So many red flags, but such huge upside if only a few things go right
Along with others here on SM I've done some head-scratching with EML over the last few days. I've had two waves to my EML journey. I bought shortly after the low of Covid and sold near the high when I thought it was getting overpriced. But more recently I bought back in with the sharp price drop towards end of Apr '22 when I thought it was becoming good value again, only to see it drop almost another 50%.
I've decided to stay in, and may even drip feed a little, although for the short term I'm mainly holding and watching given the momentum is clearly against the company at the moment.
Here's my reasoning, with bear and bull cases.
Bear case:
- There has been a long string of red flags in the last 1.5 years. It started with the PFS purchase and CBI's subsequent review of governance/compliance problems in May '21, with associated restriction of trade in Europe. Then in late Apr this year we hear that EML/PFS still has unresolved compliance issues and has not yet met CBI requirements so restriction of trade will be extended. Disappointingly we had the Chairman sell $0.5m of his shares just prior to the release of bad news about the extended trade restrictions. Then the CEO resigns with no notice or good explanation. The new CEO demands an almost-$4m yearly salary, about 4x the going rate for similar sized companies. Then most recently we hear about the fraud with Senteniel, incurring up to $8m in costs (not including the costs of investigating and resolving the problem). And I'm not confident that the bad news from this latest Senteniel issues has fully surfaced - eg, if the cost to EML is up to $8m, the top line numbers that might get reported could look even scarier, and that could result in further concerns from regulatory agencies and customers.
- All up, there is a clear picture of poor governance and risk management.
- Perhaps associated with all of the above issues, employee engagement score is 60% and turnover is 26%, lowest in at least the last 4 years.
- With all of the rectification required to deal with the above problems, in their latest investor presentation EML flagged that their "overhead" expenses are likely to increase about 25% in FY23. So that's about $25m extra costs, plus up to $8m for the Senteniel fraud, plus a couple of extra million for the new expensive CEO. So at least an extra $35m in costs. They probably need to grow at least 15% just to maintain FY22 underlying EBITDA.
- They continue to report a lot of "underlying" profit figures. I'm OK with companies using "underlying" numbers when adjusting for things like acquisition costs which are genuinely one-off. But half of EML's adjustments are for rectification costs associated with their own poor risk management. So their headline NPAT of $32m becomes a statutory loss of $5m in FY22.
- My bear case valuation assumes sluggish top line growth resulting from recent compliance failures, growing expenses and falling margins. Assuming perhaps 5% CAGR over next 5 years, with 5% NPAT in FY27, 5% dilution along the way, with PE of 12, market cap in FY27 could be around $170m, close enough to another 50% drop from current cap.
Bull case:
- They are a highly innovative company with lots of optionality. They have a lot of different product streams, and they only need a few to continue to thrive for them to do very well. Indeed, it's likely their governance/compliance issues are a result of their innovation outpacing their risk management processes.
- Increasing interest rates will be a significant benefit. They provided guidance that even with the interest rate increases that have already happened, their additional revenue from interest on card stored value will be $10m+ in FY23. With further interest rate increases in FY23 this is likely to be closer to a $20m gain. And 100% of that gain goes to net margin.
- Their new high-cost CEO is at least talking-the-talk of strong compliance and risk management. The Senteniel fraud has come to light very early in her tenure, so the fraud occurred during her predecessor's tenure (although the new CEO was on the Board at the time) , and the unearthing of the fraud may have been hastened by the new CEO's arrival and increased compliance focus.
- Although they haven't paid dividends, they are using some of their accumulated $72m in cash for a $20m buyback in FY23, which is the equivalent of a 7% yield given the current depressed share price. It's a strong sign they see their current share prices as a strong investment.
- My bull case valuation assumes recent compliance failures dry up. Their historical 5-year CAGR is an impressive 32%, so my bull case assumes a not-overly ambitious 15% CAGR for the next 5 years. If they can get through FY27 with 15% NPAT (which is their current underlying NPAT), undertake another round of share buybacks, and the market gives them a PE of 30 (reasonable for a highly profitable company growing 15% pa), the market cap would be $2.3b, more than 7x current cap.
The future for EML is highly uncertain and likely very volatile. I think my bear and bull cases are equally plausible. But for me, because the upside is so big (could quite possibly be a 5 bagger in the next 5 years), I'm willing to take the risk of an equally likely outcome of share price halving over next 5 years. If I assign equal probabilities to my bear and bull cases I get a valuation in 5 years of (.5 x $2.3b) + (.5 x $170m) = $1.2b which gives a risk-adjusted 30% pa return. I need a big return (eg, 20%+) to be interested in EML given their volatile history, but 30% risk-adjusted ROI is enough for me to stay interested.
My thesis assumes EML can hit the following milestones:
- The first half of FY23 will be messy, with the ongoing PFS/CBI and Senteniel issues. But I'll be looking for green shoots in the second half, with these issues being bedded down and nothing new and overly significant cropping up.
- Increased costs will be a strain on margins in FY23, so I'll be happy with 10% revenue growth and 5% NPAT.
- Beyond FY23 I need to see at least 10% pa growth and 10% NPAT.
