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Our investors as well as those who follow our newsletters will know that at Arysteq Asset Management we follow a defined investment process. A process that includes the quality test that we apply in order to determine whether a company is sound enough to be added to our portfolios (or should continue to be held).
Our investors will likely also know that there are three components to this quality test: Management, Business, and Financial Quality. What some investors may not be aware of is the additional weight we place on Management Quality when performing this test.
The areas that we assess within this section of the quality test include
This came to the fore in our recent decision to offload Prosus from our portfolios. After detailed analysis and consideration, we reached the conclusion that the company ceased to meet our minimum requirements in terms of quality of management. In this article, we explain why.
Prosus may be a familiar name to those who follow the South African stock market. The group was spun off from Naspers in 2019 and essentially holds all of the international internet assets previously held by Naspers. It is considered one of the largest technology investors in the world and is also well known for its successful investment in Tencent.
Since Naspers’s US$32.0m investment in Tencent back in 2001, the Chinese company has grown into a technology and entertainment giant with a particular leadership in gaming. To place their leadership into context, in 2021, Tencent was the highest-grossing gaming company worldwide. (see Figure 1). The market value of this behemoth as at 26 September 2022 is US$346.2bn.
Figure 1: Gaming revenue of leading public companies worldwide in 2021 (in US$bn) – Source: Statista
Additionally, Tencent-owned titles such as Clash Royale, Clash of Titans, Honor of Kings and PUBG Mobile, regularly place among the top 10 most used gaming apps worldwide on Apple’s App Store (in February 2022 for instance). Such is Tencent’s size and success, that it has become by far and away, the largest contributor to the fortunes of Prosus.
In terms of how much each subsidiary, affiliate or segment contributes to the group’s overall profit (i.e economic interest), in 2022, Tencent actually brought in a higher trading profit than the entire group earned from all operations (this owes to the fact that many of Prosus’s investments are currently loss-making) (see Figure 2).
Figure 2: Trading profit per segment or business (in US$m) – Source: 2022 Annual report
Looking at this from a net asset value basis, the current 28.0% stake held by Prosus in Tencent, worth US$96.9bn as at 26 September 2022, makes up 75.2% of the entire group’s net worth.
As the above would suggest, it is a fair conclusion that the success of Prosus and Tencent are largely intertwined. Moreover, that the last thing long-term investors would like to see is management selling off the group’s stake in this golden child.
However, this is exactly what management has embarked on. In June 2022, shortly after the release of the group’s financial results, management announced an open-ended and unlimited program that would entail repurchasing Prosus shares from the market using proceeds from incremental sales of the group’s holding in Tencent.
This is management’s plan to “unlock value” for shareholders and eliminate the discount between the underlying value of each Prosus share (made up primarily of the investment in Tencent) and the price at which these shares trade currently.
It would not be an exaggeration to say that closing this discount has been the bane of management’s existence since even before Prosus came to be. As a matter of fact, this was one of the key reasons why Prosus was unbundled from Naspers in the first place.
Years on, the only true benefactors of this unbundling thus far have been the investment bankers who were involved in structuring the unbundling, and management. Bob Van Dijk (CEO) and Basil Sgourdos (CFO) received approximately US$403.4k between them for their efforts in the listing of Prosus. Meanwhile, it is the shareholders who essentially have had to foot the bill. From the date of listing, up until 26 September 2022, Prosus has provided a total shareholder return of -18.1%. Over the same period, Naspers shareholders for their troubles have earned a “slightly better” -2.9% return.
There are various theories as to why this discount has proven to be so stubborn and rendered management’s attempts futile. However, one of the key factors is uncertainty over the potential value of the group’s remaining assets.
In our view, share repurchase programs are in themselves value-accretive to shareholders. By decreasing the number of available shares on the market, the relative ownership stake of each investor that remains, increases. Share repurchases also have the effect of offsetting the impact of employee stock option plans.
However, we see it to be counterintuitive to fund this creation of value by disposing increments of largely the only business that can be trusted to continue generating value for Prosus. i.e. Tencent. This poor capital allocation decision, in our view, is further compounded by the fact that the decision to sell takes place at a time when Tencent shares are some way off their previous highs.
As at 27 June 2022 (i.e when the decision was announced to sell Tencent shares), Tencent shares were trading 51.1% lower than their all-time highs, and 32.1% lower than at the start of the year. Poor timing in our view.
To touch on the uncertainty that has been highlighted over the value of its other assets, were one to look at the group’s financial results for 2022, one would find that the only segments or key businesses to have been profitable were Tencent, VK and the Classifieds segment. Extend this to 2021 and Etail aside, it is the same reading.
Unfortunately for the group, VK and the Classified segment both carry a story to them. The group has had to fully impair its investment in VK, owing to a significant decline in the stock’s price as a consequence of the London Stock Exchange’s decision to suspend trading of VK shares on 3 March 2022. The Russian online social media and networking service company was just one of many companies to bear the consequence of the Russian invasion of Ukraine.
The group’s “Classifieds” segment, which includes a 99% shareholding in OLX Group, on the other hand still stands and has gone from strength to strength, almost doubling its revenues in 2022 (US$1.6bn to US$3.0bn). However, it still only reported a measly trading profit of US$25m. This obviously pales in comparison to Tencent’s contribution of US$6.3bn.
Despite management’s optimism, the group’s Food Delivery segment consisting of iFood, Swiggy, and Delivery Hero, fares substantially worse. The food delivery industry is notoriously competitive, characterized by high customer acquisition costs and low margins. Delivery Hero’s gross margins since 2014 reflect as much. (see Figure 3)
Figure 3: Gross margins of Delivery Hero since 2014 (in %) – Source: Bloomberg/Arysteq
Revenue from the food delivery segment doubled in 2022, compared to the prior period. This was underpinned by a 53% growth in total orders received. However, rather bleakly, as revenue doubled so did the trading losses incurred. The segment suffered a US$724.0m loss compared to the US$355.0m loss in 2021. Even Uber Eats, despite the advantage of a legacy of customers acquired through Uber’s mobility business, has continuously failed to break even.
The cloud of uncertainty hovering over these other investments thus makes this particular repurchase scheme even more unattractive for us and adds to a history of non-value-adding capital allocation decisions.
Another aspect of management quality that we found unfavorable for investors, is the remuneration structure. The group aligns its remuneration practices with that of the global technology landscape, rather than with its Dutch peers. The group notes companies such as Amazon and Alphabet in its peer group, which leads to rather interesting observations.
For instance, with a basic salary of US$1.4m, Bob van Dijk, the CEO of Prosus, earns more than 70% of that earned by the CEO of Alphabet. However, as you would imagine, Alphabet generates substantially more earnings than Prosus. (Alphabet generated US$76.0bn in profit in 2021, compared to Prosus’s US$18.7bn in 2022). If remuneration is to be benchmarked against global heavyweights, we would expect performance akin to that of global heavyweights.
The remuneration report released by management in June 2022 also revealed a slight change to the policy for the 2023 financial year. Craig Enenstein, as chair of the Human Resources and Remuneration Committee, announced that the committee would be “materially increasing the CEO’s and CFO’s short-term variable compensation exposure to the reduction of the discount”. In simple words, the top two decision makers within the group will be highly rewarded for closing the discount on Prosus’s current market value.
If the group is successful in reducing this discount, Bob van Dijk, stands to earn US$3.5m in short-term incentives (R61.4m at an exchange rate of US$1/R17.61). This will represent 53% of the CEO’s total remuneration for the 2023 financial year. The CFO will receive US$2.0m as a reward. (see Figure 4)
Figure 4: CEO and CFO target FY2023 remuneration of (in US$m) – Source: 2022 remuneration report
These incentives have the effect of misaligning the interests of those at the heart of this company from the interests of long-term shareholders. We view this structure as rewarding short-term gains at the expense of long-term value. A stark contrast to Koos Bekker’s reign as Naspers’s CEO, where he earned no guaranteed remuneration and had his entire interest from the group entirely linked to the group’s share price and long-term value accretion.
All of this is merely an add-on to the complication that already surrounds this business. With three separate share classes, the group has a convoluted share class structure that almost comically summarises to the simple conclusion that Naspers is the dominant shareholder.
The company’s controlling interest of 73.6% emanates from a combination of the 1.1 billion B shares it holds (all B shares in issue) and the 1.2 billion N shares also owned (roughly 57% of all N shares on offer). This leaves other shareholders with non-existent influence on the key decisions of the business, including the group’s policies on ESG and remuneration.
To add further entanglement, Prosus holds 49% of the publicly listed shares of Naspers, meaning that Prosus has indirect exposure to itself. Such is the intertwinement that both parties had to agree on a “cross-holding arrangement” that deals with how distributions between the two groups will be managed.
Unfortunately, a shareholder has this to contend with whilst only being entitled to a negligible dividend yield of 0.25%. Shareholder returns are thus currently completely reliant on growth in the group’s portfolio of assets. All these considerations collectively led us to the decision to sell our positions in Prosus and pursue other more value-accretive, less complex opportunities on the SA bourse.
As always, we trust that our process has led us to the correct decision!
