Income Statement Review – Somero Enterprises

Continuing from the previous look at Somero’s balance sheet, I will now review the income statement.  Much of the analysis is extremely simple and easy to follow – I am simply looking, like most, for companies with good revenue and profits, low cost structures and apparent consistency in earnings.  Further, I like to consider what proportion of operating expenses are likely to remain level, allowing some insight into the forward relationship between the top and bottom lines.  The sustainability of forward earnings should also be considered but this information is not gleaned from the income statement which is, by nature, a backward looking statement.

Revenue and Consistency of Revenue

Over the past few years, since 2011, revenue has risen steadily and convincingly.  The growth rate in revenue since then has been not far off 30% – while this is certainly impressive, I think that it is prudent not to assume that this will continue.  That said, as mentioned in an earlier post, management intend to double 2013 revenue by 2018, so at least they are optimistic about forward earnings growth.

Looking back a bit further, the longer term trend in revenue is very revealing of the key flaw in this business model.  Like all construction business’s, it depends on construction demand for it’s revenue; if people aren’t building more warehouses or car parks, then Somero’s services are essentially useless.  We saw revenue fall before, and more recently have seen it rise on the back of an economic recovery, forcing me to classify it as cyclical in nature.  This analysis of revenue trends has reinforced my earlier thoughts and I believe the business to be very sensitive to a down turn in the US or Chinese economies in particular.

Cost Structure

First up is cost of sales, at $27m this year vs $59m in revenue, the business’s gross margin currently sits at 54%.  This is a stunning number in my view and just goes to show the extent of the value added by Somero’s manufacturing process – any process that takes raw inputs and doubles their value is worth taking note of.  In 2013, gross margin was 52%, in 2012 it was 49% and in 2011 47%, demonstrating that, over the past few years, Somero have been able to consistently improve production efficiency.  Whether this trend will continue is not clear but it would appear that a gross margin of around 50% can be reasonably expected.

Operating margins are certainly interesting here too.  While currently sat at an impressive 21%, they were only 14% in the prior year, 4% in 2012 and -8% in 2011.  It is important to note that during the same period where gross margins have steadily improved, operating margins have increased at a far faster rate – how could this be?  The answer is, of course, the business’s cost structure.  Operating expenses themselves are actually relatively consistent across the four periods I have examined here, starting out at $12m in 2011 when revenue was $22m, and ending up at $19m now that revenue is $59m.  Therefore, for a 2.7x increase in revenue, the business has only incurred a 1.6x increase in operating expenses.  Clearly the business is able to grow the top line without a fully proportionate increase in operating costs, a situation that has good implications for the future.

Forward Look at Margins

Sadly, Somero does not opt to provide a more detailed breakdown of what makes up operating costs, so we will have to make do with the three lines presented in the income statement itself.  The three elements presented are selling expenses, engineering expenses and general and administrative expenses.  All three appear to contain elements of variable cost, but within these costs must lie fairly significant fixed or semi-fixed costs in order for the disparity between the growth in revenue and the growth in expenses to make sense.  From the calculations above, we would expect operating expenses, on a purely variable basis, to have risen to $32.4m ($12m x 2.7) since 2011, meaning that Somero has effectively realised a saving of approximately $13.4m in the current year due to efficiencies of scale.

From this, it would appear that Somero is highly sensitive to the scale of its operations, with the break even point in revenue seeming to lie at around $25m, or a little under the half way point between 2011 an 2012 revenues.  For every dollar of revenue earned beyond this point, Somero will likely realise progressively higher operating margins and therefore, ultimately, higher net profit margins too.

Of course, the cost structure itself can change and indeed will do soon.  A look at the subsequent events note (found at the back of the accounts) reveals that the company is currently in the process of acquiring land to build a new global head office.  This can affect operating costs in numerous ways, with increased charges relating to costs such as depreciation, business rates and even electricity usage coming into play.  Overall however, assuming that revenue grows as planned, it would seem that the business will be able to at least maintain current operating margins, and that it is fairly likely to improve them further still.

Concluding Thoughts

Overall, I am really impressed by Somero’s income statements and it seems to exhibit all the hallmarks of a sustainable, growing and increasingly profitable operation.  In particular, I like that the business displays such excellent gross margins while also keeping operating costs under control.  It would not have been the first time had the business neglected cost management in pursuit of contracts wins and r&d.

Somero have displayed excellent discipline and a thorough understanding of what leads to shareholder value creation over time.  At this point, I am very tempted to buy but must first do my due diligence on the management team, perform a discounted cash flow valuation and then have a final run through the checklist questions to be sure I’ve not missed anything obvious.

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At the time of writing I do not hold a position in Somero Enterprises – LON:SOM

It is important to note that all opinions expressed in this piece are the opinion of the author only and do not, in any way, constitute investment advice.  Any individual seeking to make investments of any kind should conduct thorough proprietary research so as to fully understand the risks they are taking.