor data in Australia. This vast dataset enables the use of better data analytics—capabilities that are often out of reach for smaller, less data-rich competitors. This better data drives insight, and insight enhances the customer experience.

The vast number of transactions processed by Endeavour offers valuable data insights into customer behaviour, including purchasing patterns, seasonal trends, and preferred product combinations. This data enables Endeavour to make smarter decisions around inventory management, store layout optimisation, and demand forecasting. By anticipating customer needs more accurately, Endeavour can stock the right products at the right time, reduce waste, and improve product availability—creating a seamless and more satisfying customer experience while also enhancing operational efficiency.

Endeavour deepens its customer relationships through digital platforms such as My Dan’s, the BWS app, and Pub+. These loyalty programs don’t just reward frequent shoppers—they provide Endeavour with high-quality, individual-level customer data. With more than 5.4 million members in the My Dan’s program alone, Endeavour can personalise its interactions by delivering tailored promotions, hyper-targeted advertising, and smart product recommendations. This level of customisation increases conversion rates, strengthens brand loyalty, and creates a more engaging shopping experience that’s difficult for competitors to replicate.

Coles in its annual report reports sales per square meter of $15,860 in its liquor division Liquorland. Endeavours doesn’t report its sales per square meter, but based on the total area of its stores and total sales analysts estimate sales per square meter over $20,000.

Private Label Products

Another part of Endeavour's economic moat is its extensive portfolio of private label and exclusive brands, developed and managed through Pinnacle Drinks, its subsidiary. Its wines, craft beers and ready to drink offerings are sold exclusively through Dan Murphy’s and BWS differentiating Endeavour from competitors and enhancing customer loyalty. By offering private label brands Endeavour also controls product development and sourcing allowing it to capture a higher margin than it would from selling third party brands. By leveraging customer insights from its retail operations Endeavour can develop trend following offerings ensuring its private label portfolio remains desirable reinforcing its brand ecosystem and pricing power.

Electronic Gaming Machines (The Pokies)

Endeavours moats are not just limited to sale and distribution of alcohol, but also include electronic gaming machines. Electronic gaming machines or as they are commonly referred to in Australia as “pokies” can be found outside of dedicated gaming venues such as casinos and inside venues such as pubs and hotels. Endeavour is one of Australia’s largest non-casino operators of these pokies operating approximately 12,000 across its hundreds of venues.

Owning such a large number of pokies gives Endeavour scale advantages when it comes to operating pokies due to the number it operates. This can include:

• Access to premium gaming machine suppliers

• Preferred service and maintenance arrangements

• Ability to optimise machine mix and placement across it’s network of hotels and pubs

This results in a highly efficient, high margin revenue stream for Endeavours hotels, which requires relatively low working capital. Although Endeavour doesn’t break out its revenues from pokies, Endeavour hotels are significantly more profitable than other hotels without pokies.

Another way in which Endeavour has a moat when it comes to pokies is through regulation. Australian gambling and pokies are mostly regulated on a state by state basis and one part of this regulation places caps on the number of pokies. These caps are generally on a statewide basis, but can also be per venue or per region. Many local councils also impose strict regulations placing caps on the number of pokies. These regulations effectively lock in market share for incumbents like Endeavour, making it illegal for new entrants. With Australia’s population growing these regulations also make each machine more valuable as Australia's population grows there are more potential customers with access to the same number of machines. That said, regulations can also harm operators of pokies and create uncertainty with many states floating ideas that may harm pokies revenue, I will go into this later in this post.

Moats do not require growth they require durability and Endeavour's position in pokies is protected by regulatory restrictions, complexity and scale. Even if regulations tighten larger operators like Endeavour would have an easier time adapting as part of the cost of compliance can be spread over more venues and a larger operator can more loudly contribute to government discussions on the shape of such regulations. The hospitality industry is also a significant employer across Australia and generally supports pokies and pokies taxation is a significant source of income for state governments.

Endeavours Earnings and Historical Overview

Endeavour doesn’t have a long history as a public company. It has only been a public company since it was spun off from Woolworth's in 2021, Woolworth’s continued selling its stake until September 2024.

Endeavour has published financials going back to 2018. In general they are operating in a mature market and so their historic growth rate is steady with an occasional problem such as Covid in 2020.

Bruce Mathesion is an Australian billionaire pub baron, he negotiated a joint venture merging his pubs and hotels with Woolworth’s liquor business in 2000. He is now one of the largest shareholders of Endeavour owning 15% of shares. In 2023 Bruce expressed dissatisfaction with the leadership of Endeavour especially Chairman Peter Hearl and Chief Executive Officer (CEO) Steve Donohue criticising their retailing strategy at Dan Murphy’s, the purchase of wine companies and wine specialty businesses and Voluntarily implementing Victoria’s gaming reforms 10 months early.

“I don’t think anyone in this country would stand by the performance of this group under the leadership of Peter Hearl and Steve Donohue. It has been an absolute disaster and their decisions have been disgraceful”

• Bruce Mathieson

Peter Hearl defended the company’s strategy and board emphasising revenue growth and market leadership. He refuted Mathiesons claims, maintaining the criticisms were based on selective information and the board acted in the best interests of shareholders. The dispute was settled with a board reshuffle with chair Peter Hearl and Bruce's son Bruce Mathieson Jr. both stepping down from the board and new directors appointed.

Over the past 18 months spending on alcohol in Australia and general discretionary spending in Australia slowed down. The first six months of 2024 left same store sales at Endeavour flat, which wasn’t a good result but put it ahead of Coles Liquorland which had declining sales. This was followed by falling profits, but increased revenues in the second half of 2024. The general slowdown in alcohol sales wasn't just experienced in Australia; other liquor companies across the world have also experienced a recent drop. Sales for many alcohol brands globally went up in 2023 with the general ending of most Covid restrictions and then went down to more normal levels in 2024. Results were relatively flat in the later half of 2024 until 17 day strikes at some of Woolworths distribution centers starting in November. This led to shortages of goods in stores, late deliveries and higher costs further impacting profits. It was further compounded due to the proximity of these events to Christmas, the peak time of year.

In September 2024 CEO Steve Donohue announced he would be stepping down as CEO of Endeavour Group after six years in the role, first under Woolworths and then as an independent company. It was announced earlier this year that at the beginning of 2026 Jayne Hrdlicka will take over as CEO. In the Interim Ari Mervis will be leading the company as Executive Chairman.

Since Endeavour listed in 2021, splitting off from Woolworth’s it hasn’t had the smoothest time, especially over the past two years. Over this time it has mostly managed to increase market share, (excluding the last half of 2024 with the strikes) becoming even more dominant in the Australian market. However, especially over the past two years its stock price has fallen from a listing price of $6.1 and from a peak of $8 in 2022 to a current price around $4.

Liquor Retailing Industry in Australia

Trends

Alcohol consumption in Australia has largely followed trends in other high income countries with the total volume of alcohol consumed per capita declining since the 1970’s. However while the total volume of alcohol consumed has gone down the total spending has remained more stable as a percentage of incomes with consumers drinking alcohol in more premium forms. This can be seen below with a fall since the 1970’s in consumption of beer, while consumption of wine and spirits increases. Overall consumption of alcohol per capita has been mostly flat on a per capita basis since the early 90’s, but with beer continuing to fall.

Online Sales

In Australia over the last decade and especially in recent years with Covid19 online sales of alcohol have increased at a rapid pace. Online sales here are defined as both deliveries and click and collect (order online & pick up packed at store). Based on data analysed by Frontier Economics provided by Retail Drinks Australia for the financial year 2021-22 total Alcohol spending in Australia for the year was $16.3 billion and of this online sales accounted for $2.1 billion or about 13%. It is estimated this will grow by 25% between financial year 2022 and financial year 2028.

Online alcohol sales has been dominated by two groups:

1. Alcohol retailers especially bricks and mortar retailers who have dominated online alcohol sales in Australia.

2. Third party marketplaces such as Uber and Doordash have also popularised online purchases delivering alcohol from retailers to customers.

Endeavour Group and Coles LiquorLand are the two largest participants accounting for 63% of online alcohol sales. The “Other Retailers” includes a range of brands such as: Metcash, Naked Wines, Uber, Vinomofo, Boozebud and Liquor legends.

Regulation

Each Australian state has its own licensing authority and specific set of rules for alcohol retailing in their state. These laws and regulations are designed to reduce alcohol related harm and promote responsible consumption. Some common elements across states include: restricted trading hours, mandatory staff training in Responsible Service of Alcohol (RSA) and limits on where alcohol can be sold. Retailers must obtain licenses that take into account proximity to sensitive areas such as schools, community impact and outlet density. In recent years regulation has sought to target online sales introducing checks around: age verification, restricted delivery hours and intoxication checks. There are also restrictions on alcohol advertising, particularly advertising that might appeal to minors or encourage excessive consumption.

Long Term and Medium Term Changing Consumer behaviour

As well as the significant impact online sales have had on alcohol consumption patterns there are a number of other factors that influence consumer buying behaviour in both the medium term and longer term.

In recent years in Australia there has been a cost of living squeeze, due to elevated levels of inflation. This has seen consumers become more cautious with their spending on products like alcohol. One way consumers are saving money is by buying cheaper brands or private label brands, this wouldn’t be good for Endeavour's market share with their own private label brands that have higher margins and retailing alcohol at multiple price points. In addition, consumers may also look for special deals and promotions, which once again benefit Endeavour's market share, which through its apps and other programs can more easily target consumers with exclusive personalised deals. Finally consumers have also bought and spent less overall on alcohol products, a negative for the whole industry. This has led to lower revenues and profits for alcohol retailers, but during this period of time Endeavour has expanded market share over weaker suppliers reinforcing its moat.

There has been a long term trend for consumers to drink less but better. As discussed at the beginning of this section since the 1970’s the volume of alcohol consumption has been trending down on a per capita basis. This hasn’t been as bad for the industry as a whole due to consumers consuming more premium types and brands of alcohol and leaving spending relatively constant as a percentage of income. As seen in the graph above there has been higher consumption of wine and spirits and despite the fall in beer consumption rise in more premium beers such as craft beers. This is likely driven by multiple cultural factors such as wellness trends in younger generations or the increase in female drinkers. Offering curated selections, exclusive labels and storytelling around provenance or craftsmanship helps tap into this demand.

Electronic Gaming Machines (pokies) in Australia

Australia has one of the largest electronic gaming machine (EGM) markets in the world. New South Wales—the country’s most populous and economically significant state—hosts over 90,000 machines, second only to Nevada in the United States, which has approximately 120,000. Although Australia accounts for just 1% of the global population, it is home to around 18% of the world’s EGMs. Unlike many countries where EGMs are confined to casinos and dedicated gambling venues, in Australia they are also commonly found in pubs and hotels. The country is also the headquarters of Aristocrat Gaming, the world’s largest manufacturer of EGMs. According to the Queensland Government Statistician’s Office, Australians wagered approximately $150 billion on pokies during the 2021–22 financial year, losing over $12 billion—a figure that represents nearly half of the nation’s total gambling losses.

Regulation

EGM are subject to strict regulations in Australia from laws primarily made and enforced by state governments. Each jurisdiction on a state or even local basis controls the number of machines allowed, licensing requirements for venues, harm minimisation measures and operating hours. For example, there are caps on total number of machines, limits on maximum bet and spin speed and requirements for responsible gaming officers. In recent years states such as New South Wales have introduced and trialled measures such as cashless gaming cards and real time player tracking to address problem gambling and potential money laundering. Growing public concern over pokies has led to a general trend for greater oversight of EGMs.

In July 2023 Endeavour Group announced plans to introduce Victorian government EGM regulations ahead of their mandatory schedule. These regulations were introduced 10 months early, demonstrating a commitment to responsible gambling. They are seen as Australia’s strictest EGM regulations including $100 limits on the maximum a player can bet at any one time, Carded play with mandatory pre commitments and mandatory closure periods.

What are Endeavour Groups Future Prospects?

Digital and Omnichannel Expansion

Endeavour Group is investing heavily in its digital capabilities to meet the ever evolving desires of its customers and future proof its business. EndeavourX is its digital division enhancing online experiences and managing data across its e-commerce platforms and mobile apps.

Online ordering and click and collect has become a central and rapidly growing segment across much of Australian retail. Due to its existing advantages across its retail store network Endeavour is the current leader in Australian online alcohol retailing. The group achieved over $1 billion in online sales, capturing a 37.4% market share in FY2021–22.

Through data collected from its loyalty programs, mobile apps and even stores, Endeavour uses data analytics to deliver more personalised marketing, curated product recommendations, and seamless customer experiences. This data-driven approach not only boosts customer engagement and retention but also improves operational efficiency and drives higher average spend per transaction.

Premiumisation and Private Label

One key trend shaping the Australian alcohol market is a premiumisation, which has become a pillar of Endeavour’s growth strategy. Australian consumers are drinking more but better with less beer consumption but more wines and spirits and even more premium craft beer. Endeavour has expanded its premium offering in its stores and hotels, catering to customers seeking both value and premium drinking experiences.

A central component of this strategy is the group's growing portfolio of exclusive and private label brands managed through its business Pinnacle Drinks. These labels not only offer Endeavour better margins, but greater control over product development and supply and are enhanced by Endeavour's significant data analytics capabilities. Endeavour can quickly respond to emerging consumer trends such as low alcohol, sustainable or organic products without relying on suppliers.

The dual focus on premiumisation and private label strengthens Endeavour's competitive profitability as these products generally have higher margins. It also strengthens Endeavour's moat by giving customers access to unique products they won’t find at competitors.

Operational and Technological Efficiency

“The Group’s optimisation program, endeavourGO, delivered $100 million in benefits in F24, materially offsetting the impacts of cost inflation and taking total cumulative program benefits to $190 million.”

• Annual report 2024

As well as trying various ways to increase sales Endeavour is continuously trying to reduce costs and simplify its business. Their current program around this is known as EndeavourGO, a multi-year cost optimisation initiative to enhance efficiency across its retail and hospitality divisions. The initiative has already managed to achieve $190 million in cost savings since launch through initiatives such as workforce planning, supply chain optimisation and better stock management. Endeavour has a target to achieve over $290 million in savings by the end of 2026. The program underscores Endeavour continuous commitment to improvement and operational excellence.

Alongside EndeavourGO, the company is progressing its technological transformation with the program One Endeavour. The One Endeavour program aims to separate it from Woolworths legacy systems and construct its own independent IT infrastructure. This would allow simpler, faster decision-making, improved data accessibility, and more tailored systems that better support its liquor retail and hospitality operations.

Leader in Responsible Gaming

One of Endeavour's most profitable business segments is its pokies, which also come with significant regulatory and reputational risks. As public concern over the harms of pokies grows and government regulation becomes tighter Endeavour has a long term strategic opportunity to position itself as a best in class operator in responsible gaming. When it implemented Victoria’s tighter gaming laws early it lost some short term profits in the months that it was implementing the regulations before it had to, but potentially bought good will giving it stronger community trust and good will with regulators.

This strategy can do more than retain its licence to operate; it can also help it potentially expand market share. As regulatory scrutiny increases less compliant lower standard operators may come under greater pressure to leave the industry. Endeavour with scale, governance frameworks and greater community goodwill could become the preferred buyer, expanding its share in a tightly regulated but highly lucrative market.

Endeavours Balance Sheet

Endeavour has a very healthy balance sheet with just over $2 billion in long term debt. This is in contrast to Endeavour's most recent EBITDA of $1.3 billion and net profit of $512 million. This robust balance sheet has Enabled Endeavour to make it through all the unpredictable shocks since its spin off and whatever unexpected events will occur in its future.

Endeavours Management Team

Endeavour Groups management is currently in a state of transition with six year CEO Steve Donohue announcing his resignation in September 2024. Steve will be replaced by Jayne Hrdlicka who will commence in her role on the 1st of January 2026. In the meantime the company is being run by Ari Mervis, the Executive Chairman.

Based on numbers I could confirm the directors of Endeavour don't seem to hold many shares in the company.

Ari Mervis

Ari was appointed to Endeavours board of directors in March 2024. Prior to becoming executive chairman of Endeavour Group Ari has held a variety of senior roles in the brewing and food industries. He was executive chairman of Accolade Wines and managing director of Murray Goulburn. He spent 27 years at SABMiller holding a variety of roles. Ari holds 100,000 shares in Endeavour Group as at the 2024 annual report.

Steve Donohue

Although Steve is the outgoing CEO his influence over the past six years will likely continue to impact Endeavour Group. Steve began working at Dan Murphy’s in 1994 and was appointed managing director and CEO in 2018. Prior to 2018 he held a variety of roles across the Endeavour drinks business including buying, merchandising and marketing. Steve has 281,541 shares in Endeavour Group.

Jayne Hrdlicka

Jayne was appointed replacement to Steve as of the 1st of January 2026, she has some retailing and food industry experience. Jayne has held a variety of senior executive positions across Australia including at Qantas, CEO of A2 Milk, CEO of Virgin Australia Holdings as well as a director on the boards of Tennis Australia and Woolworths. I do not have information of Jayne holding any Endeavour shares.

Kate Beattie

Kate is the Chief Financial Officer (CFO) of Endeavour Group. She joined Endeavour in 2018 and was appointed CFO in February 2023. Prior to joining Endeavour she worked in a variety of finance roles across Oracle, Macquarie, CBA and Woolworths. I couldn’t find a consistent number on Kate's stock holdings in Endeavour Group.

Endeavours Valuation

Endeavour Group doesn't have any other similar alcohol retailing businesses in Australia, with the next largest competitor controlled by large supermarkets Coles LiquorLand and Metcash. Endeavour similarly to the two large supermarkets Coles and Woolworths is a large entrenched, mature consumer staples stock with a healthy and stable dividend. One advantage it has to the supermarkets is it has a higher market share of close to fifty percent of alcohol retail, while the two big supermarkets not only compete with each other but also with Aldi. However Endeavour does have some more negative ESG aspects with its pokies that may lower its valuation relative to its supermarket peers. In addition, the alcohol sector is a more cyclical consumer staple sector than the supermarkets, as has been seen in recent years.

In the above table I have taken some valuation metrics of Woolworths and Coles and calculated Endeavours discount to the minimum of these. This gives a discount of more than 30% across both metrics and a dividend 66% higher . I don’t think Endeavour should trade in line with the supermarkets, but think the current level of discount is too high, especially considering this is likely a trough earnings year with consumers cutting back on alcohol spending and industrial action around Christmas. A much more reasonable PE in my view would be 19-20 along with a dividend yield closer to 4%.

In my discounted cash flow analysis I ran a number of different scenarios. Most cases begin with Endeavour earnings remaining flat to dropping into 2025. This is followed by a worse case scenario of 3% growth from then on to a base case of 4%-5%. The fair value I get for Endeavour Group is $5.19, representing a current discount to fair value of 22%.

Potential returns: A Sum-of-the-Parts Perspective

Another way of looking at the medium term returns of Endeavour I’ve been working with lately is looking at three key areas of return from a stock:

1. Cash returns to shareholders (dividends and buybacks)

2. Growth in earnings per share (EPS)

3. Valuation re-rating (changes in the P/E multiple)

1. On the first metric of returns of cash to shareholders over the past twelve months Endeavour has paid 21.8 cents per share. Which at today's share price of 4.02 is 5.4%.

In addition to the above for Australian shareholders Endeavour also has a 30% franking rate. This means a part of the tax is already paid on the dividend and so the pre tax dividend is 24.6 cents per share. This would bring the yield to 6.12%

2. Earnings declined in FY24 due to several short-term pressures, including industrial action close to Christmas and broader weakness in consumer spending. While the company operates in a mature industry, there are still growth levers at play—such as Australian population growth, operational efficiencies, premiumisation trends, and continued digital expansion.

Taking a conservative stance, I estimate long-term EPS growth in the range of 3%–5% per annum, broadly in line with nominal GDP growth plus modest business-specific upside.

3. Endeavour currently trades at a P/E multiple of below 16x, which is below the level I would consider fair for a defensive, cash-generative consumer-facing business with leading market positions.

I believe a more appropriate long-term multiple is 19x earnings, assuming moderate growth, stable returns, and Endeavour’s strong market share in both liquor retail and gaming.

If the stock were to re-rate from 16x to 19x over a five-year period, this would add approximately 3.75% annualised return through valuation expansion alone.

Brining Components Together

• Adding the first two sources of returns up you get 9.3%-11.3%.

• Then if we assume the PE ratio moves over the next five years from its current 16 to 19 this adds 3.75% per year, bringing potential returns to 13.05%-15.05%.

• Finally for Australian citizens we add the 0.63% bringing potential five year returns to 13.68% to 15.68%.

While Endeavour may not offer explosive upside, the combination of a reliable dividend, modest growth, and potential valuation re-rating makes for a compelling case in today’s high-valuation market. For long-term investors seeking stable, income-generating stocks with multiple strong moats, Endeavour remains an attractive option.

What Are the Risks to Endeavour?

Transition and Transformation Risk

Endeavour Group is undergoing a complex multi-year separation from Woolworths, involving major changes to its systems, processes and operating environment. The transition involves many risks such as operational disruptions or rising costs.

Electronic Gaming Machines (Pokies)

Endeavour Group derives a significant amount of earnings from pokies which are also a source of regulatory, social and reputational risk. Increased regulatory scrutiny and shifting community expectations may lead to intensified regulatory scrutiny.

Leadership Transition

Endeavour Group is currently undergoing a senior leadership transition with changes to not only its CEO, but also changes on the board. Last year CEO Steve Donohue announced he will be stepping down and the company is being temporarily managed by Ari Mervis, who will be replaced by Jayne Hrdlicka at the beginning of 2026. This extended transition period, combined with recent board reshuffles, creates potential risks.

Changing Macroeconomic and Market Environment

Endeavour Group faces highly competitive retail and hospitality markets. Evolving customer preferences and shifting macroeconomic landscape impact consumer preferences and demand. If Endeavour fails to adapt it could face declining revenue

Regulatory Change and Compliance Risk

Endeavour Group operates in a complex regulatory environment, particularly in the areas of liquor and gaming. Increased regulatory scrutiny and evolving regulation must be taken seriously and adopted. Some of these new rules include cashless gaming or new alcohol delivery rules. Failure to abide by the regulations can lead to fines, licence restrictions or reputational damage.

Data Privacy and Cybersecurity Risk

Endeavour Groups operations rely heavily on the integrity, security and availability of its data. Any failure in data protection or breach of cyber security could result in business disruption, reputational damage or financial loss.

Team and Capability Risk

Endeavour Groups success relies on its ability to attract, develop and maintain high-quality talent. labour shortages, rising employment costs, or failures in hiring, employment or compliance (e.g. underpayment) could negatively impact performance, reputation or operations.

Safety, Health and Wellbeing Risk

Endeavour Group must ensure a safe and supportive environment for its team members, customers and partners. These risks can cause serious harm and lower employee engagement.

Product and Food Safety Risk

Endeavour must ensure the safety of products and food across Endeavours retail and hospitality stores is essential. Any lapse in food safety can cause serious health risks, financial losses, regulatory consequences and reputational damage.

Brand, Reputation and ESG Risk

Endeavour Groups brand strength and reputation are vital to its competitive position. Reputational risks can arise from business decisions, marketing practices and ESG expectations. Missteps can lead to loss of community trust, regulatory pressure, higher compliance costs and reduced profitability.

Business Resilience and Partner Risk

Endeavour Groups face risks from unexpected disruptions such as supply chain breakdowns, pandemic, weather or infrastructure failures. Operational continuity also relies on third parties including service agreements with Woolworths. Failure could significantly impact service delivery and operations.

Conclusions

Endeavour is a mature dominant player in a stable industry with multiple reinforcing moats - scale, data, private labels and regulatory barriers. It generates strong free cash flow, pays generous reliable dividends and operates with a solid balance sheet. While it is not a high growth stock, it doesn’t need to be to be a profitable investment.

Right now Endeavour faces short term headwinds - industrial action, soft consumer spending, and leadership transition. But these do not appear structural. The stock price of Endeavour has more than priced in these concerns, offering investors a stock trading a meaningful discount to peers and estimated future cash flows.

Endeavour is a stalwart of the Australian Alcohol retailing industry that is temporarily out of favor. For long term investors willing to look through the noise it presents a compelling opportunity.

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I hold a position in Dicker Data.

Executive Summary

Dicker Data is a leading, founder-led distributor of Information and Communication Technology (ICT) products across Australia and New Zealand (ANZ). The company plays a critical role in the ICT supply chain, ensuring businesses have access to the latest productivity-enhancing technologies. Its unique corporate culture is shaped by long-tenured senior management, many of whom are significant shareholders and recent active buyers of the company’s stock.

While recent financial results have been underwhelming, driving a decline in the stock price, these issues are largely the result of short-term challenges rather than weaknesses in the company’s long-term fundamentals. Despite Dicker Data’s current valuation presenting historically favorable levels and the potential for above-average returns making it a buy in my view. But I believe there are currently other investment opportunities that offer better return prospects relative to their valuation and risk profiles and so won’t be increasing my position any more without a more favorable valuation.

What Does Dicker Data Do?

Dicker Data is a leading distributor of Information and Communication Technology (ICT) products and services, serving businesses across Australia and New Zealand (ANZ). The company operates as a vital link in the ICT supply chain by purchasing technology products from hundreds of global producers (vendors) including renowned brands such as NVIDIA, Microsoft, Fujitsu, Dell, and Assa Abloy, and then distributing these products to retailers and other businesses for resale or direct use (partners).

While this function may not seem glamorous, it is an essential service. Dicker Data facilitates the movement of ICT products from vendors to its partners, handling procurement, warehousing, and delivery throughout ANZ. By purchasing in bulk, the company reduces costs, which benefits both its suppliers and customers. Beyond logistics, Dicker Data adds value by providing tailored solutions for Small and Medium-sized Enterprises (SMEs), addressing challenges like computing, cybersecurity, networking, and surveillance—areas where these businesses often lack the scale for in-house expertise.

Revenue Breakdown by Segment

Dicker Data’s operations are divided into three core categories:

1. Hardware and Virtual Services:

   • Contributing approximately 72% of revenue, this segment includes products such as PCs, servers, storage solutions, networking equipment, and consumer peripherals.

2. Software:

   • Accounting for around 28% of revenue, this segment is split between recurring and subscription-based software and perpetual licenses.

3. Services:

   • Representing less than 0.4% of revenue, this segment includes additional support and consulting services.

By focusing on these areas, Dicker Data ensures that businesses in ANZ have access to cutting-edge technology and the support they need to stay competitive in a rapidly evolving market.

Does Dicker Data have a competitive advantage/moat?

Dicker Data’s investor relations material suggests that the company does not perceive itself as having a significant economic moat. In its 2023 annual report, the company states:

“In a highly competitive industry that does not provide for the development or maintenance of any economic moats, annual profit growth and, as a consequence, our dividends, is the primary driver of value.”

This statement implies that Dicker Data views its industry as inherently challenging for sustaining structural competitive advantages. However, achieving and maintaining its position as the largest distributor of ICT products in ANZ—especially when viewed through the lens of its financial performance—suggests that the company does hold some notable competitive advantages.

It’s also possible that management strategically downplays the existence of any moats. By emphasizing the role of leadership and operational excellence, they may seek to promote their own performance rather than drawing attention to the structural advantages Dicker Data may have developed, since the company was founded.

Paraphrasing Peter Thiel’s observation, companies with the strongest competitive moats often downplay their advantages to avoid attracting regulatory scrutiny. Conversely, businesses without significant moats tend to emphasize their supposed advantages, as they have less to lose from regulatory intervention. From this perspective, Dicker Data’s stance may be more about strategic positioning than a reflection of its actual competitive standing.

Supplier Relationships

As the largest ICT distributor in ANZ, Dicker Data uses its scale to secure significant purchasing volumes from global technology producers. This scale grants the company strong bargaining power, enabling it to negotiate favorable bulk discounts that benefit both its operations and its customers. For producers, partnering with Dicker Data offers access to an expansive and efficient sales channel, making the relationship mutually beneficial.

Operating since 1978, Dicker Data has built deep, long-term relationships with many of its suppliers. This extensive history fosters trust and collaboration while providing the company with unparalleled insights into the quality, reliability, and capabilities of the vendors products it distributes. These insights allow Dicker Data to offer tailored recommendations to its partners, helping businesses choose the right solutions for their needs.

By combining its purchasing power with decades of expertise, Dicker Data cements its position as a trusted and valuable partner in the ICT supply chain.

Economies of Scale

Managing relationships and delivering products from hundreds of vendors to thousands of partners is a complex challenge. Dicker Data effectively addresses this by leveraging economies of scale. The company invests heavily in infrastructure, logistics, and technology to build a highly efficient distribution network.

As Dicker Data grows and processes larger volumes of goods, certain costs—such as warehousing, transportation and software systems—benefit from scale efficiencies, even though they are not entirely fixed. Spreading these costs across a larger volume of sales helps reduce the per-unit cost of distribution. This reinforces its position as a cost-effective and reliable partner in the ICT distribution industry.

Unique Culture

Dicker Data stands out as a well-managed company within ICT distribution with a distinct culture that has helped it outperform major competitors like Ingram Micro and Synnex.

Dicker Data was founded by David Dicker and Fiona Brown, and its culture evolved organically to align with the unique needs of the ANZ market. Unlike its competitors, the company has cultivated a leadership team with long tenures, fostering continuity and a deep understanding of the business. David Dicker’s philosophy of paying employees—particularly executives—above-market rates has been instrumental in attracting top talent and motivating them to perform at their best. Moreover, Dicker Data's focus on the SME market, rather than placing a greater emphasis on large enterprises like its competitors, has been a key differentiator.

These cultural factors have enabled the company to make smarter investments in infrastructure and talent, driving superior financial performance and delivering better returns. As a result, Dicker Data’s culture of employee investment and market specialization has allowed it to consistently outperform peers in a competitive industry.

Earnings and Historical Overview

Founded in 1978, Dicker Data has steadily grown to become a leading ICT distributor in ANZ. The company achieved a significant milestone in 2000 when its annual revenue surpassed $100 million—22 years after its inception. By 2011, Dicker Data went public, listing on the Australian Stock Exchange (ASX). The company’s growth trajectory accelerated, with revenue surpassing $1 billion for the first time in 2015 and then doubling to exceed $2 billion in 2020.

Dicker Data’s growth has been fueled not only by organic expansion but also through strategic acquisitions that have expanded its customer base, added new vendor relationships, and broadened its product offerings:

• 2014: Express Data Holdings Acquisition
  Dicker Data acquired Express Data Holdings from Dimension Data, a Japanese systems integrator..

• 2021: Exeed Acquisition
  The acquisition of Exeed, a leading ICT distributor with a strong presence in New Zealand, elevated Dicker Data to the position of the second-largest ICT distributor in New Zealand. This deal also provided access to additional vendor partnerships.

• 2022: Hills Security Acquisition
  Dicker Data diversified its offerings by acquiring Hills Security, a distributor specializing in security products. This move leveraged the company’s expertise in distributing technical goods while enabling entry into complementary markets with synergies to its core ICT business.

Recent Earnings Volatility

In recent years, Dicker Data’s revenue and profits have experienced notable variability due to external factors:

• COVID-19 Pandemic (2020–2021):
  The pandemic drove a surge in demand for ICT products as businesses and workers transitioned to remote work. This period resulted in unprecedented revenue growth.

• Supply Chain Disruptions (2022):
  Following the initial boom, profit margins were squeezed as Dicker Data adopted a strategy of stockpiling inventory to avoid disappointing customers amid global supply chain challenges and semiconductor shortages.

• Impact of Rising Interest Rates (2023):
  Higher interest rates have recently affected Dicker Data, both by increasing its borrowing costs and dampening demand among its key SME customers.

Despite these temporary challenges, Dicker Data remains well-positioned for long-term success. The ongoing need for ANZ businesses to refresh and upgrade their ICT infrastructure underpins steady demand for the company’s products and services. While recent factors have impacted profitability, they are unlikely to diminish the company’s competitive strengths or its ability to generate value in the future.

Dicker Data’s Future Prospects

Australia and New Zealand are high-income countries with steadily growing populations, fostering a strong appetite for technological advancements that enhance workplace efficiency. As the leading ICT distributor across ANZ, Dicker Data is well-positioned to benefit from both short-term factors and long-term trends driving demand for technology solutions.

Short-Term Catalysts

A significant portion of Dicker Data’s customer base comprises Small and Medium-sized Enterprises (SMEs), which have been grappling with the challenges of rising interest rates in recent years. While the timing and extent of future rate reductions remain uncertain, these businesses will eventually need to refresh their ICT infrastructure, creating a pent-up demand for upgrades.

Another factor likely influencing ICT upgrades is the upcoming end of support for Windows 10, scheduled for October 14, 2025. The loss of support is expected to stimulate PC refresh cycles, a crucial revenue driver that accounted for 22% of Dicker Data’s sales in FY2024.

Generative AI and Cloud Adoption

The rapid evolution of generative artificial intelligence (AI) is creating new opportunities across industries. The demand for AI-ready computers and cloud solutions is accelerating as businesses seek tools to enhance productivity and innovation. Dicker Data stands to benefit as AI technologies, including specialized hardware and software, continue to gain traction.

Cybersecurity: A Growing Priority

Cybersecurity remains a critical concern for businesses, particularly SMEs, which often lack the expertise to navigate the ever-evolving threat landscape. Dicker Data offers tailored cybersecurity solutions that address these challenges, positioning itself as a reliable long-term partner for businesses seeking to protect their operations against sophisticated cyberattacks.

Collaboration Solutions: The Future of Work

The COVID-19 pandemic fueled a surge in demand for collaboration tools, enabling remote work on an unprecedented scale. As technology advances, these solutions are becoming even more valuable. Emerging features such as AI-generated meeting transcripts and real-time translation services are here or on the horizon, offering businesses new ways to boost productivity and foster global collaboration.

Long-Term Outlook

The combination of ongoing digital transformation, the evolving needs of SMEs, and advancements in technologies such as AI, cybersecurity, and collaboration tools underscores Dicker Data’s potential for sustained growth. As ANZ businesses continue to adopt cutting-edge solutions, Dicker Data is well-equipped to meet their needs, leveraging its strong vendor relationships and market expertise to remain a leader in the ICT distribution space.

The ICT Wholesaling Industry

The ICT wholesaling industry serves as a critical link between technology vendors and businesses. ICT wholesalers purchase hardware and software from producers (vendors) and distribute these products to retailers or business partners (partners). In 2023, Dicker Data worked with more than 12,000 partners—over 10,000 in Australia and more than 2,000 in New Zealand—highlighting the scale of its operations and difficulty of any one vendor or partner maintaining this.

ICT wholesalers add value for their partners by streamlining procurement processes. Through their centralized operations, they connect individual partners with a wide range of vendors and their products. Beyond merely facilitating access, ICT wholesalers handle the logistics and storage of products, leveraging their economies of scale to reduce costs. Additionally, the expertise of an ICT wholesaler like Dicker Data allows them to provide tailored guidance to partners, particularly SMEs, which often lack the in-house resources to select or implement the best solutions.

For vendors, ICT wholesalers provide immense value by serving as a comprehensive sales channel. They give vendors access to a broad base of customers across a region, eliminating the need for the vendor to establish extensive direct-sales infrastructure. ICT wholesalers also manage logistics and support services, enabling vendors to focus on core production. Furthermore, wholesalers act as a feedback loop, leveraging their close relationships with end customers to relay insights that guide product development and customization.

Thin profit margins characterize the ICT wholesaling industry due to intense competition. Success hinges on accurate forecasting—wholesalers must predict partner demand for ICT products with precision. Overstocking can lead to excess inventory and forced discounts, while understocking risks losing customers to competitors due to delays or product unavailability. This delicate balance requires expertise in both demand analysis and vendor relationship management.

Dicker Data’s Competitors

Dicker Data's largest competitors in the ANZ region are Ingram Micro and Synnex, two foreign multinational companies. Despite their global reach, these competitors do not appear to be as efficiently run as Dicker Data, with lower returns on capital and slower inventory turnover. Additionally, since most of their revenue comes from outside ANZ, these companies are likely less focused and responsive to the unique demands of the ANZ market.

Synnex

Synnex derives the majority of its revenue from the Americas, with Europe as its second-largest market and Asia Pacific as its smallest. While its price-to-earnings (PE) ratio of around 16 makes it more affordable than Dicker Data from a valuation perspective, its historical performance suggests a lower-quality company. Synnex has shown slower earnings growth, lower margins, and other operational challenges compared to Dicker Data.

Ingram Micro

As the second-largest ICT distributor in Australia and the largest in New Zealand, Ingram Micro represents Dicker Data’s most direct competitor. However, its financials indicate a less efficient operation. Following its recent IPO after being spun out of private equity, Ingram Micro reported lower margins, particularly in the Asia Pacific region, which is only its third-largest market. Additionally, the company carries a significant debt load, with an interest coverage ratio of just 2.6 times, compared to Dicker Data’s much healthier 5.54 times.

Both competitors exhibit weaker financial metrics in comparison to Dicker Data, emphasizing the Dicker Data's stronger operational performance, focused market strategy, and superior financial discipline in the ANZ region.

Dicker Data’s Balance Sheet

As of December 2023, Dicker Data reported a total debt of AUD 301 million, resulting in a Debt-to-EBITDA ratio of 2. The majority of this debt (AUD 197 million) is held under a receivables facility with Westpac, primarily used for working capital purposes. The remaining debt stems from the acquisition of Exceed Group and is divided between a Westpac Cash Advance Facility (AUD 50 million) and a facility with the Bank of New Zealand (BNZ) (AUD 53.86 million). The debt associated with the Exceed acquisition is being gradually repaid, while the receivables facility continues to support daily operations.

Debt Management Strategy

Dicker Data relies heavily on debt to fund its working capital, a strategy enabled by its policy of distributing 100% of net profits as dividends. While the company’s current debt levels are manageable and compare favorably with competitors Ingram Micro and Synnex, historical debt levels have occasionally been higher. Maintaining debt at or below the current level would be prudent to ensure long-term financial stability.

Dicker Data’s Management Team

David Dicker – Chief Executive Officer (CEO)
David Dicker, one of the company’s co-founders, has been with Dicker Data since its inception in 1978. As CEO, he holds 38,032,417 shares, demonstrating significant insider ownership. Recently, David sold 18.3 million shares, primarily due to a divorce settlement. He does not take a salary and focuses on building a unique management culture at the company.

Vladimir Mitnovetski – Chief Operating Officer (COO)
Vladimir joined Dicker Data in 2010, bringing over 20 years of experience in the distribution industry. His career began at Tech Pacific, followed by a stint at Ingram Micro. Vladimir owns 930,176 shares and continues to increase his stake in the company, with his most recent purchase being 5,000 shares at $8.90 on September 4, 2024.

Mary Stojcevski – Chief Financial Officer (CFO)
Mary has been with Dicker Data since 1999 and has over 15 years of experience in accounting and taxation prior to joining. She owns 333,335 shares and has actively purchased shares, including 5,000 shares at $9.19 on May 21, 2024.

Ian Welch – Chief Information Officer (CIO) and Director of Operations
Ian Welch joined Dicker Data in 2013 after years of consulting for the company in various capacities. He holds 85,000 shares and recently purchased 5,000 shares at $9.05 on May 29, 2024.

Insider Ownership and Executive Compensation

Dicker Data’s management team has a strong track record, long tenures, and significant insider ownership. The executive compensation structure reflects David Dicker’s philosophy:

• Executives receive relatively low base pay but are entitled to a percentage of net income before tax, provided the company maintains a net profit margin of at least 2.5%.

• There is no long-term incentive plan, which has drawn criticism from some proxy advisors and investors.

• There is no cap on executive compensation, which has also drawn criticism from proxy advisors and investors

David has defended the structure, stating:

“We’ve got people working for us who make a lot of money. They make way more money than they would make working at any of our competitors. And yet, we make more money than our competitors make.”

David Dicker’s Leadership and Future Focus

As a founder CEO, David Dicker’s leadership has shaped the unique management style and success of Dicker Data. He is known for his intense dedication, saying:

“You need a commitment bordering on obsession.”

However, in recent years, David has taken a step back from daily operations, focusing instead on strategic decisions and external interests. David has moved to Dubai and has also been focused on his Rodin racing car team and efforts to enter Formula 1, as well as his divorce. His absence at the most recent earnings presentation has raised questions about his ongoing involvement, though COO Vladimir Mitnovetski and the rest of the management team continue to maintain Dicker Data’s strong performance. Vlad seems particularly up to date with all the business details and now may present the bigger key person risk.

Dicker Data Valuation

Over the past 5 years Dicker Data has traded at an average price-to-earnings (P/E) ratio of 27 times, this high number I think can be attributed to some Covid19 exuberance. Currently, the stock is trading at a P/E ratio of 19, reflecting a discount of nearly 30% compared to its historical average.

According to my discounted cash flow (DCF) model, the fair value of Dicker Data’s stock is estimated at $10.06, representing a 18% premium over its current price. The DCF model incorporates the following key assumptions:

• Best-case growth rate of 10%, matching Dicker Data’s 10-year average.

• Base-case growth rate of 7% for 5 years followed by 3% for another 5 years

• Worst-case growth rate of 3%, implying the company maintains growth aligned with inflation.

• Valuation is calculated with a margin of safety, reflecting a range of potential future scenarios.

While Dicker Data's stock appears to be undervalued compared to its historical P/E, it may seem somewhat expensive when compared to its peers. For example, competitors such as Ingram Micro and Synnex trade at lower valuation multiples, with average P/E ratios of 15.4 and EV/EBITDA ratios of 9.89. However, it's important to note that Dicker Data likely deserves a premium due to its stronger business fundamentals and its ability to outperform competitors. Furthermore, Dicker Data offers a relatively high dividend yield, currently 5.16%, which provides additional appeal, particularly to income-focused investors in the Australian market, where many investors value high dividend

Below is a good write up on Daiwabo

Sweet Stocks

Daiwabo - wholesale excellence

Daiwabo is Japan’s top IT wholesale distributor. This is an excellent business that has delivered an 18% profit CAGR over the last ten years, thanks to market share gains, efficiency-driven cuts to SG&A, and a new cloud subscription management service…

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2 years ago · 14 likes · 3 comments · Alex Sweet

Despite trading at a higher multiple than some of its competitors, Dicker Data's superior business, and high dividend yield make it an attractive investment in the Australian stock market. While the stock does not present an outstanding value at its current price, it still offers a margin of safety for investors.

A number of aforementioned factors could make my growth estimates conservative, such as the upcoming end of support for Windows 10, which is expected to drive future demand for new ICT products. Additionally, the ANZ ICT market may currently be experiencing a cyclical low, influenced by the post-COVID economic slowdown and the impacts of higher interest rates on small-to-medium enterprises (SMEs).

Risks From Investing in Dicker Data

Macroeconomic and Competitive Landscape Risk

Dicker Data can be significantly influenced by external factors, beyond its control. The company's performance is closely tied to the economic conditions in the ANZ region. A slowdown in these economies can reduce demand for ICT products, impacting Dicker Data's immediate profits and leaving the company with excess inventory. This scenario can strain the industry’s already thin margins, forcing ICT distributors to discount their stock to clear excess supply. Conversely, if demand outpaces Dicker Data’s projections, the company may struggle to fulfill orders promptly, leading to dissatisfied customers and potential loss of market share.

Additionally, competitive pressure from global players in the ICT distribution industry can further squeeze margins, threatening Dicker Data’s profitability. With small profit margins being a defining feature of the industry, even slight shifts in competitive dynamics can significantly impact the bottom line.

To address these challenges, Dicker Data has implemented robust risk mitigation strategies, including:

• Regular market monitoring to stay ahead of economic and industry trends.

• Adaptive processes and business practices designed to respond swiftly to changing conditions.

• Scenario modeling to anticipate and plan for sudden shifts in the external environment, ensuring the company can make informed decisions during periods of uncertainty.

These proactive measures help Dicker Data maintain its competitive edge, enabling it to navigate the challenges of a dynamic macroeconomic and competitive landscape.

People and Talent Risk

The ability to retain and motivate top talent is a critical success factor—and a potential risk—for Dicker Data. David Dicker, the company’s CEO, emphasizes offering the best rewards to attract and retain high-performing employees. David Dicker has said this has been a key driver behind Dicker Data’s superior performance compared to its competitors across various business areas. However, if key talent were to leave for competitors or if the company failed to attract skilled employees in the future, the business could face significant challenges.

To address this, Dicker Data has implemented several measures aimed at fostering employee retention and attracting top talent:

• Competitive Compensation: Dicker Data distinguishes itself by providing exceptional rewards for exceptional performance. Its executives are among the highest-paid in the industry, reinforcing the company’s commitment to rewarding excellence.

• Strong Organizational Culture: The company strives to be an employer of choice by cultivating a supportive culture and empowering leadership. This creates an environment where employees feel valued and motivated to excel.

• Succession Planning: Dicker Data proactively plans for the future by identifying and developing internal talent, ensuring smooth transitions and long-term stability in leadership roles.

By prioritizing employee satisfaction and professional growth, Dicker Data not only mitigates the risks associated with talent attrition but also strengthens its competitive edge in the dynamic ICT distribution industry.

Technological Disruptions and Transformation Risk

As a distributor of ICT products and services, Dicker Data operates in an industry dominated by rapid innovation and change. To stay competitive, the company must constantly adapt to evolving technologies that meet the needs of its customers. However, technological disruption poses risks as it can significantly alter demand patterns. For example, the rise of cloud computing has reduced the need for certain traditional ICT products, such as on-site computer systems, which impacts Dicker Data’s product mix and revenue streams.

To navigate these challenges, Dicker Data has implemented strategies to stay ahead of technological transformations:

• Collaboration with Partners: The company works closely with its partners to support the adoption of cutting-edge technologies that align with customer requirements.

• Technology Roadmap and Strategy: Dicker Data develops and maintains forward-looking technology strategies to identify emerging trends and position itself for future opportunities.

• Investment in Expertise: By equipping teams with the necessary resources and specialized knowledge, the company ensures agility in responding to technological shifts and disruptions.

Through these measures, Dicker Data demonstrates its commitment to innovation and its ability to adapt to a rapidly changing ICT landscape, helping it maintain relevance and competitiveness in the industry.

Supply Chain Disruption Risk

Dicker Data's business heavily depends on global supply chains to deliver products to its customers. This reliance on specific suppliers and regions exposes the company to risks, such as disruptions caused by weather events, supply shortages, or political instability. Any of these factors could delay product deliveries and impact the company's profitability.

To mitigate these risks, Dicker Data employs several strategies, including:

• Flexible working capital management: The company can increase working capital as needed to navigate difficult conditions.

• Strong contractual agreements: Dicker Data has established robust contracts and protections with its suppliers to ensure reliability.

• Diversification of suppliers: The company continually works on expanding its supplier base and sourcing products from multiple regions to minimize dependence on any single source.

Refinance Risk

Dicker Data relies on working capital facilities provided by Westpac Banking Corporation and the Bank of New Zealand to support its operations. A failure to renew these facilities or to secure renewal under equally favorable terms could significantly impact the company’s profitability and even its ability to continue business operations.

To mitigate refinance risks, Dicker Data has implemented the following measures:

• Strong Banking Relationships: The company prioritizes maintaining robust relationships with its financial institutions, ensuring trust and mutual confidence in its operations.

• Dividend Policy Reassessment: Dicker Data remains open to reevaluating its dividend distribution policy, providing flexibility to retain more capital for operational needs if required.

These strategies reflect Dicker Data's proactive approach to managing financial risks and ensuring its long-term stability. By safeguarding its access to financing, the company strengthens its ability to weather economic uncertainties and sustain its growth trajectory.

Legal and Compliance Risk

Operating within the ICT distribution industry, Dicker Data must adhere to a wide array of laws, regulations, contracts, and agreements. Staying compliant is critical to avoiding legal repercussions and maintaining its reputation. Furthermore, the company must continuously monitor and adapt to evolving legal and regulatory frameworks, ensuring any breaches are promptly identified and addressed.

Dicker Data actively mitigates legal and compliance risks through the following measures:

• Comprehensive Policies and Procedures: Implementation of mandatory policies, procedures, and ongoing training programs ensures employees are educated on key regulatory and compliance requirements.

• Specialized Health and Safety Team: A dedicated in-house team oversees workplace health and safety, ensuring compliance with relevant standards while fostering a safe working environment.

By fostering a culture of compliance and maintaining robust oversight, Dicker Data minimizes legal risks and reinforces its commitment to ethical and lawful business practices.

Environmental, Social and Governance (ESG) Risk

As sustainability and ethical business practices become increasingly important, Dicker Data is committed to minimizing its environmental footprint and meeting regulatory standards. Beyond compliance, the company recognizes the reputational risks associated with failing to meet ESG expectations, which can impact its relationships with partners, investors, and customers.

To address ESG risks and achieve its sustainability goals, Dicker Data has implemented strategies such as:

• ESG Governance Framework: A structured framework guides the company’s ESG initiatives, ensuring alignment with industry standards and best practices.

• Dedicated ESG Team: A specialized team focuses on advancing Dicker Data's ESG credentials and driving impactful sustainability efforts.

• Ongoing Oversight and Reviews: The management team regularly reviews ESG initiatives and risks to ensure progress and accountability.

By embedding ESG considerations into its operations, Dicker Data reinforces its commitment to responsible growth and aligns itself with the expectations of modern stakeholders.

Wellbeing, Health and Safety Risk

Maintaining a safe and healthy workplace is essential for Dicker Data to protect its employees and customers from both physical and psychological harm. Neglecting workplace safety could result in injuries, financial losses, and damage to the company’s reputation, impacting its ability to attract and retain talent as well as maintain client trust.

To mitigate these risks and foster a secure work environment, Dicker Data has implemented measures such as:

• Dedicated Safety Teams: Specialized teams are in place to oversee health and safety protocols, supported by robust systems and controls.

• Ongoing Monitoring and Training: Regular safety inspections, employee training, and proactive risk assessments ensure a consistent focus on workplace safety.

• Incident and Injury Management: A structured approach to managing and addressing incidents minimizes downtime and supports affected employees effectively.

By prioritizing the wellbeing of its workforce, Dicker Data not only complies with regulatory requirements but also strengthens its reputation as a responsible and employee-focused organization.

Foreign Exchange

Dicker Data faces foreign exchange risk due to commercial transactions and assets or liabilities denominated in currencies other than its base currency. This risk arises from fluctuations in foreign currency values, which can impact the company’s profitability, particularly in its overseas procurement and sales operations.

To mitigate the impact of currency volatility, Dicker Data employs the following strategies:

• Forward Foreign Exchange Contracts: The company proactively enters into agreements to lock in exchange rates for future transactions, reducing unpredictability.

• Strategic Hedging Policies: Dicker Data hedges between 30% and 80% of foreign currency transactions for the next four months, with the flexibility to extend hedging up to 12 months for specific transactions.

By implementing these measures, Dicker Data minimizes the financial impact of exchange rate fluctuations, ensuring greater stability and predictability in its operations.

Conclusions

Dicker Data stands out as a high-quality business with a dominant position in the ANZ market for ICT product distribution. The company leads the Australian market and holds the second-largest market share in New Zealand, supported by strong growth and sustained demand. Additionally, Dicker Data is diversifying its offerings by expanding into verticals such as security systems, leveraging its competitive advantage in distributing technically complex products.

Despite these strengths, I do not plan to increase my stake in Dicker Data further at its current valuation. While the stock trades below my DCF price target by approximately 18%, I have identified other businesses—both in Australia and internationally—that offer a more favorable risk-return profile and trade at a greater discount to their intrinsic value.

In summary, while I believe Dicker Data offers above-market returns, I see more attractive opportunities elsewhere at this time. For now, I’ll continue to monitor the company closely, while exploring other high-potential investments that align with my valuation criteria.

* I have a small position in Dicker Data purchased at $8.5

"I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn." 

• Charlie Munger

Executive Summary

My initial understanding of Flow Traders and its industry of market-making has turned out to be less thorough than I believed. Data recently brought to my attention has revealed that Flow Traders is losing market share in Europe, where I thought it held a strong competitive edge. This has made me realise that my grasp of the company’s business model and market dynamics wasn't as solid as I initially thought. Given these uncertainties and the company's underperformance, I've decided to label Flow Traders as 'too hard' to evaluate and exit my position.

Initial Thesis

You can read my original article here: My Initial Article.

In my initial analysis of Flow Traders, I viewed it as a form of portfolio "insurance". The idea was that Flow Traders would perform moderately well in normal market environments, distributing regular dividends, but would significantly outperform during market downturns. This outperformance, driven by increased market volatility, would lead to higher dividends and a rising stock price, providing additional capital precisely when other stocks are cheaper to buy.

Flow Traders exemplified this behaviour during the 2020 market crash induced by COVID-19. As the VIX, a key measure of volatility, soared to 65.5—its highest level since 2008—Flow Traders saw its revenues nearly triple, with profits rising nearly nine fold compared to the prior year. The company's dividend payout also surged, tripling year-over-year.

Prior to Covid19, since its IPO in 2015, Flow Traders had consistently delivered growing Earnings Per Share (EPS) and dividends, making it an attractive income-generating asset. The core idea behind my investment was that this consistent dividend growth would be supplemented by outsized gains during volatile market periods, giving investors extra liquidity at the perfect time to invest in falling stock prices.

What Went Wrong with My Flow Traders Investment Thesis

Since I started following and investing in Flow Traders, about a year before writing my initial article, their financial results have consistently worsened. So although it had outperformed over Covid it was not performing that well outside of times of market volatility as I had expected.

At the time, I attributed this decline to lower market volatility, reasoning that narrower bid-ask spreads—where Flow Traders earn their profits—reduced their income opportunities. However, I later realised that although there has been lower volatility there has also been high growth in their trading markets. 

Flow Traders highlights in its investor relations materials the growth of the Exchange-Traded Products (ETP) markets, which should have provided more trading opportunities. While narrower bid-ask spreads can decrease profit per transaction, the expanding ETP market should have led to a higher volume of transactions. In fact, the ETP market has been growing at an impressive 20% annually, as shown in the graphic below from Flow Traders investor relations material.

Analysis of long standing data recently brought to my attention has revealed a concerning trend in Flow Traders key European operations.  By examining the "Market ETP Value Traded" and "Flow Traders ETP Value Traded" data, I have calculated the Flow Traders' market share in Europe since 2016. Contrary to my belief that Flow Traders held a strong competitive advantage in this region, their market share has steadily declined from approximately 50% in Q4 2016 to just 25% by Q4 2024. This wasn’t a sudden anomaly but a clear downward trend over time.

Beyond market share, it is difficult to assess how well Flow Traders is performing relative to competitors. Flow Traders operates in a niche where the majority of their income is generated without direct customers. With only one significant publicly traded competitor—Virtu Financial—it’s challenging to get a comprehensive view of how Flow Traders' systems and business model stack up.

Additionally, another worrying sign was the sharp decline in their return on traded capital, which had been consistently high but has significantly fallen since 2020, further signaling reduced profitability.

They have recently stopped paying a dividend and even have plans to borrow money so that they have more trading capital. Some investors have praised this move, suggesting that the capital previously used for dividends could now generate returns of 50% or more as trading capital like in the chart above. However, this same argument was made when the dividend was cut the first time, and if this is the case it raises questions about Flow Traders’ capital allocation abilities. If they could achieve such high returns by reinvesting the money, why were they paying dividends all along instead of maximising those potential gains for their investors with 50%+ returns?

The main way I would interpret their falling financial results and loss of market share in their key market is declining competitiveness. There may be other reasons but I am not knowledgeable enough about the industry to really know and so that is the only conclusion I can make and why I have decided to put this stock in the too hard pile.

Lessons Learnt

The Risk of Investing in Complex and Opaque Industries

A solid understanding of the industry a company operates in is essential for making sound investment decisions. When dealing with companies in highly complex and opaque industries, caution is necessary. Such investments should either be avoided or approached with a significant margin of safety due to the inherent uncertainties.

High-Frequency Trading (HFT) is one such industry. It involves using powerful computers and advanced algorithms to analyse massive amounts of market data, executing lots of trades at high speeds to exploit short-term market inefficiencies. To remain competitive, HFT firms must constantly invest in and upgrade their sophisticated infrastructure—both software and hardware—while staying on top of technological advancements. This makes HFT a highly complex sector, where companies are required to reinvest continuously in cutting-edge trading platforms. Like other high-tech industries, failure to invest properly, or making the wrong investments, can quickly lead to a firm falling behind its competitors.

Moreover, HFT is notoriously opaque, making it difficult for outsiders to assess a company’s competitiveness. Some reasons for this lack of transparency:

1. Proprietary Algorithms: HFT firms have developed highly sophisticated algorithms which they want to keep secret from their competitors to maintain their competitive edge..

2. Speed and Volume: Speed and volume of HFT makes it difficult for non-experts to grasp what is happening in real time.

3. Dark Pools: Many HFT firms conduct a significant portion of their trading in dark pools, private exchanges where trading activity is hidden from the public.

4. Constant Technological Evolution: HFT firms are constantly adopting new technologies to stay ahead.

Even regulators who can get more transparency find it hard to keep up with HFT firms.

In addition to the above reasons it is made even more opaque in that the key firms with market share such as Citadel are private firms. This means it is difficult to get an idea of overall industry profits and margins and so get an idea of how a firm is going relatively speaking. 

Beware of ‘Clever’ Ideas Leading to the Trap of Confirmation Bias

Confirmation bias is the tendency to look for or interpret information that is consistent with existing beliefs and expectations. 

When I first encountered the idea of investing in a HFT firm that would outperform during periods of market volatility and provide extra cash at ideal times, I was excited. This excitement led me to actively seek out information that supported the idea, while downplaying or outright ignoring information that raised red flags. I overlooked the complexities and opacity of the HFT industry simply because I was enamoured with the potential of investing in such a company.

Reflecting on how confirmation bias affected my decision-making, I’ve identified some strategies to help counter this in my investment process:

1. Structured Analysis: The structured analysis I’ve been developing on this blog is part of my effort to bring more discipline to my investment process. All of my initial investment theses follow a similar format, essentially acting as a checklist of key factors I consider important. This structure helps ensure that I cover critical areas and allows me to revisit mistakes—like this one—so I can refine my approach and avoid similar pitfalls in the future.

2. Evaluate Product Quality: What has changed my mind about Flow Traders was realising Flow Traders was losing market share.. The decline could have been due to underinvestment in their trading platforms, poor management decisions, or other factors. If I had focused on finding a way to monitor the quality of Flow Traders' trading systems—rather than just building a theory around market volatility—I might have avoided this investment.

Going forward, I plan to seek out more quantitative performance indicators, such as market share or comparisons with competitors, to better assess the quality of a company’s products or services. This is something I’ll need to think about for my existing investments.

Importance of a Margin of Safety

One aspect I believe worked in my favour with this investment was ensuring a solid margin of safety. When I published my article on Saturday, December 23rd, the next trading price for Flow Traders was €18.04 on Wednesday, December 27th. Today, the price sits at €18.65. At the time of my analysis, the stock was trading at 14 times earnings and 7 times free cash flow. Additionally, Flow Traders had about €584 million in trading capital, compared to a market cap of roughly €823 million—meaning around 71% of their market cap was backed by trading capital.

By buying with a good margin of safety, even though my thesis didn’t pan out as expected, I didn’t lose much. 

Flow Traders Exit Strategy: Reflections and Next Moves

In hindsight, my investment in Flow Traders didn’t perform as I had initially hoped. The company’s declining market share, worsening financial results, and the complexity and opacity of the HFT industry have all contributed to my decision to exit this position. While the idea of owning a stock that would thrive during market volatility was compelling, I overlooked key risks and allowed confirmation bias to influence my analysis.

That said, one thing I did get right was ensuring a solid margin of safety when I entered the investment. Thanks to this, I haven’t lost much on the stock despite the underperformance. Because of this margin of safety, I’m not in a rush to sell my shares, but I do plan to exit the position over time. Moving forward, I’ll be more cautious about investing in complex industries and will continue refining my analysis to avoid similar mistakes in the future.

Disclaimer:
The information provided in this Substack is for informational and educational purposes only and does not constitute financial product advice, investment advice, or a recommendation to buy, sell, or hold any financial products. The content is general in nature and does not take into account your personal financial objectives, situation, or needs.

While reasonable efforts are made to ensure the accuracy, completeness, and reliability of the information presented, no representation or warranty, express or implied, is given as to its accuracy or completeness. All opinions expressed are those of the author and are subject to change without notice.

I am not a licensed financial adviser. You should consult a licensed financial adviser, tax professional, or legal advisor before making any investment decisions. Investing involves risk, including the potential loss of capital, and past performance is not indicative of future results.

The author may hold positions in the securities mentioned and will disclose such holdings where relevant. Any mention of specific securities, investments, or strategies should not be interpreted as a recommendation.

By accessing and reading this content, you acknowledge and agree that the author is not liable for any loss or damage arising from any decisions you make based on the information provided. You are solely responsible for your own investment research and decisions.

I hold a position in Evolution.

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

• Warren Buffett

Executive Summary

Evolution AB is a leading B2B provider specialising in live casino and Random Number Generator (RNG) games. Its wonderful business model boasts high profit margins, impressive returns on capital, and robust growth rates. Over the past decade, Evolution has achieved a remarkable compound annual growth rate (CAGR) exceeding 50%, with profit margins surpassing 60%. Despite its high-quality operations, the company's valuation has recently been fair to low, presenting investors with an attractive entry point.

The rapid growth of Evolution is driven by the emerging nature of its market, as live gaming continues to gain legalisation and regulation worldwide. However, this dynamic environment also introduces risks, as regulatory, legal frameworks and industry standards are still evolving. The primary risk facing Evolution is regulatory changes, which could significantly impact its operations. Additionally, the presence of grey markets—where live gambling is neither fully legal nor regulated—poses another challenge for the company. 

What Does Evolution Do?

Evolution AB is a leading B2B provider of innovative online casino games, which can be categorised into two main segments:

Live Casino Games

Evolution offers a comprehensive range of live casino games that are streamed in real-time over the internet, providing players with an authentic casino experience. Key features include:

• Authentic Atmosphere: Designed to replicate the ambiance of a physical casino, these games offer unique experiences that are only possible through live streaming.

• Interactive Social Experience: Real human dealers who are filmed in real time and streamed live to players, who can chat not only with the dealer but each other creating a more social online gaming experience. 

• Real Time Play: Game results are determined live, with dealers conducting activities such as spinning wheels, rolling dice, or dealing cards.

• Diverse Game Selection: Evolution's portfolio includes classic casino games like roulette, blackjack, and baccarat, as well as exclusive titles like Crazy Time and Lightning Roulette.

Random Number Generator (RNG) Games

These games rely on algorithms to determine outcomes, offering instant play without human involvement. Evolution's RNG offerings include. 

• Diverse Game Selection: There are a wide variety of such games including: Blackjack, Slots, Roulette and Taco Fury XXXtreme. 

Revenue Model

Evolution generates revenue through a mix of fixed and variable payments from over 800 clients as of 2023. The majority of its income comes from commissions, calculated as a percentage of the profits generated by its clients from Evolution's online games.

Market Presence

In 2023, live casino games accounted for approximately $1.5 billion in revenue (85%), while RNG games contributed around $275 million (15%). Although founded in Europe, Evolution now derives most of its revenue from markets outside Europe, with Asia being its fastest-growing region.

About 40% of Evolutions revenues comes from regulated markets, where online gambling is explicitly legal and regulated. The other 60% of revenues come from unregulated markets, these are markets where governments have not explicitly legalised or prohibited online gambling and are known as grey markets. 

Evolutions Moat

Evolution AB's Chief Product Officer, Todd Haushalter, once remarked that live casino games have "low barriers to entry, high barriers to success." However, I contend that the barriers to entry are indeed high, with even greater challenges to achieving success. These barriers encompass not only the creation of profitable games but also the delivery of these games to clients. Evolution has operated in Europe since its founding in 2006 and none of its European clients have ever tried to run their own live games.

Scale 

A key component of Evolution's moat is its scale. With a vast customer base, Evolution can distribute its fixed costs across a large number of players. Unlike traditional casinos, live games hosted by Evolution can accommodate virtually unlimited players, as the games are streamed online rather than confined to physical tables. This scalability reduces the per-player cost of operations, such as dealer salaries and studio expenses, as more players join.

Moreover, Evolution's extensive scale enables it to offer a broad array of games and tools, such as its One Stop Shop (OSS), which smaller competitors cannot financially justify. This scale also allows Evolution to invest heavily in research and development (R&D), using data from its large player base to optimise game design and functionality. For instance, Evolution funds a team to test its games on the top fifty devices used by players, ensuring a seamless gaming experience that smaller competitors cannot match.

Experience

Since its inception in 2006, Evolution has amassed significant experience across diverse markets, allowing it to address and resolve various operational challenges. The company has developed robust solutions to tackle issues such as cybersecurity threats, problem gambling, player cheating, and dealer errors. Evolution's training programs for dealers are informed by this extensive experience, ensuring efficiency and minimising costly mistakes despite high staff turnover.

Additionally, Evolution leverages its long-standing presence and data-driven insights and testing to optimise its games and player interactions. By analysing player behaviour and chat histories, Evolution can refine game elements and monitor for potential issues This can be seen in its monitoring of problem gambling, using advanced machine learning models.

Regulation

Regulation serves as both an advantage and a challenge for Evolution. The stringent regulatory environment creates high barriers to entry, as new entrants must navigate complex legal requirements and establish systems to prevent fraud and money laundering. Evolution's established presence in multiple markets allows it to spread these regulatory costs across a broad customer base, as well as take solutions from one market to another providing a competitive edge. 

Furthermore, Evolution's proven compliance with regulations in existing markets facilitates entry into new regions, as it can demonstrate effective systems and processes to regulators. As Evolution continues to expand and refine its regulatory compliance, it strengthens its moat against potential competitors.

Thus as Evolution grows, experiments and develops greater systems to meet regulatory requirements Evolution widens the moat between it and any potential competitor. 

Evolution's significant competitive advantages are most evident in its live casino segment, where it has consistently outpaced market growth. In contrast, its RNG segment has struggled to achieve similar organic growth, relying instead on acquisitions. Nevertheless, offering a comprehensive suite of live and RNG games enhances Evolution's value proposition to clients.

Below is the part of an interview with Chief Product Officer Todd Haushalter where he discusses Evolutions competitive advantage:

Earnings and Historical Overview

Founded in 2006 by Jens Von Bahr, Fredrik Österberg, and Richard Hadida, Evolution AB set out to create live casino games for European online gaming operators. By 2012, the company expanded into mobile gaming, and in 2013, it celebrated the opening of its 100th table at its Riga, Latvia studio. Over the subsequent years, Evolution established additional studios in Spain, Malta, and Belgium, along with engineering hubs in Estonia and the Netherlands. The company went public in 2015, listing on Nasdaq First North Premier, and later moved to Nasdaq Nordic in 2017. That same year, Evolution introduced the innovative game show category with "Dream Catcher."

In 2018, Evolution embarked on its first significant expansion beyond Europe, entering the Canadian market and forming partnerships with major U.S. clients in New Jersey.

Acquisitions 

Ezugi (2018): Evolution acquired live casino games competitor Ezugi in 2018 for an initial price of €12 million, followed by a conditional €6 million if certain milestones are met. In the first year after the acquisition the deal was expected to add 2%-4% to revenues, which in 2019 were 365.75 million Euros. This would put Ezugi’s contribution to revenues at about 7-14 million Euros, putting its initial purchase price at 1-2 times revenues. If you generously assume when integrated into Evolution it achieved the same margins Evolution had a net margin of 40.94% in 2019 which would put Ezugi’s contribution to profit at 2.9 to 5.8 million Euros and so the PE at 2-4 times earnings. Ezugi seems like a good deal based on my limited knowledge, not even from an earnings perspective based on my generous assumptions. This is because at the time Evolution was expanding outside of Europe and Ezugi gave it access to its existing markets, clients, studios and regulatory relationships in South Africa, Latin America and the USA. 

In order to improve its RNG games offering and gain the ability to offer clients a full service offering of online games Evolution has also in recent years acquired a number of RNG games companies. 

NetEnt (2020): In 2020 NetEnt was bought for about €1.9 billion, which itself had recently acquired RedTiger, another RNG games provider. It was to be paid for in shares of Evolution at an exchange ratio of 0.1306 Evolution shares for each NetEnt share, representing a 43% premium as at the 23rd of June 2020.  At the time of the takeover NetEnt had a revenue of 174.88 million Euros and an adjusted EBITDA of 82.75 million. So Evolution paid nearly 11 times earnings or 23.5 times EBITDA. This acquisition seems much more expensive than Evolutions acquisition of Ezugi. The only way such a high premium can be justified was that at the time Evolution’s shares were trading at a much higher premium in 2020 of 29.9 times revenue or 56.44 times EV/EBITDA. This means the shares NetEnt shareholders were paid with stock that was even more expensive than the premiums paid. So from that perspective it could be seen as not as bad, paying an overvaluation in overvalued currency.

DigiWheel (2021): This technology-focused acquisition involved an upfront payment of €1 million, with additional undisclosed earn-out payments. Although smaller in scale, the deal aimed to enhance Evolution's technological capabilities.

No Limit City (2022): Evolution acquired No Limit City It was an all cash deal with €200 million in all cash payments as well as an additional €140 million in performance related payments. Evolution said it expected revenue from No Limit City to reach €30 million in 2022 and EBITDA to reach around €23 million. This puts the valuation Evolution paid in cash at nearly 7 times revenues or just over 11 if you include bonus payments. As for EBITDA No Limit CIty had quite good EBITDA margins and so Evolution paid 9-15 times EBITDA, depending on whether you include bonus payments. This is cheaper than its purchase of NetEnt, although it was made in cash rather than in my view overvalued stock.

These takeovers have allowed Evolution to buy its way from a dominant leadership position in Live Casino into the much more competitive market of RNG games. Investors have expressed concerns about the amounts paid by Evolution for these companies, as well as the subsequent organic growth of this segment. 

General Earnings

Overall over the last 10 years Evolution has thrived, growing its whole business and expand its margins with revenues growing at a Cumulative Annual Growth Rate (CAGR) of 43.5% and Net Income growing at a CAGR of 56.6%. 

Earnings per share have grown at equally impressive rates of 53.5% 

Evolution's margins and EPS growth have slowed, likely due to the natural deceleration of a rapidly expanding company, alongside some one-off factors.

i) Over most of Evolution’s history it has channeled the majority of its earnings through low tax jurisdictions such as Malta paying an effective tax rate of 6.8% in 2023. However over the past year the long awaited pillar II has been introduced subjecting Evolution to a minimum tax rate it estimates at 15.2%, marking a substantial increase in its tax obligations.. This tax hike is expected to reduce Evolution's profit margins, representing a one-time adjustment rather than an indication of a broader industry decline.

ii) As part of its expansion efforts, Evolution AB has been actively hiring and training a significant number of new employees. Initially, these new hires are less productive than their more experienced counterparts due to the necessary training and mentorship periods. Additionally, many of these employees are based in North America, where regulatory requirements stipulate that some must be employed in the states where they operate. Unlike other regions where Evolution can establish studios in countries with lower wage costs and attract players from multiple countries to the same tables, North American regulations often mandate that tables be located within specific states. This results in higher labour costs and fewer players per table, which can lead to lower profit margins in these markets. The general expense of hiring new employees is a one off cost of growth hit to Evolutions margins, while its growth in the USA represents lower margin growth, but still growth in EPS nonetheless. 

In its latest quarterly update, Evolution announced a new capital allocation framework. Since its 2015 IPO, the company has aimed to return at least 50% of profits to shareholders through dividends. With excess cash remaining after investments, dividends, and M&A activities, the board has decided to return 100% of this surplus to shareholders, primarily via buybacks, and occasionally through dividends when deemed more value enhancing for shareholders.

Online Gaming Industry

According to H2 Gambling Capital, the global gambling market, encompassing both land-based and online gambling, generated approximately €489 billion in revenue in 2023. Land-based casinos, lotteries, and gaming machines accounted for roughly 75% of this total revenue.

The online gambling sector, being relatively new and increasingly regulated, has experienced rapid growth compared to the broader gambling market. Between 2019 and 2023, the online segment expanded at a compound annual growth rate (CAGR) of 20%, while the overall gambling market grew at a CAGR of 4.6%. Within the online space, live casino games emerged as the fastest-growing segment, achieving a CAGR of 24% during the same period.

The COVID-19 pandemic significantly boosted the online gambling market over the past five years, as more consumers turned to digital platforms for entertainment. However, future growth rates are expected to moderate as the market stabilises post-pandemic. 

Future Prospects for Evolution

The future prospects for Evolution AB appear promising, although being part of a rapidly expanding industry comes with inherent risks

The online gambling market is projected to grow at a low to mid-teen percentage rate over the next five years. This growth is driven by several factors, including the increasing regulation and legislation of online gambling and live casino games in new markets, as well as the expanding market share of online gambling within these regions. Currently, 60% of Evolution's revenue is derived from unregulated markets. Regulation in these areas could encourage greater investment by online casinos and offer enhanced player protection and rights, potentially boosting player engagement. Despite online gambling's current global market share of 25%, it reaches 35% in mature European markets. Online platforms could potentially dominate over time even more of the market by offering greater accessibility to individuals located far from physical casinos or other land-based gambling venues.

Evolution operates in the rapidly growing segment of live casino games and has historically outpaced market growth. Unlike the more established RNG market, the live casino segment has been a "winner-takes-most" market, with Evolution as the leading player. The company consistently grows faster than the market, generates higher margins than competitors, and produces more award-winning and popular games. Evolution supports this growth by enhancing its offerings with advanced tools for clients, such as the One Stop Shop (OSS) platform. This platform provides clients with instant access to Evolution's games, reducing time to market and offering a unified interface.

Regulation poses a potential challenge for the online gambling industry. There is a risk of issues such as compulsive gambling or fraud prompting government intervention. However, most jurisdictions have opted for increased regulation rather than shutdowns, not wanting to drive this industry underground. Another scenario is that governments may seek a larger share of industry profits through regulatory measures. While all forms of regulated gambling contribute to tax revenue, land-based casinos also generate jobs in related sectors like hospitality and tourism. Consequently, the potential shutdown of online gambling poses less of a loss to governments and their constituents compared to land-based casinos.

Lastly, the possibility of market disruption remains. Despite Evolution's strong competitive advantages, particularly in live casino games, there is always a chance that a new provider could introduce innovative games or gambling formats that challenge Evolution's position. Given the rapid pace of digital technology development, Evolution must remain vigilant to avoid missing key technological advancements that could shape the industry's future. A small-scale example is the success of the online game Aviator, developed by the relatively small company Ejaw, which gained popularity and outperformed established industry players. Although Aviator was in the much more competitive RNG gaming segment, as I have argued, Live Casino is much more difficult to enter and constitutes the majority of Evolutions revenues.

Competitors of Evolution

Many of Evolution AB's competitors are private companies, making detailed information about them less accessible. Some of Evolutions competitors include:

Playtech: is a competitor to Evolution, although it has taken a more diversified approach by offering a wide range of online casino software and services. These include online casinos, poker rooms, sports betting, live casino, and mobile gaming. In 2023, Playtech generated approximately €1.7 billion in revenue, slightly less than Evolution. However, Playtech's net margins are significantly lower, at around 7%, and it does not consistently achieve profitability. Unlike Evolution, which dominates the live casino market, Playtech spreads its focus across multiple areas, including both B2C and B2B segments.

Pragmatic Play: is a leading provider of online slots (RNG games) and also offers live casino services, bingo, and virtual sports. As a private company, detailed financial information is limited, but it is recognized for its strong presence in the RNG market.

Authentic Gaming: is another private competitor, specialising in live casino software and services. It streams games from both land-based casinos and studios and has a presence on over 200 online operator sites with a workforce of more than 300 employees.

Balance Sheet

Evolution AB maintains a robust financial position with minimal debt, as most of its operating expenses and capital expenditures are efficiently covered by the cash generated from its operations. The company’s high returns on capital reduce the necessity for significant borrowing.

Like many large corporations, Evolution carries some lease liabilities, tax obligations, and other liabilities. However, these are well-managed and comfortably covered by the company's available cash reserves. This prudent financial management supports Evolution's ability to invest in growth opportunities while maintaining financial stability, as well as rewarding shareholders. 

Management Team

Martin Carlsund: is the current Chief Executive Officer (CEO) of Evolution. Before his tenure at Evolution, he served as CEO for Highlight Media Group, Eniro Sverige, Eniro Finland, and 3L Systems. He has been employed by the group since 2015 and holds 684,710 shares of Evolution. 

Todd Haushalter: is the Chief Product Officer and Games Operations. He previously held the position of Vice President of Gaming Operations at MGM Resorts and has extensive experience in casino game development and operations. He has been at the group since 2015 and owns 96,300 shares of Evolution. 

Jacob Kaplan: Is the Chief Financial Officer (CFO) at Evolution. His previous roles include CFO at Nordnet AB and Vice President, Finance Director at Nasdaq OMX Transaction Services Nordics. He has been employed by Evolution since 2016 and owns 60,000 shares in Evolution.

Sebastian Johannisson: is the Chief Strategy Officer at Evolution. He has previously served as Chief Commercial Officer and Head of Account Management. He has been working for Evolution since 2008 and owns 700,000 shares.

Louise Wiwen-Nilsson: is the Chief Human Resource Officer at Evolution. Louise has previously held leading human resource positions within Viacom/MTV, Nike and Walt Disney. She has been employed by Evolution since 2016 and owns 22,780 shares. 

Jens Von Bahr: As the Chairman of the Board and one of Evolution's founders, Jens Von Bahr has been with the company since its inception in 2006. Before founding Evolution, he was the managing director of Oriflame Sri Lanka and has founded several companies. Von Bahr owns 22,400,140 shares in Evolution.

Overall Evolution insiders own about 14.8% of the company with members of the executive team having significant amounts of their wealth tied to the business. 

Valuation

Over the past year, Evolution AB's stock price has fluctuated from fair to undervalued levels. Its price-to-earnings (P/E) ratio has averaged 34 over the past five years, peaking at 57 in 2020 and currently standing at 17.

To assess Evolution's valuation, I conducted a Discounted Cash Flow (DCF) analysis using different scenarios:

1. Base Case: This scenario assumes a 15% growth rate for the next five years, followed by 10% growth for the subsequent five years, before stabilising at average market growth. It includes a 55% payout ratio and a final P/E ratio of 16 after ten years. This conservative estimate reflects Evolution's historical mid-double-digit growth rates, moving to low double digit and its status as a high-quality business with strong margins and returns on capital, which typically command a premium valuation.

2. Optimistic Case: This scenario projects a 25% growth rate over the next five years, followed by 15% growth in the subsequent five years, with a 75% payout ratio and a final P/E ratio of 18. Despite being a best-case scenario, it remains conservative given Evolution's past performance. The payout ratio considers both dividends and share buybacks, supported by the company's robust free cash flow generation.

3. Pessimistic Case: This scenario assumes a 10% growth rate for the first five years, followed by 3% growth in the following five years, with a 50% payout ratio and a final P/E ratio of 12.

When running a DCF with these conservative assumptions the final result comes out to 1,842 SEK. This puts Evolution at a current discount of about 45% given its current price of 1,006.5 SEK.

If we reverse-engineer the DCF to determine what growth assumptions would justify Evolution's current share price, we would need to assume a 12% growth rate for the first five years, followed by a 5% growth rate, and a final P/E ratio of 13. Given the historical popularity and market share of live casino games, such a scenario seems unlikely unless there is a significant regulatory shift, such as a coordinated global crackdown on online casinos, which remains improbable as there is currently no reason and would be difficult to coordinate.

Risks for Evolutions Investment Case

Investing in Evolution AB comes with a number of risks, especially given the rapid growth and evolving nature of the online gambling industry, which is still establishing its long-term structure and societal impact. 

Some of these risks include:

Regulatory

As a player in the heavily regulated gambling industry, Evolution faces complex and inconsistent laws across jurisdictions. Both Evolution and its online casino clients are subject to stringent regulations and higher taxes compared to other businesses. The company must maintain various licences and certifications, and any revocation or unfavourable renewal could drive customers to competitors. Additionally, Evolution must comply with a range of gaming laws, including anti-money laundering, market abuse, data protection, and privacy regulations. Compliance is costly and complex, and any failure, even accidental, could negatively impact the company’s operations and financial performance.

Regulations can impose significant fixed costs in each market, potentially reducing margins. For example, U.S. regulations requiring state-specific studios can limit economies of scale. Moreover, increased taxes could reduce the revenue share available to Evolution and its clients. Governments may also favour land-based casinos due to the broader economic benefits they provide, such as job creation in associated industries like hospitality and retail.

Regulated vs Grey Markets

Over 60% of Evolution's revenues come from 'grey markets,' where live casino gaming is not explicitly regulated. If governments decide to regulate these markets, they could impose bans, or unfavourable regulations. Even if these markets aren’t regulated, unfavourable interpretations of existing laws pose a risk to Evolution’s revenue streams.

Dependence on Major Customers

Despite Evolution's geographic diversification, 41% of its 2023 revenue came from its top five customers. This concentration risk means that any downturn in these customers' businesses or a shift to competitors could significantly affect Evolution's revenue and profitability.

Counterparty Risk

There is a risk that Evolution's customers may fail to meet their financial obligations. Although Evolution conducts thorough credit checks, changing market conditions could impact customers' ability to pay, especially in less stable markets.

Competition Pressures

The online gambling industry is highly competitive, with numerous new and growing competitors. Evolution must continue to innovate and strengthen its market-leading position to retain and attract customers. Failure to do so could result in a loss of market share.

Intellectual Property Risks

Protecting and enforcing intellectual property rights is crucial for Evolution's competitive edge. There is a risk of infringement claims, and defending these rights in court can be costly and, if unsuccessful, financially damaging.

Taxation

Evolution conducts its business through subsidiaries active in the geographic markets it operates. The business, including intra-Group transactions, is conducted in accordance with Evolution's interpretation of applicable tax laws, tax treaties and other regulations in the relevant countries. Although Evolution consults independent tax advisors, there is the risk that countries make decisions that deviate from Evolution's interpretation. 

Recently Evolutions tax rate has been significantly increased from an estimated 6.8% in 2023 to more than 15% in 2024. This is due to the implementation of Pillar II, a global minimum tax initiative. 

Geographic presence

Evolution has customers, studios and officers all over the world exposing it to the country specific risks of the countries it operates in. One potential risk in one of these countries is in the nation of Georgia, where Evolution has large studios and new laws being passed have led to significant protest and disruption in the country. In addition, the workers of Georgia have recently started forming a union and demanded better working conditions.

General Risk Management

Evolution is exposed to a variety of risks which need to be managed. In order to manage these identified risks the group applies procedures and internal controls. The Group Risk Committee meets on a quarterly basis to discuss and address potential risks. An example of this is the risk of money laundering or fraud Evolution is exposed to. Evolution has implemented internal control systems and established a primary mission control in Latvia that monitors transactions, volumes and patterns. 

Conclusions

In conclusion, Evolution AB stands as a formidable player in the online gaming industry, leveraging its robust business model, high margins, and strong growth trajectory. The company has effectively capitalised on the expanding live casino market, outpacing industry growth with its innovative offerings and scalable operations. Despite facing regulatory challenges and market risks, Evolution's strategic positioning, coupled with its efficient use of capital and strong management team, provides a solid foundation for continued success.

The company's valuation is currently undervalued, presenting a compelling investment opportunity. Although Evolution is in an industry with higher risks, it is also a premium business so a P/E ratio of 17x as well as a conservative DCF show it is undervalued today.

Looking ahead, Evolution's focus on expanding its geographic reach and enhancing its product offerings positions it well to capture further market share. The company's commitment to innovation and customer engagement, alongside its disciplined approach to risk management, underscores its potential for long-term value creation. Investors should consider Evolution's strong competitive moat, growth prospects, and current valuation as key factors in their investment decision-making process.

How often can you buy a business that dominates a rapidly growing industry, has a history of mid double digit growth and pays a dividend over 3%, not including buybacks.

I own Evolution at an average price of 1,122 SEK

Disclaimer:
The information provided in this Substack is for informational and educational purposes only and does not constitute financial product advice, investment advice, or a recommendation to buy, sell, or hold any financial products. The content is general in nature and does not take into account your personal financial objectives, situation, or needs.

While reasonable efforts are made to ensure the accuracy, completeness, and reliability of the information presented, no representation or warranty, express or implied, is given as to its accuracy or completeness. All opinions expressed are those of the author and are subject to change without notice.

I am not a licensed financial adviser. You should consult a licensed financial adviser, tax professional, or legal advisor before making any investment decisions. Investing involves risk, including the potential loss of capital, and past performance is not indicative of future results.

The author may hold positions in the securities mentioned and will disclose such holdings where relevant. Any mention of specific securities, investments, or strategies should not be interpreted as a recommendation.

By accessing and reading this content, you acknowledge and agree that the author is not liable for any loss or damage arising from any decisions you make based on the information provided. You are solely responsible for your own investment research and decisions.

I hold a position in Teleperformance.

Key Reason for Purchase:

Teleperformance has long been a strong founder led performer for shareholders. As the dominant player in outsourced customer experience management, it has cemented its position in the market. It has consistently grown earnings per share in the low double digits and maintained industry-leading margins. However, due to the impacts of COVID-19 and other short-term factors, its stock price has experienced significant volatility, shifting from highly expensive to very cheap not only relative to its historic premium but relative to the market as well. Despite these fluctuations, the industry still holds substantial growth potential, making Teleperformance a compelling investment opportunity.

One primary concern investors have expressed about Teleperformance is the potential disruption from generative AI, especially following the release of ChatGPT. While generative AI has the potential to significantly enhance the service and efficiency of customer experience across the global economy. It is unlikely to entirely replace humans and its adoption is not straightforward, creating greater barriers to entry for customer experience outsourcing businesses. Teleperformance is well-positioned to lead this transition. With its vast data resources, deep expertise, and robust client relationships, the company is better equipped than its customers and competitors to effectively integrate AI and other technologies into its operations.

What Does Teleperformance Do?

Teleperformance provides “outsourced customer experience”, this means they communicate with customers on behalf of their clients using methods such as phone, text and social media. The main medium Teleperformance uses to communicate with customers is the telephone, operating call centres is what they are known for accounting for just over 70% of revenue. 

Their business is split into two areas:

1. Core Services and Digital Integrated Business Services (D.I.B.S): Core Services and D.I.B.S covers a broad service offering including: customer care and technical support, content moderation (and related services), customer acquisition and loyalty, digital marketing, integrated complex back/middle/front-office services, Operations Consulting for Business Services, Digital Experience and Customer Integration.

2. Specialized Services: Specialized Services include niche high value added businesses. The five main areas of specialised services are: 

i) Recruitment and employee screening (PSG Global Solutions), 

ii) US health services and navigation (Health Advocate), 

iii) Translation and interpretation (LanguageLine Solutions), 

iv) Consumer debt collection (Alliance One) and 

v) Travel visa outsourcing (TLS Contact).

Core Services and D.I.B.S accounted for 6,982 million Euros or 83% of revenues in 2023 and Specialized Services accounted for 1,363 million Euros or 17% of revenues in 2023. 

Risk of AI Disruption

The risks of AI disruption are a pressing concern for many investors, so it's essential to address them upfront. Since the release of ChatGPT in November 2022, AI has demonstrated its ability to engage in realistic and informative conversations with humans. This capability might lead some investors to believe that Teleperformance's clients will soon realise they can cut costs by replacing the company with generative AI models for customer communication. Despite improvements since ChatGPT's release, generative AI models are not yet ready to fully replace human interaction. Moreover, implementing AI or other complex systems into critical processes like customer experience is far more complicated than simply switching on a model. Finally Teleperformance is already making progress with this technology and other ongoing projects aimed at ensuring it provides the most efficient and high-quality service to its clients.

Generative AI is an impressive tool, particularly in its ability to answer human questions and provide assistance through chatbots. However, since ChatGPT became the first widely popular chatbot, several limitations have been recognized:

• Hallucinations: Chatbots can sometimes generate false information, a phenomenon known as 'hallucinations.' Since chatbots are designed to produce text that sounds plausible, they might fabricate details that aren't true. This is a significant limitation, as companies cannot risk providing their clients with incorrect information. 

• Limited Creativity: Chatbots are trained on a finite dataset, and when faced with situations outside this dataset, they may deliver incorrect or irrelevant responses. This constraint limits their ability to handle unique or novel situations effectively.

• Lack of Emotional Intelligence: Chatbots lack the ability to understand and respond to human emotions. Emotional intelligence is often a crucial component of human interactions, allowing for adaptive communication based on the customer's emotional state. This deficiency means chatbots may struggle in situations where empathy and nuanced understanding are required.

Despite the drawbacks of using chatbots or other forms of generative AI, such as those mentioned above, there are ways to incorporate AI into business processes and create valuable products that minimise these limitations. Successfully doing so requires not only deep knowledge of AI but also extensive expertise in the specific area where AI is being implemented (subject matter expertise) and access to a large data pool for training. These requirements favour industry incumbents like Teleperformance, who possess both the necessary expertise and data resources.

The basic steps for implementing an AI automation service may be along the lines of:

• Gathering Subject Matter Experts, AI Experts, and Available Data:
  In this initial step, subject matter experts and AI experts collaborate to identify potential automation services that AI can perform. They focus on tasks within the subject matter experts' domain that can add the most value and that they. After identifying a suitable task, they assess if they have sufficient data to train the AI.

• Model Building:
  AI experts then develop a model that best fits the available data to perform the required task. This model is incorporated into a user-friendly program that can be easily used by non-technical staff.

• Iteration in Small Groups:
  Once the program is operational, it is tested by a small group of employees. These employees use the tool in their daily tasks and provide feedback on any issues or improvements needed. Developers then refine the tool based on this feedback.

• Iteration in Larger Groups:
  After the smaller group is comfortable with the AI tool, it is rolled out to a larger group. These users continue to report any bugs or issues, which developers address. If the tool is not customer-facing, it may be fully deployed after this stage.

• Supervised Implementation for Customer-Facing Tools:
  For customer-facing tools or those set to operate autonomously, the next step involves supervised implementation. Employees monitor the AI system as it interacts with customers, intervening or taking over when the AI makes mistakes. As well as ensuring the AI system says and does the right thing, as well as how customers respond to the system. This phase also starts with a small group and gradually expands to more users.

• Final Deployment with Human Oversight:
  Once the AI tool has proven effective for most customer interactions, it is fully deployed. However, a group of humans remains on hand to handle complex cases or when the AI encounters difficulties.

Thus the process of implementing AI is a complex and iterative process, if Teleperformance is unable to implement this new technology like they have with past technologies, the quality of their services may suffer. Although Teleperformance isn’t an expert in AI it does have the other components to successfully implement AI in its business: subject matter experts, data and real world situations. According to the Teleperformance 2023 annual report Teleperformance is currently working on over 100 different projects to incorporate generative AI to improve its business. Teleperformance has a long history of using various types of technology to improve the efficiency and quality of its services. 

Below is a summary of improvements various types of automation have helped with at Teleperformance: 

* AHT stands for Average Handle Time

Video of Daniel Julien discussing how AI is used in Teleperformance as well as its limitations:

Moat

Throughout its history, Teleperformance has achieved remarkable revenue growth. As revenues have increased, the company has leveraged its scale to enhance service quality and efficiency, resulting in expanded margins. Concurrently, the customer experience outsourcing industry is seeing heightened barriers to entry due to new country-specific requirements in each client sector. These requirements pertain to remote work arrangements, omni-channel security, and technologies essential for customer satisfaction, further driving the trend towards outsourcing.

Country specific knowledge

One of the key areas Teleperformance was able to add value to clients in its early days and still today is outsourcing call centre work to countries with lower wages. Hiring workers and conducting call centres and other work in different countries to the underlying business is not straightforward as different countries have different labour laws, data storage laws and a whole host of different laws and work practices. Working between multiple countries creates significant fixed costs in staying up to date with all the laws, practices and culture between the countries. Teleperformance can spread these fixed costs across all of its clients creating low cost services than any of its customers or smaller competitors. 

Knowledge base

Teleperformance provides services across a wide variety of areas such as: debt collection, technical support, claims management, language translation, digital visa management, healthcare process management, sales and other customer experience areas. In order to provide these services efficiently and with a high degree of quality they need good knowledge of the underlying area and strong processes in place to ensure employees cover everything involved. Teleperformance level of knowledge and processes in place to service clients act as a barrier to entry with any client having to build up a similar base of knowledge and processes. Some examples of this would be enough knowledge of the US healthcare system to know what to advise clients to do. This knowledge and processes can then be applied to other clients in similar or adjacent areas. For example if a new country decides to use Teleperformance to assist with digital visa processing they can use existing processes and tools from other countries' digital visa process.

Technology

The risk of technological disruption was discussed earlier in the article, it was concluded that it's possible but Teleperformance has key advantages in developing technology for customer experience. These advantages lie in its scale: it has more data, subject matter experts and real life situations to analyse and evaluate new technology allowing it to develop technology more efficiently. Throughout its history it has so far managed to use this advantage and develop technologies allowing it to increase its margins with its growth. 

In addition technology in this sector creates a barrier to entry not only making it difficult for new entrants to enter the industry but also Teleperformance customers to service their own customer experience as well as Teleperformance could. Teleperformance has a range of computer programs and other technologies that make their workers more efficient and high quality. For example their company AllianceOne which is a major player in the North American debt collection market uses an artificial intelligence-based analytics platform using insights into consumer propensity to pay alongside segmentation collection models to understand customer characteristics and payment patterns. This allows AllianceOne to make sure each collection effort is optimised to the customer and so less effort is wasted. This shows how running a call centre or other customer experience platform is no longer just a matter of organising some people in an office to take and receive calls, but also requires technical expertise that takes time and effort to acquire. 

Scale of offer to customers

Teleperformance is a very large company with operations in 99 countries as of its 2023 annual report. This gives it a larger menu of options it can offer to its customers to better meet their needs. With operations in so many countries Teleperformance can offer customers call centres and other customer experience personnel at various price points, across various time zones and across various languages. In addition with expertise across so many different niche areas of customer experience such as: sales, technical support, recruitment, debt collection, visa renewal and translation it likely already has efficient processes it has learnt from servicing other clients to more efficiently meet the customers needs.

Earnings and General History

Teleperformance was founded in 1978 in Paris by Daniel Julien, has seen remarkable growth under his leadership as the current Group Chairman and CEO. Daniel also holds a significant ownership stake (1.2 million shares as of the 2023 annual report). After establishing dominance in the French market, Teleperformance went public on the Paris Stock Exchange in 1986 and subsequently expanded into Europe. In 1993, it entered the US market with the opening of its first contact centre, and by 2007, following further international expansion, it solidified its position as a global leader in the customer experience outsourcing industry.

Despite achieving industry leadership in 2007, Teleperformance has continued to experience rapid growth. This growth can be attributed to the fragmented nature of the customer experience industry, coupled with expansion driven by both global economic growth and increased recognition among companies of the value of outsourcing these services. Throughout its history, Teleperformance has capitalised on this growth by capturing market share in an industry that expands above the global rate due to increasing outsourcing trends. Moreover, the company has continually improved efficiency in servicing its clients while maintaining or enhancing quality. Consequently, Teleperformance has not only seen revenue growth but also expanded margins and accelerated earnings growth.

Teleperformance earnings benefited from the COVID-19 pandemic, receiving additional work from clients who needed extra call centre support and from those who could no longer conduct their operations in-house. The company was well-prepared to handle the increased demand, thanks to its extensive work-from-home policy and infrastructure, which were already in place as part of past cost-saving measures. As a result, Teleperformance's earnings and stock price spiked during the pandemic. However, in 2023 and beyond, these COVID-related contracts have started to expire, leading to a normalisation of earnings. Additionally, macroeconomic uncertainty has caused some clients to scale back, further impacting earnings. While the company experienced a decline in earnings in 2023, it is not unprecedented and does not establish a new trend, especially given Teleperformance's long history of impressive multi-decade growth.

Customer Experience Outsourcing Industry

According to Everest, a consultant, the customer experience outsourcing industry represents a total market of US$114 billion, with Teleperformance revenues in 2023 representing about US$9 billion (8.345 billion Euros). This is with an estimated outsourcing rate of 32%. If you include Teleperformance's recent acquisition of Majorel their revenues increase to over US$10 billion. 

Teleperformance has a market share in the customer experience outsourcing industry of just under 10%. Some other major players in the customer experience outsourcing industry include: Concentrix, Foundever, Telus International and TTEC. 

Demand for outsourcing customer experience spans from large multinationals to mid-sized firms, each seeking a market-specific approach to customer service. The industry is also becoming increasingly digitised, with the non-voice segment (accounting for 29% of revenues as of 2023) experiencing the fastest growth. Additionally, new disruptive 'tech' solutions are frequently emerging. Multidisciplinary firms from the business process outsourcing sector have begun entering the market, distinguishing themselves from traditional customer experience firms by focusing on high value-enhancing services rather than merely labour cost arbitrage.

Future Prospects for Teleperformance

Teleperformance has multiple sources of growth in this industry including underlying growth in demand for customer experience, increase in the rate of customer experience outsourcing and expanding market share. In the past it has focused on all three areas to expand its business, growing with its existing customers, taking on new customers in areas it is familiar with, as well as increasing its experience in new areas of customer experience. It has done this organically as well as through acquisition, expanding into many of the areas of its Specialised Services division. 

Teleperformance strategy for expanding into new adject areas is known as its “Cube” strategy because it deepens its expertise along 3 dimensions:

i) Build deeper skills and expertise in an adjacent area through acquisition or investment 

ii) Use existing expertise and resources to improve on services in new area

iii) Apply skills and expertise in new area and new skills and expertise to existing clients and geographies

Balance Sheet

As of November 2021 Teleperformance was rated BBB by S&P with a stable outlook. Teleperformance level of debt has reached a peak of 2.2 times EBITDA in 2023 after its takeover of Majorel at 4.553 Billion Euros. This debt carries an average rate of 3.27%, 72% of it is fixed with an average maturity of 3.75 years. 

Although Teleperformance debt has never reached these absolute levels it has reached these levels relative to EBITDA and through a mix of repayments and growth Teleperformance has reduced it. 

Management Team

Daniel Julien: is the Chairman and Chief Executive Officer (CEO) of Teleperformance. Daniel founded Teleperformance in 1978 in Paris with only ten people and since then has led the company over the past 46 years. Daniel owns 1,246,980 shares in Teleperformance.

Bhupender Singh: is the Deputy CEO, CEO of Core Services and President of Transformation. Bhupender began working at Teleperformance in 2018 when the company he was CEO of Intelenet Global Services was taken over by Teleperformance. Bhupender has also worked for prominent consulting firms such as McKinsey and Booz Allen Hamilton. Bhupender owns 37,000 shares in Teleperformance. 

Olivier Rigaudy: is the Deputy CEO and Group Chief Financial Officer (CFO). Olivier began working at Teleperformance as CFO in February 2010 and was appointed Deputy CEO in October 2017. Prior to his role at Teleperformance Olivier was the corporate secretary at Conforama and CFO of Castorama (Kingfisher) group before that. Olivier owns 147,500 Teleperformance shares.

Agustin Grisanti: Agustin is the CEO of Core Services. Prior to his current role Agustin was Teleperformance president of Ibero-LATAM , he joined Teleperformance in 2004. Agustin prior to working for Teleperformance worked in management consulting for firms such as Hermes Management Consulting and Anderson Consulting (Accenture). 

Scott Klein: is CEO of Specialised Services. Before its acquisition by Teleperformance Scott served as CEO of LanguageLine. Scott has successfully led companies in multiple industries including: advertising, consumer packaged goods, market research and business process outsourcing.

João Cardoso: is the Chief Innovation and Digital Officer. João joined Teleperformance in 2003 and before coming into his current role was president for EMEA. Prior to joining Teleperformance João was one of the founders of Altitude Software (originally EasyPhone). 

Teleperformance Valuation

Historically Teleperformance has generally traded with a premium valuation, with an average PE ratio prior to 2020 of 29. It spiked in 2019 so if that number is removed and we take the 5 years prior to 2019 it is 26. But at the moment Teleperformance is trading at a PE ratio of just over 10, two and a half times lower than in previous years. 

If I run a Discounted cash flow model using 

• Best case: historic growth rates prior to covid as a best case scenario where for the next five years Teleperformance grows at 14% followed by 5%, 

• Base Case: With lower than historic growth rates where they grow at 11% followed by 4% and

• Worst case: Where they grow at 5% followed by 0%.

• All cases assume Teleperformance doesn’t return to its premium valuation.

I get a value of 214 Euros, about 106% higher than the current price. This also seems conservative relative to Teleperformance's historic valuation, if it were at this value its PE ratio would be 21, well below its historic PE ratio. So relative to historic valuation metrics and relative to below historic growth rates in a still highly fragmented and above average growth industry Teleperformance is really cheap. 

In order to get the same value in my Discounted Cash Flow model as Teleperformance currently has I have to assume Teleperformance has a growth rate of 2% over the next 5 years followed by 0 into perpetuity. So after inflation the market is assuming Teleperformance will be shrinking from now on based on its valuation and so is a business in decline with only one year's declining earnings as evidence. 

Risks for Teleperformance 

Like all businesses Teleperformance business is subject to risks over the course of doing business some of these include:

Strategic Risks

Geographic presence: Teleperformance operates globally, exposing it to risks such as geopolitical tensions, macroeconomic volatility, and natural disasters. The company carefully assesses these risks when investing in new markets, ensuring potential rewards outweigh costs. Its broad geographical footprint and strong remote work infrastructure enable operational continuity and backup solutions. While geopolitical events like the Russia-Ukraine conflict have had minimal financial impact, the company actively manages inflation risks through client portfolio adjustments and contractual clauses. Additionally, Teleperformance has adopted an ambitious climate strategy with greenhouse gas reduction targets endorsed by the Science-Based Targets initiative to address environmental risks

Technology: As previously discussed regarding AI disruption, Teleperformance faces rapid technological evolution across its markets. The company must continuously adapt to meet clients' needs and anticipate future innovations to make necessary investments. Teleperformance could also be negatively affected if any of its technological services, such as the content moderation business in Colombia in 2022, are perceived poorly. To stay ahead, Teleperformance invests in new technological solutions, developing customer relations solutions, advisory services, data analysis offerings, and integrated digital solutions. Its expertise, scale, and industry specific data facilitate the creation and implementation of these solutions. Recognition at the European Contact Center & Customer Service Awards in 2023 and partnerships with dominant US digital market groups highlight its leadership. Notably, the TP GenAI suite launched in June 2023 enhances customer experience management with AI-powered solutions. Teleperformance also promotes transparency and understanding of its high-tech approach through investor events, demonstrating its integration of AI and commitment to employee wellbeing in new business areas like content moderation.

Competition: Teleperformance is a global leader in digitally integrated business services, but it operates in a highly competitive environment. The company faces challenges from both international and domestic players across various sectors, including consulting, IT services, digital transformation, and specialised contact centre management firms. To stay ahead, Teleperformance must continuously enhance its services and may need to adjust prices. The company's strategy includes a strengthened management structure and a high-tech, high-touch approach that offers a broad range of business services. Teleperformance also strategically acquires other companies to enhance its service offerings, as seen with its acquisition of Majorel in November 2023. This acquisition expanded its market presence in Europe and other key sectors, helping Teleperformance reach its €10 billion revenue target two years ahead of schedule. With around 410,000 employees, Teleperformance continues to reinforce its global leadership.

Acquisitions: Acquisitions are integral to Teleperformance's strategy for expanding its service offerings and venturing into high-growth sectors. However, they entail various risks, including identifying suitable targets and negotiating favourable terms, as well as integrating the acquired companies. Despite these challenges, Teleperformance has a successful track record in managing acquisitions, employing a rigorous process that includes thorough due diligence and meticulous planning for integration. For instance, the recent acquisition of Majorel in November 2023 is part of Teleperformance's broader growth strategy. The company has established procedures for evaluating potential acquisitions and implementing integration plans to achieve synergies. Notably, the involvement of former Majorel shareholders in Teleperformance's board underscores their commitment to the integration's success. Through its structured approach and experience, Teleperformance mitigates risks associated with acquisitions while capitalising on opportunities for growth.

Operational Risks

Employees: Teleperformance relies heavily on its workforce of 410,000 to deliver quality services to clients. The company's ability to attract, retain, and train competent employees directly impacts its service quality and client satisfaction. Ensuring fair treatment and professional development opportunities is crucial for maintaining a strong workforce. Teleperformance has established global teams dedicated to enhancing employee engagement and well-being, aligning with its high-tech, high-touch strategy. Moreover, the company prioritises employee safety, implementing measures based on World Health Organization guidelines. These efforts have led to Teleperformance receiving certifications such as Great Place to Work in 72 of its 99 countries, underscoring its commitment to employee satisfaction. Additionally, the company has implemented succession planning and non-compete clauses for key executives to protect its interests and maintain leadership continuity.

Information Technology Failure and Cybercrime: Teleperformance relies heavily on various information technology platforms to deliver its services. Unfortunately, these platforms are prime targets for cybercriminals, who exploit vulnerabilities to commit fraud and data theft, often demanding ransom. Tactics such as social engineering and exploiting third-party software vulnerabilities pose significant risks to the company. With the increasing number of employees working remotely, the threat landscape has expanded, leading to potential data breaches or service interruptions. Teleperformance has established robust measures to mitigate these risks, including stringent compliance with data security and privacy standards, regular operational assessments, and backup procedures. The company also invests in cutting-edge cybersecurity tools and shares threat intelligence with clients and industry peers. The recent acquisition of Majorel necessitates a comprehensive plan to align its information security practices with Teleperformance's standards.

Campaigns and/or Negative Images In the Media: Teleperformance faces potential defamation or unfounded accusations via social and traditional media platforms, which could harm its reputation. To address this, the company employs an external agency to monitor media and social channels, authorises designated senior managers to represent it publicly, and has a robust crisis management plan in place. In response to significant criticisms, localised crisis protocols can be activated, alongside organised events like open days and site visits, allowing investors and media representatives to directly observe company operations.

Client Portfolio Risk: Teleperformance's business success is contingent upon securing and retaining contracts with a diverse client base. Adjustments to contract terms, including pricing, requested by clients can impact Teleperformance's margins, especially during inflationary periods. Economic downturns or other factors leading to a decline in client volumes pose significant risks to Teleperformance's business and earnings, particularly if a client represents a substantial portion of its revenue. However, the company mitigates these risks through strategies such as maintaining a diversified client portfolio across regions, sectors, and service lines, as well as fostering long-standing client relationships, with an average tenure of 14 years. Teleperformance monitors client satisfaction throughout contracts to mitigate the risk of contract termination.

Legal and Regulatory Risks

Data Privacy: Teleperformance operates within a data-sensitive environment, handling both employee and client information, necessitating adherence to numerous statutory and contractual data security requirements to avoid adverse performance outcomes. To mitigate these risks, the company has established Global Information Security Policies (GISPs), implemented compliance audits, and convened the Global Compliance and Security Council quarterly. Additionally, a Global Privacy and Compliance Office oversees the implementation of a global policy for privacy and regulatory compliance. Teleperformance also maintains a Global Technology, Privacy, and Security Committee to evaluate new technologies and resolve cybersecurity issues. With certifications including ISO 27701 and Binding Corporate Rules (BCRs), Teleperformance ensures global data transfer and processing compliance.

Litigation and Employee Disputes: Teleperformance faces potential legal and regulatory challenges, including litigation and employee conflicts, across its operational jurisdictions. These risks arise from possible breaches of local laws or regulations, legal actions involving clients or external parties, and internal disputes among employees, especially during organisational changes. To address these risks, Teleperformance adheres to both local and international regulations, monitors legal developments through its network of in-house and external legal experts, and ensures employee engagement through consultation mechanisms. Provisions are in place to mitigate known risks and disputes. 

Ethics, Corruption, and Human Rights Risk: Teleperformance, operating across 99 countries can result in potential ethical lapses, human rights violations, and corruption from employees or third parties. To mitigate these risks, Teleperformance maintains a zero-tolerance policy against corruption, outlined in its Code of Conduct and aligned with the United Nations Global Compact principles. This commitment extends to suppliers through the Supplier Code of Conduct. Additionally, in compliance with the French Sapin II law, Teleperformance has implemented a global anti-corruption program overseen by the Group Legal and Compliance Department. This program aims to prevent, detect, and respond to corrupt practices. Teleperformance's dedication to ethical business practices is evident throughout its organisational structure and emphasised in its annual reports.

Financial Risks

Foreign Exchange Risk: Teleperformance is exposed to foreign exchange risk as revenues are denominated in multiple currencies. This may come about due to appreciation in currencies costs are denominated, depreciation in currencies revenues are denominated or appreciation in currencies debts are denominated. Teleperformance has a hedging program for some of the currencies it deals with, especially currencies involving significant borrowing. 

Interest Rate Risk: Teleperformance is exposed to interest rate risk on its debts as well as cash holdings. To protect against interest rate changes on its debt Teleperformance has 72% of its debt at fixed rates. Teleperformance also has the best credit rating in the customer experience outsourcing industry of BBB from Standard and Poor’s. 

Credit Risk: Teleperformance is exposed to credit risk which is the risk of financial loss in the event a client or counterparty to a financial contract fails to meet their contractual obligations. This exposure is mainly concentrated in credit risk to clients. Credit risk is continuously monitored by the Group Finance Department through monthly reports and quarterly management meetings. 

Liquidity risk: Teleperformance is exposed to liquidity risk, which is the risk of difficulty settling its liabilities as they fall due. This could be made worse by events going on in the world such as a major economic crisis, pandemic or other unforeseen fluctuation in cash flows. Teleperformance has a policy of always maintaining sufficient cash to meet all short term liabilities. All medium and long term financial arrangements are authorised and overseen by the Group Financial Department. Standard and Poor’s has confirmed the Teleperformance credit rating of BBB. 

Conclusions

Teleperformance has a history of outperformance in its industry generating strong returns on capital, industry leading margins and growth rates. As a result it has historically traded at a premium valuation being recognised as a premium company. 

Over the past year, there has been a not unprecedented decline in Teleperformance's results. This dip in results has led to a disproportionately large drop in the stock price, transitioning Teleperformance from a stock with a valuation premium to one with a valuation implying the whole business is in decline. Among investors, a prevailing theory suggests that the emergence of generative AI poses a substantial threat to Teleperformance. While the article explores this potential scenario, acknowledging current limitations, the article concludes AI is unlikely to entirely replace humans. In addition, Teleperformance is in a great position to capitalise on AI and other technologies.

If you foresee a scenario within the next decade where AI tools, including generative AI, surpass human communication abilities with other humans across various customer experience domains without human intervention, then Teleperformance may be considered overvalued.

Conversely, if you anticipate that human expertise and data will remain crucial in certain areas, and believe that Teleperformance can continue to leverage AI and other technologies to enhance client services' efficiency and quality, then Teleperformance could be significantly undervalued.

I am long Teleperformance at a slightly higher value than where it is today.

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I hold a position in B&M European Value Retail.

Key Purchase Reason:

“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

• Warren Buffett

“Dollar Stores” today are an important form of retail in a number of countries such as the United States, Canada and Japan. These stores originally sold goods for a dollar of 100 Yen in Japan, but today are simply discount variety retailers. In the USA the leading dollar stores chain Dollar General recently opened its 20,000th store, which gives it more stores than McDonald’s franchises in the United States. Despite this, dollar stores continue to grow and produce ever larger profits in many of these countries. 

European countries have been slower to adopt the concept of dollar stores with some failed attempts such as Poundland in the UK. However, since 2004 with the takeover of B&M a struggling UK grocer by Bobby and Simon Arora the concept seems to be finally succeeding. B&M has thrived in the UK posting impressive growth, stronger margins and returns on capital than past attempts and existing UK retailers. With these impressive numbers, generous returns of capital to shareholders and growth potential, B&M is an above average business. However its valuation is relatively average for the cheap UK stock market and downright cheap relative to its more mature lower growth overseas peers.

Today B&M can continue reinvesting its profits at high rates of return into the foreseeable future by building new stores across the UK and France, not to mention potential expansion into other European markets. This offers investors long term compounding, but at value prices. 

What does B&M do?

In B&M’s own words:

“Our business model is to directly source a targeted range of food, Fast Moving Consumer Goods (FMCG) and general merchandise products at the best prices we can, enabling us to sell them to customers at value prices. Our limited assortment of bestselling products enables us to constantly introduce new products and react quickly to what’s on trend and changes in demand patterns.” 

So in Summary B&M sells a range of goods to consumers at low prices, is able to only sell the most popular goods due to a more limited assortment and introduce and try new goods rapidly.

B&M’s business is broken down by the company into three parts:

1. B&M stores in the UK: 707 (as of 2023 annual report) discount variety retailers in the UK.

2. B&M stores in France: 114 (as of 2023 annual report) discount variety retailers in France.

3. Heron Foods: 319 discount convenience stores in the UK.

The highest margin part of the business is B&M stores in the UK, as this is the oldest and largest part, but the margins for the other two parts of the business are catching up. 

Moat

One of the reasons dollar stores have been successful is due to developing strong moats. They are generally initially dependent on each business's unique circumstances, which is why some are successful while others aren’t. But as they grow successful dollar stores tend to develop economies of scale based advantages by being able to spread out a large number of fixed costs across an ever larger number of stores and use their scale to get lower cost goods consumers are more likely to want.

Infrastructure

One feature of B&M’s success is a strong infrastructure able to get goods quickly and efficiently from B&M’s many suppliers to its store shelves. B&M now has six warehouses in the UK and boasts it can have stock on shelves within 24 hours of receipt in its warehouses. 

In addition, it has also invested in its Information Technology (IT) infrastructure giving it the ability to track goods, monitor sales patterns and pay taxes and regulatory checks efficiently. 

All this has a high fixed cost in terms of money and time and as B&M grows the cost of this will be spread out over more goods creating significant economies of scale for B&M and allowing it to get goods to consumers more quickly for less. 

Supplier Relationships

B&M has a great number of suppliers who have reliably supplied it with high quality goods and as B&M has grown it has become more important to many of these suppliers. As a result of buying a great deal of products from these suppliers it can get greater bulk discounts and have a greater say on the qualities of goods these suppliers manufacture and even how they are manufactured.

Supplier relationships are an important part of retail, as the retailer needs to build trust that the supplier will supply consistently high quality goods and also fulfil regulatory requirements such as meeting minimum environmental and labour standards. B&M has operated long enough and successfully enough that it has identified and worked with suppliers that meet these requirements. Any potential competitor would have to identify similar suppliers and perform similar checks adding further economies of scale onto B&M’s moat. 

Product Selection and Organisation

B&M needs to make sure it is stocking goods customers want. As such B&M has cultivated many long-time employees who have successfully since 2004 selected goods customers want as shown by their numbers, this included Bobby Aurora who has been trading director since their takeover in 2004. B&M also has an incumbent advantage being able to collect data and experiment in its large number of existing stores, allowing it to better select goods and even better organise stores, as they have shown in fitting more fresh produce into their Herons stores.

The format of dollar stores also allows B&M to have a higher return on each unit of shelf space. This is because dollar stores are generally much smaller than other store types they compete with such as grocery or hardware stores. But they are able to select goods from a wider array of categories not being limited to just groceries or hardware. So they select less goods from a wider selection allowing each good selected to be a better than average seller relative to other store formats.

Store Location

In an interview Simon Arora did shortly after stepping down as CEO of B&M he emphasised the amount of care he took in selecting each location of B&M, personally visiting and inspecting most sites. Now B&M has a very good idea of what makes a good site for a successful B&M and can select them very well. In addition the initial start-up costs of B&M stores and dollar stores in general are much cheaper than other retailers, so if a site is chosen that doesn’t perform well it can be shut down without too much loss, allowing the company to experiment.

One interesting thing found by B&M is its ability to not necessarily compete when next to a retail competitor like Aldi or Tesco, but to complement. When opening next to other retailers or having these retailers open near them they can adjust goods and prices such that more high quality retailers attract more customers and these customers shop at both stores for a variety of stores. Allowing them to complement each other. 

Online Immunity

The goods sold at B&M are relatively low value goods, being in the category of dollar stores. This creates immunity to online retail for B&M as it makes it generally too expensive to ship goods, as the shipping would make up too large a share of the cost of the goods. 

Brand

Finally B&M has built up a popular brand in the UK ranking 11th most loved retailer.

Earnings and General History

Since Simon and Bobby’s takeover of B&M in 2004 they have taken it from 20 shops in North West England struggling to survive to England's leading discount variety retailer with over 800 B&M stores across the UK and France and over 300 Herons in England. This has generated significant revenue growth and even greater profit growth with margins expanding as the business has scaled. This growth hasn’t come without mistakes with a failed expansion into Germany, but despite this failed experiment the business has continued to thrive in many varied economic conditions.

As can be seen in their revenues and profits from the period of 2021, the Covid pandemic proved to be a temporary boom for B&M. Due to a significant enough fraction of their revenue coming from groceries, B&M were able to stay open during the pandemic when other stores had to remain closed. As a result, although they were one of many opened stores where customers could buy groceries, they were one of the only opened stores where customers could buy hardware and other home improvement goods and B&M were able to rapidly adjust their stock to provide consumers with these goods. 

After 2021 revenues and profits fell and there was a larger fall in same store sales because other stores supplying non-grocery items were able to re-open. However B&M has been able to re-start their store opening program, gradually increasing their store openings, which haven’t yet reached pre-Covid levels. In addition to that, the pandemic also allowed many consumers to discover B&M for the first time and although some have left the same stores sales are still above pre-pandemic levels. 

B&M has a base dividend which they pay each year, but at least since 2021 have also paid out a special dividend most years. This is a good sign that when management has cash that is surplus to requirements they return it to shareholders rather than finding a way to retain it or potentially investing it inefficiently. 

Industry

This year Dollar General, a dollar store chain in the USA opened its 20,000 stores, McDonalds as at the beginning of 2024 has just over 13,500 locations in the USA. Dollar General and Dollar Tree, the two leading dollar stores in the USA were the number 1 and 2 retailers in the USA for new store openings in 2023 according to retail analytics firm Coresight research. Dollar General was IPO’d in 2009 by private equity firm KKR and since then it has increased in value by approximately 27% annually, while also paying dividends.

In Japan 100 yen stores have grown their revenues from virtually nothing in the 1990’s to 400-500 billion yen (just under 2.6-3.5 billion USD) in the early 2000’s. Seria the second largest such stores (couldn’t find information on the largest Daiso) has grown its share price by an average of 14.8% since its IPO in 2003

Dollarama IPO’d in Canada in 2009 and since then has appreciated by about 26.9% annually.

Dollar stores on average have higher margins than regular retailers; selling cheap goods can be very profitable.

Dollar stores can be highly profitable for a variety of reasons:

One general reason is their limited selection of goods they choose to sell to consumers from a much larger potential range of goods. This is because dollar stores on average are smaller than your average supermarket, hardware or garden store in addition they can sell goods across multiple categories. So assuming it can adequately select goods customers want on average the goods it sells will have higher average sales. 

Another general reason is they are a lot less cyclical than other retailers. Since these stores are known as discount retailers consumers perceive them as cheaper than regular retailers, so are more likely to visit when times are difficult. Dollar Stores can be very responsive to these consumer changes as due to the wide variety of goods they can retail they can rapidly adjust their selection to consumer tastes. As B&M did during the pandemic, increasing the range of gardening and home care goods they sold.

Dollar stores also have buying power when they reach sufficient scale. When a dollar store chain reaches a particular size it buys large amounts of goods from suppliers and so can get bulk discounts. In addition, due to its limited range it can’t supply the same range of brands that a larger retailer such as a supermarket can, so it can get better deals from brands in order for these brands to get a spot on its limited shelf space.

Other retailers are being hurt by online retail, but dollar stores are thriving. The average basket of goods purchased at a dollar store is pretty low and so if it had to be delivered delivery would make up too high a share of the value of the goods making it too expensive. In addition, with a large number of retailers being hurt and shutting down due to online retail real estate is much cheaper for dollar store expansion. 

Dollar stores are not always an easy business to be in, especially in the UK as shown by the example of PoundLand, who was a UK dollar store chain that IPO’d in 2014. PoundLand had similar gross margins to US dollar stores but lower operating margins of only 4%, so in 2015 made an offer to buy one of its competitors called 99p. There were a number of problems with the takeover making it take a lot of time and by the time it was finalised 99p had deteriorated and was on the verge of bankruptcy, making the eventual conversion and upgrade of 99p’s stores much more expensive. In addition, overhead costs which PoundLand was hoping to spread over a larger number of stores through the takeover increased leading to limited synergies. Finally this was also a time of expansion in the UK for German discount supermarkets Aldi and Lidl. PoundLand went bankrupt in 2018. 

Future Prospects

B&M has additional room to get back to its pre-covid growth rates in its two markets of the UK and France. In addition as it has shown throughout its history it should be able to continue finding ways to increase returns on capital through economies of scale and other means.  Thus as the dollar store format has in past markets B&M has the ability to continue reinvesting shareholder capital at not only its current high rates of return but at potentially higher rates compounding shareholder returns.

Over the past few years B&M’s earnings haven’t really been representative of its actual potential. This is because of Covid, B&M in 2021 had unsustainably high earnings due to being one of the only stores selling particular goods such as hardware and outdoor furniture, while other stores who may sell these goods were forced to close due to not being classified as essential retailers. In addition during this period B&M was forced to halt its store expansion. So although its same store sales were up significantly its store expansion was stopped. Thus the pattern of B&M’s earnings from 2020-2023 should be seen in this light. 

In 2023 B&M restarted its store expansion program which it was forced to put on hold due to Covid:

• For B&M UK in 2023 30 new stores were opened; they hope to open an additional 40 in 2024, they currently have a target of opening 950 B&M stores in the UK, a 35% increase. 

• For B&M France only 7 new stores were opened in 2023, they hope to eventually open 20+ a year in the immediate future. The French economy is nearly as big as the UK economy so B&M could potentially open just as many new stores there and is today only at 114.

• For Heron Foods this year B&M opened 14 new stores and plans to open 20 new stores in 2024. There are currently 319 stores in the UK.

As B&M opens stores in each of the above categories they are able to gain greater economies of scale in a number of ways as described above under their moat.

B&M is constantly evaluating each unit of store space and experimenting with new products and formats. This can be seen in B&M’s recent introduction of more fresh produce to its Heron Foods stores without removing any of the existing frozen products but storing them more efficiently. This has led to newer B&M stores being larger and more profitable than older ones and that as the older ones are refreshed they often become larger and more profitable. 

Thus B&M is reinvesting its profits into new stores at high rates of return, while increasing those rates of return by becoming more efficient and making existing stores bigger and more profitable.

Balance Sheet

B&M has quite a healthy balance sheet with total liabilities of 2.867 billion. Just over 1.3 billion of this or nearly half is made up of lease liabilities. The next major component of liabilities is debt which is about 954 million, which are mostly non-current loans from B&M’s term facilities. With B&M's profit for the period of 348m this debt is very manageable at less than 3 times profit. It’s EBITDA in 2023 was 796 million making its debt relative to EBITDA a manageable 1.2 times.

Management Team

B&M was taken over and transformed by Simon and Bobby Aurora in 2004. Simon was the Chief Executive Officer (CEO) and Bobby was trading director of B&M. In September 2022 Simon stepped down as CEO of B&M after holding the role for 17 years, he was replaced by Alex Russo, the former Chief Financial Officer (CFO). In addition in 2022 the Arora holding company sold 234 million pounds of stock in B&M. The Arora’s holding company still hold a share of 6.98% of B&M representing about 365 million pounds.

The retirement of one of the founders and CEO of B&M as well as the sale of nearly forty percent of their remaining B&M holdings is a potential red flag. It can be looked at from two extremes with the actual answers likely lying somewhere in between. 

• The first point of view (extreme) is that this is a potential red flag in that one of the business founders has left and sold a large amount of shares because there is something wrong with the business or they don’t think the business can be run effectively without them. 

• The second point of view (extreme) on the other side and more positive for B&M relates to the business lifecycle and the different types of CEOs. As businesses grow they require different leaders with different skill sets. Simon has built two successful businesses in his life, first an import business he eventually sold and the second B&M, Simon may be great at starting and running businesses up until they get to a certain size, but when they reach a certain size a new skill set is required to run a business. Simon’s replacement Alex Russo does have expertise at larger retailers

https://pages.stern.nyu.edu/~adamodar/pdfiles/country/corporatelifecycleLongX.pdf

Business life Cycle by Aswath Damodaran. 

I’m not saying either is the correct answer; I am just discussing two potential extremes. It likely has more to do with Simon’s life such as wanting to retire or do other things. But it’s also important to collect evidence to see which side it likely falls more under and at the moment there seems to be less evidence for there being something wrong with the business. Simon along with his brother still hold more than 6% of B&M and Simon’s brother Bobby still works for B&M. Shareholders should continue to be monitored for whether Alex Russo manages to implement greater returns on capital at B&M and the roll out of more high quality stores from his previous experience or some of those metrics take a turn for the worse. 

Alex Russo is the current CEO, a position he has been in since September 2022. Prior to his appointment as CEO Alex was B&M’s CFO from November 2020. Before joining B&M Alex had held senior financial positions in a number of other retailers globally including Asda, Walmart, Tesco, Kingfisher and Boots. Thus Alex has senior experience at large retailers and can potentially bring his knowledge from these to B&M where appropriate. Although saying that this was financial rather than operational experience.

Mike Schmidt is the current CFO, a position he has held since October 2022. Prior to working at B&M Mike was CFO at home furniture retailer DFS Furniture, during his time at DFS Mike also held executive responsibilities over property, strategic development, legal and compliance. 

Valuation

Similar businesses around the world who are more mature, but not generally growing as fast as B&M (Dollarama excluded) in general have higher valuations. In those markets these businesses are generally priced above average due to factors such as: their resiliency across economic conditions and immunity to online shopping. B&M is a clear outlier with how low it’s valuation is. 

Running a discounted cash flow analysis on B&M with conservative assumptions ranging from maximum growth rates of 11% over certain scenarios and 0-5% in others I get a valuation for B&M implying a discount at the moment of just over 25%.

Thus B&M is a good buy at the moment valuation wise. At times over the past few years it has been even cheaper and so it’s definitely a stock to watch.

Risks 

Management

As discussed above in the management section there has been a large handover from Simon Arora the founder of B&M to Alex Russo. I presented two extreme possibilities and this should be monitored especially whether the new CEO can bring about greater returns on capital and faster roll out of higher quality stores or those metrics degrade in the future. 

In addition to B&M’s reliance on upper management another risk is improper training, poor incentives or improper succession planning for key management or leaders of operational teams. 

Economic Environment

There have been a number of shocks both globally and in the UK to the economic environment, these include ongoing impacts from Brexit, inflation and changes in consumer confidence. Although B&M is generally a more resilient agile business as shown from it adapting to changes such as Covid, large changes in any of the aforementioned or other macro-economic factors could still hurt B&M.

Supply Chain

B&M has a heavy reliance on supply of its goods from China and Southeast Asia, any disruption to this would be damaging to B&M.

In addition all factories and suppliers need to be monitored for potential breaches in conduct such as slavery, environmental problems or human trafficking.

Competition

B&M operates in the highly competitive retail environments of the UK and France. They need to continuously monitor their pricing, products and formats and that of their competitors. 

They also need to continuously experiment with new categories, formats and targeting of new customers to ensure they stay ahead of the competition. 

Regulation and Compliance

The group has a range of compliance issues including: importation of goods, pricing, anti-bribery and corruption, anti-slavery, anti-tax avoidance, health and safety, employment law, data protection, pollution and contamination of the environment, listing rules, transparency laws and regulations. These could lead to financial penalties or loss of reputation. 

International Expansion

A part of B&M and a significant part of B&Ms growth plans involve international expansion. As a result B&M needs to make sure it has experienced leaders in France and is able to share any economies of scale and advantages from its UK business.

In addition expansion into new markets needs to be closely monitored as it is not positive as learnt from their expansion into Germany.

Warehouse Infrastructure

Loss of a distribution centre or failure to maintain distribution centres and transport infrastructure could significantly impact short/medium term profitability. B&M has multiple warehouses across the UK with plans for more to support future growth as well as business interruption insurance. 

IT System, Cyber Security and Business Continuity

B&M relies on IT systems in stores and warehouses. Failure of such systems would have significant impacts: business interruption, reputation damage, loss of personal data leading to prosecution. All systems have industry standard maintenance contracts, B&M has a group recovery plan and IT budgets and security is reviewed at board level. 

Store Expansion

To grow, B&M needs to find suitable locations for its new stores, failure to find these could reduce the growth rate. Each new store is approved by the CEO to ensure risks are minimised and lease length appropriate. B&Ms flexible low cost format allows good locations to be taken advantage of and if these don’t work out the loss is minimised by its cheap format.

Stock Management

Ineffective controls over stock, lack of product availability or overstocking may impact B&Ms margins, cash flows and working capital. To deal with this B&M has a limited SKU count with markdowns on slow moving goods and non-seasonal stocking doesn’t exceed 12 weeks supply.

Summary

B&M has many aforementioned qualities that make it an above average business and worthy of an above average valuation. 

• It is growing and has room to not only expand locations significantly but also improve efficiency. 

• It also has high returns on capital and an ability to further increase those returns. 

• It is from a sector of retail which is not only likely immune to online shopping, but much less cyclical than other areas of the economy. That has in other countries generated great returns.

• Finally it is generous to its shareholders paying out special dividends when it makes money it doesn’t need rather than retaining it unnecessarily. 

There are a few areas which should be monitored in B&M at the moment:

• Whether the management change over from Simon Arora to Alex Russo, will be positive for the business

• Any future international expansions do better than their failed German one.

Overall B&M is a growing resilient that can continue reinvesting capital at higher rates of return for its shareholders. It is cheap, even in a cheap stock market like the UK. Thus I would currently classify it as a buy. 

During more normal times prior to Covid B&M was able to grow earnings per share at about 10%-15% per year. Dividends excluding special dividends at the current valuation are at 2.5%. SO assuming no special dividends or multiple expansion B&M is a resilient company that can potentially generate 12.5%-17.5% annual returns.

I am long B&M at a slightly lower value than where it is today.

Disclaimer:
The information provided in this Substack is for informational and educational purposes only and does not constitute financial product advice, investment advice, or a recommendation to buy, sell, or hold any financial products. The content is general in nature and does not take into account your personal financial objectives, situation, or needs.

While reasonable efforts are made to ensure the accuracy, completeness, and reliability of the information presented, no representation or warranty, express or implied, is given as to its accuracy or completeness. All opinions expressed are those of the author and are subject to change without notice.

I am not a licensed financial adviser. You should consult a licensed financial adviser, tax professional, or legal advisor before making any investment decisions. Investing involves risk, including the potential loss of capital, and past performance is not indicative of future results.

The author may hold positions in the securities mentioned and will disclose such holdings where relevant. Any mention of specific securities, investments, or strategies should not be interpreted as a recommendation.

By accessing and reading this content, you acknowledge and agree that the author is not liable for any loss or damage arising from any decisions you make based on the information provided. You are solely responsible for your own investment research and decisions.

I hold a position in Elders.

Key Purchase Reason:

Not only can Elders now be bought with profits at a cyclical low, but can also be bought with a low valuation based on those lower profits.

Elders sells goods and services to farmers across Australia such as agricultural chemicals, seeds, livestock broking and insurance. Its profits are also cyclical, not quite as cyclical as an individual farm, but Returns On Capital (ROC) tend to rise and fall from year to year based on a variety of factors. Based on last year's results, Elders profits are down due to a variety of temporary cyclical factors and its ROC is among the lowest in the last decade. In addition due to falls in the share price, its valuation based on those cyclically low profits is also quite low relative to past years. 

What Elders Does

Elder’s is an Australian agribusiness that provides goods and services to farmers and other agricultural businesses. It divides itself into four key segments:

1. Branch Network: Is Australia’s second largest supplier of farm inputs such as seeds, fertilisers and agricultural chemicals. As of November 2023  it operates a network of 242 retail stores, provides product advice from 256 agronomists and has a wholesale business that provides independently owned stores. 

2. Livestock Agency: provides a range of marketing and advisory services for livestock, wool and grain.  

3. Real Estate Services: Is involved in the marketing and property management of farms, stations and lifestyle estates through company owned and franchised offices. Other services include water broking and commercial real estate. 

4. Financial Services: Elders distributes a range of financial products including banking, finance, insurance and warranties.

5. Feed and Processing Services: Elders operates Killara feedlot, which incorporates grain-fed beef distribution, grass fattening operations, cow manure processing and irrigated corn production in Quirindi, New South Wales Australia. 

In the 2023 financial year gross profit was $619 million which can be broken down into each of the above segments as follows:

Moat

Elder’s first significant competitive advantage is its brand in rural Australia. The Elder’s business has been around in Australian rural communities for 185 years and according to the Roy Morgan trust score it continues to be the most trusted brand in regional Australia.

The next competitive advantage Elders has is its scale. Elder’s businesses spread across much of rural Australia providing lots of goods and services to Australia’s farmers. This allows it to invest significant sums in optimising its supply chain efficiently moving goods from its many suppliers to its many stores and customers. In addition to its efficient supply chain it is also able to purchase goods for its stores at scale discounts and even produce its own branded goods through its backwardation strategy. All this allows it to get lower prices for its customers and take more of the margin on each good and service sold. Furthermore in its agency business scale advantages are also very important as businesses based on auctions generally move to the largest auctioneers. As it allows the sellers to get their livestock and crops in front of more customers and the customers to see more livestock and crops. 

Finally another important advantage Elder’s has relative to its competitors are its relationships with its customers. Elders are invested in their customer’s success with each branch having managers who build relationships in local communities and with Elder’s many agronomists advising farmers on how to get the most out of their land and deal with the many challenges their businesses face. For example in the Northern Territory the year round hot conditions can lead to heat stressed cows developing leaky gut, where the majority of their immune system resides. This can lead to a decline in the health of the animals and productivity of the herd. Elder’s staff after researching supplementation systems developed an innovative new lick block containing chromium called KEMTRACE, that can help remove the impact of the heat stress. 

Earnings and General History

As can be seen from the chart above Elder’s revenue, earnings and ROC have more or less been in an upward direction since the financial year 2019. Financial year 2023 is the outlier with all the aforementioned figures down for the year. Given Elder’s size and coverage over all of Australia (The land of droughts and flooding rains) there is always one or more one off problems somewhere in rural Australia impacting farmers and their ability to buy goods and services from Elders. However in the financial year 2023 a number of factors have influenced Elder’s earnings. These include a delayed winter crop, interest rate and inflation, but mostly customers drawing down on their stockpiles bought from 2022 when there were fears of shortages due to supply chain problems causing farmers to overbuy and so reduced buying in 2023. Thus as stated at the beginning Elder’s is a cyclical business and usually the cyclicality is dealt with by its scale and diversification across Australia, but sometimes the size and number of the short term factors lead to lower profits and return in a given year.

The above graphic starting at 2014 makes Elder’s look like a compounder type business with earnings growing by low double digits each year and the occasional down year. However over the last 10 years Elders has gone through a transformation after a very poor performance following the financial crisis which its share price is still recovering from. 

Prior to the financial crisis Elders was more of a conglomerate trading under the name of Futuris. Over the period after the financial crisis Elders divested businesses unrelated to agriculture, such as its automotive parts business and later on businesses that did not meet its ROC hurdle. It used the money from these divestments as well as considerable capital raisings to get its debt under control. The current CEO and Elder’s current strategy began in 2013 and as a result although the above graphic shows rapid growth this is taking place from a business being rebuilt and so is likely to at least slow in the future. In addition, despite Elder's competitive advantages, anyone owning shares should keep vigilant of Elder’s debt levels, ROC and that the business stays in its circle of competence, so there isn’t a repeat of 2009-2013. 

Industry

Elder's success is tied to the success of its customers and the agricultural businesses across Australia which it serves. Based on the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) outlook from 2012 the demand for food is expected to be approximately 77% higher in 2050 than in 2007 at an average annual growth rate of 1.3%. Most of this increase is expected to come from Asia due to rising incomes where Australia has an advantage due to proximity. 

Elders largest business within Australia is its branch network which is the second largest in Australia behind Nutrien. Together Nutrien and Elders account for about 2⁄3 's of Australian agricultural retail and the rest of the market is served by much smaller independence. 

Australia, as the poem goes, is “the land of droughts and flooding rains” and so relative to other countries has a less stable climate, adding difficulty for farmers. Elder’s management team claims that now their coverage of Australia is broad enough that this is less of a problem due to the varied climatic zones in the regions covered by their store network. There is always a drought or flood or bushfire or other problem impacting farmers somewhere in their covered regions making this cyclicality less of an issue. However as can be seen this year there are a large number of factors that can impact farmers and their demand for inputs and so this business does endure cyclical lows such as the current one. 

Future Prospects

As discussed above the demand for agricultural products is expected to increase until 2050 at a rate of 1.3%. This will require more inputs to make current farmed land more productive and to make more marginal land productive enough to farm. In addition to this, Elders has a number of other avenues to expand their business beyond increases in agriculture.

In 2022 and 2023 Elders completed a number of capex programs to improve the efficiency of its supply chain and store network that will lead to lower costs and enhance customer experience. 

One of Elder’s main potential avenues of external growth and growth since 2013 is buying independent agricultural retailers. As discussed above Nutrien and Elders account for about ⅓ of agricultural retailers in Australia the remaining third are much smaller independents. These independents can be bought for much lower profit multiples than Elder’s currently trades and then Elder’s can increase profits and margins of the retailer by introducing its own products and making it a part of its more efficient supply chain. Then by controlling a larger section of the market for agricultural inputs it can lower its costs through greater scale, a type of distributive flywheel like effect. In addition to this there is also the possibility of international expansion with Elder’s with Elders increasing its stake in PGG Wrightson a New Zealand company in the same business.

https://www.farmersweekly.co.nz/markets/elders-interest-in-pgw-creeps-up/#:~:text=Australian%20rural%20servicing%20company%20Elders,2022%20and%20August%2018%2C%202023.

Another Elder’s strategy for growth is its backwardation strategy of buying suppliers of key goods, where potential returns meet their hurdle requirements. ABARES estimates that the current market of agricultural costs in Australia to be 48 billion with Elders estimates their potential addressable market in that of 22 billion and currently Elder’s revenue represents 7.3% of this market.

Balance Sheet

Elder’s debt currently stands at 463.3 million. This represents a debt to EBITDA of 2.14 times. In addition 206.3 million of this balance is made up of lease liabilities. They have interest coverage of over 11 times so should the rates of their debts go up as they have in recent years all the debt can be covered. 

Most of the liabilities in Elder’s balance sheet is for running the business and not taken out as longer term debt and is manageable given its current levels. Given Elder’s past and cyclicality it is important to keep an eye on it, but very manageable at the moment. 

Management Team

Mark Allison is the current CEO of Elders. He was appointed as a non-executive director in 2009 and then CEO in 2014 and presided over Elder’s turnaround. Mark has a 43 year career in agricultural businesses spanning technical, supply, manufacturing and distribution roles. He has worked at a number of companies including Wesfarmers, GrainGrowers Limited and Incitec.

Paul Rossiter is the CFO of Elders. He has worked for the business since 2009 and was appointed CFO in July 2023. His previous employers include Credit Suisse and Morgan Stanley.

Elder’s compensation for senior executives is a mix of fixed base pay as well as short and long term incentives. The percentage breakdown of each of these varies based on the seniority of the employee with the percentage that is fixed pay declining with seniority and the percentage that is long term incentives increasing. As below:

The 2023 financial year was a volatile year for Elders stock price with the price reaching multi year lows. Coinciding with this there have been a number of insider purchases of Elders stock both as part of remuneration program and general market purchases.

One significant issue that has led to Elders stocks volatility in 2022 and 2023 are actions by management that have been interpreted negatively by the market. In November 2022 Mark Alison the CEO announced his retirement but this wasn’t greeted positively by the market with Elder’s shares diving over 20% in reaction to the announcement. 

https://www.smh.com.au/business/companies/elders-shares-sink-as-ceo-retirement-la-ni-a-casts-storm-clouds-20221114-p5by0v.html

Then in early 2023 Elder’s stock fell another 7% on one particular day on no significant company announcements. When the ASX asked Elders for an explanation it was discovered there was a private investor briefing on that day, in which management claimed there was nothing new announced. This wasn’t taken well by investors either leading to further falls in the stock price. 

https://www.afr.com/street-talk/nothing-new-sheepish-elders-explains-7pc-drop-post-briefings-20230208-p5ciz9

Finally in June 2023 it was announced that due to the difficulty of finding a new CEO Mark Allison had been convinced to remain as CEO in exchange for a $410,000 pay boost and two year bonus of $1,000,000. Although this led to some limited share price recovery it has indicated to shareholders that the board and executive team had neglected one of their important responsibilities of succession planning. 

https://www.smh.com.au/business/companies/elders-boss-mark-allison-backflips-on-retirement-with-1-4m-pay-boost-20230605-p5de1y.html

So over the past year and a bit there have been a number of red flags by Elder’s management team. This management team prior to these recent events have however had a good long term track record creating a large amount of value for shareholders, so this should be further monitored.  It would be good to see a more formal CEO succession plan at some point, especially given it has cost so much to retain Mark Allison and it’s only another two years before they face similar problems. The stock price has fallen enough that it more than accounts for these issues if taken in isolation and assuming they are not part of a larger trend. 

Valuation

Over the past two years Elders stock price has fallen from a high of 14.39 to a low of 5.46 a fall of 62%. It is currently at 8.82 recovering significantly from its lows (and significantly since I started writing this at the beginning of January). It is currently trading at 13 times earnings and 8 times free cash flow which is on the lower side of its historic earnings multiples. However relative to past years this business's earnings are around cyclical lows (I won’t call cyclical lows as something unexpected and low probability to always happen next year to create greater lows) with per share earnings falling the most they have in 10 years from 97 cents per share to 66 cents. Thus there is a high probability of an earnings recovery, if it were to recover to close to 2022 earnings it would be trading at close to 9 times earnings, which is close to the lowest valuation it has traded at.

In addition Elder’s current historic valuation is relatively low in my view for a business that has managed to grow earnings at high rates and achieve high returns on capital over the past 10 years. In my view given its above average future potential growth, high returns on capital and dividend I believe it should trade in line with at least market averages of 15-16 times earnings. Maybe this is due to its past, it being grouped with relatively low quality agricultural businesses or a mix of the two.

Thus Elder’s at the moment presents a company trading at low earnings valuations, under earning, returning copious dividends to shareholders, growing the business and all for a low price.

Risks

General Agricultural risks

As with any other agricultural business Elders is affected by a large number of potential risks. These risks include commodity price risk, climatic risk, biosecurity infections of a large number of animals and geopolitical tensions affecting agricultural export markets or input markets. A number of these risks have been seen over the past few years with commodity prices and agricultural input prices particularly volatile in 2022 when Russia invaded Ukraine or climatic risks in various regions of Australia at any time. One way of reducing these risks relative to other agricultural businesses is Elders scale across Australia’s many climates as well as servicing farmers across many types of agricultural products diversifying away some of these risks. But despite that diversification some of these risks can still impact Elders top and bottom lines as can be seen this year. 

Succession Planning

As discussed earlier in 2022 Mark Allison attempted to retire and had to be convinced to stay with additional money. This perhaps indicates a lack of succession planning on the part of Elders for key executive positions. It would be good to see some type of plan around this presented to shareholders so that there is not a repeat in the future where the company can’t do without a key executive. 

Employee Injuries

The agricultural sector is in many parts more physically demanding than other sectors of developed economies such as Australia. As a result injuries to employees could give Elders a bad reputation as an employer not allowing it to pick the best employees to service its clients and be costly to Elders, taking care of injured employees. This is a key metric of executive remuneration and Elder’s over the years has continued to improve it. Financial year 2023 saw an average of 4.7 injuries per month across the entire business. 

Summary

Elder’s is a high quality agricultural business operating in Australia with a good growth runway ahead of itself. Over the past two years it has had a combination of cyclical factors affecting its business and management issues which have left it underearning and at a cheap valuation. I expect a high probability of recovery in the next year or two to its former valuation and at least mid single digit growth.

Disclaimer:
The information provided in this Substack is for informational and educational purposes only and does not constitute financial product advice, investment advice, or a recommendation to buy, sell, or hold any financial products. The content is general in nature and does not take into account your personal financial objectives, situation, or needs.

While reasonable efforts are made to ensure the accuracy, completeness, and reliability of the information presented, no representation or warranty, express or implied, is given as to its accuracy or completeness. All opinions expressed are those of the author and are subject to change without notice.

I am not a licensed financial adviser. You should consult a licensed financial adviser, tax professional, or legal advisor before making any investment decisions. Investing involves risk, including the potential loss of capital, and past performance is not indicative of future results.

The author may hold positions in the securities mentioned and will disclose such holdings where relevant. Any mention of specific securities, investments, or strategies should not be interpreted as a recommendation.

By accessing and reading this content, you acknowledge and agree that the author is not liable for any loss or damage arising from any decisions you make based on the information provided. You are solely responsible for your own investment research and decisions.

I held a position in Flow Traders at the time of writing.

Key Reason to Purchase

In 2012 Nassim Nicholas Taleb published the book Antifragile. Nassim defines antifragility as:

“Simply, antifragility is defined as a convex response to a stressor or source of harm (for some range of variation), leading to a positive sensitivity to increase in volatility (or variability, stress, dispersion of outcomes, or uncertainty, what is grouped under the designation "disorder cluster").”

One company which fulfils Nassims definition of antifragility is the company Flow Traders, a proprietary trading firm. When financial markets in which they operate become more volatile (as measured by VIX for this article) Flow Traders make much more money and when they are less volatile Flow Traders make less money. 

Over the past twelve months volatility has been relatively low in financial markets, this has hit Flow Traders earnings and Flow Traders stock price has reached record lows. In addition Flow Traders valuation as a function of earnings is at a low level. This is despite Flow Traders antifragile characteristics, acting as a type of market insurance which makes high profits and pays high dividends when markets are volatile. As well as growing its business and continuing to pay out dividends when markets are less volatile. Such a stock that gives investors more money when they need it most should trade at a premium rather than a discount relative to its earnings, due to its antifragile characteristics.

What Do Flow Traders Do?

Flow Traders was founded in 2004 by Jan Van Kuijk and Roger Hodenius, two former partners at Optiver. Flow Traders is a market maker, which provides liquidity in financial markets using High Frequency Trading (HFT) and quantitative strategies. Their business is divided into two segments in the first “on screen” is conducted on stock exchanges where they provide continuous bid ask prices for a range of financial products with a focus on Exchange Traded Products (ETPs). The second part of their business called “off exchange” trades bilaterally with institutional counter parties often through request for quote platforms. More recently they have diversified from their initial focus on ETPs into other financial products including fixed income, crypto currency, foreign exchange and commodities. 

As an example they will track an Exchange Traded Fund (ETF) and its underlying securities and whenever the price of the underlying securities varies enough from the ETF they will buy one and short the other. These variations are generally small, but occur enough times that all these small returns add up. 

Moat

Since being founded Flow Traders has built out a trading platform to efficiently make trades in its areas of expertise. This platform makes lots of very small returns without taking a real position in the market, but just taking advantage of the bid ask spreads. All of these small returns add up over time to make very good returns on Flow Traders capital. This is a highly complex and optimized platform, which is difficult to replicate from both a cost perspective as well as experience in the markets. 

Another difficulty of replicating the Flow Traders platform in their largest revenue center of Europe is the complexity of European financial market structure, relative to the US. Europe being made up of many different countries has many exchanges, clearing houses and regulators. This complexity deepens even further in the case of ETPs, tracking underlying assets across the world in different time zones and regulatory regimes. One way Flow Traders has found around this complexity is building relationships with European buy side firms (counterparties). So that if one of these counterparties wants to offload a large number of shares it can try to offload them to a market and hope the market absorbs them, or it can trade them with Flow Traders. Flow traders can then offset this trade across its network by trading with other firms across its off exchange network or hedging. The more counterparties added to this network the more profitable these trades. 

Finally Flow Traders has a much more robust system of risk management than most market makers. In an interview with the co-CEO’s in 2017 Denis Dijkstra and Sjoerd Reitberg said “the idea was to get a good night's sleep”, even admitting the part of the company name “Traders'' was misleading “We are not traders”  "We are operators''. Most market makers use a stochastic approach to model potential outcomes and hedge against these potential outcomes. However Flow Traders uses a more mathematically intensive approach, which allows them to eliminate more forms of risk. 

Industry/Competitors

Flow Traders as described earlier is a market maker, which uses HFT and quantitative strategies. Within this industry it is difficult to get information on competing firms as most of them are private such as Optiver, IMC BV, Susquehanna or Citadel Securities. The only other publicly traded firm is Virtu Financial. The aforementioned firms similarly to Flow Traders offer bid ask prices, as well as other proprietary strategies on most financial instruments creating liquidity in financial markets. 

While different market makers focus on different areas of financial markets Flow Traders focuses on ETPs. ETPs are baskets of assets the largest category of which is ETFs, which is a basket of stocks. In recent years ETPs have grown rapidly as investors have sought to gain exposure to particular financial markets or sectors without focusing on any specific company. 

Earnings and General History

One aspect of Flow Traders earnings which I appreciate is one reason the stock price is so low, its revenue and earnings are quite lumpy. When volatility is high in financial markets, bid ask spreads and differences between the value of ETPs and their underlying assets can become quite large allowing for greater potential profits for Flow Traders. Alternatively when volatility is low the bid ask spreads and value differences between ETPs and their underlying assets are smaller meaning less potential profit for Flow Traders. Since volatility varies so much from year to year Flow traders profits do not advance smoothly. 

Currently this is seen as a bad thing by financial markets as in general financial analysts and investors like businesses whose earnings are easier to predict and more stable. This is if you think of it as a regular stock rather than thinking of it as portfolio insurance that over earns and pays out those over earnings to shareholders when there is higher volatility in markets. 

For example in 2020 when the world was suffering from Covid19 Flow Traders paid out a dividend of 4.55 Euros after starting the year at about 21 Euros stock price, in addition the stock price rose to 34 Euros a 62% increase. So its earnings volatility, seen mostly as a problem, can also be seen as portfolio insurance that pays you whenever the market is volatile, which is often usually when the market presents opportunities and cash is at a premium. 

Since Covid19’s first impacts in 2020 volatility in the stock market and Flow Traders earnings have gone down. Investors have as a result sold the stock and the price has fallen to record lows despite growth in Flow Traders main ETP markets and Flow Traders entering and expanding into new markets (such as China and Crypto) and generally creating a better business for when volatility rises again. 

Two other factors besides volatility have affected Flow Traders earnings this year making this year a perfect storm to their earnings: 

The first is “net financial expenses related to trading activities” is up about 48 million Euros for the first six months of 2023, this increase is related to higher interest rate due to “...credit facilities with the prime brokers calculated on the drawn amount during the year.” With about 45 million shares outstanding this translates to about 1.07 Euros per share for the first six months of 2023. 

The second impact on earnings this year are currency effects reducing earnings for the first six months of 2023 by about 4.3 million Euros. 

Flow Traders earnings are currently being lower than prior years due to lower volatility, higher interest rates and currency effects. As a result, earnings in the first half of 2023 and perhaps the second half of 2022 are only representative of Flow Traders earnings in a bad year with multiple factors negatively impacting earnings relative to prior years. 

Future Prospects

Since Flow Traders IPO’d in 2015 its stock price after a brief rise has fallen from a high of 36.2 Euros to today's price of 18.02 Euros. This is despite large growth in its major market of European ETP products and expansion of Flow Traders into new markets. Flow Traders isn’t the only HFT experiencing lower profits either, Virtu Financial (NYS:VIRT) the only other publicly traded HFT is also experiencing significantly lower profits over the past twelve months. 

As a result Flow Traders as well as other high frequency Traders should benefit in the medium term from higher volatility, as well as in the case of Flow Traders more favorable currency movements. 

In the long term Flow Traders' major market of ETPs in Europe, as well as the rest of the world continues to rapidly grow at a 20% annual growth rate annually since 2011.

In addition Flow Traders has been successfully expanding into new ETP markets. It has a 27% share of global crypto market ETPs. Being a market maker it is not taking a position on crypto but simply providing liquidity. In addition it has expanded into the Asia Pacific and gotten a QFII license opening a Shanghai office. Thus Flow Traders isn’t just enjoying its privileged position market making in European ETPs but is expanding into other financial markets across the world growing and diversifying its business. 

Competitors

In purely economic terms I would classify the markets in which Flow Traders participates would likely be oligopolistic competition. This means in the main market Flow Traders contests there are a small number of large players who dominate the market. 

There are quite a few HFT firms, some of these include Citadel Securities, Optiver, Two Sigma, Virtu and IMC Financial. All of these firms have their own strategies and many likely operate in the same markets as Flow Traders, Its two largest competitors operating in similar markets are Optiver and IMC financial who are also highly active in European financial markets. But Flow Traders also has operations in the USA, which would overlap with many of the others such as Citadel, Two Sigma and Virtu. So all markets in which Flow Traders operates are contested by competitors. 

The only competitor who is also publicly traded is Virtu Financial, they are mostly based in the USA. Their performance in recent years has been very similar to Flow Traders, with much lower earnings and falling share price, despite volatility adjusted growth in their underlying markets. Relative to Flow Traders investing in Virtu has pros and cons, Virtu has been much more aggressive in buying back shares during this significant downturn in their industry, which is a benefit. However, one aspect of Virtu I do not like is their different classes of shares which give the founders extra voting rights, which is one of the reasons I’m more interested in Flow Traders Stock. In addition I believe the lower centralization of the European market creates greater barriers to entry for new competitors lowering competition. 

Balance Sheet

Flow Traders does not have a significant amount of long term debt. It does partake in short term borrowing based on its trading activity, which is correlated with its trading activity. 

Management Team

The two founders of Flow Traders are Roger Hodenius and Jan Van Kuijk, they own 10.07% and 12.22% of Flow Traders stock. They have both largely stepped down from management responsibilities but are on the board and based on their holdings have interests aligned with shareholders.

Mike Kuehnel is the Chief Executive Officer (CEO) of Flow Traders and was appointed in February 2023. He replaced Dennis Dijkstra who stepped down after ten years as CEO of Flow Traders. Kuehnel joined Flow Traders in 2021 after working as a management consultant at Bain and Company and an executive director in the financial institutions division of Goldman Sachs. 

Hermien Smeets-Flier is the Chief Financial Officer (CFO). She has served as chief financial and risk officer of Achmea Investment Management and CFO of Aegis London. 

Valuation

Flow Traders valuation is cheap regardless of which way you look at it. On a high level Flow Traders is currently trading at 14 times earnings or 7 times free cash flow. Generally I would attach those earnings multiples to a company that is shrinking and although Flow Traders earnings are down over the last few years this is due to factors that are unlikely to repeat such as further falls in market volatility from its current level. Despite that the company has expanded into new markets and the markets it participates in are growing and so Flow Traders is able to make more money from a given level of volatility (VIX level) than they could in the past when their share price and valuation multiple was higher.

If I put together a discounted cash flow model, which over the long term assumes a discount rate of 10%,  levels of growth well below those of the ETP sector ranging between scenarios from 2% to 8%, as well as relatively low earnings multiple I get a fair value of 30.11 Euros, which puts Flow Traders at a discount of about 67% today. The closest scenario I have to Flow Traders' current price assumes 2%-3% growth (one tenth of the growth of the ETP sector). In addition this doesn’t account for the added utility of Flow Traders outperforming when the market is volatile. I believe for that reason Flow Traders should trade at a relative premium to its cash flows rather than its current discount due to the unpredictability of market volatility. 

So based on Flow Traders current valuation not much needs to go right to make money from this investment. 

Risks

Flow Traders is a relatively small company in a sector that is very competitive and potentially risky. As a result an investment in Flow Traders carries a number of risks some of which are outlined below:

Mistakes: Algorithms performing large numbers of automated trades can potentially lead to large losses in very short periods of time. This was highlighted for the industry in 2012 when Knight Capital a US market making firm suffered massive trading losses leading to its bankruptcy. This was a mistake caused by a technician forgetting to copy a program to one of their computer servers. These mistakes can happen and that is why Flow Traders has a robust risk management framework to try to mitigate such incidents. Although no program is perfect based on publicly available information from Flow Traders public history there have been no major incidents where a mistake has led to significant financial losses at Flow Traders. In addition, based on information from an article on Flow Traders in 2017 (can’t find any later information) Flow Traders hadn’t lost money on a single trading day in 34 months up to the publishing of that article.

Competition: Flow Traders works in a competitive industry with many financial institutions hiring very intelligent people to build trading algorithms. These high levels of competition can potentially lead to lower bid ask spreads, for which Flow Traders depend on for profits. I believe this is always a possibility as in many other industries profit margins being eroded away are as well. However the structure of the market making industry is oligopolistic, although there are many market making firms most of these firms specialize in a particular financial market area or areas. Within each of these areas large market shares are controlled by individual firms. So any overly aggressive firm in trying to take market share with lower bid ask spreads would be significantly lowering their own profits to do so and it wouldn’t be very rational to do so. In addition I take further comfort in Flow Traders main market being the ETP markets of Europe, which although they are much smaller they are much more decentralized and require Flow Traders network of counterparties and other experience to profitably trading, giving them a greater moat in my view than similar US market markers. 

Regulation: Another area which could potentially harm Flow Traders is regulation, which is still developing for this sector. The role of market maker was once fulfilled by specialist firms, but this role is now fulfilled by a range of investors. This increased competition, as pointed out by empirical studies has reduced bid ask spreads leading to more efficient functioning of markets. However one drawback is unlike traditional market making firms who are committed to remaining in the market HFT firms can leave at their own discretion. In addition algorithmic trading firms have in the past directly led to volatility such as the flash crash of 2010. As a result HFT is likely an area of greater regulatory flux than more traditional financial industries. There is always the possibility of regulation that could make these firms less profitable or even shut them down. However the firms dominating this industry are now large enough and generating enough value for financial markets that a regulator's job would not be complete without considerable consultation with the incumbent firms. Generally unless a firm is doing something that is not generating utility for markets, any additional regulations will add additional costs to ensure greater safety, which can be better borne by incumbent firms who can spread out the cost of these regulations across more revenue than small start ups. This makes it more difficult for start ups to disrupt the industry making incumbent firms moat wider.

Conclusion

Flow Traders is currently trading around record lows, with a low earnings multiple and lower financial market volatility holdings earnings down. I have argued above that such a business that is antifragile and provides its investors with more money when volatility is high should trade at a premium to its volatility adjusted earnings. So now it's possible to buy portfolio insurance that will add an element of antifragility to my portfolio at historically cheap rates.

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I hold a position in Vonovia.

Vonovia is one of the largest real estate companies in Europe, currently trading at a significant discount to its net asset value. In addition to owning real estate, its scale gives it a significant competitive advantage in the highly regulated German and larger European apartment market. There are some risks associated with this, but these are being managed by the business and already working.

Reason For Investment

According to Vonovia’s 2022 annual report the current value of Vonovia’s net tangible assets are 57.48 Euros per share. However Vonovia’s current price per share is 24.50 per share. Since August 2021 Vonovia’s share price has fallen from a high of 60 Euros in August 2021 to 24.5 more recently. Investing in a company simply based on it trading at a discount to its net tangible assets isn’t always wise, as many factors can lead to such assets not getting a decent rate of return or the value of the assets being overstated. However in the case of Vonovia it’s assets do generate significant amounts of cash and have been shown in relatively recent public transactions to be at least close to the stated values

What Vonovia Does

In Vonovia’s own words: 

“Vonovia’s business model is based on the rental of good-quality, modern and, most importantly, affordable living space, the development and construction of new apartments, both for its own portfolio and sale to third parties, and the provision of housing related services. These housing-related services mainly relate to cable TV, automated meter reading and senior-friendly apartment modernization. This is supported by our caretakers and by our established craftsmen’s residential environment organizations.”

So Vonovia gets most of its revenue from owning and renting apartments, but also makes some money constructing apartments and performing property management services for others. It is based in Bochum, North Rhine-Westphalia Germany and as of its 2022 annual report manages 621,303 apartments mostly across Germany but also in Austria and Sweden, making it the largest owner of apartments in Europe. 

Vonovia started with a privatization of rail worker housing in the 90’s and has since grown through mergers and acquisitions. It went public in 2013 and is today a member of the DAX40 and STOXX European 600. 

Competitive advantages

Due to the size of Vonovia’s portfolio and its work over the years to increasingly concentrate its portfolio in particular areas of Germany and standardize those apartments it has managed to lower the cost of apartment maintenance significantly. 

Leading to higher operating margins and the ability to maintain apartments across Germany at a much lower cost than others. 

In addition to this Vonovia’s scale allows it to add value to its apartments in ways in which other smaller owners of apartments cannot.  Vonovia is able to conduct research with its Energy Centre of the Future to test out various ways to improve the energy efficiency of its apartments. It can also make investments in the communities of its buildings into parks and other community projects due to controlling multiple buildings that can add value that owners of individual apartments cannot. 

Finally as will later be discussed the German rental market is highly regulated and generally speaking in environments with high levels of regulation larger organizations are better able to analyze and meet the regulations in a more efficient way than much smaller entities. They can spread out the cost of complying with higher regulation across more apartments. 

German Apartment Rental Industry

Renting is a lot more common in Germany than other countries with approximately 54% of German households renting their homes.  This is one of the lowest rates of home ownership in Europe and can be attributed to greater tenant rights and regulations.

This can be seen in rental regulations. Since the 1970’s Germany has had a system rental regulation known as ‘Mietspiegel’ where rental increases are pegged to a reference rent for similar quality local dwellings, established at regular intervals. 

In 2015 an additional law was passed allowing states to further moderate rents for new leases in cities or municipalities to ensure rents can only rise up to 10% above local comparisons. As a result historically the rents have followed inflation but at a delay.

Since the 2008-2009 period the number of new constructions in Germany has gone down and more recently there has been a persistent gap between government housing targets and actual completions. This has been attributed to a shortage of skilled labour, complexities of the building code and high land prices. 

Two other large German residential landlords are: Deutsche Wohnen, which operates in many similar markets to Vonovia and LEG Immobilien who largely operates in North Rhine-Westphalia. 

Historic Income

Historically Vonovia has had very stable income from rents. Although Vonovia has done a great job historically of providing high quality accommodation to its tenants. The stability of income can also be attributed to the rental regulation. When rents are held below the price of rent the market would otherwise achieve there are less rental properties and more demand for rental properties than can be supplied.

 In addition rents don’t fall as much during recessions because they don’t go up as much during boom times. 

Despite regulations, Funds From Operation (FFO) per share (a better metric than profit for real estate companies) over the past 10 years have increased by about 11% per annum. Dividends per share were also quite stable until 2022 when Vonovia had to cut them due to debt issues brought about by higher interest rates (discussed later under balance sheet). But this cut has been called a temporary measure by management to deal with the initial shock of higher interest rates. Vonovia has a long term objective of 70% of group FFO to shareholders as dividends. 

Balance Sheet

Vonovia carries an investment grade credit rating from S&P of BBB+ with a stable outlook. This means S&P believe it has adequate margin to meet its financial commitments. As of 30th of June 2023 it has a net debt of 43,179 million Euros of Debt at a very low average rate of 1.5%. But over the next several years as the debt matures it will either need to be paid off or rolled over at a much higher interest rate. 

Vonovia intends to pay off a significant amount of the debt over the next few years rather than renewing it at higher interest rates. 

Vonovia estimates it will generate about 2 billion Euros of cash annually before any asset disposals or dividend changes. In addition by reducing the dividend they will generate an additional 500 million Euros of cash annually. Finally they also plan and have made some progress of making additional asset disposals of 2 billion Euros this covering their future debt maturities in 2023 and 2024.

On the asset disposal front Vonovia has so far made two major asset disposals this year to Apollo and CBRE. The 1 billion Euro sale to Apollo took place at a rate that was only 5% below book value as at the end of Dec 2022. This disposal is within our margin of safety reported at the beginning of the article for Vonovia’s net asset value per share. 

Management Team

There are 5 executives on the management board at Vonovia they include:

• Rolf Buch - the Chief Executive Officer (CEO), who has been with Vonovia since 2013

• Arnd Fittkau - The Chief Rental Officer (CRO), who has been with Vonovia since 2002. The CRO is responsible for the property management business.

• Philip Grosse - The Chief Financial Officer (CFO), who has been with Vonovia since 2022

• Ruth Werhahn - The Chief Human Resources Officer (CHRO), who has been with the company since 2023

Over the past few years at Vonovia there have been quite a lot of insiders buying much of it at much higher prices than we have today, by multiple members of the management board. The last insider purchase was 5,500 shares by Philip Grosse the CFO on the 8th of May at 18.29.  Over the course of 2022 management bought the largest number of shares in my records buying just under 1 million stocks for just over 30 million dollars at an average price of $30.76. In 2023 there has been much less buying despite the lower prices, maybe most of the executive maxed out their holdings in 2023.

Valuation

Vonovia looks very cheap on a number of different metrics. 

On the 3rd of November 2023 it was trading at 24.5 Euros per share and according to their 2022 annual report it made 2.56 Euros per share in Funds From Operations (FFO) putting Vonovia at a P/FFO of 9.57 times. Historically they have traded for nearly twice this on average.

Another way of valuing a real estate company is looking at the total value of the real estate per share and what that real estate would actually be worth. According to Vonovia’s 2022 annual report the current value of Vonovia’s net tangible assets are 57.48 Euros per share. This puts Vonovia’s current share price at a 64% discount to the value of its current assets. Historically Vonovia has traded at a premium to book value ranging from 10%-50%.

This discount to net tangible assets seems very promising, however it is based on how realistic Vonovia’s estimates of its assets actually are and the returns it can get on these assets. Vonovia’s apartments have a total living area 29,989,860 square meters and its estimate of the value of all these apartments is 88,242.8 million Euros, which puts a value on each square meter of living space at 2,942 Euros. This is reasonable levels when compared to market values in some of Vonovia’s main cities. With costs of inflation and other factors it may soon even be below replacement cost.

Finally as another check on the reasonableness of Vonovia’s valuations on its books you have its recent transaction with Apollo. Apollo is a private equity firm and likely isn’t paying prices significantly above market values when it buys real estate. It bought 1 billion Euro share on some of Vonovia's real estate at a 5% discount to book value (well within Vonovia’s stock discount of 64%). However this wasn’t just the apartments Apollo bought a non-controlling interest which you would expect to be at some sort of discount. 

Risks

There are a number of risks Present in Vonovia’s stock today:

Political: The first risk is political. The German real estate market is highly regulated and highly political. This high level of regulation, known as ‘Mietspiegel’ ensures that on average revenues are a lot more stable across the economic cycle as rents are probably overall lower than they would otherwise be. Governments may try pushing this further by further lowering allowable rent increases or forcing sales of these properties, which has been discussed in Berlin politics. 

If rents were further restricted this likely wouldn’t be in Germany’s long term interest because as stated earlier since 2008-09 there has been a persistent gap in the number of rental dwellings Germany needs and the number being built. In addition the persistently low vacancy rates in Vonovia of 2% (1.8% in Germany) relative to other US apartment REITs indicates at current rents there is strong demand for Vonovia’s apartments.

In terms of compulsory acquisition of apartments (example article below):

https://www.theguardian.com/commentisfree/2021/sep/29/berlin-vote-landlords-referendum-corporate

Germany is a country with strong rule of law and any compulsory acquisition would need to be performed at fair market prices, which as has been determined above is at least a premium of 64% to the current value of Vonovia’s stock.

Balance Sheet

The next major risk related to Vonovia is its balance sheet which carries 43,179 million Euros of Debt. This has been discussed above. Vonovia currently has already raised enough in cash from free cash flow, asset sales and a lower dividend to repay nearly the next two years of bond maturities. This gives it additional time to build up more cash from general operations as well as further assets sales. 

Vonovia obviously doesn’t have to repay all of its debts and can renew the bonds, but given the higher interest rates these will likely be renewed at higher interest rates, making paying off a significant portion preferable. 

German Economy

There are a number of articles in the financial press about the German economy's decline over the past 12 months. According to Reuters the German economy suffered a recession from the 4th quarter of 2022 to the first quarter of 2023. Economies go through recession and the German economy has gone through a number of negatives recently from the Covid lockdowns, as well as the war in Ukraine and sanctions of Russia significantly increasing its cost of energy. 

However Germany has a large diversified economy, with a highly skilled workforce that have allowed it to adapt to change and problems in the world before and likely will again. So it may be experiencing problems at the moment but its strength means these should likely be temporary.

Summary

Vonovia stock is currently selling at a 64% discount to the conservative value of its assets. This discount leaves a considerable margin of safety for investors creating an asymmetric risk reward situation. 

There are risks associated with this investment from Vonovia’s debt load to German politics. However all of these are manageable and Vonovia has plans in place to address these that are already showing positive results.