BHP's divestment of its non-core metallurgical coal assets in the Blackwater and Daunia mines has captured the market's attention, as the process ostensibly draws to a conclusion.
The rationale behind the divestment is sound given the asset-specific challenges as well as the broader industry headwinds for the metallurgical coal markets are anticipated to experience as a whole. This poses an interesting conundrum for potential bidders, with the evident risks counterbalanced by the potential upside as a result of sudden, unexpected externalities that could affect market supply; as we saw in thermal coal markets following the Russian invasion of Ukraine.
TailwindsThe metallurgical markets are experiencing headwinds with steel demand softening as a result of diminishing and more focused monetary and fiscal stimulus on a global basis. Governments are no longer investing as aggressively into 'nation building' infrastructure projects as we have seen over the past 3 years; instead taking a more focused approach with an emphasis on encouraging uptake of renewals as best evidenced by the Inflation Reduction Act in the US. It is likely that steel production will gradually transition over time towards the greater adoption of 'coal-free' steel production technologies such as Electric Arc Furnaces (EAF) over the present conventional Blast Furnaces.

Meanwhile, China which produces and consumes the lion's share of steel, and by proxy metallurgical coal; is experiencing a rapidly cooling housing market. Despite strong government incentives to lend into the housing market, our analysis concludes that there has been a considerable fall in consumer appetite for housing as an investment class as well as a reduction in bank appetite to lend for investment in housing as an asset class. We anticipate that this in turn will lead to a fall in new starts, potentially further softening steel demand.
Post-Covid, government intervention over immovable assets, such as natural resources, has been increasing. A large proportion of global metallurgical coal production is produced in Queensland, and the state government's enormous rise in royalties against election promises represents an unquantifiable risk going forward; so much so, that the Japanese government has disclosed they do not view Queensland as an investable jurisdiction.
The rise in Queensland's royalty rate has lifted the cost curve for these producers with industry experts expecting the 90th percentile cost curve for premium coking coal to be circa AUD$250/t on an all-in basis. We anticipate that this will depress the returns of mines that are able to produce lower-quality metallurgical coals such as semi-soft coking and PCI coals.
Portfolio assessmentBlackwater and Daunia are the lowest-quality metallurgical coal assets within the BHP portfolio; producing a blend of lower-quality coking coal products that are sold at a discount to the premium PLV coal index. The sale of these assets will vastly improve BHP's residual portfolio of metallurgical coal assets, and we believe would be an enormous value accretive process, over and above the notional sale value.
Blackwater is a longer-life asset with a highly automated, high-cost profile making it a difficult operational proposition for any potential acquirer. Daunia is a difficult deposit geologically and has the additional challenge of a relatively short mine life.
BHP's desire to sell these assets does not negative the strategic value of these assets. From media accounts, the sale process has been hotly contested to date; with a range of ASX-listed companies and foreign entities reportedly expressing strong interest. This is to be expected given the deficit of investable, producing metallurgical coal assets available for sale. However, bidders do have challenges in terms of putting together an acceptable offer given the limited appetite for bank financing in the sector as well as the present, very modest valuation of listed coal players.
For instance, a listed player who is trading at 2-3x trailing cashflows would be hard-pressed to acquire these assets for more than their present valuation multiple; given it would be a value-destructive exercise for their existing shareholders.
This is coupled with the fact that BHP, as a good corporate citizen, would likely want these assets in the hands of a responsible steward with a demonstrable track record; as well as alleviating concerns of future potential liabilities. This diminishes the pool of potential buyers considerably, not taking into consideration the opinions of the 3 levels of government that overlay these assets.
ESG
BHP as one of the pre-eminent mining company exposures globally, has a strong mandate to enact ESG best practices. These assets, by their very nature in terms of the products produced, are at odds with this objective.
We consider more onerous enactment of ESG factors to be a material negative externality and risk going forward for mining companies. It is impractical for any acquirer to ignore this potential existential risk, and that accordingly will be factored into any transaction price by a bidder.
Ultimately, BHP is fighting with RIO for investor dollars and is underachieving in terms of relative valuation. Much of this can be explained by the very proactive fashion in which RIO has aligned itself to investing in future-facing metals such as lithium. BHP whilst making this transition, has opted for more pedestrian and conventional exposures to copper and nickel; whilst holding onto lower quality, non-Tier 1 assets.
Accordingly, it's important for BHP to view the situation holistically. In our opinion, the majority of the value to be extracted will be from the improved perception of BHP and the consequent value re-rate, rather than the headline price for these assets.

For instance, a 1% fluctuation in the market price for BHP represents a move in market valuation >AUD$2 billion. A clean divestment of these assets is likely to drive quick and material value accretion via a re-rate of BHP's stock price.

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author may hold shares in companies discussed.

In August, Perpetual ('PPT') and Pendal('PDL') entering into a Scheme Implementation Deed in which PPT would offer PDL shareholders 1 PPT share for every 7.5 PDL shares held plus a fixed consideration of $1.976. At the time of the offer this represented an implied 46% premium to PDL's 'undisturbed' share price.
 
Ostensibly, the rationale behind this transaction was to provide a combined platform that would be greater than the sum of parts. At the time of the merger, PDL's assets under management (AUM) exceeded PPT's AUM by ~22%. Accordingly, to 'equalise' this AUM bridge; a fixed cash consideration to the value of around $760 million was to be paid to PDL shareholders as part of the transaction.

The cash component is expected to be funded via a debt facility that would encumber the merged entity; with PDL holding 47% of the merged entity whilst existing PPT shareholders holding a mere 53% post transaction. The proposed transaction was unpopular with investors; PPT's stock declined from a price of ~$30 a share to a low of ~$23 a share.
 
Markets have shifted materially since the announcement of this transaction, with the majority of major fund platforms experiencing strong outflows. PDL itself has experienced outflows of ~10% of AUM relative to PPT which has experienced outflows of only ~1% of AUM. In retrospect, the basis upon which the fixed consideration was agreed appears to be flimsy and non-commercial in practice.
 
In early November, Regal Funds in conjunction with global private equity firm, EQT, recognising the enormous latent value embedded within PPT's corporate trust business; disclosed a competing, superior albeit non-binding offer of $30 a share.
This offer was rejected along with a revised offer of $33 a share. In addition, PPT disclosed that other competing proposals have been received.
 
We urge the board of Perpetual to fulfill their fiduciary and statutory duties to it's shareholders. It is evident that the proposed PPT/PDL transaction is deeply detrimental to PPT shareholders relative to the alternative proposals put forth by Regal and others. 

Indeed, it was speculated as recently as July, that PPT had received an approach worth a potential $1.3 billion for its corporate trust business - with the company consequently confirming two separate unsolicited approaches for this business.

This is highly material given that prior to Regal's proposal, PPT's market capitalisation had dropped to a mere $1.4 billion.
 
The proposed PPT/PDL merger will destroy the embedded, latent value within the existing PPT business and we urge the board to consider and disclose further alternative proposals to the broader market.

Whilst a break fee of $23 million may be applicable in the case of the PPT/PDL transaction not proceeding; it is a small price to pay relative to the potential value destruction from pursuing a non-commercial agreement for Perpetual shareholders.



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Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in Perpetual Limited (PPT).

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. Datt Capital writes this as a disinterested party and holds no exposure to the companies discussed.
 
Humm Group ('HUM') is a diversified Australian financial company listed on the ASX. Previously known as Flexigroup, it is a company that we have invested in the past. Founded by its major shareholder, Andrew Abercrombie ('AA'), as a leasing business, the company has undergone a range of acquisitions, divestments, and restructuring throughout its lifetime as a listed company. Many of these have occurred as a response to regulatory changes and to changes in broader market conditions.
 
Today, HUM comprises of two divisions: Hum Consumer Finance ('HCF') and its sector-leading commercial lending division. 
 
Asset Sale
HUM has signed a binding agreement to sell HCF to Latitude Group Holdings ('LFS'), another listed financial, with the consideration being primarily in LFS scrip plus a small cash payment to shareholders. This sale is subject to shareholder approval as an ordinary resolution which only requires 50% of votes to be in favour. 
 
We believe this is an attractive deal as it is essentially a merger of consumer finance businesses, in a sector that is experiencing strong headwinds and requires scale. We consider that the LFS team is well qualified to run a consumer business at a far greater scale given their professional background. Broadly, leveraged business models benefit from a greater scale which aids in optimising financing and cost structures. 
 
The basis of any financing operation is the origination of loans that fit within the business' credit criteria to maintain a minimum level of receivables upon which an interest margin can be earned. There has been considerable press around the present negative and declining consumer sentiment, a larger organisation simply has more resources to compete for newly originated receivables when the market shrinks in absolute terms then shifting the industry structure to that of a zero-sum game. 
 
BNPL was an innovation that provided largely non-recourse, small-scale instalment loans to a long tail of borrowers; for some time it held the promise of reducing the costs of origination for financiers. However, in retrospect, the growth of this business model was supercharged by the broad and perhaps overly generous fiscal and monetary stimulus throughout the covid-affected period from 2020. This dynamic has come to a screeching halt as losses from borrowers continue to mount for all participants in the space - with the discontinuance of the various stimulus programs. Ultimately, we can conclude that the creditworthiness of a portion of borrowers was enhanced by the provision of this stimulus; a position which is now unwound.
 
The impact on ASX-listed BNPL companies has been immense, with the second largest local player ZIP's share price falling around 85% when measured from the disclosure date of HUM's receipt of multiple proposals for its HCF business.
The nature of the consumer lending market and business has changed immensely over the past 6 months. The consumer finance industry has suddenly changed into a zero-sum game. The nature and structure of the BNPL sector mean it's a 'winner-take-all' market; despite an ostensibly longer-term trend towards commodification, which is validated by the fact that Apple has just entered the BNPL sector with ApplePay now providing instalment payments.
 
This dynamic appears to have been confirmed by HUM in their latest business update which states HCF has not been profitable in the 4 months till April 2022. This implies that credit losses may be higher than originally projected. Interestingly, ZIP trades at approximately 25% of its claimed net asset value. By the same measure, HUM may be worth $152 million or around 30c a share; however, this assumption is overly onerous given HUM's blend of assets and business lines. Assuming a market value of 50% of net asset value results in a rough market value of $300 million or around 60c per share (around 20% lower than HUM's share price at the time of writing); if the LFS asset sale offer was not on the table.
 
These aspects make the LFS offer look exceptionally attractive, especially given the higher relative valuation of ~13x 'cash' NPAT and 1.8x NTA. Should the transaction not be consummated - we believe the potential downside risk for HUM is considerable based on the performance of listed sector peers.
 
Offer 
LFS's offer entails a consideration that will be paid largely in LFS shares plus a smaller cash component. HUM intends on distributing this scrip and cash received via an in-specie capital return to its shareholders. Accordingly, HUM shareholders have the option to retain their stock exposure to LFS or to sell to realise the cash value of the holding.
This optionality has value as it allows HUM shareholders to participate in any potential synergies and residual benefits that the combined entity may realise in time, in a tax-efficient manner. These residual benefits could include the combined entity trading at potentially a higher value due to inclusion within stock indices and other passive vehicles like ETFs. 
This sale appears to be a rare win-win situation for both sets of LFS and HUM shareholders
 
Residual value
HUM's commercial business, which will remain, is an excellent base to consolidate within that sector given its dominance being the 2nd largest player in the ANZ region.
This business will likely experience strong positive tailwinds to new business openings post covid, inflationary pressures that increase the investment in labour-saving machines as well as anticipated high-interest rates which may increase margins over time. HUM's foundations are firmly rooted within the commercial space and it has managed to survive through periods of commercial distress that competitors have been unable to bear.
We believe that it is likely that a high quality, pure play commercial lending business is likely to trade at a higher multiple than the current blend of business divisions.
 
The approximate value to HUM shareholders at the time of writing equates to just over 57c a share versus a current HUM share price of 76c. This implies a residual value of only around $95 million for HUM's commercial business, well under its net asset value of $268 million. This value differential is likely attributable to the uncertainty that exists at the board and shareholder level.
 
Governance
The role of independent, non-executive directors on a board, is to act on behalf of all shareholders, providing important protections for minority shareholders
The HUM board is comprised of 6 directors, 2 non-independent, and the balance independent. All directors are well-credentialed, well-known, and well-qualified individuals in their own right. 
The transaction enjoys unanimous support from the entire board except for AA who is the sole dissident against the transaction at the board level.
 
Interestingly, given AA's incumbency on the board since inception, all the non-executive directors were appointed under his aegis. In particular, one director aside from AA has been a member of the board, since 2003 pre-listing. The rest of the non-executives have an average tenure of 3.5 years between them; so, prima facie, it appears that this board was functional up until the time of the LFS offer. Accordingly it’s safe to assume that the present schism is solely related to the HCF transaction itself. 
 
LFS deal was structured via a non-binding heads of agreement. This allowed a mutual due diligence period and some exclusivity subject to a fiduciary carve-out. This bought time for any competing, perhaps improved offer from another counter-party to eventuate. This agreement was In place for over 40 days before a binding agreement was reached, so it's unlikely that an alternative appropriate offer was received. In addition, we note that AA stepped down as board chair in December, which begets the question: was AA planning his own privatisation proposal for HCF, which has consequently failed to find financial backers?
 
In a nutshell, this can be viewed as the major 20% shareholder opposed to the transaction; whereas the representatives of the other 80% of shareholders are in favour of the transaction.
 
HUM has advised that there is no competing offer. Shareholders are being asked to take it upon a single board member's word, that the business is undervalued. As part of the process, an independent expert report ('IER') has been undertaken and the proposed sale of HCF has been deemed fair and reasonable in the absence of a superior offer. Notably, the IER provided a valuation range of $260-308 million before the disclosure of the headwinds being experienced by the business in the calendar year 2022. Despite this and the fall in LFS's share price, the offer remains within this valuation range presently around $275 million. One can only imagine what a new IER would look like in the present, difficult conditions being experienced by HUM and its competitors.
 
Ultimately HUM is a business that is heavily correlated to the economic cycle. After listing in 2006, HUM's share price fell over 90% from its peak in the GFC. From this GFC low, it consequently rose 20 times into 2013 in a highly favourable macro environment for financials. However, from 2013 high to the present, the company's current share price is down around 85% despite some of the most benign conditions for lenders in living memory. 

​Questions that shareholders should ask themselves:
Can HCF prosper despite adverse macro headwinds in the consumer sector?
 
Does the HCF business have the capability to originate suitable receivables with acceptable credit metrics within a more competitive market environment?
 
Is it appropriate for the company to continue to risk capital within a sector where it has no clear competitive advantage and sub-par scale?
 
Does the potential downside risk justify the potential for greater value realisation over time? Is a bird in the hand worth more than two in the bush?
 
Does the unvalidated opinion of HUM's major shareholder trump the qualified opinion of the independent valuation expert?
 
 

The battery metals boom is primarily driven by commodity demand from present and predicted electric vehicle uptake.

Whilst we don't have a strong view on the likelihood of electric vehicle penetration reaching an arbitrary threshold within a certain time frame, it is impossible to ignore the definite trend towards greater electrification in society
​
However, by focusing purely on battery metals, in many ways, some are missing the forest for the trees.

​Pure battery exposure is not without risks, given the plethora of competing battery technologies vying for dominance in a growing market. The reality is that electric vehicles require a range of associated technologies which require an assortment of materials; all of which supply is critical for the further adoption of electric vehicles.

Ultimately, investors need to ask themselves what they want to achieve and within which risk parameters?
​
At Datt Capital, we think laterally in the way to achieve our objectives in the most appropriate manner; namely, achieve the highest return at the lowest possible risk ideally in sectors that are experiencing strong tailwinds.

Accordingly, we identified three core commodities that enjoy positive demand/supply dynamics, were critical to future electrification, and by proxy have exposure to rapidly developing future technologies. These three most critical elements to the future intensification of electrification are rare earths, tin and lithium.

We focused on the ASX-listed, sector leaders in each commodity identified which led us to Lynas Rare Earths (LYC:ASX), Metals X (MLX:ASX), and Pilbara Minerals (PLS:ASX). All companies are producing profitably in the current bullish environment, as would be expected for a sector leader.

Commodities as an asset class are highly cyclical, so it is important to have select exposure to low-cost, tier 1 producers at the right price. Risk can also be mitigated by taking a diversified, portfolio approach to commodity exposures in line with an investor's risk profile.

​Value is always relative, as such, we have compared these 3 sector leaders using some high-level, key factors namely:
Enterprise value (EV)
Net profit before tax (NPBT)
Return on fixed assets
fixed asset values
Project ownership
Estimated mine life
EV/NPBT multiple

The table above is derived from the latest half-year figures reported by all the companies.
 
This exercise ultimately identified that Metals X (MLX:ASX), despite enjoying superior business and industry fundamentals, is materially undervalued against its peer group of market-leading battery metals companies.

This value divergence between Metals X and its peer group is exceptionally puzzling, given that tin is the metal most affected by the adoption of new technologies, across the board.

Accordingly, we consider that Metals X is undervalued by some measure; trading at only a 6x EV/NPBT multiple relative to its comparables both trading at over 50x EV/NPBT multiples.

It is important to note that commodity spot prices for all 3 companies have strengthened considerably from the new calendar year, and all three are likely to continue to enjoy superb business returns in present market conditions.

We have previously examined the large supply constraints evident in the tin industry in a previous article that can be found via this link: https://bit.ly/Datt-MLX21
 

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in all companies discussed

Disclaimer: This is a high level conceptual exercise and all figures are approximations using the CY2020 accounts.


In early 2010, Berkshire Hathaway finalised the acquisition of BNSF (Burlington Northern Santa Fe), the largest US based railroad for the consideration of $26 billion for the stock it did not already own. This equated to a total deal value of $34 billion.

The consideration of $26 billion was paid with ~$16 billion in cash and the balance in Berkshire stock; with around $8 billion in debt drawn to partial fund the cash consideration. Broadly, this structure was in line with Berkshire's target leverage of around 30% against assets.

Berkshire's operandi modus is to let competent management teams run their businesses but enforcing strict capital discipline with a strong focus on cash generation to the parent company. Optimal capital allocation decisions result in a large advantage over time, which Berkshire personifies in many ways. 

Without digging too deeply into the operational performance since acquisition, it is clear that Berkshire purchased BNSF at a cyclical low with extraordinary timing; just as the post-GFC recovery was gaining momentum. The growth in top-line revenue has been anemic, with a rise of only around 25% over the 10 year period since acquisition. However, cost control, capital allocation and market conditions have been sound and allowed Berkshire to harvest outsized returns from the investment.

Since acquisition, Berkshire has invested $41 billion in capital expenditure offset by depreciation of $20 billion. This implies that BNSF may have been either 1) under-investing in capital items prior to Berkshire's acquisition or; 2) Berkshire have invested heavily in capital items due to a strategic rationale. 

The latest Berkshire shareholder letter provides some clues: "Railroading is an outdoor sport, featuring mile-long trains obliged to reliably operate in both extreme cold and heat, as they all the while encounter every form of terrain from deserts to mountains. Massive flooding periodically occurs. BNSF owns 23,000 miles of track, spread throughout 28 states, and must spend whatever it takes to maximize safety and service throughout its vast system."

Whilst depreciation is a relatively stable portion of fixed assets; year-to-year capital expenditures can fluctuate more broadly depending on capital allocation decisions and any externalities that may impact the operations. In addition, given the relatively long-life nature of heavy fixed railway assets and the inexorable push of inflation over time; this effectively means that a dollar spent today, could mean over a dollar saved tomorrow in aggregate holistic costs.
Accordingly, we anticipate that BNSF will require a relatively lower capital requirement going forward, probably a figure closer to BNSF's depreciation and amortization expenses.

Incidently, this aggressive capital investment program has come about despite almost $42 billion in dividends paid to Berkshire over this time period. No doubt that a reasonable portion of this has come from levering up the balance sheet against new fixed assets against which Berkshire has greater certainty around their effective life. None-withstanding, this is a fantastic result against Berkshire's cost base of ~$30 billion. 

The largest component of value attributable to BNSF is the terminal value. The company's claimed equity value on its books is around $65 billion which looks to be under-valued on a standalone basis. For instance, BNSF's competitor, Union Pacific Corporation (UNP), is valued at around $154 billion at a capitalised dividend yield of approx 1.8%. 

I cannot say whether UNP has invested the minimum requisite capital expenditure necessary to keep its operations running smoothly, but I can say that BNSF's heavy capital investments provides it a good degree of certainty around its future capital requirements; so it's appropriate to use UNP's dividend yield as a basis for our standalone terminal value. 

For CY2020, a $5.8 billion dividend was paid by BNSF to Berkshire; we expect this to grow over time largely dependent on the sustaining capital requirements. Capitalising this dividend at a yield of 1.8%, provides us with a terminal value of $322 billion. If we are even more conservative and decide to use a 3% capitalisation figure, this provides us with a terminal value of around $193 billion. Both figures are vastly higher that BNSF's claimed book value of $65 billion.

Berkshire's overall return on BNSF has been over 28% per annum in our upper case and almost 23% in our lower case. It's actual return on equity is significantly higher; circa 32% and 27% in upper and lower cases.

These are extraordinary returns considering the size of the investment and truly demonstrate why the Berkshire team are considered the world's pre-eminent living investors.




Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds no exposure to the stock discussed

We did it! In August 2021 we achieved our 3-year mark for the Datt Capital Absolute Return Fund, which we consider to be a key stepping stone for the Fund.

​We began the Fund with a number of factors against us: we were fund management industry outsiders from non-conventional backgrounds who invested in assets typically outside the mandate of conventional equity fund managers. Despite these challenges, we have always had an initial 5-year plan in mind to develop a sustainable, high performing boutique funds management business. At the 3-year mark, we are well positioned to deliver on this original objective. I thank all our investors, staff and service providers for their faith and understanding despite the occasional hiccups all businesses sometimes experience.

In early February this year, we wrote a piece on Livewire asking why the market was valuing Dusk Group (ASX: DSK) so cheaply? The company had a less than spectacular debut in late 2020 and subsequently has flown under the radar of many investors. But since listing, Dusk has delivered three consecutive earnings upgrades, with the share price rising around 35% since we published our original article. 

As part of Livewire’s reporting season coverage, I have addressed some questions about Dusk’s latest results and explain why we still believe the shares remain attractively priced.  

1. Briefly explain what the company does and why you’re attracted to it (at a high level).

Dusk Group is a specialist retailer operating solely within the Australian market. While known mostly for its scented candles,  the company's range also includes diffusers, essential oils and other fragrance-related homewares. 

Historically, niche homeware retail segments have been largely a cottage industry with a long tail of small boutique merchants fulfilling demand. Dusk is the largest player in the local market, holding around 22% market share, while running only around 122 physical stores in Australia. The company foresee the potential to grow to around 160 stores throughout Australasia by 2024 and also plans to eventually expand into the UK and US markets.

Dusk has a combination of soft and hard factors that make it an attractive investment proposition. The products are orientated towards making homes and offices pleasant environments, which has become exceptionally important given the recent lockdowns. In addition, the majority of the company's products are consumables or products that use consumables. This means that every sale in the present has a high probability of further follow on sales in the future, assuming the buyer remains engaged with the product itself. This confers an enormous advantage over time vs other retail niches.

This "soft factor" advantage translates into hard benefits; for example, the company's loyalty program now boasts almost 700,000 highly engaged members. This translates into exceptional gross margins of almost 70%, while the team has maintained and exercised exceptional capital discipline and allocation decisions. We expect this outperformance to persist over time.

2. How did the current result compare to your expectations? What about market/analyst expectations?

Dusk is a recent listing, only being listed for less than 12 months. In that short period, there have been three consecutive earnings upgrades - something quite unusual. Accordingly, Dusk has outperformed its prospectus projections by a large percentage.

3. Were there any surprises in the result or management’s commentary?

Like all retailers, the first seven weeks of FY22 trade has been impacted by the Victorian and NSW lockdowns. Around half the company's store network is within these two states, but it has only affected top-line revenue by 28%. This relative outperformance demonstrates that the company's products are actively sought by its loyal customers, despite the state lockdowns. This also affirms that Dusk's products are differentiated enough versus competitors for customers to actively seek them out. This is confirmed by the statistic that 60% of the group's revenue by value is derived from Dusk rewards members

4. What do you think is the most important thing for investors to know about this company?

There is significant potential for Dusk to expand overseas. The management team is very disciplined in allocating capital and is taking a careful, prudent approach given the uncertainties around COVID and international travel. However, we expect that once the present situation normalises, the company will commence its international expansion.

5. What’s your outlook for the company?

While like-for-like growth sales are down slightly, we anticipate that Dusk may be able to achieve at least 80% of FY21's revenue, while maintaining an EBIT above $30 million. This assumes that social restrictions are loosened in Victoria and NSW prior to the Christmas shopping period, as well as being open during the key Mother's Day trading period. The company has also disclosed that "reopening" events generally have a large positive impact on physical stores' trading.

The company’s initial foray into New Zealand has been delayed by covid induced travel restrictions, and we believe there is significant scope and potential to begin examining larger international markets such as the UK and US for near-term expansion, despite the delays being experienced within the ANZ region.

6. Do you still think the company looks attractive following the result (and the price response)? Why or why not?

We believe that Dusk looks highly attractive at the current valuation.
The company has a number of highly attractive factors that are conducive to future returns.
These are: 

- Zero leverage, 
- High margins and cash generation,
- Global expansion potential,
- Broader tailwinds for their specific sector, and 
- An aligned and disciplined management team.


The company looks highly undervalued when you examine its valuation on a peer comparison basis. 
​
Additionally, it has paid a gross yield (including franking credits) of around 11% over the past financial year, based on today’s price. We expect the company to continue to pay a sustainable, reliable dividend stream in the coming years, while holding significant upside potential from further expansion in its activities.

We consider the fair value for Dusk to be around $5 a share, considering all the factors mentioned above. In a nutshell, we consider Dusk to be a Growth company that's priced as a Value stock.

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in Dusk Group (DSK:ASX).

​Long-term portfolio holding, Adriatic Metals, recently delivered their Definitive Feasibility Study (DFS) over the flagship Vares Project which is the final study prior to a Final Investment Decision (FID).

The DFS demonstrated the following key project metrics:

• a 10-year mine life - reduced by 4 years by cutting out more marginal resources

 • an increase in project NPV8 to US$1.062 Billion at an IRR of 134% 

• Reduced project capex of US$168 million and a payback period of 8 months

• an NPV8/Capex ratio of 6.3x - this is a measure of capital efficiency and it is the highest we've ever seen from a greenfield mining operation

• a reduction of costs to US$7.3/oz of AgEq (silver equivalent) on an AISC (all-in-sustaining cost) basis - this is a 1st decile (bottom 10%) cost result relative to Adriatic's peer group

• 15 Moz of AgEq/year production with commodity revenue streams by value being silver dominant, followed by zinc, lead and gold

The study reaffirmed the world class nature of the project with a high level of confidence. Unusually, the company has managed a trifecta in terms of improving the economic outcomes of each sequential study; generally we see the opposite.
The changes that drove the most recent outcomes are:

• the removal of a lower quality deposit and lower value commodities such as barite which also had the benefit of reducing the number of concentrates produced to only 2 from 4 previously

• the vastly simplification of the project's processing flowsheet as a result of this decision which in turn reduces delivery risk

• Higher base metal prices relative to the PFS

• A modified mining sequence that prioritises mining the higher grade ore at an early stage from the core Rupice deposit

Importantly, the DFS demonstrates a robust project in any price environment. For instance, a 20% fall in metal prices would reduce the project IRR to ~100%; still a world class result by any metric.

The Vares Project is extremely important to Bosnia and Herzegovina, and will comprise over 30% of the nation's direct foreign investment over a 10 year period as measured since 2014; as well as being the nation's single largest exporter over the project's first 5 years. The project will also employ 350 staff with a strong commitment made towards workplace diversity - 30% of the present workforce are female. The company enjoy exceptional government and community support, legacy of a strong social licence-built up over years.

An exceptional gesture by the company was the formation of the Adriatic Foundation. This is a charitable trust that is focused on improving local community outcomes in 3 key areas: education, environmental protection & healthcare. The Adriatic Foundation will receive an ongoing share of project profits and was generously seeded by the founders and directors of Adriatic. 

Adriatic's strong ESG credentials have been recognised by the European Bank for Reconstruction and Development (EBRD) who have taken an equity stake in the company itself. This is an extremely strong point of validation, as the EBRD only participates in companies that demonstrate exceptional commitment towards best in class ESG principles.

A number of important catalysts are on the horizon for the company. These are:

• offtake agreements for the produced concentrate. We expect these to be agreed imminently.

• final environmental permits for the project, we expect these to be granted in the next month or so

• a project financing package for construction, we expect this will be delivered next month hi

• the commencement of construction, the company plan to break ground in October

Adriatic hold other promising assets aside from the Vares Project. The company recently hit an interval of over 20m at a grade similar to the main Rupice orebody to the north-west of the core deposit. Whilst still at an early stage, we consider that this could be a repetition of the Rupice orebody given the area is structurally controlled. This has the potential to be a real game-changer if further drilling proves this hypothesis.

Independently, Adriatic also control the rest of the mineral belt surrounding Vares which we consider highly prospective with many historical mineral deposits and occurrences. The company has a US$9 million exploration budget for this calendar year.

Adriatic's Raska project in Serbia also has strong economic potential in the current market environment. We believe that the project could be worth half of Adriatic's present market value on a risked NPV basis. Adriatic are targeting an MRE and scoping study to be delivered this year.

Any way we look at it, we believe the company is undervalued trading at only around 35% of the Vares Project's NPV, entirely ignoring its other assets. Similar assets have transacted for in excess of 80% of NPV. Another strong attraction is the company's strong commitment towards strong ESG principles which we believe are sound and essential business practices in today's world. We remain long-term shareholders of Adriatic Metals.

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in Adriatic Metals (ADT:ASX).

Tin is a metal critical to maintaining a modern lifestyle. Tin is used extensively in solder for critical electronic components such as circuit boards for the machines we use every day. It is estimated that tin comprises between 1-5% of a circuit boards total weight, with more complex boards requiring higher portions of solder. There is substitute available for tin for soldering applications.

Tin usage and demand is expected to grow in line with technological progression. Rio Tinto in 2018 identified Tin as the metal most impacted by new technologies given the heavy reliance on advanced electronic controls and boards that the deployment of these new technologies require.

China and Indonesia are the largest sources of tin production, followed by Myanmar, Russia, Bolivia, Peru and the Democratic Republic of the Congo.

Global tin production has been relatively stable over the past, with demand exceeding supply for a number of years. This gap has been filled historically via the secondary refining of tin and the sell-down of historical strategic stockpiles by sovereign players.

COVID has exposed the fragility of global supply chains and tin has not been immune to supply disruptions. For instance, we have seen power cuts in the Yunnan region and volcanoes erupting in the DRC over the past week; both globally significant production areas.

In markets that are subject to supply constraints, we often see enormous moves in prices when a supply shock occurs. An example being the uranium markets in 2006 when the globally significant Cigar Lake uranium mine flooded; this triggered an increase in the spot uranium price of 350% over a 12-month period before spot prices began to retrace.

The futures markets are a great place to understand the dynamics of forward pricing for commodities. In usual circumstances, we can expect the term structure of a range of futures over a commodity to be in 'contango' which means that prices tend to be more expensive the longer the duration of futures contract. Intrinsically this makes sense, as for physical commodities there is a tangible cost in storing the materials.

In this case, tin futures are in 'backwardation' where the spot contract is the highest priced with longer durations priced more cheaply. This is a relatively rare situation that demonstrates short-term market supply stress. However, on the London Metals Exchange, this situation has persisted for the last 3 months and has now occurred on the second major commodity market in the Shanghai Futures Exchange.

The situation has been supportable in the short term on the LME, as commodity traders could source metals or perform arbitrage on the SHFE and deliver to the LME. With tin on both exchanges in backwardation, the arbitrage opportunity is not so obvious anymore. Across these two major commodity exchanges, less than 6 days of global tin demand remains in stock. Accordingly, we believe that tin spot prices have the potential to trade at significantly higher prices over the next 1-6 months.

We believe the best place to capture potential returns from tin, is by investing in existing producers. On the ASX, we have one of the best-listed exposures globally in Metals X (ASX: MLX).

MLX's Renison project is located in Tasmania. 50% of Renison is owned by Yunnan Tin (the world's largest tin producer) who picked up a stake in the GFC-era when MLX was distressed. Renison currently produces around 7,000t of tin per annum.

We expect that the quality of resource will improve over time at Renison with 'Area 5' reserves (a new deposit yet to be exploited) providing a 58% uplift in grade relative to recent ore processed. This translates to tin production in excess of 11,000t per annum on a 100% basis assuming all other factors remain constant. In addition, metallurgical recovery improvements expected via investment in process improvements. In particular, a thermal upgrade or tin fumer scoping study due in Q3 is likely to improve recovery rates materially and lead to a significant improvement in financial outcomes.

MLX also hold a significant growth opportunity in Rentails, a tailings stockpile accumulated from previous processing. Rentails is the second largest undeveloped tin deposit globally when measured by tin content in the mineral reserve. At current tin prices of US$31,000 a tonne and assuming no uplift from the tin fumer process, we value Rentails at a pre-tax NPV8 of circa $300 million net to MLX.

MLX has historically had a mixed record management-wise however, present management appear to be pragmatic and commercial in their decision making.

Non-core copper assets have been sold with non-direct exposure to potential upside via an equity and derivative holding in Cyprium Metals (ASX:CYM). 

A spinoff of MLX's nickel assets is expected to be completed this year with an in-specie distribution of stock planned for MLX shareholders. We have seen positive financial outcomes for holders of ILU & ALK who have conducted similar transactions in the past 12 months, and we expect the same case here.

Shareholders will also benefit from the large embedded tax losses from legacy operations. This is a hidden asset that is value accretive but not valued by the market.

We believe that MLX holds good takeover potential with its non-core assets now largely divested. Yunnan Tin would be the most logical acquirer of MLX however, given current geopolitical circumstances a transaction may be difficult in the short term.

On a sum of parts valuation, we consider that MLX is worth at least $350 million or circa 40c per share - with further potential upside of $300 million should Rentails proceed successfully into production and the tin price remaining at present levels.


Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in Metals X (MLX:ASX).
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On Wednesday Australia's largest bank, Commonwealth Bank (CBA), announced that they were entering the buy now, pay later ('BNPL') space with the introduction of a new product, creatively named 'Commbank BNPL'.


CBA have been quiet investors in the BNPL industry since August 2019, where they made an initial investment of US$100 million into a private Swedish bank Klarna who offer their own BNPL product. This investment was increased by another US$200 million in January 2020 with CBA holding 5% of Klarna. Ostensibly, this investment was made with the perception that CBA could assist in Klarna's product rollout to Australian customers.


To date, Klarna's Australian launch has been largely an abject failure, barely making a dent in the local market. Merchant adoption has been minimal with many who offer Klarna as a payment option, prominently advertising their participation in AfterYaY Day - an annual sales day run by BNPL market leader Afterpay.


The launch of Commbank BNPL appears to be a blunt admission that Klarna's product has failed to gain traction in the local market. A cursory glance at the product design for Commbank BNPL reveals several fatal flaws that will almost certainly lead to the same outcome as Klarna locally.


Australian BNPL users span across the spectrum in terms of age as the industry has matured and hit the mainstream. A significant portion of BNPL users make use of multiple BNPL providers. In many ways, the BNPL has supplanted credit card penetration and usage especially for small-scale transaction values under $2000. This long tail of transactions and consumers is what has driven the incredible growth experienced by the broader BNPL industry as a whole over the last 4 or so years. This increase in demand from customers has led to a requisite increase in supply-side adoption of BNPL services by merchants. The key point here is that customer demand is what has driven supply.


Commbank BNPL fails in the sense that it focuses too heavily on the supply (merchant) side of the equation without any compelling proposition for the customer themselves. As a CBA executive is quoted saying "We are going to treat it like it is credit”. CBA has stated that it would conduct credit checks and would block customers if they were in arrears with other providers. This is in addition to higher proposed late fees than currently charged by Afterpay.


This level of intrusiveness and friction on the demand side coupled with the lack of lead generation tools on the merchant side leads us to conclude this proposed product will be just another commoditised fringe BNPL product unlikely to capture significant market share.


Interestingly, Afterpay are close to launching their own banking application, Afterpay Money, in an alliance with CBA's arch-rival Westpac (WBC). Afterpay intends on integrating the banking and BNPL services into a single interface in time.
As we first wrote 3 years ago, we consider Afterpay's BNPL offering to be the platform upon which additional financial services can be offered and it appears as though this forecast is coming true. 

Afterpay have commented that future product launches will not be interest-bearing, in line with its ethos of monetising its services from the supply side. Early indications are that Afterpay will launch another product directly competing with CBA's AdvancePay - a short-term payday lending facility. There is no question that the Afterpay brand is more highly recognised and respected amongst a broader swath of society than CBA.


Accordingly in this instance, we are inclined to back the entrenched, customer-centric market leader than the new entrant to the field coming out of a large conservative institution.

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Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in Afterpay (APT)

Dusk Group (DSK.AX) are a specialist retailer operating solely within the Australian market. Dusk is best known for its scented candles however, its range includes diffusers, essential oils and other fragrance related homewares. 

Historically, niche homeware retail segments have been largely a cottage industry with a long tail of small boutique merchants fulfilling demand. Dusk is the largest player in the local market holding approximately 22% market share, whilst running only around 115 physical stores. 

The company foresee the potential to grow to around 160 stores throughout Australasia by 2024. Over the last 12 months, the company's online presence grew significantly making up at least 10% of overall group revenue.

Industry structure and Business model
We have observed many instances of formally sleepy niches being disrupted and consequently dominated by a best-in-class brand and operation. In most instances, the easy availability and distribution of the product act as a demand generator from the consumer side. 

There is no doubt that the effects of government stimulus and social restrictions have benefited Dusk. Broad swathes of Australian society have been forced to spend more time at home and as a result have had more time to consider and improve their living environment. Whilst Dusk was forced to close its physical stores for a short period of time, growth was barely dented with LFL (like-for-like) sales growth of >17% for FY2020.  

In terms of expansion, Dusk intends on penetrating its core Australian market fully and starting to roll out its stores in New Zealand. It aims to grow outside the ANZ region by establishing online stores in key geographies. We note that a significant portion of web traffic (1% or so) to the Dusk website originates from the UK & US - large markets where Dusk does not yet sell its products. In time and pending successful market entries, we would expect that Dusk may one day have larger international operations than domestic. The company intends to begin international order fulfillment and to test demand in overseas markets starting from FY2022. 


History and Team
Peter King, Dusk's CEO, joined in 2015 and has grown business consistently since. Store management is flexible and low cost, largely centered around a single central employee the manager, a part-time assistant manager and supplemented by casual staff. An online training platform ensures a consistent customer experience between stores. Rewards program signups are a KPI and bonus metric for store managers and on average 1 in every 5 casual shoppers joins the rewards program. Accordingly, customer acquisition costs are effectively an embedded sunk cost into the business itself. Senior employee turnover is exceptionally low in the low single digit percentages.


Financials and Valuation
The Dusk business is reasonably seasonal with its revenues consistently skewed towards the 1st half of the financial year. 58% of revenues are accrued in this period, with the balance in the 2nd half. EBIT Margins for FY2020 were circa 15% and this period incorporated a period of time where the physical store network was shutdown. Dusk released a market update on the 29/12/20 which smashed its previous guidance and upgraded its H1/FY21 revenue to an estimated $90 million. LFL sales grew circa 49% with online sales up 120%. Extrapolating this revenue guidance normalised for seasonal variance provides us with an estimated projected revenue for FY2021 of $155 million or overall revenue growth of 54% vs FY2020. Assuming H2/FY2021's EBIT margin falls back to FY2020's EBIT margin of 15%, this gives us a projected EBIT range of between $33-$36 million for FY2021. 

Dusk has an extremely simple balance sheet with zero long-term debt. The company guided that it would hold a cash balance of approximately $33 million at the end of December 2020. Assuming a market capitalisation of $145 million (share price of $2.30), this equates to a rough enterprise value of $112 million or an EBIT multiple of just over 3 times. This is extraordinarily cheap especially in the context of today's highly valued equity markets. 

We demonstrate this via the following basic peer analysis:

As we can see Dusk's valuation is significantly less than its public listed peers in the Australian discretionary retail sector. If we assume as a conservative measure that Dusk can achieve the lowest valuation multiple out of its peers at 8.1x, we could expect to see the company trade at an enterprise value of $267 million or $4.24 per share (84% more than the current price). Note that this figure excludes the company's existing significant cash balance.

No matter which way we examine the company, it still trades cheaply by any metric.

Risk factors
Our biggest question is why is the market valuing this stock so cheaply? 

Our guess is that the IPO was effectively a sell down by existing shareholders to the public rather than raising fresh funds for the business. It would not have made sense for Dusk to raise fresh capital considering the company was strongly capitalised at the time of the IPO. Accordingly, the IPO allowed the two largest holders, Catalyst and BBRC, to reduce their shareholding in the group. We are not concerned by this whatsoever, for a couple of reasons. Catalyst, being a private equity firm, need to cash out of their investments periodically to maximise the IRR metric for its fund investors. Catalyst still hold a controlling stake of over 25% in the listed entity. BBRC have also been invested in the company since 2010, and retain a 7.3% holding in the public entity. This is quite conventional for businesses that are listed or associated with BBRC from our observation.

Another factor that probably affected sentiment was the fact that the IPO was scheduled for March however, was pulled due to the severe equity market conditions at the time. One theme that is prevalent in the retail space is that the Job Keeper government subsidies have led to a one-off bump in demand from the consumer side as well as benefiting companies from the cost perspective. Whilst this is true to a degree, it does not explain fully the large surge in the broader retail sector as well as data suggesting that Jobkeeper payments received by staff recipients has been used by many to improve their own financial position. Our thesis is that people are spending more on themselves and their home environment in lieu of traveling overseas and interstate. Whilst we cannot say with certainty when travel will become commonplace, we expect this time of restricted physical movement to last at least another 12 months.

One company that reminds us of Dusk is Lovisa which was previously floated by BBRC. Lovisa listed at a market value of around $200 million; it is now valued at around $1.2 billion with normalised EBIT of around $30 million. This company itself, we consider to have lower growth potential than Dusk at this point given the product range and current geographic spread. 


In summary, we consider that Dusk offers investors a potential strong growth opportunity while being priced as a value stock when viewed in the context of the discretionary retail sector as a whole. Its low valuation offers the opportunity for significant value uplift over time that will be dependent on maintaining its current strong operation performance along with successful international growth.

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This article is an extract of a detailed research note by Datt Capital. 

Wholesale/sophisticated investors may request a copy of the full analysis for a limited time HERE. Available only for 14 days post article publication.


Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in DSK.

In the last 3 months the price of Bitcoin, the 'gold standard' in cryptocurrencies, has more than tripled from circa US$10,500 to over US$37,000 per coin. Crypto evangelists make many claims about the future utility and value of bitcoins including its potential to replace existing currency systems along with grandiose claims of future value. It's decentralized and limited nature is an attraction for investors who have been jaded by endless bouts of issuance of fiat currencies by governments globally.

Much of the confusion around Bitcoin and other crypto-currencies stems from the question of whether these digital assets are an asset or a medium of exchange. A medium of exchange's core attributes are fungibility (standard and mutually interchangeable), portable, and commonly accepted. The key features of an asset are: that it is controllable (for the benefit of its owner), transact-able and has clear future value and utility. We believe that Bitcoin aligns more closely with being classified as an asset rather than a medium of exchange.

Which leads us to a simple question: what is the true future utility or value of Bitcoin? There is material uncertainty around this figure, even from the most hardened crypto advocates. This also explains to a large degree, the enormous volatility inherent in the asset itself including multiple draw-downs of over 50% over the years. There has been a strong correlation in Bitcoin price movements to more conventional liquid assets like stock indices, albeit at much higher rates of beta. This validates to some degree the notion that Bitcoin is being treated as an investment asset class by investors at large. Interest in Bitcoin tends to correlate heavily with its price; examining search trends and other sources of data we note that new entrants into the space tend to buy into the periods of highest price growth. I recall a colleague of mine during the crypto boom of 2017, asking me whether I thought Bitcoin was a sound investment, despite the utter lack of interest in any investment class previously from this individual. 

We have seen claims by some that Bitcoin is 'the new gold'; in our opinion, this is incorrect. I could go to virtually any individual living on our planet, irrespective of culture or creed, who would recognize that a single gold coin holds some form of monetizable intrinsic value. Despite Bitcoin's virtues, this would just not be the case in a similar instance. The asset's value is linked to its perceived utility between existing or new users. This leads us to a problem, which is the separation of utility from value. Bitcoin, for all intents and purposes, is useless in isolation. It relies heavily on a large number of 'nodes' around the world to operate the network and therefore by proxy, relies on free and open data flows between nations. This for us is a particular area of vulnerability, especially given the increase in geopolitical tensions over the past few years; is it too far-fetched to imagine that dataflow could one day be weaponized?

Ultimately, we believe that the rise in interest in Bitcoin and cryptocurrencies is driven by several factors: the ease of storage, perceived anonymity as well as the hope of making a quick dollar. Most prominently, I believe the most recent bump in Bitcoins value is driven by widespread distrust in government-issued fiat currencies and the lack of fiscal restraint by these entities. Many are worried about the extraordinary stimulus and 'money printing' activities being undertaken by governments worldwide and this has also been reflected in the pricing of other asset classes like precious metals and real estate. Whilst Bitcoin and other cryptocurrencies are uninvestable for ourselves, potential buyers should go in with their eyes wide open to the potential risks before investing in more exotic asset classes.


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Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way.

I’m often asked by clients and industry figures about Datt Capital’s position on ESG.

For a number of reasons, I have difficulty giving a black-and-white answer.

It’s fair to say that ESG, or its shorthand – ethical investing – has become part of the funds management zeitgeist, aided in part by much research pointing to better performance by fund managers that favour companies with good ESG policies and practices.

But what does ethical investing really mean?

For a start, there is no universal E (environmental sustainability); no universal S (social responsibility); nor universal G – corporate governance.

Ethics is a combination of morals, values and behaviour that is unique to each individual

When an investment is branded “ethical,” does it really mean the investments selected are consistent with the shared ethics of a reasonable swathe of society?

Another issue with so called “ethical” investing is the lack of truly ethical investments available. If we define “ethical” through the filter of “do no harm,” how many companies or businesses would qualify?

For some, the mainstays of ESG/ethical portfolio in the local context are the big four banks. Three out of four have been charged with a litany of historical offences, ranging from negligence to reporting suspicious transactions to government authorities, to facilitating payments for human trafficking and child exploitation. It is inevitable that mistakes will occur in corporate behemoths, but where does an “ethical” investor draw the line? 

The mining industry is often vilified for lack of ESG principles, although this usually a misguided belief. For instance, coal is demonised by some “environmentalists” despite it being a major contributor to the rapid elevation in human development outcomes in developing countries.

I recall having a meeting near a mining conference in Melbourne, where “climate protesters” were demonstrating. A number of protesters came into the cafe where I was seated, ubiquitously bearing smartphones which are the product of mines around the world – including cobalt mined by child labourers in Sierra Leone. They came in to order freshly ground, barista-made coffee – some of which may have been picked by “coffee slaves” in Brazil, Guatemala or Cote D’Ivoire, depending on their selection.

My personal opinion is that the core of any ethical consideration rests on the statement popularly attributed to Hippocrates: “Primum non nocere” (“first, do no harm.”)

Viewed through this lens, some industries that may be a more obvious fit for ethical investors could include: distribution, mineral royalty companies, retailers and food processors.

We also agree with the view of  some of our industry colleagues that the most effective way to give vent to your personal feeling on the E and the S  is either to donate to the cause in question, buy or boycott  products, or when investing, participate in a capital raising of a companies whose policies and actions in these areas you support. Purchasing shares in a favoured company on a secondary market does not have any meaningful impact on a company.

While I am sceptical about the rationale and impact investors can on the E and S we at Datt Capital believe that the G, governance, is the metric to focus on in deciding when to invest; as the research shows that poor corporate governance is usually related to performance.

Typical red flags include related-party transactions, not enough truly independent directors, and lack of diversity in management and staff.  

All of these points ultimately beget the question: what is the solution for ESG/ethical-oriented investors?

We believe the solution is for investors to “look deeply into what’s in the tin,” by performing research into their investments, rather than taking at face value “what’s on the label.”

We encourage using an inter-generational approach. This encourages the evaluation of investments taking a “whole of lifecycle” perspective, while also enabling investors to express their own subjective sense of ethics. For instance, some may find the lack of recycling for end-of-life solar panels to be unpalatable, whereas others may determine the shorter-term benefits to outweigh the longer-term consequences.

Finally, if in doubt about the criticality of corporate governance, the current drama being played out between the New South Wales government casino authorities and Crown Resorts reaffirms once again the primacy of getting the ‘G’ correct. Governance failures by the Crown board and management have finally caught up with the company and shareholders are suffering accordingly.

Happy investing.

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way.

The ownership of a mineral royalty (a contractually established financial asset) over a producing or near-production mining asset has been the basis of many Australian fortunes. For instance, the iron ore royalties held in the Pilbara by the Hancock/Rinehart and Wright families coupled with prudent investment decision-making has allowed them to build enduring and significant wealth. Another well-known example is the Weeks oil & gas royalty encompassing a large portion of oil & gas production in the Bass Strait.

A mineral royalty provides the holder with the right to receive a portion of revenues from a particular mining operation or area. Royalties are reasonably bespoke, contractual agreements; accordingly, there are many variations and structures. We consider the most attractive royalty structure to be a 'gross overriding royalty' ('GORR') which entitles the royalty owner to a share of the market value of the commodity being produced less delivery costs borne to a point of sale.

The advantages of a GORR royalty structure are as follows:

• simple to calculate and audit
• lowest risk - with no ongoing capital expenditure required
• no exposure to cost or direct operational risks
• lowest volatility of cashflow, with a single variable input (the commodity price)
• a readily saleable and reasonably liquid asset
• leverage to increases in commodity price and exploration success

Other risk factors associated with royalty investments are primarily linked to the risk of the asset becoming non-productive which are:

• the particular commodity being produced
• the cost quartile of the producing asset (or relative production cost position)
• the location of the asset
• the mine life of the asset

Royalty companies have become big business, with a multitude of listed exposures available on global markets. These companies generally hold diverse portfolios of royalty interests and commodity exposures.

Franco-Nevada ('FNV') is the world's largest listed royalty company with a market cap of around US$26 billion (AUD$37 billion). Prima facie it positions itself as a gold royalty company, whereas in reality it has exposure to a range of precious and base metal longer-life projects with an average mine life of 20 years. It achieves top line revenue of approx. US$800 million whilst enjoying strong EBITDA margins in excess of 80% (typical of royalty companies).

It has a diverse board of mineral industry participants including Tom Albanese, Rio Tinto's former CEO. In a nutshell, it provides an ideal investment vehicle for institutions and individuals alike for lower-risk exposure to the commodity markets.

​The sole Australian royalty company of scale is Deterra Royalties ('DRR'), recently demerged from Iluka Resources. Deterra hold what we consider to be the best single royalty exposure available on the listed markets globally in the Mining Area C Royalty ('MAC Royalty').

The MAC Royalty is a GORR of 1.232% of Australian dollar denominated, free-on-board (FOB) revenue from product mined from Mining Area C, a major growth hub for BHP's Pilbara iron ore operations which are some of the largest globally. In addition, DRR also enjoys one-off $1 million per 1 million tonne increases in annual production capacity for the areas encumbered.
Main factors that contribute to the quality of this royalty interest are:

• one of the world's best operational and financial counterparties in BHP
• situated in world's best mining jurisdiction, Western Australia
• minority asset owners and other credit exposures are large Japanese conglomerates in Mitsui & Itochu
• mining assets are within lowest production price quartile, so will produce in virtually any circumstances
• low commodity risk in higher quality iron ore - essential and irreplaceable for further global development as well as politically insulated
• in built organic growth profile with production volumes expected to double by 2023 via development of South Flank mine
• Length of Mine ('LOM') currently 30 years with expansion potential to >50 years of mine life.

DRR have committed to paying out 100% of net profit after tax ('NPAT') to shareholders via dividends.

Given the valuation of global royalty peers, we contend that DRR would make a viable and attractive M&A candidate. For instance, in a scenario where FNV acquired DRR, we could expect FNV to increase their revenue by over 20% from 2023 (assuming spot FX and iron ore prices hold) and a likely value uplift of over US$5 billion (AUD$8 billion) should their multiple remain stable which we consider conservative given the sheer quality of the MAC Royalty. 

DRR trades today at a mere AUD$2.2 billion (USD$1.54 billion) or around a quarter of its potential value to a leading royalty company.

An alternative hypothetical scenario could see BHP purchase and internalise the royalty interest given the long mine life and the present rock bottom interest rates. Iluka Resources maintain a 20% interest in DRR, making them a king-maker in any M&A action. Given the holding is non-core to Iluka, we would expect a reasonable bid for DRR would see the major shareholder accept.
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In summary we believe that DRR provides a defensive, high quality annuity style equity exposure for investors; with potential for large capital appreciation via organic growth and potential M&A action.

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in DRR.

Strategic Energy Resources ('SER') are a company specialising in frontier and undercover mineral exploration. We find this junior exploration opportunity compelling for a number of reasons: namely the strong technical management team, the ability to generate projects in regions prospective for tier 1 mineral deposits, and the company's existing suite of high-quality mineral assets all at a relatively low market valuation.

Canobie Province
SER's flagship project is what we refer to as the Canobie Province, an enormous land holding of approximately 1500 square km in Northern Queensland. The Canobie Province encompasses the entire northern belt of the Mt Isa Eastern Succession.

Contextually, the Mt Isa Province is one of the most heavily mineralised terranes globally and geophysics clearly show that these key structures continue to trend north under sedimentary cover to the areas now held by SER. Indeed the large Ernst Henry IOCG mineral complex lies under 60m of cover to the north east of Cloncurry, along the same trend as Canobie. The total resource endowment of Ernst Henry is well over 200 million tonnes of ore, and has been continuously mined since 1997. This provides an idea of the size of the potential opportunity at hand at Canobie.

The largest operational challenge in the Canobie area is the depth of cover, around 400 metres in thickness; also the fact that the cover is conductive which makes it difficult to use conventional electrical geophysics. Despite these challenges, the region has always been regarded as a promising, frontier locality for potential Tier 1 mineral deposits - similar to how the Paterson Province in Western Australia was once regarded before the discovery of Rio Tinto's Winu and Newcrest's Haverion discoveries.

Our analysis of historical drill results in the district showed that an extraordinarily large percentage of holes hit some form of mineralisation; even more extraordinary when considering the 'blind' nature of the drilling and mineralisation due to the depth of cover. Our interpretation of this data leads us to believe that the Canobie Province encompasses an extremely fertile mineral district whose scale is yet to be revealed. This is further reinforced by studies conducted by Geoscience Australia, which rate the Canobie Province as possessing the highest potential for Iron Oxide Copper Gold (IOCG) deposits. Minerals discovered to date include high-grade gold, nickel-copper sulphides as well as anomalous uranium, platinum, and rare earths.

The most advanced prospect within the Canobie Province is the Saxby Gold Project, where 200 metres of strike has been defined to date at relatively high gold grades between 10 and 15 grams per tonne along with lower grades of copper. Intriguingly, the key structure has not yet been tested and the prospect remains open to the north, south and the west. In addition, studies by previous explorers indicate the gold is largely non-refractory in nature which is positive. Favourable metallurgy can be a critical factor in determining the commerciality of mineral deposits. SER expect to commence the next drilling campaign at Saxby sometime this month.

The Tea Tree nickel-copper prospect is another lead which we find very interesting. Historical drilled by Mt Isa Mines (MIM) and Anglo American, Tea Tree has been considered by past explorers to be prospective for a Voisey's Bay/Norilsk (large-scale) style, magmatic nickel-copper system given the size of the gravity anomaly which extends around 8km in length. Past exploration holes have hit large intersects of gabbro host rock, some over 300m in length, with anomalous nickel-copper sulphides. In addition, the historical holes have encountered mineralisation over a strike length over 2km in length, definitively proving the potential for a large scale system at depth. Anglo American who last explored the prospect concluded that the gravity anomaly could be explained by a deeper, yet to be tested intrusion. There is clearly more work to be done here.

Other exploration assets
SER also hold 2 other projects in Tier 1 locations, Billa Kallina situated within the Olympic IOCG Province in South Australia and Tennant Creek East in the Northern Territory.

The Olympic IOCG Province hold numerous Tier 1 mineral deposits such the world scale Olympic Dam Mine, Oak Dam West (both BHP), Prominent Hill, Carrapateena (both OZL) etc. Successful exploration in this region has typically been via targeting using gravity and magnetic surveys along with other conventional exploration techniques. Billa Kallina is a long recognised prospect defined by gravity and magnetics however, to date untested due to the depth of cover. We expect this anomaly to be tested in the coming months.

Tennant Creek has a long and proud mining history. Today, much of the future exploration activity is expected to be directed towards the East. This area has recently been opened up for mineral explorers with a moratorium being lifted in late 2019. This has led to a land grab in the region with many companies, including Newcrest, securing ground. Interestingly, Newcrest and SER appear to have secured the most prospective ground for IOCG potential according to Geoscience Australia. We also note that the National Drilling Initiative will be drilling several holes on a tenement bounded by Newcrest and SER which should provide valuable geological information to all explorers in the region.

SER also hold a small suite of passive and legacy assets encompassing a joint venture with FMG in South Australia (Myall Creek), a mineral sands resource in Ambergate and an investment in a private graphene company.

In conclusion, we believe that the value of SER is underpinned by the quality of its exploration assets all situated in regions where the potential for Tier 1 mineral discoveries is high. Its suite of passive and legacy assets can also potentially be monetised in time. The strong emphasis on value creation via project generation and exploration in genuine Tier 1 potential locations is attractive and has the potential to provide highly asymmetric returns for shareholders in the case of exploration success. Several value accretive catalysts lie ahead over the next 6 months via the completion of drilling programs and associated targeting works.

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in SER.

​The relationship between Adriatic Metals and Sandfire Resources has been complex. In theory, the relationship should be positive; a junior miner with a world class development project allied and supported by a credible and proven Australian mine builder and operator. In practice, the relationship has seemingly been complicated by the consistent increase of Sandfire's holding in Adriatic and presumably it's influence.

We thought it would be an interesting exercise to go through Adriatic's disclosures to observe how the relationship has developed around Sandfire's actions.

The relationship began innocuously in May 2018 with both companies seemingly enthused by the strategic and technical expertise offered by Sandfire to assist in progressing Adriatic's projects. Sandfire became the largest shareholder outside the management team as part of this deal and were afforded an anti-dilution right under certain circumstances.

​The ASX granted a waiver of its listing rule 6.18 under certain conditions in August 2018.

​Adriatic Metals conducts its first capital raise post listing, raising $10 million with Sandfire participating to maintain its stake in November 2018.

Between June and August 2019, Sandfire raises its stake in Adriatic by buying shares on market. It's interest in Adriatic rises from 7.7% to 12.8%.

Adriatic conduct their next capital raise of $25 million, with Sandfire subscribing for their pro-rata interest.

​Sandfire appoint a nominee, John Richards, a respected Australian mining director to Adriatic's board in November 2019.

ASX amend their listing rules in December 2019. In particular, the rules around strategic relationships and anti-dilution rights are significantly amended effectively invalidating prior waivers granted.

​The ASX discloses that its needs to be satisfied that the basis for the original waiver granted still holds true and a genuine strategic relationship still exists between the entities. In addition, the ASX must also need to be satisfied that the terms of the anti-dilution right remain appropriate and equitable to minority shareholders. 

Notably, the waiver must be initiated by the entity that held the benefit of the anti-dilution right, ie. Sandfire.

Source: ASX guidance note 25

Sandfire continue to increase their stake in Adriatic on-market to 15.8%.
​Sandfire do not disclose the change in interest to the ASX but rather Adriatic disclose the change of Sandfire's interest in December 2019.

Sandfire withdraw the nomination of John Richards from the Adriatic board who consequently resigns in July 2020.

​Sandfire commence litigation against Adriatic, alleging contraventions of the strategic agreement between the two companies in July 2020.

This puts Adriatic shareholders in a peculiar position. We have Sandfire, a substantial shareholder of the company, alleging that Adriatic has contravened the strategic agreement between the two companies - without any specific discussion of what particular points of the agreement have been contravened. In addition, Adriatic shareholders can note the increasingly tense language and  relationship between the two companies over time which ultimately begets the question - What is Sandfire's ultimate goal?

Ultimately this raises a number of questions for shareholders of both Sandfire and Adriatic, namely:

What is the specific basis for Sandfire's claim given that they have participated in every capital raise conducted by Adriatic Metals?

Have Sandfire submitted a waiver application to the ASX, given the onus is on the benefiting party to apply for the waiver? If so, has this waiver application been rejected and in what form?

Given the litigation has been initiated by Sandfire against Adriatic, has the strategic relationship between the two companies effectively ceased? How long has this been the case for and at what point did it effectively cease?

Given that ASX listing rule 10.11 is considered as the fundamental protective clause for minority investors, is it appropriate that this rule is waived to the potential detriment of Adriatic's minority shareholders, especially if the strategic relationship appears to have effectively ceased?

Why is Sandfire, a company worth almost $1 billion, fighting over $8 million worth of stock that it is purportedly owed?

What was the reason for Sandfire removing their nominee director from the board of Adriatic? Was it to notionally circumvent ASX listing rule 10.11.3 - substantial (10%+) holders with board representation?

Why has Sandfire been non-compliant with general ASX requirements regarding substantial shareholder disclosures, especially around December 2019? What is Sandfire's current interest in Adriatic Metals?

Is Sandfire's eventual intention to control or takeover Adriatic or Adriatic's projects in some form at some point in the future?


Without adequate disclosure of the issues identified above, it is our opinion that the lawsuit brought by Sandfire against Adriatic appears to be frivolous at best. 



​
Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in ADT.

At the beginning of May, we highlighted SelfWealth ('SWF') as an outstanding growth opportunity [HERE] that would benefit from exposure to the COVID19 curfews and the generally higher levels of market volatility. In this update, we review the company's progress based on its latest regulatory disclosures and compare how it is tracking relative to our internal growth model.

Since our article, the market has recognised the growth thematic embedded within the SelfWealth business model. Consequently, the share price has tripled from 22c on the date of the release to over 66c at the close of trade on the 9th of July. The company's results did not disappoint, more than meeting our expectations and those we shared with other market participants.

The latest quarterly release once again demonstrates the strong tailwinds the company is experiencing with quarter-on-quarter ('QoQ') growth in active traders of 44% compared to the previous quarter. Operating revenue and trade volumes grew over 100% and the company achieved its first-ever positive quarterly cashflow from operating activities. The value of client cash on the platform remained stable at $366 million despite very strong trade volumes. All these metrics affirm the company's ability to capture a disproportionate share of trader 'churn' and subsequently increase its market share; which was a core aspect of our investment thesis.

We believe the company will be able to maintain its strong growth momentum given the market and product fundamentals whilst increasing the 'monetisation efficiency' of its platform. We expect this increase in monetisation to be driven by several organic growth initiatives the company has been working on that are projected to be rolled out over the next 6 months.

The first is a revamp of the SelfWealth mobile application which we anticipate will be a market leader in customer usability and experience. It is a known fact that two factors are strongly aligned with customer satisfaction and use; consequently, we anticipate that this will lead to an increase in time spent on the platform and potentially a rise in trade volume.

The second large initiative is the launch of US equity trading via the SelfWealth platform. The US equity markets are the larger and most followed in the world. The ability for SelfWealth customers to purchase direct shareholdings in global market leaders like Amazon and Google, will no doubt increase trade volumes on the platform and provide valuable diversification from reliance solely on local equity market trade volumes.

Our base growth model assumed that SelfWealth could grow to 80,000 users by the end of June 2021. The latest disclosure demonstrates that active users currently sit over 46,000, implying on average that monthly growth in users should at least 3,000 users per month. The past 6 months have exceeded this figure by a large amount, so we remain confident that our base case will be achieved ahead of the time frame we originally projected. The business model dictates that each user acquired becomes increasingly profitable as overall customer numbers grow. This adage rings true in terms of valuing the company on more traditional measures such as 'value attributed per user' or conventional financial metrics such as potential earnings multiples.

One observation we have seen in high growth sectors is that scale begets scale. As the user base grows and broadens from its initial dominant user demographic, we often see the next leg of growth driven by strong uptake by broader mainstream society attracted by a compelling product offering. We believe we will observe a similar dynamic with SelfWealth going forward.

SelfWealth remains strongly capitalised with cash holdings of over $5 million and no debt. We believe the company is in a position to maintain its current profitability as well as build upon its strong market and product position. We believe the company remains compelling long-term value at its current market value.


Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in SWF.

Following on from our recent update on Adriatic Metals Serbian acquisition, we share some thoughts on the short term outlook for Adriatic.

Adriatic aim to complete a Pre-feasibility study ('PFS') on the Vares Project by September 2020 and a Definitive Feasibility Study ('DFS') by January 2021; having previously completed a Scoping Study on the project in late 2019. The Scoping Study had highlighted the world-class economics of the Vares project with the key metrics being:
Post Tax NPV8 of USD$916
Post Tax IRR of 107%
Capex payback period of 8 months
LOM Capex of US$178 million (inc. 30% contingency)

Since the completion of the Scoping Study, we note that Adriatic have made material progress on a number of fronts. The company have successfully discovered mineralisation outside the maiden Mineral Resource Estimate ('MRE') area on which the Scoping Study was based on. Phase 2 metallurgical testwork has led to materially better outcomes than those assumed in the Scoping Study itself with the new copper concentrate proposed being 95% payable vs only 30% assumed in the study. We estimate that a revised MRE has the potential to increase ore tonnage by at least 25% at a similar grade as the initial MRE. We estimate the combination of the increased MRE and payable metal may lead to a larger NPV8 figure in the PFS relative to the previous Scoping Study. We estimate that an NPV8 of circa USD$1.2 billion (AUD$1.85 billion, 0.65 FX) using similar metal price assumptions as assumed in the Scoping Study, may be achieved in the PFS.

As such we consider Adriatic to be extremely undervalued trading at a fully diluted value of around AUD$250 million which is only circa 14% of our estimated NPV8 figure for the PFS. We have noted in the past that high-quality projects generally trade or transact at small discounts to NPV - HERE. 

Adriatic's management team are directly aligned with shareholders via their substantial shareholdings in Adriatic. They have a track record of obtaining maximum value from funds spent and being cost-conscious evidenced by the recent disclosure that they are running $2 million under budget for the PFS works. There is a strong incentive to reduce dilution for the existing shareholders and preserve the value of their own holdings. Adriatic have disclosed that they are funded until the completion of the BFS and may require additional capital at some stage next year.

We believe that it may be prudent to sell a royalty over the Vares project after the completion of the BFS. This would minimise dilution for existing shareholders given the present large value differential, provide a large capital injection and cover a large portion of the project's CAPEX requirement. 

A net smelter royalty ('NSR') is a very common form of royalty in the mineral space. Usually, it is calculated as gross revenue less transport, insurance, and refining costs. A rough rule of thumb we like to use is that a 1% NSR is equivalent to a 4-5% working interest in the royalty property. 

An NSR owner benefits in a number of ways:

• Low risk - the first dollar invested in an NSR is the last dollar spent
• Bespoke to project and is tailored to project specifics - eg can contain buyback provisions and other special clauses
• positive exposure to underlying commodity price without direct production cost risk
• a relatively liquid and transferable asset

Some factors that determine the value of an NSR are:

• quality of orebody - higher value ore and a long mine life can lead to a higher NSR value
• the current stage of the project - more certainty around the project's financial and operations lead to higher NSR values
• time-frame to production - the shorter time to production the better
• monetary environment (interest rates) - low-interest rates lead to lower NSR hurdle rates

A recent NSR transaction was where the market-leading royalty company, Franco-Nevada, created a 1% NSR over Solgold's Alpala project in exchange for US$100 million. This project is at a similar stage to Adriatic with a PEA/scoping study having been completed in 2019. The NSR was sold over this project to fund DFS study costs vs Adriatic that would require capital to bring the Vares project into production. An NSR created over the Vares project would be highly sought after and highly valued given the world-class nature of the orebody, project financial metrics and near-production status; and we believe may attract a similar valuation as the Solgold royalty.

Once the Vares project is producing, surplus cash flows could be invested in the development and exploration of its numerous brownfield and greenfield prospects across Bosnia and Serbia. We feel there is clear potential for Adriatic to evolve into a mid-tier miner once Vares is developed. The recently acquired Serbian assets provide another valuable expansion opportunity in addition to the clear exploration potential remaining in Bosnia

We believe the key Catalysts over the short term remain: 

• achieving exploitation permits for Rupice & Veovaca
• the release of an updated JORC MRE for Rupice and Kizevak
• delivery of a PFS & BFS for the Vares project

Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in Adriatic Metals (ADT).