Leyland Lines - June Insights

Welcome to the June edition of our newsletter for 2022.

Rising inflation and interest rates globally have impacted markets, with both equity and bond markets dropping to adjust for the rate rise, increasing the return on cash (risk-free rate of return). The ASX is down about 10% for the month (at time of writing).

Signs of inflation have been clear for some time, and well before the Russian invasion of Ukraine. Energy prices were rising mainly due to political ineptitude resulting in underinvestment in power generation. The global economy was reopening with demand far outpacing supply due to supply chain disruptions. This, along with many other contributing factors, has resulted in a general increase in prices.

Central banks globally appeared slow to act given their mandate to maintain price stability. More recently, central banks have aggressively increased rates to combat very evident inflationary pressures. The most effective tool to curtain demand is the ‘wealth effect’, whereby consumers feel less wealthy as asset prices fall (or visa-versa). Additionally, those heavily indebted households will experience an increase in debt servicing, although this appears manageable as unemployment is at record lows and incomes are rising. Consumer confidence is low notwithstanding technical full employment.

In short, interest rates are normalising from emergency settings impacting markets and the consumer. The US consumer accounts for 14% of global GDP, and a large portion of them are under stress (50% have zero savings). The market is cycling enormous growth. This has now normalised.

Without attempting for forecast future macro movements, it appears that several factors that have contributed to inflation are now reversing. For example, container shipping costs have dropped sharply.

Shipping freight costs

shipping-rates

Scrap metal prices have also fallen

scrap-metal-prices

Equity valuations have returned to what is considered ‘normal’

Equity Valuations

If earnings can be maintained, or fall only slightly, valuations appear reasonable. The valuation gap between the return on equities versus that of cash (risk-free) has been maintained. High quality large-cap companies have been sold off in what is a broad market retracement. These companies have weathered numerous cycles and should do so in this instance. When things become clearer, share prices will adjust accordingly.

Finally, China remains a key factor, as it recommences reopening, freeing up of supply chains (Shanghai is the largest freight terminal globally) and increasing demand for commodities.

The market tends to overshoot in both directions. The pending end-of-financial year results will tell an interesting story.

Throughout the month both Alex and Charles Leyland appeared on Ausbiz discussing highquality earners in a volatile market.

In this edition of Leyland Lines, we discuss The Lottery Corporation. For the video of the month, we include an insightful discussion our Managing Director, Charles Leyland, had with David Gonski. Finally, in light of the recent volatility, we thought it timely to reflect on the decision-making heuristics and biases that make smart people do dumb things.

Video of the Month

We were privileged to host a discussion with distinguished Australian, David Gonski.

The Lottery Corporation Limited (ASX: TLC)

Share Price: $4.49
Market Cap: $10b

Lottery

The demerger of Tabcorp has resulted in the spin-off of a powerful lotteries and Keno business into a separately listed vehicle called The Lottery Corporation (TLC). One of the highest performing lotteries businesses in the world, TLC has long duration and exclusive licences to operate lotteries. Lottery ticket sales are resilient to economic cyclicality, cash flows are steady and predictable, and there is a low ongoing need for capex. These characteristics mean we expect TLC to be able to deliver a fully franked dividend at a high payout ratio, while still paying down debt steadily. This may create the opportunity for future capital management.

Future earnings are largely predictable over the long term. The long duration of lottery licences issued to the company remove some key risks to the business. The licences to operate Lotteries have 21 years until expiry while the Keno licences have 29 years average until expiry.

TLC has a strong distribution network. The lottery tickets are sold through 4,000 retail outlets and online through its digital app and resellers. Digital sales are now 40% of revenue. This along with TLC customer database means it can reach a very large audience. The lottery is the most popular form of gambling in Australia. Keno, a game of chance, is distributed in nearly 3500 venues such as hotels and clubs.

Lottery ticket sales have historically been resilient to economic cycles, in fact sales may actually increase in tough times. TLC is, as a result, is a steady cashflow generator and not capital intensive. It is a not dissimilar to an infrastructure asset in this way. Infrastructure and annuity type assets are currently very much in demand from the large super funds, both local and overseas, seeking investment certainty. There is a chance that TLC may be taken over by one of these funds, at the very least, they are likely buying large shareholdings in the company.

Revenue 3,206 3,504 3,565 3,688
growth yoy % 9.8% 9.3% 1.7% 3.5%
EBITDA 611 695 724 768
EBIT 591 609 640 685

Broker forecasts expect TLC to deliver near 15% growth in EBITDA in FY22. Growth is expected in both the Lotteries and Keno divisions. This may be peak short-term earnings as the large number of jackpots in 2022 are expected to normalise in future years, earnings are still to be healthy but profit growth is to flatten into FY23 and FY24. The forecast price earnings ratio is currently a bit high, at 25 times based upon 2023 earnings but the dividend is expected to be 3.5%, fully franked in this year. Broker valuations have price targets of $5.40.

This stock is not risk free, demergers are complex and costly, smaller jackpots can lead to lower sales and licences might not be renewed on expiry. The question on valuation is how much of a premium should investors pay for certainty of earnings, and dividend, in these uncertain times?

Jon Stutt

Why Smart People Do Dumb Things

Leyland

Warren Buffett gave an important lecture at Florida University on 15 October, 19981. An eager MBA student asked him about his involvement in the rescue of one of the most spectacular hedge fund blow-ups in financial history.

A fund by the name of Long Term Capital Management had great success making money from the arbitrage of bond securities from 1995 to 19982. ‘LTCM’ was invincible and some of the smartest men in America were in charge.

The fund was a behemoth. $126 billion in assets under management. No less than $10 million to be part of the action. Initial success was attributed to the genius of its founder, John Meriwether—a former high flyer on the Salomon Brothers trading desk.

And he was in good company. The principal shareholders of LTCM were Nobel prize-winning economists Myron Scholes and Robert Merton plus 13 other men.
These men, “if you take the 16 of them, they have about as high an IQ as any 16 people working together in one business in the country, including Microsoft. An incredible amount of intellect in one room,” said Buffett.

But they blew up. And they blew up big. By September 1998, the company’s risky trades brought it close to bankruptcy.
LTCM’s size meant it was ‘too big to fail.’ The U.S. Federal Reserve had no choice but to step in. The pending collapse was going to spark a global financial crisis. The call to Buffett pleading for help came next.

Buffett found it fascinating, “…they’re not bad people at all; but to make money they didn’t have and didn’t need, they risked what they did have and didn’t need. That is just plain foolish; it doesn’t matter what your IQ is. If you risk something that is important to you for something that is unimportant to you it just doesn’t make sense,” said Buffett 3.

Many of LTCM’s shortcomings can be attributed to basic human biases common to all of us. The average investor can benefit greatly by being aware of some of these unusual patterns of thinking.

Following is a sample of the common biases and heuristics that get us into trouble when investing. No matter your IQ. We conclude with some advice to help overcome these biases.
It’s our job as value investors to be aware of irrational thinking and moments of wonder.
As Buffett warned in his lecture, “the downside, especially if you are managing other people’s money, is not only losing all your money, but it is disgrace, humiliation and facing friends whose money you have lost.”

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