River Capital Growth Fund ANNUAL INVESTOR LETTER 30 June 2010 Following the significant economic instability experienced during the 2009 financial year, the last 12 months returned to a more positive economic growth and corporate profit environment. However, like many investors, we remain particularly cautious on the medium term outlook. We expect the businesses that we follow in developed countries to grow more slowly than in the last decade as a result of higher taxes and a more limited and expensive supply of credit. In the twelve months to 30th June 2010 the unit price of the River Capital Growth Fund ( the Fund ) has increased by 18.5%, following a rise of 8% for the 2009 financial year. This return was achieved while holding an average cash balance of 50% during this period. Over the corresponding period, the Australian All Ordinaries Accumulation Index increased by 13.8% after declining by 22% in the preceding year. Over the course of the last twelve months we have continued to deploy capital into good quality, economically-resilient businesses at prices we considered attractive. This has seen our cash balance decline from 65% of the Fund s value to approximately 40% by year end. We continue to be disciplined in setting appropriate price targets for our purchases, with a strict focus on the uncertainties ahead. Our performance for the 2010 Financial Year The gain for investors for the 2010 financial year was 18.5%. Profits were $26.9 million. We started the financial year with unit price of $1.73 per unit. By 30 June 2010, our unit price had increased to $2.05 per unit. River Capital Growth Fund 18.5% All Ordinaries Accumulation Index (including dividends) Small Ordinaries Accumulation Index (including dividends) 13.8% 11.2% Any financial product advice contained in this report is general advice only. Any such advice has been prepared without taking into account your objectives, financial situation or needs. Accordingly, before acting on this advice, you should consider whether the advice is appropriate having regard to your objectives, financial situation and needs. Full details of remuneration and other benefits received by River Capital Limited (ACN 073 531 469) AFSL 237985, its Directors, associates and any related body corporate are contained in the Information Memorandum dated 1 May 2008. Please note that past performance is not necessarily a guide to future performance.
Results for the 14 years that the River Capital Growth Fund (and its predecessor fund) has been in operation after all Fund expenses but before performance fees are: Financial Year Ending River Capital All Ordinaries Accumulation Index (dividends included) River Capital Compounded Value of $100,000 Investment All Ordinaries Accumulation Index Compounded Value of $100,000 Investment 30-Jun-97 30-Jun-98 30-Jun-99 30-Jun-00 30-Jun-01 30-Jun-02 30-Jun-03 30-Jun-04 30-Jun-05 30-Jun-06 30-Jun-07 30-Jun-08 30-Jun-09 30-Jun-10 47% 4% 23% 74% 7% 28% 10% 56% 25% 34% 49% -31% 8% 19% 27% 1% 14% 17% 9% -5% -1% 22% 25% 24% 30% -12% -22% 14% $147,000 $152,880 $188,042 $327,194 $350,097 $448,125 $492,937 $768,982 $961,227 $1,288,045 $1,919,187 $1,324,239 $1,430,178 $1,701,910 $127,000 $128,270 $146,228 $171,087 $186,484 $177,160 $175,388 $213,974 $267,467 $331,660 $431,158 $379,419 $295,947 $337,380 Our Activities in the First Half of the 2010 Financial Year Key portfolio holdings as at 30 June 2010 and the primary contributors to the full year result are provided in the Portfolio Composition Table below: Portfolio Composition Strategic Investments IOOF Iress Consolidated Media Ramsay Health Care ASX Rightmove PLC Cash Converters REA Group Reckon Navitas Restaurant Brands NZ Webjet Invocare M2 Telecom Super Cheap Auto Group Kathmandu Holdings Credit Corp Jetset Travelworld Primary Health McMillan Shakespeare Other Portfolio Weighting as at 30 June 2010 % 5.4 4.7 4.0 3.5 3.4 3.3 3.1 3.1 2.6 2.4 2.3 2.2 2.2 2.0 2.0 1.9 1.8 1.7 1.6-6.5 59.7 Contribution to Profit/(Loss) $m 3.3 1.7 2.4 1.2 (0.8) 0.9 3.1 2.7 2.2 3.1 0.2 0.8 0.3 1.7 0.3 0.0 0.9 1.0 (1.9) 1.5 1.4 26.0 Contribution to Profit/(Loss) % 2.3 1.2 1.7 0.8 (0.5) 0.6 2.1 1.9 1.6 2.1 0.2 0.6 0.2 1.2 0.2 0.0 0.6 0.7 (1.3) 1.0 0.8 18.0 Event Driven Investments Cash and other 1.0 39.3 1.0 3.4 0.4 2.1 Management Fees (3.5) (2.0) Total Return net of Fees 26.9 18.5-2 -
Key Fund Metrics (excluding cash holdings ) FY 2011 Price Earnings Ratio 13.0x Dividend Yield (post tax) 5.20% Cash Flow Yield* 6.50% * Means free cash available after interest, tax and normalised capital expenditure A Guide to Interpreting Our Results The Statement of Financial Performance attached to the back of this letter illustrates the breakdown of our $26.9 million in profits. You will note that the three main revenue contributors are: 1. Unrealised Gains in the net value of investments - $10.9 million, 2. Net Realised Gains $10.8 million; and 3. Interest, Dividends and other Fees - $8.8 million. The nature of our investment strategy and approach will mean that a significant proportion of our profits should continue to be derived from the movement in the net value of our investments (i.e. unrealised gains). Strategic Investments Key Contributors and Detractors Pleasingly, the positive contribution to performance over the period has been evenly distributed across a number of our key holdings. Financial Services Our financial services investments, particularity IOOF and Iress, have performed exceptionally well. We took the opportunity to add to both of these positions during the year and feel that current valuations and underlying growth profiles bode favourably for both of these businesses. Our detailed views on IOOF and IRESS have been included in previous investor reports. While the capital value of our investment in ASX has remained unchanged during the year, we remain excited about its prospects. The share price has been weighed down by the pending entry of new competitors within its equity trading business, however having undertaken a significant amount of work on both the ASX and its global peers, we feel the downside from an earnings perspective is minimal. The vertically integrated structure of ASX s business model means that the earnings stream is robust and extensively shielded from competitive impact. We currently earn a 6.5% fully franked dividend and expect the earnings to be significantly higher in five years time. We will take advantage of any negative news-flow over the next 6-12 months to add to our current position. We have also continued to reduce our exposure to Cash Converters. We have chosen to do this in a measured way and this has paid off with a significant increase in the share price during the year. Importantly, while regulatory issues remain, the operating performance of the business continues to be strong, with Cash Converters adding to its franchised and company owned footprint in both Australia and the UK. - 3 -
Healthcare Services Our investment in Ramsay Health Care has played out in accordance with our expectations and its contribution to the Fund s FY10 performance has been pleasing. Importantly, with favourable industry dynamics, a dominant market position and a disciplined and strategic expansion programme, we are expecting Ramsay to grow it s after tax profits by 10%-15% for the next few years. We feel that paying 12 times after tax earnings provides a good margin of safety on this investment. Our view is that the intrinsic value of this business materially exceeds its current share price. On the other hand, Primary Health Care has detracted from the Fund s investment performance during the current year. The magnitude of the Government s funding cuts to pathology together with the impact of competitive forces has clearly unnerved some investors. We consider these to be short term issues that do not reduce our enthusiasm for this healthcare business which specialises in general practice, pathology and radiology. Of course, we will continue to monitor the regulatory changes and their impact on our investment thesis. Media/Classifieds REA Group has delivered exceptional share price performance in a short period of time. It remains a high quality franchise (capable of growing its earnings by at least 20% pa over the next few years) and a real standout in the Australian online space. Prudently, we did take the opportunity to realise some of our gains in this investment as valuations began to outpace the strong fundamental metrics of this business. Importantly, we used the proceeds from our REA investment to fund our investment in Rightmove PLC (refer to the New Investments section of this letter). River Capital has been an investor in Consolidated Media for 2 years. Our average in cost is approximately $2.80. The current share price is $3.30. During this time we have also received dividends of approximately $0.45. Both James Packer and Kerry Stokes have increased their respective holdings in Consolidated Media by not participating in recent share-buyback programs. We are of the view that the underlying assets of Foxtel and Fox Sports will ultimately be acquired. In the absence of an acquisition, we continue to view Foxtel and FoxSports as best in class assets and believe that the organic growth potential provides limited downside to this investment. Other Essential Services Our investment in education services provider Navitas has proved very rewarding. The underlying business continues to perform soundly and management are cautiously implementing the foundations for the next phase of their international expansion. While we have recently begun to reduce our exposure to Navitas, with high prices being offered to us, our stake still remains a material component of the Fund s portfolio. Likewise, Reckon continues to be a core holding in our Fund. This investment has delivered a material contribution to performance over the last 12 months. We remain confident in the exceptional management team leading this business, which has a history of strong profit growth, high returns on capital and a very defensive recurring earnings stream. Micro Caps The investments made in both M2 Telecommunications Group and Credit Corp, have delivered solid results. While we only allocated 1% to 2% of the Fund s capital to each of these investments, their contribution to the Fund s overall performance has been significant. - 4 -
Strategic Investments - New Investments or Significant Increases Since our half year letter we have made a number of new investments and added to some existing positions with the highlights being Rightmove, Super Cheap Auto Group, Restaurant Brands, Centrepoint Alliance and Kathmandu. Rightmove Over the last 6 months we have allocated 3.3% of the Fund s capital to acquiring a stake in this business. This investment has motivated us towards our best of breed approach. Rightmove owns the dominant real-estate classifieds portal in the U.K. The opportunity was identified as part of our due-diligence on REA Group. Rightmove has many of the same characteristics as REA with a similar growth profile and payout ratio, but is 25% cheaper. We are confident that through product innovation and pricing power, Rightmove should achieve at least 20% pa profit growth over the next 2-3 years. Our purchase price, at 15 times after tax earnings, provides a reasonable margin of safety and compares favourably to global peers and similar on-line businesses in Australia. Super Cheap Auto Group Super Cheap is a business that we have been closely monitoring for over 3 years. In that time, we have developed an excellent relationship with the management team, and an in-depth understanding of the business. Super Cheap is one of the largest specialty retailers in Australia. It operates a portfolio of retail brands including Super Cheap Auto, Boating Camping and Fishing (BCF) and Goldcross Bikes. A fourth concept was recently added through the acquisition of Ray s Outdoors. Across the group there are approximately 400 retail shop fronts, generating over $1.1 billion of sales and $76 million of pre-tax profits. Through a measured store roll-out program, re-investment in the existing store footprint, and continuous improvement in inventory management, we remain confident that our investment in Super Cheap will provide significant gains over the next 3-4 years. In assisting the funding of the Ray s Outdoors acquisition, we have allocated approximately 2% of the Fund s capital to Super Cheap. As we become more comfortable with our 2011 profit forecasts, we anticipate adding to our existing position. Restaurant Brands Restaurant Brands owns the master franchise licence in New Zealand for KFC, Pizza Hut and Starbucks. Over the last 2 months we have allocated approximately 2.3% of the Fund s capital to acquiring an initial stake in this business. We anticipate continuing to increase our position in the coming year. Restaurant Brands generates the bulk of its profits from its network of 87 company owned KFC stores. Under the stewardship of a new management team, the KFC business has undergone a significant transformation over the last 3 years, with approximately 50% of the network extensively renovated/upgraded. The objective over the next 3-5 years is to continue with the store transformation process and grow the existing network from 87 to 110 stores. The economics of an individual KFC store are very compelling and we are confident of management s ability to execute their strategy. - 5 -
We believe that investing in a business trading on a pre-tax dividend yield of 13%, provides our investors with a reasonable margin of safety. Furthermore, we are confident that Restaurant Brands will achieve earnings growth of at least 15% pa over the next 2-3 years. Centrepoint Alliance With Centrepoint Alliance we were presented with the opportunity to back a high calibre manager in Tony Robinson, with a proven track record of creating shareholder value. In its current form, Centrepoint Alliance is a cash box, with close to $0.20c per share in cash on the balance sheet. We have committed $2 million dollars at $0.14 per share to acquiring a 10% stake. By buying $0.20 of cash for $0.14, we believe that we have protected our down-side. The opportunity however resides in identifying and acquiring a platform asset and being part of a broader growth strategy. Significant progress has been made on this front, with Centrepoint Alliance having recently announced its intended merger with Professional Investment Services, one of Australia s leading independently owned networks of financial advisers and accountants. Kathmandu Holdings As communicated in the March quarter investor letter, we have made an initial, albeit small, investment in Kathmandu. We have high expectations for its store rollout program and the recent half year report suggests that the company is on track to achieve these expectations. We are continuing our due diligence on Kathmandu with the hope of adding to our existing position. Strategic Investments - Divestments or Significant Reductions As mentioned above, we have taken recent share price strength to reduce our exposure to Cash Converters, REA Group and Navitas. We have also exited our investment in McMillan Shakespeare. Preferred Trust Securities Tier 1 Bank Debt As provided in our half yearly report, our strategy of investing in subordinated debt securities issued by the major Australian trading banks played out as expected, with the majority of our holdings either being redeemed at face value, or sold at prices approximating face value. The recovery of the acquisition discounts together with the receipt of coupon payments provided returns to the Fund in excess of 20% pa on capital employed. With more normalised returns ( approximately 9% - 12% ) currently being generated on investment grade credit securities, we have not sought to add to our residual holdings at this time, as such returns are below the targeted returns for the Growth Fund. However, for those investors who do wish increased exposure to investment grade credit opportunities (both domestic and global) which we believe will generate fully hedged returns at the above mentioned levels, the recently launched River Capital Credit Fund is open for subscription on a monthly basis. Enquiries for the River Capital Credit Fund should be directed to our Head of Credit, Josh Ackman on (03) 9825 5111 or via email to josh@rivercapital.com.au Event Driven Investments During the current financial year, we generated approximately $1m in profits from event driven opportunities, such as merger activity and institutional placements. Given these investments are opportunistic by nature, they will continue to only consume a minimal amount of the Fund s equity and we do not expect to hold any of these investments for the long-term. - 6 -
Outlook for 2011 Financial Year A combination of sovereign debt problems in Europe, concerns of a slowdown in the Chinese economy and a number of profit warnings, triggered a major equity sell off in the last quarter of the financial year. We expect to see this volatility continue as Australian analysts reduce their 2011 and 2012 financial year profit expectations. Given our long term investment horizon, we believe that downward earnings expectation adjustments and increased market volatility will provide an excellent buying opportunity for the Fund. We retain a relatively low exposure to stocks which require a strong economic growth environment to justify their current share prices, and have identified a number of opportunities where earnings growth can be achieved in spite of a weaker economy. Although it is difficult to predict what the next 12 months or 2 years will hold for us or the investment community, our investors can be confident that we will continue to seek out businesses that we believe will generate a mix of dividend and capital growth. The opportunity to acquire businesses with sound balance sheets and attractive growth profiles continue to exist, despite market nervousness and volatile trading conditions. Finally, we would like to thank you all for your continued support and encouragement and look forward to seeing as many of you as possible at our Annual Investor Meeting, which this year will be held towards the end of September. Warm regards, Barry Carp Managing Director James Davis Executive Director - 7 -
Unaudited Income Statement for the Financial Year ended 30 June 2010 2010 $ 000 INCOME Dividends 4,309 Interest 3,496 Other income 989 Unrealised changes in the fair value of investments 10,945 Realised gains /( losses ) on disposals of investments 10,833 TOTAL INCOME 30,572 EXPENSES Investment management fee Other expenses 3,512 196 TOTAL EXPENSES 3,708 PROFIT ATTRIBUABLE TO UNITHOLDERS 26,864 Unaudited Balance Sheet as at 30 June 2010 ASSETS Cash and Other Preferred Trust Securities / Fixed Income Strategic Investments Event Driven Investments 2010 $ 000 69,509 4,407 101,076 1,698 TOTAL ASSETS 176,690 NET ASSETS ATTRIBUTABLE TO UNITHOLDERS 176,690 TOTAL UNITS ON ISSUE (actual number) 86,033,304 UNIT PRICE (actual price) $2.05 1 Notes: 1. This is the unaudited cum distribution price. - 8 -
River Capital Growth Fund Key Dates for 2010 Financial Year End Item Anticipated Date Month/Year End Unit Price (unaudited) 7 July 2010 Ex Distribution Price (unaudited) 9 July 2010 Annual Investor Meeting (see below) September 2010* Distribution Payment Date 27 August 2010 Distribution Reinvestment Processed 27 August 2010 (Effective 1 July 2010) Annual Taxation Summary Issued 27 August 2010 *In relation to the Annual Investor Meeting indicatively scheduled in September 2010, we will confirm specific details as to the time and location under separate notification. - 9 -