2007 was a year of change in the Kanday group which is likely never to be repeated. It will be remembered as a year of transformational change for the group as foundations were planted for the future. On a personal note, it may well be remembered as the year of the big spender. As is often the case when planning for the future, some costs need to be incurred, both in business and personally.
Your Chairman was married in the second half of the year (October 17 to be exact) and a wonderful future is promised with his young wife Jessica. Obviously then, a number of once off capital costs were incurred. (You all know about these costs to those of you who are married). What is encouraging then, is that it is anticipated there is a lot of silver lining to these changes, and indeed, the group still prospered in 2007.
Our gain in net worth was 26.30%.
The group continued to increase its’ focus on the equities and residential property markets during the year. This is due to a continued conclusion that funds from Crystal Brook Dental are most profitably re-employed outside the dental industry. Return on incremental capital is a very important subject when it comes to investing and is no more apparent than in the dental business. Running Crystal Brook Dental provides a very reliable annual cashflow, one which I can depend on strongly when making other capital purchase decisions. However, if I decided to use these profits in the dental business, I would not expect any significant increase in profits, if any at all.
Profitability would mostly likely fall by most measures, with expectant profits similar on an enlarged capital base. Crystal Brook Dental, then, is a great stand-alone business , but not one which can be grown profitably through retained profits. Many other dentists/groups have tried this, by purchasing satellite practices and the like, and all have returned to their principle practice with their tails between their legs.
The bottom line is that wage structures for assistant dentists and assistant dentist numbers and quality dictate that profitable expansion is unlikely.There are other issues with the dental industry which are not favourable such as high capital start-up costs and high ongoing maintenance capital expenditures, meaning profits need to be poured back into the business just to keep it operating. Indeed the group is embarking on a necessary capital investment program which will be discussed later. For this reason we have continued to re-employ dental profits elsewhere.
So what kind of business are we looking for. We want a business like Crystal Brook Dental which has high returns on capital employed, but also can re-invest income profitably at similar or higher rates of return. Additionally we are looking for a business which has low capital expenditure requirements to keep the business operating, so retained funds can be used to grow the business. Low debt to mitigate risk is also a desirable trait, especially when I don’t have my hands on the steering wheel, as is the case with minority positions. As part of this years restructuring, the Group is planning the sale of two residential investment properties and rolling these funds into the purchase of X. This is contrary to our previously announced strategy of rarely selling investment property but makes good sense when looking at the Group’s structure.
Two things are worthy of mention, one a personal move (one of this magnitude won’t occur often I hope) and secondly an intelligent(and obvious) business move. Taxation law in Australia provides that an individual’s personal place of residence is not assessable for capital gains tax when sold. Up until now your Chairman did not have an official place of residence, having sold the only property in his name last year. All other property holdings are in company structures. So this has been an issue as the capital gains tax represents as much as 25% of the gain in the property’s price, for properties held for over 12 months.
At the same time your Chairman has managed to keep his personal residence to very humble dwellings till now, preferring to focus his funds on income producing assets. This is in keeping with Robert Kiyosaki’s mantra that, “If your house is your biggest asset, then you’re in trouble”.What he is referring to here is that he really considers your personal residence as a liability by the strictest definition of the word, as the house produces a nett capital outflow, or better put a nett cash outflow (before consideration of capital gains – I can here the howls of protest).
Cashflow is the lifeblood of business. Without it , all ‘asset’ values become tenuous, especially during downturns.
As I write this letter, I am currently juggling the debt on three premium properties, two of which are not producing any income, as I go through the due process of preparing to sell my two properties in Como to fund the purchase of X. Never is it more apparent than with a nett monthly cash outflow of approximately A$15,000 from these properties, the importance of cashflow and the tenuous appraisal of balance sheet asset values.
To further highlight the subjective nature of asset valuation, particularly assets not underpinned by cashflows, the NAB has current valuations of $575K and $725K for my Como homes, when I will be marketing them at $750K and $950K respectively, a whopping $400,000 difference (or 30%). So by rolling the funds from the sale of the two Como properties into the East Perth property, two objectives are being met.
Firstly your Chairman is moving upmarket into a beautiful apartment and providing a nest for his pregnant wife (yes, thankyou or shie shie ni), and secondly moving a signficant amount of funds ($ 1.05million into a tax free position). This has come at a cost. Capital gains tax will be incurred on the Como properties, but this should be minimized through structuring into superranuation (my accountant assures me). Of significance the transaction should result in a debt free position in the place of residence, which is key as all interest assessable on debt against your home is non-deductible against other income.
Some of the brighter folk out there may have noted this and suggested why don’t I refinance the debt against the Como properties and use this to pay off the East Perth home. This way I could keep all properties and incur no CGT. Well, unfortunately folks this move would be purely motivated to minimize tax and hence is disallowed by the ATO. You may also be asking what about all those idle funds which will now just be sitting gathering dust (so to speak) whilst parked in the East Perth property unleveraged. One must bear in mind that we have not taken funds out of real estate. We have just moved them around in a transaction which results in the funds being in a no tax environment. And the funds are not idle. As part of the restructure the Group established a ‘Portfolio facility’ with the NAB during the year which groups residential property holdings together and lends up to 80% against their appraised value.
By transacting on these holdings recently we can be sure we have up to date valuations (unlike the undervaluation aforementioned). Already your Chairman has taken the initiative on this end with a deal in South Melbourne set to settle in early January. This will effectively leverage up the funds in the East Perth property (as part of the portfolio facility) and hence accelerate gains (as discussed in last year’s letter we only are comfortable with leveraging residential income producing property). There are a lot of timing issues at stake here, however your Chairman is comfortable the Group has the holding power to see these simultaneous transactions through to a satisfactory conclusion.
We show below Kanday’s proportional holdings in those non-controlled businesses for which only distributed earnings (dividends) are included in our own earnings.
| Flight Centre |
| Timbercorp |
| Timbercorp converting preference |
| Telstra |
| ANZ Bank |
| Salmat |
| Corporate Express |
| Harvey Norman |
| Westfield |
| Clime Asset Management |
| Ferngrove Vineyard |
At the beginning of this year your Chairman elected to review the policy of purchasing $X of shares on the first day of every calendar month, in the ordinary publicly traded stock which is deemed to be most appealing.
Before you become worried that this strategy was not working, all we did was increase the purchase to $X per month and defer purchases to a two-monthly basis. This reflected the increasing free cash flow of the Group, primarily through the elimination of business debt and through strong business operating performance. Also, by only purchasing every two months we can reduce brokerage fees. Though the cost of each transaction at this level is low, as a percentage and over time these ‘frictional’ costs could grow to a substantial amount.
This is what the Chairman keeps reminding himself of. That obvious business decisions which create ‘guaranteed’ returns are the best ones to make.
Protect what you already have. As Warren Buffett reminds us, 1. Don’t lose money 2. Don’t lose money.
Re-iterating, to finish the thought,the reasoning for this programmed purchasing was to help insulate management against the emotional rollercoaster which is Mr Market. A committed measured purchase (as a % of operating cashflows) on a pre-set schedule should help to ‘block out’ the noise of economic commentators.Our performance in this respect is pleasing thus far, however a longer time frame is necessary to fully analyse results.
Our allocations for this calendar year thus far are in the table below:
Share Purchase Program as per Sworn Agreement Dated 24/01/06 2007 Calendar Year
| Date | Security | ||
| 1/1/2007 | CAM | ||
| 1-Mar | CXP | ||
| 1-May | FLT | ||
| 15-May | MMA | SELL | |
| 22-May | CAM | ||
| 1-Jun | CAM | ||
| 2-Jul | ANZ | ||
| 2-Jul | ANZ | ||
| 2-Jul | FLT | ||
| 31-Jul | FLT | ||
| FLT | |||
| FLT | |||
| 1-Sep | No purchase | ||
| 1-Oct | No purchase | ||
| 1-Nov | CXP | ||
| 9-Nov | CXP | ||
| 13-Nov | FLT | SELL | |
| 1-Dec | FLT |
The pattern of stock purchases made shows that my adherence to the monthly purchase of stock has relatively insulated us from the emotions of stock selection.
Flight Centre Ltd has remained a firm favourite of your Chairman in stock choice as the fundamentals of this business remain intact and performance appears to have reversed the recent negative trend.There was a downward blip in the price of all stocks in late July and I jumped on the opportunity to purchase a significant parcel of FLT stock at depressed prices.In the future I expect we may not be so transparent in our disclosure of stock purchases as I expect if we have success of measure, copycats will follow.
As Warren Buffett said, great investment ideas are hard to come by, so we should protect our best ideas.
The psychology of investing is a deep subject often mentioned by Charlie Munger and will require further learning as the years pass. The process of stock selection continues to make this apparent to me.
Crystal Brook Dental
Crystal Brook Dental continued to take up most of your Chairman’s time, but continued to decline as a percentage of assets under management.
| Year | CBD % |
| Jan 2004 | 36.8% |
| Jan 2005 | 25.7% |
| Jan 2006 | 17.8% |
| Jan 2007 | 14.3% |
| Jan 2008 | 10.98% |
Capital expenditure will be an issue of significance for the group in 2008. A number of capital items will need to be replaced in calendar 2008.
A Velopex x-ray processor and new autoclave were purchased in 2007 but purchase of several other items was deferred due to the heavy cash requirements of the rest of the group during 2007. Items to be purchased in 2008 include compressor, suction motor, x-ray systems and potential chair upgrade.
This is a good illustration of the maintenance capital needs of the dental business. Not one dollar of extra profit is expected from these purchases, which are necessary merely to remain in business. Fortunately the majority of dental patients do not choose their dentist based on the quality of his equipment. As long as the premises are clean, the dentist remains the number one reason why they come. This will not change.
On the balance, the dental game still represents your Chairman’s specialty and offers high operating margins and returns on capital, albeit at the expense of large manager commitment ( sweat equity).
And there was plenty of it this year, breaking all personal revenue records.
Commercial Property Division
The group continued to hold only one commercial property in 2007, 34 Marri Cres Lesmurdie WA. The purchase of the dental premises has proved very intelligent, with the valuation of the property increasing significantly as commercial rents have risen. Lease increases are likely proving a significant profit burden on other dentists who failed to secure ownership of their premises.
2008 may see the return of group activity in this sector, as your Chairman considers the necessity for office space in the CBD to promote his fledgling funds management business. During 2007 the superranuation assets of Patricia Candeias were transferred to the holdings of the Kanday Super Fund.
This modest sum of money represents a move by the group in the direction of funds management. As a track record is established, advertising for other sources of capital should develop. Word of mouth is the best form of referral. We will take baby steps in this direction.
Great care must be taken when handling the funds of others, especially when they are still prisoners to the vicisitudes of market movements.
Residential Property Division
2007 was a busy year for our residential property division. As highlighted in the opening address, your Chairman has shifted his abode to swanky East Perth.
Furthermore, we completed the purchase of an apartment in Spring Hill, south-east Queensland in February. Our focus on the east coast of Australia continued when I travelled to Melbourne in August. I feel we were perhaps a little late here as prices had jumped since the beginning of the year.
However you do not make your fortune in property in 6 months. We are signed to purchase an apartment in South Melbourne, with settlement scheduled for early 2008. Your Chairman employed the services of a buyer’s agent for the sourcing and negotiating on the property. The fees upfront appear quite steep however may be worthwhile over time if the right property has been selected. Our focus remains on high yielding properties in excellent locations, with our focus shifting to the east coast where we feel relative value was to be found compared with the overpricing in WA.
This geographic spread of our holdings has taught us valuable lessons about the purchase process in other states and positioned the group to benefit from price upswings across Australia. Diversification in this case makes some sense. Of significance is the group’s move towards managed property investments. This shows our growth in this area, where our time is better spent elsewhere. Property management is a well regulated and established industry and property managers are likely a safe steward of our property assets. This has so far proven the case with our Queensland acquisition. Set-up is a bit of work but then things seem to run smoothly.
We have taken the same steps with our West Australian holding in Churchlands. Of significance, I was renting the unit for $210 per week and the new property manager has rented it for $310, albeit a year later (rents have risen in WA). Once she takes her commission, we will still be better off and better off for time. As the Group grows we will increasingly rely on our skills to source quality people to manage our interests.
I cannot finish this point without thanking the herculean efforts of my mum Patricia Candeias, who has single handedly managed my property investments. And recently, the efforts of my father Jose’ who has helped renovate prior to sale of 70 Todd Ave, mentioned below. The purchase of the East Perth apartment has necessitated the sale of our two Como investments, the student rentals. The sale process has proceeded well with 48 Bland St Como settled for at $750,000 in quick time. 70 Todd Ave is being renovated in preparation for sale.
We have learnt some valuable lessons. The gain in income from high yield students may be completely offset by the repairs necessary to the properties after the students have vacated. Todd Ave has required a full re-paint, new carpets and bathroom and kitchen from heavy usage. The budget is in the vicinity of $25,000. We may be more wary of student rentals in the future. Those kids don’t give a hoot. Perhaps small inner city apartments will become our bread and butter again. Having said this, the surge in Perth prices, means we will walk away from these investments with a strong profit, tripling the money invested in only three years. Funds from sale will be used to pay down the East Perth debt, which as aforementioned is non interest tax-deductible.
At the end of this process our gearing will be lower and we will be well-positioned to make future acquisitions when opportunities arise.
Listed Investments
When we scour the listed investments of the sharemarket we are looking for particular characteristics in a business. We want a business that demonstrates a track record of high returns on equity and an ability to maintain this on incremental equity employed in the business. In other words, a business that makes large profits without needing a lot of money to achieve it. This seems logical and it is.
Furthermore we want a business that doesn’t need to retain a lot of money to keep in business. In other words low capital requirements to maintain the business. If profits are retained we want a demonstrable ability to use that retained capital to grow profits and maintain return on equity.
We also want a business that doesn’t use a lot of debt. Debt is intrinsic to return on equity calculation, representing the leverage component of the formula and can easily skew perceived returns on equity in the business. We can get around this by looking at returns on invested capital, but debt introduces an extra variable of risk and possibility of nasty surprises. After naively flirting with companies who use debt to ‘maximise efficiency of their balance sheets’ and being poorer for the experience, your Chairman has concluded that the only person who should be using debt is himself, when Kanday is firmly in control of the destiny of that debt.
Honest and able management are another important business quality we look for, and managers who ‘eat their own cooking’ by putting their own money into the business they run. We look for the aforementioned qualities (and many others I will allude to no doubt in future letters) by thoroughly reading company annual reports, internet stories and trying to interact with companies in real life. Yes, I book my travel with Flight Centre and order my stationery through Corporate Express.
We believe we have identified two companies with most of the above qualities. I wrote at length about Flight Centre in last years report. What a twelve months. Flight Centre’s managment led by Graham Turner cast some questions over their credibility when they twice attempted to take the business private in 2007, with the help of private equity partner PEP. Institutional shareholder Lazard scuppered the low-ball bid with their 11% stake. Shortly after, Flight Centre has released 3 profit upgrades in 3 months and the share price has doubled beyond the privatisation bid price.
Flight Centre is a people business founded in wonderful principles about empowering workers to act like business owners. They happen to operate in the travel industry but the modus operandii is what makes this business special. An the managers led by Turner are the best in this ‘people’ business. The internet has created challenges but with the right attitude of its people, Flight Centre has adapted. Internal margins are recovering and can still improve a lot more so the company still does not look expensive.
Turner and the other company founders have managed to sell about 10% of their holdings ( at lower prices than today) citing the wish to diversify. Whilst my confidence that Turner is acting in shareholder’s best interests has been dented, he still owns 17% of Flight Centre personally. This will keep him acting in my best interests. Another minor concern is management commentary that they will be looking to ‘maximise the efficiency of the balance sheet’.
Flight Centre has grown using its’ own money, doesn’t need to keep a lot of it to stay in business, and demonstrates high returns on equity.
Turner is a huge fan of Buffett. Let’s hope he remembers the attributes of a fine company (like the one he currently runs).
Again my concerns are muted by Flight’s just announced acquisition of American bricks and mortar agency Liberty Travel. Turner has purchased Liberty at 6.5* pre-tax earnings against a backdrop of a credit crisis in the US caused by irresponsible lending practices. Turner did this in 2003 when he purchased Brittanic travel in the UK just after the 2001-02 recession. He buys cheap when everyone else is ducking for cover because they didn’t position their business well to take advantage during downturns. We will keep holding Flight Centre whilst Turner is in charge and managing with such dexterity.
Corporate Express is the other company we like. Since 2000 this business has increased profits 4 fold using only retained profits. Shareholder’s equity has only a little more than doubled and only modesy debt has been employed. Returns on equity and incremental equity have been wonderful. Corporate Express provides businesses with a one-source supplier for all their office needs. Over 70% of business is transacted over the internet. This company has embraced technological change and flourished and is the clear market leader in Australia.
My concerns include that Corporate Express is 51% percent owned by parent company Corporate Express NV. As a condition of its operation, CE is not permitted to expand beyond Australia and NZ. Further, managing director Grant Harrod and Chairman Ian Pollock do not hold many shares in the company.
Some feel the companies recent debt-funded share buyback demonstrates that CE is post-growth and looking to ‘maximise the efficiency of the balance sheet’.
This company has an enviable track record. Australia still presents many opportunities for growth and the international restriction may be a plus, keeping management focussed on the domestic business where it is the market leader. Being number 1 in a market place is part of the economic moat Warren Buffett always talks about creating cost efficiencies which others can’t replicate. CE focus should be to widen that moat. I believe they are doing just that.
Crystal Brook Dental sources all our stationery needs from CE and feedback from my secratarial staff is that they are always the cheapest. We will look to add to our position in CE , especially whilst others are focussing on the perceived negatives of this wonderful business.
Thirdly I wish to make brief mention of Clime Capital. This is a fund manager run by an ambitious young man (older than your Chairman) called Roger Montgomery.
We have taken a position in Clime due to their strong focus on purchasing equities based on the principles espoused by Warren Buffett. Importantly, their holdings appear to reflect this, compared with other managers who preach Buffett but practice other things. My biggest negative is the over-confidence Roger displays. Clime has only been around since 2003 (co-inciding with the bull market ) and Clime’s results may have gone to his head. Recently Clime’s largest holding Credit Corp issued a profit downgrade and the share price dropped 50% in one day. The punishment by Mr Market can be severe when we don’t understand what we’re buying or pay too much, ignoring Margin of Safety.
I don’t think Credit Corp is a mistake as Roger has appraised it thoroughly and his comments since the downgrade have been calm and focussed. Clime have added to their position whilst others may have overreacted to the short term downgrade. Your Chairman needs to investigate further to see if Kanday truly agrees with his assessment. At the least, Roger may benefit from this. The learning never ends and this should be the focus. The results will naturally come if the preparation is strong.
Primary Production
Correspondence from Timbercorp has confirmed that pulp yields from the 1997 project will be $200 per metric tonne versus prospectus forecast of $300. Furthermore they have recommended against a second rotation in the project (not that I needed their recommendation). I received a modest cheque in December 2007. At least we will see some return of our capital. I expect to see the proceeds from Timbercorp and ITC dribble in over the next 24 months, and will seek to re-invest them wisely.
Ferngrove has continued to struggle. However I had a lovely weekend at the vineyard with Jessica. Call it a small lifestyle investment (ouch).
Fixed Interest
In the increasingly competitive world of banking , new interest bearing products have been released. Idle money has been invested at rates of 6%. We expect to hold more cash in 2008 as recent transactions are completed and cashflow grows. Cash will be king when downturns occur and we plan to be ready to take advantage by not being over-committed nor leveraged.
Miscellaneous Group Separation
A significant change was enacted with company reporting in 2007. To increase transparency and facilitate decision making, the Group’s account were dissected into divisions. These divisions are CBD, property, listed investments and majority holdings.
The focus on these sectors are different (i.e cashflow versus capital growth etc) so it is useful to analyse the components of the consolidated Group as separate financial statements. This has helped us to evolve our business model. The model will mature over time but is at present:
Dental practice makes money (through my sweat equity).
Invest money in shares – no leverage.
Use dividend income from shares to purchase property using leverage.
Deposit comes from cash balance accruing or equity.
Shortfall in property expenses and mortgage repayments is serviced by dividend income to achieve cashflow neutral and hence minimise tax.
Benefit from depreciation of property to reduce taxable income.
Use increases in property valuations to redraw equity and purchase more property. Target LVR of 60%.
Consider using line of equity for lifestyle funding and payment of mortgage interest / property expense shortfall (not so sure I’ll ever do this).
Cease practising dentistry when shares / property fund each other and lifestyle.
Until next Xmas, I look forward to providing up to date reports of the group’s financial position through the quarterly reports and welcome any queries from interested parties.
Dr Marcel Candeias
Kanday Corp MD and Chairman