EM Portfolio: Listener Stock Pitch – Citadel Group

Bryce: [00:01:28] Welcome to another episode of Equity Mates, a podcast where we help you learn to invest in 45 minutes or less. We break down the world of investing from beginning to dividend so that you can hopefully make some returns. My name is Bryce and as always, I'm joined by my equity buddy Ren. How's it going?. [00:01:43][14.8]

Alec: [00:01:43] I'm very good, Bryce. I'm very excited for this episode. This hypothetical portfolio is really energising. You know, we're getting so many submissions. We're looking at some really interesting companies. And for the first time ever in our hypothetical portfolio, we've got someone from the Equity Mates community on the show to pitch a stock. [00:02:02][19.2]

Bryce: [00:02:03] Yes, getting in the pitch before I even got to give the caveat and apologies in advance, Ren's got a major case of the hiccups. [00:02:11][8.5]

Alec: [00:02:12] So I thought I would try and avoid it. And I don't think it's going to be possible. [00:02:16][4.4]

Bryce: [00:02:17] No, but anyway, I apologise in advance to the [00:02:19][2.5]

Alec: [00:02:20] I'm trying to I will try and speak as little as possible. [00:02:22][2.6]

Bryce: [00:02:23] Thank you. That's going to be impossible. But yes, Ren as listeners would know. And if you have just joined the show, welcome. Welcome to The Journey of Investing. Great to have you. As part of the show, over the last few weeks, we have been building out the beginnings of our hypothetical portfolio, both our core component, which is built up of a number of ETFs, and then also our satellite portfolio, which is where we're going to be having a bit of fun with and I guess specific analysis and discussions around some stocks that are on our watch list, but more importantly, on the watch list of some of our listeners. And recently, well, firstly, we have had a lot of listeners riding with submissions. So big. Thank you to you. If that is you, we will get to you. But to kick off, keep [00:03:07][44.0]

Alec: [00:03:07] them, keep them coming in [00:03:08][0.9]

Bryce: [00:03:10] and coming in. But to kick off today, we have Benjamin D'Souza joining us on the line. Ben, welcome to Equity Mates investing podcast. [00:03:17][7.8]

Benjamin: [00:03:18] Thanks, guys, and thanks for your time. [00:03:19][1.1]

Bryce: [00:03:20] Thank you for your time. I mean, it must be pretty nerve wracking for your family. Oh, no, I'm sorry. I'm totally joking. It's awesome to have been with us today. He is a recent graduate from U'wa and he's currently the co chief investment officer of the Student Managed Investment Fund over at the UW. And they've been doing some awesome work with the fund over there, analysing a number of different companies. And they've sent through some pretty amazing pitch decks for some of those companies. Yes, much more detailed than we would have. A very [00:03:53][32.6]

Alec: [00:03:53] well detailed. Very well designed. Yes. [00:03:55][1.7]

Bryce: [00:03:55] So we're looking forward to to Ben, you're giving us a pitch today. [00:03:58][3.2]

Benjamin: [00:03:59] Yeah. [00:03:59][0.0]

Alec: [00:04:00] We should explain as well. For people unfamiliar, U'wa is University of Western Australia. Yeah. And maybe they kick it off. Bryce mentioned that you were the chief investment officer of the Student Managed Investment Fund. Do you want to just explain what that is? [00:04:16][16.1]

Benjamin: [00:04:17] Yeah, of course. So we're a student society at University of Western Australia and we actually manage the Smith Viburnum High Conviction Fund, and that's in partnership with a funds management company called Viburnum Funds, and they operate in the public and private equity markets. So the way that the fund works is that they actually provided us with the initial capital that we invest today and they give us ongoing advice about stock selection and equity research tips. And I guess the overall purpose of the fund is really just to provide students with like a hands on and practical way of learning about equity research and learning about investing. [00:04:53][35.9]

Bryce: [00:04:54] Yeah, it's pretty epic, great experience to have at university. And I think I'd be interested to know how many universities around Australia do do it. But look, you guys have been pumping out some pretty impressive material. So it's obviously, I guess, paying dividends, no pun intended in terms of the experience that you're getting from this fund. So thanks for joining us. What we might do is we'll try and sort of follow a similar structure that we did last time when Ren pitched Magellan. And that was to firstly understand what the company is, how you found the company, and then discuss maybe the broad thesis that you have for the company, some of the competitive advantages, the growth potential, some risks around, you know, why you might not invest in this or what will change your thesis and then we'll close it out towards the end. How's that sound? Sounds great. Nice. Well, I guess big reveal what company you're pitching today. [00:05:48][53.5]

Benjamin: [00:05:48] I'll be pitching the Citadel Group, OK. The Citadel Group is an ASX listed technology company and it provides software and services to key nations within the health care, defence and education sectors. So Sillitoe provides software as a services, consulting services, managed services and also has a product services division. And in terms of financial metrics, the company has got about a hundred and sixty million market cap. So definitely on the lower end of the market cap spectrum on the ASX, but we do think it's a good one. [00:06:20][32.2]

Bryce: [00:06:21] How did you find it? [00:06:22][0.7]

Benjamin: [00:06:22] So we're looking for like really strong and high quality companies during the height of the credit. Buyer's market downturn, so we wanted to buy a company on the cheap, essentially, but we thought it outperformed during that period. So we came up with this thesis that we wanted to invest in a software as a service company that had very high levels of recurring revenues and long term contracts with a blue chip company or a blue chip client. And because of that, we thought if they had really blue chip clients, they wouldn't actually lose any contracts during that period. And therefore we could be pretty, pretty certain that their earnings would be impacted. So the way we found the company and you guys are like this. So we actually asked the Equity Mates Facebook discussion group. Right. So this is actually [00:07:08][46.1]

Bryce: [00:07:09] our pitch, I guess. [00:07:09][0.5]

Benjamin: [00:07:10] Well, yeah, we got like 10, 15 recommendations and Sido was the one that stood out. [00:07:15][4.7]

Alec: [00:07:16] So I'm looking at Citadel during the recent downturn and they lost about 80 percent of their value. Their share price was down seventy nine point three percent in a bit over a month. So it was a company that was severely hurt during the Covid crisis. Is that about the time that you found the company? [00:07:34][18.7]

Benjamin: [00:07:35] So unfortunately, unfortunately not like we do run a high conviction fund. So we probably took about a month to research the company. So we got in around three point thirty. So we didn't miss a lot of that uptick. But again, the company's revenues grew by 30 percent this year and earnings almost the same. So no matter what, it was a pretty strong investment for us as we've gained 30 to 40 percent on the investment so far. [00:07:57][22.3]

Bryce: [00:07:58] So you mentioned there that the process for discovery, I guess, other than the Facebook group with you, were pretty clear on what companies you were looking for, what characteristics they sort of needed to have with that blue chip client base, some pretty long term, I guess, pipeline of contracts. What is it about Citadel that is more attractive than other businesses that play in this space? What's your thesis? [00:08:21][22.5]

Benjamin: [00:08:22] Yeah, sure. So I think firstly with the main overarching thesis was that we thought was a great opportunity to capitalise on the fact that they wouldn't lose much earnings during the Covid period. So that was our initial phases, the government departments, hospitals and universities. And within the software services sector, they do have probably the most blue chip clients out of any of them. And, you know, like even during the worst period of Covid, you couldn't expect a government department or hospital or a university to go bankrupt. So from that regard, we thought their revenue is quite safe. And then specifically with Citadel in a longer term sense, because we are a high conviction fund, there's a lot of characteristics about the business that we think are quite attractive, and that's in terms of its business model and also its growth profile. So the first thing that we really liked about the business is it's shifting from a services business towards the software as a service business. And what that means is that they're recurring revenues. They're actually growing. So recurring revenues are attractive because they're predictable and they're very stable. And as it shifts towards that SAS business model, we expect the market to actually rewrite upwards towards a higher multiple. So from that standpoint, we expect to make some money on multiple expansion and then it also has a really strong competitive advantages. So it's got a great track record in the data management, health and I.T. sectors. And because of that, Citadel's actually been able to become a market leader in about four or five years. And because of that, that can maintain quite high margins and because they split between the global players. So, you know, the global health care IT providers is just like global IT providers and the regional businesses is somewhere in between. Because of that, they can actually be the market leader in these sectors and they do have experience there. So we think because of those competitive advantages, they can maintain those high margins and maintain that market share. And then furthermore, in terms of the shift to software and services, we think that they'll be significant market expansion as well, because it's quite high operating leverage in the software as a service operating business model. So as the revenues grow, we expect margins to expand and we expect this to take place over three to five year period. But what we've actually seen is that their software business grows sixty six percent last year. So that's looking pretty attractive on that standpoint. And then we also like to invest in businesses where there's like a structural industry tailwind. And we think that if you invest in a business where the entire market is growing, you don't have to worry about what their competitive positioning is. So within the health care and defence sectors, there's there's a shift to digitalisation and it's going to be a lot more I.T. spending in these sectors. So, for instance, within healthcare, you know, you're seeing private patient data getting put on the cloud and you're seeing the shift to e-health. And we think that will drive spend in the sector. And then in terms of defence, you have you keep seeing in the news all the IT breaches and data breaches from. Nations and stuff like that, and we think the government's going to be more likely to spend a bit more on secure data management, and Citadel has a strong position in that space. And then a final thesis is that if you look way back, maybe about 18 months or so was trading alone six to seven Dollars, and that was pre the acquisition of this company called Well-Being. So well-being is a very similar company to Citadel, except it operates in the UK and it's primarily focussed on software as a service within the health sector. So the market punished, set it out for the acquisition because it did increase debt, which is fair enough. And they thought that Citadel overpaid for well-being. But when we actually looked at it, even if you don't include synergies, the acquisition was quite attractive from a valuation standpoint. When you consider that well-being has a 99 percent retention rate on its contracts and its growth profile is fairly attractive. And we thought that the market was applying the downturn that could potentially come out of this. And at the most recent reporting event, which was actually yesterday, we saw that the acquisition is integrating. Well, financial performance is in line with that guidance. And on top of that, they've recently announced two hundred and fifty to fifty million dollars in cross-selling opportunities. And they are also announcing a one point five dollars million run rate in cost savings. And we didn't forecast this into a valuation, but that's making the business look quite attractive in terms of their overall cost growth opportunity. And then finally, we think it's a pretty attractive business, like we expect that revenue to grow at around 10 to 15 percent. And that's in line with mediastinal guidance. And when you factor in the margin expansion and the multiple expansion, you know, if you hold this business over three to five year period, we think that, you know, revenue and earnings can increase by quite a bit. And on top of that, they pay a 2.5 percent dividend yield a year. So from that standpoint, we think the valuations are pretty attractive and it's a business we're likely to hold for quite some time. [00:13:24][302.6]

Bryce: [00:13:25] So you're going to double down on the basis of the results yesterday? [00:13:28][3.1]

Benjamin: [00:13:31] I don't double down. We did have a large discussion when the share price hit four point eighty, which is above our target valuation. I'll be pretty like conservative figures and I think we're going to hold it for now. I think on the 12 month standpoint, it's approximately where we think where we think it should be trading. But I think clearly one of those businesses well, there could be some surprise on the upside in the medium to long time period, [00:13:52][21.8]

Bryce: [00:13:53] just for reference as well. We're recording this on the 28th of August. This is an interesting point, because you say you guys are a high conviction fund and you've done all this work and research. And just because it hits your target price, I'm surprised that that would trigger sort of conversation around whether or not to sell, given that, you know, that you hadn't baked in some of the, I guess, results that have come through into your valuation. Yeah, yeah. So just interesting to note. [00:14:18][25.3]

Benjamin: [00:14:19] Yeah, I think that's a really good point because I think valuation is important. But when you just look at the somatics of the business, we have significant tailwinds and long, long term, you know, we do think there's is a great opportunity for the business there. But it's almost as if, like, you know, you make a 45 percent profit on a business. You go it's reporting tomorrow. Should we should we sell out? And look, it's not [00:14:42][23.3]

Bryce: [00:14:42] very high conviction, is it? [00:14:44][1.2]

Benjamin: [00:14:45] Yeah. And I'm glad that we held the position. I think long term, we should do quite well out of it. Yeah, nice. [00:14:51][6.0]

Bryce: [00:16:43] So if we can summarise the thesis, because I think I think I was a pretty comprehensive idea of why you added to the fun, but if we try and summarise it, I think it's got good defensive characteristics, software as a service, good recurring revenue model, good blue chip, client base, good defensive characteristics, but then at the same time, quite good growth prospects. So that's kind of the sweet spot if you can find a business that is both defensive but has growth potential. So I'm interested in unpacking the growth side of it. So you mentioned that Citadel has a strong track record of acquisitions when you look at its growth opportunities. Is there opportunities for organic growth as well, or is it just that there's a pipeline of potential acquisitions that it can continue to bolt on and continue to grow that way? [00:17:36][52.6]

Benjamin: [00:17:36] Yeah, I think that's definitely a discussion that we had. And when we started looking at the business, we actually split out what they're organic and inorganic growth was because we wanted to make sure that it's not one of those rolled up stories where they're just serial acquirers. But what we found is that Citadel can acquire businesses at a relatively cheap price and then actually grow them. So what we found is this year they acquired an Aventis and the business was forecasted to grow at a certain rate. And actually at the most recent financial announcements, they announced that no Ventus was tracking 10 percent in terms of earnings ahead of what they forecasted. So they do have a great track record there. But of course, when you look at a business like this, you want to make sure that it can grow organically as well. And what we've seen is that, yes, it has some management targets, a 10 to 15 percent organic growth rate in the software business and a five to 10 percent growth rate in the services business. And I think the software growth rate, it will tend towards the software growth rate. It's capturing more and more of the total revenues. But in terms of the reason why, we think it can grow organically. So firstly, they do have a strong pipeline to growth so that a weighted average pipeline at the last financial year of around one hundred and thirty million dollars in revenue. And that's approximately what they achieved at this financial result going forwards. They've actually significantly increased their pipeline, and that's because of the acquisition of well-being. So with the well-being acquisition, Citadel already had health services in its Australian business. But when they acquired the health services in the UK business, they operated in different natures. So I think, you know, one business has pathology, another business that's oncology, another business has maternity. And because of that, they can now bring Citadel's Australian operations and Australian expertise in Australian software into the UK market. And they can bring the UK software into the Australian market so they can cross-sell on that standpoint and guided a pipeline of around three hundred and fifty million. So that's really attractive there. And then in terms of industry tailwinds, the health ICT market is the fastest growing ICT market out there. I think it's forecasted to grow at around twelve point three percent on average. And just the structural tailwinds from both defence and health, we do see organic growth in the sector. So overall, we do think the business can grow attractively in both organic and inorganic methods. So overall, we like the growth profile of the company. [00:20:03][146.3]

Alec: [00:20:04] We've touched on the fact that the company recently released its F 20 results. And I'm interested to know what your process is. Once you've chosen this stock for your fund and you've bought, what's your process when a company releases guidance or releases earnings to go back and look at the updated numbers and reassess your thesis? I mean, I know they've only released a day or two ago, so maybe you haven't done too much with the numbers. But what's the ongoing process to confirm the thesis as new information is released? [00:20:36][32.3]

Benjamin: [00:20:37] Yes, with this digital business, because that actually reported yesterday, we actually watched the earnings call in the morning. So before that, we looked at our thesis and we looked at what we expected in terms of revenue and also where the business is tracking with its integration of wellbeing and also the other main drivers of the business. So we had a good understanding of what we expected to happen during the announcement. And what we found was that it was very similar, although there were some slight differences in revenue and earnings and the business was tracking a lot better in terms of their shift to the business model. But overall, it was pretty much kind of what we expected. So from that standpoint, that's why we're just going to hold the company. We're not going to double down or so we think. The business is positioned quite well. And this most recent reporting was doing well. But then in general, when we're looking at companies and we have maybe eight to 12 companies in our portfolio say it was only this year that we actually started reviewing how the business is tracking. So it was almost like a set and forget. But when you're investing in ASX listed small caps, like, that's really not the best mindset to set. Great. Like what we found in our portfolio is some companies are up 200 percent and others were down 30, 40 percent, and we just didn't understand what was going on with these businesses. So we started reviewing them every three months. And we have someone who always watches that company. And then that way we can actually track how the company is doing according to our thesis. And every six months we do a full on review and say, should we sell this company now? What do we expect the outlook to be? And because of that, we've had a lot more success in the last six months and most of the recent year. Just because we know a lot more about the individual companies, because we fund you've got to remember that we are students. Everyone only stays for six months to 12 months, but we are holding these companies for two to three years. So it's really hard to tough some of these small cap companies. [00:22:34][117.3]

Alec: [00:22:35] So why is that? Why why are people only staying for six to 12 months? Is that just so you can rotate know who gets to make the decisions through it? [00:22:45][9.1]

Benjamin: [00:22:45] I think it's just the nature of universe. Yeah, but I think, like, 12 months is also a great opportunity because in that time you will have researched four to six companies in depth. So you will gain that understanding. And people typically join in that second or third year and once they graduate once, what's the point in staying on the club? [00:23:05][20.3]

Bryce: [00:23:06] Yeah, me. You're still there? [00:23:08][1.7]

Benjamin: [00:23:08] Yeah, I'm leaving soon. [00:23:10][2.0]

Alec: [00:23:10] And I've got to say, I'm pretty jealous of students. I would have loved to have had this available when we were at uni. [00:23:18][7.4]

Bryce: [00:23:19] Yeah, it's an amazing experience. So, Ben, you mentioned there that you've got people keeping track of the stock and I guess reviewing it against your thesis, which is a super important thing to do because and that's why with this fund, we're encouraging anyone who has a submission and ourselves as well write down the thesis because then it makes it a lot easier to at least determine when might be an appropriate time to sell, which is when that thesis is broken. What is it going to take, do you think, for all of the positives that you've spoken about for Citadel to turn against your thesis and maybe perhaps not be as attractive as it is? [00:23:54][35.3]

Benjamin: [00:23:55] Yeah, sure. So I think there's two main things that the first one is the growth outlook, which you guys talked on before, and the second one is the being acquisition. So the wellbeing acquisition was one hundred and ninety seven million dollars. And this is in a company which has a market value of three hundred and sixty million. So it's extremely material to the outlook of the business. So we did have faith that wellbeing could perform well and would integrate well. But if there were problems with wellbeing, integration, potentially financial forecast didn't materialise, then I think there would be some significant downside there. So I think for me personally, that's the main risk for wellbeing. And then secondly, when you're looking at organic growth, the business has grown 10 to 20 percent historically and management has set a target of around that, but especially in light of the coronavirus that we knew they wouldn't lose. And what we estimated that they wouldn't lose any contracts. But going forwards over the next 12 months to two years, there's a potential that organic growth will slow. And that's just because these large organisations might not want to spend a lot of money on new contracts or new businesses. So we might actually see organic growth slowed down in that perspective. And they might pick up contracts slower than we expect. And in that case, especially with a growth business, it is quite important that they hit their growth targets. So there could be some downside there. But I think just given the stability of the business model, we aren't too unhappy with their growth outlook. And on top of that, the fact that the market leader in these sectors means that they will and major significantly high margins. So there's no issues with profitability from that standpoint. The other one is with the acquisition of wellbeing, they had to raise about 90 million of debt. So they do have quite a bit of cash and they do have liquidity available through financing facilities. But they do have 50 million in net debt now. So I think we generally try and avoid companies that have a lot of debt and especially companies that have high operating leverage. You don't really want to mix operating leverage and financial leverage. So the risk is slightly elevated there. But again, with higher risk, you do have the potential for higher returns from that standpoint. But I think overall, just slightly higher debt integration risk from well being and then also potentially slower growth as a long term consequence of coronavirus could potentially lead to a slight downside there. [00:26:14][139.5]

Alec: [00:26:15] Now, Ben, you've mentioned some of the downside risks there. And if we zoom out a little bit on the share price and look sort of over the last two years, really, since the share price peaked in November, twenty eighteen, it is down a fair bit. It's down a bit over 50 percent from that high. How do you think about that? I mean, given the thesis that you outlined, painted the company as a pretty strong defensive business, what's led to that share price fall? And how do you think a. Out that in the context of your investment thesis and adding it to your portfolio moving forward, [00:26:49][33.7]

Benjamin: [00:26:49] yeah, it's an interesting one because things have fundamentally changed since that period. So that peak coincided with approximately when they acquired well-being. So we we don't think that the market likes that acquisition. But I think post the strong outlook from management about the acquisition in the most recent earnings report, we are relatively confident from that standpoint. But things have changed, like the debt profiles increase, the business has become slightly riskier, but then other the business has become less risky. So part of the reason why the company felt the share price, so there was they had a bad half year earnings and that was primarily due to a couple of major contracts which they were meant to receive pay for. I think it was a government department actually wanted to wait and see. So in that contract and this is one of the slight downsides to the contract model, is that there is some power from the university or the government department, and they rolled off the delaying the pace for a six month period. They had much lower than expected. So the market probably got a bit spooked by that. But going forward, the client concentration risk is a lot less so with the acquisition of well-being. Well, being largest client is about two to three percent of earnings. And on top of that, that brings Citadel's client concentration risk down significantly higher revenue base. So now the largest client is probably only three to four percent of their revenues took. A similar situation was to happen again. It wouldn't have a materially impact on the business. [00:28:15][86.1]

Bryce: [00:28:16] There will be an epic listener submission, first one to come through. So a massive thank you. I guess now's the time Ren where as the investment committee for the Equity Mates portfolio, we need to put it into the portfolio. So it's currently trading at four point twenty nine. Just checking your photos. Twenty nine currently trading. So yeah, look, we'll throw it in there, see what happens. But on one condition, Ben, whoever is looking after the stock and checking it in six months time, give us a daily basis changes. So, look, that was awesome. Very much appreciate you coming on and sharing what you're doing over at Smith. Sounds like an epic opportunity and experience and be for also putting your hand up to come and share this pitch with us as the first one. So it was awesome. [00:29:03][46.8]

Benjamin: [00:29:03] No worries. Thanks for having me on the show, guys. It was pretty tough following on from Ren epic Magellan pitch. [00:29:09][5.4]

Alec: [00:29:09] Oh, no, no. I think you've you've blown me out of the water here. But the good thing is, you know, we're all learning together and we're glad that you guys could share some of the work you've been doing over at Smith. And I just think if anyone is that way and is listening to this podcast and isn't a member of the investment fund, they should get over there and figure out how to join and go join up. Because looking at the presentations you guys put together, there's obviously a lot of work and a lot of thought that goes into it. And it's great to and great to hear you pitch it today. [00:29:43][33.7]

Benjamin: [00:29:43] Yeah, thanks. [00:29:44][0.3]

Bryce: [00:29:45] So head to Equity Mates dot com slash portfolio to find out more info about the addition of Citadel Group to the portfolio. Additionally, the thesis will be up there. We'll take that offline with Ben and all the information on the corps and satellite portfolios there as well. So Equity Mates dot com slash portfolio to continue following this journey. But look, Ben, we'll leave it there. EPIK Pitch again, can't thank you enough. And we look forward to seeing how Citadel goes. And please give us a call, Tik-tok. [00:30:16][31.3]

Benjamin: [00:30:18] Yeah. Thanks, guys. Thanks for having me on the show. [00:30:20][1.6]

Alec: [00:30:20] So you have a good day. Thanks. [00:30:22][1.2]

Benjamin: [00:30:22] You too. [00:30:22][0.1]

Speaker 5: [00:30:23] Thanks for listening to Equity Mates. That's your podcast production of Equity Mates Media. Please remember that everything you hear in Equity Mates investment podcast with general advice on link content has been prepared without knowing the personal objectives, specific financial circumstances or goals. The host of Equity Mates Investment Podcast may maintain positions in the companies discussed before considering any investment. Please read the product disclosure statement and consider speaking to a licenced financial professional. [00:30:23][0.0]

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