Dear stakeholder, welcome to the 7th annual letter for Kanday Group. 2012 has been a year of consolidation for the group, a year in which we faced pressure and competitive threats on several fronts. In particular, our core dental business has experienced strong margin pressure as industry fundamentals undergo significant structural change.
This year I have remained extremely disciplined, focussing on buttressing our balance sheet against unforeseen future challenges. It is always more exciting to be buying new business, focussing on acquisitions. However, I was always taught to chew properly before swallowing. With the 34 Marri Crescent development and somewhat unexpected tax liabilities incurred in the first half, this year has been all about digesting our purchases from the past few years.
Net worth increased by 12.4% versus a gain of 10.8% for the XAO index.
Our main sources of gain were again from Crystal Brook Dental and another remarkable performance from Ella Bache Nedlands.
ANNUAL PERCENTAGE CHANGE
| Calendar Year | Kanday | All Ords | +/- | |||
| 2003 | n/a | 11.10 | n/a | |||
| 2004 | 62.20 | 22.60 | 39.60 | |||
| 2005 | 23.70 | 16.20 | 7.50 | |||
| 2006 | 60.20 | 20.00 | 40.20 | |||
| 2007 | 26.30 | 13.60 | 12.70 | |||
| 2008 | -16.40 | -43.00 | 26.60 | |||
| 2009 | 31.70 | 31.30 | 0.40 | |||
| 2010 | 24.84 | 1.4 | 23.44 | |||
| 2011 | 19.6 | -13.9 | 33.50 | |||
| 2012 | 12.4 | 10.8 | 1.60 | |||
| Cumulative Return | 2003-2012 | 652% | 41% | |||
| Compound Annual Return | 2003-2012 | 25.13% | 3.93% |
Key Themes Of 2012
The dental industry started showing signs of weakness in the second half of 2011. I suddenly noted far less complex dentistry being accepted by patients. I kept asking myself whether this was related to the economy or was the impact of health fund preferred provider agreements starting to have an impact. By the second half of this year, I made the decision to join with the funds, convinced dentistry is now shifting rapidly to a high quality with lower fees model, as opposed to high quality, high fees.
In other words, dentists are being asked to produce the same quality work for less in order to remain competitive. These fundamentals are great for patients and insurers, but obviously not for dentists. I fear the quality of dentistry in Australia is going to decline over the next decade as dentists reduce quality to compensate with volume for the lower fees.
When I completed my tax return in the first half, I was mildly shocked when my accountant announced I required a further $XK to make up for a tax shortfall. From there forward, this pretty much set the sombre tone for 2012, a struggle to get back to where I thought I already was at the start of the year. Because our accounting standards are conservative, not only did I have to pony up the extra money, but I also added a bookkeeping entry to our balance sheet, increasing the anticipated tax liability to reflect the higher tax. This liability further reduced net worth. But, from every challenge comes opportunity. This tax hit has forced me to consider my tax planning for the future and we have exciting, legal initiatives planned for 2013 to reduce our tax liability going forward.
So, the majority of 2012 has been focussed on tax catch up and debt reduction. My plans for 2013 are contingent upon the group being debt free against our Australian assets, so we can begin relocating excess cash to lower tax municipalities.
As part of our family office tidy-up and to reduce our exposure to residential real estate, I sold our apartment in Spring Hill QLD in the middle of the year. With families growing and the future unknown, it is best to not mix business and family. We sold at a tidy gain so everyone was happy.
The Labor government has tinkered with super tax laws and has now made it unattractive to contribute extra funds to super. This suits us fine as I anticipate our tax strategy will be superior to super salary sacrifices.
Finally, with the Australian dollar still at all time highs, I have been adding to our position in US equities, both to diversify away from AUD and the Australian economy and to buy more of some wonderful US domiciled businesses.
Achievements
Our most notable achievements this year was a marked strengthening of our group balance sheet. This included a reduction of long term debt from $X to $Y
This was despite an unexpected tax bill of some $X in the first half.
As aforementioned, net assets increased by 12.4%.
We also increased our equities exposure and improved our framework for equities selection.
I made a key decision to join in dental health fund provider agreements in the second half, and this appears to have paid off with a busier end of year and higher new patient counts.
My continued focus has been on increasing free cashflow, in particular building passive income streams. As we reach debt free next year, I expect our exposure to ‘risk’ asset classes and passive income to increase dramatically.
We show below Kanday’s proportional holdings at reporting time in those non-controlled businesses for which only distributed earnings (dividends) are included in our own earnings.
Name/Code/Index
JB Hi Fi(JBH) ASX
Aeropostale(ARO) NYSE
Berkshire Hathaway Class B(BRK.B) NYSE
Google(GOOG) NDQ
Apple(AAPL) NDQ
Colgate(CL) NYSE
Gilead Science(GILD) NYSE
Microsoft(MSFT) NDQ
Coach(COH) NYSE
3m(MMM) NYSE
Woolworths(WOW) ASX
ARB(ARP) ASX
Flight Centre(FLT) ASX
Monster Energy(MNST) NYSE
Priceline(PCLN) NDQ
Best Buy(BBY) NYSE
CH Robinson Worldwide(CHRW) NYSE
Baidu(BIDU) NDQ
Goldman Sachs(GS) NYSE
Ebay(EBAY) NDQ
Mastercard(MA) NYSE
Guess(GES) NYSE
SCA Property(SCP) ASX
Equities and a Diversified Portfolio
It gives me pause to look at the portfolio I have constructed so far. Alot can be observed and learned.
Firstly our two largest holdings by cost were some of the first purchases I made and needless to say my analytical skills were left wanting. I have managed to scale down my exposure to ARO and probably should have sold my entire holding when the price briefly returned to near my purchase price.
Upon reflection, the prices I paid for JBH and ARO I would not have paid since my valuation framework has improved. However the fundamentals of these businesses should still see a return of our principal in time.
The position sizing of these purchases is also at odds with my current approach to diversification.
I expect to balance these skewed portfolio allocations by adding to other holdings when opportunities present. For example, if I am faced with two equally attractively priced securities in my existing holdings, I will likely add to the security which I have the smaller holding. This is common sense to me.
George Soros is famous for saying, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
This is particularly true for me at present where 15 of 23 holdings are showing gains, yet overall our portfolio is still in the red.
Why I hold such a large percentage of the portfolio in JBH still confounds me. I think I overestimated my valuation skills at the time of purchase and was emotionally driven to purchase more when the share price moved against my position. Further, I hadn’t adequately incorporated my diversification framework into my investing style at that time.
Overall our equities performance this year has been satisfactory compared with a poor 2011. This gives me confidence that my incremental capital allocation is improving and better results are in store.
The markets this year have seen trends across industries, sectors and nations. I merely observe this, not particularly trying to participate.
In the first half the US was on fire and then flat lined for the second half.
The Australian market was just the opposite. In the second half it was on fire.
None of this appeared to be supported by economic performance, with no news flow.
Commentators suggest it was more likely money flows looking for yield as international markets nearly all have interest rates at zero.
My concern is prices of Australian ‘blue chips’ are nearing pre-GFC levels and their economic performance is not.
The important takeaway here is to be adequately diversified, across sectors, asset classes, geographies and currencies.
The key is to be knowledgable so incremental capital can be allocated intelligently.
34 Marri Crescent Lesmurdie Development
We have settled well into the completed development. The work quality is good. The building is code compliant for many years to come.
However IT costs are going through the roof with the networked computer system. Whilst the computer system provides efficiency and flexibility, it feels like the productivity gains go straight to the IT support.
We are currently still negotiating to maximise the potential of the building, with chiropractor enquiry and perhaps a beautician to follow.
Dental industry
Crystal Brook dental had a solid year but the dental industry is suddenly facing several competitive threats.
Our key decision was to join HBF and Medibank provider contracts in the second half. After opposing these arrangements for a long time, it (belatedly) became apparent to me that we were losing too many patients because of insurance arrangements.
All the surrounding practices have joined these networks. We have had to follow. In doing so, we have had to accept 10-20% reductions in revenue for services acrosss the board. The dental model is towards volume now and we have to embrace this trend or perish.
It means working harder for the same reward. Fees and margins under significant pressure and it is only going to get worse.
For the first time ever, I will not be increasing fees on January 1st.
In other moves UK insurer BUPA has muscled into the Australian market and now has purchased Dentalcorp, an amalgamation of 190 Australian dental practices. Dentalcorp practices all have a common corporate owner but individual branding. I am not sure what BUPA’s plan is, but now they are in the same lot as the dentists, so one would assume lower fees are no longer in their interest?
The government has allowed a lot of dentist migrants. Dental schools are training more dentists than ever.
As a result, there are lots of dentists looking for work.
Lastly, many patients are now looking overseas when contemplating expensive dental work. Dental holidays are becoming more mainstream, where patients fly to a tropical destination like Bali or Thailand and get their dental work done there for a fraction of the price. Apparently the quality is ok. The internet is empowering the consumer like never before and price is quickly becoming the only thing that matters.
EBN grew revenues year on year by a further 15%, following another heart and soul effort from group CEO Jessica Candeias.
The challenge of small business is underscored by this. You become a victim of your own success, having to work harder and harder as demand for your services increase.
Furthermore, the salon had to survive several challenges this year, including recalcitrant staff, absenteeism from pregnancy and the end of holiday visas, and a flooding of the salon by a burst basin hose causing $25K of damage. Fortunately the salon is comprehensively insured.
Jessica introduced several initiatives this year including an expanded nail range, eyelash extensions, Botox treatments and Sunday trading, all which were successful.
Investing 2 day course
After 16 years of learning I have condensed my knowledge of business and investing into a two day course.
This is an exciting initiative and may provide a valuable new source of income and diversion from day to day dentistry for your Chairman. I have no hesitation in sharing my knowledge as there is a wealth of information available and prosperity is within everyone’s reach.
Valuation – what I have learnt this year
I have refined my valuation approach after reflecting on the decisions made over the past couple of years. Margin of safety remains at the core of our strategy. i.e return of capital not just return on capital.
The checklist approach is as follows:
Annual report and Management discussion
Website
10 yr data entry
Quality score checklist
Profit margins – normalise to account for business cycle
Return on equity – normalise to long run fundamentals
Book value multiple – compare to historical multiple, RoE, great recession and compare with other companies with similar metrics
Main competitors and existing holdings – compare opportunity cost and fundamentals
Macro – prevailing economic circumstances, expected price volatility, commodity inputs creating head/tailwinds – e.g high AUD, high cotton prices etc
Finalise future growth rate coupon, quality score and expected rate of return and long term growth potential
Cashflows – confirm correlation to reported earnings
Balance Sheet / Income Statement – composition and quality
Moat – name key competitive advantage and historical efforts to deepen moat
Management – key executives and bio , capital allocation analysis
Price – is there a margin of safety?
Note that the Quality of the business still matters the most to me. Quality will forgive you for overpaying over time.
Margin of safety is best arrived at by normalising reported results to long run averages and considering the market’s historical price to value multiple for the stock. I feel one of the best comparators is the stock performance during the GFC years of 2008 and 2009 when stocks plummeted.
AUD / Interest rates
The Australian central bank has lowered interest rates to 3% at year end, equal to all-time lows and matching the setting during the GFC.
Despite this, the AUD has remained above parity with the USD, due to money printing abroad. This is decimating domestic manufacturing and export businesses.
Whilst we still have strong cashflow, I believe this represents an historic opportunity to diversify our interests internationally and take advantage of the purchasing power of the AUD.
JBH – a case study
JBH is a good study on how to approach valuation and avoid overpaying for a stock.
#forecast
| 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | #2013 | ||
| Share price ($) | 11.8 | 12.18 | 16.9 | 19.14 | 17.07 | 8.86 | 10.5 | |
| Shares outstanding (m) | 104 | 105 | 107 | 108 | 98.53 | 98.9 | 98.9 | |
| Market Cap | 1227 | 1279 | 1808 | 2067 | 1682 | 876 | 1038 | |
| Revenue/share ($) | 12.32 | 17.41 | 21.75 | 25.29 | 30.04 | 31.63 | 33.21 | |
| EBIT/share ($) | 0.66 | 1.00 | 1.34 | 1.61 | 2.18 | 1.66 | 1.62 |
|
| Operating margin (%) | 5.37% | 5.75% | 6.15% | 6.35% | 7.27% | 5.26% | 4.88% | |
| Net profit/share ($) | 0.38 | 0.62 | 0.88 | 1.10 | 1.36 | 1.06 | 1.06 | |
| Net margin (%) | 3.12% | 3.56% | 4.04% | 4.36% | 4.54% | 3.34% | 3.18% | |
| Dividends/share ($) | 0.11 | 0.26 | 0.44 | 0.66 | 0.77 | 0.65 | 0.65 | |
| Long term debt/share ($) | 1.13 | 1.17 | 0.83 | 0.31 | 2.36 | 1.51 | 1.11 | |
| Return on equity (%) | 35.4% | 39.9% | 41.0% | 40.6% | 88.4% | 56.7% | 49.7% | |
| Return on capital (%) | 21.0% | 25.7% | 31.5% | 37.1% | 39.2% | 34.4% | 35.1% | |
| Depreciation(Maint capex) | 25% | 22% | 19% | 19% | 20% | 32% | 32% | |
| Growth % capex/share profit | 58% | 56% | 28% | 28% | 10% | 10% | 10% | |
| Book value/share ($) | 1.09 | 1.55 | 2.14 | 2.71 | 1.54 | 1.87 | 2.13 | |
| Dividend payout ratio | 29% | 42% | 50% | 60% | 56% | 61% | 61% | |
| Book value multiple | 10.86 | 7.85 | 7.90 | 7.06 | 11.07 | 4.75 | 4.94 |
|
| Valuation | 3.90 | 6.40 | 10.47 | 14.79 | 11.91 | 8.39 | 9.56 | |
| Price / Valuation | 303% | 190% | 161% | 129% | 143% | 106% | 110% | |
| 27.5% | 30% | 35% | 37.5% | 50% | 35% | |||
We paid an average price of $16, with purchases made from 2010 to 2012. We are currently showing an almost 40% loss on our investment.
I appraised JBH to be a quality company, so after making that judgement, I needed to determine an acceptable margin of safety in our purchase price. What I didn’t do was to normalise JBH outstanding results from 2009-2011 to arrive at a more conservative intrinsic value estimate. If I had done so, I would have kept net margins closer to 3% and hence used a sustainable return on equity of closer to 30%. JBH conducted a share buyback at $17 a share during 2011 and similarly we would have judged this as paying too much. As luck would have it, industry headwinds have slowed JBH profit growth in 2011-2012 and so margins have arguably retreated to historical norms and JBH share price has plummeted to reflect the pervading pessimism. Incorporating a reasonable margin of safety, JBH is now arguably fair value.
I don’t anticipate I will make errors of this nature in the future and I expect my assessment of JBH quality will still see a positive return on investment over time.
Debt free – finally!
Free cashflow and debt free is the only position to invest from. This is my belief and we are finally in sight of this stated objective.
I expect Kanday group will achieve this in the first half of 2013 and from there will be in a strong position to add to holdings from free cashflow. Now I just need the market to remain pessimistic.
The year ahead – Tax and International expansion
Onerous tax regimes in Australia are forcing us to look abroad to lower our tax rate.
In the second half of 2013 we will look to establish an investment base in Singapore, our nearby Asian neighbour.
Singapore is consistently rated as one of the top nations in the world to do business in and is very welcoming of foreign
investment. Legal and political structures are safe and stable and Singapore has very low tax rates both for individuals and companies.
So, next year you may need to drink a Tiger beer and eat some chilli crab before you read our annual letter.
I look forward to updating interested parties via our quarterly results presentations.
Yours Sincerely
Marcel Candeias
Chairman of the Board