[Commentary] Slater Recovery Fund – Annual Report for the year to 30th November 2020

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After a roller coaster ride with some wild swings and ups and downs the portfolio finished the period by delivering a solid overall double-digit gain. As our motto says: “Our ability is your stability.”


We all love a happy ending, and at the end of 2019 we received one, with a blue ribbon on the top. With the election of a large Conservative majority, the risk of a Marxist-inspired government disappeared on 12 December 2019, allowing investors to get back to their proper task of allocating capital efficiently without worrying about confiscation and capital flight.

From late February 2020 it was all change again with global stock markets experiencing extreme volatility owing to the Covid-19 pandemic. The United Kingdom (UK) Large Cap index fell over 23% between 21 February 2020 and 31 March 2020. The UK Mid Cap and AIM indexes both fell 30% over that time. At their lows during March 2020 they were down over 40%. Moves at this speed had not been seen since October 1987. The rout spread to many markets, not least crude oil, and bonds swung wildly.

Our first priority during the crisis was to focus on the survivability of our holdings. We also took the view that businesses that generated consistently good returns on capital before the crisis were likely to perform well afterwards. The uncertainties of the virus and lockdown, however, made it exceptionally hard to predict the near term, so we found it more productive to assess the situation three years into the future. It was tempting to buy heavily at that stage because everything looked ‘cheap’. However, we were careful to balance risk and reward and initially focused on adding to high conviction holdings.

The second calendar quarter saw a strong recovery in the market as the panic subsided. There was an increased level of activity during the quarter as we sought to capitalise on the turmoil with four new additions to the Fund, the topping up of 17 existing holdings and the sale of one. A further holding was the subject of a takeover. In a global context the UK market looks cheap and we expect to see acquisitions by overseas companies continuing after Covid-19 subsides.

The third calendar quarter was mixed. The major indices had a poor time, led by a 5% fall in the main UK market. The 4.5% rise in sterling against the dollar was a major headwind. Mid-cap companies were also sluggish, but growth companies performed well.

As discussed in more detail below, during the year we saw some stellar individual performances from our growth companies with a small number of the Fund’s holdings up by 100% or more, including Venture Life, up 211%, Jet2, up 143%, Ergomed, up 127%, Codemasters, up 114% and Calnex Solutions, up 100%.

During the period there were fifteen major contributors of +0.40% or more and one major detractor of -0.40% or
more.

Video game developer Codemasters was the star performer contributing +3.03% after gaining +114%. Strong trading in the 2021 half year benefitted from the launch of high-quality racing games, in particular the earliest ever release of Formula 1 (F1) 2020. Other title releases included Fast & Furious Crossroads, Project CARS 3 and its back catalogue of games, including F1 2019 and DiRT Rally 2.0. F1 2020 sales ‘materially overperformed versus the previous year’ and the franchise remains at the heart of the business. DIRT 5 was also released on the next generation of Xbox Series X/S and PlayStation 5 consoles. The investment case for owning Codemasters rests on the powerful tailwinds for greater games consumption, whether downloaded or streamed, plus the potential from mobile gaming. F1 is an evergreen franchise and Codemasters has become a world leading studio for racing games which has clearly caught the attention of Nasdaq-listed Take-Two Interactive Software, maker of popular video games like Grand Theft Auto. In November 2020 Take-Two offered to buy Codemasters in a part cash and shares deal. The share price of Codemasters has since risen above Take-Two’s equivalent offer and we took advantage of this to sell part of our holding, locking in some profits.

Future rose +28% and contributed +1.51%. The company’s competitive edge comes from its unique, proprietary ‘media intent’ technology platform. This enables the business to pursue the onboarding of declining magazine titles and scale their content profitably online. As demonstrated by the full year results to September 2020 this in turn helped deliver results ahead of expectations, which led to broker upgrades. The strategic rationale of converting specialist, niche magazine brands to digital remains compelling. During the reporting period, the company delivered record results ahead of expectations. Group revenue rose 53% underpinned by 23% organic revenue growth from its Media division. This in turn was fuelled by online organic audience growth of 48% and e-commerce revenue growth of 58%. These positive factors more than offset declines elsewhere. The company is turning profits into cash as evidenced by the 79% rise in adjusted free cash flow, validating the model. Post-period end in November 2020 Future made a recommended offer for the price comparison specialist GoCo. We believe that this will accelerate the company’s growth, substantially increase its addressable market, and add lucrative adjacent routes to monetisation.


Pharma services company Ergomed contributed +1.37% after it surged +127%. The company shrugged off the impact of the pandemic. First half revenues to September 2020 rose 15% and the order book grew 28% year-onyear, reflecting strong sales momentum across the business. In January 2020, the company acquired the United States (US) pharmacovigilance (PV) business of UDG for a bargain $10 million. The deal gave critical mass in the US, where regional sales rose 79%. PV sales rose 62% and now account for c. 64% of the group. Ergomed’s other division, a provider of clinical trial services with strengths in rare and orphan diseases, saw underlying service fee revenue decline 6.7%. Some delays to clinical trials were to be expected because of restricted access to hospitals. However, the company has an innovative operating model which enables patients to take part in trials at home rather than in a hospital. Ergomed has ambitions to expand clinical services, believing that previous rounds of consolidation have created a gap in the mid-market. Ergomed offers investors a high growth, high margin, lower risk way to gain exposure to the sharp increase in drug development and biotech innovation that has accelerated amidst the pandemic. The company remains well-placed to drive further gains through underlying growth and selective mergers and acquisitions (M&A).

Calnex Solutions, a high-end, niche provider of telecoms test and measurement solutions, contributed +0.95% after rising +100%. Calnex was a new buy after we participated in its IPO in October 2020. Maiden interim results to September 2020 saw revenue rise 37% and adjusted pre-tax profit up 90%. The company confirmed that it was trading well across all product lines and all geographies. These strong results prompted double digit broker upgrades to both revenues and earnings. The main factors fuelling strong demand for Calnex’s high value test equipment include the long-term transition of the telecoms industry to 5G, exponential growth in data and the migration of industries to the cloud, representing a major multi-year investment cycle. Calnex adopts a Research and Design-led approach, launching innovative, high value products, driving high gross margins of c. 80%, more akin to IT software companies. Lean manufacturing is achieved through third party outsourcing. The company has a deep understanding of the customer’s future technical requirements which fall out of the latest industry standards drawn up by regulatory bodies. As a result, customers are sticky as reflected in 83% repeat orders from the top ten. Calnex kit is vendor agnostic, working equally well with the likes of Huawei, Ericsson, Nokia or Cisco, insulating it from trade wars.

Jet2 (formerly Dart Group) contributed +0.75% after rising +143%, a stellar performance given how hard Covid-19 hit the airlines. Investors are looking ‘beyond the chasm’ to the ‘new normal’. Jet2 takes a conservative approach to its balance sheet. In its half-year report to September 2020, its cash position, excluding customer deposits, stood at £652.5 million, an increase of 25% since 31 March 2020. This balance included the proceeds from a £172 million equity placing in May 2020, in which the Slater Recovery Fund participated, plus the sale of its non-core distribution and logistics business. The company has modelled a downside scenario with an 80% reduction to winter 2020/21 flying, followed by a 40% reduction for summer 2021 and concluded that it would have sufficient resources for 12 months. Finances have been bolstered also to seize on any opportunities created within the industry by the weakness of rivals, as evidenced by Jet2’s recent Bristol Airport expansion. Whilst the company welcomes recent positive news on the vaccine front, it continues to take a cautious approach to summer 2021. Current seat capacity is close to summer 2019 levels and on sale to all its popular leisure destinations. The rollout of the vaccine could be a gamechanger.

Consumer self-care product specialist Venture Life contributed +0.69% after rising +211%. The explosive share price performance was mainly down to two key factors. Firstly, in interims to June 2020 revenues rocketed 80% to £16.9 million. In what was a stellar financial performance, a whopping 65% of the growth was organic. Secondly, Venture signed a stunning new 15-year exclusive distribution agreement with its oral care distribution partner in China, with minimum purchase obligations of €168 million over 15 years. This resulted in raised guidance and broker upgrades. Venture Life is not resting on its laurels. In November 2020, the company raised c. £36 million by way of a placing and open offer in which we participated. The proceeds will be used primarily to pursue additional bolt-on acquisitions as the company continues to pursue its ambitious growth strategy. Potential identified targets include the rights to a portfolio of oncological support therapies where there are vertical gains in margin from taking production in-house, a heritage brand trading in the UK and EU within oral care and a well-known, widely marketed UK dermatological brand. The company is still at an early stage of development, so we expect plenty more upside from here.

Gamesys contributed +0.67% after rising +57%. The third quarter to September 2020 saw a continuation of the trends seen in the first half with pro-forma revenues post the merger between Gamesys and Jackpot Joy up by 31% to £190  million. This was ahead of management of expectations. Revenues in Asia increased by a high double-digits percentage. Japan has emerged as its second biggest market, helped by the launch of Intercasino, a second brand. Spain continued to make good progress in the third quarter of 2020, with ‘Monopoly Casino’ proving to be one of the most successful new brand initiatives in the history of the company. The US maintained good momentum with healthy double-digit top line growth albeit operations there are currently tiny, mainly because liberalisation is being led by sports betting. Online gaming will follow state by state and the company is currently partnered with Caesar’s Palace. The company has made a good start to fourth quarter to December 2020. Net debt is expected to close the year at little over £300 million and be well below £100 million by December 2022. Deleveraging continues apace. Gamesys is a formidable cash machine which should support a progressive dividend policy and potential share buybacks.

Website domain services specialist CentralNic contributed +0.64% after rising +55%. Despite the Covid-19 crisis, after adjusting for a spate of acquisitions, the company reported healthy pro-forma revenue growth of 17% in the nine months to September 2020. The domain registration business, which accounts for over half of revenues, occupies an attractive, growing space. Domain renewal generates a predictable stream of earnings, which is highly cash generative as customers pay for renewals in advance. There is a further opportunity to upsell domain-related internet services like hosting, email and cybersecurity, a market which is five times the size of domain registration itself. CentralNic’s most recent acquisition, the $36 million purchase of Codewise, has bolstered its domain monetisation business, which now accounts for c. 43% of sales. The deal offers significant opportunities for advertisers to optimise returns bypassing Google and offers more cross-selling opportunities. We do not believe recent transformational acquisitions are fully reflected in consensus forecasts which put the shares on c. 13x earnings for next year. The industry gorilla, GoDaddy, by contrast, is on a stratospheric rating. The differential in valuation looks unwarranted.

Liontrust Asset Management contributed +0.59% after rising +40%. Over the last few years, the company has been a well-oiled machine consistently amassing assets under management (AuM). In deal terms, the highlight of the half year was the £75 million purchase from AXA of Architas, the UK multi-manager. The acquisition completed on 30 October 2020 bringing with it £5.6 billion of AuM. When added to existing AuM, up 28% since the start of the financial year, this increased AuM to £28.1 billion. We decided not to take part in the accompanying £66 million fundraising for Architas as we already have a substantial holding, though we remain enthusiastic in the medium term. Liontrust has been a great performer and has made smart purchases. The best was the £33 million acquisition of Alliance Trust in December 2016, which brought in £2.3 billion of AuM. This has since swelled to £7.5 billion as investors flock towards sustainability. Fund management is a high-beta investment class and looks set to do well as confidence returns to markets. Understandably, given its growth profile and track record, the company is on a premium sector rating but not outrageously so on a 12 month forward rolling consensus price to earnings ratio of 16.5.

Marketing automation specialist dotDigital contributed +0.57%, gaining +51%. The pandemic has only had a ‘minimal impact’ on the company, in large part because 91% of its revenues are recurring. In finals to June 2020 organic revenue growth increased to 12%. International revenues grew 20% and now account for 31% of the total. Functionality revenue increased 16% to reach 36% of recurring revenues, demonstrating how the core platform is attracting a higher end, stickier customer. 23% of clients now take more than one service, for example, online chat or SMS in addition to email. The company has demonstrable pricing power with average revenue per user increasing 12% to break through the £1,000 per month barrier for the first time. The pandemic has accelerated the adoption of email and omnichannel marketing as companies seek to engage customers at every touch point along their consumer journey. High return on investment suggests that usage of marketing automation platforms is not only here to stay but likely to increase. dotDigital has a strong industry tailwind and occupies a ‘sweet spot’ with its market leading solution in a ‘hot’ sector which is seeing elevated M&A activity.

Wealth services group JTC contributed +0.52% after rising +55%. The company’s revenues are contracted for several years in advance, so this is a safe port in a storm. In interims to June 2020, trading was broadly in line with expectations as the company delivered 10% net organic revenue growth, strong cash conversion and a 41% increase in the dividend. There was a strong performance from the Private Client Services (PCS) division and substantial new business wins in the Institutional Client Services (ICS) division where momentum remains strong. The latter’s margins were adversely impacted by the underperformance of NES Financial, the technology-enabled fund administration business acquired for JTC’s long-planned entry in the domestic US market. Business in the US should recover, however, and NES also brings some slick reporting products which will be used across JTC. The outlook remains positive and the company is benefiting from structural growth trends, which have accelerated because of the pandemic. Institutional clients are turning increasingly to the outsourcing of their middle and back offices. In the private client market JTC is seeing more demand for a fund administration white label service. The company sees long-term fundamental drivers for the industry and has a pipeline of consolidation opportunities.

Energy services and building compliance specialist Sureserve contributed +0.48% after rising +73%. In a trading statement in October 2020 the company confirmed its continued strong performance, shrugging off the pandemic. It expects year-end results for 2021 to be in line with expectations following resilient growth in revenue, earnings and cash flow. Net cash of £3 million, net of VAT deferrals, beat broker forecasts for net debt of £1 million. The order book remains strong at £375 million, providing good forward visibility and supporting the outlook for the financial year to September 2021. The company is considering reinstating the dividend at the results. The company sees identifiable market opportunities to grow and is investing significantly in apprenticeship and training schemes. The positive relative strength over one year of 81% marks a return to stability after the company shed its non-core interests in construction and low-grade property maintenance. Despite the surge in the share price, Sureserve remains reasonably priced on a prospective price to earnings ratio of 10.5.

Support services specialist Marlowe contributed +0.47% after rising +29%. The company sees itself as close to recession-proof and was only modestly impacted by the pandemic reflecting the resilient nature of its UK safety and regulatory compliance end-markets. There was an 8% like-for-like decline in revenues in the first half to September 2020 because of site-access disruption predominantly in the first quarter to June. However, with acquisitions revenues rose 7%, which is viewed by the company as a normal rate of organic growth. The company has since seen a strong start to the second half and its revenue run-rate has risen materially to £225 million of which 83% is recurring giving good visibility of revenues. Marlowe continues to consolidate its fragmented sector with its ‘buy and build’ strategy. The acquisition of Elogbooks, a leading provider of contractor management software, created a ‘one-stop shop’ service, differentiating it from the competition. Its most recent transformational acquisition of Ellis Whittam provides a new platform for the fast-growing SME compliance market. Whilst there is an undeniable element of financial engineering, the company has a clear strategy delivering synergies and scale as evidenced by the capture of higher margins. The company sees favourable structural trends.

Cybersecurity specialist Kape Technologies contributed +0.43% after rising +26%. In the third quarter to September 2020 the company reported trading at the upper end of management’s expectations. User growth in the Privacy division continued to ramp up reaching an annual run rate of 14%. This is welcome news following the planned slowdown in user acquisition promotional activities over the summer, as Kape focused on the integration of the transformational acquisition of PIA which is expected to be completed at the end of 2020. Kape experienced continued strong user retention, which in turn reduces the cost of customer acquisition, enhancing the bottom line. We participated in an oversubscribed equity placing to raise $115 million at 150 pence to eliminate ex-PIA founder shares and pay down debt. This leaves Kape with c. $17 million net cash on the balance sheet, which together with borrowing headroom, gives them the firepower to do a further material acquisition as it continues to consolidate the fast-growing cybersecurity market. In addition to M&A, management has ambitious organic growth aspirations and confirmed to us that their target for growing subscriber numbers is 20% per annum.


The other major contributor (+0.55%) was Hutchison China MediTech.

Major Detractor

Covid-19 has hit the aviation industry hard, adversely impacting aircraft leasing specialist Avation which fell – 49% and detracted by -0.54%. The share has recovered from its lows amidst positive news on the vaccine front. The most immediate and pressing problem for the company is bond redemption. Avation is hoping to sign an extension on almost $343 million worth of 6.5% bonds which are due for redemption in 2021. The company has eight planes from its fleet of 48 out of lease. This includes seven returned from Virgin Australia, which called in administrators. Virgin, however, only accounted for 6% of future contracted rents when it collapsed. 14 out of 18 airlines have agreed deferrals in exchange for lease extensions, which will draw on the company’s $114.6 million cash pile. Given a fair wind, recovery within two years seems feasible, given Avation’s big exposure to the regional market which is recovering faster than international and long-haul. The return to service of certain regional customers representing c. 60% of Avation’s future unearned contracted leasing revenue helps bridge the gap.

Purchases and Sales

The Fund sold its positions in Bonhill, Frasers, Ocean Wilson, River & Mercantile and Smartspace Software. Aggregated Micro Power, Amerisur Resources, Castleton Technology and Entertainment One were the subject of successful takeover bids.

The Fund’s positions in Codemasters and Future were both added to and trimmed during the period.

Sales proceeds were reinvested in a range of existing holdings. These were: AFH Financial, Alliance Pharma, Arrow Global, CentralNic, Clinigen, Flowtech Fluidpower, Franchise Brands, Gamesys, GoCo, Hutchison China MediTech (ADRs), Instem, Iomart, IWG, Kape Technologies, Kin & Carta, Marlowe, NCC, Next Fifteen Communications, Randall & Quilter, Redcentric, Restore, SigmaRoc, SimplyBiz, STV, Sureserve, Ten Entertainment, Tesco, Trifast and Venture Life.

A number of new holdings were also established. These included: Breedon, Calnex Solutions, Countryside Properties, Elixirr International, Fonix Mobile, Hollywood Bowl, i3 Energy, Inspired Energy, Jet2 (formerly Dart Group), Loungers, MJ Gleeson, Prudential, Rank, Renew and Scapa.

Outlook

Equity markets continue to climb a wall of worry. Alternative, non-productive assets, such as cash in the bank, increasingly offer a negative return and incur opportunity cost. There are no returns without risk. However, we believe that good opportunities remain with which to make meaningful returns from UK equities in this environment whilst maintaining a margin of safety.