Good news on vaccine rollouts and the anticipation of reopening economies gave global stock markets plenty to rejoice. The fund had a busy first half with several of our investments running up to intrinsic value. In times when the main equity markets gained so much in such a short time, we are grateful for the flexibility to invest wherever we find the best opportunities. Our efforts got rewarded with three new additions to the portfolio which we will describe in this letter. Taken together, we started the year with 77.45% of the portfolio invested versus 73.90% at the end of the second quarter. 

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Kaspi.kz AO

Our first new investment is a company that has more than tripled Earnings per Share over the last three years, has a Return on Equity over 70%, with higher net profit margins than Apple and a long runway of growth. Despite this impressive growth, the company is committed to paying out over 50% of its earnings in dividends (65% in 2020). Kaspi, which was recently listed on the London Stock Exchange, is the largest payments, e-commerce and fintech company in its home country - by a very wide margin. 

Here are a few of its impressive stats:

• Out of a total population of 18.8m, 10.2m use its app on a monthly basis, half of them use it on a daily basis
• In e-commerce it has a leading market share of 63% (source: PwC) 
• It has over 70% market share in cashless payment transactions

It wouldn't be uncommon to see a company with these characteristics trade at double-digit revenue multiples. Yet instead, we bought our stake in April at a valuation of 15x this year’s net earnings. How can this be? One explanation might be that it’s located in Kazakhstan, a country known only to most through the unflattering lens of Sacha Baron Cohen’s character Borat. Although we think Kazakhstan’s fiscal situation is in relatively good shape with low government debt levels and low reliance on external funding, we can’t ignore that it is an emerging economy with a high dependence on oil & gas. 

However, the criteria we use to evaluate the quality of a business and management are the same everywhere. For countries with a higher risk profile, we limit our allocation and our expected return has to be higher. Because of this country risk, we decided to limit the investment to 5% of the fund’s capital instead of the usual 7% for a high conviction investment.

How did Kaspi get here? The architects of Kaspi’s success are Vyacheslav Kim and Michael Lomtadze. Originally Kaspi was a traditional state-owned bank with a focus on corporate lending. It was privatised around the turn of the century and bought by Kim, a young entrepreneur who was running the largest retailer in the country. In 2006, Baring Vostok private equity invested in the bank and soon thereafter, Harvard educated Lomtadze joined. 

Over the years, the company morphed from a bank into a tech company with a customer-first strategy, adopting the Net Promotor Score as its primary KPI and placing the focus on product quality and speed. Gradually the focus shifted from consumer finance to shopping and payments. In 2021, over half the net income will come from Payments and Marketplace, up from 30% at the start of 2020. Today, Kaspi has three business segments with multiple revenue streams and services per segment.

1. Payments: In 2019 Kaspi introduced a merchant Point-of-Sale (POS) system with QR codes. Thanks to its proprietary payment-processing network, Kaspi can charge merchants just 0,95%, substantially below incumbents such as Visa & Mastercard which typically charge over 2.5%. Funds are also available instantly. Prior to Kaspi entering the market, Kazakhstan had around 100k active POS systems. Kaspi was able to connect over 150k POS systems in less than two years and aims to grow this to a total of 400k in the medium term. This strategy is also perfectly aligned with that of the Government of Kazakhstan, which is simultaneously making an important effort to move away from a cash-based to a digital (read taxable) economy. 
   
   The driving force of growth in this segment comes from converting merchants to Kaspi Pay driven by incentives such as ease of use, low payment processing cost, merchant financing and bonus points for consumers. Payment networks can be very attractive businesses benefiting from scale advantages and network effects. Kaspi has a leading market share of over 70% and a long runway for growth in a business that generates high incremental profit margins. 
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2. Marketplace: Since starting in 2014, the marketplace segment has grown to include 36,600 merchants, reaching more than 3m active customers. Kaspi carries no inventory, instead it provides a platform for merchants to sell their products to Kaspi customers. Merchants increasingly rely on the platform; by the company’s estimate they generate about a third of their sales through this channel. Kaspi earns revenue by charging merchants a fee per transaction. Growth comes from increases in GMV (Gross Merchandise Volume) and take-rate (the fee), which currently sits at 8~9%. A recent growth initiative is the addition of Kaspi Travel which sells airline and train tickets. This business is already cash positive and reached a market share of 20% in just a few months of operations.
   
   Leading marketplaces are valuable businesses that benefit from a network effect, as merchants want to be on the platform where the consumers are and vice versa. Kaspi’s value proposition in this business is further enhanced by easy and low-cost payment options and the availability of merchant and consumer financing.
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3. Fintech: This segment is the company’s original lending business. Approximately half of financing today relates to the “Buy Now Pay Later” feature, letting consumers pay for their purchases on the marketplace in instalments (“free for the first three months”). The balance is made up of car loans, merchant finance and general-purpose loans with relatively short durations. Proprietary data from its users’ payment and e-commerce profile allows Kaspi to build a highly accurate credit risk profile, resulting in losses far below the industry norm. The average yield on the loan portfolio is above 30% and credit losses are below 2%.

What lies ahead? Kaspi’s first-rate management copied successful business models in other countries (e.g. WeChat, Alipay) and applied this to what was until recently a cash economy in Kazakhstan. Each of Kaspi’s activities are high-quality businesses that dominate their market and benefit from competitive advantages and significant growth potential. Synergies between their three main businesses further enhance the value proposition and barriers to entry. The growth in digital payments, e-commerce, and the potential to add new products such as travel and merchant financing, ensure significant opportunities over the medium term. We believe Kaspi has a long runway for growth within the Greater Caspian region and Ukraine.

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Delfingen S.A.

Paris-listed Delfingen offers solutions for the protection of electrical networks and safe fluid transfer for the automotive industry and other industrial applications. Basically, these are most of the black tubes and hoses you see when lifting the bonnet of a car. The plastic protection products for the car industry are its largest business, representing approx. 50% of the group’s revenue. In this niche business, Delfingen has held an 85% market share in the US since 2008 and recently doubled its market share in Europe to 60% with the acquisition of Germany based Schlemmer, one of its two main competitors. The company has also developed several other businesses such as textile protection products and fluid transfer solutions. Within automotive, hybrid electric (HEV) and electric vehicles (EV) contain not only more, but also higher value-added protection products. Further growth of HEV and EV should support both revenue growth and margin improvement over the medium term. Synergies from the Schlemmer acquisition and increased scale should also result in higher operating margins.

Delfingen emerged stronger from the coronavirus crisis thanks to tight operational management in averting liquidity issues and a transformative acquisition at a very attractive price. Schlemmer, the company it acquired, was held by a private equity fund and unsurprisingly, was highly indebted when it collapsed into administration. During the second half of 2020, Delfingen acquired the European, Russian and North-African operations of Schlemmer out of bankruptcy, effectively adding 50% to group revenue at a depressed valuation. Due to COVID-19, the company faced little competition in the acquisition process and was able to lower its price significantly. On top of that, a strong recovery in the second half of the year resulted in better-than-expected revenue and results for Schlemmer. Management now believes a pay-back time of less than two years is achievable. At 7x our estimate of this year’s after-tax earnings we believe the valuation is attractive for a company with a strong competitive position, a tailwind of global government policies to promote HEV and EV, and the ability to grow earnings over the medium term.

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Atos S.A.

Based in France, Atos is a large IT-services business that helps clients manage mission-critical services such as migration to the cloud, cybersecurity, app development and maintenance. Approximately 70% of revenue is recurring and the client retention rate is above 80%. Atos runs this global business with more than 100,000 employees. A people-based business results mostly in a variable cost structure, although that is less the case in countries with rigid labour laws such as France and Germany. We were attracted by the combination of relatively stable earnings and a stock price at multi-year lows as a result of concerns that are likely to be temporary.

Negative market sentiment: 

First off, customers moving from private datacenters to the cloud have been a drag on revenue since 2016. We expect an acceleration of the migration to the cloud as a result of COVID-19 to hurt the company’s results over the short term. However, over the medium term we expect this will have a lower impact as more than 60% of clients have now migrated to the cloud and revenue affected by this trend dropped to less than 30% of group revenue. 

Secondly, in April 2021, the company released a statement that its auditors issued a qualified opinion on its FY2020 financial statements for issues related to the timing of revenue recognition in two US entities. But when management announced first-quarter results, they confidently stated that the misstatements were not material to the consolidated financial results. 

Thirdly, in January the press leaked that Atos was conducting due diligence into acquiring a competitor (DXC) and its share price dropped 13%. When the company announced that it was walking away from the deal the share price did not recover. 

Lastly, the market was disappointed by first-quarter results that came in below expectations, even when management attributed these to the timing of certain large contracts and maintained guidance for the year 2021. However, in July the company announced that results for the year would now come out below these expectations.

Earnings power: 

During the June 2020 Analyst Day, Atos presented its mid-term targets: revenue growth 5%-7%, operating margin of 11% to 12% and free cash flow conversion of >60%. The main drivers of revenue growth will be M&A and the continuing shift to faster-growing activities. Digital, cloud, cybersecurity and decarbonisation segments are expected to grow from 50% to 65% of revenue. These activities already generate higher margins, and profit margins should receive a further boost by the potential for more offshoring and automation. The negative impact on revenue and margins from the migration to the cloud is also expected to stabilise over the medium term. Cash conversion is expected to improve when progress is made on restructuring efforts in Germany and from lower working capital as a result of automation and increased discipline.

Valuation: 

We bought shares at less than 8x this year’s consensus after-tax earnings. Management’s mid-term targets are a significant step-up from historical results but negative market sentiment allowed us to invest at a price that does not require these goals to be achieved. Our downside is protected by stable, sticky revenues, the long-term growth for most of Atos’ businesses and a depressed share price.  

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Boustead Singapore & Boustead Projects (sold)

The two Boustead entities have been an important allocation for the fund since we invested in the summer of 2015. We often come across companies that are valued at a significant discount to the value of the company’s cash and real estate. Generally, the explanation is poor corporate governance and poor capital allocation. We believed Boustead was different. Long-term shareholders of Boustead Singapore had done well under Chairman and controlling shareholder F.F. Wong’s stewardship and Mr Wong emphasised creating value for all shareholders in the company’s communication. Boustead had all the marks of an attractive ‘asset play’; a company with a Net Adjusted Asset Value significantly higher than the stock market capitalisation, a catalyst on the horizon and management aligned with shareholders. 

Boustead Singapore, the oldest company on the Singapore stock exchange with its roots tracing back to 1828, was comprised of several business lines. Two out of the three businesses were straightforward: an energy-related engineering business and a geospatial software distribution business. The third business was the real estate business ‘Boustead Projects’. Originally this was a traditional asset-light property design & build business, but this changed during the global financial crisis of 2008. Back then, global customers like Bombardier and Airbus had lost the appetite for using their balance sheet to own their tailor-made industrial properties outright. Boustead saw an opportunity to ‘design, build and lease’, keeping developed real estate on the company’s balance sheet.

Over the years this portfolio of properties, leased to quality tenants, grew large but its value did not get reflected in the company’s financial statements and certainly not in the stock price. Management’s intention to sell the property portfolio to a REIT, unlock the value and refocus on capital-light activities was a key element in our investment thesis. The fund purchased shares at less than 50% of our estimate of Boustead’s fair value. The largest component of intrinsic value was the portfolio of leased properties (appraised by an external valuation agent). Furthermore, we expected the fair value of Boustead Singapore and Boustead Projects to grow by the value generated in the different operating entities during our holding period. Whilst we have been patient owners for more than 5 years, we were disappointed when the catalyst finally played out. 

On New Year’s Eve 2020, Boustead announced that it would sell a large part of the real estate portfolio. However, shareholders were initially kept in the dark about the use of proceeds from the sale. We were expecting a significant pay-out but were disappointed when the company announced only a small special dividend (14.5 cents per share). The bulk of proceeds was used to pay down all debt and retain cash for a challenging construction environment in Singapore and property development in Vietnam, a market in which Boustead has no particular competitive advantage.

With the catalyst gone and our doubts about how the company wants to use the proceeds of the property sales, we decided to exit the position. While Boustead was a profitable investment, it fell short of our return target. Going forward, the fund’s allocation to asset plays will likely be smaller, reflecting our strong preference for higher quality operating businesses with the potential to grow intrinsic value at an attractive rate. 

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Our next letter will be out in the first weeks of January 2022 and will mark our 10th anniversary. Wishing you all a safe and healthy continuation.

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Update on the five largest positions of the fund:

Volution Group Plc (6.95%):

Volution, a leading supplier of ventilation products, continued to show strong operating performance as a result of the increasing awareness of the importance of indoor air quality, coupled with ever-tightening regulations on energy efficiency. On a constant currency basis, organic revenue for the current fiscal year to July 2021 is expected to increase by more than 20%. This growth is supplemented by three acquisitions. 

Kaspi.kz AO (6.46%): see long-form write-up above.

Shinoken Group Co Ltd (6.02%):

Shinoken is a Japanese real estate developer that sells additional products and services to tenants of apartments and condominiums developed by the company. Condominium sales were disrupted by COVID-19 emergency measures and stricter rules on mortgage applications. A recent trading update confirmed a return to normal for sales revenue and profitability. Our medium-term outlook for Shinoken remains unchanged. 

Tyman plc (5.72%):

Tyman is a leading international supplier of engineered components for the door & window industry. Decisive management intervention during the COVID-19 crisis, followed by pent up demand release in the construction industry during national lockdowns, helped create a positive trading momentum with results strongly ahead of expectations. Revenue was up 10% and operating profit was 20% higher in the first half of 2021 vs 2019H1 despite challenges in the supply chain, raw material inflation and labour shortage. A progressive dividend policy was reintroduced and debt ratios improved to below 1x Net Debt to EBITDA.

Delfi Ltd (5.51%):

Delfi is the market leader in Indonesia’s chocolate industry with a strong ‘own brands’ portfolio and a vast distribution network. After a slump in sales and profitability due to changes in customer buying behaviour and international competition, the company was well on its way to restore both until COVID-19 hit. The most recent trading update showed that tight control on operating costs, working capital and capital spending have all helped revenues and margins back to pre-COVID levels