Weekly Commentary 31/05/21: Operating leverage

The FTSE was quiet remaining just above 7,000 through the week. Looking at the five best performing stocks since the start of the year (Ashstead +53%, Entain +47%, Evraz +38%, Glencore +38%, Lloyds +37%) and the worst five (Tesco -24%, Just Eat -23%, Fresnillo -19%, London Stock Exchange -18%, Ocado -16%) it’s hard to discern any theme. Nasdaq was up +2% last week, S&P 500 +1%. Copper, which is normally seen as a good economic indicator, is up +29% since the start of January, and spiked last week as the Democratic Republic of Congo banned exports of copper and cobalt concentrate.

This week I look at three different stocks, all with operating leverage, so I thought I’d draw some themes together. Both operating and financial leverage are a way of amplifying returns; when it goes well you have a multi-bagger, and when it goes badly you have Northern Rock. I think most investors have a good feeling for financial leverage, because it’s easy to detect by looking at equity / net debt or equity / total assets.

Operating leverage is harder to measure with traditional ratios. Perhaps the most popular shorthand is gross margin, which can be found by clicking on SharePad’s “Financials” tab, then “Ratios” within “Profit Ratios”. The theory is that as revenue grows, fixed costs like marketing and admin (which aren’t captured in the gross margin) stay relatively fixed; all else being equal, a lower Cost of Goods Sold (COGS) and a higher gross margin mean that more incremental revenue drops through to profits. The idea is that high fixed costs mean that even a small increase in revenue is disproportionately valuable. The first company I look at this week is IXICO, the medical AI company, which reports a gross margin of 68%.

The second company is Tharisa, the South African chrome and platinum miner. As the company has relatively high costs and fixed assets / capex needs, the stock is more operationally geared into rising PGM prices (e.g. Rhodium) than the likes of Sylvania. For Tharisa a +61% H1 vs H1 revenue increase translates into a 6-fold increase in net profits. For Sylvania a similar increase in top line only results in +67% increase in net profits. Like financial leverage, operational leverage amplifies returns but also risks.

Tremor International is the final company, enjoying the benefits of operational leverage. This Israeli AdTech business last week reported Q1 2021 net revenue +96% and is enjoying the benefits of a gross margin of 75%. Meanwhile the company’s fixed costs like R&D and Sales & Marketing stayed flat, so the benefits are dropping through to the bottom line.

But I wouldn’t suggest that a high gross margin, or high fixed costs, is the only way to think about operating leverage. Because operating leverage is about incremental costs associated with generating future revenue. So Amazon with its $1.6 trillion market cap is perhaps the ultimate operating leverage business. The company has rigorous cost discipline but ploughs back profit, investing in both lower prices for consumers and new businesses such as AWS. Clearly Amazon doesn’t look like a traditional business with operational leverage; its gross margin has averaged around 25% (still superior to Tesco’s 7% though) and it’s hard to argue with the $419bn FY 2020 of revenue (up from $3bn revenue in 2001).

IXICO H1 to March 2021

This profitable medical AI company, that specialises in brain / neurological diseases, reported H1 results to March 2021, with revenue +8% to £4.9m. They help pharma companies that have developed promising drugs to make their clinical trials more effective. For instance, they look for digital biomarkers to help firms designing trials to pick the patients that are most likely to respond to treatment. Despite having a gross profit margin of 68%, profits are tiny: at the moment £635K (up +29% y-o-y) but I think this could have potential. There was £7.0m of cash on the balance sheet at 31 March.

History Founded in 2004, IXICO reversed into Phytopharm (listed on AIM, with a Parkinson’s Disease drug, Cogane, that failed phase II clinical trials) in 2013. The reverse listing valued the company at £10m, or 67p per share. The four founders were research scientists at University College, King’s College and Imperial College, working on ‘Information eXtraction from Images’ (IXI), hence the company’s name IXCIO. Since then the number of shares has roughly trebled from 15m at listing to 48m, as the company has come back to investors to ask for more money.

The company struggled to generate revenue growth for a few years after listing, then in 2019 announced revenues “materially ahead” which turned out to be +41% or £7.6m FY Sept 2019. A few years of +40% revenue growth with a 68% gross margin would be very exciting indeed. Sadly growth has levelled off with a £7m hit from a de-scoped Huntington’s Disease trial (i.e. the clinical trial failed and so IXICO’s revenue will be hit). The company announced a £19m order book at March 2021 v £22m April last year. The company has now switched focus and is prioritising Alzheimer’s trials. There are around 150 clinical trials targeting Alzheimer’s at the moment, of which IXICO has less than 5%. They have worked with 9 of the 14 largest pharma companies, but also have relationships with much smaller biotech firms. There are several presentations on InvestorMeetCompany for more detail.

Broker forecasts Cenkos are the company’s broker, but haven’t published any forecasts. New trials have been delayed by the pandemic, so the +8% growth reported in this H1 is a result of contracts signed before Covid-19. This suggests to me that despite the upbeat commentary, perhaps the numbers could go backwards FY to Sept 2021F/22F? The company also said on the most recent IMC presentation that they expect the gross margin could come under “a little bit of pressure”.

Ownership BGF Investment Mgt is the largest shareholder with 18.6%. This fund manager was set up in 2011 by the large UK banks to fund smaller companies, following a campaign by Sir Nigel Rudd (Deputy Chairman of Barclays until resigning in early 2009). He was keen to see smaller growth businesses that were too risky for banks to lend to get funded. Other shareholders are Octopus 13%, Gresham House 11.2% and Amati 10.5%.

Risks Management highlight 3 key risks. 1) Losing a contract, or early termination for instance when a trial fails as with the Huntington’s Disease trial. 2) IXICO stores and analyses confidential health data, so privacy is key and adhering to GDPR and other data protection regulations is essential. 3) Risk of cyber attacks across the health sector has been growing, for instance Ireland’s health service was recently targeted by Russian hackers.

Valuation This looks expensive on most valuation metrics, e.g. Price/Sales 4.5x EV/EBITDA 23x. However the £7m of cash, current profitability and significant potential mean that I wouldn’t dismiss it either. Given that the company’s software helps with a variety of drug trials for different diseases, it has a lower risk profile than investing in a single biotech with a Phase II drug trial. The company estimates that its addressable market is £120m to £150m and that they have < 10% market share. Though I’d warn that on the IMC call, management were asked who their competition were and the answer wasn’t very enlightening, so perhaps the company’s market share statistic should be treated with some scepticism.

Opinion One to keep an eye on. Using AI to improve drug trials is a really hot area at the moment, for instance this Andreessen Horrowitz Bio Eats World podcast. It’s hard to know how the company’s technology compares with competitors, and how strong the relationships are with big pharma, but I think the key measure will be if they can start winning business again and growing the top line. That way the operational leverage should generate exciting profit growth.

Tharisa H1 to 31 March

Tharisa, the South African platinum and chrome miner reported H1 to 31 March last week, with revenue +61% to $313.6m and PBT up x6 to $104.6m. Cash from operating activities at $104.9m was almost the same as PBT, yet there were some large movements in different directions (e.g. $31.3m change in receivables, offset by adding back $16m of depreciation, $9.6m change in payables a $2.7m change in inventory) which netted off. The company has $155m of trade and other receivables on the face of the balance sheet, which is half of H1 revenue. Following the spike in PGM metals the balance sheet looks much healthier and they finished the period with $29.8m of net cash vs a negative -$26.2m at the end of H1 last year. Guidance for FY2021 is maintained at 155 koz to 165 koz PGMs (6E basis) and 1.45 Mt to 1.55 Mt of chrome concentrates.

Currently all PGM miners are benefitting from the contribution from Rhodium, which is up +63% since the start of the year and accounts for 65% of Tharisa’s revenue in H1 to March 2021 (v 48% H1 last year). See the company’s Prill Split below.

Tharisa is a different investment story to Sylvania Platinum, which has lower PGM “all in” costs of $801/oz (top quartile in the industry) for the companies H1 (i.e. July-Dec last year). This rises to $923/oz or Rand13,815/oz for SLP’s Q3. Tharisa has higher PGM mining costs as the chart below shows, and is well into the bottom quartile (i.e. right side of the X axis on the graph) in terms of “all in” costs.

However, unlike SLP which relies on host mines for chrome tailings, Tharisa is an integrated miner with its own chrome mines. This means that around 40% of Tharisa’s revenue is chrome mining and agency trading, and 60% PGM metals.

Operational gearing I thought that it might be a useful exercise to compare the two PGM companies and discuss a counter intuitive aspect of operational gearing. That is, a company with high fixed costs is more geared into a recovery, and the net profits (and probably the share price) are more sensitive to changes in revenue. Comparing Tharisa to Sylvania is fiddly, because they have different year ends: Tharisa has just reported H1 to March, whereas SLP has reported Q3 to March. However adding SLP’s Q2 and Q3 figures gives the same time period as Tharisa’s Sep to March H1. The table below shows that both companies reported comparable revenue growth, helped by the PGM basket price, notably Rhodium, with Tharisa revenue +61% and SLP +65%. However, as the table below shows, because of Tharisa’s higher costs and operational gearing, net profits were up 6.3x to $75.7m versus SLP’s less geared +67% y-o-y rise in net profits.

Fixed costs The second aspect to note with high fixed costs is that Tharisa’s approach is relatively asset heavy. I’ve compared both Group’s FY Capex and Property, Plant and Equipment as a percentage of revenue. Tharisa PPE at $279m was 9x higher and capex at $71m was 13x higher than SLP, despite the two companies having a similar market cap. It is possible that SLP’s capex rises from the very low levels reported in its FY June 2020. The company mentions “Project Echo”, which has been ongoing for a couple of years and involves more equipment (fine grinding mills and flotation circuits) to continue working on converting chrome tailings to PGMs.

The more general point remains valid though; SLP operates a more profitable and less capitally intensive model, but the downside is that rather than short term movements in Rhodium, Sylvania’s fortunes are linked to their host mines and in turn the ferrochrome and chrome ore markets. The SLP Annual Report mentions that a key risk is that “the retreatment of dump material has a finite life and the processing of current arisings alone is not sustainable. It is essential for the long-term continuation of the SDO that additional feed material is found and committed to the plants or the mining assets are further explored for development.”

Thus I don’t think the main risk for SLP is the Rhodium price falling. Even if the price fell 90% back to 2019 levels SLP would still be profitable, whereas most competitors would struggle. SLP’s current ROCE is 44% v Tharisa 22%. Instead the risk is the company needs to reinvest. A PGM prices boom is not necessarily good news; this will bring in more capital to the sector and supply of PGMs will increase as mines that were previously uneconomic will be put to work again. High PGM prices also bring the risk that the cash strapped South African Govt introduce a windfall tax on the precious metal miners.

Opinion Currently both miners generate around 70% of revenues from Rhodium, however the platinum price has recovered strongly to around $1,200 (+46% vs a year ago) and is now trading above its 200-day moving average and at a 6-year high. Because of its structurally lower costs (i.e. lack of operational gearing), I’m more positive on SLP than Tharisa. Clearly there are many other moving parts – both miners costs are rising due to inflation – but those costs are priced in South African Rand, whereas revenues are in US dollars. If others are more positive on Tharisa that’s fine, but I think it’s good to understand that though market caps are fairly similar, the two companies have rather different value drivers. See the SharePad comparison table below:

Tremor International Q1 trading update

This Israeli AdTech platform (previously known as Taptica) reported Q1 net revenues +96% to $69m. Naturally this is a relatively easy y-o-y comparison as Q1 last year saw advertising spend drop precariously; marketing budgets tend to be very sensitive to economic optimism. As a reminder, gross revenues are re-billed to clients, so net revenue is a better indicator of progress, and the same is true of net revenue at traditional marketing firms like The Mission. However, TRMR’s changed its reported revenue to recognise the Programmatic division on a net basis, while its Performance division revenue is on shown on a gross basis. The change was apparently made to be more comparable with US peers, in any case it certainly gives me a headache thinking about it.

Statutory PBT was a healthy $14.4m for Q1, vs $16.8m loss Q1 last year. I tend to ignore adjusted EBITDA, but net cash from operating activities was $19m vs breakeven last year, though there were some large swings in receivables and payables in both this year and last year. They ended March with $103m of cash. The group also announced that they have filed a registration statement with the SEC for a proposed secondary listing (American Depositary Shares) on Nasdaq.

Broker forecasts FinnCap are the company’s broker and released an 18-page research report following the results. Their broker increased FY 2021F and FY 2022F revenue forecasts by +12% and +9% to adj give EPS of 37$c FY 2021F and 42$c FY 2022F. This puts the shares on 26x next year’s earnings. FinnCap like to point to peer group comparisons of US-listed stocks such as Magnite, The Trade Desk, PubMatic and Viant, which are trading on higher valuations but enjoying lower revenue growth than TRMR.

Privacy and regulation Some commentators have highlighted that Apple’s recent decision to ask users if they are OK being “tracked” by apps may affect the whole AdTech industry, because if users opt out, then advertisers will no longer be able to use the identifiers which allow targeted advertising. However FinnCap, the companies broker, suggest Tremor could benefit from pro-competitive regulation and point to the UK’s Competition and Markets Authority (CMA) who ruled against Google/Alphabet in July last year, and a US anti-trust case against the same firm. I feel like this is an area where investors really need to be paying attention; my gut instinct is that regulation tends to benefit incumbents, rather than new entrants. That’s certainly true in banking vs FinTech, but I can see that AdTech could have a different dynamic.

Ownership Mithaq Capital, the Saudi Arabian fund remain the largest shareholder with 23%. Tosca has 16.6% and Schroders 14.7%. News Corp own 6.3% following the acquisition of Unruly (a Sell Side Platform with access to News Corp readers) at the start of last year, with Rebekah Brooks and Norman Johnston Non-Execs on the TRMR Board.

Opinion At 792p TRMR has proved the doubters (including myself) wrong, and has doubled since the start of the year. It’s up 9x since its March 2020 low. AdTech seems to me a business where things can change very quickly, and I’m skeptical of the idea that the stock should trade on a similar valuation to The Trade Desk 150x 2020A EV/EBITDA and 34x revenue suggests to me that there is better value to be found elsewhere.

Bruce Packard


The author owns shares in Sylvania Platinum

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