First Do No Harm

Airlie Funds Management

April 2025

Management should try to not forget the hippocratic oath.

An alternative working title for this note was "management teams behaving badly", but we felt it more apt to invoke the Hippocratic oath, the cornerstone of medicine that emphasises the importance of avoiding harm to patients above all else. If we consider the 'patients' in this context as public companies, management teams across Australia would do well to consider their own Hippocratic oath to shareholders: first, don't do anything dumb. This should go without saying, and yet these past 12 months feel littered with the fallout of dumb decisions from management teams, primarily regarding the pursuit of large-scale M&A.

Is this a bit too harsh? Let's examine the evidence.

• Orora's value-destructive $2.2bn acquisition of Saverglass, which managed the cardinal sin and hat trick of gearing up the balance sheet to purchase a business off private equity in a new jurisdiction (France - not renowned for its business-friendly labour laws). Orora's share price touched $3.75 in the week before the deal announcement, and today languishes below $2;
• Viva's $1.15bn acquisition of On The Run, which was touted to add $165m in EBITDA post synergies, for an acquisition multiple of 7x EV/EBITDA, yet contributed $45m in FY24 - a true price of 26x EV/EBITDA. The deal also allowed the founders to strip out the property, saddling Viva with an $80m a year lease cost;
• CSL's acquisition of Vifor, which has so far proven a dud, torching the group's historically high ROIC >20% down to a paltry 12%;
• Healius's $300m acquisition of Agilex Biolabs, promising EBITDA of $16m and delivering a paltry $4m in its first year of ownership, prompting Healius to achieve the impressive feat of exiting the covid-era pathology funding avalanche with a balance sheet issue requiring an emergency capital raise; 
• Perpetual's disastrous $2bn acquisition of Pendal;
• Ramsay's $1.4bn acquisition of Elysium in 2022, which they funded entirely through debt. To date, the business generates barely any profit.

The most topical current example of a management team violating the Hippocratic oath to shareholders has to be James Hardie's proposed $8.75bn¹ acquisition of Azek, which we will return to later on in this piece.

All of this begs the question as to why. Why does large-scale M&A typically destroy value? The answer is because of its deleterious impact on the returns of the acquirer's business. Over the long term, a company's share price will follow the return on capital it generates. The issue with large-scale M&A is that it typically enshrines a low return on capital from day one, as the acquirer must pay a takeover premium to "win" the target.

Picking on CSL as an example, much has been made of the extraordinary de-rate in CSL shares over the last five years as the share price has gone nowhere. However, when viewed through the lens of the returns the company generates, the derate makes a lot more sense.

Source: FactSet, Airlie Research

CSL enjoyed a phenomenal run-up in its share price over the decade 2010-2020, as improving return on equity (from 24% in 2010 to a peak of 47% in 2018) drove a PE re-rate from 15x to a peak of 45x earnings. ROE has since declined to 15%, primarily due to the combination of covid-era donor fee inflation shredding CSL's plasma business gross margin, and the acquisition of Vifor, which we estimate generates a ROIC of c3% on the initial A$17.2bn invested. Hence, the derate CSL has experienced makes sense in the context of some external misfortune and some capital allocation own goals. The good news, and why we own CSL in the fund today, is that we believe incremental returns should improve from here, as gross margins improve in Behring and the company shows more discipline on capex. The value destruction from the acquisition of Vifor is a one-and-done phenomenon, which is why we are so focused on avoiding harm (dumb acquisitions) in the first place, as we believe the CSL share price would be much higher today if they had not done this deal. 

Applying this framework to the Hardie acquisition of Azek highlights the likely immediate value destruction of the deal, one that tarnishes Hardie's reputation as one of the cleanest, high-returning organic growth stories listed on the ASX. Consensus estimates have James Hardie generating EBIT of $865m for FY25, from an invested capital base of just $2.8bn, for a pre-tax return on invested capital of 32%. This is an extraordinarily high return for a manufacturing business. The $2.8bn of invested capital mostly represents the sum of the capital invested over several decades in building up the company's largest division, North American Fibre Cement, comprising 19 manufacturing plants globally, three R&D centres, the working capital tied up in the channel, and the historic goodwill associated with the acquisition of Fermacell. With the proposed US$8.75bn acquisition of Azek, a new(ish) management team (CEO Aaron Erter was appointed only twoand-a-half years ago) has seen fit to add an extraordinary $8.75bn to the existing capital base of Hardie' - a 312% increase in the company's invested capital base overnight.

Consensus forecasts have Azek earning US$270m EBIT in FY25. This would imply a day one pre-tax return on invested capital of 3% for James Hardie shareholders. For Azek to generate an acceptable return for shareholders of, say, 10-12% pre-tax, you would have to believe Azek can earn a sustainable EBIT of US$875m-1bn; that is, a trebling of the current forecast EBIT. This seems highly unlikely. If we take the earnings base of US$270m and give management the benefit of the doubt on all outlined cost synergies of US$125m, this is a $395m EBIT base. For the business to generate an acceptable return of 10-12% pre-tax, Hardie's would have had to have paid US$3.3bn-$4bn for Azek; that is, the deal looks immediately value destructive to the tune of US$4.5-5bn. Now obviously if management can achieve the outlined $500m in revenue synergies from the deal, this will offset some or all of this value destruction. However, that will be proven out over the medium to long term. Incidentally, two weeks before the deal was announced James Hardie had a market cap of US$14bn, which has fallen to cUS$10bn today - indicating the market has been quick to price in this value destruction.

Now the bigger question is where to from here - the value destruction of this deal has been spotted by an efficient market very quickly. The extent to which James Hardie "makes good" on this deal (from the new, lower share price starting point) will come down to execution. Azek is by no means a bad business, and there appears to be logic to putting these products together under one manufacturer when selling into the same US R&R channel. As with any acquisition, the long-term success will be a function of the extent to which one plus one equals something more than two. However, when you pay up to begin with, one plus one must equal something more than three for value to eventually accrue to James Hardie shareholders.

Markets are efficient, no doubt, which is why we ask (beg?) Australian management teams to adhere to the Hippocratic oath when considering M&A: first, don't do anything dumb. And we'd take it so far to suggest that most large deals, no matter what the bankers cook up regarding synergies, EPS accretion, multiple re-rates, etc., are simply dumb deals for acquirers - an immediate value transfer to target shareholders that will sit on returns and immediately torch value.

By Emma Fisher, Deputy Head of Australian Equities & Portfolio Manager

Funds operated by this manager:

Airlie Australian Share Fund, Airlie Small Companies Fund

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This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision about whether to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of an Airlie financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

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Hedge Clippings | 24 April 2025

The Election (yawn!)

Amid one of the least inspiring election campaigns from either side of politics, along with a more negative and combative approach from both the candidates and some of their supporters, the polls are pointing to what seemed an unlikely outcome: An Albanese victory just 12 to 18 months since his divisive Voice referendum.

Albo's been helped by what appears to be an irresponsible showering of benefits not only to key demographics (e.g. Students with HECS debts, and first home buyers), but also to all and sundry in the form of electricity rebates. It seems that most voters couldn't care less about the government deficit we'll all have to pay for eventually, as long as individually they don't have to pay for it now. As Paul Keating once reminded us, "in the race of life, always back self-interest, at least you know it's trying".

The televised debates have been indecisive at best, and worse still, boring and petty, with plenty of lies thrown in. Don't let the truth get in the way of a good story, and sling the mud, knowing some will stick.

But the person who seems to be helping Albo back to the Lodge more than anyone seems to be none other than Peter Dutton, with on-again, off-again and delayed policy announcements, leaving him open to claims that he's either hiding something, or hasn't decided yet. He's had three years to prepare, but was perhaps waiting for Albo to trip up - or just fall off the stage.

Figures released this week by the ABS indicated that maybe Albo and Chalmers do know where the handouts are coming from. Total tax revenue for the 2023-2024 financial year was $801.7 billion, an increase of 6.1% over 2022-23. Over the same period, CPI inflation rose 3.8%. To be fair, the Commonwealth's take was "only" up 5.1%, with the states the major culprits - Victoria (not surprisingly) leading the charge, +14.2%, followed by NSW, +11.8%, and South Australia +11.3%. At least you know one source of the cost of living crisis - governments of all persuasions were taking more of your hard-earned, with Victoria's increase almost 4 times the rate of inflation.

Remember this on the eve of ANZAC Day: Federal income tax was first introduced in 1915 as a temporary measure to help fund the war effort in the First World War. If you think that's a worry, wait until the government broadens the net on taxing unrealised capital gains, surely one of the more ridiculous proposals, even for this government.

Fund Returns:

March has recorded one of the more extreme spreads of fund returns (60%) that we have seen since the GFC, with monthly returns ranging from +25.97 % through to -35.09%. This has led to the perennial debate between active vs. passive investing, with proponents of the latter (generally the index funds themselves) highlighting negative returns from their active peers over relatively short time frames.  

For the record, the March, Year to date (January - March, basically "Trump months") and 12-month averages are as follows:

Assuming index or passive funds generally track their respective index, and the above numbers are averages across a total of 900 funds, the key takeaways are as follows:

• Investing in managed funds requires careful research and selection across both fund, strategy and asset class;
• Diversification across both fund, strategy and asset class reduces risk and volatility;
• Balance performance against volatility depending on individual objectives and risk tolerance.
• Short term performance is less important than longer-term term;

For example, the top performing Australian Equity fund (Regal's Australian Small Companies Fund) has returned 20.18% since its inception in February 2015. Over 7 years, it has returned 14.99% per annum, and 25.79% over 5 years. In March 2025 it was down 14.53%.

That level of volatility does not suit all investors, but there are plenty of funds providing 8-12% returns or more outside the volatile equity space. Research is the key!

Finally, on ANZAC Day eve, we'd like to remember those no longer with us, those left behind, and those who continue to serve.

Lest we forget.

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Funds operated by this manager:

ECCM Systematic Trend Fund

Chris Gosselin, CEO of FundMonitors.com, speaks with  Michael Poulsen, Co-founder and Portfolio Manager at Canopy Investors. 

Michael shares insights into Canopy's global small and midcap investment strategy, its long-term, quality-driven approach, and how the partnership with Bennelong enables the team to focus on delivering strong returns through concentrated, high-conviction portfolios.