Small Cap Value Report (Fri 27 July 2018) - SDI, JUP, G4M, Vertical Integration

27th Jul '18 by Graham Neary

52 comments 12562 reads

Good morning!

After what feels like a manic week, it's nice to have a Friday that isn't bulging with news flow.

Following on from my comments yesterday on US markets, Facebook finished down 19% and is now trading at a forward P/E ratio 21x (using Stocko numbers). That's low enough to get me interested. So I'm tempted to have a dabble.

The NASDAQ fell by 1.4% yesterday, and is up by 26% over the past year (according to Bloomberg). So the end of the world has not arrived yet, despite all the scary headlines!

Today we have:

Scientific Digital Imaging (LON:SDI) - final results
Jupiter Fund Management (LON:JUP) - interim results
Gear4music (LON:G4M) - trading statement
Seeing Machines (LON:SEE) - OEM design award

Scientific Digital Imaging (LON:SDI)

Share price: 44.55p (+10%)
No. of shares: 90 million
Market cap: £40 million

Final Results

This is an acquisition group making niche scientific products.

I last covered it in January, at the interim results statement.

At the time, I said it looked fairly valued. The share price has gone on to increase by an additional 50% since then! It's making fresh all-time highs today.

My concerns have centred around SDI's increasing share count. The pace at which the share count was increasing made it extremely difficult to predict the future of the company and the likely returns for existing shareholders, in my view.

However, it has been suggested that growth in the share count is going to slow down now, and that future strategy could be more along the lines of Judges Scientific (LON:JDG) (i.e. using some debt from HSBC and internally generated cash flows to fund deals, rather than relying primarily on new equity).

Let's now take a look at these results:

revenue increases from £10.7 million to £14.5 million. 31% of the revenue growth is organic, so by my calculations the organic revenue growth is £1.2 million.
gross margin improves to c. 66% (SDI has been collecting companies that have a supplier/customer relationship, so this is unsurprising)
operating profit nearly doubles to £1.8 million, or £2.1 million before one-off costs and share-based…

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danielbird193

27th Jul '18

If you're interested in Ramsdens Holdings (LON:RFX) there are some interesting in comments on page 7 of today's quarterly investor letter from Downing Strategic Micro-Cap Investment Trust (LON:DSM). (https://www.investegate.co.uk/down-microcap-invtst--dsm-/rns/statement-re-investor-letter/201807270700049186V/)

Ramsdens is one of the eleven positions held by the fund and Downing have good access to management as they hold 15% of the shares.

abtan

Hi Graham

I dug up an email from the Scientific Digital Imaging (LON:SDI) CEO last year.
My question: "Is revenue being booked within one subsidiary, with a commensurate COS in another subsidiary?"
His response: "Yes the journal entries are though the sales and cost of sales"

I see what you're saying, but based on his response the journal entries are the same, so no impact to GM. Unless he misunderstood my question. Or I misunderstood his answer.

Cheers as always
A

Nick Ray

Interesting that you say that the Stocko Ranks "are not convinced yet" about G4M and call it a "Sucker Stock".

This time last year, G4M was a "High Flyer" but it has suffered a bit of a crash in the Quality Rank since then (because ROCE and other metrics have fallen after a previous great year.)

Maybe calling G4M a "sucker stock" now is a bit harsh at this point though!

Andrew L

Scientific Digital Imaging (LON:SDI) - Good to put in a ROCE calculation in there. I would personally also add in the long-term average ROCE that the company has achieved. This is because ROCE is a "flow measure" rather than a measure for one year. I.e. we are interested in the long-term ROCE rather than one year's ROCE.

Secondly, I also do ROCE without goodwill to get an idea of the underlying franchise of the business. So you have an ROCE and an ROCE without goodwill. For both measures I would exclude acquired intangibles in the balance sheet and the amortisation of acquired intangibles.

Paul Hill

FYI Graham

Rather than ROCE, I prefer to use underlying "Cash Return on Capital Employed" (CRoCE) - which likewise can be lifted straight from the accounts. (CRoCE = (Adjusted operating cashflow – capex - tax paid) / (Net assets + net debt + pension deficit + Acquisition goodwill write-backs)

If it is decreasing, then you know that any acquisitions/investments are destroying value (as was the case with Tesco’s for years when it was expanding overseas). Plus CRoCE needs to be above the group’s "through cycle" cost of capital – which for say RPC plc (acquisitive plastic packging producer - as an example ) I would pitch at around 8%-10%. Hence doing the maths, RPC’s 2016-18 CRoCE appears a bit light – hence the investor skepticism. Albeit the Board are obviously hoping that this will improve going forward.

RPC plc CRoCE

Mar'18 2017 2016

AOCF £520m £414m £232m
Capex (£246m) (£180m) (£104m)
Tax (£38m) (£23m) (£14m)
Adjusted post tax cash £236m £211m £114m

Net Assets £1,920m £1,823m £894m
Net debt £1,139m £1,049m £744m
Pension deficit £197m £256m £150m
Goodwill w/back £0m £0m £0m
Capital Employed £3,256m £3,128m £1,788m

CRoCE 7.25% 6.7% 6.4%

Paul, Thanks for that. That is the same as the CROCI outlined in Phil Oakley's book I think. The only trouble with that measure is that if capex is being stepped up this may hit near-term cashflow. So the ratio may be low when in fact capex will benefit the business and lead to a higher CROCI a few years out. So I use CROCI and ROCE together. For example, I am guessing that the CROCI for Dart (LON:DTG) was not good while they were investing in these new planes and expansion.

I guess with a low CROCI you have to ask is it because of growth capex and then if this is true will the growth capex deliver. In your example for Tesco the growth capex was a failure in terms of the returns it generated (i.e. US expansion etc).

peterthegreat

My concern with SDI would be that the directors all seem to have financial or admin backgrounds which must make it difficult for them to assess the quality of the manufacturing and technology companies they are buying.
I would prefer the people running the company to have hands-on technical experience in the type of sector(s) in which they are investing. On the other hand, I suppose they could run SDI like an investment portfolio and this could be successful.

Yes ratio-investor - In the event of one-off 'growth' capex, due to say infrastructure investments, then one just needs to use a through-cycle level of spend instead - ie to see what the underlying CRoCE really looks like.

Hence understanding the returns the company is currently generating, what is likely to do under steady-state conditions and importantly how it's going to get there and when.

matylda

Scientific Digital Imaging (LON:SDI) - I appreciate and get the comment and am in agreement, however I just place my views on the simplistic level, each to their own.

DJCP

Graham,

I menioned $FB (Facebook) in yesterdays SCVR comments, and decided to jump in this morning with a very small punt on LSE:2FB. I read up on this last night, and will do some more DYOR, but as far as I can see, it's basically a 2x investment on the underlying Facebook share - it dropped >35% yesterday, as opposed to $FB 19%. Another benefit (for me), was that there is no (1%) FX charge, as it's a GBP 'stock'.

IF $FB rises 40% over the next 6 months (see my post from yesterday), then I believe my £2FB investment will rise approx. 80%.

mrfixituk41

I was forgetting market conditions when I bought as many people are doing staycations this year. Ramsdens is also Foreign Exchange. On the beach and Thomas Cook have been going down.

john652

Scientific Digital Imaging (LON:SDI) really interesting discussion here, it’s why stocko better than so many opionion sites, I would say email, or call the ceo on these points, he is very very approachable. I’d be very interested to hear his response to some of these more technical accounting questions. As earlier, I hold, and would ask myself but wouldn’t know how to quiz him.

GavSmith01

28th Jul '18

Be careful with leveraged exchange-traded products like these. They are ok for very short term trades, but they are horrible to hold for any length of time, especially on a volatile underlier. They don’t double the total performance over your holding period, they double the daily returns. Which leads to some side effects.

Imagine you buy your product at 100p. FB (at say $200 when you bought it) goes up 5pc to $210 - great! Your product now trades at 110p, up 10% because it is twice leveraged. The following day, FB sinks back down to $200 - a 4.76% fall. Your leveraged product will decline by 9.52%, that is, to 99.5p. So you have managed to conjure up a small loss despite your underlying being flat.

The longer you hold it for, the more leveraged the product is, and the more volatile the underlying is, the faster and harder this will hurt you. You’ll get nowhere near 80pc if it goes up 40pc in six months - unless it goes up literally in a perfect straight line. And this drag happens too if the stock goes down, making the losses even worse.

Taking things to extremes - if FB goes down 50pc in one day, your product becomes worthless. If FB recovers, you get none of that as your product won’t exist!

Much better to just buy the underlying.

Trigger14

Economics of vertical integration: The main economic benefit of vertical integration tends to be the elimination of the ‘double-marginalisation’ inefficiency. This arises because, when not vertically integrated, both the upstream and downstream businesses independently want to maximise profit, but neither cares about the impact that the price they set has on the other business’s profit. So if I was the downstream business I would want to set a high price to maximise my own profit, not caring that this would also reduce the demand for my supplier and their profit (and vice versa). When vertically integrated, the upstream price is internalised and I can set a single downstream price that maximises the profit for me and my supplier collectively. This price would be lower and the overall profit higher than before the vertical integration. This is why vertical mergers are nearly always good for competition, benefiting both businesses and consumers alike...

coniston

Thanks Graham for your commentary on Jup,they have also been on my watch list for a while & are likely to remain there for a while longer .One point with Fund management businesses which you are probably aware of is that they normally trade on average 3% of AUM , Mr market is being quite efficient in valuing them accordingly.

29th Jul '18

Interesting vertical integration comments. All of it is true in theory. But it might be taken to imply that companies should always be vertically integrated to boost profit margins. From an investor perspective we aren't interested in margins but the return on capital.

So Apple shareholders benefit from the group contracting out the capital intensive business of making its products. Coca-cola generally keeps the capital intensive bottlers separate from its main business. Companies that franchise out do so for the capital intensive part of their businesses i.e. Domino's Pizza.

Secondly, it is important to recognise that companies generally do better when they are focused. Fever Tree outsources out bottling and other activities. Its total workforce is relatively low. This has allowed management to be focused on its brands and product innovation.

What can work is if a supplier cuts out a distributor from the chain they can improve their margins. I.e. Amazon selling direct. Startup razor blade companies selling direct to consumers.

But is a strategy of being vertically integrated helpful? The UK pub sector used to be vertically integrated in terms of beer. This appeared to lead to less consumer innovation and focus. Wetherspoon's doesn't own any brewing businesses it just focuses on pubs and has done very well.

The trouble with vertical integration is that you lose the competitive element of being able to choose your best suppliers. You are your own supplier. Having a stream of competing suppliers can lead to greater innovation.

Heineken and C&C have bought pubs in the UK to help in terms of supplying the end customer. However, I am not sure this is such a great idea. Better to make a product that customers want at the existing pubs. It might be considered a failure if you have to buy the end consumer facing unit in order to sell your products.

Distribution is a competitive advantage which I think Diageo has. So if they own their distribution network that really helps with pubs/bars finding them easier to work with then a competitor with a weak distribution system.

Graham Neary

30th Jul '18

You're welcome - thanks for the point on Jupiter Fund Management (LON:JUP).

Fair enough abtan, thanks for elaborating your position on Scientific Digital Imaging (LON:SDI). Sounds like you've been doing a lot of quality research into it.

Although I like what I read about it yesterday, I still don't own any SDI shares. So we have that in common - still watching it from the sidelines!

Best wishes

Graham

Hi Paul - thanks for the input! CRoCE is a very cool concept. A nice explanation.

Are you saying 8-10% is the typical hurdle rate for a company to be said to have created economic value? Sounds reasonable to me. I look for something similar (>10%, say) in ROCE. If the company would get a better risk-adjusted return by investing in an equity ETF rather than making additional capex, then I would prefer if it bought the ETF!

Best wishes

Graham

Thanks. That is a bit harder then it seems surely? Estimating steady state capex. Could you just use depreciation for the steady-state capex?

Your measure is interesting as companies with large pension deficits or that do acquisitions will be penalised. Acquisitions are likely to lower returns as they will be done for a premium. This is particularly the case in the short-term given that synergies take time to come through.

Personally I like to have a a return measure with and without goodwill. Excluding goodwill gives you an idea of the returns of the underlying business irrespective if they are acquisitions or not.

Small Cap Value Report (Fri 27 July 2018) - SDI, JUP, G4M, Vertical Integration

Scientific Digital Imaging (LON:SDI)

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Graham Neary

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