Ann: Preliminary Final Report, page-11

@MarsC,

Like you, I have been a shareholder in ARB for a considerable period of time.

When I first came across the company and started researching it from an investment standpoint, my initiation observation was that it was little more than a "metal bashing" business, and I was uncertain how it could possibly enjoy any pricing power and, therefore, any control over its operating margins.

However, the more I looked at the company, the more I came to appreciate the uniqueness of the product, as well as its reputation for quality and durability (in the minds of the sorts of people to which this matters, of which I am not one although ironically I do own an old ute that came with it an ARB canopy when I bought it second-hand).

Having closely followed and analysed the company's financial performance over many years (for a large part of my adult life, it turns out!), I can recall several occasions when the external macroecnomic environment appeared to be hostile to ARB's financial fortunes, and yet the company continued to grow and prosper anyway.

Slowing global economies in the past, high steel prices, low steel prices, high A$, low A$, buoyant consumer sentiment, depressed consumer sentiment, high interest rates, low interest rates, commodity price highs, commodity price lows, lunatics flying planes into buildings, wars in the Middle East, GFC's - almost no matter what the state of the world has been - none of these extraneous factors has stopped ARB from growing Revenues, Profits and Dividends, year-in and year-out.

I hear you expressing concerns about the commodity boom coming off the boil and the outlook for margins from the international foray.


I have learnt to have a more sanguine view of such things, believing - based on history, that even if some extraneous factors do have an adverse impact on ARB's financial performance - any disruption to growth will be short-lived.

I have great faith in the ARB board and management, combined with the robust business model, to continue to drive up the fundamental value of the company.

In fact, I think the groundwork has been laid for the next generation of growth; specifically, with the doubling of the capacity of the manufacturing plant in Thailand in recent years, as well as the establishment of new distribution centers in the US and in eastern Europe over the past 12 months, means that Sales sourced outside of Australia currently comprise 33% of Total Group Sales, which almost double the percentage of three years ago (17.4%)

[And that's not because the Australian component has dropped off; Australian sales are 9% higher than they were 3 years ago. It's also not exclusively attributable to the weakening A$ either, because, while the A$ has fallen by 30% since 2012, non-Australia Sales Revenue has doubled over the past 3 years, from $46.5m to $91.8m (the annualised JH15 Revenue run rate ex-Australia is $103m).]

So I don't sweat too much about the unravelling of the mining boom in Australia (in fact, I was/am hoping that market concerns about that particular adverse prospect would send the share price down, so that I can add to my holdings, but no such luck to date).

Instead, I think there are numerous growth channels that currently have enough clear traction to ensure ongoing earnings growth. (Also, as an aside, I notice many urban tradespeople doing just fine out of the housing boom, but maybe that's just a NSW- and Victoria-centric observation.)


As for your concerns about margins that are able to be garnered on Sales outside of Australia, there are some leading indicators for one to be able to draw on in this regard.

Firstly, the Thailand operations (which now account of 15% of Group Sales Revenue) have consistently generated EBIT margins that are higher than margins in the Australian business, although the gap has narrowed over time:

EBIT MARGINS (Australia vs Thailand)

DH2010: Australia [A] = 18%; Thailand [T] = 28%
JH2011: A = 23%; T = 31%
DH2011: A= 17%; T = 23%
JH2012: A = 23%; T = 27%
DH2012: A= 17%; T = 22%
JH2013: A = 24%; T = 24%
DH2013: A= 16%; T = 18%
JH2014: A = 20%; T = 23%
DH2014: A= 14%; T = 21%
JH2015: A = 20%; T = 20%


And then there's the fledgling European business, which has just opened a distribution center, and which made its first dollar of Sales less than 18 months ago.

While it is still very small as a contributor of Revenue, Europe is already profitable, and in the last half, generated an EBIT margin of 14%

EUROPE: REVENUE, EBIT AND MARGIN

DH2013: Rev = $0, EBIT = $0, Margin = N/A
JH2014: Rev = $1.3m, EBIT = minus $0.06m Margin = -4.7%
DH2014: Rev = $3.0m, EBIT = $0.30m, Margin = 10.1%
JH2015: Rev = $3.8m, EBIT = $0.53m, Margin = 13.8%


So, while it is admittedly early days, that the European business is generating EBIT margins in the teens, when fixed cost recovery will be limited due to the business still being sub-scale, bodes well for the final EBIT margins once the business matures, I would have thought.


The US operations warrant particular scrutiny, in relation to margin performance.

ARB has grown US-sourced Revenues from US$13m in FY2005 to US$32m in FY2015, which corresponds to a CAGR in excess of 9% pa (note: these US$ figures are not provided by the company; I have adjusted the reported A$ figures by the average exchange rate for each respective period).

While this top-line growth has yielded the sorts of operating leverage one might expect from an immature business, with margins rising over time:

USA REVENUE, EBIT and MARGIN (A$ values)

DH2010: Revenue[R] = $11.9m; EBIT = $-0.37m, Margin = -3.1%
JH2011: R = $13.2m, EBIT = $-0.16m, Margin = -1.2%
DH2011: R = $12.4m, EBIT = $0.08m, Margin = 0.6%
JH2012: A = $14.5m, EBIT = $0.18m, Margin = 1.3%
DH2012: A = $12.5m, EBIT = $0.13m, Margin = 1.0%
JH2013: A = $14.6m, EBIT = $0.50m, Margin = 3.4%
DH2013: A = $14.8m, EBIT = $1.32m, Margin = 8.9%
JH2014: A = $16.5m, EBIT = $1.94m, Margin = 11.8%
DH2014: A = $15.7m, EBIT = $1.42m, Margin = 9.0%
JH2015: A = $23.2m, EBIT = $0.10m, Margin = 0.4% (!!)


Two observations warrant making in regards to the US:

Firstly, while ARB has been actively selling into the US (via subsidiary Air Locker) for many years (since the early 2000's), it took almost a decade for this geography to generate an operating profit, and margins are still below the average for the broader ARB group.

I am not sure if this is a structural issue, or a lack of scale or lack of promotional investment, but I guess that it could be considered a disappointing result, considering how successful the decision to operate out of Thailand has proven to be, and how quickly the European operations have ramped up.

But I can offer no insights into how it is possible to improve the performance and growth rate of the USA business.

Secondly, after good momentum in the business over the past 7 or 8 half-year periods, in the last half (JH2015), revenue was up handsomely on both the prior period, as well as the previous corresponding period, yet the margin all but disappeared completely.

The only way I could possibly explain this is by suspecting (and hoping) that it represents a meaningful investment in revenue-leading costs, such as fixed costs around marketing, and a administration infrastructure associated with the establishment of additional warehousing and distribution capability.

If that is indeed the case, then ARB's JH2015 EBIT result is effectively understated by an annualised run rate of around $4m (assuming - crudely - a 10% EBIT margin on some $45m pa of USA-derived Sales).

For context, that $4m compares to $60m of annual EBIT for ARB currently, so it's not an inconsequential under-statement (if that is indeed what it is). But as I said, I can't say for sure to the extent that this cost impost in the US will reverse in coming financial periods.


At any rate, to summarise: I think one can always worry about all manner of extraneous facts that are beyond the influence or control of ARB and its management. But - given the company's history at prospering through all manner of macroeconomic environments - I suspect such worrying might be a misplacement of energy.

I am only able to invest on the basis of what is observable to me, and what I observe is a company that has - over the past two or three years - invested considerable capital (over $80m, in fact...almost the same amount that it invested, cumulatively, over the preceding decade), management effort and other enterprise resources in order to position the business for the next generation of growth opportunities.

I am prepared to say that I am certain that ARB will - in five years' time - be generating more Revenue and Profits than it is today, although I will leave the speculation about the exact path that will be followed to get there to others who reckon they know better.

A bit like you, despite being a happy shareholder, I am hoping for a stumble of some sort on the way, so that I can add to my holdings because I am not inclined to do so at the current share price and valuation based on near-term point multiples [*].

But my experience is that one needs to be quick whenever the share price wobbles, because the stock is not overly liquid and there are a good number of investors out there who tend to feel the same way - unfortunately [**] - as you and I seem to do about the company.


Adam-o



[*] Based on my modelling (which is always intended to be indicative in nature, rather than prescriptive), I see ARB generating Sales Revenue in FY2016 of some $365m, EBITDA of almost $80m, EBIT of around $70m and NPAT of a little over $50m.

Working capital requirements will remain elevated in the high 20%'s (27%/28% as a proportion of Sales) in supporting the extended global supply chain (historical WC-to-Sales has averaged around 21%) , and capex will be around $20m. The dividend payout ratio will remain at around 50% as the board looks to re-build the company's cash balance.

With these input assumptions, Net Cash at the 30 June 22016 balance date will end up being between $15m and $20m

Put that all together leaves the stock's short-term valuation multiples looking somewhat lofty:

P/E = 22.3x
EV/EBITDA = 14.1x
DY = 2.3%
FCF yield = 3.0%

Hardly mouth-watering!


[**] It is not lost on me that it is ironic that one of the most frustrating things about ARB is that just about everyone knows it is a good business. With it being a darling on the radar of just about every small cap specialist fund manager, and even some larger institutions, it is hardly an undiscovered stock. I sometimes wonder how much is baked into the premium valuation multiples on the basis of it being such a crowded investment.

What may I have been able to pay for this business otherwise? 12x P/E? 15x?

I know this is almost as futile an exercise as wondering about things that might de-rail the business permanently, but I simply can't help myself.