Despite turbulent global stock markets, the Forager International Shares Fund has had a good year thus far. Partly that’s a result of a significant increase in the price of Betfair. It’s also because our thesis on small Austrian stock Kapsch TrafficCom AG has been hitting some milestones.
It was only February when we first acquired shares in this global leader in the manufacture, installation and operation of electronic toll collection systems. With share price appreciation and a few additions, it has become one of the Fund’s largest holdings.
Recapping the Kapsch thesis
The investment thesis was highlighted in detail in the Forager International Shares Fund March 2015 Quarterly Report. To summarise, the business consists of two main divisions.
Road Solution Projects (RSP) focuses on new builds—selling and installing the equipment that goes into new or newly automated toll roads around the world.
Services, System Extension & Component Sales (SEC) is focused on the operation of existing systems where Kapsch won the operating contract—the most important ones being truck-only tolling systems in Poland, Austria, Czech Republic and Belarus—plus the sale of tag toll units to road operators around the world.
More than 80% of Australian toll roads utilise some Kapsch equipment on the gantries that sit over the road (that would be RSP revenue). And there’s a good chance that the tag toll that sits in your car was made by Kapsch—the company has supplied 8 million such units to Australian drivers over the past few decades (recurring SEC revenue).
The latter division is the crown jewel, with both operations and on-board unit sales tending to be predicable, long term contract-based businesses offering high margins (20%+). The RSP division, in contrast, used to grind out a small profit or small loss each year, an acceptable result given that much of the work done in this division leads to reliable high margin work for services division. This is not atypical, it’s a grander scale version of the razor-razorblades model or printer-cartridge model all analysts keep in their mental toolkit.
But the past few years have seen losses from the division grow. Kapsch had geared up operations to win more new truck tolling systems in Europe, and those contracts failed to materialise for numerous reasons, mostly outside the company’s control. Revenue collapsed and, more importantly, losses blew out to about €50m annually. For three years, losses in RSP masked much of the profit being generated in SEC.
The stock fell from more than €70 in 2011 to less than €20 in late 2014. Anyone could see that SEC was as valuable as ever. Concern focused on the newbuilds business, and the stockmarket priced Kapsch as if large RSP losses of 2012-15 would continue almost indefinitely.
We felt the evidence suggested that RSP wasn’t losing (much) on the contracts it had won, rather its cost structure was inappropriate in light of the contracts it hadn’t won. That was a solvable problem, and indeed CEO Georg Kapsch (his family is the majority shareholder in the company) was already working decisively to solve it at the time of our purchase. The focus had shifted to the company’s cost base.
Investment case playing out to plan
Fast forward half a year and the first substantial piece of the puzzle fell into place with the company’s first quarter results released last month. We rarely put reliance on any one quarter’s profitability, but last year’s cost cutting seems to be paying off. RSP losses shrunk, and annuity profits from SEC grew. Additionally, the company announced some important new contracts around that time.
The first win is a more than 25% increase in the size of the Belarussian network, the second such expansion in as many years. Some roads run by the Belarus government that were previously untolled will now be incorporated into the truck-tolling network.
Kapsch will install the equipment, generating revenue and, hopefully, small profits for the RSP segment. And then it will collect additional, high-margin revenues on the operating contract, which runs until 2033. It’s a good incremental win, and won’t be the last such addition. While doing business in Belarus naturally entails risk, it’s worth noting that Kapsch is an important revenue generator for the government, maintains few assets in the country and is paid in Euros.
So the thesis behind our investment in Kapsch is that the market was myopically extrapolating recent bad news from the RSP segment, and missing the turnaround already underway. Six months on, we’re even more confident in that thesis, and the stock market is starting to take note.
This investment has a wide range of potential outcomes. What we still see as the biggest real risk is capital misallocation. The truck tolling systems generates a lot of cash. But new contract wins are hard to come by, so expanding the existing business is difficult. Rather than pay out the fattest possible dividend, the controlling family wants to grow in other related areas.
Enter the budding third division, Intelligent Transport Solutions (ITS). ITS is a tech buzzword at the moment— encompassing all sorts of technological systems for urban access, dynamic parking, low emission zones, monitoring of electronic vehicle registration, traffic management and other areas. Growth in this area has entailed in-house research and development over the past 5 years, and a few acquisitions such as US-based traffic management software systems group Transdyn and, more recently, the near bankrupt ‘smart parking solutions’ group Streetline.
These have not been big dollars (or Euros) invested, but we have been hesitant about the direction. To butcher Aesop’s fable, we’d rather our investment case rest on the truck-tolling bird in hand than any potential birds in the ITS bush.
So, at the time of purchase, our downside analysis was based on Kapsch losing quite a bit of money in ITS. The upside analysis was based on them not losing so much. We spent no time trying to work out what it might look like if things actually go right—the upside can always take care of itself.
Birds in the bush starting to multiply
The second recent contract win, alluded to earlier, might cause a rethink. Kapsch announced that it has signed an agreement with the Dutch national road authority, and had received the intention to award a similar contract from its English equivalent. The two countries, through a collaborative project called CHARM, are building an integrated traffic management system for their highways.
Kapsch will deliver and install its DYNAC software in traffic management centres in each country. The software helps road authorities plan and optimism traffic flow on critical roadways under normal periods and when planned or unplanned events like lane closures or accidents distort normal patterns. Importantly, this software wasn’t even part of the Kapsch offering a few years ago; DYNAC came with the Transdyn acquisition in early 2014.
The deal will generate about €45m of revenue during a two-year installation period, and a further €15m (cumulative) of maintenance support revenue over the next 10-13 years. Considering Kapsch generated €450m of revenue last year, it’s not a game changer. But it’s not small beans either. If the CHARM project is harbinger of more ITS wins across Europe and elsewhere, perhaps it’s time to sharpen our upside estimates for the newer parts of Kapsch.
Adjusted for the recently-reintroduced dividend, the stock is up 37% on the Fund’s average purchase price. With a little luck, there’s more to come.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.